Let me add an addendum to my Trade of the Decade:
Silver, the longtime poor cousin to gold, is $et to $oar!
The shorting of silver by the bullion banks is insane and unprecedented.
Admittedly, the Makian Distribution predicts massive volatility in commodity prices with increased leverage/debt, and that’s exactly what we’ve had in the silver market over the last 50 years.
But something tells me silver is due to switch across to the right hand side of the bifurcating normal distribution very, very soon.
I would love to see a short squeeze in the silver market. It would be like watching fireworks on New Year’s Eve.
Yet another old, ignored, research paper on business cycles which emphasised the potentially “catastrophic” non-linear dynamic that could arise from a combination of an economic downturn and changed savings patterns arising from the wealth effect.
The reason this stuff is ignored by the mainstream is because the mainstream can’t handle non-linearity.
So they prefer to have models that are “precisely” ridiculous rather than imprecisely realistic.
I’ve finally gotten around to dragging out some discussion material on the hoary old deflation/inflation debate from the Ozrisk.net website here, where I explained my position. It will (mainly) be deflation, oscillating violently between the two. Here is the detailed discussion:
Most people just support their own little position (Rothbardians scream that govt everywhere is evil and must be killed. Some may have supported the repeal of Glass Steagall, as signalling a reduction in govt regulation. Idiots if they did). The real evil is central bank supported FRB. That’s what kills an economy through cancerous malinvestment. Socialism is preferable to fascism, if that’s the choice we have to make.
Similarly, there’s a debate between Keen/Mish debt-deflationists and Gary North/Jim Sinclair hyperinflationists. In a sense they are both right. There is and will continue to be both deflation and inflation – JUST IN DIFFERENT SECTORS OF THE ECONOMY. [I use the terms in the "modern" terminology (not in the old Austrian way - meaning an increase/decrease in the total money supply).]
Let me explain my position because I think this is interesting.
Near hyperinflation DID (already!) occur. For a decade. In HOUSE PRICES. Because housing prices were grossly underweighted in the CPI (housing is essentially a consumption good) this didn’t show up in conventional measures. But I agree with Keen/Mish – credit is money and debt issuance results in “money” (purchasing power) being created when some sucker goes into debt and buys whatever is on offer. What was on offer for the last decade was housing. It had the features of a classic bubble/Ponzi scheme with people looking at returns rather than yield. And because the asset was security for a loan, this could go on for many years longer than consumer credit/debt bubbles, which generally peter out because the issuance of debt “leaks” into consumption goods and doesn’t go back into an asset so doesn’t generate the recursive cycles that asset bubbles generate.
The “winners” in this game (like always) were the recipients of the debt money – property developers like Triguboff who rezoned land from industrial to residential and sold units en masse to the sucker public. They got debt and a 30 year mortgage. He got the debt money into his account. Magic! Where did the hyperinflationary money go? Into the pockets of the FIRST RECIPIENTS of the debt money – mainly residential property developers.
Now that the bubble has burst, the Japan deflation scenario is kicking in, because the main source of fresh debt money into the economy is fresh suckers going into debt to buy housing. The property market is double the value of the stockmarket.
But now that Ponzi scheme is over the Triguboffs are looking for a safe place to stash their cash. They don’t want their bank to blow or the exchange rate to collapse. So they take the money out of circulation (don’t keep developing units) and stash it overseas in gold or buy land and sit on it. Money velocity slows as the beneficiaries of the Ponzi scheme collect their winnings, take the chips off the table and stop paying their contractors and leave for Europe.
OK, that signals DEFLATION. Big DEFLATION. Keen/Mish are right – we’re turning Japanese.
But, hold on, what about North and the Austrians? Base money has exploded. It’s sitting at the banks. The problem is the banks can’t find a credit worthy borrower to “give” the new money to. If they could another bubble would quickly form. Bernanke is also keeping the powder dry by paying interest on the money held with the Fed. Why would a bank lend in this economy (at risk) when he has a risk-free client willing to pay interest income on the money just created? It’s like a mouse trap pulled back, waiting to snap. All that money just sitting there – like a dam waiting to burst into the next asset bubble.
When either (1) interest stops being paid or (2) the banks find a new bubble, then things will get interesting. What is the new bubble? It’s ALREADY HERE!
The new bubble is govt debt. Private clients have proven unexpectedly risky. Businesses and household default rates have spiked. Stuff them. Lend only to the Fed or the central govt (not even States or councils can get comparable rates to the biggies). “At least we’ll get paid back,” say the big gun-shy banks.
So ultimately this new govt debt money is going to govt employees (mainly) and on govt payouts. The size of govt is actually increasing in this recession. Incredible. For the first time a govt employee is paid more in the US that the average private worker.
So there is an “inflationary” bubble RIGHT NOW – in govt employment. These idiots sit around writing reports, writing regulations, filling in non-existent potholes. They exist simply to spend the money back into the economy. They are like zombie-consumers, doing nothing that is actually “needed” by the real economy but existing solely off coercive taxes/debt issuance from the govt. If the govt couldn’t counterfeit the money the whole apparatus of excessive govt employment would collapse and these guys would have to find real jobs.
But what happens when you have a bubble in govt employment? You have skills sucked out of the private economy. What skills are required most (that would be evident if the money supply was stable and govt couldn’t sell bonds to the Fed)? Sustainable technologies, agriculture, farming, etc. Govt sucks the factors of production away from where they are needed to where the money is – WITH PARASITIC GOVTS.
If this continues, who will actually do physical labour? Who will plant the food we rely on to survive? SUCKERS. Stupid people who don’t understand the game. But stupid people are the least qualified to produce sustainable agriculture!
So like the budding nuclear scientist being “sucked” into parasitic banking by the screwed by pricing structure from central bank supported FRB, now budding farmers/labourers are being sucked into the police-force, the local and State govts etc as useless pen pushers.
So it is inevitable that a destruction of our farming industries will occur, with “quantity” adjusting (ie a reduction in the quality and quantity of food) rather than price, because indebted dumb farmers can’t price adjust – they are trapped in debt (as Rowbotham has pointed out). That doesn’t mean there aren’t consequences. It just means quantity/quality adjusts, not price.
So North is wrong to see “hyperinflation” coming up soon. Hyperinflation is here in the West – in the form of zombie govt employees. Deflation for the private economy will continue. Then eventually starvation for low-income countries as oil spikes, food prices spike and availability becomes scarce.
Rothbard is timelessly brilliant.
How in a world of incredible technology can we have regressed in our understanding of monetary economics?
I blame the Reptilians.
Impersonal mathematical modelling has proven to be the most ridiculous, unscientific, useless, dangerous option of all!!!
I’ve discussed elsewhere the “madness” of using the normal distribution for financial market modelling and also the correlation between non-normal volatility and debt.
This analysis is actually well-grounded in Austrian theory and has empirical support as well.
Mandelbrot, in his book “The (Mis)Behaviour of Markets” (2005), lays out the data for the empirical distribution of stock price changes and compares it against the predictions of the bell curve based EMH (any version). Clearly the empirical distribution has fatter tails than the normal distribution implied by EMH. To quote from page 13:
“In fact, the bell curve fits reality really poorly. From 1916 to 2003, the daily index movements of the Dow Jones Industrial Average do not spread out on graph paper like a simple bell curve. The far edges flare too high: too many big changes. Theory suggests that over that time, there should be fifty-eight days when the Dow moved more than 3.4 percent; in fact, there were 1,001. Theory predicts six days of index swings beyond 4.5 percent; in fact, there were 366. And index swings of more than 7 percent should come once every 300,000 years; in fact, the twentieth century saw forty-eight such days. Truly, a calamitous era that insists on flaunting all predictions. Or, perhaps, our assumptions are wrong.”
There is also now clear evidence of a correlation between high volatility and leverage (debt).
I merely repeat my plea to consider a new paradigm, where the long term bell curve is replaced with “bifurcating bell curves” as debt levels increase.
This, I believe, would “close the circle” on the models and more accurately predict price volatilities (although not movements) in a whole range of markets.
It would be impossible, a priori, to predict whether a particular market will be captured by a bubble with overleverage – the bubble moves. Dot com. Then housing. Then oil. Then gold. The some other essential commodity.
But accepting that the financial system has Minsky-like Ponzi dynamics would be much more fruitful than assuming it has stabilising bell curve foundations. It has been conclusively proven that it does not.
My rule is: If you can’t replace a model with something that “works” (i.e. at least fits with the historical data), don’t use any model at all. Just look at the markets and see what “imbalances” exist and bet against the “imbalances” because they don’t last.
A simple application of the rule would be to short whatever market went up the most last year and go long whatever market went down the most last year (if you do the analysis this actually works out to be a surprisingly successful investment strategy!).
It is the very definition of madness to continue using a model that doesn’t fit with the historical data (at minimum).
Therefore, using this test, anyone using the bell curve in financial markets is literally insane.
I’ve suggested another “model” (bifurcating bell curves) but lots of work needs to be done here. What is the rate of bifurcation? How does this correlate with levels of increasing leverage/debt/gearing? What markets are vulnerable to bubbles? (I suggest markets closest to essential human needs – housing, oil, food…however tulips and dot com I don’t understand – it’s more a social/fashion issue).
Really all this model would do is correlate volatility with leverage. Big deal. That’s not particularly useful from a modelling perspective but it is very powerful from a policy viewpoint. It suggests debt is dangerous and socially destabilising. Policy-makers should be much more concerned about absolute and relative levels of debt, as well as the rate of growth and the marginal productivity of debt (as Fekete brilliantly points out).
Finally, this perspective signals a more fundamental message. Years ago, after 1987, as a student, I searched for an alternate “model” to picture the probability distribution because I was acutely aware we were entering a new world. This came from my interest in the Austrian School understanding of “money” and Mises’ (and Hayek’s) numerous writings on the history and importance of “free market money” (generally gold and silver) and the evils of embezzling FRB.
The lesson is this: The future is most likely to be radically different from the past when the institutions around the creation of distribution of “money” change. If you don’t pick up the importance of these changes you’ll miss the seismic shifts these institutional changes bring about.
August 15, 1971 was a revolution only the Austrians seemed to understand. Repeal of Glass-Steagall – again seismic. These two changes alone should have sent alarm bells screaming “Something dramatically different from the past (good? or bad?) is going come from these changes”. Yet no one from the mainstream seemed to understand the importance of what was occurring because none of them understood the importance of “money” and how far from the historical free market in money we had moved.
Again, a tiny tip from a suicidal madman (genius?):
Be prepared for maximum change when the institutional framework around money production (banking and exchange rates) changes. These changes generally manifest their results with a lag of 10 years.
Who cares if risk and leverage are related?
Well, let’s look at a practical application of the theory. Let’s look at silver.
The fundamentals for silver look shockingly good. With all the liquidity sloshing around the world, it’s going to end up somewhere. Currently it’s ending up in US bonds, oil and gold. With some left over going into propping up shares with ridiculous P/Es and insanely low dividend yields (at least in the US). So some markets are undoubtedly subject to “bubble-like” dynamics due to “excessive” liquidity from the Fed searching out diminished investment opportunities.
The question is not whether there will be bubbles (that’s guaranteed given the Fed’s “please use me as a carry trade” policies). The question is where the next bubble will form, getting on that train before the others and riding it for everything it’s worth.
Silver has an interesting combination of (1) limited supply (2) historically low prices (both in absolute terms and relative to gold) and (3) having been the subject of a bubble in the past – but not in the recent past. So it’s a prime candidate in my view for a tsunami of money to wash over it, with dynamics similar to what we saw in the 1970s.
If the Makian distribution is useful during bubbles, then silver will be unlikely to return its long term average of a couple of percent, and will probably go ballastic, only to face severe volatility and extreme negative returns in a couple of years’ time. Between then and now, it’s likely to be a wild ride.
Similarly, bank shares appear vulnerable to bubble-like dynamics. Just look at US and Aust and UK bank shares over the last 12 months! Drops of over 80% in some cases, only to see rises of equal magnitude in the second half of 2009. If you used the normal distribution to model bank share movements these extreme movements would have been considered “insane”.
Use the Makian Distribution on the other hand and you would have predicted that the least likely outcome this year would have been the steady long-term mean average return on bank shares. You would have expected extreme volatility, switching from extreme negative to extreme positive. Just like what happened!
One way of making money out of the Makian Distibution when most market participants are using the normal distribution is simple: If the theory is correct, put options would be ridiculously, insanely underpriced in markets subject to extreme leverage. So if you buy bank shares and also buy put options for those shares exercisable in 12 months time at a 10% – 15% discount to today’s prices (to protect you from likely – not unlikely – Black Swan volatility) then you should come out ahead. Why? Because Black-Scholes is used to price options, Black-Scholes uses the normal distribution and the normal distribution underestimates extreme volatility in highly leveraged markets. And banks shares are nothing if not highly leveraged. So returns during these times will likely be highly positive or highly negative – but unlikely to follow their long-term mean return.
Bank shares have already skyrocketed since March 09, but unlike some I still think they have a little way to go on the upside, before collapsing on the downside. Why, given that so many respected, experienced commentators are warning against buying the banks?
Well, given the obviously close connection between governments and the major banks (and I’m only talking about the two or three biggest banks in each country here) then I am confident central banks will continue to pour money down the throats of the major banks to keep re-capitalizing them. The markets are so distorted that I believe any method will be found to re-capitalize and “re-profitize” the big banks.
For example, anyone betting against Goldmans, or hoping Goldmans execs will be prosecuted for insider trading or fraud, is deluding themselves. Goldman is the US government right now. In other words, it’s hardly going to prosecute itself. It decides its own profitability, regardless of market conditions. It will only go down if the US government goes down. That may happen, but there’s a lot of upside between then and now. Why not climb aboard the gravy train?
Of course, I’m obviously not your financial advisor and I’m not recommending you go out and invest on this basis. I’m merely saying that if the Makian Distribution is a better reflection of the “real” distribution of returns in highly leveraged markets, then it necessarily follows that there are opportunities for “arbitrage” profits when everyone else is stupid enough to price using the normal distribution. This is just one example of how this misperception by “mainstream” market participants could be used against them.
To be more precise, the distribution during periods of market stress and high leverage is likely to be a “M” shape, which I call the Makian Distribution.
For those interested in the economic theory behind the combined deflationary/inflationary high-volatility M-shaped “Makian” distribution, I give you this Austrian School analysis of the modern monetary system, which predicted the financial crisis and also predicted a combined/simultaneous deflationary/stagflationary financial crisis from which there will be no escape, other than complete destruction of the monopoly currency and an associated social implosion of the Weimar Republic kind.
The fundamental point is that the mainstream think a nice, neat, “use all the time”, “off the shelf” bell curve-based quantifiable model that has been shown not to reflect the dynamics of real markets is still “useful” because it just might (might!) approximate reality in the short run and does allow quantification (and therefore pricing) of risk. Often mainstream financial modellers admit the normal distribution is wrong, but nothing (quantifiable) is better, so we may as well use it in order to price risk in the financial markets.
There have been a few attempts at modelling using non-normal distributions, and they have included some useful modelling of time dependency. However they haven’t gotten very far and haven’t integrated the very recent research on agency modelling which suggests that sudden changes in risk distributions are associated with levels of leverage.
I happen to believe the use of the normal distribution is worse than useless because it leads the whole financial sector to underestimate volatility during periods of high leverage and debt. An “M-shaped” distribution (which I call the “Makian distribution” for want of a better term) would at least warn people of the impending volatility when leverage hits unprecedented levels.
The technical term for this phenomenon would be “bifurcating bell curves” or “bifurcating normal distributions” where, as leverage increases, you actually see a bifurcation of the long-term normal distribution into two overlapping normal distributions, which can go either way (deflation or hyperinflation) depending solely on what the central bankers decide to do in the middle of the panic (which in itself cannot ever be quantified).
Deflation is when they panic one way, and keep the money supply reasonably stable. Hyperinflation is when they panic the other way, and try to “compensate” for lack of liquidity during a credit crunch. But one thing is clear through all the empirical history – whoever is in charge, they always panic (as 2008, 2001, 1991, 1987, 1982, 1970s, 1960s, 1930s, 1912, and the whole of the 19th century so clearly shows).
It can go either way. What is actually least likely during these periods of high leverage is the maintenance of steady growth in financial markets consistent with the long-term mean.
Taleb (sort of) understands this by saying that the modelling underestimates extreme events, but even that doesn’t capture what I’m saying. He just worries a lot, but doesn’t replace the normal distribution with anything else. With Taleb, you’re “flying blind” with the distribution really being a horizontal line across the returns spectrum. I don’t think that’s very helpful either.
No one else seems to have the required combination of skills to analyse probability and financial modelling from first principles. The academics built a huge edifice on shaky foundations because none of them studied the philosophy of probability. They shoved the normal distribution on to financial markets as a Procrustean solution that would never work because they focused on fitting a familiar model onto a messy world. Disaster!
To understand financial modelling you need to have (at minimum) the following attributes: (1) studied Mises on probability (2) studied the philosophy of probability (3) reflected on the inherently subjective nature of probability for non-replicable events in financial markets (4) know something (anything!) about Austrian economics (5) be qualified and reasonably competent in financial modelling and mathematical econometrics.
An “M” shaped bifurcating bell curve would seem to me a neat way of combining Austrian School analysis of probability with recent agency-based models suggesting a link between volatility and leverage.
Are you in banking or finance? Do you use the normal distribution to model risk? Why?
Given the research destroying the applicability of the bell curve in financial markets, and the recent research from agency-based models suggesting that extreme volatility is triggered by excessive leverage, the worrying danger is that the normal distribution is the WORST possible model to use in financial markets. If there is a correlation between increased volatility and debt, the probability distribution during periods of high debt is likely to be a “U” shape – with the least likely outcome the long-term mean and the most likely outcomes either deflation or high inflation (the extremes on the returns distribution).
The tragedy is that this mindless, zombie-like application of an inapplicable theoretical model materially contributed to Iceland and the sub-prime bust.
There is a cartoon where Lenin is talking to his advisors as he sees a row of academic economists walk by him in parade. The advisors ask “Where are the parades of nuclear warheads and missiles and the Soviet tanks?”.
Lenin replies “We discovered that Western academic economists are cheaper than nuclear warheads and do much more damage!”
Nearly all mainstream financial economists are mad. Most financial market participants are trained by financial economists and use these models mechanically when trying to anticipate market movements. Therefore, ipso facto, the whole financial market is blind, and bark raving mad.
Why do I say this?
Well, the definition of madness is doing the same thing again and again and expecting a different result.
Mainstream financial economists almost universally use the normal distribution to model risk in financial markets, when the data clearly prove that the actual distribution of returns in financial markets does not match the normal distribution. Incredibly, the Basel II Accords mandate its use for modelling capital adequacy – even though the evidence is clearly against the applicability of the bell curve in financial markets, with the historical data consistently displaying “skewed” distributions.
Recently developed, highly complex, agent-based market simulations appear to support the hypothesis that volatility is correlated with leverage and that there is a “freeze-point” in the markets where leverage becomes unsustainable and results in cascading failures, very much like what we saw in Q4, 2008. The traditional models do not deal with these dynamic aspects of the markets, and did not predict or anticipate anything like Q4, 2008.
Yet there has been minimal attempt by the mainstream to adjust their models to reality.
This is madness, pure and simple.