Comments on economics, mystery fiction, drama, and art.

Monday, June 29, 2009

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 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.

Saturday, June 27, 2009

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.

Monday, June 08, 2009

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.