The takeaway: Germany is pot committed

The short-term market reaction to the Spanish bank deal should not blind us to the important longer-term implications: Germany is now pot committed.

Most of you know the poker term, I suspect. Pot committed is when you have bet such a large percentage of your chips that you cannot fold your hand. You are not all-in yet, but you eventually will be unless the others fold. (“Crossing the Rubicon” has roughly the same meaning, but seemed a little too evocative in the present context).

The Spailout, as it is being called, is the biggest one-shot resource commitment the EZ has made in this crisis. In fact, the commitment seems somewhat open-ended. And it is the first one explicitly made (SMP purchases are really indirect) to a large EZ member state. Moreover, reading between the lines of the official statements from inside and outside the EZ indicates a fairly high degree of commitment to going further and forging a banking union. There are increased murmurings of fiscal union as well. Greece may be already outside the circle of trust, but all this suggests that the EZ—and Germany—very much wants the rest of the EZ to be indivisible.

I have serious doubts about the feasibility of these ambitions, but this is not germane to the point here. What is germane is this: If Germany is indeed pot committed, and you believe as I do that the other players are not going to fold (i.e. the crisis will continue), then we now know on whom the peripheral countries will default.

It will be the official sector and local banks, where the risk has been increasingly concentrated with each round of official intervention. The supranational institutions take down a lot of the bad assets, plus Spanish banks buy the Spanish debt, Greek banks the Greek debt, Italian banks the Italian debt, etc. This is, has been and, we now know, will be the dynamic.

Whether the bulk of default falls on the official sector and local banks, or the default falls on markets makes a big difference for contagion beyond the defaulting countries. If market participants are levered long troubled assets, or own troubled assets and are elsewhere leveraged—as was the case for markets pre-Lehman—contagion will be severe and collateral damage great. If, on the other hand, the official sector and the local banks (de facto official sector) own the bulk of the risk and market participants are not, in general, highly leveraged, the consequences—while still brutal for the defaulting countries—will not propagate through the rest of the financial system with anywhere near the same violence.

I am not arguing there will be decoupling. But for a number of months now I have been trying to gauge on whom EZ defaults will fall, the private sector or the official sector, because, ceteris paribus, the contagion implications are vastly different. And now I have my answer: Germany is pot committed, and the other players are not about to fold. This might not be fair or even efficient, but it matters a lot for eventual burden sharing, and on this count we just found out that markets are going to come out well ahead.

Quick market comment on the Spanish rescate

The Spanish loan and the statements around it are a big deal, IMO. That a deal for Spanish banks was in the works has been clear. What the statements and official comments have brought into sharper focus for me is how much commitment there already is to build a banking union and, in the more distant future, fiscal union.

The takeaway, however, is not that I now think they are going to make it, at least not to fiscal union. Nor do I think this will materially change Europe’s fatal flaw: its growth prospects. But there are two significant positive implications from a market perspective:

  1. It is now more clear to me than ever that the bad risks in the system will migrate fairly fully to the balance sheets of the public sector (either explicitly of by contingent liability) by the time this is over.
  2. They’ve bought themselves another chunk of time.

Together, this suggests that when—X years from now—the peripheral countries realize their growth trajectories are insufficiently robust to get them out from under their debt burdens, and some enterprising politician tells them they should not subject themselves to the Nth round of belt-tightening, the reverberations through markets when countries leave the single currency will be much less than they would have been if markets hadn’t already largely passed the hot potato to the public sector.

Bernanke, breakevens, and volatility

I was surprised when I saw Tim Duy’s post, via Mark Thoma (Tim Duy is a blogger and economics professor at the University of Oregon) that took Bernanke to task for his poor management of market-based inflation expectations since the 2008 crisis.

This is what he says:

“Bernanke doesn’t appear to see that the inability to hold market-based inflation expectations at a consistent level as a problem:

 

What’s wrong with this picture?  Notice the volatility of expectations after the recession (Ryan Avent has made this point as well).  The Fed claims to have some mythical “credibility,” but it certainly isn’t evident in this graph.  If anything, it is clear that the Fed has failed miserably in establishing credible expectations for either 2 percent or stable inflation.  Instead, what they have created is very unstable expectations because of start-stop policy.  It is almost ludicrous to place so much blame on Congress for the unstable fiscal picture when they themselves are creating an unstable financial and economic environment.”

Psychological testing has shown than in building a story what matters most is not the completeness or quality of the information set, but rather its coherence relative to one’s priors. In other words, simple wins. And I’ll take this a step further: often the less we know, the easier it is for us to build a coherent story. (This is yet another well-kept secret of the money management business). The bottom line is that if a story is simple and intuitively compelling, it is fiendishly hard to disabuse people of it, no matter how false it might be. (Why do you think it was so hard for NBA talent scouts to give Jeremy Lin a shot?)

One would have thought that academia would be one of the spheres in economics best insulated from this confirmation bias. Evidently not.

I have three problems with his assertion.

The first is the premise.  The volatility patterns exhibited in his graph of 5-year and 10-year breakevens (the Fed’s preferred market-based inflation expectation input is the 5-year breakeven, 5-years forward, commonly denoted as 5y5y breakeven) is no different from the volatility pattern is ALL markets since the crisis. A good proxy for this is the VIX.

 

You will note that the pre-crisis average level of the VIX was 14.3 percent (green line), while after the crisis (using the same date used in the first chart) jumped to almost 23 percent. Moreover, as one might expect after a crisis, the volatility of the volatility also increased significantly.

In fact, as a market participant, I recall thinking in early 2009 how remarkably stable market-based inflation expectations were, given the prevalence of the fear of hyperinflation and overall levels of market volatility. You can get a sense of just how prevalent the talk of hyperinflation was if you look at the timeline of Google search for that word:

 

Second, at these levels of inflation, it is pretty clear that any volatility in market-based inflation expectations is the tail and not the dog. And the dog is doing all the wagging. What I mean is that variations in inflation at low levels have little negative effect on economic growth. At these levels the causation, empirically, runs from growth to inflation expectations, not the other way around.

We frequently hear in market commentary that every tick up in inflation is a tax on the consumer and every tick down is a windfall. But that’s not so much the case here at these levels of inflation. In reality, the level matters. A lot.

From low levels, upticks in inflation levels tend to indicate an increase, or an expected increase, in economic activity. And downticks, especially when growth is punk, are bad. The structural break in this relationship comes, again empirically, when inflation gets north of, say 5-8 percent. At this point the function that relates inflation to economic growth goes non-linear and the effects of inflation get very bad very quickly. So even if inflation expectations were more volatile, as long as they are well south of 5 percent it is not likely that they do much damage.

The third issue is conceptual. I could imagine someone looking at the chart of the VIX and the chart of breakevens and saying, okay, there was volatility in all markets, but that too was all Bernanke induced. And there may be some truth to that. But after a shock or crisis, normalization in markets typically follows the pattern of what is called disaster myopia: the acute memory of a disaster leads us to overstate the probability of its recurrence. In markets, that means volatility stays in the system. Volatility of the volatility stays too. Then, over time, as the memory fades, we progressively ratchet down our fears. (And, if a long enough time has passed, normalization eventually crosses over into complacency, FWIW.)

This is the pattern that you would expect to see across markets after a financial crisis like the one we had in 2008, and indeed, that is what is happening. Fear of the next Lehman, or the ‘next shoe to drop’ are waning, spasmodically, but waning. Hopes of a V-shaped recovery have exhibiting a progressively less amplitude as well.

Though there is much debate over whether the Fed has done too much or too little, it is hard to imagine that a radically different policy approach from the Fed would have led to a markedly different behavioral pattern, or to a rapid return to pre-crisis levels of volatility.

How you can go broke taking profits. Really. Reflection effects.

How many times have we all heard the line “You can’t go broke taking a profit”? Unfortunately, it’s dead wrong. Perhaps the dirtiest of secrets amongst professional money managers is that ideas—the primary basis on which they sell themselves to clients—come in third behind risk management and portfolio construction in generating replicable returns.

It doesn’t matter how much you explain to clients the centrality of risk management, they obligingly nod, wait for their turn to speak, and say, “Oh, that’s great, Mark. Very nice. And you were great on TV last week. Now, what do you think about the euro here?” Clients, like traders, crave stories. They want to believe the people to whom they entrust their money are genetically superior, multi-lingual polymaths. We managers want to believe this about ourselves, too.

But the truth is that in addition to loving stories we are all hard wired to be poor risk managers. Behavioral studies show that we are risk adverse when it comes to losing money, but we take on much more risk when we are trying to ‘get back to even’. This is referred to as the reflection effect (Tversky and Kahneman, The framing of decisions and the psychology of choice, 1981). Translated in trading, this means we tend to harvest profits too early, and tend to let our losers run. This is where the famous “I’ll sell it when it gets back to where I bought it” comes from. The reflection effect generates negative payoff asymmetries

One of the most important risk management tools I know, therefore, is doing the opposite: generating positive payoff asymmetries. Risking one to make three. Risking two to make five. This is what good traders do, even if they claim their P&L comes from superior intellect. And, of course, if a trade breaks your way you can use trailing stops and/or other techniques to improve your payoff asymmetries even further.

So, what one really needs to do is set up trades so that winners run and losers are dumped quickly. Think about the math. If you are risking one to make a minimum of three, and your ideas are right 50 percent of the time, you will be doing very well. In fact, your batting average could be far less than 50 percent and you’d still make money. If you regularly take profits quickly, as nature (and the aphorism) would have us do, your batting average would need to be far higher. Anything that appeals to our instincts to take profits quickly is likely to make us worse traders, not better. And trading is hard enough as it is.

This may seem obvious, but if it were that obvious, no one would ever again say “You can never go broke taking a profit”. Ever.

Euro. It’s a Design flaw. And it’s fatal

Eduardo Porter captured the sentiment of many in the run up to the launch of the single currency when he said this the other day in The New York Times: 

“Virtually every economist on this side of the Atlantic – and most of those on the other – figured out that the euro would be fatally flawed.  What took economists some time to understand was that Europe’s leaders didn’t much care what they thought.”

The Book List

I’ve been getting a lot of requests for a book list on behavioral economics, finance, etc. I promised a few of you I would post one.

Here are what I find to be some of the best books on these subjects. I picked books that are aimed at the intelligent reader who does not necessarily have specialized training in economics, sociology, or evolutionary psychology.

But I would also suggest you start with the 30 minute video of Daniel Kahneman’s Nobel price lecture. Videos are always easier than books, and it’ll open your eyes to our cognitive limitations as a species. Yes, that means you, too. Especially you.

Daniel Kahneman’s Nobel lecture

James Montier, The Little Book of Behavioral Investing

 Dan Ariely, Predictably Irrational: The Hidden Forces That Shape Our Decisions

George Akerlof and Robert Shiller, Animal Spirits: How Human Psychology Drives the Economy

Richard Thaler, The Winner’s Curse: Paradoxes and Anomalies of Economic Life

Eduardo Porter, The Price of Everything: Solving the Mystery of Why We Pay What We Do

David Brooks, The Social Animal: The Hidden Sources of Love, Character, and Achievement

And, my favorite all time book—though I don’t recommend this if you are interested exclusively in how behavior affects finance, and only should be read if you have a hard-core interest in evolutionary psychology—is:

Robert Wright, The Moral Animal

Since I first put this book list together, Daniel Kahneman came out with an accessible version of his life’s work, Thinking Fast and Slow. I highly recommend it. I have read many of his papers over the years, but this book is by far the most jargon-free of anything I’d seen from him.

Lastly, if any of you are interested in Africa, or economic development, I would recommend you the best, least politicized book I have read on the subject: Paul Collier’s The Bottom Billion: Why the Poorest Countries are Failing and What Can Be Done About It.

Happy reading.

IMF and Spain – putting on the face paint

A quick note on how the IMF works with its member countries (in this case, Spain).

The IMF is always monitoring its members. There are teams with desk officers assigned to each country. They track all the data, news, policy measures and political backdrop. As times get tougher in a particular country, or set of countries, the resources allocated to tracking increase. Communication with the member is also stepped up.

If things get bad enough and/or the country is systemically important enough, the IMF will “war game” contagion effects. They will also get as prepared as they can for “the call”, the moment when the authorities of the member country formally ask for assistance in putting together a program. A country asking for a program has a stigma attached to it—especially for a wealthy, developed one. So the IMF is painstakingly scrupulous about “not getting out in front of” a member request. This is what is going on here.

So, up until “the call” the IMF will publically say “we are not in talks with country X about a program”. This may lead to some confusion because many wrongly infer preparations are not being made. But they are. They always are.

The IMF is an extremely professional organization. The most impressive bureaucracy I’ve ever seen (and I’ve seen a lot of them). Trust me; they are putting on the face paint.

More Greek Cognitive Illusion: What they really think about Germany

A quick update on the post about Greece and cognitive illusion when under stress from Tuesday. I mentioned one of the most powerful attributes of human nature is our insidious, and often subconscious, ability to shift blame to others when things aren’t going well. Another thing we do is take shots at others’ success.

For example, here’s a slide from the results of a recent Greek survey of “Greek Public Opinion about Germany and its policy”, from VPRC, an Athens-based public opinion survey consultancy.

Basically, Greeks surveyed attributed 51% of Germany’s economic performance to corrupt foreign practices, and only 18% to its competitiveness. If this is truly the mindset, this should be a warning to those suggesting Greece could reduce its financial burden by pledging, privatizing, or somehow monetizing its assets. Not gonna happen. And any political support for doing so is going to decline, not increase, as the pressure to leave the single currency continues to mount.

Reagan’s gone. You’re old. Get over it.

“We might as well require a man to wear still the coat which fitted him when a boy as civilized society to remain ever under the regimen of their barbarous ancestors”, inscribed inside the Jefferson Memorial

Though it is hard for anyone to take their eyes off of Europe these days, I came across blog posts from Kevin Hassett of AEI and John Taylor of Stanford that really jumped out at me, for the same reason. Both of them were pining hard for a return to Reagan’s world. They argue austerity and supply-side policies across the developed world would, if given enough time, right the ship by freeing up resources for the private sector…okay, I see I’ve lost you. You’ve heard this debate so many times before that your eyes reflexively gloss over. But my argument is different. It’s simple.

It’s about how individuals behave. Rather than assume their policies always work, it would have been much cleaner if Hassett and Taylor started with the question: under which circumstances would supply-side policies be most effective? Then you could see whether those conditions actually obtained in the current environment.

Basically, supply-side policies work best when there is pent-up private sector demand. By lowering the cost of investment, you can unleash a self-reinforcing cycle. The bigger the pent-up demand, the bigger the payoff to an improvement in expectations. Without that pent-up demand, resources freed from supply-side measures and austerity get saved, not spent, and no self-reinforcing cycle is triggered.

The world of 1980 had tons of pent-up demand and gale-force tailwinds. Inflation and interest rates were coming down from high levels, household leverage was very, very low, financial innovation non-existent, consumption had been deferred, and demography was coiled as the baby boomers were just coming on line. On the government side, unions were powerful, price and wage controls were a reality, and tax rates were high. This was the ideal set up for supply side reforms.

Fast-forward to post-2008. Whatever the opposite of pent-up demand is, that’s what we have. Inflation and interest rates are already low, household leverage is a major burden, consumption was pulled forward during the boom, and demography is no longer our friend. Plus, we have globalization acting like a supply shock to our labor pool, holding down wages. In short, the tailwinds are now headwinds. On the government side, unions are far less powerful today, there are no price and wage controls, and tax rates are low. It seems next to impossible to make the case that supply-side policies can have anywhere near the effect today that they had in the 80s.

Yet, so many still do. Much of our body politic is stuck—along with the bulk of the baby boomers—in the 1980s, still trying to relive those old battles in the rear-view mirror. The US has changed. The world has changed. The problems have changed. The emerging world is rapidly plugging into the grid, hungrier and willing to work for less. We need to be pragmatic. Adjust and compete. Look around the globe without preconceived notions and see what we can learn from others. Being stuck in the same old big government/small government debate keeps us from doing this. Sometimes supply-side policies are right and sometimes they’re not. Sometimes Keynesian polices are right, sometimes they’re not. Until we approach policies as tools in a toolkit and not as divine scriptures, we are going to be stuck in an ideological logjam, wasting precious time. Time to get off the ideological paradigm.

We have explained in previous notes that interest rate cuts may not help, but Chinese policymakers have a way of circumventing this systemic inefficiency by calling on the animal spirits of local governments to generate investment demand themselves.

SocGen’s Wei Yao.  (via ftalphaville)