Saturday, April 20, 2013

Rogoff, Reinhart, and minding your "D'oh"s and "Duh"s

"D'oh!" according to the Oxford English Dictionary (really!) is self--and-past-referential (think "eureka" with a self-deprecating slant) while "duh" refers, insultingly, to others without any sense of time.  In the words of Matt Groening, "so, you might say 'D'oh!' when you've been stupid, and 'Duh!' when you think someone else is being stupid, but then duh!, everyone knows that, right?"

Timing, as the saying goes, is everything.  In Carmen Reinhart's and Kenneth Rogoff's experience timing is the difference between enjoying bestselling author status and wearing a (metaphoric) dunce cap.  Examining centuries of history and most major trading nations of earth, This Time Is Different, their impressively researched, financial perspective on financial crises won them great fame, credibility and, I assume, money.    Based on the same data and premise- too much debt is bad- their paper,  "Growth in a Time of Debt", merely narrowed its focus to the public sector.   Their timing, and tone, with the benefit of hindsight, couldn't have been worse. 


Why?    


It's as simple as the difference between "D'oh" and "duh" and an interesting mental habit known as confirmation bias.


As evidenced by the wild who, how and why speculations following the Boston Marathon bombing, people's search for meaning in the face of disaster often leads inside rather than out.  Upset when the unthinkable becomes real, the threatened mind redoubles its efforts confirming other assumed aspects of "reality."  Those fearful of radical Islam before the bombing weren't surprised when first a Saudi National, and then Chechen immigrants were labelled suspects.  Their bias confirmed, no further questions needed to be asked.


This mental habit has its virtues. Imagine feeling the need to thoroughly examine a table's stability before putting a coffee mug down?  or a road's stability before driving?  A quick biased glance usually suffices for most.  Expertise in a field depends, in part, on informed bias.  An experienced auto mechanic (at least back when human diagnostics were the norm) usually narrowed down problems after a few questions, glances and a listen (whether they used this information to save you money is another matter entirely).


Sometimes, however, even well-informed bias misses warning signs hindsight, informed by consequence, can't ignore.  Homer Simpson's famous "D'oh!" got laughs because we've all been there.


For Reinhart and Rogoff, however, the crisis of 2008 wasn't a "D'oh" but a "duh" event.  Their bias wasn't a revelation occasioned by the crisis, its roots, as I'll soon explain, are much older than that.  The revelation was that others, influential others, didn't share their bias and maybe they could change that.


Years before This Time is Different was conceived Mr. Rogoff revealed his bias in a letter to Joseph Stiglitz just dripping with "duh": You seem to believe that if a distressed government issues more currency, its citizens will suddenly think it more valuable. You seem to believe that when investors are no longer willing to hold a government's debt, all that needs to be done is to increase the supply and it will sell like hot cakes. We at the IMF—no, make that we on the Planet Earth—have considerable experience suggesting otherwise. We earthlings have found that when a country in fiscal distress tries to escape by printing more money, inflation rises, often uncontrollably. Uncontrolled inflation strangles growth, hurting the entire populace but, especially the indigent. The laws of economics may be different in your part of the gamma quadrant, but around here we find that when an almost bankrupt government fails to credibly constrain the time profile of its fiscal deficits, things generally get worse instead of better.
 

Ouch!

In book form, their bias won them fame and fortune by eliciting "Doh"s.  Unlike the letter excerpt above with its reference to different laws in your part of the gamma quadrant, their book modestly hoped to give future policy makers and investors a bit more pause. 

That same bias, in the follow-up paper more closely resembled the letter in tone than the book.  In Congressional testimony, Carmen Reinhart wasn't sharing their bias to give pause, but to form policy.  Stripped of some nuance, and thus more actionable (politicians dream of such one-handed economists) correlation became dissent quashing causation. 


A unilateral causal pattern from growth to debt, however, does not accord with the evidence. Public debt surges are associated with a higher incidence of debt crises. In the current context, even a cursory reading of the recent turmoil in Greece and other European countries can be importantly traced to the adverse impacts of high levels of government debt (or potentially guaranteed debt) on county risk and economic outcomes.

There is scant evidence to suggest that high debt has little impact on growth.


Duh (ok, she didn't say that)

Another thing she didn't say was: In most instances, with enough pain and suffering, a determined debtor country can usually repay foreign creditors. The question most leaders face is where to draw the line. The decision is not always a completely rational one. Romanian dictator Nikolai Ceau┼čescu single-mindedly insisted on repaying, in the span of a few years, the debt of $ 9 billion owed by his poor nation to foreign banks during the 1980s debt crisis. Romanians were forced to live through cold winters with little or no heat, and factories were forced to cut back because of limited electricity.  
Reinhart, Carmen M.; Rogoff, Kenneth (2009-09-11). This Time Is Different


I copied the above from their book and am not surprised Reinhart didn't share it with Congress.  The story didn't fit what she was trying to sell.  In the event, Ceausecu's policy of austerity led not only to revolution, but his own execution.  That tale would have made for bad "optics" as they say in Washington.

 
Switching tone from "D'oh" to "duh" has its perils as explained hereDuh is more derisive than doh. Perhaps because the word is associated with Homer Simpson, doh has a humorous quality about it. Duh is sometimes deployed with humorous intent, but more often for the purpose of mocking oneself or another. Put another way, saying duh in the wrong place at the wrong time could ignite a bar brawl. To my knowledge, no physical violence has ever been sparked by the word doh.

Dissenting economists, who'd previously been civil, dropped the gloves. Preferring to brawl in words and numbers rather than fists, the growing number of dissenters increased their scrutiny of the data.  Hell, it seems, hath no fury like an economist duh-ed.  Like Joe Wilson  fighting "stove-piped" data and the 16 words the dissenters' charges of cherry picked data, un-reproducible results, and excel coding errors started flying.  The damage, however, had been done.  Austerity in policy circles became a "duh".  I hope the bias doesn't lead to self-fulfillment.


In the event the US might have muddled through but for this, don't assume I'm laying the blame entirely on their, no doubt, well meaning shoulders.  To me, their bias was a catalyst which ignited another more commonly held bias.

Money not only matters, it matters a lot.

Hoping to give pause to austerity cheerleaders I'll offer a dissenting opinion (most likely to a chorus of "duhs" from the dissenting economists noted above).  It's not so much the size of the debt, it's what you do with it that matters.  Duration, source and relation of debt to current growth shouldn't be ignored but, in my view, the use of debt generated funds and the context of time and place are at least as important considerations.  While nothing is guaranteed in such matters, debt incurred to build hoped to be productive capital shouldn't incite as much worry as debt incurred to buy sports cars and vacation homes (or debt incurred to pay banks to hide the true level of debt).


What we in the US have been doing with debt sourced funds is a study for another time.  What we will do with it in the future is still unwritten.

Thursday, April 18, 2013

Goldenfreude? how about Bankenfreude

Cheer if you will Goldbug bashers, but I suspect if Gold starts another swan dive, it won't be alone.  There may even come a time when you wish Gold would rise.

"Triumphalism," Paul Krugman opined in a 1997 New Republic article, "presents its own problems." Under the, dare I suggest, ironic headline, Superiority Complex, Mr. Krugman completed his thought: " though the "American model" has scored some important successes, it continues to fail in other respects, above all in generating an ever-increasing level of inequality. And we won't begin to address those failures if the national mood remains dominated by self-congratulation." He closed the article with sage advice for his readers: "The truth is that nothing in the experience of the last few years contradicts the idea that we could have a kinder, gentler economy that preserves the main virtue of the American system--high employment. All it would take is compassion. And a little less gloating."

Compassion, and a little less gloating might also help Mr. Krugman understand, rather than mock, Goldbugs- a label which, contra Krugman's caricature thereof, denotes a group exhibiting a very wide range of economic/investment views- while they are nursing their recently suffered monetary wounds. I imagine for every gold hoardin', gun totin', doomsday preppin' angry white male proclaiming the end of the world (they annoy me too),there's at least one confused, upset and perhaps unemployed person who's fed up with Wall Street's "head's I win, tails you lose" investment strategy, (or one, like myself, who believes structural reform-blocking rigidities in the developed world won't be overcome easily leaving only 2 eventual paths for excess liquidity, inflation or default). Those confused and unsettled Goldbugs, having witnessed a succession of bursting investment bubbles at home and more recently read about bank runs abroad might, not without justification, have decided to save in Gold, rather than a bank, or his mattress.

Mr. Krugman, alas, is not gloating alone over Goldbug's recent misfortunes. One clever soul coined the term Goldenfreude to describe his state of mind. Joe Weisenthal proclaims, EVERYONE Should Be Thrilled By The Gold Crash- a view echoed by Felix Salmon. Barry Ritholtz leavened his disdain for Goldbuggery with a sliver of compassion, I do not want to engage in Goldenfreude — the delight in gold bugs’ collective pain — but I am compelled to point out how basic flaws in their belief system has led them to this place where they are today. Gold, he avers, has no fundamentals and those who buy are engaging in the ultimate greater fool trade.

While living in SE Asia during their late 90s crisis I witnessed first hand one of Gold's great virtues- when a nation's banking system, and almost always coincidentally, currency, comes under pressure Gold holds its value. The haircut recently forced on Cypriot savers was far less than that inflicted on Gold by the market. In other words, despite recent declines I'd rather be holding Gold in Cyprus than waiting in an ATM line to withdraw my daily allotment of currency.

America, the gloaters might retort, is not Cyprus. No, it isn't, and I (casting off one aspect of Krugman's Goldbug caricature) sincerely hope we don't find ourselves in their financial straits. My bet is that such can only be avoided by further monetization AND, in the absence of rapid real sector productivity gains which don't exacerbate income inequality induced domestic tensions (unlikely given right wing intransigence on welfare state expansion or a domestic Modest Proposal a la Swift), wage and price inflation.

"A ha," Krugman, beating his gloating compatriots to the punch, would likely argue, "you Goldbugs are always talking about runaway inflation. Didn't you read my recent article mocking your inflation worries thusly: "But the runaway inflation that was supposed to follow reckless money-printing — inflation that the usual suspects have been declaring imminent for four years and more — keeps not happening."

I agree, and the absence of broad based inflation given the stimulus in an environment of limited structural reform outside the developing world is my concern. I suspect if Mr. Krugman would stop gloating, it might be his too (more on this below).  If the recent decline in Gold signals, as many gleefully hope, a decline in inflation expectations, might the US, and, I suspect, other mature industrial economies (Europe and Japan) be drawing ever nearer to a stall in growth followed by a liquidity crunch?

Consider this potential catalyst for the Gold crash. "Macroeconomic stimulus," said a US Treasury FX Report chiding Japan for the recent, now reversed, Yen slide, "...cannot be a substitute for structural reform that raises productivity and trend growth." We'll return to structural reform momentarily after a look at market reaction. The Yen's rapid recovery following this report's release was coincident with the Gold crash- perhaps both price adjustments represent market belief that inflation games (currency debasement either externally or internally) won't be tolerated.  With austerity the rage in European policy circles (we aren't far behind in that regard, thanks to the Republicans), competitive devaluation verboten and Gold signalling, to the cheers of many, declining inflation expectations, I'd be surprised if yet another liquidity crunch isn't around the corner.

Factors Behind the Forecast:  Structural Rigidities and Over-Leveraged Finance

Despite recent record profits, the US financial system, still dependent on a few highly leveraged (how else to achieve such profits in a low interest rate environment) TBTF banks, is far from stable. Many mortgaged home-owners are still looking up at the zero-equity line. Those cheering the absence of inflation simply, it seems to me, because such makes Goldbugs look stupid, might want to consider that in a highly leveraged economy, the cascading defaults of deflation- the "it" Bernanke assured us wouldn't happen here- always loom in the background.

Cheer if you will Goldbug bashers, but I suspect if Gold takes another swan dive, it won't be alone. As we've seen over the past few days, Gold price declines are mirrored to various degrees by oil, other commodities, and equities. Declining prices, if such becomes the trend, will lead to higher unemployment and, amplified by the former, declining house prices and rising foreclosures. In the teeth of such an event, some might be yearning for the days when Gold was rising and inflation was assumed. I'll admit, such a scenario favors the dollars-saved-in-a-mattress strategy rather than Gold ownership but both tactics are anti-investments ridiculed by Goldbug bashers.

The elephant in the room for the Goldenfreuders is the lack of structural reform in the developed world- an omission perhaps due to a focus on high frequency and exclusion of low frequency economic factors. Structural reform, for those unfamiliar, refers to changes in the capital structure (factories, transport systems, education programs, agricultural methods, etc.) that hope to produce more for less. China's rapid economic growth over recent decades is, in large part, an effect of these reforms such as the shift, in 1978, from communal to industrial farming.

Significant structural reforms are often resisted.  Consider the resistance some individuals display when asked to eat less, drink and smoke less, and exercise more.  Note, "when asked."  Change is much easier (but not guaranteed) when it's wanted.  Consider, for example, the rapid adoption of computers and cell phones.  I doubt even severe coercion could have done half as much in twice the time.  Fortunately the benefits of these new technologies were readily apparent and despite some resistance by, e.g., book store owners to Amazon, those individual losses were smaller than the aggregate productivity gain.  Those productivity gains created an environment where jobs were plentiful, further easing stress caused by the destruction economic creation usually entails- agriculturalists rarely coexist harmoniously with hunter gatherers but they produce more food per acre meaning, if the latter adapt to the new system, both groups can survive.

In cases when reform calls for the destruction of wealthy industries with government ties, substantial legal changes, or labor downtime and re-education for a significant portion of the work-force (especially in the absence of a decently funded welfare state), resistance can effectively block what would likely be widespread productivity gains.  Pre WWII rail transport in continental Europe seems a case on point.  International disagreements over railway standards and routes (an example of structural reform-blocking rigidities) kept the continent from reaping the productivity gains a fully connected rail system promised- and delivered, after a devastating war cleared away both dissent and, sadly, large chunks of the old rail system.  Expanding on von Clausewitz for the modern world (which finds the more apt term, political-economy, too archaic) war is not just politics by other means but economics by other means- the worst means, in my view.

Structural reform-blocking rigidities are, in a sense, other words for productivity sapping rent seeking- e.g. from a bottom up perspective, Luddites breaking machinery or US autoworkers striking to avoid being replaced thereby, and from a top down perspective, trade barriers (tariffs) or de jure monopolies (Britain's BBC prior to 1955).  Profits and Investments in rent seeking industries, particularly when higher productivity methods are known and feasible, tend to be misdirected from entrepreneurial activity (why make a better or cheaper widget when it's cheaper to bribe a competition stifling official?).  Bribery doesn't seem to me a very economically productive activity although it obviously benefits some while irking others.

For an example of a structural rigidity overcome consider recent changes in US law which reduced regulations on where and how (think fracking) petroleum products can be extracted.  Fracking has changed N. Dakota from a deficit to a surplus state and driven unemployment to near zero.  Before you send me a nasty-gram, I'm not arguing such is an unalloyed good- insufficient profits are likely flowing to those who have been and certainly will be negatively affected (this is no environmentally neutral practice).  I'm merely pointing out the positive economic benefits thereof.

To digress for a moment, first with an apology to the economically literate for the rudimentary and likely (to some) unsatisfactory treatment of these issues and second with further explanation thereof: the ideological (and physical) battle between communism and capitalism over the past two centuries is the battle between productivity and people.  In my view, productivity is most effectively and durably enhanced at an imaginary "sweet spot" between radical laissez faire (think Ayn Rand) and communal ownership (Marx).  Transfer payments, whether private (charity) or public (government welfare) are, in my view, necessary to ensure social cooperation within the capitalist framework.  Domestic dissent is a sign that transfer payments are, whether as a result of insufficient funds or inefficient distribution, not performing their function.  Labor dissent in many developed economies (Occupy and austerity protests in America and Europe respectively) suggest to me a hopefully solvable but currently intractable transfer payment crisis.  The pendulum has swung too far right which isn't meant to obviate calls therefrom for greater transfer payment efficiency.

Cheers for the Gold crash sound to my ears like cheers for austerity in Europe and further dismantling of the welfare state in the US. If Japan needs inflation now, don't we as well? Perhaps we too should join the Euro? and give up our right to buy time with inflation?

I'll close with a look at another structural reform-blocking rigidity whose removal might justify a moment of schadenfreude. The phrase "Too Big To Fail" speaks to a de jure monopoly of sorts for those protected banks.  Potential competitors were blocked from taking over business which would have looked elsewhere for financial services absent government support.  Competition was stifled and the public debt increased.  I believe, but for delusional faith in the virtues of these institutions (more below), a less costly, competition enhancing solution could have emerged from the crisis of 2008 and resolving that rigidity would have eased tensions between labor and capital. 

Consider: Would current budget negotiations in the US be so contentious in the absence of the recent bail-out and additional debt incurred?

Returning to the delusion, TBTF banks remind me of Alchemists wasting labor and resources trying to turn lead into gold, or, more accurately, trying to squeeze more profit out of trade than trade generates.  Finance, at best, facilitates trade. In practice it records, analyses, calculates and communicates. What Amazon did to the local book merchant a similar company (or 5 or 20) can do even more effectively to finance.  Surely networked computing should decrease the cost of finance for the rest of the economy. 

On the bright side, the presence of rigidities suggests greater future productivity upon their resolution, although it would be tragic if such resolution comes via violence rather than diplomacy.  I believe a new cooperation enhancing agreement between labor and capital is possible.  Given the European example, I believe American energy efficiency can be increased.   As noted above, I believe American financial efficiency can be greatly enhanced through the dissolution of TBTF. 

When that happens I'll suggest a new word- Bankenfreude- and might even indulge in some myself.  I'll swap my Gold for currency and put it back in the game.  Until then, I'll remain a Goldbug.

Full disclosure (if it wasn't obvious) I own gold.