King of the Quants, Paul Wilmott, has a great blog post on his very popular site about the current financial crisis. If you’re wondering how popular a site about quantitative finance can be then consider there’s about a 65,000 subscribers engaging in debate (some heated, some light-hearted & some perhaps ridiculous) on his forum.
Wilmott is the author of the authoritative textbooks on the subjects relating to financial modelling of derivatives. So you’d be thinking “it’s all his fault” and you’d be wrong. In his writings and courses you’d be hard pressed to find a “rocket scientist” more skeptical of the limitations of risk management using financial models. Unless you happened to be Naseem Taleb but that’s another story.
I’ve been reading Liar’s Poker recently and it’s given me a better understanding of how market’s don’t work. To save time for novice investors I’ve created a few helpful definitions to guide them in their investment choices. In no particular order:
Bank – the generic term for an organisation that seeks to profit by controlling the flow of money.
Market – a mechanism to exploit the foolishness gap (often slim) between someone who has the means and desire to buy something and someone who knows what it’s worth. Innovations in the market have effectively rendered the “means to purchase” an outdated concept. Markets have the trappings of formality and the veneer of structure.
Risk Management – The process of substituting a relatively reputable product like insurance for bonds of indeterminate risk with the objective to save money over a specified term.
I’m going to stick my neck out and make a prediction. I believe that if you ask this question in 5 years time the answer will be NAMA as a catch-all term for the taxpayer support of dysfunctional banks. NAMA fuels the nightmares of the public’s imagination. The amounts are staggering. Effectively Anglo has already cost over 12Bn and could cost another 10Bn. These are just estimates remember. NAMA requires a recovery in the property market to avoid the “fire-sale” losses Lenihan fears in an immediate wind-down.
To say that we could need another 10Bn is like saying that it might be a fine day on March 30th next year. The variables are arguably too complex to give a good prediction. This is partially why Lenihan is so vague about the period in which the promisory note backing the recapitalisation is payable. He just doesn’t know. It assumes a solidity to the rest of the loan book and the Irish economy which appears difficult to justify given what’s transpired over the past 18 months. Ireland Inc’s actual exposure is only limited by the size of the loan book and depositor base. We cannot legally compel depositors to stay with the bank, no matter how tempting the lock-in interest rates are.
Insightful short documentary by Fred Harrison about the boom bust nature of economics and his analyses determining an 18 year economic cycle. Well worth a look.
The simple facts of the matter are that booms and busts are unstable situations exploited for profit by banks and other financial organisations. Banks and bank-employed economists tell punters bullshit fairy-stories about how every recession is different to further the goals of companies profiting from market instability. Unfortunately, complex mathematics and better technology provider the veneer of risk management for what is, essentially, more risky than a poker bluff. This is discussed at length in the Black Swan.
Sometimes quants and economists they get it badly wrong by incorrectly managing risk. It is unfair to suggest this is done entirely consciously as the economic shibboleth is reinforced in many economists minds throughout their college years. Those unwilling to take risks cannot progress. So we see a darwinistic system in place whereby those bankers moving the most money (traders, hedge funders etc.) are the ones most genetically and culturally oriented towards risk taking.
Building an economic and regulatory system on pseudo-“free” market instantaneous valuation of assets (particularly housing) will always produce the same disastrous results. Rolling averages are much more desirable as they protect the valuation of assets of the majority of people. Free marketeers claim this reduces liquidity and risk capital, stifling enterpreneurship. This is mistaken based on a persistently re-inforced view that industry is best funded using asset-backed leverage. i.e. the current banking system. It’s an entirely circular argument. Geoists make a convincing argument that asset-derived income and leverage fundamentally distorts economies and leads by-purpose to market instability. They argue that land taxes should be applied to discourage businesses based solely on the acquisition and leasing/sale of natural assets such as land and minerals. On the face of it, there’s a lot of merit to this suggestion. Milton Friedman saw the value of such taxes as they neither distort economic activity nor excessively burden the labour market. Pretty much exactly what’s happened in Ireland over the past few years.
In many ways the current recession is so bad and so potentially hazardous for international trade BECAUSE we managed to “inflate away” the obvious symptoms of previous recession. These being price falls, unemployment etc. The key to understanding this is to understand what inflation really is. As Peter Schiff points out we often misunderstand the cause/effect of inflation. We’ve had about 3 recessions since the great depression and subsequent war and each one was “fixed” by combinations of printing money and quantitative easing perpetuating what Schiff calls a “phony economy”. Indeed more than the Information Age this could rightly be called the Inflation Age. We’re seeing the culmination of a over 50 years of inflationary delusions coming home to roost.
The doctrine of this wild speculation of the past ~18 years has been “too big to fail”. America’s stimulus package is based on their close economic relationship with China and the belief that both economies are too big to fail. Remember that Chinese workers don’t have pension plans and so invest their savings in Chinese and international markets which are largely reliant on the US remaining the dominant consumer economy. Equally the US is reliant on investment from oil-rich Arabs, Europe is reliant on China as a manufacturing engine and the US as a consumer. Globalisation leads to increasingly internationally entangled economics. Not saying that’s a bad thing, just that it is.
This recession is compounded by environmental factors such as peak oil. Ireland with NAMA debt on board may not leave recession before the initial effects of peak oil hit the economy further. For the global economy to exit this recession the traditional way (through economics brinksmanship like quantitative easing) we may enter a period of hyper inflation to cover the severe losses of the past few years and the effects of peak oil on heating, industry, power generation etc.
The globalised world market resembles a Ponzi scheme that is exposed every 18 years or so but keeps going regardless. In many ways an economically disastrous 2010 for the US, EU and China might force world leaders to reevaluate the economic status quo and negotiate new international accords to improve matters. I often feel we need a new Bretton Woods..
Thanks to a friend on the David McWilliams blog site for making me aware of the documentary.