To pick up a brilliant point made by Peter Schiff in the video to the previous post below (but not understood by those on the brain-dead panel):
Inflation is simply debasement of the currency, or increases in the money supply. Inflation is occurring, just not where you expect it. It’s occurring in govt pork and govt employee numbers and in govt contractors making big bucks off govt spending.
Banks are lending massive amounts of new money – to governments around the world. They are the only entities the banks can find who will pay them back (even if it has to be in worthless paper currency – ha ha ha!).
Therefore, the “de”-flation that we should have seen occur to “cure” the credit bubble has been deferred – by way of an increase in brain-dead govt employees!
This is unlikely to “cover” for the loss in private sector activity because govt spending is generally unsustainable and therefore has a lower “velocity of money” than genuine private sector investment. However, these ridiculous “heroin stimulus packages” do cover up (temporarily and only to some degree) the deflation we should have had, coming out of the “credit boom” years.
Because of the massive distortions and misallocations caused by (1) the classic ABCT credit-fuelled Ponzi-boom and (2) now the ridiculous unsustainable govt spending, crowding out the private sector’s access to cheap capital for real sustainable projects that the public actually wants, we are now going to get (at the end of the day) much higher unemployment.
Higher unemployment is baked into the cake because of the massive stimulus spending. Take any specific “stimulus” measure, be it “Cash for Clunkers” in the US or the “First Home Buyer’s Grant” or incentives for home insulation or solar panels. Now, simply ask yourself:
What happens when the “stimulus spending” stops?
Most of the “stimulus spending” simply brings forward future consumption patterns - it re-allocates inter-temporal spending patterns, but doesn’t actually increase the total consumption over time.
I explained all of this in much more detail several months ago here. I see the balance of the forces being slight deflation rather than hyperinflation, but the dynamics are the same. I see possible inflation (possible hyperinflation) in 2012-2015, but that’s a long way off – and I mightn’t even be alive then (here’s hoping!).
Only Austrians such as the brilliant Peter Schiff understand that you can have very high inflation and very high unemployment because of preceding bad investments and unsustainable economic activity, leading to an economic dead-end rather than to ongoing economic activity.
When you build on Ponzi-quicksands, you fall into Ponzi-quicksands.
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.
Gold was down today on US dollar strength. Treasury yields were up (and conversely bond prices down) on news of “growth” in the US economy.
If the govt “”borrows” (prints?) trillions and then spends these trillions on handouts and killing people, of course “GDP” numbers will spike. The question is: What happens when the handouts end and there are no new people to kill?
Govt spending is invariably unsustainable. So these ripples in the market mean nothing when the tide continues to recede. If I was still in the US, I’d buy gold today and continue to reduce exposure to the US dollar, despite these short-term movements.
Volatility is your friend now. Use it.
As the year comes to an end, let me list my predictions for 2010. Note: Anyone who says their predictions are based on modelling is an idiot or a liar.
As was clear from our experience in 2009, politics, connections, favours, and plain old everyday third world corruption play a major part in any economic outcome today.
The “logical” prediction for 2009 would have been the bankruptcy of AIG, the bankruptcy of a number of major US and UK banking institutions, deflation, a continued stockmarket collapse, a spike in long-term interest rates (caused by a decline in demand for T-bonds due to US govt deficits), a collapse in the value of the US dollar and a spike in gold. Almost none of these happened because of the multiple, trillion dollar interventions of the Fed and the US Treasury. AIG was saved, US and UK banks received hundreds of billions in bailouts, swapping toxic trash at the discount window 100 cents in the dollar, the stockmarket was artificially supported, the long end of the bond market was (allegedly) supported by the Fed, and gold was shorted relentlessly by the primary dealers.
So predictions for 2010 are really political predictions and these cannot be taken very seriously. Nevertheless, it’s fun to speculate, so here goes:
1. A CRE and housing bust in Oz in the second half of the year due to (a) wholesale funding costs jumping for Cth Bank and Westpac in particular and a fight for deposits (b) APRA liquidity requirements kicking in (c) high $A killing exports and local manufacturing, combined with a generally slowing economy due to a fall in Asian growth and a crisis in Japan (d) pullback of the FHBG and other handouts from Rudd Bank (e) pull back on the govt backing of Oz banks, exposing them to “market” rates for wholesale funds especially for LT debt (f) housing prices already being ridiculously too high, as Steve Keen has pointed out many times in the last 3 years. It should be a bloodbath in CRE in 2010.
We’ll see whether the govt and the desperate Oz banks can hold back the receding tide. Unlisted funds with illiquid assets were massacred in 2009 by the govt’s bizarre, indiscriminate bank guarantee (thereby predictably and savagely killing off the supply of liquidity for unlisted CRE trusts). This should mean that the marginal players in the finance industry have simply had their executions stayed, not commuted. Will this now infect the whole CRE market, as supply continues to overwhelm declining demand due to liquidity tightening for the dumb Oz retailers of debt? Bank guarantees should have engendered moral hazard in the marginal lenders. This should have made the problem worse. This problem may be deferred until 2011, but something tells me this Ponzi-scheme can’t be sustained throughout 2010. We’ll see.
2. S&P 500 down for the year, with a “crisis” in early and/or mid 2010 due to (a) the fallout from the bubble being delayed this year – meaning that the bust will be even bigger and flow into 2010 (b) a significant portion of consumers (70% of the US economy) being bankrupted in unsustainable debt (c) debt levels threatening the long-end of the US bond market (d) unemployment continuing towards 15% in official terms and 25% in unofficial terms (e) a possible US dollar/bond crisis, with an unprecedented volume of bonds being needed to be flushed into the market (f) the banks being supported, but the bulk of US industry being left to die. The S&P 500 includes much more than just Goldman Sachs (which will continue to perform well, given they print their own profits).
3. Gold up – for all the reasons in (2) above, plus the fact that the Fed will continue to pour e-dollars out into the market in the trillions, without any effect (see Japan over the last 15 years). So gold will be the only place for the e-dollars to go.
4. Silver to go up more than gold – for all the reasons in (3) above, plus the fact that silver is a tighter market with the massive short positions in silver finally having to be unwound on reality.
5. Oil higher. Inflation’s got to go somewhere. And Peak Oil has arrived.
6. Food and food inputs higher. Possibly significantly higher.
7. Fed Funds Rate probably around where it is now. The big story will be everything BUT interest rates. Interest rates will stay low (to save the banks) but chaos and volatility with be a tempest around stable, low rates. The debt load is massive and people will be killing themselves to extract themselves from this killer debt-load by repeatedly trying – and failing – to spark a new bubble in the stockmarket. Then in desperation they’ll spark a bubble in oil, food, gold and silver. Currency volatility will be unprecedented. There is the real prospect of a US dollar meltdown. If so, gold will soar on its angelic wings.
The overall theme for 2010 will be continued unprecedented volatility. Price swings, especially in the stockmarket, will be violent as liquidity sporadically dries up due to the unsustainable debt loads and banks desperately juggling debtors to stave off insolvency – both in their clients and themselves.
The Makian Distribution predicts increased volatility with increased debt. We have increased debt. So, according to the theory we must have increased volatility.
I like this piece from Nadeem Walayat, Market Oracle editor.
But how do you pump debt-money into an economy going broke? To whom are you going to lend this newly created debt-money? Who is idiotic enough to borrow in this environment (other than the govt, of course)?
I’m still in the deflation camp because I can’t see the mechanism by which Zimbabwe in the West becomes a reality. Unless the central banks start LITERALLY showering us with fiat paper money from UN black helicopters, I can’t see it happening. And somehow I don’t think that Ben will order the helicopters to be fired up for anyone but Goldman Sachs.
Yes, I can see isolated “Icelands” occurring on the periphery. I’ve already stated that some time ago and have recently identified Greece as the next Icelandic candidate. But I don’t see the US being able to “achieve” inflation even if they wanted to. Japan tried to inflate for over a decade and it couldn’t. Will the US be any more “successful?”
When paper money starts being tossed around in the streets like confetti, wake me up and I’ll switch sides and dive into the inflation camp. Until then, please don’t disturb me. I’m dreaming of deflation.
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 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.
Then deflation, then inflation.
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.