A case can be made for more regulation of the United States Financial system. With the Federal Reserve now involved with more financial institutions than just the commercial banking system, more tax payer dollars seem at risk and if this is, in fact the case, then rules and regulations should be extended to a wider range of institutions than they have been in the past. Furthermore, the financial environment has changed. The reality of this statement is underscored by the innovations the Federal Reserve has had to introduce over the past six to nine months. An ‘out-of-date’ financial system needs to have its rules and regulations updated.
BUT,
a question needs to be asked about the role that bad economic policy has played in the financial distress that has appeared over the last eighteen months. The government’s economic policy creates the environment in which the financial system…and the economy…have to perform. A government’s economic policy sets up the incentives that institutions respond to and, therefore, the behavior of the institutions are not entirely their own fault.
People and organizations do respond to the incentive system in place! It is a very competitive world and if you do not respond to the incentives that are ‘out there’ then your competition outperforms you and you lose your position in the marketplace. One can always say that they maintained their discipline within, say, an inflationary environment, but, it is harder and harder to maintain that discipline when others are surpassing you by following policies that are rewarded within an economy that is experiencing inflation. For example, increasing financial leverage tends to benefit companies within an economy that is going through a period of rising inflation.
The economic policy of the George W. Bush Administration created an environment that was not conducive to disciplined financial behavior. And, why should other organizations be disciplined when the Federal Government that does so much to determine the economic environment that everyone else works within is acting in an irresponsible way with respect to its own financial affairs? If the Bush Administration is creating incentives for undisciplined behavior, it is not beneficial, at least in the short run, for others to act in a restrained way.
I would strongly argue that this is not just my conclusion on the consequences of the Bush Administration. Strong evidence that others believed this to be the case comes from the foreign exchange markets. The value of the United States dollar has declined almost continuously over the past six years or so. It is usually the case that the value of a country’s currency declines when market participants believe that the economic policy of the government of that country is irresponsible and can lead to excessive amounts of inflation in the future.
The environment in which this decline in the value of the dollar took place was one of tax cuts that moved the budget of the United States government from surplus to deficit. These tax cuts were followed by a ‘war on terror’ that was not really planned for and that exacerbated the trend to larger and larger budget deficits. Furthermore, the absence of an effective energy policy contributed to the accumulation of wealth in nations and governments around the world. Large holdings of dollars were gathered by other hands that would not always act in the best interest of the United States. Finally, the Federal Reserve System, under the leadership of Alan Greenspan, kept short term interest rates excessively low for approximately three years, thereby helping to underwrite the large and growing Federal deficits.
The international banking community knew that imbalances were growing in the United States economy, but the United States government did nothing about them. The Bush Administration talked about a ‘strong dollar’ but never backed up the talk with actions. Participants in international financial markets became very cynical about the intent of the U. S. President and his administration.
Seven years of such an environment got built into the financial institutions that operated within the United States financial community. It was an environment that did not stress discipline in risk taking and that encouraged being ‘out-on-the-edge’ when it came to financial innovation and competition. The previous thirty years or so had been a vibrant period of creation in the United States and one could argue that because of this innovation, the financial markets became more efficient and served more areas of the economy than ever more. However, as the environment changed, the financial system responded, emulating the undisciplined behavior of the fiscal and monetary policies that were setting the tone for the whole market.
Now, this period in which there was a lack of discipline has ended. The consequences of the incentives created during this time are being felt, not only throughout the United States, but throughout the world. However, the thing that we must be aware of going forward into a new age of regulation is that the financial institutions themselves are not completely at fault. If the ‘bill’ for saving the financial system is a large one that must be assumed by the American people, it is right that they pay this bill for they were the ones that put the Bush administration into office. That is, the legacy of the economic policies of the past seven years will be not only higher taxes, but also a new administration that is ‘strapped’ in what it can do for there will be no room for new programs as an attempt to re-establish fiscal and monetary discipline so that as to bring the financial system back into order. My next post will discuss more fully some of the issues surrounding the potential new regulations that are coming to the United States financial system.
Should the American people have been aware of this lack of discipline? Well, most people I know were continually being shocked by the exchange rates they were faced with when they traveled internationally. “What,” they would say, “I have to pay two dollars to get one British pound? Ridiculous!” And, yet that was the case. Still, little or no concern was raised at the national level about this lack of fiscal and monetary discipline. Maybe the lesson is now being learned…even the United States cannot conduct its economic policy independently of the rest of the world! Let’s hope so!
Monday, March 31, 2008
Wednesday, March 19, 2008
Goldilocks at the Fed
The financial markets gave the Federal Reserve System three choices. The Fed could cut their target rate for the Federal Funds rate by one-half of a percentage point to 2.50% from 3.00%; or it could cut the target rate by three-quarters of a percentage point to 2.25%; or it could it could cut the target rate by one full percentage point to 2.00%.
The Federal Reserve tasted the full percentage point cut and felt that this choice was way too hot and so did not make that choice. Next the Fed tasted the choice of a one-half point cut and said that it was way too cool and so did not make that choice. Finally it tasted the choice of a three-quarter point cut and believed that it was just the right cut to make…and so yesterday it made the three-quarter of a percentage point cut.
The financial markets seemed very happy with this choice. The stock market staged a strong rally.
A question exists…who is in charge here? I believe that the financial markets are not convinced that they have the answer to this question yet.
The Federal Reserve tasted the full percentage point cut and felt that this choice was way too hot and so did not make that choice. Next the Fed tasted the choice of a one-half point cut and said that it was way too cool and so did not make that choice. Finally it tasted the choice of a three-quarter point cut and believed that it was just the right cut to make…and so yesterday it made the three-quarter of a percentage point cut.
The financial markets seemed very happy with this choice. The stock market staged a strong rally.
A question exists…who is in charge here? I believe that the financial markets are not convinced that they have the answer to this question yet.
Monday, March 17, 2008
When Bandaids Don't Seem to Work! The Current Crises.
Currently, nothing seems to work. Chairman Bernanke and the Federal Reserve are working overtime to calm things down. Still, things seem to be getting worse and worse.
Maybe the reason nothing seems to be working is that these actions are not really attacking the main problem. Maybe these actions are just ‘quick-fixes’ that try to keep things together but do not really solve the underlying difficulty. It is like the ship has been build with a deficient plan and, as a consequence, has sprung holes. The holes certainly need to be plugged in order to keep the boat afloat, but the longer term question relates to how sea worthy is the ship itself. It the ship has been constructed using a plan that cannot weather the current seas, then somehow the ship is going to have to be rebuilt according to different specifications so that it can continue to function. The problem is that we do not have the luxury to bring the ship into dry dock for the rebuilding to take place, the rebuilding must occur on the high seas.
The American financial system has achieved the position it has through the support and encouragement of the United States government. Not only has the government contributed an infrastructure to support the financial system along with rules and oversight, it has also contributed relatively sound monetary and fiscal policies that have helped the system grow and get through some difficult spots. The government and its agencies have not always performed perfectly, but they have performed well enough so that system became the envy of the world.
After the Second World War, the American financial system continued to surpass itself, in volume, in stability, and in terms of innovation. But, the system was constructed upon the foundation of the United States government being able to do pretty much what it wanted to with respect to its fiscal and monetary policy. For the most part, the government behaved pretty well. It ran into a little trouble in the late 1960s and 1970s as it attempted to provide a wider expanse of social programs to the country while, at the same time, it took on the responsibility of financing a war in Southeast Asia. The result was one of the worst bouts of inflation in United States history. Still, the government could act very much as it pleased because the American economy was robust enough and the U. S. dollar was strong enough so that world markets and market participants maintained supreme confidence that the dollar and dollar denominated securities, like the government securities used to finance the Federal deficits, could be held without fear.
Other major countries in the world did not find this to be the case. The world financial system had been constructed to allow, as much as possible, sovereign nations to conduct their monetary and fiscal policies independent of the rest of the world. Building such a system was one of the major goals of many of the participants who were a part of the peace negotiations following the First World War. This carried into the 1920s, the economist John Maynard Keynes being one of the major intellectual forces behind the effort.
Why did Keynes and others want to build such a system? There was great concern at that time over the social unrest amongst the ‘working classes.’ The Russian Revolution was a real example of what could happen in a country if this discontent got out-of-hand and became inflamed by radical leaders. Nations that did not want this to happen could only combat the situation by creating economic policies aimed at attaining the highest amount of employment possible. But, all agreed that conducting such policies could tend to be inflationary and when inflation occurred, bankers sold the currency in foreign exchange markets and the value of the country’s currency declined.
The question Keynes and others posed was how could countries conduct policies to maintain high levels of employment if their currencies would come under attack because of such policies? They believed that such a system would require fixed foreign exchange rates so that some, at least, short run stability could be achieved in their foreign exchange rate while the government could focus on the construction of a fiscal and monetary policy built to achieve high levels of employment.
This system became an institutional reality with the Bretton Woods Conference held in the United States in July 1944. It was said that Keynes ‘dominated’ this conference. In the same spirit, the United States Congress, in 1946, passed an “Employment Act” that emphasized the government’s responsibility to seek and maintain ‘maximum employment’ within the country. Other major governments supported such efforts to maintain high levels of employment in their own countries. This allowed governments to conduct economic policies in a relatively independent manner, changing foreign exchange rates from time to time as market conditions warranted. The U. S. dollar, the strongest currency in the world, was also tied to the price of gold, at $35.00 per ounce, giving it further importance in world financial markets.
The breakdown in this system started to occur in the late 1960s and 1970s. In the early 1970s, the dollar’s tie to gold was severed and the value of the U. S. dollar was allowed to float freely in the world’s foreign exchange markets. Other currencies were also freed from time-to-time as economic and political conditions warranted. Still sovereign governments continued to act independently of the rest of the world as envisioned by the Bretton Woods agreements even through currencies were allowed to trade freely.
Then the system began to break down. Major government after major government found that devising their economic policies independent of the rest of the world would not be tolerated by ‘international bankers.’ Governmental policies that were inflationary in nature were met with these ‘bankers’ selling their currency so that it became impossible for the governments to act without a consideration of what would happen to the value of their currency once the path of their fiscal and monetary policies were determined. And, the reaction of these ‘bankers’ became swifter and swifter the longer a government delayed changing its approach. As a consequence, budget deficits were reduced or eliminated and central banks were made independent of their national governments. “Inflation targets’ were introduced as guides to policy.
The United States government was able to maintain its independence relatively well through the 1980s and the deficits created by the Reagan administration. Perhaps one very strong reason for this was that Paul Volcker led Federal Reserve System at this time. As the story goes, Volcker was not the choice of President Jimmy Carter to become Chairman of the Board of Governors of the Federal Reserve System…he was too independent. But, the Fed, under Volcker’s leadership put the United States through the necessary pain in order to constrain prices increases and bring inflation under control. Alan Greenspan seemed to be a worthy successor to Volcker as the 1990s began. The Clinton Administration then proceeded to bring the Federal budget under control leaving the budget in surplus as it left office, a fiscal stance that provided the best of all possible worlds for the conduct of monetary policy.
In these twenty years, however, the world changed. First of all, globalization really took hold along with the development of world financial markets. Second, inadequate energy policies meant that the nations that produced oil could accumulate massive amounts of wealth to become an offset to American economic dominance in the world. Third, China and India became more important as world powers with sufficient economic clout. Fourth, the United States government put itself in a hole by creating substantial budget deficits, primarily caused by a massive tax cut and the need to finance a ‘bottomless’ series of wars. This situation was exacerbated by a monetary policy that kept interest rates excessively low for around three years. The result…the last nation that conducted its economic policy independently of the rest of the world came under attack.
The recent actions of the Federal Reserve System and the Federal government have only confirmed what the world financial markets have been betting on for the past six or seven years. The United States is now monetizing the debt that it had created through its ill-advised tax cuts and its very expensive wars. The old ship is no longer sea worthy and plugging holes that have sprung leaks will not provide the blue print for the future. Yes, the holes need to be plugged in order that the world financial system can limp along. But, there must be a new plan for the ship that takes into account the new water it is sailing in.
Maybe the reason nothing seems to be working is that these actions are not really attacking the main problem. Maybe these actions are just ‘quick-fixes’ that try to keep things together but do not really solve the underlying difficulty. It is like the ship has been build with a deficient plan and, as a consequence, has sprung holes. The holes certainly need to be plugged in order to keep the boat afloat, but the longer term question relates to how sea worthy is the ship itself. It the ship has been constructed using a plan that cannot weather the current seas, then somehow the ship is going to have to be rebuilt according to different specifications so that it can continue to function. The problem is that we do not have the luxury to bring the ship into dry dock for the rebuilding to take place, the rebuilding must occur on the high seas.
The American financial system has achieved the position it has through the support and encouragement of the United States government. Not only has the government contributed an infrastructure to support the financial system along with rules and oversight, it has also contributed relatively sound monetary and fiscal policies that have helped the system grow and get through some difficult spots. The government and its agencies have not always performed perfectly, but they have performed well enough so that system became the envy of the world.
After the Second World War, the American financial system continued to surpass itself, in volume, in stability, and in terms of innovation. But, the system was constructed upon the foundation of the United States government being able to do pretty much what it wanted to with respect to its fiscal and monetary policy. For the most part, the government behaved pretty well. It ran into a little trouble in the late 1960s and 1970s as it attempted to provide a wider expanse of social programs to the country while, at the same time, it took on the responsibility of financing a war in Southeast Asia. The result was one of the worst bouts of inflation in United States history. Still, the government could act very much as it pleased because the American economy was robust enough and the U. S. dollar was strong enough so that world markets and market participants maintained supreme confidence that the dollar and dollar denominated securities, like the government securities used to finance the Federal deficits, could be held without fear.
Other major countries in the world did not find this to be the case. The world financial system had been constructed to allow, as much as possible, sovereign nations to conduct their monetary and fiscal policies independent of the rest of the world. Building such a system was one of the major goals of many of the participants who were a part of the peace negotiations following the First World War. This carried into the 1920s, the economist John Maynard Keynes being one of the major intellectual forces behind the effort.
Why did Keynes and others want to build such a system? There was great concern at that time over the social unrest amongst the ‘working classes.’ The Russian Revolution was a real example of what could happen in a country if this discontent got out-of-hand and became inflamed by radical leaders. Nations that did not want this to happen could only combat the situation by creating economic policies aimed at attaining the highest amount of employment possible. But, all agreed that conducting such policies could tend to be inflationary and when inflation occurred, bankers sold the currency in foreign exchange markets and the value of the country’s currency declined.
The question Keynes and others posed was how could countries conduct policies to maintain high levels of employment if their currencies would come under attack because of such policies? They believed that such a system would require fixed foreign exchange rates so that some, at least, short run stability could be achieved in their foreign exchange rate while the government could focus on the construction of a fiscal and monetary policy built to achieve high levels of employment.
This system became an institutional reality with the Bretton Woods Conference held in the United States in July 1944. It was said that Keynes ‘dominated’ this conference. In the same spirit, the United States Congress, in 1946, passed an “Employment Act” that emphasized the government’s responsibility to seek and maintain ‘maximum employment’ within the country. Other major governments supported such efforts to maintain high levels of employment in their own countries. This allowed governments to conduct economic policies in a relatively independent manner, changing foreign exchange rates from time to time as market conditions warranted. The U. S. dollar, the strongest currency in the world, was also tied to the price of gold, at $35.00 per ounce, giving it further importance in world financial markets.
The breakdown in this system started to occur in the late 1960s and 1970s. In the early 1970s, the dollar’s tie to gold was severed and the value of the U. S. dollar was allowed to float freely in the world’s foreign exchange markets. Other currencies were also freed from time-to-time as economic and political conditions warranted. Still sovereign governments continued to act independently of the rest of the world as envisioned by the Bretton Woods agreements even through currencies were allowed to trade freely.
Then the system began to break down. Major government after major government found that devising their economic policies independent of the rest of the world would not be tolerated by ‘international bankers.’ Governmental policies that were inflationary in nature were met with these ‘bankers’ selling their currency so that it became impossible for the governments to act without a consideration of what would happen to the value of their currency once the path of their fiscal and monetary policies were determined. And, the reaction of these ‘bankers’ became swifter and swifter the longer a government delayed changing its approach. As a consequence, budget deficits were reduced or eliminated and central banks were made independent of their national governments. “Inflation targets’ were introduced as guides to policy.
The United States government was able to maintain its independence relatively well through the 1980s and the deficits created by the Reagan administration. Perhaps one very strong reason for this was that Paul Volcker led Federal Reserve System at this time. As the story goes, Volcker was not the choice of President Jimmy Carter to become Chairman of the Board of Governors of the Federal Reserve System…he was too independent. But, the Fed, under Volcker’s leadership put the United States through the necessary pain in order to constrain prices increases and bring inflation under control. Alan Greenspan seemed to be a worthy successor to Volcker as the 1990s began. The Clinton Administration then proceeded to bring the Federal budget under control leaving the budget in surplus as it left office, a fiscal stance that provided the best of all possible worlds for the conduct of monetary policy.
In these twenty years, however, the world changed. First of all, globalization really took hold along with the development of world financial markets. Second, inadequate energy policies meant that the nations that produced oil could accumulate massive amounts of wealth to become an offset to American economic dominance in the world. Third, China and India became more important as world powers with sufficient economic clout. Fourth, the United States government put itself in a hole by creating substantial budget deficits, primarily caused by a massive tax cut and the need to finance a ‘bottomless’ series of wars. This situation was exacerbated by a monetary policy that kept interest rates excessively low for around three years. The result…the last nation that conducted its economic policy independently of the rest of the world came under attack.
The recent actions of the Federal Reserve System and the Federal government have only confirmed what the world financial markets have been betting on for the past six or seven years. The United States is now monetizing the debt that it had created through its ill-advised tax cuts and its very expensive wars. The old ship is no longer sea worthy and plugging holes that have sprung leaks will not provide the blue print for the future. Yes, the holes need to be plugged in order that the world financial system can limp along. But, there must be a new plan for the ship that takes into account the new water it is sailing in.
Saturday, March 15, 2008
Foreign Central Banks and the Dollar
There is continual talk that, if not in the short run, at least in the longer run, foreign central banks, especially the European Central Bank, should cut interest rates. My question right now is “Why should they?” They have played by the rules. The United States hasn’t. For the past seven years, the United States government has gone it alone…in foreign policy…and in economic policy. It is not in the interest of other central banks to ease up on the disciplined monetary policy they have worked so hard to establish. There is also some resentment they must get over caused by the ‘go-it-alone’ policies of the United States.
Since 2001 the value of the dollar has declined against the Euro by more than 7% per year. This certainly should have been a signal to the US that the rest of the world thought something was wrong with its economic policy. But, the Bush Administration did nothing about it. Now, the chips associated with globalization and the absence of an energy policy are coming home. The rest of the world is strong enough economically and financially that the United States cannot act independently anymore.
The current activity is exactly why world markets react against the monetary and fiscal policies of a country that are not sound and disciplined and sell that country’s currency. Sooner or later that country is going to have to monetize more and more of its outstanding debt. That is what the Bush Administration is now doing. No wonder the value of the dollar continues to decline and the price of gold rises along with the price of oil. The United States is paying for its lack of discipline. However, the rest of the world is also concerned about the price it will pay for the past behavior of the United States.
Since 2001 the value of the dollar has declined against the Euro by more than 7% per year. This certainly should have been a signal to the US that the rest of the world thought something was wrong with its economic policy. But, the Bush Administration did nothing about it. Now, the chips associated with globalization and the absence of an energy policy are coming home. The rest of the world is strong enough economically and financially that the United States cannot act independently anymore.
The current activity is exactly why world markets react against the monetary and fiscal policies of a country that are not sound and disciplined and sell that country’s currency. Sooner or later that country is going to have to monetize more and more of its outstanding debt. That is what the Bush Administration is now doing. No wonder the value of the dollar continues to decline and the price of gold rises along with the price of oil. The United States is paying for its lack of discipline. However, the rest of the world is also concerned about the price it will pay for the past behavior of the United States.
Monday, March 10, 2008
Markets and Uncertainty
This is not the best time to be recommending books to people. But, I thought that, given all the turmoil around, it would be worthwhile for us to remember some relatively recent works that might help us to regain some perspective on markets (financial and otherwise) and guide us back to the fundamental issues we have to deal with during times like these. It is all too easy to get caught up in personalities or specific situations and that, in my mind, is exactly what we don’t want to do. For example, Paul Krugman’s Op-ed piece in the New York Times on March 10, 2008, is an example of emotional reporting and needs to be tempered with a review of the basics on which market participants need to concentrate: http://www.nytimes.com/2008/03/10/opinion/10krugman.html?hp.
I have great admiration for former Treasury Secretary Robert Rubin and have found his book (written with Jacob Weisberg) titled “In An Uncertain World: Tough Choices From Wall Street to Washington (Random House: 2004) to be helpful in the sense that Rubin has apparently systematically applied the techniques of decision making under uncertainty to both business and governmental situations. (I, like a lot of other people, are waiting for his next book in which he will discuss his role in the recent events at Citibank.) In terms of dealing with uncertainty there are two important ‘take-aways’ from this book. The first is that uncertainty in pervasive in human decision making. The thing that differentiates one situation from another is whether greater uncertainty or less uncertainty applies. The second pertains to the methodology used: the decision maker must be try to identify all of the possible outcomes related to the decisions that are available to her or him; and the decision maker must, in some way, assign probabilities to each of the possible outcomes.
Of course, the methodology that Rubin proposes is not an easy one to apply, particularly when one is under stress and is having to deal with markets that can move quite rapidly. Difficulty, however, is no excuse for not attempting, even in a simple way, to deal with the uncertainty that the individual is facing. We must do our research, we must read a lot and listen to many different opinions, and we must then make the best effort we can. There are no objective criteria for determining a comprehensive list of possible outcomes and the probabilities to assign to each outcome: everything is ‘subjective’. Intuition and experience are important factors alongside knowledge and skill.
Another book that is helpful in understanding the process of decision making under conditions of uncertainty is that of Michael J. Mauboussin titled “More Than You Know” (Columbia University Press, Updated Expanded Edition: 2007). There are several ‘take-aways’ from this book that should be remembered in dealing with uncertain markets. One of the first is that people tend to consider too narrow a range of potential outcomes. Thus, it is always relevant for people to expand their perspective and give attention to the possible outcomes they might otherwise exclude. It is a good discipline to force yourself to consider outcomes that you think only have a small probability of occurring. In doing so, you protect yourself from unintentionally eliminating outcomes that you might ordinarily dismiss from careful consideration.
A second thing that Mauboussin discusses which might be important in our analysis of uncertain situations is that all analysts and commentators will not be correct all of the time. Thus, we must not rely on one or just a few individuals for their view of the market. However, we should pay more attention to those analysts and commentators that have a higher ‘batting average’ than others. Even though we know that all will be wrong some of the time, those with a higher’ batting average’ will tend to have more ‘streaks’ of being right and longer ‘streaks’ than those whose ‘batting average’ is much lower. Thus, there are some analysts and commentators we should review more than others even though we know that they will be wrong a fair percentage of the time.
A third relevant factor is that individuals, according to the research that Mauboussin cites, do not always act in a completely rational way. For example, they may weigh possible losses more heavily than gains in their decision making. However, even though individual participants in the market may not be completely rational, if these participants generally act independently of one another, markets will ‘tend’ to be priced appropriately. This is because that, when aggregated into the whole market, the deficiencies of the individual decision makers seem to cancel out and the resulting prices tend to be a relatively adequate reflection of all the information that is available to the market at that time.
The time when this will not be true is when individuals do not behave independently of one another. At these times, the market becomes unbalanced because opinion tends to congregate on the buy side of the market or on the sell side and people act more like a ‘herd’ than independent individual decision makers. These are the times when the markets become ‘disorderly’ and present the greatest problem to policy makers. We have given special names to some of these disorderly situations such as ‘liquidity crisis’ or ‘credit crisis’ or ‘market collapse’.
There are two other books on markets and uncertainty that provide a good deal of insight into the world of decision making under uncertainty. Both of the books are by Nassim Nicholas Taleb: the first of these is titled “Fooled by Randomness” (Random House, 2005); and the second is “The Black Swan: The Impact of the Highly Improbable” (Random House, 2007). Both of these books contribute to our understanding of the point made by Robert Rubin that there are, at most, only a limited number of situations in life that are not subject to uncertainty. Uncertainty comes from not having all the information we need in order to make a decision or to solve a problem. The idea that we have complete information on every situation we face in life is just a fantasy. The tendency to narrow the range of possible outcomes we consider in any specific case is related to our desire for greater certainty in life: humans tend to act as if they had complete information. Taleb presents us with example after example of the absence of complete information in our decision making or problem solving.
One additional fact is emphasized by both Mauboussin and Taleb: the probability distributions that apply to most uncertain market situations are not normal distributions. Although the probability distributions used should all conform to the general rules of probability theory, it has been shown that the tails of these probability distributions are ‘fatter’ than those of a normal distribution. That is, extreme events should have more probability assigned to them than would be the case if the probability distributions were normally constructed. Thus, these extreme events may not be very probable, but the expected impact of their occurring can be more substantial than might be thought. This conclusion is not meant to frighten, but only to serve as one more piece of information that will help us to understand the performance of the markets in which we operate.
Recently in a talk, Federal Reserve Governor Fred Mishkin indicated how uncertainty can impact price relationships within a market. The case that Mishkin discussed related to the calculation of inflationary expectations measured by the difference between the yield on the10-year Treasury bond and the yield on the 10-year inflation protected Treasury securities, TIPS. This differential has been increasing since the first of the year and the general interpretation given the increase is that financial market participants now expect more inflation over the next 10 years than they had expected last fall. Mishkin argued that the increase in this differential was not due to an increase in inflationary expectations but was due to an increase in the ‘uncertainty’ of what inflation will be. In this respect, uncertainty can affect markets. But, we must deal with uncertainty as analytically as possible, for that is the best way to make decisions because it tempers the impact of the more dramatic events that we generally see in the headlines.
I have great admiration for former Treasury Secretary Robert Rubin and have found his book (written with Jacob Weisberg) titled “In An Uncertain World: Tough Choices From Wall Street to Washington (Random House: 2004) to be helpful in the sense that Rubin has apparently systematically applied the techniques of decision making under uncertainty to both business and governmental situations. (I, like a lot of other people, are waiting for his next book in which he will discuss his role in the recent events at Citibank.) In terms of dealing with uncertainty there are two important ‘take-aways’ from this book. The first is that uncertainty in pervasive in human decision making. The thing that differentiates one situation from another is whether greater uncertainty or less uncertainty applies. The second pertains to the methodology used: the decision maker must be try to identify all of the possible outcomes related to the decisions that are available to her or him; and the decision maker must, in some way, assign probabilities to each of the possible outcomes.
Of course, the methodology that Rubin proposes is not an easy one to apply, particularly when one is under stress and is having to deal with markets that can move quite rapidly. Difficulty, however, is no excuse for not attempting, even in a simple way, to deal with the uncertainty that the individual is facing. We must do our research, we must read a lot and listen to many different opinions, and we must then make the best effort we can. There are no objective criteria for determining a comprehensive list of possible outcomes and the probabilities to assign to each outcome: everything is ‘subjective’. Intuition and experience are important factors alongside knowledge and skill.
Another book that is helpful in understanding the process of decision making under conditions of uncertainty is that of Michael J. Mauboussin titled “More Than You Know” (Columbia University Press, Updated Expanded Edition: 2007). There are several ‘take-aways’ from this book that should be remembered in dealing with uncertain markets. One of the first is that people tend to consider too narrow a range of potential outcomes. Thus, it is always relevant for people to expand their perspective and give attention to the possible outcomes they might otherwise exclude. It is a good discipline to force yourself to consider outcomes that you think only have a small probability of occurring. In doing so, you protect yourself from unintentionally eliminating outcomes that you might ordinarily dismiss from careful consideration.
A second thing that Mauboussin discusses which might be important in our analysis of uncertain situations is that all analysts and commentators will not be correct all of the time. Thus, we must not rely on one or just a few individuals for their view of the market. However, we should pay more attention to those analysts and commentators that have a higher ‘batting average’ than others. Even though we know that all will be wrong some of the time, those with a higher’ batting average’ will tend to have more ‘streaks’ of being right and longer ‘streaks’ than those whose ‘batting average’ is much lower. Thus, there are some analysts and commentators we should review more than others even though we know that they will be wrong a fair percentage of the time.
A third relevant factor is that individuals, according to the research that Mauboussin cites, do not always act in a completely rational way. For example, they may weigh possible losses more heavily than gains in their decision making. However, even though individual participants in the market may not be completely rational, if these participants generally act independently of one another, markets will ‘tend’ to be priced appropriately. This is because that, when aggregated into the whole market, the deficiencies of the individual decision makers seem to cancel out and the resulting prices tend to be a relatively adequate reflection of all the information that is available to the market at that time.
The time when this will not be true is when individuals do not behave independently of one another. At these times, the market becomes unbalanced because opinion tends to congregate on the buy side of the market or on the sell side and people act more like a ‘herd’ than independent individual decision makers. These are the times when the markets become ‘disorderly’ and present the greatest problem to policy makers. We have given special names to some of these disorderly situations such as ‘liquidity crisis’ or ‘credit crisis’ or ‘market collapse’.
There are two other books on markets and uncertainty that provide a good deal of insight into the world of decision making under uncertainty. Both of the books are by Nassim Nicholas Taleb: the first of these is titled “Fooled by Randomness” (Random House, 2005); and the second is “The Black Swan: The Impact of the Highly Improbable” (Random House, 2007). Both of these books contribute to our understanding of the point made by Robert Rubin that there are, at most, only a limited number of situations in life that are not subject to uncertainty. Uncertainty comes from not having all the information we need in order to make a decision or to solve a problem. The idea that we have complete information on every situation we face in life is just a fantasy. The tendency to narrow the range of possible outcomes we consider in any specific case is related to our desire for greater certainty in life: humans tend to act as if they had complete information. Taleb presents us with example after example of the absence of complete information in our decision making or problem solving.
One additional fact is emphasized by both Mauboussin and Taleb: the probability distributions that apply to most uncertain market situations are not normal distributions. Although the probability distributions used should all conform to the general rules of probability theory, it has been shown that the tails of these probability distributions are ‘fatter’ than those of a normal distribution. That is, extreme events should have more probability assigned to them than would be the case if the probability distributions were normally constructed. Thus, these extreme events may not be very probable, but the expected impact of their occurring can be more substantial than might be thought. This conclusion is not meant to frighten, but only to serve as one more piece of information that will help us to understand the performance of the markets in which we operate.
Recently in a talk, Federal Reserve Governor Fred Mishkin indicated how uncertainty can impact price relationships within a market. The case that Mishkin discussed related to the calculation of inflationary expectations measured by the difference between the yield on the10-year Treasury bond and the yield on the 10-year inflation protected Treasury securities, TIPS. This differential has been increasing since the first of the year and the general interpretation given the increase is that financial market participants now expect more inflation over the next 10 years than they had expected last fall. Mishkin argued that the increase in this differential was not due to an increase in inflationary expectations but was due to an increase in the ‘uncertainty’ of what inflation will be. In this respect, uncertainty can affect markets. But, we must deal with uncertainty as analytically as possible, for that is the best way to make decisions because it tempers the impact of the more dramatic events that we generally see in the headlines.
Friday, February 29, 2008
What About Inflation and the Dollar?
Paul Volcker, former Chairman of the Federal Reserve System, has written that “a nation’s exchange rate is the single most important price in its economy; it will influence the entire range of individual prices, imports and exports, and even the level of economic activity.” (Paul Volcker and Toyoo Gyohten, Changing Fortunes, Times Books, New York, 1992, page 232.) If “a nation’s exchange rate is the single most important price in its economy” one really has to be concerned that the United States has allowed the value of the dollar to decline so precipitously over the past six years or so. Volcker alludes to all kinds of things that can happen to the nation that lets its exchange rate decline, but he doesn’t even mention one other possibility, a situation that has arisen since he wrote the quotation presented above, and that is the situation, like the one that has arisen, in which a country’s assets become so cheap that foreign interests can acquire them at historically low prices.
It is important to see just how badly the United States Dollar has declined in value to get some appreciation for the problem. From the year 2001 through the year 2007, the Dollar has declined at a compound rate of over 7% per year to the Euro. In terms of the British Pound, the Dollar has declined at a compound rate of over 5.5% per year. The same is true of an index of major currencies against the Dollar as compiled by the Federal Reserve System. An index that includes a broader range of currencies produced by the Federal Reserve shows a more moderate rate of decline of about 3.3% per year. However you measure it, though, the United States Dollar has not fared well in world markets during much of the Bush Administration.
These market results are important because they indicate how world financial markets are betting on relative rates of inflation in the different countries. If one works with what is called the Purchasing Power Parity (PPP) Theory for exchange rates in its pure form, one can argue that the change in any nation’s currency against the currency of another nation can be represented by the difference in the expected rates of inflation between the two countries. In this were the case, it could be argued that the difference in expected rates of inflation between the United States and England is in excess of 5.5 percentage points. That is, whatever the market expects the rate of inflation to be in England, they expect the rate of inflation in the United States to be 550 basis points higher.
Since the PPP Theory does not work exactly, we cannot just extrapolate the figures presented above and apply them to differences in expected rates of inflation. However, we don’t need to do this. We can just argue that the differences presented above provide some ballpark ‘guesstimate of anticipated relative rates of inflation. If one argues in this way, the conclusion can be drawn that, whatever the real estimates are, participants in world markets believe that inflation in the United States is much worse than it is in other countries or areas in the world. If the differences were just 1% to say 1.5%, it could be argued that the differences were non-existent or too small to worry about since the PPP Theory was not exact. However, at the magnitudes that have existed over the past six years, the differences, I believe, cannot be ignored. Market participants believe that inflation is expected to be much worse in the United States than it is in other areas of the world! The only country that is not listening to this is the United States.
Why is this happening to the value of the United States Dollar?
Let’s step back for a minute. At one time it was assumed that the United States government could run any kind of economic policy that it wanted and not have to pay for it to any degree in world financial markets. The reason for this was that the United States was a ‘big’ country and was not subject to the same pressures that ‘small’ countries were. Much of International Macroeconomic Theory relates to ‘small’ countries, but theorists and practioners, historically, have generally argued that because of its dominating size, the United States could act in a way that the ‘small’ countries of the would could not. They could get by doing what they wanted to do without much regard to international financial markets.
What happens to the ‘small’ countries when they try and do this? Well, they were kept in hand by that amorphous, unidentifiable, shady group of people called ‘international bankers’. If a ‘small’ country conducted its fiscal policy in a way that ran substantial deficits (for that county) and did not have an independent central bank, thereby increasing the possibility that the inflation rate in the country would rise, these ‘international bankers’ would sell the currency of that country in the foreign exchange markets, the foreign exchange rate would decline and the government would have to back track and reduce or eliminate the deficit and make its central bank independent of the national government.
The argument was put forward that this clandestine band of ‘international bankers’ usurped the sovereignty of nations so that the nations could no longer run their own economic policies. During this time we saw leaders, like Francois Mitterrand of France, a militant socialist, back off from combating the ‘international bankers’. They made their central banks independent of the government and began to conduct a more conservative fiscal policy. For example, Mitterrand freed the central bank of France making it independent of the national government. And, in the 1990s and the early 2000s, many other nations followed suit, making their central banks independent and mandating inflation targets for the conduct of monetary policy. But, these were all ‘small’ countries.
Now we come to the United States. After balancing the Federal budget, the United States Government, under the leadership of President George W. Bush, created massive Federal deficits through the implementation of major tax cuts and the expenses related to fighting a foreign war. In addition, the Federal Reserve System, led by Alan Greenspan, acted as a complacent component of the Federal Government and kept its target for the Federal Funds rate below 2% for over two years and at 1% for approximately a year during this time. In the past, the United States government could ignore the ‘international bankers.’ No more!
Just like any ‘small’ country in a similar situation, the international bankers’ began to sell Dollars and continued to sell them as the large deficits persisted. Yet, the Federal Reserve remained seemed to ignore the decline. The result? The United States does not seem to be a ‘large’ country anymore! Globalization has come back to hit the United States!
Still the price indices produced in the United States do not reflect this perceived inflation…at least up to this time. But, there are those that believe these price indices understate the true rate of inflation. See, for example, the perceptive article “Inflation May Be Worse Than We Think” by David Ranson of H. C. Wainwright & Co.: http://online.wsj.com/article/SB120407506089695263.html?mod=todays_us_opinion. Furthermore, we see in the commodity markets that wheat, oil and gold have all hit new highs. And, the Euro rose above $1.50 for the first time. Maybe the United States needs to put aside ideology and listen to what the market is telling us.
And, there is one piece of anecdotal evidence that maybe needs to be mentioned. In the early 1920s, John Maynard Keynes wrote about the ‘profit inflation’ that existed in England. This was a situation where profits had risen but the real wages of the worker had not. He was concerned with the restlessness in the country that had arisen due to the resulting redistribution of incomes. What I would like to point out is that all of the major candidates campaigning to become the Democratic nominee for President of the United States have taken a more and more populist position on economic policy as the campaign has progressed. Ohio is a prime example of how this message has resonated with a fairly large portion of the population. The question therefore is…has inflation really been a problem for the United States over the past several years? The magnitude of this inflation has not yet surfaced in the statistics, but it may have been experienced and felt by participants in the financial markets and by workers and by households.
It is important to see just how badly the United States Dollar has declined in value to get some appreciation for the problem. From the year 2001 through the year 2007, the Dollar has declined at a compound rate of over 7% per year to the Euro. In terms of the British Pound, the Dollar has declined at a compound rate of over 5.5% per year. The same is true of an index of major currencies against the Dollar as compiled by the Federal Reserve System. An index that includes a broader range of currencies produced by the Federal Reserve shows a more moderate rate of decline of about 3.3% per year. However you measure it, though, the United States Dollar has not fared well in world markets during much of the Bush Administration.
These market results are important because they indicate how world financial markets are betting on relative rates of inflation in the different countries. If one works with what is called the Purchasing Power Parity (PPP) Theory for exchange rates in its pure form, one can argue that the change in any nation’s currency against the currency of another nation can be represented by the difference in the expected rates of inflation between the two countries. In this were the case, it could be argued that the difference in expected rates of inflation between the United States and England is in excess of 5.5 percentage points. That is, whatever the market expects the rate of inflation to be in England, they expect the rate of inflation in the United States to be 550 basis points higher.
Since the PPP Theory does not work exactly, we cannot just extrapolate the figures presented above and apply them to differences in expected rates of inflation. However, we don’t need to do this. We can just argue that the differences presented above provide some ballpark ‘guesstimate of anticipated relative rates of inflation. If one argues in this way, the conclusion can be drawn that, whatever the real estimates are, participants in world markets believe that inflation in the United States is much worse than it is in other countries or areas in the world. If the differences were just 1% to say 1.5%, it could be argued that the differences were non-existent or too small to worry about since the PPP Theory was not exact. However, at the magnitudes that have existed over the past six years, the differences, I believe, cannot be ignored. Market participants believe that inflation is expected to be much worse in the United States than it is in other areas of the world! The only country that is not listening to this is the United States.
Why is this happening to the value of the United States Dollar?
Let’s step back for a minute. At one time it was assumed that the United States government could run any kind of economic policy that it wanted and not have to pay for it to any degree in world financial markets. The reason for this was that the United States was a ‘big’ country and was not subject to the same pressures that ‘small’ countries were. Much of International Macroeconomic Theory relates to ‘small’ countries, but theorists and practioners, historically, have generally argued that because of its dominating size, the United States could act in a way that the ‘small’ countries of the would could not. They could get by doing what they wanted to do without much regard to international financial markets.
What happens to the ‘small’ countries when they try and do this? Well, they were kept in hand by that amorphous, unidentifiable, shady group of people called ‘international bankers’. If a ‘small’ country conducted its fiscal policy in a way that ran substantial deficits (for that county) and did not have an independent central bank, thereby increasing the possibility that the inflation rate in the country would rise, these ‘international bankers’ would sell the currency of that country in the foreign exchange markets, the foreign exchange rate would decline and the government would have to back track and reduce or eliminate the deficit and make its central bank independent of the national government.
The argument was put forward that this clandestine band of ‘international bankers’ usurped the sovereignty of nations so that the nations could no longer run their own economic policies. During this time we saw leaders, like Francois Mitterrand of France, a militant socialist, back off from combating the ‘international bankers’. They made their central banks independent of the government and began to conduct a more conservative fiscal policy. For example, Mitterrand freed the central bank of France making it independent of the national government. And, in the 1990s and the early 2000s, many other nations followed suit, making their central banks independent and mandating inflation targets for the conduct of monetary policy. But, these were all ‘small’ countries.
Now we come to the United States. After balancing the Federal budget, the United States Government, under the leadership of President George W. Bush, created massive Federal deficits through the implementation of major tax cuts and the expenses related to fighting a foreign war. In addition, the Federal Reserve System, led by Alan Greenspan, acted as a complacent component of the Federal Government and kept its target for the Federal Funds rate below 2% for over two years and at 1% for approximately a year during this time. In the past, the United States government could ignore the ‘international bankers.’ No more!
Just like any ‘small’ country in a similar situation, the international bankers’ began to sell Dollars and continued to sell them as the large deficits persisted. Yet, the Federal Reserve remained seemed to ignore the decline. The result? The United States does not seem to be a ‘large’ country anymore! Globalization has come back to hit the United States!
Still the price indices produced in the United States do not reflect this perceived inflation…at least up to this time. But, there are those that believe these price indices understate the true rate of inflation. See, for example, the perceptive article “Inflation May Be Worse Than We Think” by David Ranson of H. C. Wainwright & Co.: http://online.wsj.com/article/SB120407506089695263.html?mod=todays_us_opinion. Furthermore, we see in the commodity markets that wheat, oil and gold have all hit new highs. And, the Euro rose above $1.50 for the first time. Maybe the United States needs to put aside ideology and listen to what the market is telling us.
And, there is one piece of anecdotal evidence that maybe needs to be mentioned. In the early 1920s, John Maynard Keynes wrote about the ‘profit inflation’ that existed in England. This was a situation where profits had risen but the real wages of the worker had not. He was concerned with the restlessness in the country that had arisen due to the resulting redistribution of incomes. What I would like to point out is that all of the major candidates campaigning to become the Democratic nominee for President of the United States have taken a more and more populist position on economic policy as the campaign has progressed. Ohio is a prime example of how this message has resonated with a fairly large portion of the population. The question therefore is…has inflation really been a problem for the United States over the past several years? The magnitude of this inflation has not yet surfaced in the statistics, but it may have been experienced and felt by participants in the financial markets and by workers and by households.
Thursday, February 28, 2008
More Concern over Sovereign Wealth Funds
The United States is concerned over the investments of Sovereign Wealth Funds in the United States. (See my post of February 26, “Bad Policies Eventually Catch Up With You.”) We now learn that the European Union is looking into voluntary codes of behavior for Sovereign Wealth Funds who invest in European companies. (See the February 28 article in the Wall Street Journal: http://online.wsj.com/article/SB120411561508896669.html?mod=todays_us_page_one.)
Yes, the problem is now being recognized, but the bull has already been released into the china store. The question is “Will these funds voluntarily behave over time or will nations have to legislate how Sovereign Wealth Funds should behave, and thereby put up barriers to free and open global trade?“ The Wall Street Journal article says that “Germany said yesterday it would push ahead with its own legislation aimed at shielding companies from unwanted foreign takeovers.” The United States has prevented some investment into areas that are related to national security. These may seem to be minor efforts, but once begun they can always be used as examples to push legislation a little further and then even a little further.
There is one important question and one fact that needs to be assessed relative to the situation the United States now finds itself in. The question is: “If globalization is good for our expansion throughout the world shouldn’t globalization be allowed to return to our shores with the expansion of other countries into the United States?” The fact is: the United States is now a ‘small country’ in terms of economics and finance and cannot just follow any fiscal or monetary path that it desires. Other sizeable countries in the world learned this about themselves in the 1980s and 1990s. The United States is learning this right now!
Yes, the problem is now being recognized, but the bull has already been released into the china store. The question is “Will these funds voluntarily behave over time or will nations have to legislate how Sovereign Wealth Funds should behave, and thereby put up barriers to free and open global trade?“ The Wall Street Journal article says that “Germany said yesterday it would push ahead with its own legislation aimed at shielding companies from unwanted foreign takeovers.” The United States has prevented some investment into areas that are related to national security. These may seem to be minor efforts, but once begun they can always be used as examples to push legislation a little further and then even a little further.
There is one important question and one fact that needs to be assessed relative to the situation the United States now finds itself in. The question is: “If globalization is good for our expansion throughout the world shouldn’t globalization be allowed to return to our shores with the expansion of other countries into the United States?” The fact is: the United States is now a ‘small country’ in terms of economics and finance and cannot just follow any fiscal or monetary path that it desires. Other sizeable countries in the world learned this about themselves in the 1980s and 1990s. The United States is learning this right now!
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