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CompoundingHappens.com Blog

Everybody else seems to have a blog, so we decided to follow suit.

The blog that has inspired us most is Paul Krugman's. Krugman has long been a very insightful commentator on economic matters. In 2008, his long line of distinguished achievements was enhanced with the award of the Nobel prize in economics.

Heads We Win, Tails You Lose: Asymmetric Incentives Have Created a Dysfunctional Finance Industry

Tuesday 6th January 2009

On 2nd January 2009, the Wall Street Journal published the story Mr Rajan was Unpopular (But Prescient) at Greenspan Party. This story is about Dr Raghuram Rajan, professor of finance at the University of Chicago Booth School of Business.

Dr Rajan achieved notoriety in August 2005, when he presented a paper Has Financial Development Made the World Riskier? This paper is mainly about incentives in the finance industry. Rajan argued that the structure of the managed funds industry provides investment managers with two incentives that increase the probability of a market crisis:

1. an incentive to take as much risk as possible, and to hide that risk in the tail of their return distribution.

2. An incentive to herd together (to minimize the investment manager’s business risk). This means that when investment managers misprice assets, they are going to all do that together (driving the mispricing even further).

Dr Rajan also singled-out Credit Default Swaps and possible failures of bank liquidity (because banks now depend on markets for liquidity just as must as markets depend on banks for liquidity). He saw these two as destabilizing to the financial system. In retrospect, this does seem somewhat prophetic.

As the Wall Street Journal reported, Rajan saw considerable potential for catastrophe in asymmetric incentives: “Incentives were horribly skewed in the financial sector, with workers reaping rich rewards for making money, but being only lightly penalized for losses, Mr. Rajan argued. That encouraged financial firms to invest in complex products with potentially big payoffs, which could on occasion fail spectacularly.”

Perhaps asymmetric incentives have been identified as the latest demon that we will exorcise from our financial system.

Before concluding, we are compelled to mention the Beelzebub of asymmetric incentives: performance fees as widely implemented in the hedge fund industry (and even for some managed funds in regulation-phobic countries such as Australia). Many investors paid performance fees before and during 2008, as their investment managers occasionally managed to outperform benchmark. However, by the end of 2008, it was evident that we had witnessed value-destruction on a scale never seen before. Many investors have been forced to sell their investments at huge losses, yet we have yet to hear a single report of an investment manager handing back a performance fee that accrued in a positive year, even though the investor’s overall experience with the manager may have been to incur a huge loss. If investors are obliged to pay investment managers performance fees for periods when the portfolio has positive alpha, isn’t it just an elementary principle of fairness that the investment manager should return that performance fee if the investor’s longer-term in the portfolio is one of negative alpha? This is a debate we have to have.

Krugman Critiques the "Madoff Economy"

Saturday 20th December 2008

December 2008 was not a convenient time for the world to discover that Bernard Madoff — who had appeared to be an unbelievably talented active investment manager — was actually a scam artist. For some background on how Madoff's exploits have affected ordinary people, have a look at Robert Powell's The Madoff Scheme Hits Home: Wife's Job, Entire 401(k) Disappear, Along with a Good Cause.

Madoff claimed to be generating extraordinarily good investment returns, but apparently he has now confessed that it was all a Ponzi scheme, where he simply used new money from investors to pay distributions to earlier investors.

Paul Krugman's New York Times column for 19th December suggests that Madoff is merely an extreme illustration of a corrupt culture in investment management, where investors are exposed to downside, but investment managers only have upside:

"Consider the hypothetical example of a money manager who leverages up his clients’ money with lots of debt, then invests the bulked-up total in high-yielding but risky assets, such as dubious mortgage-backed securities. For a while — say, as long as a housing bubble continues to inflate — he (it’s almost always a he) will make big profits and receive big bonuses. Then, when the bubble bursts and his investments turn into toxic waste, his investors will lose big — but he’ll keep those bonuses.

O.K., maybe my example wasn’t hypothetical after all."

Now that professor Krugman mentions it, the investment management industry is good at structuring arrangements so that, when things turn sour, the investors receive much more bitter medicine than the investment managers do. An example that is particularly relevant concerns performance fees. These are usually constructed in an asymmetric way, so that the investment manager receives a big fee during periods of outperformance, yet they sacrifice nothing during periods of underperformance.

Under the current market conditions, many investors are being forced to sell investments that carried a performance fee. In many cases, the investors have paid fees along the way for outperformance, yet what the investors have received over the long run is extreme underperformance. It seems plainly unethical that an investor should end up paying a performance fee for negative active performance. Yet that is what frequently happens because of the ways performance fees are usually calculated.

See our page on Performance Fees for some information about the rationale behind charging performance fees.

We think that the question of asymmetric performance fees is one of the greatest collective ethical failures in modern investment management. This area cries out for reform.

Experimental Economics: An Explanation for Asset Price Bubbles

Tuesday 16th December 2008

Virginia Postrel covers some fascinating ground in her article "Pop Psychology" (The Atlantic, December 2008). She covers the field of experimental economics, a field in which Vernon L. Smith won the Nobel prize in 2002. The experiments described in the article involve getting a number of students to trade with one another using computer screens. The trading takes place over 16 rounds. At the end of each round, the asset they are trading pays a dividend of 24 cents. Elementary economics tells us how to value the asset based on its fundamentals (i.e. the value of the dividends). Notwithstanding this, there seem to be reproducible results in which asset bubbles take place, followed by an inevitable crash, as the final round approaches.

Interestingly, the most profitable strategies in these experiments do not involve anything to do with the fundamental valuation of the assets. Rather, the greatest profits are obtained by players who speculate early on the formation of a bubble, and then liquidate their positions before the bubble collapses.

This reminds us of Keynes' observation that investing is like predicting the outcome of a beauty contest, except the goal is not to choose the most beautiful woman. Instead, the goal is to choose the woman that most of the other players will choose as the most beautiful woman.

How any of this can be reconciled with the efficient markets hypothesis is difficult to see.

US Treasury Bills Trade At Negative Interest Rates

Thursday 11th December 2008

It has been reported widely that investors accepted an interest rate of zero in the US Treasury's recent auction of four-week bills. Moreover, on the secondary market, bills even changed hands at for a short time at negative interest rates.

Is this an outbreak of mass insanity, or is it an indicator that the economic outlook is not particularly bright?

Canada Cuts Rates to 1.5%

Wednesday 10th December 2008

The Bank of Canada has just cut interest rates by 75 basis points to 1.5%. The announcement stated that “While Canada’s economy evolved largely as expected during the summer and early autumn, it is now entering a recession [our emphasis] as a result of the weakness in global economic activity. The recent declines in terms of trade, real income growth and confidence are prompting more cautious behavior by households and businesses.”

Meanwhile, the Reserve Bank of Australia is still "relaxed and comfortable" with a cash rate of 4.25%. We wonder what enormous difference exists between the Canadian and Australian economies to explain the 275 basis point difference in interest rates?

"Anal-Retentive Gradualists"

Thursday 4th December 2008

Willem Buiter is professor of European Political Economy at the London School of Economics, a former member of the Bank of England’s monetary policy committee and chief economist of the European Bank for Reconstruction and Development. On his blog on the Financial Times web site, he writes of official interest rates:

"If zero is the floor, there is no reason not to go there immediately. The recession in the US, the UK, the Eurozone, Japan and the rest of Europe is, with probability verging on certainty, going to be so deep and so prolonged, that the zero lower bound will be reached even by the most anal-retentive gradualist central bank before the middle of 2009. So why not get it over with in December 2008 and possibly do some good in the mean time?"

We would not dream of calling the Reserve Bank of Australia (with their 4.25% cash rate) "anal-retentive gradualists". We will leave it to Professor Buiter to make that pronouncement.

Is 4.25% Still Low Enough for Australian Cash Rates?

Wednesday 3rd December 2008

In a press release yesterday, the Reserve Bank of Australia announced a cut in its interest rate target from 5.25% p.a. to 4.25% p.a. This sounds like a very bold move! However, we have to compare the cash rate with inflation (which is diving downwards at an unprecedented rate), and with cash rates in other countries. Comparing with other countries, the picture we see is that:

30 day T-bills in the USA are trading at 8 basis points per annum: essentially a zero-interest rates policy;
Japan is back to a policy of essentially zero interest rates;
The Bank of England is expected to cut at least 50 (but quite possibly 100) basis points from the current Bank Rate (3.0%) this Thursday;
The Swedish Riksbank has brought forward its next meeting by two weeks as data showed the fastest contraction of manufacturing activity since 1994. They are expected to cut strongly.

From this perspective, Australia still seems to be playing "follow the leader" on monetary policy, and we are only just managing to stay with the back of the field.

Meanwhile, in regard to fiscal policy, Paul Krugman's lucid article Deficits and the Future shows clearly that the downside risks all sit with administering too weak a fiscal stimulus, rather than too strong a fiscal stimulus. Like any good Keynesian, Krugman regards it as a positively wise and prudent action that the government should go into deficit in order to increase the fiscal stimulus on the economy while we most need it. At the same time, here in Australia, Malcolm Turnbull (the opposition leader) is pandering to populist naive economics when he repeatedly demonizes the idea of going into deficit, as shown in this transcript of a radio interview. Turnbull says:

"[...] what I'm saying to you is that Kevin Rudd [the Australian prime minister] is seeking a leave pass, given the strong economic hand that he's inherited from the Coalition. Him seeking a leave pass to have undisciplined Labor spending, have another how many years? At least two more years of deficits."

"Kevin Rudd is not capable of exercising the economic discipline and the management that this country needs and he's seeking a leave pass to be excused from everything he promised the people in the lead up to the election."

This seems to be code for the naive idea that any deficit is a failure of government policy.

Instead of Krugman's clear message that we need maximum boost from monetary and fiscal policy, the messages that Australians are receiving from the Reserve Bank and the Federal Opposition are, more or less, "Forget about the Global Financial Crisis; let's just fight inflation regardless of the chasm of risk to the downside, and let's fool around with the demonstrably fatal decision (see Franklin Roosevelt's 1936 blunder as described in the Krugman Article) to try and keep the budged balanced during the start of a deflationary down-spiral.

It is a pity that economic debate in Australia is so parochial and uninformed. If we don't act decisively now, we may go down in the history books as one of the countries that has the rare distinction of going into the Global Financial Crisis with incredible strength, and stumbling out the other side with lots of essentially self-inflicted damage.

"This Can't be Happening!"

27th November 2008

Over the course of human history, whenever a war or catastrophe has burst forth, eyewitnesses have exclaimed "This can't be happening!"

Perhaps you are thinking "This can't be happening!" when you think of the current Global Financial Crisis.

Two recent pieces nicely sum-up the extraordinary nature of the events that are unfolding:

Firstly, Thomas Friedman's article "All Fall Down" neatly catalogues the multiple levels of failure (intellectual and moral) that were essential to generating the current crisis.

Secondly, Michael Lewis (the infamous author of Liar's Poker) has written a compelling essay entitled The End of Wall Street. Anybody who works in financial markets should read this essay. Everybody else should also read it.

Lewis gives a compelling account of the background to the financial crisis. He focuses on the role of investment banks and rating agencies. If you have ever wondered what sort of environment could lead people to invent and popularize toxic debt instruments, Lewis provides a detailed background portrait.

Incidentally, Lewis' essay provides yet another point of reference on short sellers. He doesn't depict the short sellers as angels — indeed, he paints a vivid picture of the self-doubt they feel about their role in the financial crisis. But it does come through clearly that the short sellers of toxic debt and derivatives were some of the first people to understand the emerging problem. That they profited from the problem is undoubted. But if there were more people who adopted the viewpoint of the short sellers, or even listened to them as possible early warning signals, the crisis may have been averted.

Certainly, the short sellers were much more useful at spotting danger than the rating agencies were.

In Lewis' account, the investment bankers and ratings agencies emerge as not just riddled with amorality and greed, but also as not particularly competent. While Lewis doesn't try to make any political points in his essay, any reader who accepts even half of what Lewis has to say about investment banks, brokers, and rating agencies will most likely feel compelled to search for new regulatory responses to an industry that has so effectively distributed wealth-destruction around the world.

The top item on everybody's reading list should be Lewis' essay. It should also be compulsory reading in any course of study on finance.

Inflation In Australia is Not a Problem

20th November 2008

Paul Krugman has now declared that "deflation is a problem". It has been reported in the Financial Times that the US Federal Reserve has vowed to fight against deflation. Equity markets are in a downward spiral that has been described as a "1 in 100 year problem".

To try and prop up the flagging economy, the US Federal Reserve has a cash rate target of 1%, and they are talking of cutting further. The Bank of England has set the Bank Rate at 3%.

The Bank of England's November 2008 inflation report warned that, "The risk of inflation materially undershooting the inflation target in the medium term had increased substantially" (p. 56).

Yet, in Australia, the Reserve Bank of Australia still has a cash rate target of 5.25%. The minutes of the Reserve Bank Board Meeting on 4th November state the Board's decision that, "given the changing balance of risks, there was an advantage in moving the setting of monetary policy quickly to a neutral position."

This is the extraordinary thing: the news media are full of reports that the global economy is in crisis, yet interest rates in Australia have only just been moved into a neutral position (from the previous contractionary position).

Given that monetary policy is a blunt instrument that takes 6-12 months to have an effect on the economy, what will it take for the Reserve Bank of Australia to conclude that stimulatory interest rates would be appropriate?

Admittedly, there were many signs early in 2008 that inflation was an emerging problem. But that was then; this is now.

Inflation is not a problem in Australia at the moment. On the contrary, deflation is in prospect.

Update (1st December 2008): We have just received news that the TD Securities Melbourne Institute monthly inflation gauge fell 0.6% in November, following a 0.2% fall in October. Just as we wrote on 20th November, it is becoming increasingly obvious that inflation is collapsing. Real interest rates in Australia remain considerably tighter than they need to be. Further big rate cuts are inevitable. It is quite possible that we will soon all be scratching our heads wondering why the Reserve Bank of Australia was so "relaxed and comfortable" in gradually unwinding tight monetary policy in an environment where the risk of a global deflationary spiral was building rapidly and obviously.