Thursday, January 29, 2009

Time to be a market taker, not a market maker

As I said in Harvard ten years ago, we need an early warning system so that international financial flows are properly monitored. UK PM, Gordon Brown

I've had the good fortune during my career in finance to be both a market maker, one who sets prices, and a market taker, one who trades on prices made by others. Depending on market conditions there are virtues of either approach. When markets are efficient, using Fama's definition, market making tends to be profitable as price setters capture the bid-offer spread. When markets are inefficient, and thus likely to be discontinuously volatile, market taking seems wiser as you don't get forced out of (or into) positions.

Modern Central Banks, by definition, are the ultimate market makers in the shortest term interest rate markets of their respective currencies- e.g. The Fed sets the Fed Funds rate and maintains it against all market takers.

More and more over the past few decades, Central Banks and other public sector directed funds have expanded their market making activities into foreign currencies, equities and commodities, especially, Gold. If, for instance, mortgage bonds fall in price, Central Banks, in one manner or another act to set a floor under the market. Setting a bid in a market is a market making action.

Setting a ceiling in a market, like Gold, as Britain, in effect, did in 1999, when Gordon Brown was Chancellor of the Exchequer was also a market making action, one which proved to be most unwise.

That same Mr. Brown, now promoted to Prime Minister (Peter Principle perhaps) would like some credit for seeing the current crisis coming. Mr. Brown, as the opening quote relates, may have seen the crisis coming, but he didn't understand it.

Let me explain with the help of a Brit wiser than Mr. Brown, one Bertrand Russell.

In The Analysis of Mind Russell argues: a person understands a word when a) suitable circumstances make him use it, b) the hearing of it causes suitable behavior in him......Understanding words does not consist in knowing their dictionary definitions, or in being able to specify the objects to which they are appropriate.... understanding language is more like understanding cricket: it is a matter of habits.

He gives an example: Suppose you are walking in London with an absent-minded friend, and while crossing a street you say, "Look out, there's a motor (i.e. car) coming." He will glance round and jump aside....He "understands" the words, because he does the right thing.

In Gordon Brown's case, it would be as if someone told him, while he was in the road, that a car was coming at him and he said, "We need an early warning system to help pedestrians know if cars are coming at them," but didn't get out of the way.


It seems clear now that selling England's Gold Reserves was not the "suitable behavior" of Russell's definition if one understood a crisis was coming. According to the Sunday Times, Mr. Brown's actions were not considered "suitable" at the time: At a secret meeting with senior gold traders, Bank of England officials were warned that the proposed auctions would achieve the worst price for taxpayers. The officials are understood to have agreed with the analysis but said they were powerless to influence the Treasury.

In my first post on equilibrium I related an observation which might explain Mr. Brown's curious view: I sometimes wonder if the distinction [between correction, i.e. the government produced variety or, as they seem to think of it, exogenous action and self-correction, i.e. the private sector induced variety, or as it is known, endogenous] is, in part, a result of a desire to see government as Aristotle's (or Aquinas' if you prefer) "unmoved mover," adjusting a game board on which the rest of the world plays.

As the disgraced and recently deposed former government of Iceland can attest, the state is not exogenous to the rest of the country.

In hindsight, the financial managers in Iceland likely see the wisdom of pricking a bubble before it implodes, instead of fomenting it and taking credit therefore. Even if the managers are impotent in pricking a bubble, policies, both in word and deed which aim to prick a bubble will save at least their credibility when it does implode, as all such bubbles must.

But, I digress, a bit.

I began by arguing the current virtues of being a market taker. One key aspect of such a strategy is the perspective of market taking- endogeneity.

Market takers don't fight the market, they try to profit from it, or at least avoid losing in it. Market takers are aware that unrealized profits are less valuable than realized profits, by which I mean, profits which might accrue due to a position in an ongoing trend are not profits unless that position can be liquidated, either by reversing the trade or making use of the material. To wit, a market taker who bought gas early in 2008 at $100 could have profited either by selling the position at a higher price or by using the gas himself when prices at the pump were higher.

Market makers, when markets are inefficient, by contrast, often find themselves with large and growing positions which they cannot liquidate- liquidation is a market taking action. Because the market maker's price is wrong, sometimes radically, market takers are always acting on one side of the price and thus never take the market makers out of their position. The Bank of England's failed defense of GBP in 1992 is a classic example of market making run amok- market makers who get the price wrong will inevitably be forced to become market takers, at the worst prices.

Here at home, I find some of the talk of the Fed becoming a market maker in long dated Treasuries a disaster in the making from the same mold that led to the BoE's error.

Far better, it seems to me, for US Financial managers to be market takers. If the world wishes to buy long dated Treasury paper at such low rates, the US should sell it and extend the duration of the public debt.

Alas, market makers, whose self-image tends to that so aptly described by Tom Wolfe in Bonfire of the Vanities- Masters of the Universe- rarely see the wisdom of becoming market takers without "touching the stove" and being forced to liquidate during a crisis. Sherman McCoy for Treasury Secretary?

Me, I'm just happy to be a little market taker.

Tuesday, January 27, 2009

A bit more 'bout Equilibrium

A diligent (and, in my view, quite perceptive) reader of this blog, STS, was curious about my views on equilibrium.

I marvel a bit at the confident use of the term equilibrium in a case where a system spends so much of its time out of equilibrium. It's almost a kind of magical thinking. But your point about the timescale of equilibration (or trend reversal, at any rate) is well taken. Markets have timescales which relate somewhat inversely to their depth and liquidity. I suspect a better way to think of market equilibrium would draw upon an analogy with the rather turbulent 'vacuum' in quantum field theory -- full of spontaneous creation and annihilation and anything but 'settled'.

Before addressing his views directly, let me warn that discussion of words such as "equilibrium" which are used alternatively to describe both external natural world phenomena and the relation of human consciousness thereto is fraught with great peril of miscommunication. It would perhaps be better to use different words for each: a) to describe a stasis in a physical system as an equilibrium b) to describe the human condition of one-ness with reality with another word, perhaps the Greek eudaimonia, or the Buddhist enlightenment to avoid confusion. For the sake of brevity, (and because I'm too lazy) I'll use "equilibrium" and hope this warning will be sufficient to express my meaning.

(Whew!, who knew pedantry would be so exhausting)

Onward and forward.

To directly answer STS's comment, my argument was not that markets specifically or human consciousness of reality, of which markets are but a small subset, more generally were at equilibrium but that they tended thereto. The distinction noted above comes into play here as the path of human consciousness to equilibrium with reality is, at times, non-linear, and sometimes quite violent. Moreover, the, in my view, tendency of human consciousness to equilibrium with reality is a process, not a state- it can always be improved.

The Greek word, apocalypse, speaks to the non-linear path of equilibration when false views long believed are suddenly exposed as such.

There is a Zen Koan (riddle-story) which might explain this point.

There once was a young man who wished to be enlightened as to the secrets of life and death. He went in search of a monk who lived alone near the summit of a mountain who was thought to know such things. After a long search, the young man found the monk and asked his question. The monk though for a while and then told the young man of a large tiger who lived in the valley below. "Put your head in the mouth of the tiger and you will learn the secrets you seek," advised the monk.

I'll play Bodhisattva and share my views on the koan- the true purpose thereof is to inspire the listener to think, thus its apparent unfinished-ness.

If the young man does not seek out the tiger, but instead contemplates the likely outcome of such an action, he chooses a path of less apocalyptic enlightenment. One "secret" of life and death is that we all die. Another secret which often remains hidden is how. If you young man seeks out the tiger and puts his head in its mouth, both that we die and how he dies will be revealed. This would be an apocalyptic path to enlightenment.

In either case the tendency is for human consciousness to equilibrate to reality, gracefully or violently.

Now, if we could only find the monk who advised world leaders seeking the path of monetary enlightenment to adopt the policies of the past few decades...for the tiger's jaws are closing.

Next up: Gordon Brown, who sold Britain's Gold for, in hindsight, peanuts, as Cassandra. He saw it coming.

Tuesday, January 13, 2009

It's not the Size of the Stimulus, it's what's in it that counts

One of the aspects of President-elect Obama' stimulus plan that seems, to me at least, lacking, is vision. Debate seems focused on size, as in $s, or locale, as in which elected official gets to bring home the bacon. I wonder what would be done with the money and more importantly how these public works will improve efficiency. That is, what returns are we expecting from these expenditures.

Although my view is not as dire as that of my friend, James Howard Kunstler, I agree with him that we need to retool our economy for a world with less available petroleum for us. Public works without vision become Keynes' nonsensical notion of virtuous hole digging and refilling.

One needn't believe in Peak Oil to envision a world with less oil available for US consumption and use that vision as basis for infrastructure construction. Yes, I've read Obama argue for the need to wean ourselves from foreign oil dependence and even the need for high speed rail service but the arguments seemed to me more like talking points cobbled together rather than a vision of the future.

Contrast the debate of Obama's stimulus plan (the language of which speaks to a very financially centric view of the world) with that of Eisenhower's push for an Interstate Highway System (yes, I'm aware that the latter created the mess we are in) or even the Clinton Era vision of the "information super-highway."

Section 108 of the Federal-Aid Highway Act of 1956 states: It is hereby declared to be essential to the national interest to provide for the early completion of the "National System of Interstate Highways", as authorized and designated in accordance with section 7 of the Federal-Aid Highway Act of 1944.

Returning to the notion of our, in my view, overly financial perspective on economics, contrast the above quote with recent economic issues considered "essential to the national interests" such as recapitalizing the current banks (whose wisdom, in part, led us to this impasse) or maintaining a strong dollar. Economics ain't just finance, indeed the former exists without the latter, while the reverse isn't true.

It seems to me time to return to a more "bricks and mortar" (remember that snide view of the old economy our Finance fueled Tech gurus gave us) view of economics. To paraphrase Marie Antoinette- let them eat (alternatively) integrated circuits or dollars!

Alas, a return to a more bricks and mortar view of economics brings us to the problem Kevin Phillips explained in American Theocracy. Adopting a new vision for the future means hurting certain vested interests (and creating new ones).

One of the causes for America's rapid ascent on the world stage was its new-ness. Unlike Europe, where cities are often many hundreds if not thousands of years old, America was, in a sense, a blank slate. Had the World Wars not been so destructive in Europe, thus erasing some of the slate, if you will, Europeans' adoption of efficient rail transport et. al. would have been much slower.

Perhaps we could add an addendum to Bastiat's views on the broken window- breaking a window as a stimulus does make sense if a door would be more efficient and there is reluctance to part with the window.

I'd love to see Obama roll out a vision of an energy efficient America based on a much increased railway system for both goods and human transport in the same mode as Eisenhower's embrace of Highways. Let the auto companies go bust, re-employ their plants and people making rail cars, roads and stations.

Of course, this means the value of the stock of automobile centered suburbia will crash, but that will likely happen anyway.

Alternatively we blow a bunch of stuff up like the Europeans did by having the next war in our backyard.

I'd prefer the former approach.

Thursday, January 08, 2009

Of Course Markets Seek Equilibrium

The salient feature of the current financial crisis is that it was not caused by some external shock like OPEC raising the price of oil or a particular country or financial institution defaulting. The crisis was generated by the financial system itself. This fact—that the defect was inherent in the system —contradicts the prevailing theory, which holds that financial markets tend toward equilibrium and that deviations from the equilibrium either occur in a random manner or are caused by some sudden external event to which markets have difficulty adjusting. The severity and amplitude of the crisis provides convincing evidence that there is something fundamentally wrong with this prevailing theory and with the approach to market regulation that has gone with it. George Soros

During a self-imposed hiatus from writing- I needed some time to fill the tank, if you will- I had ample time to allow a few thoughts to germinate and grow. Sometimes the rush to put something on the blog isn't conducive to following a thought in sufficient depth.

But, I digress.

As you can infer from the title of this post, I disagree with Mr. Soros' view that markets don't tend to equilibrium.

This view begs the question, what is equilibrium? Mr. Soros, I imagine, looks at the current financial chaos and sees disequilibrium. I take a longer view and see much of the past few decades as a period of disequilibrium obscured by easy credit. As credit conditions have tightened the hidden disequilibrium comes into view, or as Buffett would put, the outgoing tide exposes naked people.

The current chaos is, to me, part of the process of awakening people to need for change- an equilibrium seeking process. Chaos has its purpose.

A decade ago equity investors valued tech companies like the Dutch valued tulips during the early 17th Century- dearly. Today, after some chaotic price action, one can buy both items at much more reasonable, by which is meant, nearer to equilibrium, prices.

A few years ago US real estate investors valued properties at, in some cases, many multiples of replacement cost. This overvaluation has been and continues to be unwound.

Markets correct.

I'll repeat myself and argue that markets self-correct, to draw your attention to what I see as a distinction without difference- correction and self-correction.

To distinguish between correction and self-correction is to assume exogenous factors when, it seems to me, all market participants, be they private or public, are endogenous thereto. Had the Greenspan Fed decided to prick the numerous asset bubbles rather than let them expand, implode and clean up the mess left behind, this too would have been self-correction for the Fed is as much a market participant as you or I are.

I sometimes wonder if the distinction is, in part, a result of a desire to see government as Aristotle's (or Aquinas' if you prefer) "unmoved mover," adjusting a game board on which the rest of the world plays. The prevalence of this view might explain the rather curious distinction between public debt and private debt- a view which seems to assume that governments don't ultimately operate under the same financial constraints private sector corporations do.

The question of market regulation should not, it seems to me, be debated as if, in the absence thereof, markets wouldn't correct. They have and will. Rather, the question of market regulation should be debated in much the same way that education is debated, as a means of expediting and improving a process- in the case of education, general human awareness of the world- which occurs naturally, albeit sometimes slowly and even, at times, regressively.

Further, market regulation (and education) should not be seen as something imposed on others from outside but rather as a policy one would (and hopefully does) impose on one's self as Rawls argued in his Theory of Justice.

Some Austrian leaning readers may well be cringing at the thought of advocating market regulations as if a specie standard is not a form thereof. The classical Gold Standard was a severe regulation which allowed everyone to act as regulator, albeit with varying impact. Under that form of regulation one needn't turn to a public sector bank regulator, one merely forced the bank in question to return your deposits in gold at a fixed price.

Given the "success" of the alphabet soup of public sector financial regulators of late, a return to such a system might prove wise. In hindsight, it may be clear to many that such a system of regulation would have attenuated excesses. From the perspective of the self-regulator, those who thought of their money as real, i.e. those who self-imposed this regulation, have certainly outperformed those who thought that credit would always be easily found- an outcome which fits the Rawlsian perspective noted above.

When market regulation is considered from that perspective, the view proposed recently by Krugman, et. al. that FDR's regulatory system was some peak, relative to pre-Depression and current times seems a bit odd. Rather, market regulation has been in decline for decades. FDR did impose regulations on the financial sector but only after removing that regulatory power from the common man of means by outlawing private sector Gold holding. This substantial deregulation meant that financial firms need only convince the state that they were solvent.

Thus the Greenspan-era financial sector deregulation can be seen as just another step in a long process. As the Madoff (et. al.) scam demonstrates, convincing the state one is solvent is apparently quite easy, if you are considered to be an inside guy.

Coming full circle, recent steep market corrections in this environment of virtually no regulations seems to disprove Mr. Soros view.

Markets correct. It would just be better if they corrected sooner.

Up next: It's not the size of the stimulus, it's what's in it that counts.