Friday, February 26, 2010

Leverage and Risk

Leverage alone doesn't cause recessions, so there is no problem with leverage, right? No. Leverage increases the risk of recession due to an unexpected shock, and adds rigidity to the economy making it more difficult to deal with the result. Leverage is often the symptom of other serious problems such current account imbalances due to mercantilism, or an unwillingness to face the real risk of investing for the future, or subterfuge in submerging real risk beneath the surface. Investors may prefer a lower exchange rate, or saving to investing, or the illusion of risk avoidance, but these are not necessarily in the interest of the country or the economy as a whole. Investor preferences are often the result of government policies themselves, so we need to make sure what we encourage is what we want.

Leverage is a tool and not good or bad in itself. One should expect leverage to grow with more productive opportunities and the income to support it and diminish with fewer of them and reduced prospects. One must be extremely cautious of leverage for other purposes, such as for currency manipulation, or to increase consumption or speculation. Increasing leverage is expansionary while decreasing leverage is contractionary. There can be real dangers to our economic financial well-being due to leverage and risk.

harply increasing leverage demands negative real interest rates to combat it, more inflation, but increasing asset prices can cause bubbles and keep real interest rates too high until they burst. Trying to avoid risk by shoving it onto government isn't avoidance at all. Unless we really want the socialist paradise where government is the only equity owner and everyone else can be debtors and lenders, it is in public policy to discourage it.

Thursday, February 11, 2010


Risk depends on concern and time. If you are unconcerned about the future, or concerned about a loss of future value, you may prefer to consume rather than save, or save rather than invest, or prefer short term to long. If you are unconcerned with the present, or concerned about a loss of future income, you may prefer to invest rather than save, or save rather than consume, or prefer long term to short. These preferences are not fixed but will change with your position, your income and wealth, your attitude, concerns, and expectations for the future, including the expectations of others. Risk varies across assets as well as time and people can differ in their reaction to these different kinds of risk. Often it is not your perception of risk but your perception relative to that of the market that matters. Since income risks, sources, and sinks, range and vary over time, a diversified portfolio generally provides the best match.

Tuesday, February 9, 2010

A Theory of Bubbles

Everyone has a personal discount rate that informs them and determines how much of their income they save and how much they spend, how much they invest and how much risk they will take. This will vary with income and expenses that they have become accustomed to, their wealth, changes in these, and with theirs and others perception of risk. The weighted sum of all these individual rates produce a market discount rate. Those with discount rates greater than the market I will call traders and those with ones less than the market, investors. Individuals may experience individual changes that move them between traders and investors, or changes in the market rate may move them from one to the other. While some movements are conscious and deliberate, others are often accidental and disconcerting and they will adjust their portfolios to return to their relative position.

Investors trade little and are mostly fully invested, but their flows into and out of the market are fairly steady forming slowly changing trends that are part of long term investment fundamentals. Traders trade often setting market prices at any given moment and their shorter term focus leads them towards short term value or momentum investing. An investment that starts out fairly valued according to long term fundamentals may experience a some unexpected good news. Traders will become encouraged and bid up the investment. Others will see the increase and bid it up more. The more that can be persuaded these represent long term fundamentals, the more investors will see it as less risky and join in, raising the price more. Eventually the number of new investors that can be persuaded diminishes, possibly due to exhaustion of supply or some less positive information. Value traders will have begun seeing it as overvalued and began selling. Prices after holding steady for a while will begin to fall. Momentum traders sensing weakness will shift from long to neutral and eventually short causing them to fall further. Some investors realize those weren't long term fundamentals, come to see it as riskier than they thought, or realize their risk tolerance is lower than they thought and sell more. Eventually the number of investors that were actually traders falls through attrition and declines slow. Value traders come to see it as undervalued and begin buying. Momentum traders sensing strength will shift from short to neutral and eventually long. Prices will once again rise to their long term fundamental value. This appears as short term embellishments on long term trends.

The price changes caused by traders are large compared to variations in long term fundamentals but usually small compared to what is called a bubble. Yet these microbubbles seethe almost continuously keeping the market perking. For one to get large by market standards some conditions usually must be present. A long period stability can encourage the dismissal of risk. Lower interest rates can provide a notable initial bump. Innovation and a story can obscure fundamentals and cause investors to believe in a new era and this time is different. A large number of increasingly wealthy but inexperienced traders believing themselves investors that entrain themselves into the bubble without much fear of loss. Once one bursts, it can be difficult to reinflate since they have lost a sizable amount and become highly skeptical of any new one, at least in the same asset class, while those who profited have to resort to trading in a new asset class they are less familiar with in the hope of finding more. Eventually traders are faced with the more difficult prospect of profiting at each others expense, trading success and interest diminish, and after a long while, after it proves itself again, long term investing comes back into favor.

Friday, February 5, 2010

Efficient at what?

The primary problem is people misinterpreting and overinterpreting EMH, often as not its proponents as its opponents. It actually says very little. Like Yglesias, if it were called the unpredictable market hypothesis, it would likely both be more widely accepted and less controversial. The problem is efficiency is equated to rationality but if markets were rational prices would not be subject to tectonic changes, nor would they vary widely from fundamentals. Markets may be efficient at reflecting our beliefs but our beliefs are not necessarily rational. Often people interpret it as markets may not be efficient but they tend towards efficiency (rationality). Yes, markets can stay and increase their irrationality longer than you can stay solvent, and when everyone is being irrational, there is efficiency in being irrational.

If one interprets information in an objective sense, then efficiency would imply rationality, but if one interprets it as future expectations, and especially as expectations of others expectations, then there can be no objectivity nor rationality because we are not considering the past but the future, all information concerns the past, and we are free to imagine any possible future. As future becomes past these expectations can swing wildly and imaginations can trample the hardiest of fundamentals. Imaginations are free to soar and plummet even as fundamentals keep us tethered to the realities of the past. Markets are efficient at reflecting our hopes and skepticism, greed and fear, dreams and nightmares.

Progress in Economics

What does it mean to make progress in economics? I was thinking of how Austrians are the logical descendants of the Free Banking School, Monetarists and Keynesians of the Currency School, and Real Business Cyclists of the Banking School, and how little the arguments have changed or disagreements have been settled. There may be more acceptance of a variety of causes of recessions from low interest rates and credit expansions, to high interest rates and credit contractions, to exogeneous shocks, or perhaps not. There may be a broader diffusion of responsibility from government regulation and central banks, to banking and market misjudgments or non judgments, to changes in circumstance and new information, or perhaps not. There may be more ambiguity as to problems and solutions and their effectiveness and efficiency, or perhaps not.

It also brings to mind what is meant by cause. If there is a cause than removal of the cause should prevent the effect, while if many causes it may only shift the source. If the cause may not be removed it may not be possible to prevent the effect, but if the cause may be addressed the effect may be remedied ex poste if not ex ante. If a cause under our control is powerful enough to create an effect, it must also be powerful enough prevent or remedy one, or if not, there is nothing to be done. If one has the power, one also has the responsibility, and while it may be disclaimed, it can never be disavowed. If we are capable of doing bad, we must also be capable of doing good. Causes are often selected more for the remedies they offer rather than their actual effects. This is bad science but can be in one's self interest and difficult to resist.

Science progresses through incorporation of the useful and elimination of the unuseful, and we shouldn't expect valuable insights to disappear, but neither should we expect fringe views to disappear on their own. If there weren't some truth to them they would have never been adopted and if there weren't some utility to the promulgators they would have never been kept. Progress is possible but often painstaking.