Academic Finance – Page 7

Don’t Buy Stocks on Margin, Unless you are an Expert

Posted on 17 April 2010 by David Merkel

Most academic economists are irrelevant, so we can ignore them.? The few that are relevant are worth noting.? They can write such that ordinary people can understand — think of Milton Friedman with his “Free to Choose.”? Such economists are viewed skeptically by the “profession” because they interact with the unwashed.

So it is with Ayres and Nalebuff.? I have rarely been impressed with what they write.? Like Freakonomics, they write about stuff that is sensational, and challenge the conventional wisdom.? Yo, the conventional wisdom is right most but not all of the time.? Anyone that focuses on where the conventional wisdom is wrong will commit a lot of errors in an effort to be novel.

Now, Abnormal Returns and Sentiment’s Edge have made their polite comments, but now it is time for my less polite comments. I have five main critiques of their paper, which stems from the lack of practical experience in the markets for these two professors.

1) History is an accident.? It is fortunate that they are analyzing the US, rather than nations whose markets got wiped out during a war.? It is not impossible that the US could face a similar crisis in its future.? Try the same analyses with Argentina or Peru.? Will it work?

2) Even in the US stocks don’t outperform bonds by that much.? My estimate of the equity premium is around 1%.? Yes, the economics profession says the equity premium is higher, but they use a wrong metric; they should use dollar-weighted returns, not time-weighted returns.? The estimate of 4% equity returns over margin rates, which are higher than bond yields, is hooey.

3) Average people aren’t capable of managing portfolios that are 100% equities, much less levered equities.? It is well known that people invested in equity funds tend to buy and sell at the wrong times.? It would be far worse with leveraged portfolios.

4) Leveraged ETFs tend to underperform over time, have you noticed?? This is a mathematical necessity.? Through options and swaps, which have larger bid-ask spreads, maintaining the leverage is at low cost is tough.? If the advantage over margin rates were true, there would be real advantages to leverage.

5) What if everyone did it?? The paper is a typical, “If you had done this in the past, you would have done a lot better.”? Duh, and I can do better versions of that than the authors.? Going back to point one, history is an accident, and cannot be relied on.? Point two, their math is wrong.? Point three, average people can’t implement it.? Point four, those who try to do this don’t do as well as you might expect.

The last point is that everyone can’t do this.? Can you imagine what would happen if everyone aged 25-41 suddenly invested into equity exposure equal to twice their assets?? Stock prices would shoot up, and would offer little future returns to holders.? Stocks aren’t magic, and over the very long haul, they tend to return what the GDP does plus a few percent.

Think of Alan Greenspan encouraging people to finance using ARMs at the worst time possible.? The authors here encourage young people to speculate on equities with leverage at a time when the market is somewhat overvalued.? If this were a good idea, you would have seen many people doing it already, and it is not a common practice.? Don’t listen to academics that have little practical experience for investment advice.

One final note: when I wrote at RealMoney, I took a contrarian view that for average investors, no one should be fully invested.? Even the great Ben Graham never exceeded 75% invested.? My view is that average people must limit their risks or they will not be able to sustain their investment plans.? A 50/50 or 60/40 balanced fund approach is best for the average person — they will never get scared enough to abandon it.

Leverage is for experts only, and I have never used leverage.? Only use leverage if you are more of an expert than me.? (I write this not out of pride, but out of my experience where so many have gotten burned by taking too much risk.)

Are Utilities Like Bonds or Like Stocks?

Posted on 16 April 201016 April 2010 by David Merkel

I like CXO Advisory, and always read them as they publish.? That said, I think they sometimes have a weakness in their methods by not using multivariate techniques when it would make sense.? So, when their article, “Interest Rates and Utilities,” I asked myself, “What would this look like if I used multiple regression?”

Rather than looking at correlations one at a time, multiple regression looks at them all at once, and tries to analyze which are the biggest factors.? Now unlike CXO, I used interest rate variables that have credit risk.? Why?? Corporations face credit risk, and they fund themselves with risky paper, unlike the US Treasury.? So, my two interest rate variables are the Moody’s Corporate Baa Average, which contains only long bonds, and the 30-day A2/P2 commercial paper yield as calculated by the Fed [H15s030Y].? These better measure funding costs for corporations.

All of these variables are highly significant.? Two go the way one would suspect, and one doesn’t.? Like REITs, performance is positively related to the market as a whole, and negatively related to Baa yields.

But, A2/P2 yields are positively related to returns.? Fascinating, and a reason why we should always use the long and short end of the yield curve for analyses.? They don’t measure the same thing.? Short-term liquidity is different from long-term borrowing rates.

Why are short-term rates positively related to returns?

They are a measure of confidence in the economic system.
Inflation drives both short-term rates and utility profit margins.

At least, I think that is the case.? As I often say, be skeptical about statistical arguments about the market, particularly when there is little economic reasoning behind the discussion.

With that, I simply say that yes, higher long-term interest rates do affect utility stock prices.? And higher short term rates will indicate inflation, and drive utility prices higher.? Beyond that utilities go higher as the market does, but the beta is low.

Are Utilities Like Bonds or Like Stocks?? They are like both of them.? Learn to enjoy that, unless the regulatory regime changes.

Book Review: Monetary Regimes and Inflation

Posted on 27 March 2010 by David Merkel

I did not ask for this book, but I am glad the publisher sent it to me for free.? There is a lot of concern over inflation in the present era, but not a lot of structured thought about what drives inflation.

This book takes the long term perspective, and looks at the wide array of monetary arrangements, and analyzes which arrangements produced more or less price inflation.? The author shows that there is generally an inflationary bias in all currencies.? Currencies that are backed by precious metals tend to experience less inflation, but many governments using such currencies debase the metals or clip the coins.? That said, it does restrain inflation, because inflating a? metallic-based currency takes a lot of work.

To have significant inflation, one must have unbacked paper money.? The same is true of defaults in bonds.? In order to have a crisis, much debt must be issued relative to the assets and earning power of the companies.? The debt is not backed by sufficient repayment capacity, and thus there are some defaults.

A fiat currency in and of itself, is not sufficient to create hyperinflation.? Hyperinflation only happens when the government finances itself by printing money with abandon.

The book further distinguishes itself by explaining situations where foreign currencies come in to act as shadow currencies inside nations.? Further, the book describes how inflationary situations end.? One constant is that people quickly analyze where purchasing is declining, and seek stability through metals or relatively stable fiat currencies.

One strength of the book is that at the end of each chapter, the author summarizes all of the main points.? I recommend this book.

Quibbles

The book is not dry, but it has a distinctly academic feel.? Not everyone will take to the book easily.

Who would benefit from this book?

Economists would benefit from the book, and also those that like reading about the history of inflation.? Few things truly change in History; the names may change, but we make the same mistakes.

For those who want to buy the book, you can buy it here: Monetary Regimes And Inflation: History, Economic And Political Relationships.

Full disclosure: Though I get books for free from publishers, I burn time to read books in full, and write reviews that are balanced.? Those entering Amazon through my site and buying anything will end up sending me a small commission, but they will not pay more in order to do that.

Book Review: ECONned

Posted on 26 March 2010 by David Merkel

Many of you have heard of the blog Naked Capitalism, and its pseudonymous writer, Yves Smith.? Well, she has written what I regard as an ambitious book, ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism.? It is ambitious for several reasons:

It tries to be comprehensive about all aspects of the crisis.
It digs deeper than most, analyzing flaws in economic and financial theories that underpinned the errors of the crisis.
It looks at the political angle of how laws and regulations were subverted, while alleging conspiracy probably too much, when ordinary greed in the open and stupidity could cover the causes of the crisis.

There is a tension between capitalism and democracy.? We don’t like to talk about it, but it is there.? Property rights are human rights, and should be protected.? Governments often determine that certain contracts are not valid on public policy grounds.? (I.e., gambling, prostitution, arson, assassins, etc.)

Democracies also do not like rivals for power.? If business gets too big, to the point where it is influencing the decisions of the government, democracy fights back.? I write this as one who would err on the side of property rights rather than democracy.? Property rights are a direct descendant of the eighth commandment, “You shall not steal,” whereas the form of government of any nation is a thing of relative indifference.? Many nations have different ways of ruling themselves.? It is not yet proven that democracy is the best form of government.? Personally, I think it is more prone to corruption than most governmental forms.? But it has the advantage of motivating the people.

I draw the line when businesses use political power to exclude rivals.? It is one thing to be really clever, and dominate your market, like Google.? It is another to have a natural monopoly like the old AT&T, before technology obsoleted them.? But it stinks to have a system where major financials, who have nothing of patentable value, hold the nation hostage, saying “Bail us out or the financial system fails.”

I argued against the bailouts, as did Yves, but the government caved under the asymmetry of “Heads we win, Tails you lose.”? It came up tails for all of us.

Yves digs deeper than many critics.? She questions the assumptions of the economics profession,with its gloss of pseudo-science.? She pokes at the questionable assumptions underlying much of finance theory.?? She looks at those who got it right regarding the crisis, and were marginalized as a result.? Where I differ is that there isn’t necessarily a conspiracy behind unwillingness to listen to discordant theories.? Academic guilds ignore researchers who question their closely held beliefs, regardless of the truth of the matter.? They know that it couldn’t be true, and the outsider doesn’t really understand their discipline.? I do not charge them with ill intentions, but stupidity.

What I really appreciated about the book was its willingness to challenge academic economics and finance.? She did it well, but left little in her wake as to what to look to as a substitute.? The willingness of economics to engage in pretend games with high level math is ridiculous.? If we restarted economics from scratch today, whether mathematical or not, it would not look like much of the sterile games that are played in leading economic journals.? Ask the question: how many benefit outside the economics profession from what is written in economic journals.? Answer: precious few.

I have many more things to say about this book, but this review is long enough as it is.? Let me say that there are few books that I have marked up as much as this one.

Quibbles

I do not go in for conspiracy theories.? Usually, most evil can be performed outside of darkness; people still don’t notice for the most part.

Yves should have spent more time on the enablers of the crisis — yield hogs.? You can’t buy protection on a company that you think will die, unless there is a yield hog out there that wants extra income that they think they are getting for free.? AIG was the largest of them, but by no means the only one.

She complains a bit much about “free markets.”? Aside from trading with the enemy, why should trade be constrained?? Why should I try to take away the property rights of my neighbor?? Beyond that, suppose you are right.? Where would you draw the lines?? It is one thing to criticize, and quite another to propose new policy.? Personally, I make an effort that when I suggest that something be demolished, that I recommend something else to take its place.? It is easy to be a critic, but hard to be a builder.

Who would benefit from this book:

Most people would benefit from the book, if they read it realizing that the things that happened do not require that parties conspired to make this happen.? Those who would especially benefit include economics and finance professors; they need the criticism.

If you want to buy the book, you can buy it here: ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism.

Full disclosure: The publisher sent me the book for free.? I spent several hours reading it in full.? If you enter Amazon through my site and buy anything, I get a small commission (6-7% typically).? But, your costs don’t rise versus going to Amazon directly.? I have avoided doing a “tip jar” because I would rather people benefit from the books I review, while allowing Amazon to pay me indirectly.

The Rules, Part II

Posted on 6 March 201020 June 2017 by David Merkel

Before I start tonight, a reminder, those that want to follow me on Twitter can do so here.? I will be sharing posts and ideas that I find insightful, that I might or might not share on the blog.? I?m still working with it.? Thanks to all of those that tweeted and retweeted, and those that are following me now.

One more note, I disagree with Volcker and Sarkozy regarding supporting Greece, versus the Euro.? If Greece defaulted, Greece would lose the low cost funding of the Euro.? The Eurozone would lose a country, but the Euro would retain its strength, and marginal nations prone to cheating would come into line.? Tough love is the best policy; don?t bail others out if you care about the union as a whole.

On to tonight?s rule: Unless there is a natural purchaser of an exposure that one is trying to hedge, someone must speculate to a degree to allow you to hedge.? If the speculator is undercapitalized, risks to the financial system rise.

This rule is pretty simple.? There are few places in the financial markets where there are naturally offsetting exposures that have not been remedied by an institution created for that very purpose, such as a bank.? In most cases with derivatives, the one that wants to reduce exposure relies on a speculator.? There are rare cases where the risk of one is the benefit of another, but situations like that tend to create new firms to internalize the trade.

The trouble occurs when the speculator can?t make good on his obligations.? As with many speculators, he overcommits.? He is short of funds because many trades are going against him at the same time.? It is in these cases that those who hedge learn to evaluate counterparties for their riskiness.

That is why it is worth knowing who is at the end of the chain in this financial game of crack-the-whip.? The status of the ultimate speculators, and whether they can make good on promises or not is a huge thing.? After all, subprime mortgages were downplayed by many as the crisis was rising, but they were at the end of the financial game of crack-the-whip.? They were one of the main classes of marginal borrowers.

-=-=-==-=-=?==-

Taking this a different way, this argues against the academics that look for complete markets in the sense of Arrow-Debreu.? There are trades that no one wants to take at any price that a seller could live with.? There are securities that can be created that no one wants to buy, at prices that are unprofitable to the securitizer.??? Complexity is a minus.? We can create securities that are the financial equivalent of toxic waste, but no one should pay much for them.? It is the price of creating safe securities.

No surprise: people pay a lot more for certainty, even if it is seeming certainty.? We see it in corporate bond spreads.? High quality borrowers borrow cheaply.? Low quality borrowers pay up. So what else is new?

What is new is the low-ish spreads for going down in quality.? This one could go either way; spreads are wide against history, but might be narrow against current difficulties.? The rebound has been rather sharp.

Note: this is reposted because of a system glitch.

Notes and Comments

Posted on 4 March 2010 by David Merkel

1) After reading a piece on Falkenblog yesterday, I decided to add up all of the profits from Fannie and Freddie over the last 20 years.? Ready for how much they made?? Ta-da!? They lost $114 billion.

When writing at RealMoney, I was always skeptical of the GSEs, and felt that they were too lightly reserved, because eventually they would run into a situation where real estate prices would fall.

2) Bruce Krasting comments on the solvency of the FHA.? I comment:

“I’ve argued that FHA would go negative for some time. Even the FDIC is engaged in a bit of chicanery by fronting future premiums forward to avoid borrowing from the Treasury.

We may avoid a banking crisis — at the cost of a sovereign crisis.”

3) I probably have a longer post coming on the paradox of thrift, that bogus concept that Keynes put forth.? But Paul Kedrosky crystallized it for me when he posted this.? And so I wrote:

The problem with the “paradox of thrift” is that it assumes there is only one way to save. Same for the “paradox of toil.” It assumes that all work is interchangeable and uniform.

The aggregation of all saving and all labor is necessary to make these models work mathematically, but isn’t valid in real life.

Yes, if everyone tries to do the same thing, stupid things happen, like bubbles from overinvesting. If there only a fixed possible number of tasks, and people work longer hours, it takes fewer people to do them.

But there are many opportunities, including ones that we don’t presently know about. Businesses that no one could imagine before the crisis can spring out of hard times.

This paper oversimplifies the economy. If the economy were that simple, he would be right. But the economy is not that simple.

4) I don’t know if the Volcker Rule will be eliminated or not, but I do know that the same ends could be achieved through changes in the risk-based capital formulas.? What I wrote:

The same ends of the Volcker Rule can be accomplished through adjusting the risk-based capital formulas ? Equity-like risks should be funded through a 100% allocation of equity. Few banks would take on that level of speculation at that level of capital used.

If you need proof, look at the life insurance industry. Companies used to hold a lot more equities prior to the tightening of RBC rules. Now they hold little, except at a few mutual companies that are flush with capital.

For another off-the-wall idea: ban interstate banking, and let the states rule all depositary institutions. Results: No more too big to fail, and you get back ?scaredy cat? regulators who don?t let banks deal in anything they don?t understand, which isn?t much.

That also has preserved the insurance business in this crisis, leaving aside mortgage and financial risks, where the state regulators still have no idea what they are doing ? that a proper reserve level would leave most of the companies insolvent today, but had it been implemented ten years ago, would have preserved the companies, but eliminated much of their profits.

But Life and P&C insurers survive the process because of RBC, and ?scaredy cat? state regulators. What a great system, which prior to the crisis, was criticized as behind the times.

PS ? if we ever get a national regulator of insurance, there will be a big boom and bust, much as in banking at present. It is easier to corrupt one regulator than fifty.

5) Is the stock market overvalued?? Probably, but consider this article here.? I wrote:

truth, P/Es are best related to corporate yields, not deposit rates or government bonds. And, you have to flip them to be E/Ps. Current E/P on the S&P 500 is 5.4%. A dividend yield of 2.05% is 38% which is close to the long run average.

The longest corporate series that I have is the Moody?s Baa series ? because of the growth inherent in stocks, for bonds to be the better deal versus stocks, Baa bonds need a 3.9% premium over the earnings yield, or a yield of 9.3% in the present environment.

So, I?ll take it back, because the present Baa yield 6.45% augurs in favor of stocks versus bonds. Not crazy about bonds in this environment ? few categories offer good risk-adjusted yields. Now, maybe both are overvalued vs. commodities, but that one I don?t know.

6) Perhaps the phrase “Greek Banking System” will be a cuss word someday.? Fitch recently gave them a downgrade, and I wrote:

Rating agencies exist to be scapegoats. When they are proactive (yes there have been eras where they have been proactive) the bond buyers scream ? ?Ratings are supposed to be good over a full market cycle!? When they are reactive, which is most of the time, they get accused of being coincident indicators.

They can?t win, which is why institutional investors ignore the ratings, aside from the capital charges that they force, and instead, read what the rating agency analysts write. The true opinion is in the writing, not the rating.

7)? Barry comments on how Goldman Sachs bags clients.? Truth, almost all investment banks bag clients, selling complex products that they understand better than their clients do.? My comment:

I always advise retail investors not to buy structured notes ? Wall Street offers an above-average yield, and has the buyer sell short some expensive option. You lose more in capital losses than you gain in interest on average.

This isn?t any different. It just that bigger players that should have known better are getting hosed.

There is no better defense than ?buyer beware,? and ?Don?t buy what someone else wants to sell you. Buy what you want to buy.?

Unless we want radical revisions to contract law, you are your own best defender.

8 ) One story with more sizzle than substance is put-backs, at least as far as it affects homeowners.? It was featured by Barron’s and picked up in a piece by Barry.? Investors that purchase a mortgage or any o=ther sort of loan have a limited window of time to give the mortgage back to those that they bought it from for full value.? My comment:

This seems to be useful for investors, but not for homeowners. Reps and Warranties claims can be enforced by investors that bought loans through securitizations. It does not help homeowners.

9) Jeff Matthews wrote a piece that was a little critical of splitting the “B” shares and Buffett’s logic on the Burlington Northern acquisition.? My comment:

I don’t always agree with Warren Buffett, but I do agree here. Index investors are passive investors. Individually, they are dumb. As a group they are smart, because they lower their investment costs.

Warren is also correct on Burlington Northern — it should be like his utilities, and throw off a growing inflation-protected return over time, allowing him to earn a spread over his cost of funds (negative) that his insurance enterprises generate.

He is still a bright man after all these years.

PS — I am a Calvinist Christian; the question asked regarding Jesus is not relevant to the short-term running of Berky, but is relevant to an Christian investor who cares about the ethics of the organization. Also, it is relevant to the long-term well-being of Mr. Buffett. The rest of us will have to face the results of that question one day as well.

10) The Developments blog at the WSJ hides in the shadow of better known blogs, but often puts up some really good pieces.? They recently did a piece on whether it is better to buy a home now or wait a while.? My comment:

Anytime you have an artificial deadline for losing a benefit, as the deadline draws near, behavior can become more uneconomic ? ?gotta buy before the credit expires.? Since one can?t see what the price of the house would be in absence of the credit, the higher price doesn?t get factored in. People think, ?If I want it, can I afford the monthly payment and make the down payment??

I suspect that if/when the credit expires, prices will sag on the low end by more than the amount of the credit. We?ll have to look at Zillow to get some hint on that if/when it happens.

11) An interesting piece from the WSJ regarding the fight between wind power providers and natural gas power providers in Texas.? Wind is inherently variable, and so can’t offer guarantees, which other power providers have to. My comment:

The logical way to end this is to align interests — have the wind power producers own some natural gas peakers to offset their variability, and then compete by offering a base load type of power more cheaply.

Or, let them enter joint ventures together, and split the profits. If natural gas and wind can work together they can offer cheap clean power.

12) Another post in the WSJ, asking whether Economics deserves the title “Science” or not?? My answer today is different than if you had asked me 25-30 years ago, when I was a student.? My answer today would be “no.”? Mathematics has added a gloss of seeming science to economics, but the models do not work.? Macroeconomic models don’t forecast well.? Microeconomic models do not explain human behavior well, let alone forecast.? And, models of development economics common when I was a student actually retarded development of countries.? And don’t get me going on Modern Portfolio Theory.? Anyway, my comment:

More to the point, until the economics profession abandons their macroeconomic models, and moves to something closer to ecological models, they won’t have a shot at understanding how things work. Economics has physics envy when it should have ecology envy.

And then, they will realize that you can’t come up with good mathematical models there either, at least not those that allow for prediction and control. Then we can bring economics back to what it should be, a non-mathematical discipline that attempts to explain how men act to gain/create resources to pursue goals.

13) Felix had a good piece on Buffett’s recent shareholder letter.? My comments, edited, because they did not post right:

Felix, for what it is worth, if Berky wanted to issue debt today, they would have to issue at around 0.75% +/- 0.15% over agency yields. More around 5 years, less around 30.

While I?m here, here are 2 curiosities ? Bloomberg?s DLIS function doesn?t work with Berky, which gives a list of maturities, probably because of all the nonguaranteed debt, and EETCs [enhanced equipment trust certificates] from BNSF.

But, using a download feature on Bloomberg off of [BRK Corp] a list is easily available. Sorting it by size of issue outstanding, what is fascinating is that most of the holding company debt has a short tenor. My estimate is an average maturity of 4.4 years and an effective duration of 2.8 years. 90% of it comes due by 2015.

Now, Berky doesn?t have that much debt at the holding company level, but it is remarkable that they are financing so much short. It is a negative arb, because he has a little more cash on hand than holding company debt.

The non-guaranteed debts of Berky are much longer ? an effective duration of around 8.4 years ? three times as long as the holding company debt.

I?m not sure if any of this is significant, but it makes me wonder what Buffett?s philosophy is with holding company debt.

It is a fascinating side of Berky.? Buffett could pay off all of his holding company debt with cash on hand but does not.? He pays a small price to stay flexible, in case he wants to make a big investment.

14) Finally, I’m going to be on the Ron Smith show today, talking about my recent piece on the finances of our Federal Government.? If you are not in the Baltimore area, you can listen here.? I will be on at 5PM Eastern.

Fear the Boom and Bust — an Economics Lesson

Posted on 29 January 201031 January 2010 by David Merkel

Ordinarily, I don’t think much of video on the web.? Writing is usually a more concise way to get a view across.? But video can be more effective if it gets past the genre of “talking heads,” in which case, one is usually better off reading a transcript.? Consider the State of the Union message as an example: regardless of who is president, would you rather spend an hour on it, of five minutes?? And, it would be five minutes where you are not distracted by the crowd, and can dissect things rationally.? I pick reading.

There are places where video can be useful, but it has to be well thought out.? I first saw the above video over at “The Big Picture,” which has enough readership to kick up a video’s viewings.? I thought it was clever, representing the economist’s views in a short catchy way, and capturing their philosophies? as well.? The next day, I showed it to three of my boys — they thought it was interesting, and mentioned it the next night at dinner.? My wife, incredulous at the idea of an economics rap video, then watched it the next night with all of the kids, while I cleaned up the dinner dishes.

Then the surprise happened.? “Dad, what are animal spirits?”? “Are animal spirits the bull and the bear?”

Interesting.? The video prompted questions from the children for me to answer.? I’ve written on Animal Spirits before, at least twice.? Animal spirits attributes irrational risk taking and avoidance to businessmen, as if they are irrational animals.

I told my children that businessmen are generally rational, and they make their decisions off of their own balance sheets, and the general willingness of the market to spend, which is related to balance sheets in aggregate.

The contrasts of the video are considerable:

Keynes is known, Hayek is unknown.? Desk clerk immediately knows Keynes.
The two men are hybrid in what they portray.? To some degree they represent the schools of thought that each was a leader of, and to degree the men themselves.
Hayek reaches into the hotel room drawer, and rather than finding the Bible, finds the General Theory. Similarly, Keynes says, “I am the agenda.”? This is a statement of the dominance of Keynesian thought in modern macroeconomics.? Keynes was important, but not as dominant while he lived.
Hayek assumes they will go via the subway.? Keynes hires a limo.? Keynes is worldly wise, having a great time, and Hayek is uncomfortable.? Keynes has alcohol; if Hayek is having alcohol, he is sipping it through a thin straw.
Alcohol is an allusion through the whole piece.? Stimulus is just more of “the hair of the dog that bit you.”? The boom is a good time where we drink freely, and the bust is where we deal with our hangover.? It was no surprise to see that the Bartenders were named “Ben” and “Tim” and that they were serving up alcohol for as long as the patrons would survive.? Even the pyramiding of the glasses had meaning — building up to a stuporous, unsustainable level.
Keynes holds money as he begins his rap, and throws it midway through.? It is an aspect of how incentives from the government or central bank can lead behavior for a time.
Keynes ends his rap with “We’re all Keynesians now.”? Keynes himself did not live to hear that comment uttered by Friedman in the ’70s.
Keynes and Hayek had different views on spending and savings.? On spending, Keynes didn’t think what money was spent on mattered, only that it was spent.? Hayek felt that intelligent spending would grow the economy more.? On savings, Keynes was negative, whereas Hayek said that moderate savings were valuable, and would facilitate future investment.
As for animal spirits, businessmen only get bold when they have sufficient free capital to act.? When interest rates are artificially low some businessmen invest, trusting that good times will continue.? Alas, those good times never last; avoid long commitments when times are good.
There are liquidity traps, but they occur when banking systems are broken due to misregulation.
“In the long run we are all dead.”? Well, Keynes, way to care for our progeny.? You had no kids, for a variety of reasons, but some of us care for how our children, and the nation that we love will do after we have died.

The video portrays a Goliath and David situation.? Keynes is dominant, and totally assured of his position in the world.? Hayek is less certain of himself, but certain in his message.

My wife and my kids have a better understanding of the current economic situation now than they did before the video came out.? I am grateful that the video was made.

Rationality versus Time Horizons

Posted on 16 January 201017 January 2010 by David Merkel

Would that there were one time horizon — a goal to shoot for, similar to the dispensationalists that plague Christianity with an announced date for the return of Christ.? But a major reason that the Chicago School (as well as the Keynesians) is wrong in their view of economics is that there are multiple time horizons that people consider.

Why one time horizon?? It makes the math simple.? It is similar to the foolish Modern Portfolio Theory which has one version of risk which bears no resemblance to risk in the real world.? Modern Portfolio Theory exists so that bright people who can’t interpret the real world can receive salaries and look smart.? What’s that, you say, Modern Portfolio Theory has a fixed time horizon?? Another reason to cast it over the edge.? It is useless.

There have been a series of interviews at The New Yorker with Chicago School economists to try to test them in their allegiance to the free markets.? There is a problem here in that what makes sense in the short run does not always make sense in the long run.

Bubbles develop from short-run thinking.? What has worked in the immediate past? will work even better in the future.? In hindsight, it sounds dumb, but remember that most people are imitative; they imitate the seeming success of others.? People are rational, but not rational in the way that most economists posit.? Imitating your neighbor is a logical move for many actions.? If he is doing something that looks good, it can make a lot of sense to do the same thing — e.g., asking for the recipe for the delicious meal you had at their house, as well as asking where they got a certain obscure ingredient.

Imitation conserves on thinking.? People avoid thinking, because it hurts.? “If it works for my loser brother-in-law, than it certainly will work better for? me,” is the way some think.? There is the implicit appeal to taking an action out of greed or jealousy.? Smart people avoid those temptations, and think for themselves, looking to the long term consequences of any action.

Momentum investors live on the short-term horizon; value investors invest for the long term — if success comes quickly, very good, if slowly, good.? The ability to wait is a plus, because the ability to wait allows for optionality that may produce more value.

Back to bubbles.? They usually exist because financing is too cheap relative to what financing costs on average over a full market cycle.? Lending or equity investing at such times goes on with little thought for what can go wrong.

“This junk bond won’t default.”

“This equity will grow into its valuation, and then some.”

But near the peaks of bubbles, two things happen.? The prices of the assets being financed are so high, that one borrowing to own the asset faces a negative arb — he has to keep paying to keep the asset afloat — the net yield is negative.? The second thing is that chatter becomes uncertain, and the pace of closing deals slows.

These are signs that the cash flows that the assets throw off are less than the cash flows needed to hold the assets.? Such a condition can only exist for a short time during a mania.? When the pace of deals slackens, and the arb is negative it is time to run, not walk to the exits.

If enough economic actors did this, bubbles would self-deflate.? But it hurts to think.? Valuation questions are tough, and it is much easier to mimic the seemingly successful actions of others.

Better it would be if the Fed, which is the main blower of bubbles through easy monetary policy, would pull back on policy when aggregate levels of debt in the economy get above 200% of GDP, or, would allow us to go through recessions where there is significant pain, and liquidation of bad investments.? But no, during the bubble years, Greenspan was lionized for keeping the economy going smoothly — limiting the impact of recessions.? All that time, debts kept building up until the ratio far exceeded that achieved during the Great Depression.? Now Bernanke is lionized for increasing the Debt/GDP ratio while shifting debts from private to public hands.? He has saved us from the final reckoning of debt service.? Now what will the US Government do as its total obligations pass 4x GDP and head toward 5x GDP?? As I have said before, we are in uncharted waters here.

Debt is not neutral.? It creates inflexibility in the economy, because an economy built on fixed commitments has higher bankruptcy risks than one built on equity commitments.? Real reform would force banks to delever.? It would force the US Government to delever.? Real reform would get the government out of the prosperity business (it has never been good at that), and get it to focus on areas where it can make a difference — justice, defense, public health, and other public goods.

One simple solution: phase out the deduction for interest expenses, and phase in a deduction for dividends (preferred dividends would be at 50%).? Disallow trust preferred and hybrid debt structures.? Make finance more transparent by eliminating complex structures, and limiting all derivative transactions such that only hedgers may initiate transactions.? Transactions between two speculators should be regulated as gambling, because that is what it is.

If the government is not willing to take actions that hurt those being regulated, they are not worthy of being called a government.? The government should look out for the best interests of the nation as a whole, regardless of whom it might seem to favor.

Once again, back to bubbles.? Bubbles don’t get popped by the powers that be because the powers that be like bubbles as they are inflating.? Who would be a humbug and stop the sunbeam of prosperity when it is shining with full power?

But when the deflation of the bubble happens, everyone points the finger outward, few point at themselves.? Let Messrs. Greenspan, Paulson, Geithner, and Bernanke, among others, come before the cameras and apologize for their mismanagement of the US economy, and, let them suggest that the government get out of the economy business, because the government has consistently failed there.

To come back to the beginning of this article, the fetish of rationality exists in economics because the math doesn’t work without it.? Many tests of rationality have failed, yet the profession does not give up, because their skills are useless if man is not economically rational.

It is time to unemploy a lot of economists.? Unemploy them at the Fed; if we don’t eliminate the Fed, at least let’s slim it down.? Unemploy them at universities and colleges.? Let the business departments teach practical economics, and close the economics departments themselves.

The failure of Keynesian, Chicago School, and Neoclassical economics in this present crisis is severe.? We need a new economic paradigm to replace the failures that exist within our universities.

Neoclassical economics will fail; I may not live to see it fail, but it will fail.

My TIPS, Treasuries, and Inflation Model

Posted on 23 December 200923 December 2009 by David Merkel

I finished the first phase of a project today.? But first let me tell you a story.? It was 1990, and the Society of Actuaries Investment Section was holding a conference.? It was a great conference; I still have the binder from it.? There are few meetings from twenty years ago that still have relevance for me.

One of the presentations was by Stanley Diller, a managing director of Bear Stearns, who insulted all of the actuaries at the conference by telling them the the insurance industry was dead wrong for talking about yields and spreads.? Everything was duration and convexity, and those that did not understand that would lose.

He ended his presentation suddenly, did not take questions, and stormed out of the room.? I’m not sure why, but I had a seat in the back, and intercepted him.? I said, “You can’t just say this and not give any justification for your views, how do you back it up?”? He thrust a business card into my hand and said, “Call my secretary, she will send you the info.”? He stormed away.

The next day I called the secretary, and she told me she would send the information.? Two days later, I had it, and a few days later, I had replicated it in my own model.

Since then, I have used the model profitably many times.? Today I use it to describe the yields in Treasury Notes and TIPS.? I have used it to produce an estimate of future inflation expectations.

Using closing prices, here is my estimate of the coupon-paying yield curve:

And here is the spot curve (estimating where zero coupon bonds would price):

And finally, the forward curve, which estimates the expectations of future short-term rates, inflation, and real rates:

Pretty neat, huh?? Let me tell you a little about the model:

Values are as of the close 12/22/2009, but the model can be run in real time.
It is estimated from the full coupon-paying Treasury Note and Bond markets — over 200 bonds in the model.
The model estimates a nominal spot curve, fitting prices with 4 parameters, over 99% R-Squared.
The model estimates a forward inflation curve, fitting TIPS prices with 4 parameters, over 99% R-Squared.
The two models are estimated jointly, through nonlinear optimization.
The model has one constraint — nominal spot yields must be positive after 4 months.
Every other curve is derived from those two curves.

What are the useful things that we learn from the model?

There are mispricings in the Treasury and TIPS curves, but they are typically small, and would be hard to make money off of.? That’s? demonstrated by the high R-Squareds.
The Fed has achieved its goal of making real rates negative in the short term.
And, has made made nominal rates negative for some very short instruments inside 6 months of maturity.
Inflation expectations start low, and peak around 2022, then tail off.
Long term inflation expectations are still under 3.5% — ignore the portion of the inflation and real curves after 23 years, they are extrapolations.
Implied short-term real yields go positive in 2011, peak in 2024 and tail off thereafter.
The nominal forward curve is steep as a mountain on both sides.? Though there is a lot of fear over what will happen over the next 12-14 years, those fears have not been built into the prices of longer-dated Treasury securities.
The nominal spot curve peaks after 22 years — in my experience, that is normal, and is a reason why longer nominal note yields decline.? US Treasury — take note.
Inspecting the differences between coupon-paying yields on Treasuries and TIPS makes inflation expectations look more tame than they really are.? Federal Reserve — take note.
30-year TIPS would likely fund cheaper than 20-year TIPS — US Treasury, take note.? The scarcity value would help as well.

This is just the beginning.? I’m not planning on writing about this every day, but I should be able give you some updates every now and then.? Hopefully the firm I work for should be able to benefit through research that this enables me to create for institutional clients.

Full disclosure: I own shares in Vanguard’s TIPS fund.? And truth, we all own Treasuries somewhere if we look deep enough. 😉

Book Review: Where Keynes Went Wrong

Posted on 28 November 200929 November 2009 by David Merkel

When I was a grad student, I always felt weird about Keynes.? I grew up in a home that was not explicitly “free market” but was implicitly so.? My Dad was a small businessman and my Mom was a retail investor (as well as home manager).? My Dad’s business did well, but it had its share of hard times, including the depression of 1979-1982 in the Rust Belt, where many of his competitors did not survive.? He had to be a member of the local union and run a closed shop, but as an owner, he had no vote in union matters.

I worked for my Dad for two summers.? During one of them, when we went to get parts, the parts dealer said to me,”I’ve heard good things about you.? Even the union steward has heard about you.”? My face and my Dad’s face went white. I was not in the union. After an uncomfortable pause, he said, “Eeeaaah! Got you!” and he laughed.? Dad and I looked at each other, embarrassed but relieved.

My Mom, like Keynes, and like me, has beaten the stock market for most of her life.? There are excess profits available for wise investors, some of which stem from the foolishness of other investors.

Keynes was a fascinating man who understood asset markets well, but when trying to consider the economy in general, looked to what would work in the short run.? The author of Where Keynes Went Wrong points out repeatedly from Keynes’ writings his view that interest rates are almost always too high, and that interest rates should only rise when inflation is rising quickly.? Can lowering short term rates juice the economy.? Yes, in the short run, but in the longer run it fuels inflation and bubbles.

The strength of Where Keynes Went Wrong is that it spends a lot of time on what Keynes actually said, rather than the way Keynesianism developed into a branch of Macroeconomics, eventually becoming part of the dominant macroeconomic paradigm — the Neoclassical Synthesis.? I admit to being surrprised by many of the statements Keynes made — granted, the author is trying to prove Keynes wrong so he goes after what is least defensible.

The author dissects the errors of Keynes into a few main headings:

Lower interest rates are almost always better.
Growth comes through promoting consumption.
You can’t trust businessmen to do the right thing when it comes to capital allocation.
Government planning is superior to decentralized planning, because experts in government can allocate capital better than businessmen.
Crashes require government intervention.? Using the balance sheet of the government will have no long run negative impacts.
Markets do not self-correct.
Globalization is good, and the nations of the world can cooperate on creating a standard of value independent of gold.

For the most part, those are my words summarizing the author.? After going through what Keynes said, he then takes it apart point-by-point.? The author generally follows the Austrian school of economics, citing Mises, von Hayek, and Hazlitt.

After that, the book continues by taking on the rhetoric of Keynes, both oral and written.? He was one sharp man in being able to express himself — orally, there were few that could match him in debate.? In writing, where time is not so much of the esssence, there is more time for readers to take apart his arguments, and point out the fallacies.? The author points out much of the fallacies in how Keynes would argue his points.

The book finishes by pointing out the paradoxes involved in Keynesianism, e.g., in order to reflate a debt-ridden system, the government must lower rates and borrow yet more.? Also shows how beginning with manipulating the money supply leads to greater intervention in credit, banking, currency, and other economic policies over time, and why the politicians love the increase in power, even if they realize that the policies don’t work.

One surprise for me was how many ways Keynes suggested to intervene in a slump, and how many of them are being used today.

Rates down to zero.
Direct lending by the Fed.
Directing banks to make certain loans.
Bailouts.
Nationalizing critical companies.
Inflating the currency.

The idea of letting the economy contract in any way was foreign to Keynes.? He felt that a seemingly endless prosperity could be achieved through low interest rates.? Well, now we have low rates, and a mountain of debt — public and private, individual and corporate.? Welcome to the liquidity trap created by Keynesian meddling, together with the way our tax code encourages debt rather than equity finance.

I recommend the book; it is an eye-opener.? It makes me want to get some of Hazlitt’s books, and, read the whole of Keynes General Theory for myself.? The book that my professors once praised as a tour de force has holes in it, but better to read it all in context.

Quibbles

The book could have used a better editor.? Too many things get repeated too often.? The book also has two sets of endnotes, one for reference purposes, and one for expanded discussions.? The endnotes that were expanded discussions probably belonged in small type at the bottom of the page rather than as endnotes.? Many of the endnotes are quite good, and it is inconvenient to have to flip to the back to see them.

Also, on page 274, the author errs.? The risk to a business owner is higher after he borrows money.? The total risk of the business is not higher, but the risk to the equity owner is higher.? Whether that risk is double or not is another question.

There’s another error on page 328.? When I buy stock in the secondary market, I am putting my capital to work, but someone else is withdrawing capital from the market.? There is no net investment.? When I buy an IPO, not only do I put my money to work, but there is more investment in the economy (leaving aside the venture capitalists that are cashing out).? It is hard to say when investment in the economy is increased on net.

The table on page 330 is confusing.? The first row should have been set apart to show that GDP is not a government obligation.

Finally, I don’t think that Say’s Law (“Supply creates its own Demand.” Or in the modern parlance, “If you build it, they will come.”) is true, but neither is its converse (“Demand creates its own Supply”).? The two are interconnected, and either one can cause the other.? Markets are complex chaotic systems, and entrepreneurs sometimes produce goods that no one wants.? Similarly, when consumers discover a new product or service, that demand can help create a whole new industry.? Supply and demand go back and forth — the causality doesn’t go only one way.

Who would benefit from this book: Send it to your Congressman, send it to your Senator.? Make sure every member of the Fed gets one, and the fine folks at the Treasury as well.? Beyond that, think of your liberal friends who think of Keynes as a hero, and give them one.? After reading this, I want to add Keynes’ General Theory to the list of books the everyone cites, and no one reads.? (That list: The Bible, Origin of the Species, The Communist Manifesto)

If you want to buy it you can get it here: Where Keynes Went Wrong: And Why World Governments Keep Creating Inflation, Bubbles, and Busts.

Full disclosure: I review books because I love reading books, and want to introduce others to the good books that I read, and steer them away from bad or marginal books.? Those that want to support me can enter Amazon through my site and buy stuff there.? Don?t buy what you don?t need for my sake.? I am doing fine.? But if you have a need, and Amazon meets that need, your costs are not increased if you enter Amazon through my site, and I get a commission.? Win-win.