Is Sterling About to Tank?

Il faut bien reconnaître que le seul aspect positif de cette crise est le renversement d'image du royaume uni. Que de chemin parcouru depuis la victoire de Londres dans la sélection des villes olympiques, quand l'on n'avait entendu que louanges du modèle anglais et de son incontestable supériorité.
Yark Yark Yark

Is Sterling About to Tank?

via naked capitalism de Yves Smith le 20/01/09

Willem Buiter, who had a ringside seat at the Iceland meltdown, warned that the UK could follow back in November:

With the pound sterling dropping like a stone against most other currencies and credit default swap rates on long-term UK sovereign debt beginning to edge up, this is a good time to revisit a suggestion I made earlier on a number of occasions (e.g. here, here and here), that there is a non-trivial risk of the UK becoming the next Iceland.

The risk of a triple crisis - a banking crisis, a currency crisis and a sovereign debt default crisis - is always there for countries that are afflicted with the inconsistent quartet identified by Anne Sibert and myself in our work on Iceland: (1) a small country with (2) a large internationally exposed banking sector, (3) a currency that is not a global reserve currency and (4) limited fiscal capacity.

In the rest of a quite long and detailed post he shows how the UK is indeed at risk.

Fast forward, today we have a post from Ambrose Evans-Pritchard on the plight of the pound. Even by his standards (he has a great fondness for apocalyptic views), he is, as he warns, "Seriously Alarmed":

The slide in sterling has turned "disorderly"....

For the first time since this crisis began eighteen months ago, I am seriously worried that British government is losing control.

The currency has fallen five cents today to $1.39 against the dollar. It is now perched precariously on a two-decade support line -- the levels tested in 2001 and 1992. If it breaks that line, traders may send it crashing down towards dollar parity.

The danger is blindingly obvious. The $4.4 trillion of foreign liabilities accumulated by UK banks are twice the size of the British economy. UK foreign reserves are virtually nothing at $60.6bn. (on this, more later in a piece I'm writing today)

If the Government is forced to nationalise RBS and perhaps Barclays with their vast exposure in dollars, euros, and yen, it risks being submerged. It is one thing for a sovereign state to let its national debt jump in a crisis -- or a war -- perhaps even to 100pc of GDP. It is another to take on foreign debts on such a scale with no reserves. Yes, the banks have foreign assets as well to match the debts. But how much are these assets really worth?

This is the moment when the "rubber hits the road" -- to borrow from American argot -- the moment when the reckless debt experiment of our economic and political leaders comes back to haunt.

We cannot even do what Iceland did to save its skin. Reykjavik refused to honour the foreign debts of its buccaneering banks. It let them default, parking the losses in Resolution Committees. Small islands can do that. Iceland has fish instead, and lots of metals.

Britain cannot follow suit. The debts are too big. If London takes such disastrous action it will set off global panic and lead to an asset death spiral, drawing the entire world into deep depression.

What have our leaders wrought? The reckless conduct of City, the fiscal incontinence of Gordon Brown (3pc deficit at the top of the cycle), and the pitiful regulation of the UK housing boom have all combined to bring the country to the brink of disaster.

England has not defaulted since the Middle Ages. There is a real risk it may do so now.

And no -- just so there is no misuderstanding -- it would not have been any better if Britain had joined the euro ten years ago. The bubble would have been just as bad, or worse, as Ireland and Spain can attest. We have our disaster. They have their disaster. When the dust has settled in five years we can make a proper judgement on the sterling-EMU issue. Not now.

The Baby Boomers have had their moment in power. The most spoilt generation in history has handled affairs with its characteristic hedonism. The results are coming in.

The blithering idiots.

The one cheery bit of news is I haven't seen this line of thinking elsewhere....

Central Banks, Markets and Economists: Perpetual Unreadyness

Central Banks, Markets and Economists: Perpetual Unreadyness

via Paul Kedrosky's Infectious Greed de pk le 15/01/09

I liked this quote from a recent book:

It is a strange paradox that today's central banks are generally staffed by economists, who by and large profess a belief in a theory which says their jobs are, at the very best, unnecessary and more likely wealthy-destroying…

If central banks are necessary because of an inherent instability financial markets, then manning these institutions with efficient market disciplines is a little like putting a conscientious objector in charge of the military; the result will be a state of perpetual unreadyness.
-- Source: The Origin of Financial Crisis. George Cooper (2008)

Sur Keynes et Bastiat, destruction de richesse et stimulus

Don't Throw in the Towel

via Economist's View de Mark Thoma le 14/01/09

Someone from the Cato Institute sent me this with the message "I've been reading your blog posts on the Obama stimulus plan, and I wanted to bring this to your attention, something I think you'll find interesting." I interpret "interesting" to mean "you are mistaken to think fiscal policy can benefit the economy":

Making Work, Destroying Wealth, by David Boaz: Journalists are telling us that John Maynard Keynes, the intellectual inspiration of the New Deal and its tax-and-spend philosophy, is all the rage again. The Wall Street Journal offers an interesting vignette on Keynes's view of how to create jobs:

Drama was a Keynes tool. During a 1934 dinner in the U.S., after one economist carefully removed a towel from a stack to dry his hands, Mr. Keynes swept the whole pile of towels on the floor and crumpled them up, explaining that his way of using towels did more to stimulate employment among restaurant workers.

Now I should say that various people report this story, including Ludwig von Mises, but no one cites an original source. Assuming it's true, though, it just seems to underline the absurdity of the whole "make-work" theory that is back in vogue. Keynes's vandalism is just a variant of the broken-window fallacy that was exposed by Frederic Bastiat, Henry Hazlitt, and many other economists: A boy breaks a shop window. Villagers gather around and deplore the boy's vandalism. But then one of the more sophisticated townspeople, perhaps one who has been to college and read Keynes, says, "Maybe the boy isn't so destructive after all. Now the shopkeeper will have to buy a new window. The glassmaker will then have money to buy a table. The furniture maker will be able to hire an assistant or buy a new suit. And so on. The boy has actually benefited our town!"

But as Bastiat noted, "Your theory stops at what is seen. It does not take account of what is not seen." If the shopkeeper has to buy a new window, then he can't hire a delivery boy or buy a new suit. Money is shuffled around, but it isn't created. And indeed, wealth has been destroyed. The village now has one less window than it did, and it must spend resources to get back to the position it was in before the window broke. As Bastiat said, "Society loses the value of objects unnecessarily destroyed."

And the story of Keynes at the sink is the story of an educated, professional man intentionally acting like the village vandal. By adding to the costs of running a restaurant, he may well create additional jobs for janitors. But the restaurant owner will then have less money with which to hire another waiter, expand his business, or invest in other businesses. Before Keynes showed up in town, let us say, the town had three restaurants among its businesses, each with neatly stacked towels for guests. After Keynes's triumphant speaking tour to all the Rotary Clubs in town, the town is exactly as it was, except the three restaurants are left to clean up the disarray. The town is very slightly less wealthy, and some people in town must spend scarce resources to restore the previous conditions. ...

Now we are told that "Keynes is back," and we need a new New Deal, and the Obama administration is going to create millions of jobs by shuffling money through the federal government. And the theoretical underpinning of this plan comes from a man who thought you could stimulate employment by breaking things. ...

President-elect Obama proposes that the federal government "create or save" jobs by spending upwards of $600 billion. Where would this money come from? If it comes from taxes, it will be taken out of the more efficient private sector to be spent in the less efficient government sector, and the higher tax rates will discourage work and investment. If it is borrowed, it will again simply be transferred from market allocation to political allocation, and our debt burden will grow even greater. And if the money is simply created out of thin air on the balance sheets of the Federal Reserve, then it will surely lead to inflation. ...

You ... can't get economic growth back by breaking windows, throwing towels on the floor, or spending money you don't have.

It's easy enough to dispense with this by simply mentioning public goods, i.e. goods with high social value that, because of market failure, will not be produced without government intervention. Producing these goods is just the opposite of "throwing towels on the floor," and the net benefits from these projects are particularly high now since input costs have fallen so much as the economy has weakened. There are other easy counterarguments as well, but rather than rehashing those, I want to play the window game.

Suppose there is an economy that is humming along at full employment. Then, all of a sudden, out of nowhere, a giant, extremely rare windstorm - it's like nothing anyone can remember - comes along and blows out many of the windows in town's homes and businesses. The windows are broken.

This is unfortunate. The town specializes in delicate goods that cannot be exposed to the weather, and when the windows were broken and the weather rushed in all of the inventory, or much of it anyway, was destroyed. In addition, since all of the town's wealth was invested in the inventory, and then some (i.e. they had borrowed to finance some of the inventory), the people of the town lost both their wealth and their ability to borrow from residents of other towns.

So they are wiped out. With all of their wealth gone and no way to borrow, there is no way to rebuild the town and go on as before. Most people are struggling just to get by each day, they don't have time to repair the windows, let alone the resources to finance the repairs and then restock the shelves.

Or maybe there is a way. Suppose the government steps in and hires people to replace the broken windows, and then makes loans as needed (or makes loan guarantees, with an appropriate allowance for risk, or even outright grants in some cases) to recapitalize the businesses and cover the cost of the repairs. That way, the business owners can purchase new inventory and go on as before (well, not exactly as before, one condition of the government loan is that windows of a certain strength are installed, by regulation if necessary, so that the government financed inventory is safe from another disaster).

Thus, instead of destroying wealth, the government is essential in creating it. After the economy-wide window disaster, the government ignores the advice to turn its back in a time of need, and instead steps in and provides the help that is needed to get the economy up and running again. Because of the government action, the economy is revived, and they all live happily ever after.

Risk Management

Risk Management

via Economist's View de Mark Thoma le 04/01/09

I probably should have done more to highlight the article on risk management by Joe Nocera that appeared in the NY Times Magazine this weekend. Fortunately, James Kwak and others have it covered:

Risk Management for Beginners, by James Kwak: Joe Nocera has an article ... about Value at Risk (VaR), a risk management technique used by financial institutions to measure the risk of individual trading desks or aggregate portfolios. ...

VaR is a way of measuring the likelihood that a portfolio will suffer a large loss in some period of time, or the maximum amount that you are likely to lose with some probability (say, 99%). It does this by: (1) looking at historical data about asset price changes and correlations; (2) using that data to estimate the probability distributions of those asset prices and correlations; and (3) using those estimated distributions to calculate the maximum amount you will lose 99% of the time. At a high level, Nocera's conclusion is that VaR is a useful tool even though it doesn't tell you what happens the other 1% of the time.

naked capitalism already has one withering critique of the article out. There, Yves Smith focuses on the assumption, mentioned but not explored by Nocera, that the ... changes in asset prices ... are normally distributed. To summarize, for decades people have known that financial events are not normally distributed.... Yet ... VaR modelers continue to assume normal distributions..., which leads to results that are simply incorrect. It's a good article, and you'll probably learn something.

While Smith focuses on the problem of using the wrong mathematical tools, and Nocera mentions the problem of not using enough historical data - "...VaR didn't see the risk because it generally relied on a two-year data history" - I want to focus on another weakness of VaR: the fact that the real world changes.

Even leaving aside the question of which distribution (normal or otherwise) to use, VaR assumes the likelihood of future events is dictated by some distribution, and that that distribution can be estimated using past data. A simple example is a weighted coin that you find on the street. You flip it 1,000 times and it comes up heads 600 times, tails 400 times. You infer that it has a 60% likelihood of coming up heads; from that, you can calculate the probability distribution for how many heads will come up if you flip it 10 more times, and if you want to bet on those coin flips you can calculate your VaR. Your 60% is just an estimate - you don't know that the true probability is 60% - but you can safely assume that the physical properties of the coin are not going to change, and you can use statistics to estimate how accurate your estimate is. ...

By contrast, imagine you have two basketball teams, the Bulls and the Knicks, who have played 1,000 games, and the Knicks have won 600. You follow the same methodology, bet a lot of money that the Knicks will win at least 5 of the next 10 games - and then the Bulls draft Michael Jordan. See the problem?

Now, are asset prices more like coin flips or like basketball times? On an empirical level, they may be more like coin flips; their probability distributions aren't likely to change as dramatically as when the Bulls draft Jordan.... But on a fundamental level, they are more like basketball teams. The outcome of a coin flip is dictated by physical processes, governed by the laws of mechanics, that we know are going to operate the same way time after time. Asset prices, by contrast, are the product of individual decisions by thousands, millions, or even billions of people... We have little idea what underlying mechanisms produce those prices, and all the simplifying assumptions we make (like rational profit-maximizing agents) are pure fiction.

Whatever the underlying function for price changes is,... importantly, no one tells us when the function changes. Going back to asset prices: To estimate the probability distribution of price changes, you need a sample that reflects your population of interest as closely as possible. Unfortunately, your sample can only be drawn from the past, and your population of interest is the future. So you really face two different risks. You face the risk that, in the current state of the world (assuming you can estimate that perfectly), an unlikely event will occur. You also face the risk that the state of the world will change. VaR, at best (assuming solutions to Smith's criticisms), can quantify the first risk, not the second. ...

There was one part of Nocera's article that I liked a lot:

At the height of the bubble, there was so much money to be made that any firm that pulled back because it was nervous about risk would forsake huge short-term gains and lose out to less cautious rivals. The fact that VaR didn't measure the possibility of an extreme event was a blessing to the executives. It made black swans [unlikely events] all the easier to ignore. All the incentives — profits, compensation, glory, even job security — went in the direction of taking on more and more risk, even if you half suspected it would end badly. After all, it would end badly for everyone else too. As the former Citigroup chief executive Charles Prince famously put it, "As long as the music is playing, you've got to get up and dance." Or, as John Maynard Keynes once wrote, a "sound banker" is one who, "when he is ruined, is ruined in a conventional and orthodox way."

This, I think, is an accurate picture of what was going on. If you were a senior executive at an investment bank, even if you knew you were in a bubble that was going to collapse, it was still in your interests to play along, for at least two reasons: the enormity of the short-term compensation to be made outweighed the relatively paltry financial risk of being fired in a bust (given severance packages, and the fact that in a downturn all CEO compensation would plummet); and bucking the trend incurs resume risk in a way that playing along doesn't. ... Or, in the brilliant words of John Dizard (cited in the naked capitalism article):

A once-in-10-years-comet-wiping-out-the-dinosaurs disaster is a problem for the investor, not the manager-mammal who collects his compensation annually, in cash, thank you. He has what they call a "résumé put", not a term you will find in offering memoranda, and nine years of bonuses.

Qui aurait pu deviner ?

J'aurais dû écrire la même chose

Washington Post Crashed-and-Burned Watch (Robert Samuelson Edition)

via Grasping Reality de Brad DeLong le 01/01/09

Why oh why can't we have a better press corps?

Hilzoy: "I take the point of [Robert Samuelson's] op-ed to be that he is not competent in his alleged area of expertise, and moreover lacks one of the basic skills that a PhD in a discipline almost always provides: the ability to spot good arguments in that discipline made by other people, and to decide who is worth listening to and who is not":

Obsidian Wings: What Do You Mean 'We', White Man?: Robert Samuelson has an infuriating op-ed in today's Washington Post. It's called "Humbled By Our Ignorance":

"It's the end of an era. We know that 2008, much like 1932 or 1980, marks a dividing line for the American economy and society. But what lies on the other side is hazy at best. The great lesson of the past year is how little we understand and can control the economy. This ignorance has bred today's insecurity, which in turn is now a governing reality of the crisis.

The entire column is devoted to explaining all these things that "we" were ignorant of. But who, specifically, are "we"? It's hard to say. Mostly, it seems to be the nameless subject of the passive voice:

"It was once believed that the crisis of "subprime" mortgages -- loans to weaker borrowers -- would be limited, because these loans represent only 12 percent of all home mortgages. (...)

It was once believed that American consumers could borrow and spend more, because higher home values and stock prices substituted for annual savings. Ed.: Apparently, it was also believed that stocks and home prices always went up.

It was once believed that the rest of the world would "decouple" from the United States.

And so on, and so forth. All these beliefs, and no believers in sight. All this bustle and commotion, and there's nobody around!

The closest Samuelson gets to identifying people who actually believed these things is at the beginning of his piece ("The great lesson of the past year is how little we understand and can control the economy"), and at the end ("Our ignorance is humbling.") Which is to say: it's "us".

And yet, strange to say, I did not believe these things. I'm almost sure I wrote about this in 2006, but I can't recall where, so this from March 2007 will have to do. In it I predict that the mortgage meltdown will knock the legs out from under consumer spending, create a serious credit crunch, and slam the many investors who own CDOs based on mortgages; and that the combination of these three things will be very, very bad, even without taking into account the possibility of systemic risk.

Apparently, I did better than Robert Samuelson. I'm not saying this because I think I deserve credit for that. I don't. That's the point. I'm not especially astute about the housing market, or an expert in economics. I do tend to be common-sensical and cautious about economics -- I do not, for instance, tend to believe such things as: that houses will go up in value indefinitely, or: that we can keep living way beyond our means forever. But that shouldn't exactly set me apart from anyone.

The only reason I saw this one coming was that I read people who know a lot more than I do: people like Paul Krugman, Dean Baker, Tanta at Calculated Risk, Stephen Roach at Morgan Stanley, and Nouriel Roubini. They all challenged one or another of the myths Samuelson lists, and they did so years ago. Moreover, they had arguments to back up their claims, and I found these arguments much more persuasive than the arguments of the people who disagreed with them.

There were very smart people who did predict this. Their writings were not arcane or hard to find -- I mean, I found them, and this is not my area of expertise. Nor was their basic point that hard to grasp. If I could grasp it, then anyone remotely worthy of having an economics column in the Washington Post should have.

Whether or not Samuelson realizes it, I take the point of his op-ed to be that he is not competent in his alleged area of expertise, and moreover lacks one of the basic skills that a PhD in a discipline almost always provides: the ability to spot good arguments in that discipline made by other people, and to decide who is worth listening to and who is not. In his shoes, I would ask myself what, in the absence of competence or the ability to learn from the writings of others, could possibly justify my continuing to take up valuable space in the Post. It's certainly not obvious to me.

Cool SF illustrations

http://www.conceptships.blogspot.com/

3 Smart Things About Sleeping Late

3 Smart Things About Sleeping Late

via Wired Top Stories de Daniel Dumas le 31/12/07

1 // You may need more sleep than you think.
Research by Henry Ford Hospital Sleep Disorders Center found that people who slept eight hours and then claimed they were "well rested" actually performed better and were more alert if they slept another two hours. That figures. Until the invention of the lightbulb (damn you, Edison!), the average person slumbered 10 hours a night.

2 // Night owls are more creative.
Artists, writers, and coders typically fire on all cylinders by crashing near dawn and awakening at the crack of noon. In one study, "evening people" almost universally slam-dunked a standardized creativity test. Their early-bird brethren struggled for passing scores.

3 // Rising early is stressful.
The stress hormone cortisol peaks in your blood around 7 am. So if you get up then, you may experience tension. Grab some extra Zs! You'll wake up feeling less like Bert, more like Ernie.