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)

Big, Fat Cognitive Illusion (and all of us are more Greek than we think)

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.

Chinese growth: of Panda Huggers and Muggers:

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.

In a world dominated by equity traders and ETFs, this is why credit guys are the ones to listen to on these issues. This is plausible. Nice work, @credittrader

Was JPM hedging, unhedging, or speculating?

No one yet knows exactly was JPM was up to in the credit derivative markets. But this hasn’t stopped a lot of people from linking the loss to their pre-existing views on the Volcker rule, TBTF, moral hazard, and the Fed’s low interest rate policies, etc. There was also more than a touch of Schadenfreude, as the golden boy of finance revealed his new black eye.

We will ultimately get the information from JPM about what it was doing and what exactly they thought they were hedging. Once we do we will be in a better position to judge whether the hedge was reasonable or constituted speculation in disguise, and whether there are broader policy implications.

But setting judgment aside, and after having following this issue for a while, I do have an educated guess as to what likely happened:

  • We know that JPM is naturally long corporate credit through its loan book.
  • We know that over the last 2-3 quarters of 2011 we were gripped by the fear of a European financial meltdown and a second recession in the US.
  • We know that that the Fed’s swap lines and the ECB’s LTRO reversed this market view and crushed credit spreads lower, hurting those who had been buying protection in the previous months.

Against this backdrop, it seems likely to me that the aggressive selling of protection we heard about in April 2012 was actually the unwinding of the hedge that had been accumulated in 2011 and was by then deeply underwater.And given the way a bank’s loan book is held and priced, they couldn’t show commensurate gains to offset these losses.

This story fits the price action. Below is the one-year chart of the spread of the hedging instrument in question, the CDX.NA.IG series 9:

 

It is hard to imagine JPM coming out and announcing the loss while they still have the bulk of the loss-making position still on. Hedge funds and other banks—at least banks in the pre-crisis days—tend to gun for large, vulnerable positions in the hopes of profiting from the vulnerable party’s subsequent capitulation.

The story also fits typical big-bank behavior. It doesn’t ring true that a large bank would put on such a large speculative position in the current environment, given (1) the crisis we just went though (banks, like generals, tend to fight the last war and therefore the next mistake they make is likely a new one) and (2) we are very much in the middle of defining our new regulatory framework, and a mistake of this nature would be potentially crippling to a bank’s negotiating position in that process.

On the other hand, the natural human tendency of observers is to overstate the probability of the banks repeating the same mistake. This is often referred to as disaster myopia. Having lived through two bubbles now, I think it is fair to say one of the telling characteristic of financial bubbles is that in their aftermath there is a proliferation of people immediately declaring new bubbles (a bubble in bubbles). For similarly backward-looking reasons we are likely to overstate the probability of seeing similar issues now surface in other large banks.

Anything is, of course, possible. And I will withhold definitive judgment until the facts are in. But given the way institutions and people behave in the wake of a traumatic shock, the odds suggest that is was indeed a hedge gone wrong and that we are overreacting to it.

The far bigger issue that the JPM news obscured on Friday was the continued deterioration of the growth numbers in China. But more on that later….

Why we misinterpret Chinese RRR cuts

A quick comment on China’s RRR cuts: The underlying mechanics of Chinese RRR cuts and their implications for the country’s monetary policy stance still seem to be misunderstood.

A Chinese RRR cut is NOT like a rate cut in the developed world. And it does not necessarily signify an easing of the monetary policy stance. If you want to understand whether China is increasing or decreasing accommodation you only need to look at one thing: China CNY Monthly New Loans. The Bloomberg ticker is CNLNNEW.

The transmission mechanism of monetary policy in China is too crude at this stage of development to judge the stance of monetary policy by interest rates or reserve requirements. In China, it is all about credit controls. By hook or by crook, the Chinese target a quantity of credit. Whether they get there by regulations, open market operations, rate changes, or moral suasion matters little: the acid test it the rate of increase in the quantity of credit.

Here’s a snapshot of the time series:

So, last month, in the wake of several RRR cuts since last December, the quantity of RMB loans came in at 682B, versus a survey estimate of 780B. In other words, the money supply is roughly flat since all the RRR cuts began in December. RRR cuts are not a reliable predictor of future credit growth.

Why not? The mechanics in China work like this. China targets growth in the stock of RMB credit. Last year the target was 7.5T Yuan. As of this year the authorities have stopped publishing their target, but most analysts think they are aiming for between 8 and 8.5T Yuan. (FWIW, this would imply an increase in nominal GDP growth between 7 and 13 percent if you assume no monetary deepening).

There are three basic ways in which they can “finance” this growth in the stock of credit. One, they buy T-bills in OMOs (open market operations). Two, they receive balance of payment inflows (current account surplus plus capital account inflows). Both of these sources increase base money. Three, they can lower the RRR for banks to free up resources for lending. This doesn’t increase base money but increases the multiplier. The net effect of these three levers determines the change in liquidity in the system with which banks can expand lending.

The reason the RRR cuts have taken on less meaning in the current context is that they have been mostly offsetting the diminution of China’s balance of payment inflows. Once upon a time China’s trade surpluses were so large and the capital inflows so strong that BOP inflows provided more than enough base money to fuel any amount of credit expansion the China authorities desired. In fact, there were excess inflows that China had to sterilize. Now the trade surpluses have diminished and the speculative inflows have cooled (in fact, we have even seen net outflows at various point in time). If RRR were not cut, there would be an effective tightening of liquidity conditions. (This diminution of BOP inflows is also why the Chinese have been buying fewer US Treasuries.)

The bottom line: you need to know what is happening in with the constituent elements of base money before assessing whether an RRR is accommodative or just offsetting other developments. And, in the final analysis, only the growth rate of the stock of RMB credit will tell you the unambiguous truth.

So, the next time you hear an equity analyst trumpet the arrival of an RRR cut to bolster his bullish case, make sure you check the overall context and draw your own conclusions.

Intro to my Behavioral Macro microblog

I’m a money manager with roots in policy economics. I worked at the US Treasury under both a Republican and a Democratic administration. I did a tour of duty at the International Monetary Fund as well. For most of the 90s, I was a sovereign debt specialist/negotiator—when emerging market debt crises were the center of the financial universe. Since then, I’ve managed real money and fast money, mostly focusing on global macro. As a result I come at markets from both the perspective of a policy guy and a market guy, which all too often is like oil and water. My initial grounding was in sovereign credit risk and global fixed income. I am very active in currencies.

When I first came to the markets, I was taken aback by how superficial the market’s understanding of economics was. Not stupid, but superficial in the most neutral sense of the word. This was particularly true in emerging markets. It seemed that guys would have a hunch, based on price action or intuition, and then would reverse engineer a story that to them would explain what they saw or felt. In other words: the conclusion comes first and the investment hypothesis would then follow.

But these guys made money—at least, for the most part. To me, this did not compute. How did guys who didn’t even understand basic macroeconomic identities or dynamics successfully manage money? I was highly skeptical of EMH (the Efficient Market Hypothesis) well before I came to the markets. But from my first contact with animal spirits I realized that I had still vastly overestimated man’s abilities to be that textbook rational maximizer of utility.

All this got me thinking and reading. I started to consume books on technical analysis and, importantly, behavioral economics—a discipline that didn’t exist when I went to grad school. A conclusion soon started to emerge: good risk management was far more important than good ideas in money management (more on this later). And a good understanding of market psychology, positioning, and technical analysis were central to risk management.

Exploring the growing literature on behavioral economics and finance also helped me put labels on the many ways in which the standard economic and financial models failed capture the actual behavior of economic agents. This was hugely liberating. By identifying the systematic ways in which the efficient market logic fell short, it validated much of what I was observing. The implications for the reigning ideology of the past 30 years of free, equilibrating, self-regulating markets were profound.

The aspiration of this blog is not cure the world of cognitive biases. Rather, by trying to put global macro issues and markets in a more behavioral context, the hope would be that we might be able to better recognize situations in which our biases are likely to surface so that we—whether as analyst or risk taker—can make that extra effort to try to avoid the systematic pitfalls inherent in the human condition. Not everything will have a behavioral angle to it either; I intend to splash down ideas wherever I think my background might lend itself to insight into current economics, finance, or politics.

In recent months I have become fairly active on Twitter (@mark_dow), and in recent years I have written articles and guest-blogged from time to time. But writing in my own blog is a new experience, one I am likely to take a step at a time. Not sure how it will go, or how often I’ll post. So, for those interested, please bear with me while I work things out.

Mark Dow