Saturday, May 23, 2009

Debt Deflation Depressions

As Irving Fisher noted, depressions are always associated with high indebtedness. Attempts to liquidate this debt then induce deflation which actually increase real indebtedness. The only ways out of this are repudiation of the debt through default, reduction of the debt through inflation, or repayment of the debt over time. Is it possible or even desirable to prevent the rise of indebtedness?

The source of indebtedness changes between depressions. The Panic of 1837 centered on real estate, the Long Depression of 1873 on railways, the Great Depression of 1929 on stocks. Not that these areas alone were affected. Debt spreads to whatever can absorb it, it is just that there are not that many areas of sufficient capital value at a given time to absorb large amounts of debt. Real estate is a common one, as are large scale infrastructure such as canals and railroads, utilities such as electricity and telecommunications, to stocks. Only the largest, most capital intensive, most geographically extensive, most economically productive, most impressive new industries qualify, but as these are at the center of the economy, all others are encompassed by them.

The amount of lending reaches a climax, optimism reducing risk perceptions. Conservative lending can prevent credit bubbles by focusing on retrospective rather than prospective views, and based on income as much as asset values, but whether conservative lending can be maintained amidst the temptation of quick easy gains is difficult. Easy lending then chases out hard lending as easy lending increases all asset prices, even those hard lending lends on. Once the price of an asset becomes detached from the value of the income to pay for it, once the price comes from the gain expected rather than the dividend generated, a bubble becomes inevitable.

Some approaches to preventing this have been to limiting the amount of debt raised through debt covenants, limiting the debt leverage involved which was done in the case of stocks, and limiting the types of loans allowable such as requiring income documentation and requiring qualification at market interest rates, and these can work, but only if maintained and required. It will probably take another generation for people to forget and for the temptation of easy lending to arise and it will likely occur in some different area as yet untouched by it. A vigilant market and a vigilant regulator may keep it at bay longer, but when our guard is down and we least expect it, it may come again.

Friday, May 22, 2009

Double, double, toil, and trouble

Can bubbles be predicted? Can they be avoided? One of the key functions of the financial system is not to avoid bubbles but to blow them. The greatest profits are to be made in skimming money from fools and bubbles offer the ideal prospect. It is the why behind ponzi schemes. It is just most of the time the ability of finance to persuade others to bite is limited, the burden of defectors can be heavy, and all too easily you can end up the fool, the fool being the last one in and last one out.

There are two methods of profiting from bubbles, for investors it is timing them, and for dealers it is trading them. Timing is always difficult, but trading is always profitable. It is just necessary to avoid investing the profits into the bubble.

The book Contrarian Investment Strategies: The Next Generation by David Dreman, begins with a tale of casino with two rooms. The red room is crowded and exciting with large sums being won and lost but the house always gets their cut. The green room is sparse and quiet and actually rewards investors for playing but it is boring. Most people prefer the excitement of the red room to the dull rewards of the green room.

A successful theory of bubbles could be preventative. Yet it is always tempting to believe what you want to believe. Anyone looking at incomes and housing prices or equivalently debt from 2004 on knew we had a bubble. It was apparent they simply could not be afforded. Even knowing this doesn’t tell you how big the bubble will get, when it will burst, where the wreckage will end up, or how bad it will be afterwards. Some will avoid them, some will hope to get out before they burst, some will play them for what they are worth, some will misjudge them, and some will be suckered into them. Bubbles exist, but they are difficult to predict and difficult to profit from them.

I doubt most bubbles could be predicted but that is unnecessarily stringent. A theory might still be useful even if it only made predictions after one burst. One might not be able to avoid them but might still be able to address them after the fact. I don’t even see bubbles as something to be avoided at all costs. They may well play an important part in creative destruction.

Credit bubbles are an altogether different matter. They are tend to be easy to see and prevent by requiring lending be limited to retrospective rather than prospective views and based on income as much as asset values. All losses aren’t preventable but systemic losses usually are. Such a bubble could continue to grow, but only through equity rather than debt. Even this isn't foolproof, though, as debt can be floated rather than formally lent. Debt makes bubbles far worse because its systemic nature results in far larger bubbles, its rigidity makes it difficult to deal with, and its liquidation can lead to deflation.

I view bubbles as a transition from assessing value to assessing other peoples assessment of value, recursively providing convergence in expectations and a positive feedback loop.

Thursday, May 21, 2009

Tell me Sammy, what do you know about the world of business

Did you know, beginning in the late 19th century, corporations were granted all the rights of the individual, but none of the annoying responsibilities. They lack, almost by design, any kind of moral compass, conscience, or compassion. Basically corporations are way to enact sociopathic behavior on a grand scale. In short, they're what makes this country so damn great!

-- The Devil, Reaper Season 2 Episode 12

It wouldn't be so hilarious if there weren't a bit of truth in it, at least from the Devil's point of view.

This illustration of the corporate hierarchy/social pyramid is that of GapingVoid

Monday, May 18, 2009

Ebbing economic tides

Rising tides usually lift all boats, while ebbing tides lower most if not all of them. When the economy grows, people don't mind when some prosper inordinately as long as they themselves are as well or better off than they were before. They like to believe they will also prosper. When the economy shrinks though, the easiest gains are often at the expense of others. For that reason, there is a strong counter tendency towards egalitarianism in times of economic stress to prevent this. We must find a commonality of purpose to pull together to overcome our hardship. We must share in the punishment and reward alike and strengthen our resolve to stand united or divided we fall.

Saturday, May 9, 2009

Market Fundamentalism

Market fundamentalists believe markets can handle anything the world sends at them, except government. They are fooled by government, naively misled by it, unable to anticipate it, or induced to take advantage of it, forced to misbehave by it, or cynically exploit it. Whenever markets fail it is the fault of government, they were only doing what was expected. The devil made them do it. How lame. Well since everything is the government's fault, it must be their responsibility to fix.

Thursday, May 7, 2009

Debt and Deflation

The banes of credit crises are debt and deflation. Debt is the destruction a credit crisis leaves in its wake. Attempting to liquidate it can result in deflation and the ridigity of debt then results in a vicious cycle. Since deflation increases the real interest rate, it makes it more difficult to repay debt while making it more imperative to do so, leading to more liquidation through default or reduction, and more deflation. Deflation must be prevented and debt defused over time. Reasonable inflation can help defuse it, allowing debt to be liquidated and easing the drag on the economy from it.

Austrians and Economics

Markets good, government bad. Markets never fail. When they fail, it is always the fault of government. Austrians suffer from an extreme anti-government bias that taints all their reasoning. Since government always exists and is always to blame, it is impossible for markets not to fail. Austrians should give up before they start since they can’t use history to establish anything. All we have is assertions that something else will be better, even though that something suspiciously resembles what we had in the past and were not happy with. At best it is assertions and wishful thinking. Wishful daydreams of ancient golden age market utopias. A kingdom for ‘the right monetary policy’. Austrians offer little in the way of explaining, preventing, or responding to business cycles than interest rates and ideology. That summarizes Austrian economics in all its tediousness and answers any question that arises.

There is some truth in credit induced booms and busts. Austrians explain a business cycle, but not the business cycle. There are more reasons than low interest rates for booms and more causes than high ones for busts. In this one it was far more relaxed lending standards than low interest rates. While lower interest rates can, although not necessarily do, relax lending standards, that is not the only way. Higher monetary velocity can as well and the central bank has even less control over that than interest rates or money. It seems evident from experimental work that bubbles are inherent to market processes.

Central banks make mistakes. So do markets, and no, they are not all due to government however fervently Austrians want to believe. The ability to make mistakes also implies the ability to correct them. We live in a more complex world than Austrians admit. While money is predominately created by the central bank, they are not alone in creating credit. While interest rates are powerful, other things such as lending standards and monetary velocity are as well. While one answer for everything may be satisfying to the zealot, it leaves a lot to be desired for the rest of us.

It is possible the central bank can’t really prevent cycles, that the most they can do is redistribute their occurrence, frequency, and magnitude, but if it is possible to make them worse it should also be possible to make them better. While accidents may happen, our actions in response need not be accidental.

Now both markets and government are subject to human foibles and both can error. Even Adam Smith thought interest rate caps prudent to prevent bad lending. Certainly the Fed should have watched the burgeoning of credit and taken steps to limit bad lending which was what made this boom unsustainable, and it should probably be doing more rather than less now to prevent further damage, but those are errors of omission rather than commission.

Tuesday, May 5, 2009

Credit Crisis Severity

Why do some asset booms end so much worse than other asset booms? Why did the housing boom end so much worse than the tech boom for example? The answer is amount, debt, and expectations.

The amount most have invested in equities is much less than they have invested in real estate, partially due to less leverage, partially due to the necessity of shelter, and substantially due to real estate coming in such large units.

Consider an asset that rises from price p to price 2p before falling back to p. Anyone that held it for the duration would be no better or worse off. Someone that sold at the peak would have a gain of p, and the buyer would have a loss of p when the price fell. In total, there is no gain or loss, only a transfer from the buyer to seller. It is zero sum to first order. Any losses leave no debt behind. Wealth was not created or destroyed overall, only redistributed.

Now consider the same situation where the asset is acquired with borrowed money. Since these asset prices are afforded by incomes which change little over a boom, they will often vary roughly inversely with interest rates, with rates falling by half before rebounding. Anyone that held it for the duration and did not refinance would be no better or worse off. Anyone that refinanced the same amount to a lower fixed rate at the peak would be better off, while anyone that refinanced to the full amount at the peak may or may not be worse off depending on the terms of the loan, but may be much worse off than they expected if they did not anticipate the decline. Someone that sold at the peak would have a gain of p, and the buyer would have a loss of p when the price fell. The lender will also have problem if the owner cannot make the payments, must sell the asset, or even is no longer willing to pay, as the asset no longer provides sufficient collateral for the loan. This is not something the lender expected. Though this is also zero sum to first order, expectations make the result worse. Some will have consumed temporary gains leaving themselves more indebted. Some will have lost any equity they may have had. Some won't be able to afford it. Some won't be able to repay the loan if they have to sell. Some won't want to pay for something that has lost so much. The lender will suffer unexpected losses. Losses often leave debt behind, debt being the residual of crushed expectations. Wealth was not created but it very often is destroyed by being consumed during the boom leaving only the debt afterwards.

So what makes equity markets so much different from real estate markets? Equities amount to much less then real estate in most instances. Equities are much more liquid in most cases. Equity markets offer much lower leverage to retail investors, a factor of 2 (50%) compared to 10 (90%) or more for real estate. Equity markets are callable and marked to market daily, limiting losses, while real estate is at the option of the owner and marked to market only on sale. Equities are volatile, fast, and changes are expected, while real estate has low volatility and changes slowly with considerable inertia and momentum.