Monday, 29 November 2010

Turducken? Meh! I want a TurBacon Epic

We survived Thanksgiving with the Unknown In-Laws. The Unknown Wife, her mom, and her sisters are all good cooks, so we easily put on a couple of pounds.

Many of you have heard of the Turducken (a dish consisting of a de-boned chicken stuffed into a de-boned duck, which itself is stuffed into a de-boned turkey).

But these folks have gone several steps better - the TurBacon Epic: a 20lb pig stuffed with a 8lb turkey, a 6lb duck, a 4lb chicken, a cornish hen, a quail, bacon croissant stuffing, and 10 lbs of bacon wrapped around all the layers. It's "only 79,046 calories and roughly 6,900 grams of food coma inducing fat.

To quote Yakov Smirnoff, "What a Country!"

Wednesday, 24 November 2010

New Video on Risk and Return

I've posted a new video on Risk and Return - it covers the typical material presented in and introductory class from the math of risk and return (Expected returns, standard deviations, covariance and correlation) through Markowitz Portfolio Theory and the Capital Market Line through the CAPM and the Security Market Line. it has a table of contents, so you can skip around. Click on the video below to see it - it's a pretty big file, so it might take a while to load.

In case you don't want to view the whole thing at one sitting (it's a bout 90 minutes), the video is organized as follows (I reference the numbers in the Table of Contents):
  1. Sections 1-13 (roughly from the beginning to 38 minutes in - the "math" risk and return (Expected Returns, Standard Deviation, Covariance, and Correlation)
  2. Sections 14-25 (from minutes 38 to 75): Markowitz Portfolio Theory and the Capital Market Line
  3. Sections 26-32 (Minutes 75 to the end): Systematic and Unsystematic Risk, The CAPM and the Security Market Line
I hope you find it useful. Comments (of course) are welcome.

Happy Thanksgiving

It looks like Unknown University is all but deserted the day before Thanksgiving. I finally decided to quit swimming against the tide, and canceled classes for today (I usually only get about 30% attendance on the day before Thanksgiving in the best of times, so it's no big loss).

Instead, I told the students that I'd put up a video with the lectures for the week on Risk and Return. Once it's done, I'll post a link here. I'm pretty happy with it - it runs the gamut of topics from the calculations for standard deviation, covariance, expected returns, etc... to Markowitz Portfolio Theory and the Capital Market Line to the CAPM and the Security Market Line.

Although I don't use all this material in my intro class, I expect to use it in my investments class this spring. So, this should allow me to go a bit faster and cover more material there.

Unfortunately, I have to wait another hour before the video software is done rendering the final version and I can go home. Then it's off the the Unknown In-Laws house tomorrow for turkey overload and football.

Here's wishing you all a Happy and safe Thanksgiving

Tuesday, 23 November 2010

Kissing Up is Good Practice

It's important to be good at the technical aspects of your job. But the "soft" stuff may be even more cirtical - the ability to get along with coworkers (and more important, with bosses) has a lot to do with eventual career success.

Tow researchers (Ithai Stern at Northwestern University and James Westphal at the University of Michigan) recently published a study in Administrative Science Quarterly titled "Stealthy Footsteps to the Boardroom: Executives’ Backgrounds, Sophisticated Interpersonal Infl uence
Behavior, and Board Appointments (here's an ungated copy). They lay out several effective ways of "kissing up" to the boss:
  • Go with discomfort: Preface compliments to the boss with something like "I don't want to embarrass you, but..."
  • Frame it in question form: Ask for advice - it's just as flattering as a compliment. goes down a lot easier
  • Bait and switch: Start out by disagreeing with the boss and then gradually warm to their opinion. Instead of being a "Yes Man", be a "'No,' then 'Yes'" man).
  • Go around the corner: Find a third-party (best if it's a close confidant of the boss), and talk admiringly about the boss. Odds are, it will get passed on.
  • Look for common ground: Pick a topic (anything from parenting to religion to politics) and make unsolicited statements and opinions about the matter that you think are also held by your target. Positive impressions will lower the red-flags on future praise.
  • Look for common groups: Bring up social affiliations that you may have in common.
All in all, pretty clever stuff. Not that I'd ever use any of these, but if I were to...

Monday, 22 November 2010

Happy Thanksgiving From the TSA

Luckily, we're not flying this Thanksgiving - we live a mere 2 hours from our families. But in case you are, here's a pretty funny clip from SNL.

Now take off you D**n shoes!

Thursday, 18 November 2010

Take Me Down to the Paradox City

Assume, for a minute, that Paul Krugman is 100% correct in his analysis of the economy: assume that we are indeed in a liquidity trap, and the only way to escape the trap is through higher inflation. What's the best way to create this higher inflation? Why, through inflation expectations, of course. And what's the best way to foster inflation expectations? Well, here are some ideas:

- complain endlessly about government deficits;
- claim that QE2 will debase the dollar;
- whine about higher food and gas prices;
- tout gold as the ultimate investment.

Conversely, what's the absolute worst way to create an inflationary mindset in the populace? Hmm, I don't know, but writing a New York Times column that constantly warns of the dangers of deflation while pooh-poohing claims of inflation current or future, real or imagined -- that's gotta be pretty high on the list.

So within the framework of Prof. Krugman's own model, it's the right-wing fringe that is doing what's best for America, and Prof. Krugman who's doing what's worst.

But let's not steal (credit) from Paul only to pay (credit to) Peter. The situation is in fact almost perfectly symmetric. Consider Peter, Peter Schiff that is. He is a well-known inflationista and, by his own admission, owns lots of gold and other commodities ("real assets") on behalf of his clients. Yet he's constantly berating the Fed for its easy dollar policy, and calling for tighter monetary and fiscal conditions. Again, it would seem that Schiff's antagonists are doing what's best for his portfolio, while he himself is doing what's worst.

What a wonderfully paradoxical world we live in!

Monday, 15 November 2010

Annoying or Amusing?

I had the genuine pleasure this past Thursday of speaking to 150 new faculty members in the Virginia Community College System. It is always a treat to work with people at the very beginning of their teaching careers. They have such a wonderful opportunity to help change the world.

One of the themes that I explored with the group was the idea of improvement. If you continue to improve as a teacher, year after year, you will get very good and eventually become great. And, the amount of annual improvement doesn’t have to be huge. In connection with their teaching, I suggested that every person work toward making a mere 5 percent improvement per year. That is doable and at that rate, in not too many years, you can become the best teacher in your building.

However, a great majority of teachers get better for awhile but eventually plateau. Many people who were B- teachers two decades ago are still B- teachers. I find that troubling. Why doesn't a B- teacher eventually become an A+ teacher?

There is a point where it simply becomes easy to say “I am what I am and I am never going to get any better so I’m not even going to try.” As you can imagine, that is not an attitude that I like. As far as I’m concerned, if I am not dead, I should be working to get better.

The question comes up, then, as to what causes a teacher to plateau. I have known a fair share of people who were good teachers and then suddenly began to become disgruntled. After that, they never got one bit better.

When does that happen? I have a theory. When you first start teaching, it is easy to find your students amusing. My students are all about 19 years old and I occasionally refer to them as puppies. They are just beginning to try out the responsibilities of adult life. As with growing puppies, this time can often be a very humorous period of transition.

However, there can come a time when those same students and those same actions can become annoying. A student will say something bizarre and instead of finding it amusing, the professor finds the student’s ignorance to be annoying.

In fact, if a professor ever says to you, “students simply aren’t like they used to be,” that is a clear sign that they have gone from viewing students as amusing to annoying.

If you find students in general to be amusing, then you are willing to do the work that is necessary to continue to improve. Five percent improvement is clearly a possibility. But, if the students have started to annoy you, then improvement becomes a much more difficult task. It is very easy, at that essential moment, to hit that plateau where your days of improvement cease.

So, wherever possible, I try to view the actions of my students as relatively amusing. And, even though they do incredibly dumb things at times, I try to avoid staying in a constant state of annoyance. The reason is fairly obvious. I really do want to get better. I want to get 5 percent better by this time next year. And, that is hard to accomplish if everything the students do seems to annoy you.

Sunday, 14 November 2010

Yo Momma is a Data Miner

Having a lot of data makes research easier - we now have more data in easily readable formats than ever before, and an amazing amount of computing power on our desktops (I have far more horsepower on my desk than NASA had in total in the 1980s)..

Unfortunately, there's a flip side to that coin - we can easily find variables (or specifications) that seem to "predict" returns (or just about anything). In reality, we're often just overfitting the data.

Here's a pretty good piece on the topic titled "Yo Momma is a Data Miner", by David Leinwebber in which he fits a polynomial time-series regression to the S&P 500 with surprising (if you don;t follow what he's doing) good results - particularly since he's using things like the sheep population and Bangladesh Butter production as regressors.

Thursday, 11 November 2010

Positive Feedback, for a change

Nattering nabobs of negativity? Nyet! Instead of finding further fault with economists who I disagree with, let me share some interesting articles from economists who I agree with.

First, Jim Hamilton reports on a beautifully simple test for inflation: the rolling correlations between various commodity prices. It turns out that these correlations have increased quite significantly in recent months and years. This is strong suggestive evidence that there is a common factor driving all prices higher. What could that factor be? Hmm, I wonder.

Second, Steve Waldman has a great post on the role of morality in economics. Is there such a role? He says yes: “The thing is, human affairs are a morality play, and economics, if it is to be useful at all, must be an account of human affairs”. I couldn’t agree more. There’s a follow-up post here.

Third, Raghu Rajan has two policy suggestions that are exactly the same as my own: “The US should dial back its aggressive monetary policy, focusing on repairing its own economy’s structural problems, while emerging markets should respond by allowing their exchange rates to appreciate steadily, thereby facilitating the growth of domestic demand.”

Tuesday, 9 November 2010

I Did Not Know Damodaran Had a Blog

Aswath Damodaran has written a couple of excellent textbooks (on valuation and corporate finance), both of which are among my core reference materials. He also wecasts his valuation class at NYU (available here)

But I didn't know that he also has a blog - Musings on Markets. Just a quick glance over the last couple of months gave me several good articles to read:
High Dividend Stocks: Do They Beat the Market?

Capital Structure: Optimal or Opportunistic?

What if Nothing is Risk Free?

He doesn't update regularly (but who am I to talk). In any event, check it out.

HT: Finance Clippings

Making The Grade

I was cleaning out some to the 1500+ emails I've let accumulate in my gmail account (unlimited space leads to sloppy housekeeping), and I came across this old (but still excellent) piece titled "Making the Grade", by Georgia Tech physics professor Kurt Weisenfeld:
IT WAS A ROOKIE ERROR. AFTER 10 YEARS I SHOULD HAVE known better, but I went to my office the day after final grades were posted. There was a tentative knock on the door.
""Professor Wiesenfeld? I took your Physics 2121 class? I flunked it? I wonder if there's anything I can do to improve my grade?'' I thought: ""Why are you asking me? Isn't it too late to worry about it? Do you dislike making declarative statements?''

...Time was, when you received a grade, that was it. You might groan and moan, but you accepted it as the outcome of your efforts or lack thereof (and, yes, sometimes a tough grader). In the last few years, however, some students have developed a disgruntled-consumer approach. If they don't like their grade, they go to the ""return'' counter to trade it in for something better.

What alarms me is their indifference toward grades as an indication of personal effort and performance. Many, when pressed about why they think they deserve a better grade, admit they don't deserve one but would like one anyway. Having been raised on gold stars for effort and smiley faces for self-esteem, they've learned that they can get by without hard work and real talent if they can talk the professor into giving them a break.

Read the whole thing here - it'll be part of my next semester's syllabus.

Monday, 8 November 2010

We Shouldn’t Take It For Granted

Topic One: On this coming Thursday, I will be having one of the great pleasures of my life. I will be leading a 3 1/2 hour teaching workshop for 150 new teachers in the Virginia Community College System. When you are given the opportunity of working with 150 new teachers, you realize that you are looking at a group that can truly make a difference in the lives of an almost countless number of students for decades and decades to come. This truly is an honor for me.

Topic Two: This past Friday I sat in my office for about 30 minutes and talked with an official in the Afghanistan government. That certainly is not a traditional part of my job. However, his daughter is a student at the University of Richmond and he was on campus visiting her. Because I knew the daughter, she brought her father by so we could meet.

We talked about the progress being made in Afghanistan and he immediately started talking about the problems caused by illiteracy in his country. His point was that for nearly 25 years, the country was without a formal education system. First under the Russians and then under the Taliban, schools as we know them were often nonexistent. Can you imagine, he asked, what it is like to go 25 years without education? An entire generation is lost.

Instead of producing doctors, engineers, accountants, and the like who could serve as the leaders to help pull the country out of poverty, an entire generation basically went without education. And, what can most people really do without education? I do not know if this is accurate but I found the following on the Internet: “The overall literacy rate in Afghanistan is reported to be 28.1%; according to an Afghan Ministry of Education report, ‘In rural areas where 74 percent of all Afghans live, however, an estimated 90 percent of women and 63 percent of men cannot read, write and do a simple math computation.’”

That is a staggering set of statistics. If you simply stop and think of how limiting those numbers are for the people, the challenges faced by the entire country seem overwhelming.

How hard it must be to try to create a peaceful, prospering country with those kinds of statistics working against you.

There is a lot of criticism of the educational system in the US and, most certainly, improvements can be made. However, regardless of what you think of US education, no one can deny how important it is to the growth and prosperity of our country. Sometimes it is easy to say “oh, I’m just a teacher” and view the job as unimportant but those of us in education need to constantly remind ourselves of how essential our job is. If you are a teacher, never take it for granted. Our country needs great education. As teachers, we each have students who are depending on us to help them read and learn and go out into the world and make a difference. And, through that learning, they will be able to help continue the building of a great nation.

I couldn’t help thinking, as I sat and talked with the Afghan official, that I wished every teacher could hear what he was saying about the total loss that comes from lack of education. There are a lot of the world’s problems that I cannot do a single thing about. However, when it comes to helping to educate the next generation, that is a challenge that I can personally address—even as soon as Wednesday—when I walk back into class and make a little difference in the lives of my 64 students. I want to be part of the solution and not part of the problem.

Contra Krugman, Continued

A few follow-ups to my previous post.

First, of course, the obvious question: why does any of this matter? So what if Government Gus has to pay a slightly higher interest rate on his debts? Won’t the benefits of his spending (higher employment, income and consumption, which combine to help the private sector clean up its balance sheet) outweigh the costs?

I don’t think they will. And the reason, as usual, is positive feedback. If the tipping point is reached, Gus won’t have to pay a ‘slightly higher’ rate on his debts; he will have to pay a rate that is significantly higher. High enough to burst the bond bubble and send foreign investors running for cover; high enough to send the dollar plummeting; high enough to put into serious doubt the government’s ability to roll over its debt. The US could end up in a situation like Greece. Worse, in fact, given the size and importance of the US economy, the US bond market and the US dollar.

The bursting of a bond bubble is far more dangerous than the bursting of an equity bubble or a real estate bubble. Immediate consequences include massive benefit cuts (social security and medicare), large tax increases and high inflation. Delayed consequences include steep declines in the standard of living, social unrest, and possibly war. Any policy that increases, however minutely, the likelihood of such outcomes should be considered very very carefully: is it really worth it? And in the case of QE2, I don’t think it is.

Second, I have just read through several hundred NYT blog posts by Prof. Krugman, and I notice that he has (explicitly or implicitly) addressed several of the arguments I made in my previous post. I would like to counter his points, one by one.

But before I do so, I want to make it clear that there is no personal or political animus behind my current stance. For what it’s worth, I was and am a great admirer of Prof. Krugman, as an economist and as a communicator. And I suspect that my policy baseline is very similar to his (pro free markets but with a strong appreciation of their limitations). In many cases and on many topics I agree with everything he writes.

Having said all that, I think he is dead wrong when it comes to the bond market and how it interacts with optimal government policy. And since that is a subject on which I consider myself an expert, I feel duty-bound to comment, at length. Hence my current series of blog posts.

On to Prof. Krugman’s points, in italics below.

“I base my argument on fundamentals, not market signals”

A bit of background: some critics (not me) have pointed to the fact that Prof. Krugman did not believe in the accuracy of market prices in 2006 (at the peak of the housing bubble), but seems to believe in their validity today (when it comes to interest rates). Prof. Krugman’s response to this criticism is that in all cases he is building from fundamentals, and not relying on market signals.

Fair enough, is what I say. There’s no rule that states you have to agree with the market all the time, or for that matter disagree with the market all the time. Sometimes you may think prices are justified, at other times you may think they’re incorrect. That’s fine.

What’s not fine, however, is to then use market prices as ‘additional support’ for your fundamental thesis. If you’re building from fundamentals, then fundamentals should be all you talk about. It’s not fair to constantly cite (as Prof. Krugman does) the low level of interest rates as support for your position that the market is unconcerned about deficit spending. Especially if at other times you are willing to discount market prices since they don’t conform to your position. This I think is hypocritical.

“QE2 does not materially affect the path of future deficits”

I agree that QE2 as currently envisaged won’t really affect deficits; it’s too small (or, equivalently, the current level of deficits is too big!). For the same reason, I think QE2 will be largely ineffective when it comes to its primary purpose, which is boosting spending1.

But that’s irrelevant. The relevant mechanism here is positive feedback operating on traders with short horizons, who know that they’re in a Keynesian beauty contest. The actual level of deficits matters less than the psychological perception thereof.

This of course leads neatly into Prof. Krugman’s next point:

“Explanations that invoke market psychology are worthless”

With all due respect to Prof. Krugman as a brilliant academic economist, I think I’m much better qualified to judge the value of psychology in markets than he is. And speaking with the experience of over a decade as a (fairly successful) hedge fund trader, I have to say that Prof. Krugman is simply wrong. Psychology, herding, momentum, feedback, call it what you will: it matters, it really does.

Again, note that by invoking ‘psychology’ I am not invoking ‘irrationality’. It is perfectly rational for traders in a Keynesian beauty contest to care about other people’s (no doubt subjective) perceptions of value; indeed, that’s the whole point of Keynes’ argument.

“Critics have their own personal or political agenda”

I addressed this in my preamble; let me add here, for the record, that I am not a US citizen, do not live in the USA, and do not pay US taxes. My personal stake in US fiscal / monetary policy is minimal. However, I do believe that a strong and healthy US economy is in the best interests of the world at large, and I would like to see such an outcome eventuate. Political economy need not be a zero-sum game.

“Critics were wrong about the dotcom bubble and the housing bubble; why should we listen to them now?”

There is a whiff of ad hominem in this point, nonetheless I think it’s justified; after all economics is an inexact science with no impartial arbiters, and there are lots of hacks out there who are either incompetent or malicious or both. I think it’s fair to ask ones’ critics what their credentials are, and if they have a track record of being consistently and risibly wrong, then it’s fair to ignore them.

For what it’s worth, my first ever professional trade, shorting USD swap spreads in 2000, was based on the macroeconomic conviction that the dot-com bubble would burst, pushing tax receipts lower and necessitating increased Treasury issuance. In 2001 I predicted (not online, unfortunately) that low interest rates would lead to a housing boom and potentially a housing bubble. In 2004 I set my first small shorts in homebuilder stocks. I added to these over the next few years; by 2007-08 I was short Toll Brothers, Fannie Mae, Freddie Mac, Citibank and Goldman Sachs. Every one of these trades made money. I have made many mistakes in my time as a trader, but failing to recognize the dot-com and housing bubbles was not one of them.

Of course, I could still be wrong about what happens next; I could be imagining a bond bubble where none exists. Past performance is no guarantee of future returns. But at any rate I think I deserve to be taken seriously, as a credible analyst of markets.

“Inflation is not a worry; core CPI is at just 0.8% yoy”

This point is usually bracketed with some snide remarks about inflationistas always being wrong; this time, I will ignore the ad hominem, and confine myself to four points in reply:

First, this is a statement about the past and the present, not about the future, and thus has limited predictive power, especially with respect to a measure as driven by expectations as is inflation. It’s equally relevant (or irrelevant) to point out that just 2 years ago, all-items CPI was running at 5% yoy.

Second, core CPI (that is, CPI excluding food and energy) is a terribly flawed measure. Food and energy prices may be volatile, and demand for them may be price-inelastic, but if they show a decade-long secular uptrend, then they should be included in any accurate inflation index.

Third, even non-core CPI is suspect, because of all the hedonic and other adjustments that have been made over the years. Almost every adjustment seems to have biased CPI downwards. Is it mere coincidence that the entities that publish these numbers have an incentive to keep them low? I think not.

Fourth and most important, I believe the macro dynamics at play make CPI (whether core or all-items, whether hedonically adjusted or not) an irrelevance. The danger is not CPI inflation, it is asset price inflation. As I wrote on this blog some time ago:

China has exported deflation, but this has been concentrated in very specific segments of the economy: in the prices of retail goods, and in worker salaries. It so happens that these segments are precisely the ones captured in standard measures of consumer inflation. Central bankers, lulled by this quiescence in measured inflation, have time and again erred on the side of loose monetary policy, leading directly to the asset price bubbles that have done so much harm in recent years.

Or to put it another way: China supplies certain items that are mostly included in CPI (labor and goods); China demands certain other items that are mostly excluded from CPI (food, energy, and assets – mainly bonds). Naturally, this distinction affects the quoted level of CPI. Ignoring this distinction means fundamentally misunderstanding the macro dynamics at work today.

“Critics have no coherent macro model of their own”

Actually, I do have a macro model of what’s going on, and I think it’s very similar to Prof. Krugman’s own. I am happy to concede that the US is in a liquidity trap similar to that of 1990s Japan, and I concur fully with the analysis in Prof. Krugman’s classic paper addressing the Japanese experience.

Where I differ from Prof. Krugman is in the policy implications of his analysis. Specifically, I disagree strongly with this paragraph, which many would call the key conclusion of that 1998 paper:

The way to make monetary policy effective [in a liquidity trap] is for the central bank to credibly promise to be irresponsible – to make a persuasive case that it will permit inflation to occur, thereby producing the negative real interest rates the economy needs.

I have no doubts that such a strategy would ‘work’. But the thing is, such promises have a way of getting out of hand. You can’t ask for ‘slightly higher’ inflation – say, from 1% to 4% – and expect matters to stop there. Inflation is all about expectations, and once expectations become unanchored, the sky’s the limit. Arthur Burns and William Miller (successive Fed chairmen in the 1970s) both tried to foster temporary ‘slightly higher’ inflation in order to boost employment. Both failed miserably: unemployment stayed stubbornly high while inflation skyrocketed. It took Paul Volcker and two deep recessions to bring it back under control.

I think this a clear case of the cure being worse than the disease. But then, what’s the alternative? This brings us to Prof. Krugman’s last and best point:

“Critics have no policy solution of their own”

Okay, so I don’t believe that the Fed should promise to irresponsibly deliver inflation. And I don’t believe that the Treasury should spend trillions of borrowed dollars to bail out the consumer. So what do I believe? How do I propose to get the economy out of its current recessionary mire?

Sadly, I don’t think there’s an easy answer. Economic policy is not a magic bullet; it cannot achieve the impossible. And to expect that 300 million Americans can be returned to the same patterns of income, employment and consumption that obtained before the crisis, with no adverse long-term consequences, is to expect the impossible.

Why so? Because those patterns were always unsustainable. For many years, the United States has been consuming more than it produces; importing more than it exports; spending vast sums on unnecessary wars; and spending not enough on education, infrastructure, research and technology. These deep structural imbalances were allowed to persist by a complex global financial web, which was in turn driven by the short-term incentives of participants around the world (from the Wall Street mortgage machine, to Bretton Woods II and the Asian accumulation of Treasury debt). But ‘if something cannot go on forever, it will not’. In 2008 we saw the first unravelings of that global financial web. The process picked up momentum (positive feedback as usual), and before we knew it we were in the Great Recession.

This unraveling is not something that can be easily reversed, or perhaps reversed at all. And perhaps it should not be. After all, we have been here before. When the dot-com bubble burst, the Greenspan Fed eased monetary policy to an unprecedented degree, in order to avoid short-term pain. The result was an even bigger bubble, in housing. And now that the housing bubble has burst, Prof. Krugman wants the Bernanke Fed / Geithner Treasury to break new frontiers in easy policy, again to avoid short-term pain. The result will be a still bigger bubble, in bonds. You can’t play this game forever; sooner or later the piper will have to be paid. And every new bubble inflicts more pain than the last, when it eventually bursts (see the fourth paragraph of this very blog post).

So my policy solution, insofar as I have one, is to embrace the unraveling. The recession won’t last forever. Over time, I expect to see some combination of a lower dollar, higher inflation and lower real wages in the United States. These will lead to a lower standard of living and higher exports. And these two consequences are the key: it is these, and these alone, which can see the United States break out of its rut. A lower standard of living and higher exports are necessary to repair private sector balance sheets, bridge the gap between production and consumption, and plug various deficits. But it will take a long slow grind to get there; we could easily see a decade or two of secular stagnation, a la Japan.

It’s not what I would have wished for. But it’s the least bad option.


# 1In fact, you could make a strong argument that for QE to be effective at all, it has to materially affect deficits; this is akin to the idea of being ‘credibly irresponsible’ which I shall address below. (No, Virginia, Ricardian equivalence does not hold in the real world).

Entrepreneurship and Satan's Learning-Challenged Little Brother

Although most people know him as the creator of Dilbert, Scott Adams may also be one of the funniest writers around. Here's a recent piece that appeared in the Wall Street Journal Online where he talks about dissatisfaction as a major driver of entrepreneurship:
I wasn't suffering alone. Many of my co-workers already had active side businesses and ambitious expansion plans. The guy in the cubicle behind me was running a concert equipment rental business. Across from me was a guy running a computer tech support business. We had Amway dealers, Mary Kay sales people, inventors, authors and just about any other business you can imagine. That's not counting all of the business plans in the incubation phase. I think we all understood that working in a cubicle and being managed by Satan's learning-challenged little brother was not a recipe for happiness.
Actually, it was a hamster-brained sociopath of a boss that made me think about going into academia.

Read the whole thing here. - it's good for a laugh (and it makes a lot of good points, too).

Saturday, 6 November 2010

The Fun of The Exam Continues

It seems like every semester, I get at least one student who bombs an exam (or two) and reacts in a way-over-the-top manner. Last semester, it was a senior finance major (with a pretty high GPA) who suffered from anxiety attacks. She drew a complete blank during my Advanced Corporate Finance midterm. She subsequently appeared in several professors' offices wondering tearfully if she should change her major in her senior year. We eventually talked her down off the ledge, and she even subsequently took my Student-Managed Investment Fund class, where she did just fine.

But this semester took the grand prize. The 80/20 rule says that 20% of your students cause 80% of your problems. That would be true this semester if you counted ONE student alone as my 80%. She (we'll call her Brittany henceforth) is to put it succinctly, a bit of a Princess - high maintenance, dressed entirely in designer clothes, vocal, bossy to her friends, and simply not doing well in the class. BP informed me two weeks into the class that she's taking 18 (or is it 20) credits this semester because she needs to graduate this spring. So she "really really really needs to pass this class." She constantly whines in class about the workload because she has soooo much on her plate, and complains about any thing that doesn't pass her standards (by which she means, anything that she doesn't understand easily). And nothing is ever her fault.

Her first exam grad was a 55. The most recent exam (the second of four) was a 58. The rest of the class seems to be getting it -- in fact, as I recently posted, the class average was one of the highest I've seen on this exam in about ten years of teaching. The class has really respodned to the challenge - they've not only stepped up their game, they seem to have realized that complaining to me about the workload is like trying to teach a pig how to sing (i.e. they expend effort, accomplish nothing, and both they and the pig (that's me) get annoyed). Except for Brittany the Princess - she's used to getting her way with whining and intimidation, so she keeps trying.

After she got her exam back, (it was handed back Monday - the drop deadline for the class), she came to my office wondering if she should stay or drop. She wanted assurances that if she was "close", I'd give her the minimum passing grade (since it's required, all she needs is a D-). Unfortunately, I couldn't give her any such assurances - I said that I often make the cutoff for the various grades somewhat lower than what's in the syllabus, but that's done on a case by case basis after looking at the overall class performance, and that whether or not she should stay in the class is a decision that only she could make. So far, there's nothing new to the story - pretty much standard stuff we've all seen many times.

Then the fun started.

BP goes out into the hall and starts sobbing and wailing. That's right, wailing. You could hear her almost on the other side of the building. Of course, I stay safely in my office - there's no way on God's Green Earth I'm going out to deal with that, because there are (like Bear Bryant said about passing the football) only a few things that can happen, and most of them are bad. Luckily, one of the female staff from one of our institutes came out and said "honey, why don't you go into that empty classroom so that you'll have some privacy" (read: "so that you won't be such a spectacle"). The staff worker said that she figured that the student in question was used to using the "cry out loud and maybe you'll get what you want" card. Shortly thereafter, several of her classmates (the ones who she hangs with) came in to my office and said "don't worry about Brittany, UP - she'll be fine. She does this to get attention and to see if she can get you to give her what she wants).

Unfortunately for my blood pressure, she decided not to drop the class.

Ah well - another day in academia. At least I'll have more Brittany stories to share as the semester progresses.

Wednesday, 3 November 2010

The Unknown Students Nail an Exam

I've been teaching the undergraduate core finance class this semester, . If you've been teaching for a while, you know that it's easy in that class to get discouraged by students who are (pick any or all that apply) unmotivated, unable to do simple math, whiny, unwilling to be stretched, never darken your office doorway, etc...

This semester, I made a conscious decision to really push my students - since the first week of September, they've two exams, three very involved problem sets (with a lot of curves thrown in - the typical one takes about 3-5 hours to complete), eight online quizzes, and short pop quizzes (they typically last 5 minutes or less and contain 1 or 2 basic questions on the material to be covered for the day's class) on average every other day, and almost constant cold-calling in class (in a 50 minute class, I typically call on 15-20 students). I like to think that I've set the bar at a far higher level than the other sections of the intro class being taught this semester. In fact, some of my students have told me that I've brought the class together - they're getting together in study groups of as many as 10 at a time (and there was supposedly a study group the night before the first exam of almost twenty students).

I've also made a decision to teach in full-blown crazy mode. Those who've heard my bloviations over the years know that I'm a flaming extrovert that tends toward (in my better moments) impressions of Ahnuld (I Am The Denominator!), Mister Rogers, Kermit The Frog, Inigo Montoya, and various characters from the Simpsons, South Park, and Monty Python, often in rapid succession. The last few years, the Unknown Son's illness had really taken a toll on my zest for teaching (and it showed in my evaluations). While he passed away almost 18 months ago, it's only been this semester that I've really felt like the "old" me. So, teaching has been a real pleasure.

Well, my class just had their second exam, and to put it bluntly, they did more damage to the exam than the Republicans did to the Democrats in the last election - they knocked it out of the park. There was the usual variation in grades, of course (one student got a 23 - It's never when your grade approximates your age), but on the whole they performed better than any comparable class I can remember going back to the late 1990's.

So, there is hope. It's nice to see that when you set the bar high (and meet the students more than halfway), they respond to the challenge.

Tuesday, 2 November 2010

Liquidity, Solvency, Switching Equilibria -- and Paul Krugman

Paul Krugman believes that we are in a liquidity trap (interest rates can’t go any lower), and that the only way to break out of it is via increased government spending. Here’s a column expressing his views (apologies for the long excerpt but I want to make sure I don’t quote him out of context):
One of the common arguments against fiscal policy in the current situation – one that sounds sensible – is that debt is the problem, so how can debt be the solution? Households borrowed too much; now you want the government to borrow even more?

What’s wrong with that argument? It assumes, implicitly, that debt is debt – that it doesn’t matter who owes the money. Yet that can’t be right; if it were, we wouldn’t have a problem in the first place. After all ... one person’s liability is another person’s asset.

It follows that the level of debt matters only if the distribution of net worth matters, if highly indebted players face different constraints from players with low debt. And this means that all debt isn’t created equal – which is why borrowing by some actors now can help cure problems created by excess borrowing by other actors in the past.

To see my point, imagine first a world in which there are only two kinds of people: Spendthrift Sams and Judicious Janets ... In the past the Sams have borrowed from the Janets to pay for consumption. But now something has happened that has forced the Sams to stop borrowing, and indeed to pay down their debt. For the Sams to do this, of course, the Janets must be prepared to dissave, to run down their assets. What would give them an incentive to do this? The answer is a fall in interest rates. So the normal way the economy would cope with the balance sheet problems of the Sams is through a period of low rates.

But what if even a zero rate isn’t low enough; that is, low enough to induce enough dissaving on the part of the Janets to match the savings of the Sams? Then we have a problem.

What can be done? One answer is inflation ... But what if inflation can’t or won’t be delivered?

Well, suppose a third character can come in: Government Gus. Suppose that he can borrow for a while, using the borrowed money to buy useful things like rail tunnels under the Hudson. The true social cost of these things will be very low, because he’ll be putting resources that would otherwise be unemployed to work. And he’ll also make it easier for the Sams to pay down their debt; if he keeps it up long enough, he can bring them to the point where they’re no longer so severely balance-sheet constrained, and further deficit spending is no longer required to achieve full employment.

Yes, private debt will in part have been replaced by public debt – but the point is that debt will have been shifted away from severely balance-sheet-constrained players, so that the economy’s problems will have been reduced even if the overall level of debt hasn’t fallen.

Prof. Krugman is correct as far as he goes. Increased (deficit-financed) government spending can indeed boost incomes, employment and consumption, and thus help the private sector clean up its balance sheet. Then when the private sector has recovered, government can unwind its fiscal expansion and return to running a primary surplus, thus paying down the (temporary) debt it has accumulated.

So all is hunky-dory? Not quite. We have skipped over a very crucial assumption in Prof. Krugman’s argument: the assumption that Government Gus is a ‘player with low debt’, and can thus borrow money at low interest rates, both now and in the future, for as long as it takes until the private sector has recovered and primary surpluses can be reinstated.

Is this assumption valid? Well, it certainly appears valid at the moment. After all, 30-year bond yields (the rate at which the Treasury finances its debt) are close to multi-year lows. Surely if the market were truly concerned about the size of government debt it would charge a higher interest rate on government bonds?

Not quite. Appearances can be deceptive. In this particular case, there are two errors that contribute to the mistake: a confusion between liquidity and solvency, and a misunderstanding of how markets work. Let’s take a deeper look at both of these.

Consider, first, the aforementioned two measures of fiscal position: solvency and liquidity.

Solvency is a ‘stock’: if your total assets are larger than your total liabilities, then you’re solvent.

Liquidity is a ‘flow’: if your monthly income is greater than your monthly expenditure, then you’re liquid.

Put another way, solvency is the level of your “assets minus debts” while liquidity is the derivative (the rate of change) thereof.

Now, you might think that solvency is somehow more important than liquidity, when determining the future of an enterprise. But this is not necessarily the case. You can be insolvent but stay in business for a long time, as long as you have the cash with which to pay your monthly bills. Conversely, you can be perfectly solvent but go out of business, if you don’t have cash in hand when the bill-collector comes calling.

This is a key point. Bankruptcy is always and everywhere a liquidity event. Nobody ever goes bankrupt because their consolidated balance sheet shows greater liabilities than assets. No, they go bankrupt because they can’t make a payment in the here and now.

Does that mean solvency is unimportant? Again, not quite. Because solvency and liquidity are not independent; they feed into each other. Specifically, it’s usually the perception of solvency (or insolvency) that drives the availability (or absence) of liquidity.

If you appear long-term solvent, you can often borrow money to tide you over any short-term liquidity problems. What’s more, the interest you pay on the borrowed money will be low, reflecting your perceived status as a ‘safe’ borrower, and thus enhancing your solvency. High credit quality is thus a self-fulfilling prophecy. (Once again, it’s our old friend positive feedback!)

And the converse is also true. If you appear insolvent, it’s hard to borrow money except at punitive rates; the high cost of servicing your debt further degrades your solvency, and before you know it you are in a ‘liquidity death spiral’ and out of business.

How does this apply to Government Gus? Well, there’s no question that Gus has ready access to liquidity; that is the message of the capital markets (30-year bond yields at 4%). But Gus is most definitely insolvent:
The fiscal gap is the value today (the present value) of the difference between projected spending (including servicing official debt) and projected revenue in all future years ... Based on the Congressional Budget Office’s data, I calculate a fiscal gap of $202 trillion, which is more than 15 times the official debt. This gargantuan discrepancy between our “official” debt and our actual net indebtedness isn’t surprising. It reflects what economists call the labelling problem. Congress has been very careful over the years to label most of its liabilities “unofficial” to keep them off the books and far in the future.

(The quote is from BU’s Prof. Lawrence Kotlikoff, who specializes in inter-generational accounting.)

Prof. Krugman elides the distinction; he claims that because Gus is liquid right now, he will have no problem borrowing money for as long as it takes to help the economy recover; and long-term solvency simply does not matter.

But it does. And to understand why, you have to understand how markets work.

See, traders don’t really care about long-term solvency per se (or long-term anything, for that matter). Traders only care about short-term price action, because that’s what they get paid for. Annual bonuses depend on annual profits.

And short-term price action is a mess of positive and negative feedback, self-fulfilling prophecies, tipping points and overshooting.

Right now, 30-year bond yields are low because we’re in a feedback loop, wherein banks borrow money from the Fed at 0% and deposit it in Treasury bonds at 4%. The low level of interest rates convinces everyone that government insolvency and inflation are nothing to worry about. And that in turn justifies further buying of bonds.

Thus we are in what appears to be a stable equilibrium. But we could easily flip over into another less healthy equilibrium. If, for whatever reason, the market loses some of its confidence in the government’s ability to roll over its debt, then positive feedback will begin to operate in the opposite direction1. Rates will go higher, debt service payments will go higher, and the liquidity/solvency situation will get worse, causing rates to go higher still. We saw an example of precisely this dynamic in Greece earlier this year.

Another way to look at it is this. There is no ‘right’ and ‘wrong’ when it comes to trading; no ‘fundamental value’ or ‘fair price’; there is only ‘profitable’ and ‘unprofitable’. And the sole determinant of whether a particular trade is profitable or not, is the behavior of other traders. (Keynes’ famous analogy of the beauty contest). If the market as a whole believes that Government Gus is liquid, then the optimal strategy for any given trader is to lend money to Gus and take home the carry; if the market as a whole believes that Government Gus is broke, then the optimal strategy is to squeeze him. And the belief system of the market as a whole can turn on a dime.

This is what Prof. Krugman does not seem to understand: the rapidity with which markets can go from one equilibrium to another, once a tipping point is reached, thanks to feedback effects. And the worse the initial solvency position of the government, the more likely it is that the tipping point will be reached. This is the link between solvency and liquidity; it has nothing to do with fundamentals, and everything to do with trader behaviour in a feedback market.

So we’re in a race against time. Will deficit spending resuscitate the private sector before the debt service tipping point is reached? That, indeed, is the question, and it is one that Prof. Krugman does not even ask, let alone answer.

(Personally I’m pessimistic on both fronts. I doubt that government spending will suffice to repair private sector balance sheets or confidence any time soon; Japan is Exhibit Number One for how an economy can remain in the doldrums for years despite massive government spending2. And I think the tipping point may come sooner rather than later, simply because there seems to be an utter lack of political will to do anything at all about the deficit situation. I hope I am proven wrong.)


# 1You don’t need a complete loss of confidence; all you need is a change on the margin, and positive feedback takes care of the rest.

# 2I believe Prof. Krugman’s response to the ‘Japan critique’ is to say that Japan’s own implementation of QE was not aggressive enough. There are two problems with this response. First, of course, it is a classic unfalsifiable argument. Second, and more important, I believe that one should defend or attack QE as it is, not QE as it ‘should be’. Perhaps in an ideal world we would get a sufficiently large QE to in fact solve the economy’s problems just like Prof. Krugman hopes. But in the real world the amount of QE that is politically tenable is likely to fall well short of this ideal amount. And there is no reason to expect that the effectiveness of QE scales monotonically with size; it is entirely possible that ‘no QE’ will be better for the economy than ‘half-hearted QE’, albeit worse than ‘ideal QE’.

Teaching Is Serious Business

I was asked, about four years ago, to write an essay on teaching. The following was my response. I believed this then. I believe it now. Joe

Teaching is serious business. We have wonderfully bright and talented students at every school. They have almost unlimited potential. For most, this is their one shot at college; they deserve nothing less than an excellent education,
an academic experience that challenges them to excel from their first day to their last.

Faculty members have a responsibility to the world to coax the very best from their students because they will certainly become the next generation of leaders. Where they go from here, what they accomplish, how they impact the world, depends in large part on how much we are able to push and nurture their development. I want every student to leave my class at the end of the semester saying, “I had to work very hard but I am so amazed by how much I learned.” Anything less is unacceptable.

If a teacher challenges students to think and do their best, word gets around campus quickly, but having a tough reputation is both good and bad. When students walk into my class on the first day, they tend to be very quiet and pay attention right away. On the other hand, I am always so disappointed when a student says to me “I hear you are a good teacher, but I didn’t take your class because I know you are very demanding.” Isn't that just incredibly sad? I think all of college education (as well as the world in general) will be better when students become convinced to sign up only for classes where teachers push them each day to do their best.

During each semester, I occasionally point out to my students that the grade of A, according to the University catalogue, reflects “outstanding” work. A student does not earn the grade of A for a good effort, only for consistently outstanding work. That’s a great goal; it inspires a wonderful level of effort. Grade inflation has hurt college education across this country and could be fixed simply by faculty members saying, “You earn an A when the work that I see is truly outstanding.” Don’t fool yourself; students are well aware of the difference between “good” and “outstanding.”

I use the Socratic Method. I call on every student every day in class. I don't ask them to regurgitate material; I ask them questions that I believe will cause them to think and reason—on the spot. That is what adult life is like. I then follow my initial question with others based on their answers. If I don’t get good replies from a student, I don’t just nod and smile; I demand better of them. A student once compared my class to a contact sport. Students should be ready, willing and able to discuss and debate issues. This is college, not high school.

I want a reasonable effort from my students because students get back based on what they put in. I expect them to study four to six hours each week outside of class so they’ll be ready to participate in class discussions. I use carrots and sticks. I say, “Good job!” when a student gives me a thoughtful, well-conceived answer, and I say, “Listen, you can do better than that!” when a student gives me a bad answer. I don’t view that as being disagreeable, although I do realize that it injects a bit of tension into the class. But this is not Sesame Street; a bad answer is a bad answer. There is only one primary goal in my class: to improve each student’s ability to think, reason and understand. Students realize how capable they are, but human nature loves to take the easy path.

A good basketball coach adapts to the talents of his or her players. A good teacher does the same. You cannot take an identical approach with every student. Some love to be pushed and pushed hard. They enjoy “in-your-face” challenges. Others are more fragile. You have to coax and nurture them. So toughness comes into my class where toughness is necessary. You teach each student, not each group. However, every student needs to be willing to prepare and to think. That is not negotiable.

One of the keys to becoming a good teacher is learning to walk into a room of students and “see” what is happening to the individual members: Billy needs a few extra seconds to formulate an answer, Susan loves to be called on, Andy doesn’t know what is happening right now, Ellen is not prepared. You have to be able to adapt to your students on the spot every day. What a wonderfully exciting job.

Our students can do amazing things, but if we don’t challenge them fully, they will never realize what marvelous talents they truly possess. Signing up for demanding classes might hurt a student’s GPA, but which is more important: developing a good mind or a good GPA?

Monday, 1 November 2010

Terry Pratchett Quotes

Before J.K. Rowland, Terry Pratchett was the best-selling British fantasy author of the 1990s. He's written more than 60 books (either by himself or in collaboration with a coauthor). In fact, while I was at the recent FMA conference I made a comment "There can only be... one thousand" at a reception,a and found that an Irish friend of mine was a fellow Pratchett-phile.

So imagine my enjoyment at finding out there's a repository of Pratchett quotes titled the Pratchett Quote File (you can also get it in a test file here). Here's one that struck home (note that the Unknown Wife and I just celebrated our 20th anniversary):
Sam Vimes could parallel process. Most husbands can. They learn to follow
their own line of thought while at the same time listening to what their
wives say. And the listening is important, because at any time they could
be challenged and must be ready to quote the last sentence in full. A vital
additional skill is being able to scan the dialogue for telltale phrases
such as "and they can deliver it tomorrow" or "so I've invited them for
dinner?" or "they can do it in blue, really quite cheaply."
-- (Terry Pratchett, The Fifth Elephant)
Unfortunately, skimming through the quote file just burned an hour and a half of my time. I guess I really don't want to start grading the 70 exams currently sitting on my desk (each of which has 10 pages of work in it). Unfortunately, I just gave the exam tonight, and I want to give them back on Wednesday (it's the drop date for the semester).

Month-End Recap, Oct 2010

This is a new feature: a very quick summary of my investment positions, to be published monthly. This is not investment advice and should not be construed as such.

I am currently 93% invested, as follows:

59% Agricultural commodities
11% Other commodities
17% Emerging market equities
6% Miscellaneous equities

My largest position is in soybeans, followed by sugar.

I usually try to be between 85% and 105% invested, so I am a touch below my average exposure here. Indeed I plan to drop down to around 90% in the next few weeks or months, mainly through selling EM stocks especially India.