The CERF Blog

Previously published in the Orange County Register

I encountered the phrase “A well-ordered anarchist society” in Michael Huemer’s book The Problem of Political Authority. The phrase grabbed my imagination, and it hasn’t really let it go.

For most of us, those words just don’t go together. Our vision of anarchy is chaotic and violent. Huemer, one of our great modern philosophers, argues convincingly that our vision is wrong. He contends that society’s unthinking decision to grant authority to government is misplaced. He starts with a very few basic principles that most of us would agree with, and systematically builds his case.

In his section, “Society Without Authority”, where the phrase is found, Huemer describes how an anarchist society would function. He argues that markets would provide all the services that governments currently provide. This might help us understand the private provision of traditionally government provided services that we see today.

The standard economic discussion of government is one of decreasing returns to scale. Initially, government spending has big returns, providing defense, police, laws, courts, and such. As government grows, it gets harder to find those big returns, and the return on marginal investment gets smaller. I believe that the returns eventually turn negative. My socialist and communist friends disagree.

Total government spending (federal, state, and local) in the United States today is about what it was at the peak of WWII, more than 35 percent of gross product. It is reasonable to believe that we might be in the range where marginal gains are low, and there is evidence. Examples of well-funded, but apparently useless, studies abound, such as the almost $1 million study that found male fruit flies are more attracted to younger female fruit flies than to older female fruit flies.

What happens, though, when governments have to cut back? Cities lay off police officers and close fire stations. California Gov. Jerry Brown recently extracted a major tax increase by threatening more cutbacks on education. When sequestration hit, no one talked about ending studies of fruit fly mating preferences, but we saw talk of cutting air traffic controllers and airport security.

Part of what we see can be explained by powerful constituencies or a desire to punish an uncooperative electorate. But, a big problem is that governments at all levels genuinely have very little flexibility when it comes to spending.

At the federal level, entitlements (mostly Social Security and Medicare) are consuming ever-greater portions of the budget, crowding out all other federally provided government services. In California, prisons, schools, and pensions are crowding out other state-provided services, consuming increasing portions of the budget and apparently yielding little in return. In California cities and counties, ever-increasing personnel costs and pensions are driving out locally provided services.

Government is becoming a wealth-transferring institution, and in the process it is abandoning traditionally provided government services. As if on cue, private markets are stepping in to fill demand.

At least three media outlets (Contra Costa Times, KHOY Houston, Christian Science Monitor) have recently published articles about neighborhoods across the country hiring private security firms to replace police service withdrawn because of budget cutbacks.

Private firms are even providing money. As central banks worldwide vastly increase their money supply, people are questioning the value of their money. Private markets are there to offer an alternative. Bitcoin is a decentralized open-sourced virtual currency that is becoming increasingly popular, and you will soon be able to access it at your local ATM.

We may end up with Huemer’s society where private firms provide traditional government services. The irony is that it could be because of too much government, not a lack of government.

The California Economic Summit published a piece reacting to what President Obama’s push to raise the minimum wage from $7.25 an hour to $9 an hour would mean for California. There were a number of economists quoted who made some true statements – but they all missed the point.

First, here is some of what they said:

“Stephen Levy, Director and Senior Economist of the Center for Continuing Study of the California Economy: “”The minimum wage increase will not have a huge impact on the overall economy. There are probably some jobs that would not be filled at a higher minimum wage. There really are conflicting studies on that.”

“Levy says a minimum wage increase would be the least of California’s worries.

“For California, the minimum wage increase is a less important economic issue than, say, the sequester or immigration reform or funding for investments in R&D,” Levy said. “To make it a big deal about the economy would be a mistake.”

“Christopher Thornberg, founding partner at Beacon Economics, said that the discussion is driven by the extreme proponents and opponents.

“You hear lots of, I think, really aggressive points of view on both sides of the fence, and they’re both highly exaggerating the situation,” Thornberg said. “On one side of the fence, you have those in favor of raising it that claim it’s such a wonderful thing. You even have some clowns at Berkeley that have their so-called papers, where some way or another raising the minimum wage will increase employment, which begs the question if it’s that easy, why don’t we raise it to $1000 an hour? It’s preposterous how they twist it out of proportion.

“On the other side of the fence, those against it scream it will destroy small businesses and make unemployment rates go sky high. I don’t think it’s going to destroy businesses by any stretch of the imagination. If going from eight to nine dollars an hour bankrupts you, you have other problems,” Thornberg said.

These quotes, and the piece, are all about how the change in minimum wage will impact California’s economic statistics.  Levy and Thornberg are correct.  The impact on the state’s data will be small, because the increase is not particularly large, and unless indexed, it is temporary, as inflation will effectively drive it back down.

All this is completely beside the point.  The appropriate question is how will the proposed change impact Californians?

Most Californian’s will not notice any impact.  Their wages are above the minimum wage, and the price impacts will be small.  A few Californians will receive a pay raise.  A very few could suffer personal tragedies, and these are the people we should be thinking about.

The people displaced by a minimum wage increase will be disproportionally young and minority, because they are disproportionally the ones receiving the minimum wage.  They are already suffering way too much. For example, as of January, the unemployment rate for African Americans 16 to 19 was 37.8 percent.  For African American men over 20, the unemployment rate was 13.4 percent, while African American women had a 12.3 percent unemployment rate.

It’s a big event when an African American teenager loses a job.  A job loss could change the entire trajectory of his life.  It increases the probabilities of drug abuse, crime, prison, and teenage pregnancy.

Thornberg is right.  The change is unlikely to destroy any businesses.  It is, however, likely to destroy some lives.

We spend a lot of money on social programs for young minorities, but the best social program is a job.  It makes absolutely no sense to implement a policy that puts even one at increased risk.

This piece appeared previously in the Orange County Register

The year 1972 was a big one for me. I left the US Air Force, and I married the woman I still love. Once it dawned on me that I needed income to support my wife and our future family, I started looking about for what to do.

I seriously considered working in one of Southern California’s aircraft manufacturing facilities. Good thing I didn’t, instead going into banking and later academia. Most California aircraft manufacturing jobs are gone. Lots of other jobs are gone too. In 1972, Southern California was a major manufacturing center. Beside aircraft, Southern Californians built cars, tires, ships, and lots of other things.

It was also a time of optimism and economic growth. California was still the place anything could be done. Since then, I’ve watched California lose one industry after another.

Today, California has few sources of economic growth. Our trade is increasingly threatened by an expanded Panama Canal, increased capacity in Mexico and Canada, and our own unwillingness to expand our ports and supporting infrastructure. Our entertainment industry is threatened by changing technology and increased competition from other geographies. Our education sector is threatened by funding challenges, bureaucracy, and a reluctance to adapt to a rapidly changing environment.

But, we still have one really good sector. Tech, with its venture-capital infrastructure and concentration of talent, will be a persistent source of economic strength for California. Or, so I thought before I recently met Dino Vendetti.
Vendetti is a serial entrepreneur and a veteran venture capitalist. He’s a Silicon Valley insider. He’s a threat to California’s tech future.

Startups used to require $10 million to $30 million to get going. The big investment was associated with big burn rates (rate at which losses ate up capital). They required big teams and big infrastructure. Because of this, they located in the Silicon Valley, New York, or Boston.

Not any more according to Vendetti. He talks about structural changes going on in early-stage tech entrepreneurship. According to him, the cloud, open-source development tools, low-cost bandwidth, web 2.0 as a distribution channel, modern accelerators, and scalable business models have allowed low burn rates by delaying scaling until revenues materialized.

This shift toward lean-start-up methodologies is changing the way start-ups are financed. It allows more risk taking, because smaller individual investments allow increased portfolio diversification. This is a threat to the Silicon Valley’s dominance. It is an opportunity for other California cities. If other cities don’t capitalize on the opportunity, it’s a threat to California.

All this is leading to what Vendetti calls a Democratization of Entrepreneurship. It’s reduced but not eliminated the disadvantages of a start-up located outside the traditional centers of venture-capital driven entrepreneurship. It’s made vibrant regional tech clusters feasible.

Vendetti says that anywhere with a university, risk capital, and accelerators can grow a tech cluster. I would add that you also need plenty of bandwidth and an airport with easy access to the traditional tech centers.

Vendetti is putting his money where his mouth is. He’s building what looks to me to be an entrepreneurial farm system in Bend Ore. It’s a complete venture-capital infrastructure that includes Start-up Weekends, where ideas undergo vigorous vetting for market and profit potential; mini three-week programs to follow the start-up weekends; and finally an accelerator,  (an intensive, few-months-long, process of building a business plan and firm to the point where it’s ready for initial-stage venture capital). He’s also organizing investors around a venture capital fund.

It’s not just Vendetti’s money. He has investors and partners from the Silicon Valley. This is a big deal for Californians. Entrepreneurial tech is our last economic engine. Somebody from Sacramento needs to talk to Vendetti and find out what it would take to keep him and others like him in California.

This previously appeared in the Orange County Register

Journalist Helaine Olen has produced a strong criticism of the personal finance industry¹.  She claims the industry does not add much value, makes unsubstantiated claims, charges huge fees, is fraught with conflicts of interest, and redirects attention away from its failures by preaching a false solution – financial literacy.  But aside from that, the industry is fine.

The fundamental problem is well known:  thanks to declining defined benefit pension plans and other factors, people increasingly have to take responsibility for managing their financial affairs, yet a large percentage of people are financially inexpert.  Financial products are complex (intentionally so, according to Olen), and are not easy to understand even by experts, and certainly not by the average person.

Meanwhile, a huge financial advisory industry has risen up to provide assistance.  Olen reports that as of the end of 2011, there were more than 300,000 financial advisory firms in the U.S.  Total advisory fees in 2011 were approximately $500 billion (about one percent of household financial assets).  Olen claims that customers did not receive commensurate value.  This is largely because advisors claim abilities they do not have (in particular, the ability to predict what will happen in the future with stocks, bonds or real estate). 

She singles out for specific criticism many of the more familiar personal financial “experts” like Susie Orman (keep a positive attitude toward money), Dave Ramsey (stay out of debt), Ron Kiyosaki (Rich Dad, Poor Dad), and CNBC’s Jim Cramer.  She notes that each of these people has developed a financial empire of their own, but has provided (she claims) dubious value to customers.  This is not really a new story.  One of the financial best sellers of the 1950’s was Fred Schwed’s classic “Where are the Customers’ Yachts?”

In contrast to many authors, Olen does not believe financial literacy programs provide the answer.  She asserts that there is no evidence of superior decision making by individuals even after twenty years of financial literacy programs.  Other “solutions” are equally disparaged, like the notion that you can become a millionaire by foregoing the daily Starbucks latte.  Olen shows that the assumptions lying behind this calculation are extreme.  She refutes the “Millionaire Next Door” story in which frugality and entrepreneurship lead to financial success by pointing out that most entrepreneurial efforts fail and most sole proprietors are people who have been laid off from their regular job.

The bottom line to Olen is that the obstacles to financial affluence and independence for most people are overwhelming and out of their control.  These obstacles include:  falling real wages for the middle class, declining mobility, rising inequality of income, and a weakening safety net.  Thus, she boldly claims:  “we do not live in an economic environment that will permit mass personal financial prosperity.”

While I follow Olen’s argument on many points, including high fees and commissions, widespread conflicts of interest, and financial product complexity, I was surprised by her conclusion that widespread financial prosperity is not feasible in this country.  This is because we already have it!  The average household real consumption is more than 20 times what it was 200 years ago and 7 times what it was 100 years ago.  By any reasonable historical standard, the median income household in America today is rich, and even the poverty line household is doing better than the vast majority of people that have lived before.

But what about Olen’s claim that real wages have been falling for 30 years?  In fact, data from the BLS show that the median real wage (using the consumer price index as the deflator) has been flat since the mid 1960s.  However, total compensation includes wages and benefits, and the benefit share has been rising steadily.  Yes, health care costs are rising, but so in the quality of health care.  Yes, the cost of housing is rising, but so is the size and amenities of the average house.  Yes, the cost of higher education is rising but so is the return on investment in education.  This does not mean it is easy for the average person, or even the higher income person, to save a high proportion of their income.  But it is not impossible.  Like gases in a closed container, spending tends to expand to fill available income.  The trick is to automate savings, so that consumption expands to exhaust income net of desired saving.

 There is, I believe, substantial opportunity for nearly everyone to improve their financial position.  The first step is build savings.  The second is to avoid paying the giant fees that are charged on some financial products, while maintaining product quality.  For example, broad based passively managed equity funds provide the retail investor equity-like returns at very modest fees (typically about .1% per year).  While there are very complex versions of every financial product, there are simple versions as well.  Following Olen, it is important to realize that much of the financial advice you run across may be influenced by the size of potential commissions.  You need to find a source of good advice that is not biased.   

 ¹Helaine Olen, Pound Foolish, Wiley, 2012.

In the fiscal year beginning October 2008 (the 2009 fiscal year), federal government spending exploded from 20.8 percent of GDP to 25.2 percent of GDP.  This was due to a confluence of factors including a decline in GDP due to the recession, an increase in automatic expenditures such as unemployment insurance, the $750 billion Toxic Asset Recapitalization Plan (TARP) that was passed late in the Bush Administration, and the $800 billion stimulus plan that was passed early in the new Obama Administration.  Federal spending remained elevated relative to GDP at 24.1% during each of the subsequent two fiscal years (2010 and 2011) in part due to the fact it took some time to deploy the stimulus.  Then, last fiscal year (FY 2012, which ended last September), the ratio of spending to GDP fell to 22.8 percent.  Furthermore, the supposedly non-partisan Congressional Budgeting Office (CBO) projects further decline the spending ratio and an average over the next ten years of about 22%.  This is only about 1 or 2 percent over the long-term average.

So, it looks like what happened was a spike in spending (the stimulus and the TARP added $1.5 trillion to spending, or about 10 percent of GDP).  It took three years for this spending to take place and this accounts most of the elevated spending to GDP ratio for the fiscal years 2009-2011. 

Now along comes $87 billion of budget cuts for the coming year due to the “sequester” (actually, since the fiscal year is roughly half over, the effect during the current fiscal year will be about $40 billion).  This represents about 2 percent of total federal spending and ½ percent of GDP.  Republicans assert that this is a drop in the bucket (except they decry the disproportionately large cuts in defense spending), while the Democrats argue that any spending cuts will be extremely harmful.    The predictions for the impact on the economy if the sequester is implemented range from negligible to about one percent for real growth in 2013. 

What is interesting to me is that it does not take much spending restraint to get us back to the long-run average of federal spending to GDP, at least in the short-run (next five or ten years).  The mandated $87 billion of cuts is about half of what we need. 

On the tax side, federal tax revenues collapsed during the financial crisis from its historical average of 18% of GDP down to 15% of GDP.  The revenue share has increased in the past three years but is still one percent below the long-term norm.  If tax revenues were at the historical average then the near-term deficit would actually be reasonably manageable at 3-4% of GDP. 

Of course, an important factor is that we are benefitting massively in the short-run by the extremely low level of interest rates.  The Treasury yield curve (yields on various maturities of Treasury debt) ranges from 0% for short-term bills to 3% for 30-year bonds.  If interest rates were normalized, say at twenty year averages of 2-3% for bills and 4-5% for bonds, then the interest burden would be much greater and growing much more rapidly.  The condition for debt to become unmanageable is when the interest rate on outstanding debt exceeds the growth rate of nominal GDP.  In that case, absent surpluses aside from interest, the debt burden (outstanding debt/GDP) will explode. 

Long-Run Challenges

Despite the apparent incompetence of our political leaders, the short-run federal government spending, deficit and debt problems do not appear to me to be unmanageable.  However, in the long-run the situation is more difficult.  First, thanks to rising longevity entitlement spending will increase much faster than GDP.  Second, eventually interest rates will normalize.

Thus, it is imperative that the long-term gap between expenditures and revenues be closed.  In theory, this can be done either by reducing expenditures or by raising revenues.  But in practice it will have to be a combination.  My own preference would be to implement tax reform that broadens the tax base and generates 18-20% of GDP even with lower marginal tax rates, combined with tweaking entitlement programs so as to keep spending at 20-21% of GDP.

The alternate strategy, apparently preferred by the Democrats, is to find ways to dramatically increase tax revenues relative to GDP.  This cannot be achieved simply by closing loopholes and raising tax rates on the rich.  It can only come from imposition of a new broad based tax, like a consumption tax or VAT (Value Added Tax) or maybe a carbon tax.  This would enable continued operation of the entitlement programs, but at the possible cost of imposing long-term economic lethargy and risking the economic and political turmoil that is currently on view in Southern Europe.

At the recent World Economic Forum in Davos, Goldman Sachs Chief Operating Officer (COO) Gary Cohn suggested that many investors and banks might not be prepared for what he called a “significant repricing” in bond markets.  What he means by “significant repricing” is that bond yields may spike higher and bond prices fall dramatically.  His boss, Goldman CEO Lloyd Blankfein said at a recent conference that the risk of a bond market crash is growing, and that many investors seem to be unprepared for this.  Meanwhile, Goldman Sachs is getting prepared.  They have dramatically reduced their exposure to rising rates by shortening the duration of their assets and lengthening the duration of their liabilities.  Goldman does not refer to such positioning as proprietary trading, they are simply adjusting their risk exposures.

What can you do to mitigate the risk of rising interest rates?  Just like Goldman, you can sell long-term bonds and invest in shorter term bonds or simply hold cash.  And you can issue long-term debt (like fixed rate mortgage debt) and pay off short-term consumer debt (like credit cards).  So long as interest rates remain very low, the cost of this strategy is that you will earn a lower return on your assets. 

One giant market participant that is doing exactly the opposite of the Goldman Sachs strategy is the Federal Reserve.  In Operation Twist they are buying long duration securities (Treasury bonds and MBS) and selling shorter term securities.  So long as rates stay low, the Fed is the most profitable entity on the planet.  Last year Federal Reserve income was $91 billion, mostly from positive net interest income on their $3 trillion balance sheet.  The vast bulk of this income, approximately $89 billion, was turned over to the Treasury to reduce Treasury borrowing by a like amount.  If interest rates were to rise sharply, this could hurt Fed income in several ways.  First, there would be mark-to-market losses on their vast securities holdings.  Under market value accounting rules, banks and other financial institutions are required to show these market value losses as accounting losses as well.  It appears that the Fed does not have to follow this accounting rule.   Second, if rising interest rates is associated with stronger growth and the desire of the Fed to reduce its holdings of securities, then the Fed must sell the securities and recognize the market value losses.  Third, so long as the Fed continues to pay on reserves, rising short-term rates mean higher cost of funds and potentially negative net interest income.  Not to worry, however, because the Fed sets its own accounting standards.  And in a change made in February 2011, any losses experienced by the Fed will not reduce capital, but will instead be recorded as a “deferred asset,” effectively a reduction in the interest to be paid to the Treasury.

It seems a little strange to contemplate the Federal Reserve being exposed to interest rate movements, given that it is widely believed that the Fed controls interest rates.  If rising rates hurts the Fed, then why not just keep them low?  The problem arises if and when inflation begins to take off.  In a rising inflation environment, Federal Reserve attempts to keep rates low has the paradoxical impact of pushing inflation and nominal interest rates higher.

It is generally agreed that inflation and interest rates will rise, eventually.  But most market participants believe this will not occur in the near term.  The Japanese experience over the past twenty years or so suggests that periods of very low interest rates can extend for long periods.  But it appears that Goldman Sachs does not share the consensus view that rates will remain low in the near term.  Don’t forget that Goldman was the one major bank that successfully hedged itself against the mortgage collapse of 2007-2008.  They did this by taking short positions in derivatives that were tied to mortgage credit risk.

And today the company is taking steps to lessen or eliminate rising rate exposure.  This suggests that executives place substantial probability on a near-term bond market event (price collapse, yield spike).  Clearly, they are at odds with the consensus forecast and the Fed forecast (the latest FOMC statement repeats the assertion that the Committee expects short-term interest rates to remain low through 2014).  It is will very interesting to see who has made the better market call.

If Goldman turns out to be correct, this will be a little embarrassing for the Fed, but it will be more than embarrassing for investors and financial institutions that fail to take precautions against rising rates.  One feature of bond market mathematics that is often overlooked is that the sensitivity of bond prices to interest rates is greater when market rates are lower.  As interest rates have continued to fall, this has created larger and larger capital gains for owners of long-term bonds.  But, when interest rates start to move back up, owners of long-term bonds will experience large capital losses.  And, unlike the Fed, other financial institutions do not have the luxury of creating a “deferred asset” to absorb these losses.

Gracie University is the online division of the Gracie Academy.  The Gracie Academy based in Torrance, California is the U.S. home of the Gracie style of Brazilian Ju-Jitsu.  Gracie University is run by the two eldest grandsons of Helio Gracie, the founder of the Gracie style.  The Gracie name is very well known in martial arts circles, in large part due to the family’s long-standing challenge that any Gracie adult male could defeat anyone outside the family in a no-holds-barred fight.  Also, one of Helio’s sons, Royce Gracie, dominated the first few years of Ultimate Fighting Championships (Royce’s older brother Royion was a founder of the UFC).  So, there is a lot of credibility behind the claim that if you want to learn to protect yourself in an altercation, an excellent approach would be to study with someone from the Gracie family.

Gracie University has been up and running for five years, and currently has 75,000 paid subscribers around the world.  The Gracie grandsons running the program, Rener and Ryron Gracie, claim that online learning is even more effective than in-person instruction.  This is because they have carefully organized the lessons, so that there is a clear progression from each lesson to the next, and anticipated nearly every question.  All you need is a training partner, access to the online lessons, and the willingness to put a lot of effort into practicing the techniques.

One problem with online learning is certification.  How do you prove you have learned the material?  Gracie University addresses this by offering students video testing.  They demonstrate exactly what is required for each rank or belt test, and then encourage you (and your training partner) to make a U-tube video of your movements which you can send it to the Gracie Academy for evaluation.  If your score (100 less the number of mistakes you make) is satisfactory, you receive a rank promotion. 

Now, do I believe very many of the 75,000 online students will become Ju-Jitsu experts solely through the online courses?  No, not really.  I don’t think that most people will make the necessary commitment.  For example, how many people have the ability to maintain a rigorous exercise program without benefit of a personal trainer or a class to attend?

But what I think is important is that technology now enables anyone in the world to study Gracie Ju-Jitsu, or nearly anything else for that matter, without having local access to qualified teachers or schools.  This is a monumental step forward in human progress.  People anywhere around the world can become experts in any field they wish, even without having the benefit of great local schools or wealthy or educated parents. 

Khan academy

Perhaps the leading online academy in academic subjects is the Khan Academy, a non-profit school started by former investment banker Salman Khan.  With financial backing from the Bill and Melinda Gates Foundation, the Khan Academy mission is to “give a world-class education to anyone anywhere for free.”

Role of the Instructor

Many traditional teachers (including Ju-Jitsu instructors) are put off by what appears to be online competition.  The Gracie brothers argue the opposite.  The effect of Gracie University will, they claim, increase global popularity for the art and will increase the demand for in-person instruction.  Sal Khan argues that the best role of the Khan Academy videos and technology is to enhance the classroom experience.  In what he calls “reverse instruction” the course lectures are contained in the videos, which the students review at night.  Then class time is available for higher value interactions and tutorials between student and teacher.

Consequences for long-term economic growth

A common refrain today is that the “new normal” for economic growth among developed countries is very low, around 1-2%.  Partly this is a consequence of the de-levering process that began with the bust of the 2000s housing boom.  But also in part it is due to a concern that technological change and innovation has slowed down.  While I am not an expert in this area, it seems to me that just the reverse is more likely to be the case.  Technological change comes from ideas which come from people, particularly educated people.  Online instruction has the potential to dramatically expand the number of educated people and therefore the number of new ideas or inventions or process improvements. 

Not only that but online education can offer a massive increase in opportunity for the less fortunate.  While it will almost surely not lead to equality of outcomes, it has the potential to dramatically even the starting blocks, and therefore promote equality of opportunity.

Last month JP Morgan released the report of a task force set up to explore the huge trading losses suffered last year in its CIO group.  The facts, in brief, appear to be as follows:

CIO stands for Chief Investment Officer, and the original purpose of the CIO group was to manage JPM’s liquid asset portfolios.  In 2010, an additional objective was established of seeking to manage the credit risk exposure of the bank.  That is, the purpose of a bank is to make loans and manage the interest rate, credit and liquidity risk of doing so.  Given the existence of derivatives markets in corporate credit (chiefly, the Credit Default Swap or CDS), it is now possible for a bank to lend heavily in commercial credits and then hedge or reduce that risk by appropriate transactions in CDS or other credit derivatives.  As of the end of 2011, the CIO group had positions in CDS that had the effect of reducing JPM credit risk.  In particular, they were “short high yield” which means they had taken positions in derivatives that would pay off if credit spreads on high yield (risky) credit rose.  Then, the feeling among top management was that credit conditions were improving so that the CIO group was directed to reduce its hedge positions.  Well, it began to do so but found that the exit prices were not attractive.  That is, they were only able to offset existing positions at prices that meant losses, and the feeling was that further selling would drive prices lower and create more losses (the accounting for hedge positions, as opposed to loans, is that they are marked to market).

So, instead of reducing the short high yield position, the CIO traders decided to build a long investment grade position.  The idea, apparently, was that the high yield CDS and investment grade CDS would move in tandem, and if the combined position was short high yield and long investment grade, the longs and the shorts would more or less offset one another, so even though the gross amount of positions was rising, the net risk was falling.  Between January and March 2012, the traders kept building both the long and short positions.  In the report there are references to the traders attempting to “defend” their positions.  I take that to mean that by expanding an existing position a trader would tend to support the pricing or valuation of that position (and improve that trader’s profit/loss statement).  In just a few months these positions got to be enormous.

By the end of March 2012, rumors were circulating in the market of a “Whale” (very large trader, who was affecting market prices by the size of his positions) operating in the CDS market.  This “Whale” was rumored, rightfully so as it turns out, to be a member of the JPM CIO team.  Having established the existence of the whale, other traders took opposite positions in the market, on the theory that the whale would eventually have to trade out of its positions (to “surface” so to speak).  By the time of the earnings release for the first quarter of 2012, the JPM management team were fully apprised of the situation, but still thought that it was manageable.  It was a “tempest in a teapot” according to Chief Executive Officer Jamie Dimon.

The task force report carefully tracks the assessment of actual and prospective loss through the days of March and April 2012.  The expected loss, and range of possible losses, turned out to be woefully inaccurate.  Ultimately, JPM suffered a trading loss of $6.2 billion on the Whale position.  Yet, risk reports as late as mid-April showed a worst-case loss of a few hundred million dollars.  What is disturbing about this is that JPM no doubt has the best trading and analytical people and systems in the universe.  And yet they were massively wrong.   

One take is that there were mistakes made and there now have been improvements in the risk management process to address those mistakes, so that the system is now stronger.  This is the point of view taken by the task force report.

A different take is that we continue to place undue confidence in quantitative models that are based on historical data.  Yet again we see in this report mention of a large standard deviation (SD) event (in April the head of the CIO Group, Ina Drew, asserted that they had just experienced an “eight SD event”).  The implication is that this event was so unlikely as to be out of the realm of reasonable consideration.  Yet, huge SD events seem to happen all the time.  We should become disabused of the idea that high SD events are remote. 

It is impressive that JPM has sufficient capital and earnings power to absorb a $6.2 billion trading loss and still report positive earnings in every quarter of 2012 (it is also testament to the skill and dexterity of the accounting staff at JPM).  However, in my view, this episode does undermine the notion, most forcefully pushed forward by Jamie Dimon himself, that bank capital requirements are adequate and should not be raised. 

Three percent of JPM capital was wiped out in this episode, with little or no contemporaneous understanding by senior management.  Fortunately, JPM had a capital cushion, but had they been operating at the current capital standard, they would have become capital deficient and might have needed yet another government bailout.  Let’s agree on a level of capital that banks need to operate, say 10% of assets, and then require a capital cushion above that to absorb losses for 10 (or at least eight) SD events.

Fourth quarter United States GDP contracted by about $5 billion dollars, which is 0.1 percent negative growth annualized. This is after 3.1 percent growth in the third quarter which was the strongest quarter in 2013. The largest drivers of the fourth quarter decline were a contraction in government spending of 6.6 percent and a change of inventory investment down by $40 billion. The change in government spending was driven by a massive contraction in defense expenditures. Given the massive expansion of government expenditures in the third quarter, I wonder if some defense purchases were moved forward from quarter four to quarter three. Trade also detracted from GDP growth with a net overall contribution to GDP of negative 0.25 percent.

Consumption expenditures grew at 2.2 percent in quarter four, compared with 1.6 percent in quarter three. Fixed investment grew 9.7 percent, compared with 0.9 percent in quarter three.

I put a table with relevant data here:

Forecasting GDP is hard enough, but the volatility makes the task even harder. The drivers of the volatility in recent quarters have been inventory investment and government, where the contribution to GDP growth each has changed sign twice in the last two quarters.

I do not actually try to forecast the volatility in GDP, our GDP growth forecast is purposely “smoother” than recent history. This makes our forecast easier to explain to our clients, and reduces the risk of a large forecast error, particularly the error of getting the sign wrong. This strategy did not help this time, as our forecast was 1.5 percent for fourth quarter.

What we try to do with our forecasts is to be closer to the truth than our competition. Our competition is the Wall Street Journal consensus of forecasters, a survey of 50 of the top forecasters from around the country. The consensus forecast was 1.6 percent. We were slightly closer to the reported truth than consensus.

The partner to the numerical calculation of the forecast is the story we tell our clients. From this point of view, we have been more accurate than our competitors. We have cautioned our clients about underlying weakness in the economy for many years now, in fact, ever since the fall of Lehman Brothers in September 2008. The new quarter four data provide evidence that weakness still exists.

Residential investment has been strong now for five quarters in a row, and home prices are indicating a gradual housing market comeback. This is good, but the housing comeback will take time and it might never reach pre-recession highs. This probably means some of those construction workers will never again work in that field.

Our January 10 forecast for 2013 quarter one was 1.2 percent, weaker than our forecast for quarter four of last year. With the new quarter four data, I will rerun the model, and while the negative contribution to GDP from government expenditure will likely need to be viewed as a one-time hit, the slowdown in inventory investment and export growth will likely be viewed as indication of weaknesses that will continue to exist in the this quarter.

In early 2007, before the financial crisis hit, author Naseem Taleb published his best-selling book “The Black Swan” in which he argued that extreme events occur more frequently than most of us are trained to expect.  We are trained to think in terms of the “normal” distribution, or bell-shaped curve, in which events more than three or four standard deviations from the mean are wildly unlikely.  Yet, every few years in the financial markets we observe a six or ten (or, in the case of the stock market crash in October 1987, a twenty) standard deviation event.  These repeating occurrences should have completely disabused us of the notion that normal probability rules apply to financial markets.  But it does not that appear that this is the case.

Taleb’s contribution in the Black Swan was to offer an explanation for why extreme events occur more frequently than we expect and a suggestion for what we should do about it.  He distinguished between what he called “Mediocrastan” – the world in which the normal curve works – and “Extremistan” – the world in which it does not.  He showed that in this latter work, probabilities are driven by so-called “power laws.”  A simple example of a power law is the famous 80/20 rule, invented by French economist Pareto to describe land ownership in France in the late 19^th century (20% of the families owned 80% of the land, and 20% of the 20% owned 80% of the 80%, etc.).

Taleb argues that the effects of winner-take-all technologies and globalization mean that more and more phenomena are falling into the Extremistan world.  In order to survive and thrive in this world, you must on the lookout for negative Black Swans (that is, extreme events that are harmful to you) and seek to minimize exposure to them.  Also, you should be on the lookout for positive Black Swans (extreme events that improve your position) and seek to increase exposure to them.

As mentioned above, Taleb described these ideas before onset of the financial crisis.  It would have been highly beneficial for market participants, for example mortgage investors, to have applied these ideas.  A negative Black Swan for mortgage investors is a huge drop in housing prices.  One way to mitigate exposure to this event would have been to purchase protection in the form of mortgage credit derivatives, or to sell mortgage exposure.  As described in Michael Lewis’ entertaining book “The Big Short,” a few investors did precisely that, but not many.

In his latest book “Antifragility,” Taleb pushes these ideas forward by distinguishing between phenomena that are hurt by disorder from those that are benefited by disorder.  You are fragile if you are impaired by an increase in volatility.  You are “anti-fragile” if you are benefited by an increase in volatility.  A great example of anti-fragility is evolution.  The process of natural selection is enhanced by greater variation in genetic characteristics.  Other examples of anti-fragility include bottom up decision making, local governments, and trial and error experimentation.

Examples of fragile systems include large corporations, central governments, top down planning, large indebtedness and conventional risk management.  Taleb predicts that fragile systems will eventually blow up and fail.

How can you tell if a system is fragile or not?  Taleb, who began his career as an options trader, argues that it comes down to whether you are “long options” (you own them) or are “short options” (you have sold them).  Recall that an option is the right but not the obligation to buy or sell a commodity at a specified price.  The payoff to a long option positive is positive or zero.  The payoff to a short option position is negative or zero.  The option seller receives cash up front and is benefited by little or no movement in the price of the underlying commodity.  The option buyer pays cash up front and is benefited by greater movement in the underlying price. 

In financial markets, options prices can be bid up to very high levels, so that it appears to be more attractive to sell them than to buy them.  Thus, many investors and financial companies actively manage positions in which they sell (what they think are) overpriced options.  Taleb believes these types of positions are inherently fragile and will eventually blow up.  He prefers to own what he calls “barbell” positions which are made up of combinations of unlike positions, like 90% cash and 10% long out-of-the-money options.  The typical performance of this type of position will be a modest or even small negative return, but periodically there will be a very large positive return. 

To measure fragility, Taleb proposes that you estimate the performance of your strategy or position across an array of shocks to the underlying value drivers.  If you plot these outcomes and the shape is like a frown (big losses with large shocks), then you are fragile.  If the shape is like a smile (bigger gains with larger shocks), then you are anti-fragile.

Application:   Personal Financial Planning

Suppose we define a financial plan as a lifetime path of consumption such that its discounted present value is less than or equal to the discounted present value of resources including future income and current wealth.  To prepare such a plan includes making a monumental set of assumptions about future wages, rates of return on investment, retirement timetable and other factors.  Naturally, those forecasts are going to turn out to be incorrect, perhaps wildly incorrect.  Periodically, those projections will have to be updated.  A fragile financial plan is one in which the original consumption plan turns out to be infeasible under the revised projections.  On the other hand, a sustainable (non-fragile) plan is one which has sufficient cushion such that revised projections do not jeopardize the path of consumption.

Characteristics of a fragile plan

-          Low savings rate

-          High assumed future investment returns

-          High assumed growth in real wages

-          Big debt levels

-          Low amounts of insurance (health, life, property)

Characteristics of a sustainable plan

-          High savings rates

-          Modest assumed future investment returns

-          Modest assumed wage growth

-          Modest debt levels

-          Sizeable amounts of insurance

It is clearly desirable to put into place a sustainable plan, so that the chance of wrenching downward adjustment in the future is minimized.   The way to accomplish this is pretty simple – make conservative assumptions.  But, people have a hard time doing this.  Impatience leads to greater immediate consumption and lower savings.  Over-confidence leads to aggressive assumptions about future wage growth and investment returns.  The combination results in a fragile plan.   

¹Naseem Taleb, Antifragility, Wiley, 2012.