Category Archives: Economics

The other other shoe to drop: big government in-the-loop?

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This depression is historic in many ways, but one way that doesn’t get talked about a lot is that it’s the first time America has had a credit-based downturn with a government that is a major existing factor in the economy. Before the Great Depression, in the 1920s, government spending at all levels was around 15% of personal income. Today, it’s close to 50%. Sure, government spending shot up under FDR, but the point is it shot up from virtually nothing. What happens when you hit a depression when government spending is already over one third of GDP before the depression?

Tax receipts projection

Tax receipts projections.

So, we have this situation where there is a huge economic entity that is about to see its income drop precipitously, as tax revenues fall off a cliff. Whether by spending cuts or inflationary printing, future real government contributions to the economy are going to have to decline. It’s easy to forget, but the government doesn’t actually make anything. Whatever money they spend either comes from the present or the future or from inflating the currency, but either way it is a hole that has to be filled sometime. Due to the large delay between the effects of a downturn and government spending, this will take a while to play out, and it’s a huge overhanging issue that has yet to completely hit the proverbial fan.

Here’s the thing that scares me about all of this: one of the tenets of control theory is that having a strong feedback loop with a large delay in any system is a good recipe for instability, and yet that’s exactly what we have when the government becomes such a large factor in the economy. Of course, an economy is not a model system, and it could never experience runaway instability like a linear circuit could. But if there are forces pushing it towards instability, I’d argue the result may not be exponentially growing oscillations, but it won’t be good. Humans don’t like unstable systems, especially when their money is involved, and rather than suffer oscillations, I suspect the economy would just fall and stay down.

Why hasn’t this happened before? Well, one likely possibility is that I’m completely out of my mind to be applying principles of control theory to the national economy. But another is that we’ve simply never tied this big of a feedback loop around our economy before. The last time we had a credit dislocation, perhaps government was small enough that these oscillations were damped. But the gain is way up, now, and I’m a little nervous to see what happens now that the system has been given a big kick.

Investment gains may become harder to find, long or short.

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I had an interesting discussion with some folks last night. The question was whether it is possible for all investments to go down in the short term if things get bad enough. One conclusion was that it’s a harder question to answer than you might think. Do you consider perceived value, or just market price? If you buy a farm, and the market collapses for real estate, that farm might still be the best thing you’ve ever bought (high value), even if the price plummets. So, while the general question is interesting philosophically, it quickly unravels into a debate on definitions, so I’ll just limit the discussion to what people normally think of as investments: things you can hold in a brokerage account.

My theory is that it is certainly possible for every conceivable investment to lose value, where no matter if you’re short or long you lose money. Just consider the absurd case where everybody becomes clinically depressed agoraphobics, sitting at home wasting away. Clearly, financial markets will freeze, and you’ll find out that your assumptions on value were predicated on the Wall Street showing up to work, the computers which record your trades running, and people holding out enough hope in the future to bother trading anything but cigarettes. Every asset, no matter what, has some finite counterparty risk. You may be right about everything, but the universe doesn’t owe you a bid. There probably weren’t a lot of good places to put your retirement funds during the declining Roman Empire, for example.

Granted, total collapse of financial market functioning is a rather extreme, and seemingly academic, case to consider. But as I thought about it a bit more after the discussion, I realized that this isn’t academic at all. Between fully liquid bull markets, where everybody makes money (on paper) and the macabre situation I posited above, is a continuum of completely plausible scenarios where it gets harder and harder to make money in any asset. In fact, this is already happening right now.

Bid-ask spreads on options have been widening in the past few months, which makes it harder to hedge either direction as liquidity dries up. While derivative markets are zero sum if you average out to expiration, in the short term both parties can have losses on paper due to wide spreads, and if you can’t close your short option position, you are forced to tie up cash as collateral, which could cause you to lose money. Thus, in a way both parties to an option contract can lose out if liquidity dries up.

Certain stocks are becoming impossible to short (nobody is willing to loan out any more shares). Others (such as Sears) are starting to require short holders to pay interest. It’s quite likely for somebody to go long Sears, somebody else to go short at the same time, and for both people to lose money.

Is this discussion of any practical value? I think so: if the market continues to deteriorate, even those that correctly predict it will have trouble making money from it. For example, it will become increasingly difficult to make money in inverse ETFs, no matter how brilliantly you predict the underlying stock market trends. The counterparties to the derivatives owned by the ETF will become so adverse to risk that they will insist upon prices which are less and less favorable for the ETF. This will manifest as extreme slippage in the ETF relative to the index it inversely tracks. Again, this is already happening. Consider the following plot of SKF versus the Dow Financials Index, which it is supposed to track the inverse of times two:

FXK: How to lose money both long and short.

SKF (green) versus Dow Financials (black): How to lose money both long and short.

The underlying index went down about 25%, but so did the ETF (there were no distributions from SKF in this time frame). Everybody lost money, long or short! Some slippage is inevitable as a “cost” of leverage and shorting, but my point is that the slippage is getting worse. Six months ago SKF was tracking much closer to its target. It might be useful to consider an index of inverse ETF slippage as an indicator of the health of the financial markets, or at the very least a index of how crazy you’d have to be to remain in the market. So, the ETF slippage, the option spreads, tight short supply: they might all be subtle hints from the market that the market is no place to be right now, long or short.

How to get a good deal on a new car

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There is an historic backlog in cars. Every day brings the dealers deeper in debt, the auto companies’ unsold inventories pile up, and the introduction of the 2010 models looms ever closer. The amount of unsold 2009 models will be astounding. So, if you’re going car shopping, just bring along a copy of this photo:

Unsold cars pile up in a British lot.

Unsold cars pile up in a British lot.

If the manager gives you any trouble, just quietly pull out this photo, and maybe a few others from the Guardian’s piece, and leave them on his desk. Stand up, point to them and say “Maybe somebody will make me a good deal on one of these.” Then slowly walk away. If he doesn’t stop you, fine. Just leave the picture with him and come back next week. After he’s stared at that picture for a week, he’ll soften up.

In all seriousness, if you are in the market for a car, wait until the 2010 models come out. You will probably be able to buy a 2009 model for an unbelievable price if you hold out for it. The automotive industry is so screwed, it’s hardly believable. They just keep churning out cars, and nobody is buying. I’m thinking of picking up a new Hummer at the end of the year and using it as an apartment.

Are our demographics engineered for moral hazard?

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For all of the hand wringing about the $700B bailout, the Feds have put our nation’s children on the hook for about $8T (and counting) without a single vote from Congress (who, by the way, is doing everything they can to do as little as they can so that they can avoid political liability that comes with actually doing anything). I have a feeling that if (a) Americans weren’t so constitutionally apathetic and (b) ignorant of what is happening, there would be marches in Washington, Greenwich would be burning, and people in Manhattan would be throwing bricks through every piece of tinted glass on Wall Street. Hell, this country was started by enraged citizens chucking tea in Boston Harbor because they felt they were being unfairly taxed, and now we sit around doing nothing while HALF OUR GDP is spent to bail out the criminally stupid (and sometimes just plain criminal) without due process.

Maybe not enough people care about the debt burden on our nation’s children because the only people who are having kids these days are the bottom half of the income ladder, who pay no federal taxes. The upper half is too busy working dual incomes (about half of which goes to the government) to have kids (I don’t remember the stats, but the birthrate is well below replacement).

So, the people who pay for the government have no interest in the next generation, and people with an interest in the next generation have no stake in the government. Exactly a recipe for bad government and massive public debt.

Are long bear market rallies history?

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I have no clue what’s going to happen on the market, but I’d just like to point out something that I haven’t seen anybody really talk about yet. For all the talk about comparing this present market to the bear market of the early 30s, there is one huge, obvious difference: information moves a lot faster today, and we have much more extensive “instrumentation” on the worlds economies. Not only does the flow of information mean that markets will adjust quicker, but the liquidity provided by ubiquitous electronic trading and derivatives means that market swings will occur on a much shorter time scale. Perhaps most importantly, we have much more universal access to economic data than ever before. This means that price information and the beginning of deflation have become apparent much quicker, and to a wider audience, than they did during the great depression.

The upshot of all of this, if I’m right (which is a big if), is that we may never see the kind of extended rally that occured during the bear market that started in 1929. Maybe they’ll just last a few days, or maybe a few weeks. A corrolary of this is that volatility will be much higher than in the aftermath of the 1929 crash. This may be one explanation for why we’ve seen historic levels on the CBOE volatility index (VIX). Usually the VIX peaks around 40 or 50, but these days we’re seeing sustained levels around 70.

So, while I’m going out on a limb, if you’re sitting on cash and tempted to try to time the market and ride the rally we’re currently in, you might want to rethink it. In this day of electronic data and trading, I think the aftermath of the financial crisis will be an extended period of volatility that will eclipse anything the market has seen in its entire history. This crisis may have put the final nail in the coffin in the foolish academic theory of “efficient markets,” but that doesn’t mean the markets can’t be inscrutible and chaotic for an extended period.

Schwarzenegger to nation: Let’s drag out the recession as long as possible, ok?

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The central cause of the current recession (or maybe depression) was the overextension of credit, especially in the housing sector. So, how do you get out of that kind of jam? Foreclosures and time. Those that can’t afford their homes will have to lose them, and the banks will get back as much as they can, allowing their balance sheets to be repaired up to a point. Those that can afford their houses will just have to stop taking on more debt, and begin the process of paying off the principle to the point where the loan is right-side up. This will eventually lead to healthy bank balance sheets, and thus the resumption of normal (but hopefully not excessive) lending that will get industry moving again.

If you really wanted to screw with the country, what would be the worst thing you could do? Halt foreclosures and/or slow down the repayment of debt. And yet that’s exactly what Arnold “I am here from the future to destroy your economy” Schwarzenegger has just proposed. He has asked that state lawmakers impose a 90 day moratorium on foreclosures. That sounds really good, but another way of saying it is that it’s a three month state imposed time window wherein banks will not be able to repair their balance sheets. Given that California is ground zero for the housing bubble, this is pretty significant, and in my amateur opinion is tantamount to extending the recession by at least three months. It’s also a slippery slope, and given that it’s highly unlikely a farm hand living in a $750k house (yes, true anecdote) will be able to suddenly improve his cash flow in 90 days in the middle of a recession, I can’t imagine the moratorium will do anything besides delay the day of reckoning.

It would also be the height of selfishness for Californians to use the power of their state government to clog up the nation’s financial system in order to avoid having to deal with the consequences of their feckless consumerism. Where California goes, so goes the country, and that includes really bad ideas. I expect other states, such as Nevada, to follow suit with similar populist legislation. Hopefully the Feds will clamp down before this gets out of hand, because otherwise I can see economically illiterate do-gooder state legislators launching the mother of all depressions by bringing down our entire financial system through a morass of legislation designed to prevent banks from clearing bad credit.

Why is foreclosure considered such an anathema, anyway, at least compared to the prospect of having our entire financial system collapse? People will be released of their debt burden, with the only consequence for their foolishness being that for the next seven years they’ll have to rent an apartment at a much cheaper monthly payment than they had before. I can’t imagine that’s such a bad thing, especially when the alternative is for the credit crunch to deepen, an outcome that would have potentially dire consequences for everybody. Given that the Fed has been only marginally successful in freeing credit markets, the last thing we need is for states to push the other way by obstructing the necessary process of clearing out bad debt through default.