Let the mailbox burn

Last week I went to a speech given by a major private equity firms COO.  He was highlighting the global economic crisis from his perspective.  (He noted that being a lawyer and not an economist he wasn’t sure why people wanted to hear him talk about it….he did a reasonable job).  But before the speech began I was discussing the new PPIP (public private investment partnership) program another attendee.  She argued that it would fail because there was bound to be fraud just like with RTC (resolution trust corporation) after the SNL crisis in the early 90s.  Given, she argued, that fraud was the underlying driver of the economic crisis, we could never get out of it by bring to life another program that would be rife with fraud.  I pointed out that although fraud facilities the crisis it was not the underlying cause (global economic imbalances) and that just because a program has a bad side affect it shouldn’t necessarily be scraped.  I noted that if the PPIP gets the financial system working so that credit is moving around (new balance sheet capacity) but some fraud occurs the net is positive.  She was insistent that this was not the case. 

To me she was letting the house burn and focusing on saving the mailbox.  Or according to Nietzsche she was engaged in the most common form of human stupidity; forgetting what one is trying to achieve. 

But she did, unknown to her, have a point.  The success of any public program, in a democratic society, that requires continuous support depends on at least the tacit support (or at least not the vehement opposition) of the program.  If fraud in PPIP undermines the federal government’s ability to respond to crisis it will have serious consequences.  To fix the analogy it would be as if the firefighters had the hose cut by an angry mob because the mailbox was burning.  Foolish but if the hose is cut the house will burn.  You could see some of this as an affect of the AIG bonus fiasco; we nearly let a few million dollars undermine the legal system which is part of foundations of a 15 trillion dollar economy.

Inflation is Your Friend!?

Inflation is a dirty word which – if you wish to increase your credibility – you will only say bad thing about it.  Here’s a small sample:

The best way to destroy the capitalist system is to debauch the currency.  By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.  – JM Keynes.

The first panacea for a mismanaged nation is inflation of the currency; the second is war.  -E Hemingway

Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man. – R Reagan

Althought these statements are fairly rhetorical, they are also reasonably true.  But, why is inflation bad?  (1) It can breakdown the price mechanism which is how resources are allocated and thus – in a sense – randomize the production system and (2) it can create transitional problem between nominal (money) and real prices which can destabilize society.  These problems emerge from having too low inflation (deflation debt spiral), or having a large change in inflation over a short period of time, or having a high (>8% annual inflation).  So the ideal of low stable inflation – which is what we shoot for – is a good middle ground. 

So why is the title of this post, ‘inflation is your friend.’  We’ll I could mean that inflation could help us get out of the real debt burden on the economy by increasing the nominal (money) price of the assets and thus decreasing leverage but what I am thinking about is inflation as a political buffer.  Consider that a large chunk of the most recent IMF recapitalization is going to go to Eastern Europe.  Why not just have Western European countries bail them out directly instead of through the IMF.  The IMF gives Western Europe political cover; the elected official in the West don’t have to answer to voters that they are bailing out Eastern Europe (which is what they are doing) instead they are sending money to the IMF.  Inflation can fill that role when it comes to the real size of government.  As long as spending grows slower than inflation (or slower than inflation and the growth of the economy) the real value (or % of GDP) value of government spending will decrease (in real terms).  Given it is pretty clear that we are incapable of shrinking (nominal) spending (would be nice but doesn’t appear that it will ever happen) because politicians view it as political suicide, inflation is our political cover. 

I’m not suggesting that we should target 10% inflation (playing with fire) but maybe we ultimately want 4/5% instead of 2%.  (There are also leverage discouraging side effect of this that may be beneficial). 

Confirmation Bias

Voltaire said ‘doubt is not a pleasant condition but certainty is absurd.’ 

Although many, if not most, people implicitly operate based on probabilistic thinking.  It is uncommon for that thinking to be pervasively explicit (systemically intentional).  Because of its implicit nature, far too often,people will behave as if the after an event has occured it was a certainty.  Now I don’t plan to argue about an all encompassing pre-destination either from a theological or Newtonian perspective; I simply don’t need to counter the argument that events are certainties.  I only have to prove that you – as an actor who knows his desires- cannot know with certainty the future and thus the best way for you to operate within this uncertain world is to act with an explicit recognition of the likelihood of events and the distributions of outcomes.   (I know there are some paths of this debate I’m not addressing but you’ll have to forgive me because for the moment that is not the point). 

With the background out of the way let’s look at one benefit of this modus operandi: an enhanced ability to change (for the better).  Beside the reality that you will be able to more quickly recognize opportunities and risks with explicitly probabilistic thinking but you will also not be embedded to a singular mindset.  You don’t have to commit inextricably to some tenant and thus feel as if you are a ‘flip-flopper’ or betraying your first love when you change your mind.  This is not a trivial problem.  Consider that fact that most people go into debates knowing which side they will choose well before anything is said. 

People will start pulling out evidence that supports their position and ignore evidence that counters it.  If that person was thinking probabilistically about the issue they have an easier time taking in new information because any information is not counter to your view but simply causes slight shifts in the estimation the probabilities or payouts (and your confidence in them). Another way to say this is, there is no emotional angst because everything is a confirmation. 

This self confirming bias is most problematic when little is known about the subject.  This failure comes from people not treating their actions around a probabilistic world with levels of confidence.  People feel uncomfortable saying I don’t know (or ideally this is what I think, but with an extremely low level of confidence). 

An example of these failures in logic is being displayed at the G-20 meeting with the reception of Barrack Obama.  He stumbled over Dmitry Medvedev and he was given the benefit of the doubt that he is not foolish (as he should be, really who cares if you can pronounce names), but I’m suspicious George Bush would have received the same treatment.  According to a graffiti artist in London, Obama has ‘good morals.’  I’m suspicious that he has (1) the right level of confidence in that statement and (2) the probabilistic nature of if that view is true.   For the U.S. this bias is good because we may be able to achieve goals that we may not have been able to achieve before and the greater the bias the longer we will be able to get away with over achievement. 

[Notes: (1) Obama popularity with street people really does matters to foreign leader because working with him will affect their domestic political standing and (2) foreign policy issues where there is a real conflict will be determined by national interests not by personalities].

Democracy and The Rule of the Stupid

The word democracy makes people feel good.  Just like the ‘Axis of Evil’ sounds bad (however cartoonish).  But hopefully the reasons for our choice of societal organization is based on more then semantics and rhetoric.  I’m not going to try to provide the rational for why democracy is good (justice but also robustness) but I’d like to point out some of its weaknesses and why you should care about them in the context of the economic crisis.  

I’ve ranted about the fact that banks were giving back capital and that our bank bailout plan might retroactively fail because politicians were providing incentives for bankers to treat the capital as a short term loan instead of the equity injection that was needed.  Why would politicians do this?  They care about being elected and they want to keep their job (and increase thier power).  Thus they are pandering to what makes people feel good at the moment.  Which unfortunetly is beating up the financial system instead of fixing the problem.

So then the ignoble question is ‘are the legislator evil or stupid?’  Many politician basically understand the banking crisis (if not I’d be happy to explain it to them) and they know that paying back the capital is not entirely desirable.  If it all just about being elected how do they reconcile with thier conscious.  They tell themselves that if they are not reelected they won’t be able to do any good down the road and if they could just get a supermajority then they could do so much good.  So they justify foolishness now in order to allow them selves to do good in the future.  Of course it is important to note that they are nearly always in the short run and thus never get away from foolishness to go ‘good’.  But it seems weak to argue that politicians should not behave politically.  Politicans will be politicans. 

This policy vs. politics problem – the inability to do the right policy even when smart people agree about what it should be because of the political element – is always a popular conversation among wonks.  But it is not a new problem.  Aristotle wrote about the problem of the rule of the masses (or more bluntly the rule of the stupid) would be mitigated by the rule of the wealthy.  He also argued that one of the keys to a healthy democracy is a large middle class because they will be able to balance the rule of the stupid and the rule of the oligarch.  This could be because they view themselves as possibly being in each of those classes in the future and want the rules of the game (how society works) to be tolerable in both states of the world.  I tend to think that the truth to this argument is not about a large economic middle class but a large educated class.  Eduated voter use thier minds to make decisions based on reality and not a fantasy that a policitcan may be selling. 

From this educated middle class perspective some policy issues have a more substantial middle class than in other policy areas.  To be honest I suspect that people are more in tune with education, military, and health care issues than they are with macro economic issues.  Nearly everyone has experienced the education system, many people know someone who is in the military and most of us interact with the health care system.  And although I’m not a strong proponent that experience makes one an expert it does help increase understanding.  Many macro economic issue are simply not understood by the public and thus the rule of the stupid is risking poor policies that will compound the economic crisis. 

We’ve seen the enemy and he is us.

The Obama Portfolio

Our president did something some what un-presidential by offering some investment advice… ‘What you’re now seeing is profit and earning ratios are starting to get to the point where buying stocks is a potentially good deal, if you’ve got a long-term perspective on it’

I actually think he is basically right and I think that the implicit approach he has suggested (‘potentially’ -> considers uncertainty and ‘long term’ -> beta – collecting risk premia- investing, which is what most people should be doing) is spot on…but as a political leader he should likely stay away from the market.  Not only could an undesired focus and expectation be built around your words but you could be blamed for (or given credit for) things that you really don’t deserve….you clearly don’t want some throwing their 16 year olds college fund all into stock now because ‘Obama said so’.

All this said…what are the chances that he called it.  It being the bottom.   Given that the market was up over 2% today and an assumption of future equity returns as 5% expected returns and 30% annualized vol (both of which are wrong but not crazy for the point I’m trying to make here) there is about a 3% chance that the equity market will not go bellow (according to my small montecarlo test) yesterday value.  We’ll that means there is a 3% chance that bad historians and bad economist will imply that (and if you open up the interpretation of bottom to a broader degree much higher) his call had something to do with a bottom. 

What does this mean?  In the grand scope not much; really just an interesting factoid.

Designing Democracy

Iraq voted for the 4^th time last Saturday and the news reports coming out of the election could have been about a US election.  The major complaint was that some people found they were not on the voting roles. Does this mean that they have a well functioning democratic government? Not exactly.

Going from a world in which you were subservient to the government to a world in which the government in theory is subservient to you (the people) is a major switch. It is a major conceptual challenge and designing the electoral process to facilitate ‘buy in’ (the acceptance and participation in) the system is a key for success. Now I’m not an expert on the electoral process in Iraq but given some very simple information one can guess at some things. There were 15,000 candidates for 440 seats. This suggests a few things. (1) The barriers to entering the political realm are low, lots of people can participate; on the surface this is good. (2) Although I’d like to believe that people are simply very eager to serve in the government I suspect the temptation and perceived benefits of power is a larger draw; this suggests a misunderstanding of the government’s roles and likely misuse of power. (3) Assuming the winner is the candidate with the plurality these elections are almost certainly not picking the truly desired candidate (open question how ‘bad’ the results are).

Let me comment #3 for a moment. If I assume the candidates are distributed across the positions equal there are 34 people in each election. First consider how much effort a well informed US citizen goes through to find out only two candidates. It is not feasible for an Iraqi voter to be will informed. Second even if all the voters were well informed an election with this many candidates is likely to have batches of candidates that are focused around the core issues that most voters care about and thus split the vote. Imagine if 33 of the candidates are all centrist and 1 is crazy. If 95% of the voters want a centrist but they all split their votes amount the 33 centrist so they each have 2.9% and the remaining 5 % are crazy and vote for the crazy person; the crazy person wins. A democratic system has allowed the will of the 5 to overwhelm the will of the 95. Now should we have instituted a complex run off system in Iraq to prevent this problem? Probably not, start with small step, just get people voting (and use endorsements and like minded collaboration to prevent the crazy from winning) and then move up the democratic food chain in a more robust system.

So the fact that the reporting from the Iraq election was benign does not suggest that they have a well established democracy but that they have laid a foundation that should be built upon.  Instituting a framework for progress and improving the foundation could serve them well.

Poltical Cover

When discussing the economic environment I find that we are often coming back to discuss policy. This is unusual but we live in unusual times and I think it is the right path for the discussion to be taking. Policy, at the moment, matters alot and will greatly influence how we get out (or don’t get out) of the financial crisis. In many ways the basic needs of the financial system are known – in short more capital (but also a belief that their counter parties are not going to collapse and faith that they will be able to fund themselves in a reasonable manner). When discussing how to accomplish recapitalization someone, at some point, will say ‘that will never get through congress.’ Then a discussion ensues about is it because they are stupid or evil.  Do they know what they are doing and trying to block good policy in order to use it for political gain or do they simply not get it and are trying but failing to understand a complicated world. Unfortunately the typical consensus is that they are not stupid but rather evil; that they are trying to get ahead using rhetoric and framing in the political arena.  (Although I think it is not particularly insightful for criticizing politicians for being political).  They know that bailout of the financial system is unpopular, they know that foreclosure holiday and housing programs are viewed favorable, and they know that ’sticking it’ to the banks and bankers is also popular. Well the truth is that re-capitalizing the financial system is the only way we come of the recession with a prospect of sustainable growth and the banks are a major part of this.  Additionally a major foreclosure holiday will change the calculus for many homeowners so that it would become advantageous to not pay, thus spurring a new wave of defaults and eventually foreclosures which would further impair the banking system (yes it could be structured so with a start date in the past but if you think homeowners don’t have that in mind and are including that in the calculus you are too pollyannish).

So what does this mean for someone who is not trying to run for political office (not everyone in policy is political) and is just doing this for the challenge of solving hard questions? It means that all questions have two meta dimensions. First the problem at hand. For example ‘how do we fix the economy.’ Then second how do we get this plan rolled out (in other word past the political process). For example you may say we’ll use the TARP funds to revive the mortgage market and set out 50 bln to do so but then use the rest like you wanted to all along and recapitalize the banks (or set up a good bank/bad banks entity). The 50 blns was used in a less than ideal way but it provide political cover for the rest. This intractable problem has the same root as Hitler famous quote ‘I use emotion for many and reserve reason for the few.’  The root being that most people are not terrible thoughtful.

Will we be able to find the solutions that both solve the problem and pass the political hurdle?  We’ll see.

Did Geithnier start opening Pandora’s box of populist rhetoric?

The Bush administration or maybe more correctly the Paulson treasury used a rhetorical breeze through meetings of collaborations to urge the Chinese to move their currency toward economic equilibrium and thus easy the pressure of global imbalances.  Who knows whether this was helpful or not.  Would the fx had appreciated more or less if this encouragement didn’t happen.  In what form could we have been more forceful in demanding a solution to the global imbalances before they sunk our economic well being?  In my view public pressure on the Chinese is likely to backfire because they do not want to appear subservient to the United States.  Showing them why – although I suspect they already know – they need to adjust the currency (inflationary pressures, global imbalances) may be helpful.  As well as providing advice about a transition to a robust financial system (do we have any credibility here?). 

 

The Obama administration has quickly taken a more aggressive approach – whether this is in light of the continued large surpluses or the fact that the RMB has re-pegged to the dollar or some other reason is unclear.  This was brought into focus with Tim Geithner’s comment that ‘China is manipulating its currency.’  China didn’t take kindly to this.  I’m a little nervous about a more aggressive strategy.  It will embolden trade protectionist and its not clear to me that it will improve our chances of getting China to move it currency.  The best we can do is to adapt our fiscal situation and financial system to better handle the barrage of capital that is being sent our way. 

 

Interesting enough the last Democratic president took a similar approach to another eastern power about 15 years ago.  Japan was running significant at the time – 120 billion – trade surplus with the world in 1993 of which 60 billion was with the United States.  When talks about the bilateral imbalance stumbled comments about the problems of a weak yen emerged.  Clinton said, “there could be reasons other than closed-market policies for the lack of progress — no domestic demand, changes in exchange rates, inadequate efforts by Americans, not competitive products or services (2/11/1994)” when describing why Japan may have the surplus.  This comment was read by the markets as being negative for the dollar; bond yields rose and the yen rallied.  See the following chart for the Yen rally after the executive branch rhetoric (admittedly the massive surplus is a economic reason for the yen to rally but the 1990s were not a time of stellar economic growth in Japan).  So the very soft rhetoric worked – in large part because market participants believe that unless the Yen rallied the US would do something. 

 

 

So could the rhetoric work again except this time on China?  I’m doubtful.  First the RMB (chinese currncy) is effectively pegged; the Yen was floating – even if the BOJ would step into the fx market from time to time; thus it is not easy for the markets to do the adjustment for us (not that any spare risk capital is floating around could do the job anyway).  Hot money is already coming out (it seems like) not into China and given the state of the financial market deleveraging this seems likely to continue for some time…so sterilized fx intervention is getting easier not harder.   Second no country likes being told what to do; China especially.  I doubt they are going to take instructions from the US.  Even if we offer advice any subsequent action will need to look like it was their own.  Now if we step up the pressure via trade sanction we are shooting ourselves; demand for treasuries would fall and the world trading system – already in free fall – would become chaotic.  I suspect they would call out bluff…one of which I’m not sure we could back down from.  Did Geithnier start opening Pandora populist rhetoric?  I hope not. 

Political Transition

Tuesday’s executive branch power transition is a powerful example of the robustness of our society.  It doesn’t strike the typical American that the transition of power in a peaceful and organized way is not only extremely beneficial and it is not normal.  

It is easy to see why transitions in power can lead to problems.  When the power is lost by it prior holder and is floating to find a new home the nation is at risk from opportunistic foreign attacks as well as domestic disturbances (in both cases ask yourself who coordinates the response) but if the rules of the transition are understood power the risk of foreign or domestic groups trying to take advantage of transition less.  Consider czarist Russia went through centuries of destabilizing power transitions until Paul I established a transition law laying out the way in which power would be transfer (male Romanov succession).  Although his motives (ensuring his own power and out of distaste for his mother) were not in line with creating a stable or just society he resulted in at least creating a more stable one.  I don’t know if these rules where ingrained in the ethos of Russian society but it created enough momentum to create peaceful power transitions till the time of the Russian Revolution over 100 years latter.  The rules for U.S. power transitions are ingrained in U.S. ethos but are not ideal: consider the fact that the upcoming fiscal stimulus has basically been put on hold which is clearly less than ideal.  In fact the transition between Hoover and FDR during the great depression was call the ‘the interregnum of despair’ and the idea was floated to have FDR become secretary of state and have the president and vice-president resign so that FDR could get into power more quickly. 

You might quickly realize that a democracy that chooses who it wants as its leader every 4 years has a much larger number of transitions than a dictatorship (think Cuba’s Castro has lived through Kennedy, Johnson, Nixon, Ford, Carter, Reagan, Bush, Clinton, Bush, ~Obama…) but the incremental risk of transition doesn’t outweigh one of the major benefits of democracy; the benefit of structure revolution.  In the same way that power transition rules lead to stability in a country a democracy gives a set of governing rules which allow for peaceful revolutions.  Consider if GW was not subject to a term limit or an electoral boot?  Even though he is thoroughly unpopular would it be worth the cost of a revolution to remove him from executive power?  That is very unclear to me; what is clear is that the fact that the U.S. people can remove him and his party through a organized method is vastly beneficial.

Why not just buy the banking system?

In a backdrop of further banking collapse (Bank of America seems to be the next focal point) the senate has released the next portion of the TARP.  I had thought its passage would be a drawn out battle. Maybe congress learned from the markets response when they did not pass the plan originally but more likely the chosen one – wisely – used some of his powers of persuasion.  This begs the question: What should be done with the next 350 billion?  Big picture is simple continue to recapitalize the banks.  You might respond that it hasn’t work so far so why keep throwing good money after bad.  This is like telling a firefighter that the fire is not out so he should stop dosing the house in water.  Try telling that to a firefighter who has only partially extinguished a house fire.  He would look at you as if you had lost it.  We understand the dynamic of a house fire (or at least better than we do about a financial market collapse).  We know that we have to drown the house is water and we keep drowning it until the fire is out – just because we’ve used a lot of water doesn’t mean we should stop (or wait for the new administration).  We won’t be able to stop all the knock on effects (the house next store might still burn down) and that we create moral hazard (the third house isn’t damaged and thus the owners perception of fire risk is smaller than if would have been if we had let his house burn.  He then doesn’t put in a sprinkler system).  Firefighters don’t spend their time when they get to a house fire lecturing the occupants on why they should not use candles; they focus on the fire and then they afterwards they may criticize and suggest new rules and regulations.   Once the banks have been swamped with capital they will find themselves overcapitalized and paying for that with low returns; they will start to look for good investments (or pay it out in dividend…why can banks with federal money pay dividends?  Federal Capital in one door and out the other to the share holders?  I don’t understand that.)

One argument is the government should receive equity stakes for their investments.  If the government has the downside (insured deposits and bonds) then they should get some of the upside.  I’m sympathetic to this sentiment but only if it doesn’t get in the way of getting the financial system working again.  One possible path is to buy the financial system (take all the upside) with the next 350 billion (as shown below).  

 

It is too bad buying the banks would be a bad idea; it might have some rhetorical/political appeal.  It is a bad idea because it would risk politicizing the credit system and because it would not recapitalize the banking system.  The cash would go to the old shareholders.  We’ll what if the banks were taken into receivership and the 350 was used to recapitalize nationalized banks?  Given the fact that much of the banking systems market cap is coming from option value (this point is illustrated here with interest rates 0 floor) the government could be justified in simply taking out the equity.  This is a bad idea because of the politicizing the banking system and because it will lengthen the time that the financial system is non functional (ignoring the goal of recapitalizing the banks and focusing on the form).  Taking out the equity makes it non functional (think AIG) and the share holders will fight you.  If you want to bail them out you have to bail them out.  Fix the system (higher FDIC insurance fee and making all financial pay them, as well as a number of other things) after the fire is out and credit is flowing.