Derman’s child

When my son was a little less than two years old, I used to play a game he liked, bouncing him up and down on my knee while chanting a nursery rhyme:

Half a pound of tuppeny rice

Half a pound of treacle

Mix them up and make them nice

Pop goes the weasel

On “Pop goes the weasel”,  I would sharply drop my knee all the way down and let him bump to the floor. He always chortled. He liked the game so much that one day he asked me to repeat it over and over again, laughing at each bump except the final one, when he turned to me in surprise and asked, “Why it’s not funny any more?” From outside himself, he understood something within himself. He had discovered that something repeated over and over again becomes progressively less funny until it’s not funny at all.

Source: Emanuel Derman, ‘Models.behaving.badly’, Chapter 3 (‘The Absolute’)

Great man Kahneman

On Nov.8th, good friend Sushant Singh sent me this lovely piece by Michael Lewis on Nobel laureate, Daniel Kahneman. What struck me about the man were two qualities. I have been wanting to blog  on them for over six weeks. Ashwin Parameswaran beat me to it with his blog post on Professor Kahneman and on Joseph Schumpeter.

Professor Kahneman seeks out those who disagree with him and collaborates with them. Then, they write joint papers! Once, he paid four anonymous referees to come up with a case for why his book should not be written and that it would be a wasted effort. His referees (thankfully for us) did not say so and the result is his new book, ‘Thinking fast and slow’.

Stability and interventions

Good friend Srinivas Thiruvadanthai (of Levy Forecasting) recommended that I read Ashwin Parameswaran’s post in his ‘macroresilience’ blog. Indeed, it is a perceptive post and it requires careful reading. I recommend that post. These are my thoughts on reading that post:

Shorn of all the complexity, it makes the simple point that the more you intervene to change/minimise/eliminate natural processes, the more frequently such interventions will be needed and in increasing quantities, to maintain that stability. the perceptive points in the post are:

(1) The withdrawal symptoms reinforce the need (tragically) for the drug and more of it – no realisation that it is the drug that is causing the post-withdrawal instability. The dependency is not felt or appreciated until it is too late

(2) The other point is that perhaps that the world does not need more safe assets but for all to become aware that there are only risk assets and that they should be able to live with it. That is a lovely point.

(3) The third point that Ashwin makes in the ‘comments’ section is that the ‘cure’ is the systemic collapse. That is what we get regardless even after we intervene. In fact, ironically, collapse becomes certain after intervention because the system demands more and more and more intense interventions. Then, the doctors can no longer provide it without causing the rest of the body enormous damage. They let the patient die. In economics, the system coallpses.

But, why do we still engage in this behaviour?

Just to name two factors (there could be more):

(a) A sense of guilt that comes about if we do not do anything about it. Democracies accentuate this ‘guilt’

(b) It postpones the consequences (the collapse is postponed) and some one else will take care of the collapse and the consequent mopping up. It would not happen on my watch.

Coming to think of it, this (b) is the feature of all actions and their consequences. If individuals know that the consequences of bad karma happen instantaneously, most would not engage in them. This is the ‘beauty’ of creation, if you will. But, we know that the consequences come through or come true in the next birth and that too randomly.

Perhaps, that is in the nature (or, the dharma) of the ‘Kali Yuga’. That is what makes it so difficult for human and human-engineered systems to stick to the right path in this time and age. Perhaps, this is how it is supposed to be in this Yuga. So, what is the answer?

Presumptuous of me to think of THE ANSWER. My answer – and one that has been stressed by a spiritual scholar-friend several times – is to let nature play out, accept and ‘surrender’ to the higher force.

Related comment from Swami A. Parthasarathy in his ‘Vedantic Treatise’ (page 38):

True happiness has a distasteful beginning. The happiness that is found within yourself is bitter to start with. But it develops later into enlarging ripples of a bliss. It is a strange phenomenon. In short, sorrow appears in a mask of joy and joy appears in a mask of sorrow. It seems paradoxical. But it is the law of nature. The ignorant masses led astray by its superficiality. In this confusion they discard happiness and court sorrow! This has been the sad history of mankind.

It should not be too difficult to extend the analogy to engineering a true, lasting and sustainable recovery from crises vs. creating a phantom recovery through quickfixes.

Setting the tone for 2012

Christian Noyer, the head of the Bank of France said that Britain deserved to be downgraded before France is downgraded. These words may not launch a thousand ships but their equivalent in the modern era.

The Reserve Bank of India did the right thing on Friday. It left the monetary policy setting unchanged. Wise move. Its forward-looking guidance was too open. The current RBI dispensation is too eager to be too transparent in terms of policy guidance. No need. Of course, it clawed back some maneuverability in the last paragraph.

Thoughts on gold

I post here a brief note I sent to former colleagues:

As we write about the performance of various assets in 2011, we do find that the US dollar has appreciated the most against Indian rupee and has gone down the most against Gold. The margin is around 15%(this number would be a bit lower now that gold had dropped a lot overnight). In spite of all the angst at the recent inability of gold to rally in the face of mounting risks globally, the fact remains that Gold has ended 2011 a lot higher than it was at the beginning of the year.

Many people think that Gold is a safe-haven against risks and these risks are mounting, the world over. However, as long as faith in paper money remains intact, gold will be one of the safe havens and not the only safe-haven. After all, it is a non-yielding asset. In a year when most fund managers – long, short, long/short – found it very difficult to make any money, it is tempting for them to sell gold where they might have good gains in 2011 and invest the money elsewhere for some quick gains in the last few months or weeks of the year.

Then, there is the forced liquidation of MF Global. We do not know exactly what kind of bets were taken, how much needs to be unwound and within what time-frame, etc. That might be having its own impact on the prices of commodities, incl. Gold.

Third, Indians who are the world’s biggest importers of Gold, have reduced their gold imports in the last two months. Their gold imports in the first nine months of the year were significantly higher than in 2010. But, as the Indian rupee declined rapidly in October and in November, Indian gold imports declined. At the margin, it is a negative but not a very significant factor.

Fourth, many European banks are actively deleveraging and selling off assets. They are not lending. They need to resize their balance-sheets and hence, their clients too. Gains in gold must be handy for many to re-liquefy themselves. In fact, this deleveraging is the most important driving force behind the last two days’ accelerated sell-off in gold.

I could think of the above four explanations as to why the recent performance of Gold has been disappointing.

Nonetheless, I would not despair. I would keep my faith in gold as a potential store of value, as an alternative to fiat money and as an insurance against the ‘end of the world as we knew it in the last thirty years’.

When we look ahead to 2012, we must include two other reasons that not only explain the recent lacklustre (pun intended) performance of Gold but also potentially point to a bright outlook for the metal:

(1) Recent US economic data have been on the stronger side and that has also put a gloss on the US dollar. At one stage, as the US economy appeared to disappoint in the summer months of July/August, the talk of an imminent round of quantitative easing (no. 3) by the Federal Reserve lifted the price of Gold. But, political opposition in the US was fierce and data improved too. Talk of another round of QE in the US has diminished considerably lately. That is another reason for the dollar to do well against Gold.

However, we do not think that the performance of the US economy or that of the US dollar to be sustainable. Indeed, as we approach the second quarter of 2012, the US economy is likely to begin to flounder again. Recent consumer spending strength is bound to be transitory. Both jobs growth and income growth are too anaemic to support US consumer spending on a sustained basis. Talk of a looser US monetary policy would be revived soon. That will cause dollar weakness (esp. vs. Gold) to resume in 2012.

(2) In the Eurozone, the European Central Bank (ECB) has, so far, set its face against unlimited and unrestricted support of the debt markets of Eurozone sovereigns. This is mostly semantics as ECB bond purchases have been helping to keep the bond yields of Italy and Spain from rising alarmingly high. Nonetheless, the market is looking for signs of unqualified ECB support. In the interests of preserving the single currency as it stands today, Eurozone leaders would go through the political process of granting rights (or, responsibilities) to the ECB to be a lender of last resort to Eurozone governments. That would open the doors for money printing by the ECB in 2012.

Thus, once we have economic weakness in the US and unqualified money printing by ECB, the next phase for gold gains would commence.

In the final analysis ,it is important to remember that gold is a portfolio insurance. If Western governments are willing to go through de-leveraging and deflation rather than resort to money printing, gold will lose its appeal because that would signal to the markets that western governments are not prepared to engage in fiat money debasement. If there is no fiat money debasement, then there is no case for gold.

In that environment, de-leveraging and deflation would be negative for all assets including Gold. But, such an attitude on the part of Western governments – if adopted – would preserve the long-term integrity of Western economic systems, capitalist societies and financial markets. If that scenario pans out, investors would have to abandon gold and buy on financial assets.

However, we think that such a scenario has a low probability and that governments would inflate their way out of debt. Neither the public nor governments in the West have the patience for hard work and the mental make-up for bearing pain.

The Euro again

That global policymakers feel trapped by financial capitalism is evident in the latest round of EU crisis measures. These are the key measures:

  • a closer fiscal accord to save the currency
  • adding 200 billion euros ($268 billion) to their bailout fund
  • tightening rules to curb future debts
  • start a 500 billion-euro rescue fund next year and
  • diluting a demand that bondholders shoulder losses in rescues

Private sector participation in debt restructuring has been diluted so much as to be off the agenda completely. Overall, it is underwhelming.

More austerity – how different that is from the European Growth & Stability Pact or the earlier rounds of austerity – and more money so that indebted governments can bail out their creditors?

Austerity will be credible in the eye of the market if there is economic growth to make the austerity-related goals feasible.

The answer for that – from academics and journalists and others – is to ask ECB to lend to the sovereigns. A wholesale Euro deprecation or debasement is their answer. See this from Wolfgang Muenchau, for example:

To solve the crisis, the eurozone requires, in the long run, a fiscal union with a prospect of a eurozone bond and, in the short run, unlimited sovereign bond market support by the European Central Bank. What we now have is no treaty change, no eurozone bond and no increase either in the rescue fund or in ECB support.

Raghuram Rajan comes up with a better answer than most. But, even he does not have answer for economic growth that would help these countries and their people meet all the demands made of them in terms of higher taxes, cuts in entitlements, etc. I had given my answer here and that is why I am growing tired of analysing the European situation and the solutions, with all their technical obfuscations aimed at desperately hiding debts somewhere.

Most commentators want to solve one problem by creating others – global inflation, social instability in emerging markets, currency wars and capital controls. I think they would prevail, eventually. So, we won’t have a Europe crisis in 2012 but something worse on a global scale.

Do we need a financial sector?

VoxEU has commenced a worthy debate on whether we need a financial sector in the first place. Two recent briefings in VoxEU website document the inefficiency and the economic uselessness of much of the activities in the financial sector.

Thomas Philippon shows that the introduction of information technology (IT) and productivity improvements led to a declining share of retail and wholesale trade in GDP whereas in the case of finance, the share of finance in GDP rose along with IT investment in the sector. It is not as though the sector found ways to contribute to economic activity. It was because financial market trading activity exploded. Since when? The Eighties, of course! Has increased trading led to better price-discovery or risk-sharing? The evidence – in terms of the number of bubbles and crises – provides its own conclusive evidence. The verdict is in even before the trial commences.

Andrew Haldane, in another paper, as part of the same debate, says that the value-added of the financial sector is measured through the compensation paid to the sector for financial risk-transfer activities. Second, compensation in the sector was tied to risk-taking. Risk transfer does not lead to economic growth. But, risk management does. How good a job has the financial sector done in risk management? Again, we know the evidence. Three years after the crisis caused, in large measure, due to the inability of financial institutions to understand (let alone manage) risk that they had created, UBS reported another couple of billions of dollars of loss in financial trading activity. Not only does the financial sector not add to economic activity or welfare through its risk-transfer or risk-bearing activities, but it reduces welfare and dampens activity when it imposes the losses of its risk-taking on the rest of the society.