Grantham

Jeremy Grantham can be a bit of a perma-bear, but there's a point in his most recent letter that rings especialy true to me:

China’s ability to sustain rapid growth and avoid a
serious stumble has become an article of faith that
I was buying into without much skepticism. But
why? No sooner do we fi nish wallowing in the idea
of Soviet incompetence than we start to believe that
Chinese central planners can wonderfully manage
a complicated economy, growing unprecedentedly
fast and transforming overnight from a rural society
to a capital-intensive industrial wonder using half of
some of the world’s resources. Economic logic and
history suggest that their governmental interferences
will be sub-optimal, and that China’s current level
of investment will turn out to be dangerously high,
encouraging waste. They continue to build basic
capacity on automatic pilot even as they encounter
dangerous times for their export-led economy, since
we are all facing the rising probability of a global
slowdown in economic growth and trade. China also
has to deal with rising energy costs in their particularly
energy ineffi cient economy. Surely they will stumble.
And if we are all unlucky, they will stumble right into
the global credit crisis.

Magical Mystery Accounting

As usual, Barry Ritholtz has some good points:

Just when you think there is a glimmer of hope that some of these ne'er do well, lying, cheating, sniveling, cowardly bank CEOs might finally be forced to step up to the confessional and tell all, this comes along: FASB Postpones Off-Balance-Sheet Rule for a Year.

There will eventually be a financial sector recovery, and some smart people will make loads of money off of it, but I'm afraid they will be smarter or luckier (or simply better connected) than I. Right now though, I can only imagine investing in some special case that I can actually understand, and I'm setting the understanding bar (understandably, given the eternal litany of writedowns) pretty high.

Question: How can anyone value a financial company if they cannot tell what are on their balance sheets?

Answer: You cannot. If you buy a financial under these conditions, you are flying blind.

Investment Thesis: Ritholtz Rule #1: Know What You Own.
Whoever buys Financials under these circumstances loses the right to whine down the road about companies not being forthcoming. If you own them, don't complain when you get what you deserve.

Google Lobbies

I recently wrote about this in a more reflective mood, but it's worth revisiting in the sobriety of the office: Google spent $730,000 to lobby in second quarter.

US Socialism

I like this one:

Two major related threats loom over the world economy: credit crises and rising inflation. What do these two menaces have in common? Bankers, hedge-fund managers, speculators and capitalism in general have been taking the hit for the economic turmoil, both for credit risk and inflation. But the looming collapse of Fannie Mae and Freddie Macin the United States should help change the focus a little. We are now getting down to the heart of the matter, which turns out not to be rampant capitalism but out of control back-door socialism.

- Terence Corcoran, The culprits behind credit, inflation risks

Learning about markets

Despite its academic cachet and theoretical appeal, I've never been much of a believer in the idea that markets are truly efficient. Free and open markets are a pretty good tool in a wide variety of circumstances. They are an equilibrium tending process both theoretically and (usually) in practice. However, they consist of monkeys buying and selling stuff (capitalism is an animal behavior pattern after all) and they occasionally suffer from the flaws associated with this status. I've never believed markets were completely efficient, because if they were, I wouldn't have a job and companies would in general not have profits, both of which predictions are verifiably false.

What I don't understand about the current market crisis is all the people who claim we have recently learned something fundamentally new about markets. Even a cursory knowledge a financial history extending beyond the last 10 years will show you that a boom-bust credit cycle tied to over-investment in real estate is the most often repeated error in all of capitalism. We've got literally two centuries of examples of this phenomenon, from all over the world, with all different kinds of economic backdrops, states of technological development, and monetary conditions. We've got an entire century of data about how this phenomena occurs even when there is a lender o last resort. The current situation is the most predictable, least surprising economic fact I can think of. We have run this experiment literally hundreds of times; we know how it ends.

So, when someone like Paul De Grauwe in the linked article, claims that we have now had a cherished myth about markets destroyed, that only now it has become apparent that unregulated financial markets are not perfect, I go nuts. On two levels.

First, I can't possible see how this is surprising. All the fancy econo-physical models about risk and volatility and rational expectations and whatnot were obviously and transparently wrong right from the beginning. Anybody who has spent any time at all actually looking at how a business or a stockmarket works knows this immediately and intuitively -- the only way to make money is precisely to avoid the places where there is an eficient market. Make whatever model you want, but don't ask me to be shocked when it turns out that assuming the cow is a point in space isn't good enough to turn you into a dairy farmer.

Second, stop coming to conclusions about how markets have failed us when in reality all that has happened is that the reality of these markets hasn't corresponded to the toy model you made of them. It reminds me of the idiocy of people in the 90's saying that the USSR collapse somehow proved that "communism doesn't work". The truth is that you can't come to any conclusions about "markets" from the current experience, because the financial system doesn't even come close to resembling a free, open, and transparent market. The problem here is that there are three definitions of "market" involved in this discussion -- the economist's efficient market, real functioning markets (of which they are many concrete examples called 'commodities businesses' which no one is very excited about owning in general, the current euphoria for this sector aside), and the most common type of market, which is not at all free, but a system which whole going under the name of the 'free' market is actually rigged by the biggest players to their own advantage via the political system. The implosion of Freddie and Fannie has absolutely nothing to do with the first two definitions of the market because these companies never ever operated in a truly free market. They have always been the classic example of a government sponsored private monopoly -- the precise opposite of what a market is supposed to be.

This is why it drives me so nuts when the opportunistic moralists come out of the wood-work to proclaim that "unregulated markets have failed". Because there is no such thing as an unregulated market -- it's a complete oxymoron. The only unregulated market is the one where we go around hitting each other over the head with sticks and dragging women back to our caves by their hair. All real markets are regulated extensively with legal systems defining and enforcing property rights, contracts, etc ... There can be no market without regulation. The question is whether the regulation puts everyone who wants to play the game on the same foot, or whether it unfairly advantages the biggest players in the game. The current crisis is a failure of regulation -- that regulation failed to create the conditions of a free market because (among other things) it let people who knew they would be bailed out by the government gamble with other people's money. The current crisis is not a failure of anything resembling a "market" -- but it is a dramatic failure of something vaguely resembling a government.

The Banana Republic Club

Yves Smith has inaugurated the Banana Republic Club, which aims to commemorate respectable folks comparing the US to a Banana Republic. Given that the first members are William Buiter of the FT, and Mohamed El-Erian of PIMCO and Harvard Endowment fame, the company looks good, and I would like to sign up for a front-row seat at the next event. Maybe we can all get together at Burning Man?

Have you got rocks?

I no longer remember which year it was, but I do recall Warren Buffett's discussion of the Hadrocks and the Gotrocks in one of his annual letters (2005 it turns out). His point was simply that unlike in Lake Woebegone, not everyone can be above average or beat the market, and that if we all pay hedge fund 'helpers' 2-and-20 in an attempt to do this, we are simply collectively transferring our wealth to the helpers. The appropriate physical analogy is indeed friction -- financial industry profits are the frictional drag on our economic system.

I was reflecting on this this morning, and on the current financial meltdown, and realized that Buffett is right when it comes to beating the stock market, but not quite right about the financial sector in general -- some financial profits can come from creating a non-zero sum game. If I have capital and you have a business idea, neither of us is going anywhere fast unless we can meet and form a partnership. Someone who introduced us would actually generate economic value, and could capture (some of) this value without us being worse off. In fact, I think one of the big problems with the emerging markets is their lack of this non-zero sum game infrastructure, which is every bit as important as roads and schools.

I started wondering how one might measure what percentage of financial profits are real, in the sense of generating economic value, and what percentage are frictional. A tough question, but FT Alphaville has a post today suggesting one simplistic but plausible way of doing this. Barring some radical new-age-of-finance argument, there's nothing to suggest that finance has become dramatically more non-zero sum in the last decade. Hence, the sector's profits as a percentage of GDP ought to be about the same as it was a decade ago. If you check out the graphs in the post, you'll see graphically that financial profits have soared with respect to GDP, and you will find a measure of the excess profits generated over the last ten years -- $1 trillion dollars of light and heat, smoke and mirrors, friction at its most fricative and explicative. Fuckers.

Now, should we really be surprised that some of this excess may have been invested politically in making sure there was no mean reversion? Should we really be surprised that we have to bail these guys out.