Tuesday, February 24, 2009

Black Swans for Breakfast

Yesterday, Bloomberg Television had a great interview with Nassim Taleb, the derivatives trader who has made a name for himself talking about so-called Black Swan Events -- unforeseeable random developments that can shake the world and its markets.
Some of his comments are worth quoting here:

"This crisis is not so much a Black Swan for me, because say you have a pilot who doesn’t know about storms, namely Bernanke and Greenspan, flying the plane. Of course, the first storm, they’re going to crash the plane. So that’s not too much of a Black Swan. It’s a grayish or white swan.
The Black Swan for me would be for us to emerge out of it unscathed and return to normalcy -- that would be the black swan. That would be the highly improbable event."

I obviously agree with him on this. On a deeper level, I think Taleb places too much emphasis on randomness to understand history. After all, he provides a pretty good systemic explanation of what happened in this crisis:

"The system is designed to blow up...
We helped them (banks) blow up late ...Greenspan did not allow them to blow up early.

He then says the Fed bailed them out after the incidents such as the Latin American debt crisis in the early 1980s. Taleb's argument is that by attempting to maintain stability, policymakers allowed problems to fester until they reach a devastating size. I think it's a bit like a water accumulating behind a dam, which eventually breaks. The man-made levee, not the natural rainfall, is the problem.

In an earlier blog entry, I quoted Peter Drucker's explanation of how war and economic dislocation cause greater chaos than something like an earthquake because they result from human actions rather than being random "Black Swan" events:
"The new demons, though no less inescapable, are unnatural. They can be released by man only, but once they have been turned loose, man has no control over them." -- Peter Drucker in The End of Economic Man: The Origins of Totalitarianism

Drucker was examining the calamity and economic turmoil that followed WWI to understand the rise of Hitler and Mussolini. He argued that man's embrace of rationalism had created a far less rational and more dangerous world: Tools of civilization intended to make life better, such as railroads and factories, were used to organize millions of men and the productive capacity of entire countries into killing machines. Throw in Weimar-era inflation, which undermined established power relations in the family and social classes, and the Germans were a rootless, drifting people, lacking the philosphical antibodies to fight off the the Fascist infection.

In the late 19th century, the Prussians invented a military model of massive and total mobilization, where millions of soldiers, along with their supplies and support units, would all converge on the field of battle. This was an enhanced version of Napoleon's concentration of force doctrine -- the idea that by rationally marshalling the resources of a modern nation state you could quickly overwhelm the enemy. The problem with this strategy is that once mobilization began, it couldn't be stopped. (A bit like deleveraging.) Millions of men expecting a glorious offensive victory were bogged down in a miserable defensive trenchwar, borrowing into the earth like worms as rats consumed their fallen comrades.
In the end, a military model designed to keep countries safe produced greater horrors than Europe had ever seen. When society's own defences turn against it, the resulting crisis can be much larger and insidious than expected because you don't have just a war or economic crisis to deal with, but a deeper existential crisis.
The same lesson could apply to our economy today because government policies to encourage homeownership have transformed into demons that haunt the finances of banks, insurance companies, households and municipalities. In every other crisis since the 1930s, the consumer and residential real estate remained strong, allowing a "return to normal." This time there may be no normal left.

For decades policymakers have embraced Keynesianism in an attempt to assure economic stability. This started in the fiscal and legal arenas in the 1930s and continued until the Reagan era as the government used taxes and spending to control the economy. (Through the late 1970s, the result was monopoly capitalism, high taxes and inflation.) Keynsianism then moved into the monetary sphere under the influence of Milton Friedman, a proponent of the modern-day Fed doctrine of raising interest rates when the economy is growing and cutting them when it's slowing.

Many experts would say I am wrong to lump Friedman and Keynes together. I do this because both supported counter-cyclical measures and argued against reality in favor of a government-endorsed economic outcome. For instance, how does it make any kind of economic sense to lower interest rates during a credit crunch? Credit was somehow too cheap and people used too much of it. If an ordinary company or person borrows too much and faces bankruptcy, they're forced to pay higher rates to borrow. Somehow when we move from the singular level of the individual or business to the plural of the entire society, people like Milton Friedman and Alan Greenspan think the rules should no longer apply.

In fact, almost everyone in the world of economics and finance embrace this theory today. I hear almost no one on CNBC or Bloomberg arguing in favor of higher interest rates. The thing I find most distressing is that none of the journalists ever ask the follow-on question: What comes after you cut rates to 0%?


This problem is simply ignored, but to me is an underlying reason why the Japanese stock market is still miles below where it was 20 years ago: Low interest rates become a curse because they are impossible to ever raise again. This is why I argued for rate hikes in the summer of 2007 so that banks would attract more deposits and the Fed would have the ability to cut rates once the inevitable recession came. Instead, they cut rates right off the bat and triggered both an inflationary spiral and a wider credit crunch. (Again, most people probably think the Fed's rate cuts helped ease the crisis. They should read this blog entry.)

I fear low interest rates will cause much more harm than good because people know they can't go any lower. One of the most basic ways to value equities is to compare the "earnings yield" to the yield on a benchmark like the 10-year Treasury bond. (Earnings yield is EPS/Price -- the inverse of P/E ratio.) This is often called the "Fed Model," and essentially dictates that falling interest rates are positive for stocks. Most market watchers understand this implicitly.

In many ways the stock market's strength in the 1981-2007 period resulted from a steady decline in interest rates. This pushed borrowing costs lower, allowing companies to cheaply buy each other and consumers to buy more stuff.

Rather than the absolute level of interest rates, the key factor is direction. For instance, you want to buy a house and can afford to pay $2000 a month in payments. If interest rates are 20%, you can borrow roughly $120,000. Assuming you put 20% down, you can afford a $150,000 home.

If the interest rate falls to 10%, you can now support about $230,000 in debt, and afford a $287,000 home. This is not rocket science.

Low interest rates are bad because they destroy dynamism in the market. Once they can't go any lower, why should I even bother to buy a house, or buy stocks?

(Of course some people will argue that you shouldn't buy a house based on speculation, and that it's "a good thing" to see houses go from being speculative assets back to normal "use" assets. The problem is that the period of speculation leaves an overhang of supply that will drag on the economy and society for years. Furthermore, if you take the speculation out of houses, it makes more sense for many people to rent in the first place. Don't forget the government had to subsidize homeownership for a reason -- namely it didn't make any sense for the average American, when you consider all the financial and legal risk involved. See this and my Vatter quote below for more.)

Again, policies put in place to ease economic cycles and prevent distress cause the economy to work less efficiently because it allows bad activities to keep going longer:

"Whatever breaks is fragile, whatever doesn’t break survives, and then that’s capitalism. Capitalism is: You let what is breakable break fast. Now we’re letting things break late, but odds are they’re going to break anyway." -- Nassim Taleb

Taleb's version of history is that banks have made money steadily for years and convinced people they were conservative and low risk. This allows them to grow so large that all of society is dependent on them, which creates a new kind of risk and forces the government to bail them out when they fail. That means "we are sponsoring the asymmetric risktaking on the part of banks. Everything was geared to building up a deferred blowup scheme."

I think Taleb should take it even further. This wasn't just about bailing out the banks. It was the result of a 60-year secular bull market in the U.S. consumer and his house. The government fed that process by subsidizing homeownership and transferring wealth from cities to suburbia. It was part of a larger Keynesian plan to build a mass-consuming society that could keep the factories going and maintain full employment.

It began with direct expenditures such as highway building and defense spending in the South. The government also provided preferential loans to develop suburban areas. Here's a quote from economic historian Harold Vatter on page 22 of his edited book History of the U.S. Economy Since World War II:

"By the beginning of the 1950s the whole system of housing credit was substantially underwritten by the government..."

Vatter then quotes a 1950 report from the Council of Economic Advisors: "The credit policies and programs of Government played an indespensible part in the expansion of the market demand for homes. This expansion depended on low interest rates, small or nominal down payments and long periods of amortization. Without public assurances, the policies of private investment institutions could not have been extended far enough to permit this type of financing."

The subsidization of sprawl started in the 1950s with explicit government spending (highway building, defense spending) and gradually morphed into a quasi-state lending scheme under Fannie Mae and Freddie Mac. This second stage really took off in the late 1980s when Fannie and Freddie became widely held stocks and pursued aggressive growth. Despite what some people claim, these organizations were never private and always relied on the credit of the U.S. government. (That's why the government is now backing them. There was actually a quiet debate in central banking circles for years about the safety of their bonds, which concluded that they were more or less the same of soveriegn debt. That's why foreigners bought so many of them in the first place, and why they could be considered AAA. It's also why the Federal Reserve in its Flow of Funds report has always treated them separately from other banks.)

This androgynous public/private status was hugely successful for a long time, giving them access to unnaturually low interest rates. Their share prices rocketed higher for most of the 1990s as they grew into giant lenders.

It was great for the economy because, instead of citizens being taxed to pay for their neighbors' houses, the expense was concealed by GSEs borrowing in the name of the public. It wasn't that different from the practices of General Motors, which mortgaged its own future to sell cars at steep discounts. This also allowed the company to "maintain full employment" and to pay workers sitting idle in the jobs bank.

In the end, the Keynsianism road ends at a corruption of capitalism because resources are "invested" for political purposes rather than for profit. Whether you're looking at the Fed or Fannie Mae, both were designed to deny natural economic and financial reality. In the long run, this rewarded bad behavior and caused a huge misallocation of capital. That's why we have millions of homes standing unsold across the country. Even more tragically, we encouraged millions of human beings to engage in unsustainable economic activity such as construction and retail. Those people gave up precious years of their lives when they could have been learning new skills or developing new sources of income. The wasted human capacity is the real tragedy.

I'd like to end this blog entry comparing the growth of GSE debt and private financial-sector debt, most of which was securitized. The majority of the debt underlying both lines is linked to home mortgages.

GSEs led the surge in mortgage lending for more than a decade before they retrenched and were replaced by players like Countrywide and Bear Stearns. While the private sector drove the movement to its final, insane peak, it only came after decades of the government building the bubble.

This is not a crisis of capitalism. This is a crisis of Keynesianism.

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