The Perfect Bet

What are financial markets?  Financial markets at first apprehension are simply places where borrowers meet lenders, or where risk-takers meet investors. But these markets do more than channel what economists call “savings” into claims on the (profitable) outcome of “investments.” Savers shift their consumption from the present to the future; borrowers often do the opposite when they shift future consumption to the present. Investors and lenders absorb the “foregone consumption” of savers into “capital accumulation,” which, if deployed intelligently, would yield future interest or profits. This process feeds the engine of economic growth, while giving meaning to the idea that market participants should be able to shift their consumption patterns over time according to their individual preferences. There is thus also embedded in this process that concept made popular by Adam Smith, the idea of the Invisible Hand.

The process is not always perfect. The plans of mice and men often go awry. The markets then adjust to these changes in fortunes. Debt papers get discounted to reflect the lessened ability of a borrower to repay, and stock prices drop on expectations of a cut in future profits.

Underlying the adjustments, or even the initial transactions, are acts that constitute betting. The lenders bet that the borrowers will repay, while the (stock market) investors bet on the actual or eventual profitability of the business of the corporations that issue stocks. At times the betting does not even relate to these economic “fundamentals.” There are also those who bet on the basis that there would be, at some point in the future, a “greater fool.” For such bettors, the wait can take forever, although successful practitioners are usually “gurus” who can inspire the “greater fool” following, and who get out soon enough. The gurus win at the expense of their followers. It seems unfair, but there is rough justice meted to the greater fools in this story. The motto should be “know your guru!”

Is there a perfect bet?  In such an imperfect world, can there be a perfect bet? This is like saying we’ve experienced hell or purgatory, and then asking if we will get to heaven. A religious bettor would bet his soul on it, but can expect the payoff only in the afterlife.

Despair not. Philosophers, mathematicians, and diehard gamblers have at various times achieved success. To do this, they’ve had to set the bar a bit low. A “perfect bet” is definable as one that beats any other in the circumstances. Often this ranking of bets is simply based on an arbitrarily chosen aiming for the highest return for a given level of risk, or for the smallest risk for a target rate of return. And typically, the perfect bet is revealed after the fact, but not before!

If risk avoidance is valued highly, insurance can be a perfect bet. Indeed it is one that can go on forever because insurer and insured do not play a zero-sum game. Both parties to the insurance contract “win.” The insured avoids an unbearable catastrophe, while the insurer, who pools the risks from individual contracts, gets a more or less steady income. This means that stock in good insurance companies, those who employ honest actuaries and whose managements are kind enough not to engage in Ponzi schemes, are great long-term (though somewhat risky) investments.

Religion is akin to insurance. The high priests play the role of insurer; the faithful are the insured. No one is being taken for a ride, except perhaps for those cult religions where the believers give up too much on Ponzi-like fraudulent claims of their leaders. By and large, mainstream churches are institutions that promote social good and order on earth. Whether religions should escape taxes is, however, another story. My own view is that if insurance companies, doctors, dentists, and fortune tellers like Warren Buffett pay taxes, then so should churches.
Are lotteries perfect bets? No, because innumerable studies of winners tend to conclude that the winners get a brief high from a temporary surge in income or wealth; but they soon go back to their pre-winning miseries. Humans are decidedly social beings who prove time and again that misery loves company, and company soothes misery. But lotteries are perfect bets for those who benefit from the house edge, typically governments and charities.
When the game is a simple one in the mind of an individual investor, it is pretty much a zero-sum game. Cash or short-term government paper becomes the perfect bet when the likely foreseeable event is a rise in interest rates or a fall in stock prices. The problem is that interest rates and stock prices are inherently unpredictable. If they could be predicted, the acts of capable individual investors acting on their “predictions” would cause interest rates and stock prices to move in directions that would eliminate the profitable trades that might be envisioned from such predictions. The next time somebody comes to you to tout his (past) great stock market performance, just ask if he thinks he can replicate that performance forever. His honest answer has to be in the negative. He could do better because of luck; or worse, if the future is one of “reversion to the mean.” The mean in this context is also not a fixed thing; it depends on how long a time frame you take to calculate the mean.

What about the risk of ruin? Or the risk of missing the “next great move”?Can an individual nonetheless learn to avoid the most egregious errors when investing his hard-earned savings? This is a difficult question requiring a definition of what an egregious error is. The answer to this question will be for another column.


Quo vadis Blockchain?


Can the reputation mechanism be made robust? Can there be a Law Merchant on the internet if miscreants can hide behind encryption?

In some ways, Bitcoin has spawned a new wild West.

The questions then are:

Can blockchain identify a fraudulent transaction?

Will the community of users pre-agree to a readily enforceable clawback or restitution mechanism?


What next, after 2008? A book review

Mervyn King (The End of Alchemy, W. W. Norton, 2016) has a message. We are not safe. The economics profession has failed us. So have the economic policy makers of the US, Germany, China, and Europe. The banks still play a game that King calls ‘alchemy.’ Central banks won’t or can’t escape the infamous Keynesian liquidity trap. And we are prisoners facing dilemmas, macroeconomic policy is a paradox, sovereign debts are unbearable, and the world is full of ‘radical’ uncertainty.

In short, what we have today is pretty much a lull before the end of the world; 2008 was just the preview trailer. Alternatively, the world may not end but it will take a long while for robust economic growth to re-emerge, and there is very little that can be done about the matter. Either way, it’s a sobering conclusion.

Is the book worth reading? Yes, if only to get a handle on how central banks thought as they dealt with 2008 and its immediate aftermath. In addition, the curious but uninitiated reader gets introduced to the concepts of Prisoners’ Dilemma, the Keynesian Liquidity trap, liquidity transformation by banks, and the difference between risk and uncertainty.

King’s book also contains a longish but bureaucratic take on why 2008 happened. King gets to it on pp. 26-39 and pp. 317-328. Going by his view, as well as that of others in the fields of central banking and macroeconomics, the ‘conventional wisdom’ on 2008 might be summarized as follows.

It began with the fall of the Wall in 1989, also known as The End of History, that ushered in the Great Stability, an era of low inflation and robust economic growth all around. The main central banks finally imbibed the religion of the Quantity Theory in the 1990s and early 2000s, making themselves accountable to the public through pledges to abide by (low) inflation targets. King calls this period The Great Stability. (Never mind the hiccups of the 1997 Asian crisis or the bubble-crash of dotcoms in 1997-2001.)

Beneath the gloss of prosperity were gathering problems. Banks were raising their leverage in the hunt for profit. Prices in stock and real estate markets outpaced inflation of everyday goods, and central banks felt that paper wealth was not a worrisome thing (after all, one cannot eat stocks or houses), and the US Fed actually thought it would boost consumer spending. Some countries pushed their luck with foreign borrowings, notably Greece, Italy, Ireland, Portugal, and Argentina.

The failure of Lehman Brothers in September 2008 is considered the trigger of the crisis. It was, with hindsight, the outcome of the unexpected fall of real estate prices in the summer of 2007 and associated mortgage defaults in the US. The failure exposed the extreme leverage in the US financial system, and with banks unwilling to recognize their paper losses in the derivatives market for sub-prime mortgages, a run for liquidity, called The Great Panic, ensued. The panic was arrested only by official rescues. Consequently, in 2008-2009, the financial crisis affected real economies, with world trade falling and global GDP decelerating into The Great Recession.

King, as do other observers such as Edwin Truman, believes that underlying macroeconomic imbalances were also to blame. The extreme example often cited was the ‘savings glut’ in China that fueled ‘overconsumption’ in the US. Supposedly, the excess saving in China was intermediated by the banking systems of both countries. The theory is that without such imbalances, there would have been no resources that could fuel the asset price inflation in the US and in other countries.

So far so good. King then ends up suggesting that the re-capitalization of major banks since 2008 is a good thing but probably not enough.

As to the book’s shortcomings, they are:

King seemingly ignores the work of Charles Kindleberger (Manias, Panics, and Crashes, 2005) where Kindleberger had formulated an economic model of financial crises, based on the work of Hyman Minsky. King does mention Minsky but in a somewhat negative light.

King nonetheless cites (on p. 34), with some tongue in cheek, two ‘laws’ on financial crises, which he attributes to Dornbusch. One is that ‘an unsustainable position can continue for far longer than you would believe possible.’ The other is: ‘When an unsustainable position ends it happens faster than you could imagine.’ It is of course almost vintage Minsky.

And yet, to date, the economics profession’s best ever model of financial crises still seems to be the Kindleberger-Minsky model. That model cannot be used to make precise predictions, but it does give the best explanation, ex post, of how a financial crisis plays out. The major central banks had been using, in 2008, something called DSGE (‘dynamic stochastic general equilibrium’) macro models. These models were not at all designed to incorporate Keynes’ deus ex machina of ‘animal spirits,’ except as ‘shocks’ external to the structure of DSGE models, which meant that the central banks had essentially no inkling of the crisis before it hit. The IMF insiders called it ‘group think.’

If we could ask Kindleberger or Minsky today on their views on 2008, most likely they would say that it fits their model that sees a financial crisis in three parts — mania, panic, crash. The story is not much different from King’s, except that Minsky would give greater emphasis on the trigger of 2008 as one rooted in overconfidence, what Greenspan had called ‘irrational exuberance.’ That there had to be other villains is a given. In 2008, they included the toxification of bank balance sheets (with inexplicable financial derivatives) that was an outcome of a ‘deregulation’ tilt that allowed subprime debts to be brazenly sold by lenders as ‘almost prime.’ Since King doesn’t like the fractional reserve nature of modern banking, he gives more emphasis to the alchemy-like leveraging that modern banks practice. In effect, King would not disagree with Minsky that it was a kind of Ponzi game that allowed banks to trap themselves into a corner that would eventually ‘blow up.’

This comparison of models means that King’s main proposal — his view that central banks should act like a ‘pawnbroker for all seasons’ — to narrow monetary base creation to ‘safe’ banks, while widening the securitization of other lending by bank-like institutions, is just another way of allowing excessive exuberance to be seen as a can to be kicked down the (future) road of ‘fundamental uncertainty.’ In short, since King has set up the medium and long term as a problem of fundamental uncertainty, there isn’t much that central banks or governments can do to tame business cycles. That is not different from Minsky and his ‘moments.’ There is an inexorable underlying tension between free capital markets and macroeconomic management by governments and central banks, something Robert Shiller and others had more or less also observed (see Shiller and Akerlof’s Animal Spirits, 2009).

King does not quite succeed in explaining the arcana of modern economics in the areas of: (a) how Keynes was co-opted into the ‘neoclassical synthesis’ (King merely says that Keynes was at odds with ‘neoclassical economics,’ a basic lesson from an introductory economics class); (b) the ‘paradox of policy,’ where he asserts that the short-run need to overcome the liquidity trap is inconsistent with the need in the long run to let the private sector decide how to correct ‘structural imbalances’ in the economy; and (c) how ‘fixed’ exchange rates and differences in saving rates across countries lead to ‘imbalances’ that in the long run need to be addressed.

It appears that it is up to others to try to make better sense of what King wants to recommend as a way out of the economic doldrums post-2008. Perhaps this explains why the book blurbs on the outside back cover hint of mystery amid faint praise from the usual suspects.

Rappler and oblivion

I’ve tried to make sense of its business plan. Now and then they produce good work. The problem is in the in-between.

Click-bait for ads won’t work. Advertisers can monitor effectiveness.

Leading thoughts and brilliant conversation won’t either. They just leave you dangling, if you ask Simon and G.

Wannabe journalism cum political correctness is too a dead end. That would be too much on feelership. And also trying hard to mimic Huffington.

Can Rappler be a kinda FB for the in crowd? Not if it has to hang on FB to skate. The in-crowds can exist within FB as it is.

Could it be a pay-for-play version of Linked-In? For the PH market? Who will pay? Too thin.

Maybe some b-school type a la McKinsey is giving its investors advice. Only they’re not talking. If you had an undiscovered gold mine, would you?

I don’t know and know that I don’t. Maybe if they know, then they’d know. And I wouldn’t have to ask.

If only it could go to IPO, at least the early birds could do a ponzi dance. Good luck.

The shrinks might say cycling between bargaining and acceptance can take forever. But sooner not later the potato chips run out.

It is a puzzle.

EC 11. Special HW on the stock market

Imagine that your grandparent willed you P1 million. You have decided to invest this inheritance in the Philippine stock market, specifically in only one company.

Your homework assignment is to choose that one company, and report at how much you acquired the stock (any price at which it traded in the PSE will do) in an email, and to give a short explanation for your choice.

A second part of this assignment is to report at the end of the semester how your investment did, and to give a brief explanation of how or why the outcome came about. Try to answer the following questions, based on your readings and your experience in this imaginary experiment: Are stock market investors who win just lucky? To what extent do diligence and smarts matter?

The first part is due by Friday, February 5, 2016. The second part is due on March 20.