The Big Picture - Macro Perspective on the Capital Markets, Economy, Technology, and Digital Media

Steve Waldman was a software developer who became fascinated by finance and started writing about it. He is now a doctoral student in finance at the University of Kentucky. He blogs at Interfluidity.

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Lisa Pollack at FT Alphaville mulls a question: “Why are we so good at creating complexity in finance?” The answer she comes up with is the “Flynn Effect“, basically the idea that there is an uptrend in human intelligence. Finance, in this view, gets more complex over time because financiers get smart enough to make it so.

That’s an interesting conjecture. But I don’t think it’s right at all.

Finance has always been complex. More precisely it has always been opaque, and complexity is a means of rationalizing opacity in societies that pretend to transparency. Opacity is absolutely essential to modern finance. It is a feature not a bug until we radically change the way we mobilize economic risk-bearing. The core purpose of status quo finance is to coax people into accepting risks that they would not, if fully informed, consent to bear.

Financial systems help us overcome a collective action problem. In a world of investment projects whose costs and risks are perfectly transparent, most individuals would be frightened. Real enterprise is very risky. Further, the probability of success of any one project depends upon the degree to which other projects are simultaneously underway. A budding industrialist in an agrarian society who tries to build a car factory will fail. Her peers will be unable to supply the inputs required to make the thing work. If by some miracle she gets the factory up and running, her customer-base of low capital, low productivity farm workers will be unable to afford the end product. Successful real investment does not occur via isolated projects, but in waves, forward thrusts by cohorts of optimists, most of whom crash and burn, some of whom do great things for the world and make their investors wealthy. But the winners depend upon the existence of the losers: In a world where there was no Qwest overbuilding fiber, there would have been no Amazon losing a nickel on every sale and making it up on volume. Even in the context of an astonishing tech boom, Amazon was a pretty iffy investment in 1997. It would have been an absurd investment without the growth and momentum generated by thousands of peers, some of whom fared well but most of whom did not.

One purpose of a financial system is to ensure that we are, in general, in a high-investment dynamic rather than a low-investment stasis. In the context of an investment boom, individuals can be persuaded to take direct stakes in transparently risky projects. But absent such a boom, risk-averse individuals will rationally abstain. Each project in isolation will be deemed risky and unlikely to succeed. Savers will prefer low risk projects with modest but certain returns, like storing goods and commodities. Even taking stakes in a diversified basket of risky projects will be unattractive, unless an investor believes that many other investors will simultaneously do the same.

We might describe this as a game with two Nash Equilibria (“ROW” means “rest of world”):

If only everyone would invest, there’s a pretty good chance that we’d all be better off, on average our investments would succeed. But if an individual invests while the rest of the world does not, the expected outcome is a loss. (Colored values wearing tilde hats represent stochastic payoffs whose expected value is the number shown.) There are two equilibria, a good one in the upper left corner where everyone invests and, on average, succeeds, and a bad one in the bottom right where everybody hoards and stays poor. If everyone is pessimistic, we can get stuck in the bad equilibrium. Animal spirits are game theory.

This is a core problem that finance in general and banks in particular have evolved to solve. A banking system is a superposition of fraud and genius that interposes itself between investors and entrepreneurs. It offers an alternative to risky direct investment and low return hoarding. Banks guarantee all investors a return better than hoarding, and they offer this return unconditionally, with certainty, without regard to whether other investors buy in or not. They create a new payoff matrix that looks like this:

Under this new set of payoffs, there is only one equillibrium, the good one on the upper left. Basically, the bankers promise everyone a return of 2 if they invest, so everyone invests in the banks. Since everyone has invested, the bankers can invest in real projects at sufficient scale to generate the good expected payoff of 3. The bankers keep 1 for themselves, pay their investors the promised 2, and everyone is made better off than if the bad equilibrium had obtained. Bankers make the world a more prosperous place precisely by making promises they may be unable to keep. (They’ll be unable to honor their guarantee if they fail to raise investment in sufficient scale, or if, despite sufficient scale, projects perform more poorly than expected.)

Suppose we start out in the bad equillibrium. It’s easy to overpromise, but harder to make your promises believed. Investors know that bankers don’t have a magic wealth machine, that resources put in bankers’ care are ultimately invested in the same menu of projects that each of them individually would reject. Those risk-less returns cannot, in fact, be riskless, and that’s no secret. So why is this little white fraud sometimes effective? Why do investors’ believe empty promises, and invest through banks what they would have hoarded in a world without?

Like so many good con-men, bankers make themselves believed by persuading each and every investor individually that, although someone might lose if stuff happens, it will be someone else. You’re in on the con. If something goes wrong, each and every investor is assured, there will be a bagholder, but it won’t be you. Bankers assure us of this in a bunch of different ways. First and foremost, they offer an ironclad, moneyback guarantee. You can have your money back any time you want, on demand. At the first hint of a problem, you’ll be able to get out. They tell that to everyone, without blushing at all. Second, they point to all the other people standing in front of you to take the hit if anything goes wrong. It will be the bank shareholders, or it will be the government, or bondholders, the “bank holding company”, the “stabilization fund”, whatever. There are so many deep pockets guaranteeing our bank! There will always be someone out there to take the loss. We’re not sure exactly who, but it will not be you! They tell this to everyone as well. Without blushing.

If the trail of tears were truly clear, if it were as obvious as it is in textbooks who takes what losses, banking systems would simply fail in their core task of attracting risk-averse investment to deploy in risky projects. Almost everyone who invests in a major bank believes themselves to be investing in a safe enterprise. Even the shareholders who are formally first-in-line for a loss view themselves as considerably protected. The government would never let it happen, right? Banks innovate and interconnect, swap and reinsure, guarantee and hedge, precisely so that it is not clear where losses will fall, so that each and every stakeholder of each and every entity can hold an image in their minds of some guarantor or affiliate or patsy who will take a hit before they do.

Opacity and interconnectedness among major banks is nothing new. Banks and sovereigns have always mixed it up. When there has not been public deposit insurance there have been private deposit insurers as solid and reliable as our own recent “monolines”. “Shadow banks” are nothing new under the sun, just another way of rearranging the entities and guarantees so that almost nobody believes themselves to be on the hook.

This is the business of banking. Opacity is not something that can be reformed away, because it is essential to banks’ economic function of mobilizing the risk-bearing capacity of people who, if fully informed, wouldn’t bear the risk. Societies that lack opaque, faintly fraudulent, financial systems fail to develop and prosper. Insufficient economic risks are taken to sustain growth and development. You can have opacity and an industrial economy, or you can have transparency and herd goats.

A lamentable side effect of opacity, of course, is that it enables a great deal of theft by those placed at the center of the shell game. But surely that is a small price to pay for civilization itself. No?

Nick Rowe memorably described finance as magic. The analogy I would choose is finance as placebo. Financial systems are sugar pills by which we collectively embolden ourselves to bear economic risk. As with any good placebo, we must never understand that it is just a bit of sugar. We must believe the concoction we are taking to be the product of brilliant science, the details of which we could never understand. The financial placebo peddlers make it so.

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Some notes: I do think there are alternatives to goat-herding and kleptocratically opaque semi-fraudulent banking. But adopting those would require not “reform” but a wholesale reimagining of status quo finance.

Sovereign finance should be viewed simply as a form of banking. Sovereigns raise funds for unspecified purposes and promise risk-free returns they may be unable to provide in real terms. When things go wrong, bondholders think taxpayers should be on the hook, and taxpayers think bondholders should pay. As usual, everyone has a patsy, someone else was supposed to take the hit. Ex ante everyone was assured they have nothing to fear.

I have presented an overly flattering case for the status quo here. The (real!) benefits to opacity that I’ve described must be weighed against the profound, even apocalyptic social costs that obtain when the placebo fails, especially given the likelihood that placebo peddlars will continue their con long after good opportunities for investment at scale have been exhausted. By hiding real economic risks from those who ultimately bear them, status quo financial systems blunt incentives for high-quality capital allocation. We get capital allocation in bulk, but of low quality.

Our quote of the day comes from an article in this Sunday’s NYT magazine, Don’t Blink! The Hazards of Confidence by Daniel Kahneman:

“The illusion of skill is not only an individual aberration; it is deeply ingrained in the culture of the [financial] industry. Facts that challenge such basic assumptions — and thereby threaten people’s livelihood and self-esteem — are simply not absorbed. The mind does not digest them. This is particularly true of statistical studies of performance, which provide general facts that people will ignore if they conflict with their personal experience.”

I find that, unfortunately, to be terribly true.

For those of you who may be unfamiliar with Kahneman, he is a professor at Princeton and Nobel laureate. He is notable for his work on the psychology of judgment and decision-making, and behavioral economics.

The Fed released its G.19 report on Consumer Credit last Thursday, and it stirred some optimism (see also here):

The new U.S. consumer credit numbers reflect an economy that is reaccelerating, and that is very bullish for growth — as well as inflation. All in all, U.S. household credit surged by $7.62 billion in February, ramping up faster than at any other time since June 2008.

I respectfully beg to differ.  While the story gives a passing nod to the rise in student loans, the fact of the matter is that student loans are virtually the whole story, and the downward trend/trajectory in credit, save that category, has really not reversed.

Let’s have a look:

What we’ve got above is Total Revolving, Total Non-revolving, and Total Non-revolving minus TOTALGOV (the category that includes student loans).  Without the increase in student loans — which is to say the green line and the blue line — the trend in credit (both revolving and non) continues downward.

But let’s take a look at exactly how much the TOTALGOV (i.e. Student loan) series is goosing non-revolving credit:

It is, quite literally, a reverse cliff-dive.

In short, fade the notion that consumer credit is experiencing some sort of credit renaissance and that happy days are here again.

That said, we are indeed moving in the right direction, as these two indicators of leverage clearly show (below).  So there would appear to be light at the end of the tunnel.  We’ve got a way to go, for sure, but progress is being made.  When the consumer credit cycle does eventually turn it is my belief that, for a variety of reasons — such as demographics and the lessons (hopefully) learned by today’s younger adults –  it will be fairly weak.

Information is Beautiful has this tasty chartporn depicting the UK emergency budget:

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click for larger graphic

via The Guardian

Giant graphic of information, courtesy of Billshrink:

click for ginormous graphic

Interesting argument here by Richard Posner on the (f)utility of GDP.

Money shot:

“But it is necessary to emphasize that it [GDP] is just a starting point. I disagree with economists who say the “recession” ended in the third quarter. The depression (as I think we should call it if only because of its enormous potential political consequences) has caused massive unemployment with all the associated anxieties and hardships, has greatly reduced household wealth, has caused private investment to turn negative, has cost the government trillions of dollars in lost tax revenues and recovery expenditures (TARP, the fiscal stimulus, the mortgage-relief programs, the auto bailouts, etc.), has undermined belief in free markets and altered the line between government and business in favor government, and is threatening a future inflation while deepening our dependence on foreign lenders.

To view a change in GDP from negative to positive as signifying the end of a depression (by which criterion the Great Depression ended in 1933 and again in 1938) is to misunderstand the utility of GDP as a measure of economic activity.

Worth a read . . .

The Austrian government has nationalized the insolvent bank Hypo Group Alpe Adria (HGAA). The financial institution, which has 40 billion Euros in assets, is the country’s sixth largest bank. But, in relative terms, this is a very large bankruptcy – using GDP at purchasing power parity, an American HGAA would have assets of $2.5 trillion, larger than any of the American banks. So, this is a very big deal and it speaks to the size of Austrian banks’ international exposure, renewed risks in banking and the possibility of contagion.

HGAA is considered a subsidiary of the troubled German state-controlled bank of Bavaria BayernLB.  Just last month BayernLB pointed to trouble when it reported a huge loss over 1 billion Euros for the second quarter running. The trouble: HGAA.

The FT reported at the time that:

HGAA would report a significant loss for the year and a capital injection for its subsidiary would be unavoidable, BayernLB said. The bank warned it would take a goodwill impairment charge at the end of the year on the value of its HGAA investment.

“Increased risk provisions and the expected impairment at HGAA will weigh significantly on… earnings in the fourth quarter. It is not yet possible to quantify it exactly, but it can be expected that as a result of these effects, the group will report a loss of well over €1bn,” BayernLB said in a statement.

The problems are the latest sign of how Germany’s Landesbanken – regionally owned public banks – have been thrown off course by risky attempts to boost profits by diversifying away from their core regional lending activities. BayernLB lost more than €5bn last year after writedowns on its huge stock of toxic assets, forcing it to seek a bail-out from the Bavarian regional government.

The bank’s purchase of HGAA in 2007 is already the subject of an inquiry by Germany state prosecutors, who are considering whether the former chief executive of the German bank committed a breach of trust by paying too high a price for HGAA.

Along with other Landesbanken, including HSH Nordbank and WestLB, BayernLB is reducing the scale of some of its foreign ventures. Michael Kemmer, chief executive, said the “more focused business model” was improving the bank’s performance.

This is what is commonly known as reckless lending and it happened in spades during the boom in Eastern Europe. Most of the actors are banks in Scandinavian and German-speaking countries.  HGAA was most exposed to the former nations of Hapsburg empire, with the Balkans in first place on that list.  The purchase of HGAA by BayernLB even after a global housing bubble had popped needs investigation and reminds me of the flyer taken by Hypo Real Estate in Ireland via its purchase of Depfa. And the fact that two large German institutions increased international exposure into Austria, the Balkans, and Ireland at the top of the market demonstrates the laxity in banking regulation globally.

The fact that the HGAA bankruptcy is happening now should remind you of the Dubai situation again.  When the crisis there first struck I talked about exogenous shocks and contagion, saying:

But now that Dubai is back in the news, I have looked back in my archives to see what (if any) links I have had on the situation in the country. The last two were in April about developers defaulting and in May about an S&P debt downgrade. Since then – as the global equity markets have turned up – nothing.

What does this tell me? First and foremost, it hints at the fragility of this recovery and the real risk exogenous shocks pose.  We are barely recovering now and a lot of debt and unemployment put us at stall speed, making the risk posed by events of this nature that much greater.

More importantly, however, the Dubai World events underline the unpredictability of exogenous shocks. All of these potential crisis situations — dollar carry trade unwind, debt crisis in the Baltics, oil price spike, an unexpected surge in interest rates, war in the Middle East — are still there lurking in the background. We don’t see coverage in the press on them everyday, but they are still there.

I have been optimistic about the near-term prospects for the global economy in large part due to the myriad pro-cyclical effects of recovery. Longer-term, however, there are some serious obstacles to a sustainable recovery.  This is not a garden-variety recession and recovery. It is a recession within a longer-term depression.  And while we are in a technical recovery, I believe much of the fundamental problems which triggered this downturn are still there, lurking. The debt troubles at Dubai World bring this point home.

[emphasis added]

The first signs of Dubai contagion popped up in Greece and Ireland because of similarities to Dubai regarding mountainous sovereign debt problems. Now that we have this rather large bankruptcy in Austria, we can talk about further contagion. Looking back in my archives at Austria this time, it has been a long time since I have discussed the banking situation in Austria.  It was most critical in the December 2008 to March 2009 time frame when we were in serious crisis mode.  Below are the posts I wrote relating to that topic.

• Is this Austrian real estate company a canary in the coalmine? – Dec 2008
• Austrian banks have emerging-market financial exposure that is 70% of GDP – Jan 2009
• The Eurozone and the spectre of banking collapse – Jan 2009
• Peer Steinbrueck says Germany might bail out the Austrians – Feb 2009
• The European problem – Feb 2009
• While Rome Burns – Feb 2009
• EU planning 200 billion euro package for Eastern Europe – Feb 2009
• The EU promises to bail out eurozone members – Mar 2009

That’s it! As with the situation in Dubai, it was radio silence until the Dubai World panic. 

I should add that no post on banking in Austria is ever complete without reference to Creditanstalt’s 1931 bankruptcy as the trigger event for the global banking crisis which gave the Great Depression its ‘greatness.’ So when we we talk about contagion, Creditanstalt is the gold standard of contagion, if you will.

The most telling statement in my earlier posts on Austria is this one which comes via the Vancouver Sun about comments by International Economy magazine’s David Smick:

Internationally, Smick said export-dependent developing countries, and the western banks that financed their growth, are particularly vulnerable.

“If too many of these emerging markets go down, the IMF (International Monetary Fund) lacks the necessary resources to mount rescue operations,” writes Smick, author of the 2008 book The World Is Curved: Hidden Dangers to the Global Economy.

“To put things in perspective, Austrian banks have emerging-market financial exposure exceeding $290 billion. Austria’s GDP is only $370 billion.”

As in the U.S., the critical thing in Eastern Europe is maintenance of asset prices underpinning this financial exposure. There is zero chance Austria will survive a further collapse in asset values in Eastern Europe without EU or IMF support.  This is the major reason central banks are flooding the system with liquidity.

Now, if the Dubai contagion does result in renewed weakness in asset prices, then I may have to eat my words about how unlikely it is that Ireland or Greece leave the Eurozone. My comments from last January on Ambrose Evan-Pritchard’s Euroscepticism are still my thinking today:

My take on events is that a number of countries within the Eurozone will face banking crises, starting with Ireland.  At that point, leaving the Eurozone will make no sense because the damage has already been done.

Evans-Pritchard’s calculus is more to the point: Ireland must threaten to leave now if it wants to maximize any EU help it expects to receive, before the scope of other EU banking crises become apparent.  Weakness in the financial sector has infected all of the Eurozone members. I have mentioned that Austria has a weak banking system (see posts here and here). But, there is even growing evidence that Germany too has a fragile banking system.  To be clear: this is an ‘every nation for itself’ strategy pitting Eurozone members against each other, where those nations savvy enough to request help sooner are likely to benefit at the expense of others. The question is whether the Germans would go along with this.  If they do not, tensions will rise and that will change the calculus for Portugal, Italy, Ireland, Greece, and Spain. I don’t have a view on this as yet because the situation is still evolving.  However, I lean toward believing the Eurozone will remain intact even while individual nations or banking systems collapse.

This is a guest post by Edward Harrison. A version of this post originally appeared at Credit Writedowns. See also Too big to rescue as the Icelandic collapse is the scenario feared by every government in a small country with a large banking system that is too big to bail.  Has the policy response in Europe been enough to avert renewed crisis? Let’s hope so.

What is the greatest deception in the history of finance?  Depending upon your perspective, some entities and events of deception that come to mind might include corporate accounting scandals, rogue traders, Ponzi schemes, and various entities and events related to the financial crises (market bubbles) throughout history.

“The greatest hazard of all, losing one’s self, can occur very
quietly in the world, as if it were nothing at all.  No other loss can
occur so quietly; any other loss — an arm, a leg, five dollars, a
wife, etc. — is sure to be noticed.” ~ Soren Kierkegaard

In terms of damages caused by these entities and events of deception, the financial losses, some of which are in the hundreds of billions of dollars, are the most tangible and easiest to measure.  Using the most recent and obvious reference point, the current financial crisis slashed retirement assets in 2008 by nearly $4 trillion, as reported by Reuters.  This decline in assets is epic in proportion; but what is the non-monetary cost and what led most of these people to place their life savings in the stock market to begin with?

Returning to the question of what is the greatest deception in the history of finance, consider this scenario:  Hundreds of millions of people are led to believe that one particular financial pursuit, which, to accomplish, requires the largest financial effort of a lifetime; but more importantly, and for most people, it is also the most physically and emotionally taxing effort of a lifetime; working in various unsatisfying and stressful jobs and sacrificing meaningful pursuits for this one financial pursuit; and the effort requires 30, 40 or even 50 years of time, assuming the end destination of this pursuit is ever reached — or if it even exists… and this doesn’t include the $4 trillion decline (see above)…

This financial pursuit, this deception, is called financial freedom.

“Man acts as though he were the shaper and master of language, while in fact language remains the master of man.” ~ Martin Heidegger

The idea of financial freedom is no conspiracy to deceive the masses; but it sure has sold unimaginable amounts of financial products and services!  Furthermore, how many books, websites, blogs, magazine articles, media advertisements and financial planning sessions have used the term financial freedom as leverage to sell something?

Financial freedom is such an overused and abused term that its meaning is bordering on abstract.  As of this posting, a Google Search for “financial freedom” produces more than 33 million results.  What is financial freedom anyway?  Who decides the meaning? How can one be free if their idea of freedom is defined by someone else, or not defined at all?  Does financial freedom even exist?

Common words, phrases and abstract ideas can be practical for use in language and mass communication; but for an individual to spend the predominant amount of financial and non-financial resources of a lifetime for something that has not been clearly defined for the individuals particular life, how can this not be described as anything but aimless, illusory or even the greatest deception in the history of finance?

“Ever more people today have the means to live, but no meaning to live for.”~ Viktor Frankl

The true deception of financial freedom need not be blamed on anyone but oneself; however, this is not necessarily an intentional deception — it is a result of the human condition.  As humans, we are constantly searching for patterns that will reveal the shortest distance from point A to point B; and we are searching for meaning and fulfillment; but we trick ourselves into believing that we are searching for pleasure — and money buys pleasure, at least according to the thousands of implicit and explicit messages we receive on a daily basis.

Certainly, the messages of media noise and social conventions are difficult to ignore.  Nearly every media (print, television, Internet) image you’ve seen in your life implies that your current existence is lacking something — and this something is a certain article of clothing, a watch, a beverage, a pill, a car, a house, an investment strategy or particular physical appearance — to be somebody other than who you are now — all of which can be purchased with money (whether it be your money or someone else’s money).

So, if wanting more is a natural human behavior and we are deluged daily with enticing messages that encourage and support this behavior, what can be done, if anything, to manage this challenge?  To help make my point, I will defer to an anecdote delivered to MBA graduates of Georgetown University, back in 2007, by Jack Bogle, founder of Vanguard:

“At a party given by a billionaire on Shelter Island, the late Kurt
Vonnegut informs his pal, the author Joseph Heller, that their host, a
hedge fund manager, had made more money in a single day than Heller had
earned from his wildly popular novel, Catch-22, over its whole history. Heller responds, ‘Yes, but I have something he will never have: Enough.’ “

In summary, the best way to “get rich quick” is to be content with “enough.”  What greater tragedy can there be than to chase something for one-half to two-thirds of a lifetime that may not be actually acquired by the means for which you have sacrificed?

“If thou wilt make a man happy, add not unto his riches but take away from his desires.” ~ Epicurus

To conclude, there is no such thing as financial freedom, at least not in the conventional sense of the term, which is the great deception.  Paradoxically, the pursuit of financial freedom is closer to slavery than it is liberating.  Furthermore, and in my humble opinion, freedom cannot be procured by financial means — freedom most likely lies at the point at which the utility for money begins to diminish — the point at which the basic sources of physical well-being — food, shelter and clothing — have been met.  Beyond this point, freedom cannot be procured by financial means, yet millions continue pursuing the idea of financial freedom.  This is the deceit.  This is the illusion.

True freedom begins by learning contentment — by the realization that you already have “enough” — where the search for pleasure can be replaced by the search for meaning.

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Kent Thune is the blog author of The Financial Philosopher

Fascinating stuff:

“New York has withstood the worst economic crisis in seven decades and remains the leading global financial center, followed by Singapore, which topped London as investors’ preferred place for doing business, according to Bloomberg Global Poll.

Twenty-nine percent of respondents in the quarterly poll of investors, traders and analysts who subscribe to the Bloomberg terminal say New York will be the best place for financial services two years from now. Singapore is chosen by 17 percent of respondents and London is the pick of 16 percent. Shanghai has 11 percent, while Tokyo, once considered a global hub, gets the nod from only 1 percent.

I have mixed feelings about this poll: I am thrilled the home team (and my home town) took the top spot, but I am an Anglophile who loves London, and was sorry to see them slip to 3rd.

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Source:
New York Eclipses London as Financial Center in Bloomberg Poll
Alison Fitzgerald
Bloomberg, Oct. 30 2009

http://www.bloomberg.com/apps/news?pid=20601087&sid=aEC0OYmvvcZM

A few interesting reads for your Tuesday:

• Goldman Sachs: U.S. Stocks Primed for Takeovers (Bloomberg)

• Climbing the Golden Wall of Worry (Barron’s)

• Zen Lessons in Market Analysis (Hussman)

• Home rescue plan delaying, not solving crisis (Reuters)

• End the war on drugs, start the legalization (Marketwatch)

• The Years of Magical Thinking (NYT)

• Vitriol, invective at the speed of light (Associated Press)

• The Appraisal Process Moves Front and Center (Matrix)

• In handy spreadsheet form, a complete listing of the always stimulating TED Talks

• Credit Report Card: A Truly Free Look at Your Credit Record (Credit Bloggers)

• Thanks for all the great comments on car buying!

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What are you reading?