November 09, 2012

It's the Geophysics, stupid!

Elections are over. SuperPAC's bidding wars for the oval office have ended, marking the beginning of the new electoral cycle. The sheer cost of this year's election and its result prompts many questions. Will the Republicans have to rethink their stance and diversify their reliance on a shrinking white male voter population? Is the personalization of corporations' influence on elections a pernicious one?

Some people might be tempted to rationalize the astronomical figure by downplaying it. "America spends more on Halloween candy than on political campaigns." That may be true, but what about the fact that campaign spending has grown 12.4 times faster than overall US population in the last 12 years? People still decided whom to vote for in 2000 with $6/per person spent by political campaigning. This time around they spent $13.34/per person. It is clear that the current election model, coupled with the mediatization of  politics, provides incentives for each party to outspend each other with the specific intention to occupy a bigger mind share in the increasingly fleeting attention span of the voter. Political pundits' claims that Sandy helped Obama prove that political campaigning is all about moving the perception needle just enough, and at the right time. Spending one-upmanship is the name of the game.

But what if all this money was absolutely inconsequential in determining who will occupy the oval office every 4 years? What if the intention of vote is determined by a set of deeper, structural factors that have nothing to do with mudslinging or how much money is raised? Well, it turns out, this could very well be the case. By applying the principles of geophysics, Allan Lichtman has been able to predict every presidential outcome with months --in some cases years-- in advance since 1984. He has discovered that unseating the incumbent party follows the same pattern as an earthquake. At its most basic level, you either have geological (political) stability, in which case the incumbent party retains power, or upheaval, in which case a change of power ensues. It is so simplistic it deserves entertaining the idea. To determine "geological" stability (and therefore a victory of the incumbent party) he asks 13 questions --"keys", in his parlance. Six or more negative answers to these questions, and the incumbent party loses the White House. "Is the country in recession?", "Was there a foreign policy disaster?" You get the idea. (for a list of the 13 questions and the answers that predicted Obama's 2012 win a year ago, go here).

If the oval office is decided by political tectonic variables way before election day, why spend campaign money then? The answer is: just in case the other party gains an advantage by spending. Or put in a Game Theory Matrix:

Spend as much as you can
Don’t spend at all
Spend as much as you can
Campaigns cancel each other.
(“Tectonic Variables” determine victor)
Spender wins
Don’t spend at all
Spender wins
Campaigns cancel each other.
(“Tectonic Variables” determine victor)

Unfortunately, the Utopian possibility of  having both parties take the 13-key questionnaire one year before election day and say "Let's agree not to harass Ohio this time" is null, obviously. The incentives to outspend the other party are not erased by the fact that simple common sense could potentially allow anyone to predict who is going to win the election one year in advance --especially not when donations buy political favors. I just wished they were. So much disappointment averted. So much money saved. So many political Facebook posts not published...

September 01, 2012

Give me my fix, Doc

"One more round of QE please. The world economy needs it. I am feeling the withdrawal." That is the market's plea to our MIT-trained monetary Dictator. The market's starvation for the much-needed next QE fix seems to be creating a never-ending game. "The market needs more accommodating monetary policy. We can't allow deflation to set in", the rational goes. The terror of deflation drives Central Bankers around the world into competitive devaluations, pushing everybody else into a self-accelerating monetary easing race that precipitates a monetary flood of epic proportions. USD $2.3 trillion in the United States. GBP £375 billion in Great Britain. EUR €1.0 trillion in Europe via the ECB's LTRO, just to name a few significant examples. Central Banks around the world are forcibly participating in a game of one-upmanship, the likes of which we have never seen.

Central Banks Balance Sheet size has almost tripled in 6 years.
Graph by James Bianco
All of this in the hopes of preventing the collapse. Quite a noble goal, indeed. And everything is a-OK so far --until it is not, of course. All it takes is a trigger for all that money floating around to turn into a massive stampede running for safety. Investors start looking for the one currency that does not make them lose value, or the one that has the least inflation. But how do you avoid inflation when every major Central Bank in the planet is churning out bills at the speed of light? Well, that is easy if there is no inflation to run from (if you believe what we are being told, that is).

Is there really no inflation as our monetary Dictators around the world tell us? Are expectations so "well anchored" that savers don't have to fret nor take cover in safe-heaven currencies or precious metals? Well, first of all, to believe this we'd have to assume that Central Banks are credible institutions with good reputations. Reputations are gained via good track records --good "batting average" keeping inflation within their own stated targets. Actual inflation hitting target inflation. We all know target inflation in advance (that is clearly stipulated publicly by Central Bankers). Measuring actual inflation, however, is the tricky part. The Central Bank has every incentive to make "actual" inflation fit into target inflation. The problem is that there is no "fail safe" mechanism built in the system to keep the Central Bank from tampering with actual inflation. Actually, it is the very Central Bank who measures and reports actual inflation. There is no need to bribe, corrupt or influence any third party into producing an actual inflation figure that conveniently hits your own target. Beautiful. That's like an Airline claiming to have an outrageously high punctuality rate, when in reality they are the ones who measure their own flight times (Hello Ryanair!). How do they do it? Through pompous, hard-to-understand gimmicks:

The first one is the concept of "core inflation" (which is the most widely known). This concept strips food and fuel (the "bread and butter" of daily expenses of the average consumer --pun intended) out of the CPI basket. Those exponential crude oil price increases or $4 per gallon of gasoline? Gone. Global grain shortages? No problem. None of that is accounted. The second one is substitution effect, which states that when an item in the CPI basket increases in price, a rational consumer behavior is assumed and the basket automatically switches to a close, cheaper substitute product. Thus, the basket is always guaranteed to hold the cheapest products. This gimmick implicitly condemns this imaginary average consumer (the one that consumes the CPI basket) to continuously downgrading its standard of living and to use lower quality, cheaper products. Then you have geometric weighing, which reduces the weight in the CPI of a category that is rising faster than all the other categories. Finally, you have hedonics baked into the actual inflation statistic. This one states that when technology improvements make products better --regardless of price-- a downward adjustment in the price of the improved product in question is made for CPI calculations (like an iPad that sells in year 1 and in year 2 for $350, but in year 2 it enjoys better definition technology, then the CPI in year 2 will consider the price of this iPad at $250 instead of $350). Experts state that 46% of the CPI is adjusted for hedonics.

What would happen to actual inflation if we reversed all these gimmicks? The answer is obvious. In fact you don't even have to undo all these gimmicks to know what the actual level of inflation is. You already know it from you daily life. Your last trip to the grocery store will tell you what is your level of inflation. Or, if you are one of those who don't do the groceries at your household, you might be surprised --or not-- to learn what is happening with all those stratospheric amounts of money floating around in the world economy. They push real estate prices to stratospheric levels in some very exclusive market segments. Of course, you don't have to worry about those price increases affecting the CPI. One57 does not make it into the CPI basket these days, so don't expect any pull from its $100,000,000 condos.

Collapsing currencies behave in quirky ways. When they are in the first stages of their demise, luxury items see outrageous price inflation. Iran, hit by sanctions and isolation, is seeing record sales of Porsches. In the times of the Weymar Republic, the currency flight began with the frenzied buying of diamonds, gold and country houses. It turns out wealthy people --usually shrewd people in terms of financial matters-- run for cover and buy what they know other wealthy folks will buy too. Jewelry, art, exotic cars. This is why I feel unease when people rationalize insane U.S. real estate prices by redefining real estate as "art" (some other times, however, I just laugh).

Inflation is a psychological phenomenon as much as it is a monetary phenomenon. If inflation expectations depend on the reputation of the Central Bank, the Central Bank's reputation depends on its track record, and its track record depends on a baked statistic, we should be concerned about the fact that the world's money supply in the most important, biggest Central Banks has grown 177% in the last 6 years while the world's nominal GDP has grown 41%. Especially if the stability of your status quo --people trusting Central Banks' reputations-- rests on a cooked statistic. Deflation is not the only thing monetary Dictators should be afraid of. By trying too hard to the get away from the evil of deflation, they are dangerously getting closer to another, equally hurtful, calamitous outcome.  So, in evaluating if administering the next heroin dose to our patient, monetary Dictators should be careful not to induce a monetary OD.

Update 9-19-12
In the 18 days following the writing of this piece the World Monetary Dictators (WMD's) have gone "all-in" on their monetization efforts. Europe has committed unlimited amounts of Euros to buy Sovereign paper; the U.S. has written its blank check and pledged Zero-rates until 2015; and Japan doubled its Asset-Buying program. Heavy heroin doses, indeed.

June 20, 2012

Closer to the Clouds

Are we all lazy creatures? Some would say we always look for shortcuts to obtain what we want --even in the most disciplined version of ourselves. The path of least resistance defines our every move. The behavior goes deeper than what we see in our penchant to become couch potatoes. The brain also is always looking for ways to do the same tasks in the most efficient (effortless) way possible. Amblyopia is an example of the brain turning off the visual signal in one eye, choosing to overdevelop the other to compensate the loss of vision in the first one. There have been reported cases of people losing hearing in one ear without any apparent reason while at the same time overdeveloping the other ear. When the brain realizes that it can accomplish the same task with less resources, it appears it decides to shut down redundancies.

But what happens when a redundancy in the brain is created by an external agent? Some discovery -fire-, some tool -utensils-, some technology created for the convenience of humans, and a brain skill is rendered redundant, shut down and put to rest. Examples: the written word lightened the brain's memory burden. Calculators made the need of mentally calculating arithmetic operations almost disappear. Kids nowadays lack handwriting skills thanks to texting. Wikipedia killed the need to peruse volumes upon volumes for hours to find what we wanted. There has been a marked concern about the way Google creates brain skill redundancies. The immediacy of information reach, coupled with the model of internet monetization (where a plethora of ads compete in the screen for the reader's attention to get the much-coveted "click") has hindered the ability of the brain to achieve profound, prolonged levels concentration. ADD is fomented by the way we process information in our daily lives, some argue. 

Is the waning of a brain skill caused by an app, gadget, or any other form of mental crutch creating a new generation of good-for-nothing neophytes doomed to failure by its mental laziness? If the storage and processing of information in our brains can be outsourced to the clouds, where is the need to really learn anything? Are Universities becoming eventually extinct? Could we get to a point where all we would need is a handheld device connected to the clouds, and someone to ask Google a question and follow/implement the clouds’ indications to solve any problem? Does the internet foment irreversible mental atrophy? 

The answer is no. The brain is not getting dumber by the mental redundancies created by technology. Improvements in living standards would have stagnated decades ago had that been the case. If anything, brain skill redundancies created by technology free up human capacity to focus on more specific discoveries. Think of it in terms of comparative advantage theory: When a nation (person) is able to produce something (solve a problem) at a lower opportunity cost (foregoing less of other product), that nation (person) should specialize and import (outsource from others) that what it (he/she) is not competitive at. 

And this happens because knowledge is a non-rivalrous public good. Because it has no opportunity cost (nothing is sacrificed to use it) and because it shows no diminishing returns the way capital goods do (every additional unit of labor combined with the technology in question yields the same incremental output). More to the point: thanks to the internet, knowledge is becoming increasingly non-excludable (to a point where it affects property rights). This is a powerful, paradigm-shifting phenomenon. The internet agglutinates every single discovery ever achieved by mankind throughout history, and it is available in fractions of a second. For free. Think about what that means. Of course this molds brain skills. It creates Otaku people. Instantaneous (or "fake”, as some bemoan) experts. Socrates in his time disdained the written word for creating people who would falsely appear as erudite, or "filled with the conceit of wisdom instead of real wisdom". He would definitely be turning over in his grave now.

With all the respect that deserves who is arguably the biggest philosopher humankind has ever seen, Socrates was wrong to think that way. Change should not be feared. The written word served as a revolutionary way to spread knowledge. The printing press then catapulted it. Every iteration of knowledge dispersion technology has led to human progress. The internet is just the latest one. Any incremental improvement/discovery in human knowledge is added to the internet and immediately shared with the rest of the world. Ready to be used by someone else and be taken to higher levels. To the clouds. Literally (well, kind of).

April 23, 2012

As Delicate as a Butterfly

We live in an unstable world. The probability of what used to be thought as improbable is becoming more and more likely. The old definition of a statistical outlier as a "1 in a 100 years" event has morphed into the now famous "Black Swan" event. Using Didier Sornette's term, "Dragon Kings" are now becoming more likely.

Put it probability distribution terms, the distribution of all possible outcomes is becoming more bimodal (tails are "fatter", as shown in the graph below). It appears that reality is abandoning the familiar Normal probability distribution shape, depriving us of the standard tools we used to rely on to estimate the future. The comfort of saying that there is a 95% probability that an event will be within 2 standard deviations from its mean is gone, leaving analysts and futurologists clueless.

Sornette (2011): Scaled Distribution of Runs of Gains (Right) / Losses (Losses) for 30 major US stocks. 
Notice the fat tails of the distribution

"Dragon Kings" are crises which are exacerbated due to the combination of a series of elements that reinforce each other, creating a singularity that cannot be explained by the parameters of past events. Think of the potential energy contained in a mass of snow until a tipping point is combined with gravity, mountain inclination, and absence of vegetation to create a huge avalanche; or the epileptic attack, where a neuron firing barrage is unleashed when the inhibitory and excitatory mechanisms in the human brain fall out of balance. The shocking magnitude is caused by the interaction of amplifier forces built in their own system. Real life examples: the flash crash of May 2010 was the result of high frequency trading algorithms combined with stop orders; the Venezuela megaflood of December 1999 was the consequence of persistent orographic winds blowing from a relatively warm ocean surface meeting the coast.

Notice the importance of the meeting of the reinforcing elements. Without the interconnection of these elements, amplification doesn't occur. In human systems, interconnection amongst people allows imitative (herding) behavior that helps reinforce an event. We have all been witnesses of the effect of interconnectedness on social causes, like The Arab Revolutions. Here, potentially reinforcing elements (people willing to do something about a common problem) are interconnected thanks to a platform (the social networks) that exacerbate an event (social discontent) to create a "Dragon King" (simultaneous revolutions that have overthrown decades-old regimes). Once social discontent reaches a tipping point, all it takes is a trigger (Mohamed Bouazizi setting himself on fire) and interconnectedness fuels the fire.

Are we headed for a Dragon King in the global financial markets?

If we are looking for the orographic winds or the critical mass of snow in the global economy, by now it should be clear (thanks to the hyper-coverage in the media) that they are in the banks' high levels of leverage. Specifically, in the assets denominated in USD held by foreign banks (see graph below). Yes, those at the very center of the European debt crisis [gasp]. The critical mass for the snow avalanche or the orographic conditions for a Venezuelan flood are silently setting in.
Shin (2011). Global Banking Glut & Risk Premium.
Interconnectedness, following our framework, is in international trade. Trade synchronizes economic cycles of countries around the world (see graph below). Unfortunately, Harry Markowitz' Nobel Prize winning idea of putting your eggs in different baskets is of no use if the baskets are on a table at risk of imploding.

with world Bank Figures
Normally, "Dragon Kings" are not triggered by a shocking event. It is often an innocuous event that sets the wheels of the full system in motion and unleashes the potential energy contained in the reinforcing elements. Very much like the butterfly effect. With so many potential financial triggers lingering in the air (Spain and Italy's unsustainable yields, France's election, Holland's political crisis) any of them could unleash the next Dragon King.

Our sky is filled with butterflies, and they are flapping their wings. Hard. Which one will create the next big hurricane? Who knows. No wonder people are nervous.