Inflation? What Inflation?

Buttonwood notes that commodities have been on a tear lately:

Higher wheat and metals price have been hitting the headlines, so it is no surprise that the all-items index is up 8.4% on the last month. It is more surprising that it has risen 28.1% over the last year. Furthermore, this is not a boom that is driven by oil. The crude price has only risen 10.2% over the last year.

Buttonwood then asks a question:

Ben Bernanke warned last week that the level of inflation was too low for comfort. Indeed, the core rate is just 0.8%. Why aren't higher commodity prices showing up in the CPI?

Buttonwood answers the question:

In part, this is down to lags; in part, it's down to the relatively small weight of commodities within the index. But it may be down to methodology. John Williams at Shadow Government Statistics runs an inflation measure that ignores all the methodological changes that have been made to the CPI since 1980; this has inflation running at 8.5%. A separate measure that ignores changes since 1990 has inflation running at 4.4%.

But then Buttonwood questions the answer:

My feeling is that, if inflation were as understated as the Shadow numbers suggest, it would have shown up somewhere else in the numbers (by analogy, if a company is fiddling its profits numbers, the evidence will probably show up in the cashflow figures). No-one is suggesting that the annual wage growth numbers are artificially low. So if prices have been rising much faster than wages, wouldn't that show up in declining consumer demand?

Buttonwood’s conclusion is that the understatement of CPI is not that big an issue.

I disagree, and here’s why. The period in question also happens to be a period of dramatic increase in the availability (and utilization) of consumer credit. Coincidence? I think not. Prices rose but wages did not; the only way to plug the gap was for the consumer to become ever more leveraged.

And then, the crash: after credit dried up in 2008, “declining consumer demand” is precisely what we have seen. It all fits.

Who's Pegged To Whom?

I find it revealing that when China hiked interest rates last week, the USD promptly rallied. Of course the rally was short-lived, but it confirms a suspicion I have long held: it's not the renminbi that is pegged to the dollar, it's the dollar that's pegged to the renminbi.

(Aside: treating the US and China as a single economic entity -- albeit one with large internal imbalances and frictions -- is a very useful construct when thinking about global trade flows. Maybe some day I will write a longer post about the implications of such a world-view).

(Another aside: quite a few macro traders believe in the DGDF (dollar goes down forever) hypothesis, for very good monetarist / inflationary reasons. But in my opinion the dollar won't really begin to decline until it is delinked from the world's fundamentally strongest currency.)

The Return of the Meta-Finance Blogger

Hello to all my faithful readers, and my apologies for the long hiatus. Apart from the usual excuses (being busy, being lazy, being otherwise inclined), the main reason I've written just 3 blog posts in all of 2010 is that quite frankly, global markets have been pretty boring, year-to-date. But that seems like it's changing; the last couple of months have seen some quite interesting dynamics take root. I plan to address a few of these in coming posts.

But with a difference: instead of my old style of writing lengthy disquisitions on particular subjects, I am going to try shorter and snappier posts which will hopefully nonetheless be interesting and insightful. And I am going to write more explicitly about topical issues (aka "market commentary") rather than sticking solely to abstract generalizations. As always, reader feedback (positive or negative, ha ha) is very welcome. Happy reading!

Michael Lewis on Michael Burry

Michael Lewis, whose writing I generally enjoy, has a new book out. It’s not about the financial crisis per se, but about a handful of traders who made huge amounts of money from the crisis. There’s an excerpt available on the Vanity Fair website, in which Lewis talks fairly admiringly about one such trader, Michael Burry.

I haven’t read Lewis’ book beyond this extract, nor do I know Burry personally (though I do know the trade he executed – it was a simple yet powerful idea, and full credit to him for conceiving it). But I do want to emphasize a couple of points that the VF article glosses over:

First, any story of this sort suffers from a huge amount of survivorship bias. For every Michael Burry or John Paulson who foresaw the crash and made money off it, I can name ten – nay, a hundred! – hedge fund managers who knew full well that there was a bubble in the housing market but could not get their timing right, and hence went bust¹. (Either they bled to death on the negative carry, or their investors got impatient and pulled their money). Of course none of these other managers got their stories recounted in Vanity Fair, which is where the bias comes in. Lauding survivors for their investment acumen is meaningless without knowing the a priori probability of survival. Hindsight is always twenty-twenty.

And why are the odds of survival so very low? This brings me to my second point. The way the article describes it, Michael Burry was in the perfect position to do the subprime-CDS trade. Over previous years he had outperformed the S&P by huge margins, in good years as well as bad; by not looking to maximize his AUM he could pick and choose his investors; said investors loved him and hung on his every word; and his funds were structured with long lockup periods. If anyone had the wherewithal (deep pockets as well as credibility) to take a few quarters of losses while waiting for the big payout, it was Michael Burry.

But no. Quoting Lewis:

[Burry] assumed he’d earned the rope to hang himself. He assumed wrong ... He had told his investors that they might need to be patient ... They had not been patient ... Many of his investors mistrusted him, and he in turn felt betrayed by them ... To keep his bets against subprime-mortgage bonds, he’d been forced to fire half his small staff, and dump billions of dollars’ worth of bets...

If even a trader in Burry’s strong position was forced to the very brink by irrational investor behavior, what hope for lesser souls?

My point here is that traders do not operate in a vacuum. If your investors are myopic and greedy, that forces you to be myopic and greedy as well. If your colleagues are picking up nickels in front of a steamroller, then you have to go after those nickels as well. In Wall Street’s current “quarterly-earnings-are-everything” mindset, you simply cannot afford to sit back and be patient if you want to keep your job.

Of course the equilibrium is unhealthy: decisions that are rational at the micro level for individual traders, add up to an irrational macro market situation. In other words, a bubble. Quelle surprise!

Footnotes

# ¹Conversely, I know plenty of hedge fund managers who either did not recognize, or chose not to recognize the bubble. For the most part these folks banked big bonuses pre-crash, and they haven’t had to return the money post-crash. Does this make them any dumber than Burry or Paulson, or any worse traders?

Moral Hazard and Conventional Wisdom

Was moral hazard, in the form of expectations of a bailout, responsible for the reckless behavior that led to the banking crisis? James Surowiecki argues, quite convincingly I think, that the moral hazard argument is overrated:

In order to believe that the banks engaged in reckless behavior because they assumed that if they got into trouble, the government would bail them out, you have to believe not only that financial institutions thought it would be fine if their share prices were driven down to near-zero as long as they were rescued in the end. You also have to believe that the banks knew that what they were doing was reckless, and that there was a meaningful chance that it would wreck their companies, but decided that it was still worth doing because if everything went south, the government would step in. And that, even before Dimon’s comment yesterday, always seemed improbable, because all of the accounts of the banks’ behavior in the years leading up to the crisis suggest that most of them were swept up in housing-market hysteria like everyone else.

In a way, the moral-hazard argument ascribes far too much foresight, intelligence, and rationality to the banks. It assumes they were coldly calculating the chances and consequences of failure and forging ahead nonetheless, when the reality seems to be that for the most part they were blissfully ignorant and arrogant about the flaws in their lending and investment strategies.

I think Surowiecki is correct as far as he goes, but he doesn’t go far enough. To me the interesting question is, just why were bankers so ‘blissfully ignorant and arrogant’? The Epicurean Dealmaker provides an eloquent answer:

I also explained that the fast pace and high pressure of the business tend to attract individuals who do not attach great importance to deep, theoretical, or introspective thought. Rather, quickness of intellect, nice interpersonal judgment, and a certain calculating capacity akin to the ability of practiced chess players to think several moves ahead are the most valuable and prized attributes in my industry. What I did not explain was the natural corollary to these observations; namely, that due to their vocational preoccupations and intellectual predispositions, investment bankers tend to be extremely adept and quick at sussing out and acting on what is commonly known as the conventional wisdom.

This should not be surprising, either. After all, investment bankers spend all their waking hours figuring out and relaying to clients what "the market thinks" about deals, securities, and prices. Investment banks are gatekeepers to the markets, whether underwriting securities, trading financial instruments, or structuring and executing mergers and acquisitions. And what is the market itself but a gigantic, multi-tentacled, complexly interlinked engine for the real-time calculation of conventional wisdom? Figuring out, anticipating, and shaping conventional wisdom is what investment bankers do. It is the ocean in which we swim.

(More words of wisdom from TED can be found here).

The Regulator's Dilemma

If there’s one idea that has achieved consensus over the past few months, it is that regulators were asleep at the switch as the credit bubble inflated. A better regulatory system would have preempted the bubble, precluded the need for bank bailouts, and saved the world much misery.

If only it were that easy!

Imagine that you are the regulator in charge of the banking industry. What are your aims?

Well, on the one hand you want to prevent ‘unwarranted’ bank runs. An unwarranted bank run is one in which the bank did nothing wrong, and is actually well-capitalized, but due to ‘irrational’ investor panic faces a potentially life-threatening short-term funding gap. Preventing unwarranted bank runs is what lies behind well-known CB catchphrases such as “contagion”, “systemic risks”, “lender of last resort”, and “too big to fail”.

On the other hand, you as the regulator are (moderately) in favor of ‘warranted’ bank runs. If a bank does something stupid, it should pay. Depositors should withdraw their money from badly-run banks, and you don't want to stand in their way. You don't want to bail out the incompetent; that’s deeply unfair to the competent, and it messes up incentives all through the system. (To quote one famous investor, “Bailouts are bad morality as well as bad economics”).

Unfortunately, these two aims are fundamentally incompatible. Because smart bankers will simply pile into precisely those trades which pose systemic risks!

Why should a banker take the trouble to build a unique portfolio, thus exposing himself to all sorts of idiosyncratic risk factors? If these idiosyncratic factors go against him, he will appear (uniquely) stupid, and will probably not be bailed out. It’s much better for him to pile into the same trade as everyone else¹. Then if things go sour, it will be a systemic crisis and so everyone will be bailed out, including the banker in question.

(This insight is nothing new; it is merely the compensation dynamic for 1 trader on a desk of 10 traders, applied to 1 bank in an economy of 10 banks, with bailouts substituting for bonuses.)

In fact the situation is even more perverse than it appears. A standard measure of trade quality is the risk-reward ratio: the lower this ratio, the better the trade. But if systemic crises and consequently bailouts are in play, then the reasoning becomes inverted. Losses from low-risk trades are, by definition, small; hence low-risk traders are unlikely to be bailed out. Conversely, losses from high-risk trades are, by definition, large and potentially life-threatening; hence high-risk traders will often be backstopped by the government. This is moral hazard at its most pernicious.

It gets worse. The more enthusiastically people herd into one (systemically risky) trade, the higher the odds of a bailout; the higher the odds of a bailout for a particular trade, the more people will want to enter that trade. Yes, it’s our old friend, positive feedback!

So what’s a well-meaning regulator to do? There are only two coherent choices, really: put an end to bailouts, or put an end to bank proprietary trading.

Sadly, I don’t see either of these happening.

Footnotes

# ¹ Throughout this post I use ‘trades’ as a convenient short-hand for ‘institutional strategic decisions’.

Do Deficits Matter?

In a previous post I described the theoretical implausibility as well as the empirical rarity of governments inflating away their debt. I concluded that a deficit-driven buyer’s strike was unlikely, by itself, to pop the bond bubble.

Does this mean that “deficits don’t matter”? Oh no, quite the contrary. Deficits do matter, but it’s important to understand the mechanism. Deficits don’t operate via a buyer’s strike unless you go into hyperinflation. Instead the channel is monetary policy.

The Treasury issues bonds. The Fed buys them. As far as I’m concerned, that’s just an internal transfer. The external effect is not bond supply; the bonds never hit the street. Instead, the external effect is government expenditure. Essentially the Treasury is spending dollars that have been newly printed by the Fed.

In the short run this policy will boost private sector consumption and employment, as indeed it is designed to do. But in the long run it will lead to inflation; seigniorage always does.

Note that this inflation will not necessarily manifest itself in the form of rising interest rates, at least not immediately. If the Fed is willing to buy 75% of each Treasury auction (matching China at its peak) then sure, bond yields will stay low.

But the increase in money supply has to be reflected somewhere. Two obvious candidates are the dollar and real assets. Sure enough, in the last year or so these two instruments have fallen and risen, respectively. Policymakers who look only at bond yields to determine inflation pressures are missing the point.

Ultimately of course rates will have to go up. If something cannot last forever, it will not.