Tuesday, October 14, 2014

We really have no idea what we're doing

This would be baffling if it wasn't so predictable.  The New York Times reports of concerns among global leaders at last week's IMF meeting:
As economists and politicians heap pressure on global central banks to continue, and even escalate, their unusually loose monetary policies in order to spur global demand, the fear that these measures could provoke another market convulsion is spreading. 

“A major lesson of the last crisis is that accommodative monetary policy contributed to financial excesses,” said Lucas Papademos, a former vice president of the European Central Bank. “We are pursuing a similar policy for good reason. But there are limits — if you do this for too long, risks in the financial markets will materialize.”
Inflation is low and collapsing, households have undertaken unprecedented deleveraging, low risk bonds pay little to nothing, equity premiums are very high.....on and on and on.

And our best and brightest think monetary policy has been "unusually loose" and think our major concern right now is too much risk-taking because financial institutions are going farther and farther afield to bid up safe assets.  I think everyone agrees that the 1970's was a period of loose monetary policy.  What exactly is going on now, in terms of financial risk taking, that mimics the 1970's?  If loose money is the key factor, this should be an easy question to answer.

We tend to think of interest rates and risk premiums in an additive fashion.  We start with a risk free rate and add risk premiums to model risky assets.  I wish we, instead, began with a benchmark required return for assets and then thought of the rate on debt as a discount from that required return.  It looks to me like the market asset real required return has been fairly stable over time.  If we looked at it this way, then we would now say, "Short term risk free bonds are paying an 8% discount in order to avoid exposure to manageable cash flow risk."  It would be easier to think of increases in debt ownership as a flight from risk.  High corporate profit levels are, in part, a product of a huge pool of risk averse savers saying, "Hey, if you're willing to take the residual risk, you keep the profits.  Give me 1% a year, and leave me out of the rest of it."  Since corporations tend to deleverage when debt rates are low (and are currently not very leveraged), some savings is drawn back into equity (because it is now less volatile) and into non-corporate debt.

This is why the tendency to demonize the financial industry seems so dangerous to me.  Market prices contain a wealth of information, which we frequently misinterpret.  (Why would we expect to always understand it?).  We view investors as some sort of Frankenstein monster in a tux, and we demand that it be controlled by committees that can't tell the difference between loose and tight monetary policy.

Here is an educational video about the politics of finance and monetary policy.


  1. "Market prices contain a wealth of information..."

    This is exactly right, and it is why I think government intervention tends to do more harm than good. For example, the Fed targets interest rates, which requires buying and selling securities without regard to their fundamentals or attractiveness as an investment. This changes market prices artificially and distorts the market signals that give us that wealth of information.

    If interest rates would be higher absent the artificial manipulation by the government, then there is a very good reason for that. Perhaps we need to save more and borrow less to restore balance to the economy.

    Personally, I think artificially low interest rates are a mistake because it stimulates both *consumption* and *investment* while discouraging savings. That is a recipe for trouble, because you need savings to make the investments worthwhile. Without savings, consumers can't consume the product of the investments in the future. We would have to use increasing levels of debt to keep the ball rolling.

    1. Mark, I have found that corporate leverage is not that responsive to short term interest rates, and in fact declines over the long term when rates increase.

      Also, I think corporations tend to borrow to match the duration of their investments, so long term rates may be as important or more important than short term rates, and these rates are more dependent on expectations. These rates have increased during the Fed's QE periods.

      And, while the Fed can control the money supply fairly directly, I'm not sure they have that much control over rates, even on the short term.

  2. TravisV here.

    Off-topic but have you looked at Hertz / Avis stock?

    Yesterday, I sold a bunch of my P&G and replaced it with Nestle and Unilever......

    1. Wow. The bottom fell out of the car rental firms. What's up?

      Is your P&G to Nestle/Unilever move just because of the recent movements?

      I only tend to take positions on large disconnections (more than 100% expected returns), so I don't tend to follow these things. But, there do appear to be short term movements with this correction that might revert. That Hertz chart is pretty compelling. Do you use options in a case like that?

    2. TravisV here.

      I don't know the rental car business very well. Haven't acted on it. Just think it's interesting. Tons and tons of long-term debt and sunk (fixed) costs.

      Glad you can kinda see my reasoning re: Nestle.

      I'm still hanging on to the hope that equities will beat the 30-year U.S. treasury over the next five years. And I have a lot more confidence in the long-term growth / profitability of Nestle than that of P&G.

      The fact that Nestle is trading at the same multiple as P&G seems irrational to me.

    3. Well, Uber, Lyft and Sidecar can't be helping Hertz and Avis's business.

    4. Hmm, Patrick. I wonder how much competition they really pose for the rental firms. A car is still a lot cheaper than a taxi ride.

      It's a great example of how fast obsolescence is happening now, though. If Uber, et. al. are taking business from rental firms, just wait until the Google self-driving car is legal. Then the rental firms will be back in the driver's seat (no pun intended) and Uber et. al. will be obsolete.

  3. The intelligence level difference between the post and the commentary is striking. Mark, you have no clue. Money is too tight, not too loose. The Lucas critique is there to remind us that yes, the Fed's policy affects the markets (and their signals), but that's equally true of any policy, including doing nothing.

    Kevin, have you looked at the problem of getting a more sensible monetary policy regime enacted, e.g. NGDPLT? Even price level targeting would be better than what we've got today. Scott Sumner has been working on this problem recently (and I've been trying to help in little ways).

    Kenneth Duda
    Menlo Park, CA

    1. I'm excited about Scott's recent developments.

      Please try to stay civil. I don't see anything in Mark's comment that should outweigh a presumption of civility. He might even respond thoughtfully to a civil comment, and the rest of us might learn something.

    2. Kevin, thanks for the response. I will respect your preference here.

    3. Please continue commenting. I, like Travis, enjoy reading your comments over at themoneyillusion. And, kudos for being among the supporters for the NGDP market!

  4. TravisV here.

    Kenneth, I'm a huge fan of your comments on Sumner's two blogs!

    And yes, Kevin is very aware of what Sumner is doing. Has participated pretty actively in Sumner's comments section in the past.

  5. "And, while the Fed can control the money supply fairly directly, I'm not sure they have that much control over rates, even on the short term."

    I think Kevin is correct, Mark. There is tremendous popular MISconception about the degree of FRB control over market interest rates. The Board tries to effect policy on markets, subject to the interest rate (not through it, if you will).

    Consider: the estimated natural rate of interest is almost certainly between 2 and 3 percent. Call it 2.5%, with an inflation expectation premium (this latter is a big part of how the Fed exerts influence).

    The 10-year T-bill rate is at 2.53%, give or take, and Fed policy is supposedly LOOSE. Where is the evidence that the Board has depressed long-run market rates significantly below where they "should" be?

  6. TravisV here.

    Cliff Asness’s influential forecasts need to be critiqued / rebutted by a Market Monetarist……



    1. That Fortune article is awful.

      Cliff is fun to read sometimes. It's a shame that some of his analysis seems off.