When Genius Failed

I'm re-reading Roger Lowenstein's When Genius Failed, and I'm finding it a remarkable book. Again. It's about the Long-Term Capital Management debacle of 1998, but it could easily be about the financial meltdown of 2007-2009. On pages 71 - 77, Lowenstein discusses "fat tails" in the distribution of returns to financial assets, beginning with this quotation from Eugene Fama's dissertation, about daily volatility of stock prices:

"If the population of price changes is strictly normal, on the average for any stock...an observation more than five standard deviations from the mean should be observed about once every 7,000 years. In fact such observations seem to occur about once every three to four years."

Such large, discontinuous, and "unexpected" events (based on a normal distribution happen fairly frequently. Only seven years before LTCM was founded, prices on the NYSE fell by 23% in one day, an event that Lowenstein characterizes as follows: "In fact, had the life of the Universe been repeated one billion times, such a crash would still have been theoretically 'unlikely.' But it happened anyway." "Theoretically unlikely" means "almost impossible, if the distribution of price changes is normal." But the non-normality of returns was well known...

Lowenstein attributes this, in part, to the (high) probability that returns on Day i and on Day i+1 are not independent of each other (which is an assumption of random walks and normal distributions). While that may be sufficient, it is not necessary. The distribution of returns can be non-normal (e.g., have fat tails), but still display independence of observations.

What remains amazing is how short the memory of people engaging in financial speculation can be. After the Great Crash of 1929 - 1933, it took nearly 40 years for people to begin to forget. But the lessons of 1987 seem to have evaporated by 1994, and the lessons of 1998 (the LTCM crash) seem to have dissipated by 2002 or 2003. Oddly enough, the new lesson was not that returns to investments in housing would follow a normally-distributed random walk, but that they were non-normal in a specific way--highly, extremely positively skewed.

The events that resulted in these crashes may have been low-probability events (even if they were not as low-probability as people thought). But they were probable enough to result in financial crises.

Keynes pointed out, 70 or 80 years ago, that even low-probability events, even events that we might attribute to "irrational" movements in market prices of financial assets could be devastating: "Markets can remain irrational for longer than you can remain solvent."

I wonder how long we'll remember this lesson this time.

Some things are too good not to quote

"Nothing stands for content-free corporate bullshit quite like PowerPoint."

Charles Stross, The Jennifer Morgue, p. 43.

Another month...another basket of bad news

I've been putting this off, but it's not going away.

The employment situation report for May came out last Friday (June 5), and, while the employment decline was less severe than most forecasters expected, a loss of 350,000 jobs does not count as good news. What might count as good news is that there was a small growth in the (seasonally-adjusted) labor force in May, but that's sort of counter-balanced by a continued decline in the employment-population ratio.

Even ignoring the labor situation (where the best we can say is that things are getting worse more slowly), there's not a lot of good news.

On the monetary front, the M1 money multiplier remains below 1. This means that bank reserves continue to be greater than checking account deposits in US banks. The M1 money multiplier has declined from about 1.7 in the first quarter of 2008 to about 0.95 in the first quarter of 2009. And, although M1 has increased fairly substantially (by about 14% between the first quarter of 2008 and the first quarter of 2009), the M1 velocity of money has declined by just about enough to offset it (down by nearly 13%).

Despite unprecedented growth in bank reserves (which were, in May, $903 Billion, up from $45 Billion a year earlier--an annual growth of 1900%), total bank lending is up only 3.3% between April 2008 and April 2009. Banks are maintaining a huge excess reserve position, apparently finding that a better option (especially now that bank reserves at the Fed are paying interest) than is making loans. (Bank lending was about 200 times bank reserves a year ago; now, it's only about 11 times bank reserves.)

For all of the Fed's efforts, we appear still to be in a liquidity trap.

Steel, again

The shoes appear to have dropped--in northwest Indiana, in Cleveland, and in Georgetown, SC. But the really big shoe dropped in Europe, where workers are rioting in Luxembourg, and where Mittal has shut down 16 of its 25 blast furnaces. Lakshmi Mittal is quoted as expecting an additional 15% to 20% drop in world steel output this year, and this comes on the heels of a nearly 50% drop since the middle of 2008.

In northwest Indiana, steel employment had continued to rise until at least February, when it was fractionally above the February 2008 level (about 17,000). However, Mittal began to lay off workers in April, and US Steel had to shut down part of its operations in Gary for emergency maintenance. (USX has been shifting production from the rest of the country to Gary).

With the 980 layoffs announced today, and the additional layoffs I've been able to identify, it appears that employment in steel in northwest Indiana has declined by something in excess of 1,500 in the last month or so. With the declines that have already occurred in steel output, and if Mittal is correct about continuing production declines, we're going to lose more jobs.

While this is not as devastating an occurrence as it would have been 30 years ago, when more than 25% of local employment was in steel (compared to less than 6% now), steel workers continue to earn much, much higher wages than the average. These layoffs will cost northwest Indiana families about $2.7 million a week in wages, with spillover effects in other industries.

The recession has, I think, finally come home to northwest Indiana.

NFL decides to stiff its coaches

The National Football League (well, actually, the owners of the NFL teams) has voted to allow individual teams to withdraw from the current league-wide pension plan for coaches (here and here). And, apparently at least nine teams have already done so (I say "at least," because, apparently, the teams are not moving rapidly to tell their coaches what they're doing). A number of members of NFL coaching staffs have decided to retire now because of this change.

The change is not simply that teams will be able to have their own pension plans for coaches, but also that lump-sum distributions from the existing pension plan will soon be restricted. And, just as a side benefit, the NFL has also made it very difficult for coaches to retire, take their pension benefits, and then come back, on a contract, non-employee, basis, as "consultants," for the same (or a different) team.

The move to team-based pension plans will almost certainly lead to reduced pension benefits for coaches. This is almost certain simply because most pension plans have minimum vesting periods and, in defined-benefit plans, benefits are based on years of service and earnings, and rise faster than years of service--long-term employees get larger benefits that the same employees, with the same earnings, would receive if they had split their careers between employers. It has long been common, in industries in which workers move frequently between employers (construction, for example, or coal mining, or trucking) to have multi-employer pension plans, often negotiated by unions and at least co-administered by unions.

It appears clear that the primary justification for this move is to reduce team costs. And this will happen as teams move to defined-contribtution (401K-type) pensions and, for those teams that continue to provide defined-benefit plans, from a reduction in expected benefits.

So this change will almost certainly reduce the pension benefits of NFL coaches, many of whom are long-time assistant coaches who do not earn the multi-million dollar salaries that "star" coaches receive and who were never highly-paid star players, either.

The restriction on lump-sum distributions flows directly from the declining balances in pension funds that have resulted from the stock market decline. Allowing lump-sum distributions also means requiring larger current contributions to the pension plan. But is also reduces the flexibility that retiring coaches have in doing retirement planning.

The NFL's public position is that this makes pensions for coaches more like pension plans elsewhere--employer-based. But this is clearly not true for the professional sports business, and, as I note above, also not true for a wide range of industries in which the employee's primary identification is with a skill or profession, not with an employer.

This is about reducing costs, and doing so by inflicting losses on a group that cannot effectively fight back. (There is an NFL Coaches' Association, but it does not bargain for the coaches. The NFL argues--I think correctly--that coaches are management, and thus not afforded the same orgainzing rights under the National Labor Relations Act as the players are.)

Legal? Sure. Cost effective? Undoubtedly. Fair? Not so much.

Things about my job

There are things about my job that I really like a lot. And then there are things about my job that I really dislike a lot. One of the things I really dislike a lot is writing final exams (although writing them is more fun than grading them).

Guess what I'm supposed to be doing right now?

The Continuing Recession, GDP Edition

The preliminary numbers for real GDP for the first quarter of 2009 have been released, and they are worse than expected, but pretty much in line with the kinds of employment declines we've seen in January, February, and March. GDP declined at an annual rate of 6.1%; apparently the consensus expectation was a decline of 4.7%.

The truly striking decline was in Gross Private Domestic Investment (purchases of new capital equipment), which fell at an annual rate of 37.9% (compared to a fourth quarter 2008 decline of "only" 21.7%). Investment has declined more sharply in this recession than in any recessions ince at least 1974/75.

But even more strikingly, Investment has declined as a percent of GDP since the first quarter of 2006, from 17.3% of GDP to 11.7%. This is a lower Investment share than at any time since the 1991 recession (but the decline then was only from 13.6%). Even in the "biggest recession since World War II" (the 1980-82 recession), Investment's share of GDP declined only by 2.6 percentage points.

The current decline in Investment spending, because it means our capacity to produce is growing much more slowly and we are incorporating new technologies at a much slower rate, has significant implications both for the recovery and for our longer term growth.