Author: Mark Dow

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 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.

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.”

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.

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.

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.

“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.

Joe Wiesenthal at Business Insider put out a quick post this morning on the Pew Research Center study, “European Unity on the Rocks”, released today. It is an eye opening read.

To start with, it strongly supports the working hypothesis of many that the political forces now unleashed in Europe are centrifugal, not centripetal. This reality makes betting on solving the crisis through a deepening of the EU a longshot whose odds are getting longer by the day.

The main thing the report underscores to me, however, which also jumps out from Wiesenthal’s post, is the extent to which human nature is gifted in self-deception, especially when under duress. But more on Europe below the fold. First, a word on behavior.

Starting about 15 years ago, I developed a strong interest in behavioral economics and evolutionary psychology. This came about when I started working in asset management and realized (1) how poorly economics was served by the assumption of ‘man as a rational maximizer’ and (2) how emotional and inefficient markets really were.

In the literature I ran into four takeaways time and time again. Specifically:

We overestimate our abilities, our uniqueness, and our objectivity, even more so when under emotional strain. We have all seen the studies: 90% of people say they are above average drivers. Rarely do people think those around them work harder or better than they do. And so on…

We systematically understate the role of ‘random’. We crave order, and we are willing to torture the facts to get there. But sometime things just happen, and sometimes problems don’t have solutions. No fundamental cause, no guilty party, no concrete answers. Moreover, on the up side, when random does break our way it’s appropriated as skill. The investment world is shockingly bad at separating outcome and process—yes, even those who drone on and on to prospects about their processes.

People will find a way to believe what they are incented to believe. As the saying goes, “The most dangerous place to stand is in between someone and what they want to believe”. In my experience, it’s hard to overestimate the power of this statement. Starting with the conclusion and reverse-engineering the supporting arguments is central to the human condition and, surprisingly, serves an important role in our evolution.

When presented with points 1, 2, and 3, almost everyone recognizes their validity, but believes at some level that he/she is exempt. The typical reaction is “Yeah, for sure, of course that’s how [other] people act”. It is always easier to see others’ mistakes than one’s own. And this is one of the reasons we have a very hard time changing our cognitive biases. All of us.

Now, back to the Europe and Greece.

Here’s the table that was screaming of self-deception:

Look at the first column. Once the giggles have subsided, and you’ve shown it to your colleagues so that they can share in the derision, don’t you wonder how it is that Greeks—and only the Greeks—believe they, and not the Germans, are the hardest working people in the Eurozone? Okay, you may be tempted to think it’s somehow a mistake. Or you might consider for a sec whether tax evasion and statistical manipulation is somehow considered work by the Greeks surveyed. But, most likely, the answer is Greeks at this stage of the crisis are deep into a siege mentality. They increasingly see themselves as victims, with their suffering exacerbated by the demands of outsiders. They are simultaneously trying to buck themselves up by convincing themselves of their stoicism in the face of this onslaught and lashing out at those who they perceive are doing them harm. Perfectly in tune, the report finds that “Anti-German sentiment is largely contained to Greece, at least for the moment”. We know the Greeks have long been lying to the EU. The table shows that they are now lying to themselves as well.

There’s also an important side point here for sovereign analysis. There is a tendency to listen more to the people in the country being analyzed. It is presumed they have ‘better information’ and understand better how things work. But what I have learned in my experience with sovereign crises over the years is that whatever informational advantage they have is usually more than offset by (1) their difficulty in distinguishing between things that matter and things that don’t; (2) the psychological baggage with respect to their own past, and (3) the often emotionally-charged nature of their perspective. Shorter: never ask a Brazilian about Brazilian inflation risk.

The third column tells us something else about human nature. Five out of eight countries chose their own country as the most corrupt in the survey. Why? I, for one, still haven’t been to a country where people complain they are being taxed too little. Similarly, I hear in virtually all countries going through rough times that they could solve their problems if they could only end corruption in government. This is the height of wishful exculpation. It also ignores the fact that China has grown spectacularly over the past decade, despite what many believe to be a highly corrupt system. And, even if it were true that corruption were the primary cause of a country’s ills, it also ignores the reality that government is usually a reflection of a country’s culture, and changing the politicians doesn’t change the incentive structure that gives rise to corrupt behavior.

What politicians can be blamed for is opportunistically tapping into our cognitive weaknesses. At this, they are ruthlessly efficient. Having observed politic cycles in countless countries over the past 20 years, I have boiled campaigns down to a three point message.

I feel your pain. Politicians need to connect, to empathize convincingly. Or, to paraphrase George Bernard Shaw, they need to be able to fake sincerity.

You deserve more than you are getting, and it is not your fault.

I’m gonna get the bastards who are keeping you down. Northern Italy accuses the laggard south of holding them back, and minimizes the role of northern tax evasion. Southern Italy thinks the north is deliberately holding the south down so the spoils—whatever those may be—can accrue exclusively to the north. I also remember, back in the day when I played a lot of pick-up basketball in Washington DC, my black teammates telling me about “The Plan”. You get the gist…

You can fill in the details about what you should be getting, and who is keeping whom down, but I have seen this formula play out, time and time again, from Equatorial Guinea to the United States. The bottom line, brutal though it may be, is that when in pain human nature is well equipped to convince itself that the group it belongs to is not to blame and then to find another group at whom to lash out. And while politicians are less responsible for crises than we are inclined to allege, they are certainly there to pitch themselves to us opportunistically in our moments of weakness.

As things continue to heat up in Europe, expect less rationality, not more—especially from the countries deepest in the pressure cooker. And, be on the lookout for more, not fewer opportunistic politicians.

People seem to be settling into the view that China is slowing down. How much, how fast, and whether it is cyclical or something more secular like the lower-middle income trap or a Lewis turning point is still very much the subject of debate.

I find it at odds with this growing impression, therefore, that so many investors and analysts seem to be clinging to high growth forecasts. The Chinese government only tweaked its forecast lower to 7.5% for this year, while I would cuff the mean private sector forecast at slightly higher.

But the underlying argument of the panda huggers seems to be drifting. Until recently, many were essentially citing the power of the conditional convergence growth hypothesis as the reason China’s slowdown would be shallow and ephemeral. Lately, however, the defense of Chinese growth has been shifting toward the argument that any slowdown could and would be countered aggressively by monetary and fiscal stimuli, as was the case in 2009, thereby keeping growth robust and any slowdown firmly under control.

While I am by no means a panda mugger, I do think that there is significant room for further disappointment for two reasons: (1) the secular slowdown in China’s growth rate looks to be greater than most analysts are currently factoring in and (2) China has far fewer financial and political degrees of freedom with which to combat the cyclical elements of the current deceleration.

The secular case—China’s growth rate will be much lower and much more volatile:

1. Base Effects.  China’s growth has been nothing short of parabolic. When you have over a billion people and a USD$1 trillion economy, it doesn’t take much to generate huge productivity gains, and you can grow at 15% while still being a price taker in global markets. However, when your economy is USD$6 trillion and your dollar growth is 15% (Chinese GDP + inflation + FX appreciation) you have become a price maker and the supply function with which your burgeoning demand is met is no longer so elastic. This curtails growth. (For a fun related interactive graphic, go here.)
2. Demography. The Prime worker ratio (working age population, 20-59, divided by those 60 and older) is currently at 5, but projected to be at 2 by 2035. (Japan went from 5 to 2 from 1980-2006 as its growth went from 8% to sub 2%. The US is at 3.2 today, and is projected to be at 2 by 2027). The graph below should give you an idea of the dynamics in China:
   
3. The Lewis Turning Point. It is impossible to say with precision whether we are at that point, but we do know dollar-based unit labor costs (international competitive benchmark) in China have gone up sharply over the last few years—despite significant productivity gains. This suggests, inter alia, that the supply of labor is becoming less price elastic, which is consistent with what one would see near a Lewis turning point. Experts in China say the 2nd derivative of labor force turns negative in either 2013 or 2014. This means what has been a huge tailwind for China becomes a headwind.
4. Changing the growth model. Everyone knows that China is trying to switch from and investment/export growth model to a consumption-led model. The implication is that consumption-led model does not accelerate or decelerate on command the way investment does. Trying to manage this new economic paradigm in the way the old one was will lead to greater fits, starts and policy missteps: hence, more volatility.

The Policy Backdrop—why China can’t and won’t respond as forcefully to the coming slowdown:

1. China is still digesting all the leverage it put into the system in 2009-10. Non-financial debt in China went from 160% of GDP to 200% in two years. Non-financial corporate debt breached 100% of GDP, more than in the US and Germany, about the same as in Korea and the UK, and less than in Japan. To put the 40 percentage point increase in perspective, it is roughly the same percentage point increase the US experienced over 2003-07. It is true that the “denominator” in China grows much faster and this lessens the danger from the growth in the “numerator”, but the point here is that China is not in a position to repeat anywhere near the credit stimulus it unleashed in 2009.
2. The economy’s ability to absorb new investments has also diminished. A sponge can only hold so much water, and there seems to be very little in the way of low hanging fruit on the productivity side in the wake of the wave of credit that was unleashed in 2009. So, even if the authorities were to attempt a 2009 repeat, it is highly likely they would be getting far less bang for their RMB. Moreover, the tradeoff with inflation today would be far more pernicious.
3. Now the Chinese have to deal with managing growth AND inflation. Until this last cycle, Chinese policy makers had to worry only about growth. Yes, there were transitory spikes from exogenous shocks like the blue-eared pig disease of 2007-8, but the underlying wage dynamic and expectations were well anchored and stimulus ran very little risk of inflationary side effects. As noted above, this is no longer the case. And those in power in China remember the experience of the early 90s where inflation was on the verge of destabilizing politics. These new structural elements to Chinese inflation will also keep any urge to relive the stimulus of 2009 in check.
4. 2012 is a political transition year. Chinese policy makers are notoriously conservative and incrementalist. Their revealed preference is that they fear the law of unintended consequences above all. Innovative? Yes. Bold? No. One can expect this tendency to be all the more true in a political transition year. And the unusual degree of turbulence so far in the transition process—notably the demise of Bo Xilai, the ongoing backroom maneuvering with respect to Standing Committee membership, and even the postponement of the Party Congress—suggests that until the transition is secured, there is a greater risk of errors of omission than commission.

From my standpoint, the bottom line is clear: the headwinds to Chinese growth are underappreciated and growing, and if you are counting on policy stimulus to bail you out, think again. Our tendency to recall the last stimulus and overstate the parallel (availability heuristic), could end up being a costly mistake for all of the investors still hiding out in Asia as the last bastion of growth in their emerging market allocation.