Wednesday 28 July 2010

Banks and Basel 3: Asking kids to mark their own homework

One of my colleagues sent around a bloomberg article which stated that Westpac (the Aussie bank) had opined that the Basel 3 rules were flawed and risked constraining lenders! Wasn't it unconstraining lending that help get us into the GFC (global financial crisis for non-aussies)?

Why anyone would care what any bank thought of attempts to regulate it remains beyond me. One of the major problems of Basel 2 was that banks were allowed to use their own risk models to value assets. This is akin to asking kids to mark their own homework, one shouldn't be surprised when they report they got 100% correct.

Talk about not learning from mistakes. Hasn't anyone heard of regulatory capture?

Tuesday 27 July 2010

Is Austerity the Road to Ruin

My latest paper for GMO: Is Austerity the Road to Ruin can be found here:

Very interesting response to this paper, I have rarely been called a moron more often.
Others have accused me of talking my book, presumably wanting QEII to drive the markets higher, frankly given the stocks we own the last thing we want is yet more speculative demand for junky stocks!

Thursday 22 July 2010

On the price of insurance and the bull market in tail risk

From the people who bought you such wonderful ideas as CDOs, now comes the bull market in tail risk products. Deutsche are launching a long equity volatilty index, Citi has come up with a crisis index (mixing equity and bond vols, swap spreads and structured credit spreads). Bloomberg reports that PIMCO is planning a fund that will protect investors in the event of a decline greater than 15%. The CBOE is planning a new index based on the skew in the S&P500.

In the past I've talked about the need for cheap insurance, and the benefits that this can bring to a portfolio in terms of robustness. However, the key word is that the insurance must be cheap (or at very worst fair value). Buying expensive insurance is a waste of time. I used to live in Tokyo and was constantly amazed that the day after an earth tremor the cost of earthquake insurance would soar, as would the demand! You should really only want insurance when it is cheap, as this is the time when the no one else wants it, and (perversely) the events are most likely. Buying expensive insurance is just like buying any other overpriced asset...a path to the permanent impairment of captial. Rather than wasting money on expensive insurance, holding a larger cash balance makes sense. It preserves the dry powder for times when you want to deploy capital, and limits the downside.

So buy insurance when it's cheap. When it isn't and you are worried about the downside, hold cash. As Buffet said holding cash is painful, but not as painful as doing something stupid!

Wednesday 7 July 2010

Barbie does economics

Barbie does economics!

The sheer hubris of many in the economics profession never ceases to amaze me. Take for instance a recent paper by Kartik Athreya of the Federal Reserve Bank of Richmond[1] entitled “Economics is Hard. Don’t let Bloggers Tell You Otherwise”. In a move that is eerily reminiscent of the controversial talking Barbie of the early 1990s who fatefully uttered “Math class is tough”[2], Athreya’s short paper essentially lays out a quite staggering claim :- that economics should be left to those with a PhD in the subject!

Athreya describes himself as “a worker bee chipping away with known tools”. He goes on to say “writers who have not taken a year of PhD coursework in a decent economics department…cannot meaningfully advance the discussion on economic policy”[3]. You’ve got to love the ‘decent’ in that sentence – it reeks of intellectual snobbishness of the highest order.

In fact, Athreya’s ire isn’t limited to what he sees as uninformed debate, he seems to object to anyone who attempts to make the policy issues of the day clear even if they have a PhD. He pejoratively describes both Paul Krugman and Brad DeLong as “Patron saints of the Macroeconomic Policy is Easy” movement.

He argues that we won’t expect particularly informed discussion on the causes, consequences and treatments for cancer from non-Oncology specialists, so why we would we expect non-specialists to offer any useful debate on economics.

However, the analogy is false. Modern medicine is based on scientific principles and follows an evidence based approach. Even then some estimate that the majority of published findings in medical journals are false[4]!

Economics starts from a far worse place. It isn’t a science, and often seems more interested in twisting the facts to fit a theory rather than the other way around. In fact, as Nassim Taleb has pointed out, economics is more akin to medieval medicine than its current practice, “Medicine used to kill more patients than it saved – just as financial economics endangers the system by creating, not reducing, risk.[5]

The idea that what we need is more ‘worker bees’ gaining their PhD’s from conducting ‘angels on a pin head’ like work based on minor alterations to previous research makes me want to cry. Where were the warnings from the orthodox economics establishment ahead of the global financial crisis? Oh, that’s right there weren’t any.

Indeed many of those who warned of the problems ahead did so because they weren’t constrained by the kind of training that an economics PhD suffers. I did my own training in economics a long time ago now, it included a fair amount of equation bending but I was incredibly fortunate that it included generalist topics such as Marxian and post-Keynesian economics, subjects that are oddly absent from the vast majority of syllabi.

In many ways economics as it exists today is largely a victim of learned helplessness - a phenomenon was first documented by Martin Seligman in the 1960s. He was working with dogs (dog lovers look away now) and studying conditioning when he came across something interesting. Seligman was subjecting pairs of dogs to nondamaging but painful electric shocks. However, in each pair of dogs one animal could put an end to the shock by simply pressing the side panels of its container with its head. The other dog was unable to turn off the shock. The electricity was synchronized, starting at the same point for both dogs, and obviously ending when the dog with the control turned off the power.

This gave the each of the pairs of dogs a very different experience. One experienced the pain as controllable, while the other did not. The dogs which had no control soon began to cower and whine (signs of doggy depression) even after the sessions had stopped. The dogs which could control the shocks showed no signs of this behaviour.

In the second phase of the experiments dogs were placed in box with a low wall separating the container into two. One side (the side on which the dog started) was electrified. To avoid the pain the dog simply had to jump the low wall. The dogs which had controlled the shocks in the first round quickly learned to jump the wall. However, the around two-thirds of the dogs who had no control in the first round, simply laid down and suffered the pain, they had learned to become helpless.

Modern day economics is much like these poor animals. Many economists have learnt to become helpless. They would rather lay down and whimper and whine about how unfair the world is, and mutter that everything would be alright if only people behaved like their models, than seek to look outside the narrow confines of their obsession with rationality and mathematics to see if others might just have some useful insight.

The age of the specialist (people who learn more and more about less and less, until they know absolutely everything about nothing) has proved to have some fundamental flaws. Three cheers for the generalists!

[2] For more on the weird and wonderful versions of Barbie that have graced the shelves over the years see
[3] Atherya does have the sense to point out “Taken literally, I am almost certainly wrong.”
[4] John Ioannidis (2005) Why Most Published Research Findings Are False. PLoS Med 2(8): e124. doi:10.1371/journal.pmed.0020124
[5] Taleb (2007) The pseudo science hurting markets, Financial Times, 23 October 2007


Can't believe that it has been over two years since my last blog post! The good news (if you like my writing) is that I'll be posting the odd comment on this blog once again. As ever, I'll only post when I have something to say. The first entry will follow shortly.

Just for the record, I now work as memeber of the asset allocation team at GMO. However, the views expressed on this blog are entirely mine, and mine alone. They in no way reflect the views of GMO.