Must-read: Matthew Klein: “Private Equity’s Mark-to-Make-Believe Problem”

Must-Read: Matthew Klein: Private Equity’s Mark-to-Make-Believe Problem: “No asset is inherently worth anything…

…just some multiple of the income you think it will produce over time. Both the earnings forecast and the multiple can change at a moment’s notice–sometimes because the outlook for the future has genuinely changed, but often for other reasons…. One sensible response is nihilism: the great appeal of buy-and-hold passive investing is you don’t need to have any opinions…. Others… still try to earn a living betting some of today’s market prices will change, often but not always because they think the average opinion is improperly interpreting the available information. Then there are those, such as private equity firms, who invest in illiquid assets. ‘Illiquid’ in this case means ‘thing that’s almost never traded’, which in practice means ‘we won’t pretend to know what it’s ‘worth’ in the absence of a market, but here’s a number if it makes you feel better’. (This is distinct from the other meaning of ‘illiquid’… which is ‘oh of course we’re good for the money, we just don’t have it on us right now’, usually in response to questions such as ‘I’m not getting back what I lent you because you blew it retaining junior tranches in subprime mortgage bonds, am I?’)…

Notes on the global economy as of early April 2016

A Note on the Likelihood of Recession: With global inflation currently more than quiescent, there is no chance that global recovery will be—as Rudi Dornbusch used to say—assassinated by inflation-fighting central banks raising interest rates.

As for recovery being assassinated by financial chaos, we face a paradox here: Financial risks that policymakers and economists can see are those that bankers can see and hedge against as well. It is only the financial risks that policymakers and economists do not see that are truly dangerous. Many back in 2005 saw the global imbalance of China’s export surplus and feared disaster from a fall in the dollar coupled with the discovery of money-center institutions having sold massive amounts of unhedged dollar puts. Very few, if any–even among those who believed US housing was a massive bubble likely to pop—feared that any problems created thereby would not be rapidly handled and neutralized by the Federal Reserve.

The most likely danger of recession is thus absent, and the second most likely danger is unknowable.

That leaves the third: a global economy that drifts into a downturn because both fiscal and monetary policymakers sit on their hands and refuse to use the stimulative demand management tools they have.

Here there is, I think, some reason to fear. A passage from a recent speech by the nearly-godlike Stan Fischer was flagged to me by Tim Duy:

If the recent financial market developments lead to a sustained tightening of financial conditions, they could signal a slowing in the global economy that could affect growth and inflation in the United States. But we have seen similar periods of volatility in recent years–including in the second half of 2011–that have left little visible imprint on the economy, and it is still early to judge the ramifications of the increased market volatility of the first seven weeks of 2016. As Chair Yellen said in her testimony to the Congress two weeks ago, while “global financial developments could produce a slowing in the economy, I think we want to be careful not to jump to a premature conclusion about what is in store for the U.S. economy”…

And Tim commented:

This… again misses the Fed’s response to financial turmoil…. I really do not understand how Fed officials can continue to dismiss market turmoil using comparisons to past episodes when those episodes triggered a monetary policy response. They don’t quite seem to understand the endogeneity in the system…

However, anything that could be called a “global recession” in the near term still looks like a less than 20% chance to me. But that is up from a 5% chance nine months ago.


A Note on China: I do not understand China. And I know I do not understand China. Perhaps that gives me an advantage in analyzing China, perhaps not. The relevant long-run fundamentals of China seem to me to be two:

  1. Your typical wealthy Chinese plutocrat-political clan seeks in the long run to have perhaps 1/3 of its wealth outside of China as insurance against political risks, and thus seeks an opportunity to export capital from China.
  2. Your typical North Atlantic business or investment group sees returns from further massive investments in China as uncertain and sees political risks as large but as capable of resolution over the next decade, and so will delay investing in China.

That means renminbi weakness as a background trend behind shorter-term financial- and political-business cycles. And that has to shape what the real risks are (large) and opportunities (smaller).

A Note on the Non-Need for a New Plaza Accord: I would say that international monetary affairs in the Global North high now need not an accord but, rather, the right kind of discord.

At my Berkeley office I dwell in the zone of influence of the truly formidable Barry Eichengreen. His strongly, and I believe correctly, argued view is essentially that he set out in Eichengreen and Sachs (1986): that what we need is not an accord but a currency war. Global North blocs—the U.S., Britain, the Eurozone, Japan—leapfrogging each other with aggressive competitive devaluations every four months or so are likely to produce positive monetary spillovers as large as anything that monetary policy could now produce.

But what could monetary policy now produce?

My career analytical nadir was my memo to my Treasury bosses in 1993 that NAFTA was likely to put upward pressure on the peso. My second-worst was my confident prediction at the end of 2008 that within three years North Atlantic nominal demand would be back to its pre-2008 trend. My third has been my prediction that Abenomics would be an obvious and substantial success. That third prediction was based on my reading of the 1930s, in which four aggressive reflationary régime changes—that of Neville Chamberlain as Chancellor of the Exchequer in 1931, that of Takahashi Korekiyo as Finance Minister in 1932, that of Hjalmar Horace Greeley Schacht as Reichsbank President in 1933, and that of Franklin Delano Roosevelt as President in 1933—had been substantial successes. The mixed success of Abenomics thus tells me that my views of what monetary policy tools would work and how well they would work are almost surely wrong, and that I need to rethink.

Thus as far as monetary policy is concerned I am at sea.

With respect to fiscal policy, however, I am much more confident: Blanchard and Leigh (2013) is convincing. DeLong and Summers (2012) is correct. Coordinated North Atlantic fiscal expansion—unless the money is spent in a truly perverse fashion—is highly likely to boost production with North Atlantic-wide multipliers of around 3 and to reduce debt-to-GDP ratios. Whether it will generate enough inflation to be unwelcome hinges on the state of aggregate supply in the North Atlantic. And there we are so far outside the bounds of previous experience that I do not think anyone can or should speak with confidence.

A Note on Negative Interest Rates: Cash should be a very attractive asset vis-a-vis Treasury bonds at any negative or, indeed, slightly positive interest rate. Containers full of durable, storable commodities should be a very attractive asset vis-a-vis cash—and more so vis-a-vis Treasury bonds and even cash at a wider range of interest rates up to nearly the long-term expected rate of inflation. The only way I can understand current strong demand for the interest-bearing securities and, indeed, the cash of reserve currency-issuing sovereigns possessing exorbitant privilege is that 2008-9 and the political reaction thereto has cast the existence of the Bagehot lender-of-last-resort into grave doubt. Thus we not only have East Asian and other sovereigns desperate for reserves to avoid another 1998, we have every major financial institution desperate to avoid another fall of 2008. These economic agents seem to me to be no longer pursuing sensible risk-return optimization strategies. Instead, they seem to seek enough reserves to surmount any possible future crisis so that they can stay in the game and then earn profits whenever normalization and the future come.

As to dysfunctionalities—so far I see no signs of massive malinvestments in physical or organizational capital that will pay large negative societal returns, and I see no taking of extraordinarily risky large positions by too-big-to-fail entities. I feel that dysfunctional asset prices that produce dysfunctional investments and dysfunctional portfolios. But I cannot see what they are…

Must-read: Yuka Hayashi and Anna Prior: “U.S. Unveils Retirement-Savings Revamp, but With a Few Concessions to Industry”

Must-Read: IMHO, long, long overdue…

Yuka Hayashi and Anna Prior: U.S. Unveils Retirement-Savings Revamp, but With a Few Concessions to Industry: “The Obama administration Wednesday rolled out a long-anticipated new rule aimed at transforming the way the financial industry delivers retirement-savings advice…

…Administration officials intend it as a direct attack on what they consider ‘a business model [that] rests on bilking hard-working Americans out of their retirement money,’ Jeff Zients, director of the White House National Economic Council, told reporters Tuesday. About $14 trillion in retirement savings could be affected… which requires stockbrokers providing retirement advice to act as ‘fiduciaries’ who will serve their clients’ ‘best interest.’ That is stricter than the current standard, which only says they need to offer ‘suitable’ recommendations…. Still… the financial industry… has fought the regulation since it was first proposed six years ago, [and] the final version includes a number of modifications… extending the implementation period… giving advisers more flexibility to keep touting their firm’s own mutual funds… curbing the paperwork and disclosure requirements…. Those fixes… could also give opposing companies and skeptical lawmakers more time to try to dilute the rule further or even try to kill it altogether under the new administration…. The new rule will be the centerpiece of President Barack Obama’s efforts to help middle-class families build retirement savings in an era when few have guaranteed pension benefits…

Must-read: John Plender: Uncertainty Principles: ‘The End of Alchemy’, by Mervyn King

Must-Read: John Plender: : “King’s hugely ambitious aim in his book is to put an end to the alchemy…

…that has made financial crises a permanent feature of the landscape and allowed money — a public good — to become the byproduct of credit creation by private-sector banks. Above all, he argues that the crisis of 2007-09 reflected not just a failure of individuals or institutions, but a failure of the ideas that underpin current economic policymaking…. King argues that in a world of what economists now call ‘radical uncertainty’… there is simply no way of identifying the probabilities of all future events and no set of economist’s equations that describe people’s attempts to cope with that uncertainty…. In King’s terms, the coping strategy of households, businesses and investors involved adopting a narrative of stability while the level of spending ran at unsustainably high levels….

Western consumers’ urge to spend was not strong enough to offset the greater urge of northern Europeans and Asians to save, [so] global interest rates fell. Banks then satisfied investors’ desperate search for income by creating increasingly complex and risky financial products…. Bank balance sheets grew explosively…. The financial crisis changed the narrative. In King’s estimation, policymakers were right to adopt a Keynesian stimulatory response in 2008-9…. They averted a repetition of the Great Depression but, in doing so, created what King calls a paradox of policy. Interest rates today, he says, are too high to permit rapid growth of demand in the short run but too low to be consistent with a proper balance between spending and saving in the long run….

King argues that Bagehot’s famous dictum on central bank crisis management — lend freely on good collateral at penalty rates — is out of date because bank balance sheets today are much larger and have fewer liquid assets than in the 19th century. Central banks are thus condemned in a crisis to take bad collateral in the shape of risky, illiquid assets on which they will lend only a proportion of the value, known as a haircut…. King suggests this lender of last resort role should be replaced by what he calls, with a pleasing irreverence towards central banking mystique, a pawnbroker for all seasons…. Banks would decide how much of their asset base to lodge in advance at the central bank to be available for use as collateral. For each asset, the central bank would calculate a haircut…. The system would displace what King regards as a flawed risk-weighted capital regime ill-suited to addressing radical uncertainty…

Must-read: John Plender: ‘Lehman Brothers: A Crisis of Value’ by Oonagh McDonald

Must-Read: Either Lehman was a reasonable organization caught in a perfect storm–in which case its creditors should have been bailed out as part of its resolution–or Lehman should have been shut down and resolved while there was still enough notional equity value left in the portfolio to cover the inevitable surprises and the likely negative shock to risk tolerance. As I have come to read it, Paulson, Bernanke, and Geithner were afraid to do their job in spring and summer of 2008, and also afraid to take responsibility to do what their forbearance with Lehman in the spring and summer had made prudent in the fall.

Perhaps Paulson, Bernanke, and Geithner thought that although the way they handled Lehman was a small technocratic policy mistake, it was a political economy necessity. Perhaps they thought an uncontrolled Lehman bankruptcy that would deliver a painful shock to asset markets and economies would generate strong political benefits: constituents would feel that shock and then complain to congress, which would then give the Fed and the Treasury a free hand to keep it from happening again. Perhaps such considerations made it the right political-economy thing to do. Perhaps not.

But we have never had the debate over that. Paulson, Bernanke, and Geithner have instead claimed that they did not have legal authority to resolve Lehman in the fall. Combining with their failure to resolve it in the summer to generate the conclusion that they did not understand what their jobs were:

John Plender: ‘Lehman Brothers: A Crisis of Value’ by Oonagh McDonald: “The collapse of Lehman Brothers in 2008 was… a spectacular curtain raiser…

…Oonagh McDonald, a British financial regulation expert and former MP, brings a regulatory perspective to the story, exploring the multitude of flaws in the patchwork of rules… examines how, one weekend in September, Lehman went from being valued by the stock market at $639bn to being worth nothing at all…. Lehman… was so highly leveraged that its assets had only to fall in value by 3.6 per cent for the bank to be wiped out. The tale of how the management reached this point under the leadership of Dick Fuld is compelling. The response… to the credit crunch that began in mid-2007 was pure hubris. Having survived episodes of financial turmoil when many expected the bank to fail, Mr Fuld and his colleagues decided to take on more risk. Meanwhile, they neglected to inform the board that they were exceeding their self-imposed risk limits and excluding more racy assets from internal stress tests…. Much of the decline in the value of Lehman’s assets came from direct exposure to property….

The conclusion is a broader, provocative exploration of the concept of market value, in which McDonald tilts at the efficient market hypothesis that underlay much of the thinking in finance ministries, central banks and regulatory bodies before the crisis…. The brickbats McDonald aims at regulatory behaviour before the crisis are amply justified. More questionable is her critique of crisis management by the US Treasury and the US Federal Reserve. She thinks Lehman could and should have been bailed out in the interests of systemic stability, but does not address the question of how the troubled asset relief programme would have found its way through a hostile Congress without the extreme shock of Lehman’s collapse…

Must-read: Ken Rogoff: “The Great Escape from China”

Must-Read: Just how large is the Chinese elite’s potential demand for political risk insurance in the form of dollar assets underneath the U.S.’s legal umbrella anyway? The extremely-sharp Ken Rogoff

Ken Rogoff: The Great Escape from China: “The prospect of a major devaluation of China’s renminbi…

…has been hanging over global markets like the Sword of Damocles. No other source of policy uncertainty has been as destabilizing…. It might seem odd that a country running a $600 billion trade surplus in 2015 should be worried about currency weakness. But… slowing economic growth and a gradual relaxation of restrictions on investing abroad, has unleashed a torrent of capital outflows…. Private citizens are now allowed to take up to $50,000 per year out of the country. If just one of every 20 Chinese citizens exercised this option, China’s foreign-exchange reserves would be wiped out. At the same time, China’s cash-rich companies have been employing all sorts of devices to get money out…. Now that Chinese firms have bought up so many US and European companies, money laundering can even be done in-house…

Must-read: Amir Sufi: “Household Debt, Redistribution, and Monetary policy during the Economic Slump”

Must-Read: Amir Sufi: Household Debt, Redistribution, and Monetary policy during the Economic Slump: “High-income and low-income individuals respond very differently to monetary policy shocks…

…as do savers and borrowers. Monetary policy has been especially weak in advanced economies over the past seven years because the redistribution channels of monetary policy have been severely hampered. Recognising the importance of such channels can guide central bankers on what monetary policies are most likely to be effective: the same policy may have different effects on the real economy depending on the distribution of debt capacity across individuals.

Must-read: Justin Fox: “Vanguard’s Low Blow”

Justin Fox: Vanguard’s Low Blow: “Vanguard tax lawyer turned whistle-blower David Danon and his hired expert, University of Michigan law professor Reuven S. Avi-Yonah…

… are… reasoning… [that] Vanguard is cheating state and federal tax authorities by charging its customers much less than other fund companies do. Which is exactly as bonkers as it sounds…. My Bloomberg View colleague Matt Levine has dubbed this ‘the faked moon landing of financial news stories, except that it might be true.’ Danon collected a $117,000 whistle-blower bounty in Texas in November, meaning that Vanguard paid the state at least $2.3 million. It’s possible that Vanguard’s payment had nothing to do with the fee issue–a company spokesman told Bloomberg’s Jesse Drucker that Danon’s arguments didn’t come up in the company’s discussions with state tax authorities…. At almost every mutual-fund group other than Vanguard, the management company is out to make a profit, so charging too-low fees isn’t really an issue. But at Vanguard, the funds… own the management company, and expect it to keep fees as low as possible. Why the difference? A little history is in order, in part because it shows that Vanguard isn’t so much a weird outlier as a worthy carrier of the mutual-fund tradition….

Vanguard is run on behalf of its customers, who also happen to be its owners. It has revolutionized the money-management business, putting pressure on competitors to lower fees…. It’s a virtuous cycle that has both changed investing for the better and brought the mutual-fund industry back closer to its roots. If the IRS or the courts decide to go after Vanguard for its frugality, it would amount to throwing all this into reverse…. Saying that competition on the basis of price shouldn’t be allowed… sounds awfully un-American.

Must-read: Olivier Blanchard and Joseph E. Gagnon: “Are US Stocks Overvalued?”

Must-Read: I think that this is completely right: expected returns on U.S. stocks right now are lower than average, but the gap between expected returns on stocks and on other assets is significantly higher than average:

Olivier Blanchard and Joseph E. Gagnon: Are US Stocks Overvalued?: “Are stocks obviously overvalued?…

…The answer is no, and the reason is straightforward…. What matters for the valuation of stocks is the relation between future growth and future interest rates. Put another way, the equity premium… has if anything increased relative to where it was before the crisis…. The Shiller P/E ratio reached 26 late last year and is currently around 24, compared with a 60-year average of 20. This elevated Shiller P/E measure is commonly cited as an indicator that stocks may be overpriced, including by Shiller himself….

The deviations of the P/E from its historical average are in fact quite modest. But suppose that we see them as significant, that we believe they indicate the expected return on stocks is unusually low relative to history. Is it low with respect to the expected return on other assets?… [But] in all six cases, the equity premium is higher in 2015 than in 2005. Put another way, stock prices were more undervalued in 2015 than they were in 2005….

If you accept current forecasts, and you accept the notion that stocks were not overvalued in the mid-2000s, then you have to conclude that stocks are not overvalued today. If anything, the evidence from 150 years of data is that the equity premium tends to be high after a financial crisis, and then to slowly decline over the following decades, presumably as memories of the crisis gradually dissipate. If this is the case, then stocks look quite attractive for the long run…