What do you do on the business front? Cut prices or raise them? If your industry is competitive, demand is likely to be elastic. If you are a monopoly, almost surely you are producing where demand is elastic. If you weren’t marginal revenue would be negative. (This is a feature of monopolies.)

Either way, cutting prices and trying to increase cash flow takes priority over turning a profit, especially for a stressed company.

Now imagine you are a country. Your balance sheet is stretched, so is debt service, your bond spreads have widened. What do you do? Raise taxes? Or lower them?

Before globalization took hold the above argument would not hold. Under increased labour and capital mobility, demand for domicile has become elastic.

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We will only invest with managers who did well through 2008. Did 2008 represent normal conditions? What is the probability that the liquidity conditions of 2008 repeat themselves? How does one manage around this probability? What is the opportunity cost of assuming a high probability say > 20%?

We will never invest with any manager who suspended or (gated) restricted redemptions in 2008. Would it have been preferable to have a firesale, or an orderly liquidation? Would it have been fair to all investors both those who want out and those who want to remain invested? Was the manager protecting their own franchise or exercising due care in discharging their fiduciary duties?

We were surprised and disappointed at the behaviour of the manager in 2008. Did one understand what the manager was doing prior to crisis? Leading into the crisis? Did one understand what the manager was facing in the midst of the crisis? Coming out of the crisis? To the extent that one is comfortable investing in distress investing funds, does one see some parallels between gating and suspension and the Chapter 11 reorganization process?

We will only invest with liquid funds. Does one need the liquidity? If the only time one needs the liquidity is in a crisis then is seeking partially liquid investments which end up illiquid in a crisis the right strategy? An illiquid strategy or portfolio offering liquid fund terms is usually a failure of asset liability management, but how about a liquid strategy or portfolio with less liquid fund terms? Is it fair for a manager to demand some level of stability of assets for business stability reasons?

We will only invest with managers who have a long and consistent track record. How does one differentiate between skill and luck? Track records are the result of the combination of skill and luck. How many teaspoons of skill were added to how many thimblefuls of luck? See my coin tossing experiment.

We will only invest with managers with a record of making money on the short side. We will not invest with managers who use futures to short. Does it matter how the pasta is made if it is healthy, non toxic, hygienically prepared and tastes good? Or perhaps the diner would like to take a turn as cook?

We will never invest in managers who are short volatility. Is a short volatility portfolio always vulnerable to tail risk?

We always want the manager to have substantially all of his liquid net worth in the fund. Would you put substantially all of your net worth in your portfolio of hedge funds? Is such a manager diversifying their own personal portfolio sufficiently? What does this say about the risk aversion of the manager, their confidence in themselves and their propensity to take risk in the fund?

We will not invest in highly levered funds. In fixed income arbitrage, what level of leverage is acceptable and what is typical? In a futures based portfolio, how do you define leverage? What does margin to equity tell you about sensitivity of the NAV to fluctuations in the underlying markets?

We like to invest in market neutral funds. What market is the portfolio and the underlying positions neutral to? In credit for example, is the spread neutrality matched across the term structure?

We seek a fund with percentage of winning months over 90%, volatility below 3%, average returns of 11-12%, drawdown of no more than 1%, an 18 year track record, assets under management of several billion USD, monthly liquidity and fees of 1 and 20. Does one require an independent custodian and administrator? Does the fund sound familiar?

Investors are still adjusting from the shock of 2008 and the shock of 2009. It will take time. In the meantime, the measure of rationality in the world remains constrained. While it remains so, there are still obvious opportunities.

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I often wonder how effective central bank policy is at maintaining economic stability and price stability. Unfortunately I cannot observe comparable economies of size and complexity which do not have central banks actively managing inflation. Central banks who do not target inflation by and large manage dirty floats which import developed world monetary policy often to address mismatched sets of problems.

Perhaps it is a good idea for policy to be active only when price changes falls outside accepted bands, say +8% inflation to -3% deflation. Perhaps policy has no impact when price changes are within the range 0 to 5%. Perhaps policy needs not necessary in the neighbourhood of this range. This is speculation that is hard to test.

The money multiplier measures the ability of the fractional reserve banking system to take a buck of real money and turn it into 8 or 9 bucks of … real money. Central banks control over this multiplier is via a required reserve ratio. It tells banks how much of each buck of cash deposit they can lend out. If the ratio is X, then the multiplier is 1/X. The proof is simple. Bank 1 lends out X which is deposited in bank 2 which can lend out X^2 and so on. The sum of this series is 1/X in the limit. But here is the problem that we face today. It requires that for every 1 buck, there is X bucks demand for credit. The appetite for credit just isn’t very robust. Companies have just come out of an acute recession. Individuals have been over levered and over spending and now need to save. If the savings rate is increasing, the marginal propensity to consume must be falling and demand for personal credit must be falling. Even as central banks are expanding their balance sheets, banks just aren’t. The actual money multiplier is shrinking.

The pessimist is worried that monetary policy is not working and that the disconnect between M0 and M2 is storing up future inflationary pressures of dangerous proportions. The optimist is happy that the printing of money has not had immediate inflationary effects and that households have increased their savings rates as they should to address the imbalances between East and West that had built up to the crisis of 2008. These, however, are the dynamics of household credit. What about corporate credit?

A low interest rate presents a low hurdle rate for investment. Corporate demand for credit will be dependent on product demand which is dependent on domestic and export demand. Domestic demand is a function of household propensity to consume. Export demand is dependent on a whole bunch of exogenous factors. It is sensitive to the terms of trade and thus exchange rate and inflation. As global growth recovers from the recession of 2008 and it becomes apparent that growth either is less robust than expected or less robust than necessary for tax receipts to pay down public debt, desperation often leads to beggar-thy-neighbour exports policies.

On the consumption side, one of the imbalances leading up to the crisis was a negative savings rate of the US consumer and a generally low savings rate in developed countries. Economists at the time prescribed prudent financial management and raising the savings rate. At the same time, they prescribed lowering savings rates in emerging economies like China as a means of correcting trade imbalances. The credit crisis had an instantaneous effect of reversing the direction of trade imbalances and addressing the domestic savings rates. Faced with lack of credit, US and rich world consumers had no choice but to increase savings rates. In addition, sudden risk aversion and uncertainty over investment portfolios, performance of pensions and employment prospects helped to raise savings rates. This manifests in a reduced marginal propensity to consume. What is individually rational collectively self defeating and detrimental to aggregate demand in what is known as the paradox of thrift. The paradox of thrift has several well known counterarguments.

-          Slack demand leads to lower prices spurring demand.

-          Savings are loanable funds representing an increase in potential lending. Consumer spending is offset by institutional lending.

-          Assumes a closed economy. Savings may be invested abroad.

The problem faced today is that:

-          Quantitative easing is balancing deflationary pressures. Moreover, price inflation is more prevalent in asset prices (claims on future goods) than in goods (current goods).

-          Savings are loanable but its not just individuals who are hoarding money, institutions are hoarding money as well, as evidenced by the reduced multiplier. The expansion of central bank balance sheets has not found an analogous or proportional expansion of commercial bank balance sheets.

-          The paradox of thrift actually holds for closed systems and the World is a closed system. In addition, trying to break the paradox at the domestic level leads to a beggar thy neighbour approach towards trade policy.

So the paradox of thrift is a real issue and likely to mean weaker real growth and less inflationary pressure.

In emerging markets, a larger proportion of income is spent on subsistence hence the marginal propensity to consume is not only higher but more stable. In more mature economies where incomes are higher, the proportion of income spent on subsistence is lower and thus the marginal propensity to consume is less stable. As government spending seeks to fill the deficiency, the transmission mechanism, the velocity of money, is a function of the marginal propensity to consume. Much as the fractional reserve system of banking has a multiplier, fiscal policy passes through a spending multiplier. That multiplier has in the current economic climate, been reduced. Where once government spending was multiplied, today it is being saved. Why? Because we can. Because greater uncertainty encourages more saving. Because the reaction to more inflation may perversely encourage cash hoarding. Because people make strategic errors. The result is a realization of the paradox of thrift at a global level.

The loss of the multiplier is not catastrophic as long as it is not counted on. It is therefore crucial that Government therefore directs its fiscal efforts at productive expenditure. If a road is built, it should be a toll road and a profitable one. If a railway needs to be built it has to be a profitable project. Bridges to nowhere lead to nowhere physically and fiscally.

Time is necessary for savings and consumption rates to stabilize and to reflect income and employment prospects and inflation expectations. It takes time for businesses to stabilize their demand for credit, for lenders to stabilize their risk aversion, for the banking system’s multiplier to re-establish itself. In the meantime there is little that capitalist systems can do to steer an economy in the path they wish.

For centrally planned economies the problem is not easy but it is easier. They have better short term control over the path of development of the economy, but over the longer term are hostage to the same noise and uncertainty, perhaps more so, than their capitalist counterparts.

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One way of measuring correlations between managers is to look at cross sectional standard deviations of returns, i.e. the dispersion of returns, between different hedge fund strategies.

Here is what raw dispersion looks like across the HFRI strategy indices:

Disperson is fairly stable in a range except for the 1999/200 equity bubble bursting and the 2008 cerdit crisis. The chart is distorted by overall high volatility across the industry. To get a better picture of dispersion it is necessary to adjust for the industry wide volatility.

Here is what adjusted dispersion looks like across the HFRI strategy indices:

Dispersion looks more stable now. There is still a spike in the credit crisis of 2008. This can be explained by a marked divergence between liquid and illiquid strategies.

A smoothing of the above series reveals a pattern similar to that often found in volatility series whether in credit, equities, commodities or FX. Just as volatility tends to spike and fade, there is a cyclicatility of dispersion that tends to spike and fade. This can be explained by how new strategies, which initially outperform and are also uncorrelated, are learnt and emulated by competition and quickly eventually become crowded.

I’ve extended this analysis to the subset of Asian managers represented by the Eurekahedge Indices.

Here is what adjusted dispersion looks like for Asia ex Japan strategies:

There doesn’t appear to be anything remarkable here. The market recovery in Asia seems to have been captured by most managers and strategies as dispersion fell throughout 2009. We see also how dispersion fell from 2003 once managers adjusted to the reality of a real recovery in Asia post SARS. What it seems to indicate is that for all the opportunities in Asia, Asia remains a very macro dominated market where managers struggle to differentiate themselves and decouple from market beta.

A remarkable chart is one of adjusted dispersion of Asia hedge funds including Japan.

Dispersion has been low since 2004. The dominance of Japan in this data set is indicative of Japanese hedge fund behavior. The herd mentality is high. Dispersions were low going into the bumper 2005 period, and remained low even as managers lost money the following year in a market cap mismatched bear market.

The low dispersion in hedge fund returns in the Japan inclusive sample mirrors the low dispersion of opinions and forecasts among Japan equity analysts.

The silver lining is that for the independent thinker, Japan is a great environment for differentiating oneself.

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What is driving equity markets lower is tightening of monetary conditions as central banks across the world try to normalize policy after a period of unprecedented monetary stimulus.

India and China have increased their reserve ratios, the Aussies have raised rates, even the Fed is slowing its pace of mortgage asset purchases.

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Debt levels as a percentage of GDP:

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Credit Markets Inverted:

Credit markets are considered normal when, to put it crudely, borrowers want to borrow more than lenders want to lend. There is no way to put it rigorously. Of course lenders want to lend but they really really want their money back and then some. When lenders are more desperate to lend than borrowers are to borrow, the credit markets are no longer normal, and all sorts of perverse phenomena arise.

Sound lending principles require the lender to know and understand the borrower, their situation, their objectives, their ability and intention to repay, structure the loan to suit the borrower and the lender and their respective objectives, monitor the loan and the borrower through the life of the loan. As long as lenders are ‘reluctant’ lenders, the level of diligence in the credit process will be high.

What went wrong that led to the 2008 credit crisis? Was it proprietary trading? Sub prime lending? Hedge funds or private equity? Was it LBOs? I don’t think so. Some of these are symptoms but they are not the cause. I think it will be difficult to define a cause, but I also think that we can be more specific about the causes and get closer to the mechanics of the meltdown.

How the bubble was blown:

Lenders became too willing to lend. They became more willing to lend than borrowers were to borrow. This resulted in weak lending standards and weak loan covenants. Basically, people borrowed too much because some other people lent them too much. But what made lenders behave this way?

There was demand to buy mortgages. This came from demand for mortgage backed securities which in turn came from demand for CDOs. Every link in the chain is an intermediary. There was demand for yield. There was excess demand for yield. Why?

There was insufficient supply of income bearing assets, or the yield from income bearing assets had compressed to very low levels. This was certainly true of corporate debt. Spread compression occurred across all corporate credit across all credit qualities. There was excess demand for yield. Why?

Was it that investors were allocating away from equities and commodities and towards fixed income? Certainly pension funds in the aftermath of the Dot Com induced bubble and crisis would have allocated away from risky assets towards less risk assets, or so they thought. The losses arising from equity investments from 2001 – 2002, the increasing funding deficit building at many pensions meant that pensions became desperate yield seekers.

Yield seeking investors will typically invest in sovereign as well as corporate bonds. The developed markets by running large trade and thus current account deficits, by implication ran large capital account surpluses, reflecting in most cases the recycling of surpluses. These surpluses were recycled through the purchase of sovereign securities, US treasuries. Chinese and Japanese central bank buying pressure seriously depressed yields on US treasuries keeping the yield curve very flat. This meant that investors were faced with low interest rates across the curve so that they could not create a levered carry trade in USD alone, and they were not getting sufficient yield on their longer dated treasury bonds. Yield investors had to look elsewhere; however, many of them had restricted mandates which limited them to highly rated credit instruments.

Here is where financial innovation became an accomplice to the bubble and the beginnings of the credit crisis. Wall Street is one of the centres of human innovation.

Securitization is nothing new and can be traced to the 1970s. GNMA was one of the pioneers and issued MBS as early as 1970. By the mid 80’s securitization had been adopted in other types of loans such as auto loans and credit card debt.

The period 2003 to 2007 is interesting. A general spread compression led to investors seeking yield in more complex albeit highly rated securities paying higher yields than corresponding single name credits of equivalent rating. Enter CDOs. By pooling and leveraging, CDO’s achieved a sleight of hand which resulted in such securities being available to investors. The demand for such products resulted in demand for the underlying collateral ultimately leading to demand for mortgages, on the lender’s side. As even CDO products experienced yield compression, the quest for yield resulted in sub-standard collateral: sub prime mortgage loans.

The quest for yield led to other cool innovations such as synthetic CDOs where the underlying collateral consisted not of bonds or loans but credit default swaps, that is, side bets on whether loans or bonds would pay or default.

A note about credit ratings agencies: Investors were at the time investing in securities awarded investment grade ratings by the credit ratings agencies. These agencies are paid by the firms that arrange the products offered to investors and not by the investors themselves. This is a flawed model of course and anyone can see it. Nobody will fix it, however, as investors prefer free conflicted advice to paid for unbiased advice. Quite how investors could have relied on the output of these conflicted ratings agencies is remarkable.

How the bubble burst:

The instability:

As the credit markets grew out of hand, lending standards were weakened resulting in poorly structured loans being made to weak borrowers. Probabilities of default therefore rose. These were not measured by any models since models have always been based on historical data and are better suited to more symmetric risk. Credit risk is highly non-spherical.

Not only were default probabilities higher but loan to value levels were also higher. This was due to the availability of credit ironically inflating the value of the very collateral that was supporting it, and also weaker lending standards requiring less security.

I do not want to talk too much about the Shadow Banking System here. This was a lattice that evolved after Glass Steagall was repealed during the Clinton administration leaving financial institutions only Basel II to optimize around. By 2006, hedge funds, investment banks, structured investment vehicles and CDOs were a thriving part of the thriving Shadow Banking System.

The problems created by excessive indebtedness had been building from 2003 peaking in 2007 when several sub-prime lenders went bust. Since mid 2007, the mortgage crisis had been slowly unfolding. The highly visible failures such as Lehman and AIG were merely symptoms of a more fundamental weakness. The breaking point in the mortgage market was not a singular event. There obviously came a point when debt service became impossible and collateral cover had become inadequate.

One can argue that the crisis was precipitated by fatigue in the housing market. There is a more concrete phenomenon than this. As lending standards get weaker, for a given level of variability in income in the case of debt service, and for a given level of volatility in capital values in the case of collateral cover, the probability of breaching covenants gets higher. Foreclosures exert downward pressure on capital values which in turn result in further defaults.

A note about Lehman and AIG: These casualties were collateral damage. Lehman had large exposures to lower rated tranches of CDOs collateralized by mortgages. Typically, the higher rated tranches were sold to long term investors seeking liability driven investment solutions. In order to market these higher rated tranches, it is often necessary to retain the lower rated tranches in a demonstration of alignment of interest. Whether Lehman retained these exposures intentionally or whether they were retained to market the senior tranches is unclear.

Calling bank failures collateral damage is a bit much. As intermediaries in credit creation banks are accomplices to excessive indebtedness. Their multiple roles, particularly in the finance of trade also make them important as a utility. The interconnectedness of the banking system and the shadow banking system implies that some institutions are too big to fail or too interconnected to fail. Operating under this assumption is a prime example of moral hazard. The existence of a lender of last resort significantly strengthens this phenomenon.

The tipping point:

There is no distinct tipping point. However, the maximum level of safe leverage is a function of the variability of assets. For a given level of variability, increasing leverage increases the probability of insolvency. Poor lending standards increase leverage towards this point. For a given level of level of variability of income, increasing debt burden increases the probability of delinquency. Poor lending standards increase debt burdens towards this point.

Defaulting mortgages, increasing delinquencies result in decreasing values of mortgage pools, result in decreasing values of mortgage securities, result in decreasing values of collateralized mortgage securities, result in decreasing values of investors’ portfolios and ultimately to insolvency in the case of levered holders of these assets.

Secondary market effects provide a positive feedback. A positive feedback on the way down is a bad thing. Foreclosures lead to falling collateral values causing a cascade of declining values in all the securities down the chain and ultimately to investors’ balance sheets.

The medium term effects:

As the solvency of banks is threatened, the LIBOR market is impaired, cost of capital surges and there is an acute retrenchment of credit leading to an acute reduction in investment and employment.

We won’t delve into the bailouts that ensued in 2008 or their merits. In a crisis situation there is no good or bad rescue. There is only a rescue. What we know is that the scale of fiscal and monetary policy targeted at reviving credit markets has been unprecedented. Central banks the world over created money to fuel credit reflation and to pay for government expenditure. Fiscal policy was similarly expansionary to replace private consumption and investment. The result has been an inflation of the nominal output in each asset and goods market. Where real output has been constrained, prices have risen. This has been more true in asset markets as asset creation was capacity constrained.

Ten seconds into the future:

Fixing the system:

Let us assume that the system was flawed. We need to assume this because it is not clear if it was. It may be that the trade off for avoiding big blow ups is more frequent but smaller blow ups, or no blow ups but a reduced rate of growth and development. In the long run, a smoother path is fairer because it reduces the impact of luck in timing. Booms and busts are disruptive and introduce perverse and sub-optimal behaviour at the major inflexion points. Cycles may be acceptable. However, we cannot know ex ante if our policy or model will truly prevent busts so we should budget for some level of cyclicality. Back to the analysis, lets assume the system is flawed.

The first step to solving a problem is to understand the circumstances leading up to the crisis. Blame has so far been ascribed to bankers, hedge fund managers, regulators, central banks, in that order. There is a growing recognition that the public and investors were to some degree to blame. There is a growing suspicion that perhaps the general model and philosophy is broken. The poor understanding of the public, the media, even industry specific media, of one constituent of another’s sphere of operation, regulators of the shadow banking industry, the shadow banking industry of investors, investors of regulators, central banks of hedge funds, is highly illuminating. If this is the quality of information and communication across the financial system, which one central planner or regulator has the information and the understanding to fix it?

Now I am going to waffle. There is no other way. I have no answers, only more questions which I hope will provide a framework for considering the future. Apologies.

As we sift through the cinders, we find not one smoking gun but a series of failures. I list them in no particular order.

Investors were not diligent or cautious enough. Why?

Banks were not diligent or cautious enough. Why?

Central banks were complacent and left interest rates too low and for too long.

Regulators acted after the fact and were ineffective. Could they have acted any other way and was this an optimal response?

Central banks acted swiftly and effectively. Is this so unquestionably a good thing?

Pension fund behaviour emerging from the 2001 recession

Global imbalances from the emergence of China as a world economic power

The rise of the shadow banking industry as a system of levers

The death of volatility post 2001 and the implications for risk capital provisioning

There will be regulatory response. Especially since the regulators took a good portion of the blame for the crisis. Also, the bailouts of 2008 required large amounts of public money which will translate into either of inflation or taxation. Taxpayers will expect to be heard. The phase of regulatory reform is upon us. The path of regulation will be driven by public opinion, politics, money and logic, in that order. The appropriate analysis of regulatory reform should therefore be approached in the same order of seniority: public opinion, politics, money and only then logic. Since public opinion is fickle, politics is often individually rational but otherwise makes no sense to society, the path of regulation is a roll of the dice. We suspect, and can see some momentum behind heavy handed regulation pandering to the cries of the public to ‘crucify them!’ Money controls politics in every capital in the world from the most capitalist to the most socialist. The bankers will lobby the politicians and regulation will be delayed, diluted or otherwise misdirected. More inefficiency.

Yield investors such as pension funds have already been on the path of diversification into alternatives such as private equity and hedge funds. Their initial hunger for yield in the wake of the 2001 recession led to unnaturally low interest rates. If their weight of capital is sufficient, they can bring more efficiency to markets through arbitrage strategies. In a sense this was what happened from 2004 to 2007. Arbitrage strategies were the preserve of the few sophisticated investors, clubby family offices, a handful of private banks and their clients, mainly scions of Worms et Cie and their contemporaries. Until 2004. From 2004 a wall of institutional money went in search of arbitrage profits leading to market efficiency and no-arbitrage. The beauty of arbitrage is that it is eminently leveragable. Hedge funds increased leverage and capital employed from 2005 to 2008. Note the poor performance of hedge funds in 2005 coincides with a period of massive growth of unlevered assets in hedge funds before they had the opportunity to adjust their leverage up to meet the new low-arbitrage environment. Where do these institutional investors go next? The sophisticated ones will always lead and the less sophisticated will follow. The less sophisticated ones are less stable investors and likely responsible for flight of capital since they invest in fear and inadequate information. You can recognize them by the liquidity terms they demand; they are unsure and therefore need an out. Intermediaries like funds of funds are forgiven this allegation since they are hostage to the liquidity they provide their own investors.

Global imbalances built as China and India emerged as the manufacturing powerhouses of the world. The opening of China to external investment opened up a huge resource of cheap labour. Optimal planning required developed world economies to build reliable production capacity in low cost countries. Thus capital and intellectual property was exported to China and India just as cheap goods were imported in return from these countries. This created the beginnings of the trade deficit. It is difficult to justify the argument that the Chinese save too much. The marginal propensity to consume is higher at lower incomes. The Chinese should have been saving less than the American. The pattern of expenditure is as important as the macro variables they constitute. The Chinese worker can hardly afford imports. The low cost producer can hardly afford imported inputs. They are likely to save in the form of buying a home. The amortization will be accounted for as a saving. In the US, the consumer is well described by Friedman’s permanent income hypothesis. An equity bull market and rising home values led to optimism about future income. Stable credit markets and low interest rates also supported the hypothesis; until now. A feedback loop was created as the Chinese recycled their trade surplus by purchasing US treasuries effectively providing vendor financing for Chinese exports. This feedback loop will take some time to unwind but is in progress. The current account imbalance has made a significant correction and looks set to continue despite some volatility in the time series.

Volatility is a very interesting quantity. It tends to spike and fade. Its one of those few series where an inverted chart is immediately recognized as an inverted chart. Here is where I really waffle. As a measure of risk, it is not a very good one. There are a whole host of micro technical reasons why an investor is more concerned with the shape of a distribution than merely its second moment. An investor is therefore concerned about all the even moments of a distribution. Only under the assumption of normality does the second moment together with the first, fully characterised the distribution. Risk is a very complex concept that can hardly be characterised by a single measure. But now lets waffle. It seems that dynamic systems have a fairly stable quantity of risk that doesn’t go away. As volatility falls, it stores up the potential for discontinuous or gap risk. Why? Complacency seems to be the waffly answer. If investors focus on volatility as the sole or primary measure of risk, they must add exposure as volatility falls. As exogenous risk falls, investors would attempt to keep their risk exposure constant by adding exposure, usually through leverage. This probably also explains why volatility tends to spike and fade. Leverage is added up until the point where volatility results in negative or zero equity. At this point investors reduce leverage, an act which precipitates further downside volatility, further destroying equity and triggers more selling.

Capital adequacy is a framework in banking regulation require banks to hold capital to ensure their solvency under the variability of their risky assets. The capital ratio is a single number that hopes to characterise factors in credit such as character, cash flow, conditions, capital and cash flow. Focus reduce complexity at the expense of granularity. One of the criticisms of the Basel II framework for capital provisioning is that it is pro cyclical, a criticism that has gained validity in the 2008 crisis. While the Spanish economy has acutely underperformed its counterparts in the Eurozone, Banco de Espana’s dynamic provisioning framework has arguably led to a more robust Spanish banking system. Basel II, however, results in less capital being required the longer a bull market lasts. This supports the storage or accumulation of gap risk concept that results in the spike and fade phenomenon exhibited by volatility time series. Dynamic provisioning is not a panacea. It still requires econometric estimation of past cycles in determining a forecast default rate. Models are not always robust and can result in over provisioning (and thus higher cost of capital) and to a lesser extent under provisioning. Be that as it may, if sufficient numbers of banks apply some sort of counter-cyclical provisioning, and if the econometric models forecasts are taken in the context of how wrong they can be, a degree of safety can be had which does not over-provide for losses to the extent that there is a long term secular impact on cost of capital.

More interesting than all these micro issues is the question why investors were over confident and not cautious enough. For investors, either information was inadequate or misleading. If it was misleading, regulation needs to be reformed to improve transparency and clarity in the financial system. If it was inadequate, one has to ask why an investor would risk capital under insufficient information. Transparency and clarity in the financial system certainly needs to be addressed. One can argue that investors should put a premium on transparency and clarity and thus provide a market solution. If they did not, then reference the analysis for the case where information was inadequate. Transparency and clarity should be encouraged or imposed by regulators on financial markets so that financial institutions have to provide a certain level of disclosure on a standardized basis in a format that is clear and not misleading. Arguably this is already covered by the law, in particular under the concept of misrepresentation under contract law. Standardization and format are simple concepts but can be difficult to implement given the level of complexity of financial products and instruments. However, the level of complexity and the inability to report in a particular format is already a signalling device to investors.

If investors operated under inadequate information or if inadequate information was not priced then it is likely that investor sophistication is the issue. Investors require education. This certainly should apply at the retail level. If we teach basic skills in schools, we should teach people how to manage basic household finances. This is no different from hunter gatherer teaching the basic management of resources. Any education beyond this probably needs to be paid for by the investor much as an aspiring surgeon needs to pay to acquire those particular skills. We still need to teach our children language and basic mathematics. This part sounds particularly waffly but is probably more important than any other initiative.

As interesting is the question why banks were over confident and not cautious enough. Risk compensation and risk homeostasis can explain some of the behaviour of banks. Compensation design is another significant factor. Compensation schemes in banks offer considerable optionality to the agent (employee). The reward for success is a share of profit and the price of failure is unemployment. Risk compensation and homeostasis result from the implementation of Basel II, the increased awareness and publication of financial stability reports, and the existence of a lender of last resort. Depositors and shareholders were complicit in their complacency likely for the same reasons. The existence of a lender of last resort and the idea that an institution can be to big to fail contribute to moral hazard and complacency.

The complaint that central banks, notably the Fed, kept interest rates too low for too long is a valid one, but the point is subtler. While the Fed kept rates well below that suggested by the Taylor Rule, the BoE and the ECB did not. The unanswerable and to me most interesting question is, what would equilibrium short term rates be had there been no prescription from central banks. To answer this, central banks would have to avoid signalling interest rates to the economy. One could argue that, at the margin, inflationary pressures would debase the current stock of money leading to higher equilibrium interest rates while disinflationary pressures would inflate the current stock of money leading to lower interest rates. Unfortunately there is not theoretical support for this as for every model that supports it, there is an equal and opposite one that refutes it. Such is the dismal science. One can argue against activist interest rate policy on the grounds of ‘first do no harm’. The instability of dynamic systems, the probability that any sort of policy is pro-cyclical, that the information available to a central planner (that is what a central bank is when it is setting interest rates) is inadequate and that the market is a better processor of such information. So the complaint that the Fed kept rates too low for too long can be generalized to the complaine that the Fed sets interest rates at all. Perhaps we should rethink the whole raison d’etre of a central bank.

Where do we go from here:

Let’s look at the general level of debt in the US economy. The periods of major expansion of household balance sheets in recent times occurred in the mid to late 1980’s slowing only in the recession of the early 1990’s. From 2001, household debt as a percentage of GDP accelerates again, no doubt on the back of easy credit and low interest rates. The acceleration goes all the way through 2008 and falls off in 2009. Similar patterns are seen across corporate and business debt to GDP ratios. In the case of mortgage debt, the acceleration from 2000 is quite pronounced and accelerates well above trend to peak in 2008. Corporate debt, however, while exhibiting the same general trends does not exceed trend growth rates and from 2000 to 2009 stays below trend. Corporate indebtedness also exhibits less autocorrelation and thus less trending and momentum than household or mortgage debt. Federal debt to GDP is actually trending down from 1952 to 1979 only accelerating in the early 1980’s to peak a decade later. From 1995 Federal debt to GDP falls through to 2000 when it begins to pick up again. In 2008, it spikes of course as the some proportion of private sector debt is transferred to the public sector and emergency fiscal measures take effect. From these patterns it seems that private debt will decline or grow below trend in the coming years while public debt has already grown above trend in compensation and will likely remain above trend for some time. This analysis is flawed since it is inconceivable that debt to GDP can grow indefinitely without bound. At some stage, trend rates must flatten, and the level of specialization and credit creation must plateau. But it does confirm the transfer of debt from private to public balance sheets, and gives us some idea of magnitude and periodicity. A 3 to 5 year period of credit retrenchment is likely. As for the Federal debt, that can and has stayed above trend for more extended periods. The public sector is a very poor CFO, seems to be the message.

Corporate earnings were boosted in 2009 by a combination of inventory restocking and cost cutting. Quantitative easing and deficit fiscal spending helped certain sectors such as infrastructure and the auto industry grow top line at above trend rates. History teaches us that recoveries don’t follow a straight line and that oscillations can be expected as the global economy adjusts to a new reality.

Credit will no longer be so readily available and will be rationed. Cost of capital will rise despite the efforts of central banks to distort prices. Excess capacity still persists in many quarters such as the auto industry and the real estate industry. Most credit dependent industries will suffer from this overhang and until the capacity is removed there will be no sustainable recovery.

Interest rates will likely be kept lower for longer. Inflation fighting remains a concern but below trend growth and unemployment are likely to be the political expedients. This is likely to store up inflationary pressures or fuel another asset bubble somewhere in the world but may not be as effective in tackling unemployment as hoped. Bull market employment conditions resulted in individual undersupply and collective overemployment in the labour market, conditions which may not return for some time.

Asian central banks will continue to finance the current account deficit, albeit a shrinking one. Global imbalances will likely unwind with the China US trade position moving towards balance, with associated implications for the currencies and interest rates, those less subject to central bank interference that is.

Basically, the global economy has healed itself and has found a new (dynamic) equilibrium. Business as usual, pre 2003, cycles included. Anticlimax.

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People out of work tend to stop their efforts in December as the year comes to a close because they know employers stop their searches close to the year end. In the new year, the number of people who return to actively seeking work picks up. This explains why the initial jobless claims are usually in bigger deficit every January, February.

Macro data are often seasonally adjusted to take into account temporal dependencies in the data.

Similarly, forecasts of macro data often use the same estimation models to arrive at their forecasts. Say that we have a fairly comprehensive model that assumes that the data exhibits seasonality, cyclicality, momentum, mean reversion (more generally than suggested by cyclicality and seasonality), a general drift. Models are estimated based on some assumption as to the stability of the uncertain part of the data. It is always assumed that the data consists of a portion that can be explained (by explanatory variables, by autocorrelations, moving averages etc.) and a portion that cannot. Before a model can be estimated and ready for use in forecasting, assumptions need to be made about the behaviour of the portion that cannot be explained.

Unfortunately, when you have a big crisis like 1930, 1970, 1987, 2001, 2008, the data violates most of the assumptions in previously stable models. There is no good way of dealing with extreme events which by definition don’t happen very often. You just can’t calibrate a model on a few pieces of data. In any case, the inclusion of crisis period data simply confounds models and their predictive abilities.

Like now. Models calibrated on pre crisis data are no good in the crisis. The same models calibrated on crisis data, are simply no good for post crisis prediction. It is far more useful to understand the dynamics behind the numbers. The way in which initial jobless claims are calculated introduce lags, introduce behavioural phenomena which are hard to quantify. Expect more volatility in the series as the number of people who come back to the job market inflate this unemployment measure. As the economy recovers, expect to see the measure lag, and overshoot on the recovery.

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