Feeling sorry for Steve Keen

I feel sorry for Steve Keen.  Which makes a pleasant change from feeling sorry for myself. 

I often ask myself:  How can I remain completely ignored despite predicting (indeed, screaming!) about the GFC 12 months before it occurred again and again?  Then I think of Ron Paul, Peter Schiff, Frank Shostak, The Mogambo Guru (ha ha ha!), Bill Bonner, Robert Landis, Mike Hewitt, the guys at PrudentBear.com and about 500 other Austrian School thinkers and realise I’m far from alone, both in predicting the crisis and being completely ignored (or ridiculed or hated) by the mainstream.  So feeling sorry for myself is completely unjustified and very unhealthy.  Perhaps I’m just a garden variety Austrian surrounded by mainstream idiots who don’t want to listen?  Being Austrian may be special (especially here in Oz!) but there’s nothing particularly special about my analysis within Austrianism.

Turning to the more healthy, productive task of feeling sorry for Steve Keen, I’m worried he may get heat stroke and die on his trek up Mt Kosciusko.  He looks pretty frail to me and as an academic with reasonably thick glasses he doesn’t look like the hiking type.  I hope he gets through the ordeal.

The reason for this bout of masochistic self-flagellation on Steve Keen’s part is that he lost a big public bet with Rory Robertson.  Badly.  I try to bet alone, discreetly, so if I lose only I know.   Much better for the ego.

If one of Steve Keen’s students was “out” by the orders of magnitude Keen was out in his prediction (up to 40% decline in house prices when they actually went up, albeit marginally), I suspect she’d receive an “F” with a “Must do better next time” message scrawled across the top in big red letters.

To quote Bloomberg:

“The concession follows a report published earlier today…shattering Keen’s forecast…Robertson, 43, challenged Keen to hike Mount Kosciuszko if values fell by less than 20 per cent.

“Keen could scarcely have been more wrong,” Macquarie’s Robertson said today in Sydney. “I wish Dr. Keen well on his long walk. The Sydney academic will do the walk wearing a tee-shirt saying: ‘I was hopelessly wrong on home prices! Ask me how’.”

Ouch.  The humiliation!

I have some sympathy for Keen’s overall analysis of credit money, which (after much brutal, hand-to-hand combative edit-warring) I finally succeeded in sticking into WP here.  As someone with broadly similar views (and some sympathies with Minsky’s analysis – although not his policy prescriptions) I reflexively (ha ha ha George Soros!) feel the need to come to Keen’s rescue.

Aside from Keen’s own pet excuse (the damn govt-manipulated FHBG rigged the market!), I think there may be other deeper, more secular factors at work as well.  The FHBG can’t explain all the massive discrepancy in prediction.  It existed at the time Keen made his prediction – although he argues the subsequent unexpected hike in the grant skewed the results even further.  His point about the correlation between any housing subsidy and a disproportionate, spiked response in pricing (because of extreme levels of leverage in the market) is valid – and made more pertinent by the fact that this particular distortion in the market would have had more of an effect on median house prices than other sectors of the housing market (such as the upper quartile). 

The proceeds from the FHBG most likely went to median house buyers, who then used the fresh proceeds to bid up the prices in the median tier.  Most mainstream analyses you see from institutional (institutionalized?) economists focus on the effect the FHBG had on the lower tier, forgetting the funds actually flow to the vendors (something Keen picks up in his analysis).  Given house prices are invariably (and very strangely) measured by the median (why not the mean average?), this would certainly have had some – but not all – of an effect.

The second, most obvious, reason for Keen being wrong is that he was simply early.  Lots of commentators predicted the GFC “too early” and paid the price by having to remain in relative obscurity forever.  Landis was spot on in August 2004.  Arguably nobody listened because he was too right.  You could say that pro-gold submissions incorporated in the Report of the U.S. Gold Commission twenty-some years ago were also prescient.  And wrong, because they anticipated hyperinflation way, way, way, way too early.  Hyperinflation only looks like a possibility in 2011-2012 and even then an unlikely possibility.  Japanese-style boa constrictor-style stag-deflation looks more likely, frankly.

In a sense, very perceptive analysts such as Murray Rothbard and Robert Landis can often be too right – seeing deep underlying trends before they manifest in the market and seeming to jump at shadows, only for the ghost of fiat paper nightmares past to come haunt us years after their plaintive screams were silenced by the mainstream.

As Ron Paul has repeatedly stated, predicting the collapse in confidence in the paper dollar system is impossible.  As impossible as predicting the exact date and time Madoff would be found out.  How gullible are your clients?  How good is your cover?  How long can you run from the authorities?  How long can you keep bribing them with lunches, seminars, conferences, papers, academic economists, employment prospects, day trips, and hookers?

It’s impossible to quantify something as ephemeral as people’s gullibility.  Housing’s gonna have a bust in Oz, but predicting when is virtually impossible.

The third, more subtle reason is that we may not be (completely) in a  pure housing bubble.  Unlike the US and the UK, our supply of housing stock is tight.  As tight as a drum.  And funding problems have resulted in a squeeze on new building projects, so this supply problem is not going to switch over into oversupply any time soon.  The tight rental market puts a floor on any drop in demand caused by marginally higher interest rates or falling employment.

Another aspect of this very un-Anglo “floor” in housing prices may be the particular ethnic mix of new migrants to Australia and the slightly more pronounced “Asianisation” of Australia compared to the UK and US.  I must choose my words carefully here, and fortunately my readership numbers are miniscule (and hopefully will remain so!) but I think this point has to be made.

Let’s take this slowly, calmly, step by step…

(a) Price-to-income ratios in some Asian cities for housing stock are insanely high – much higher than in Oz – due to population pressures (and therefore higher numbers per household living in the one apartment) and the unequal distribution of income.  Check out price-to-income ratios in Hong Kong, Shanghai, Beijing, Singapore, Mumbai and I’m sure you will be shocked.  And Hong Kong house prices are spiking up from even these lofty levels – yet again!

(b) Meriton and other bulk apartment builders deliberately target the Asian market, putting a floor on any adverse price movements here in Oz.  Asian buyers often buy not for yield, but for their kids or for strategic reasons (I may need to escape if my country explodes).  So prices for these kinds of apartments have a “natural” floor.  Money created by the Fed, finding its way to Asia and then being recycled here in housing stock.  Quite a round trip.  Unless another Asian financial crisis hits, these cashed-up newly wealthy buyers will keep the Australian housing market bubbling (ha ha ha!) away.

(c) Migrants (of all kinds) may “under-report” tenant numbers for a whole host of reasons.  One tenant may sign the lease and then get 5 friends to live in a two-bedroom apartment to pay the rent and offset his costs at university.  This happens.  Often.  This means that each apartment can potentially support higher rental than the historical rental “limits” for 2 bed and 3 bed apartments.

(d) Fertility rates in Australia remain stubbonly healthy.  Household formation has been growing in recent years.  I personally think the carrying capacity of this dry land of Oz is quickly being reached and I’m mildly suicidal over the thought that the govt is planning to allow increased immigration to “permit” the population to get to 35 million (has Rudd checked out drought-affected farmland? Poisoned rivers?  Poisoned land from the rising watertable?  This is insane!).  Nevertheless, it’s probably going to happen because the govt lives off the taxes and other funds that a higher population brings forth.  The simplistic analysis of govt mandarins in Canberra: If we have a budget problem, just bring in more people.  It works.  Until it doesn’t.  If you know what I mean.

This is obviously speculative and, as the head of the RBA, Glenn Stevens, often says, “I don’t want to get the hares running!” – but I do think there could be a secular trend towards higher housing prices in the major cities at any given income level.  I would hesitate to say that indigenous Aussies are being “squeezed” out of the housing market by foreign cashed-up invaders (that would be too harsh) but at the margins there are good (fundamental) reasons why housing may continue to detach (apparently “bubble-like”) from its historical mean average ratios (in terms of debt-to-income, price-to-income, and rental yields). 

Before some 20 year old gears up to the gills to buy a Meriton apartment (bad idea in any case!), please note the following qualifier:

I do think we are due for a housing “correction” at some point.  The private debt levels in Australia are unbelievably scary.  But any housing bust will be underpinned by a number of…of…”exogenous” factors that may put an unexpected floor on any precipitous falls.

Of course, if there’s a synchronised bust in Asia and Australia in the next few years, then watch out below!

Practical uses for the Makian Distribution

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.