Friday, January 23, 2015

Money, huh, what is it good for?

There are basically two ways that money is useful- you can spend it (duh) and you can not spend it (huh?  duh?).  These two functions are usually called the unit of account (spending) and a store of value (not spending).  The invention, and wide spread acceptance, of money is truly a wonderful thing, and is possibly the second most important discovery of all time for humans (fire rules!).

Now money is fairly unique as a medium of account.  Within a currency zone, say the US, the national currency does the majority of the heavy lifting (yes exceptions exist) when it comes to transactions.  

On the other hand there are many competitors for stores of value, and I am not just talking about gold.  Stocks, bond, and precious metals can all, under the right circumstances, be vehicles for storing and increasing wealth. The closer to zero that interest rates drop the less of a distinction there is between cash and other "stores of value".  This is all basic, generally accepted, stuff.

So the question is how does QE work?  When a CB prints and swaps out dollars for bonds- be they government or private- they are swapping one store of value for another.  If there was a shortage of cash and people wanted to make purchases but were cash (or liquidity) constrained then you could make a case that by swapping cash for bonds provides a functional value to the economy and that money will move around.  But what evidence is there for a lack of cash in the system?  M2 velocity has been declining since the late 90s-

If people wanted money so that they could buy things and there was a shortage of money then velocity should shoot way the eff up, not down.  If people want money to hold onto because the opportunity cost of other stores of value has declined then this is the type of graph you would expect.  Of importance note how velocity has declined since the end of the recession as well as the fact that the decline started prerecession.  If anyone tries to paint this recession as being CAUSED BY declining velocity, as I recall some did, they have a lot of 'splaining to do. 

These are really pretty basic ideas in economics I know, but they fundamentally explain how the ECB can promise to buy AT LEAST 1 trillion Euros worth of bonds and nudge expected inflation around 0.2%

 OK- back to what I said about stores of value- I mentioned PMs, but funnily enough there really isn't any evidence of them being a store of value since the US dollar went off the gold standard in 1913 (haha!) it has been highly volatile and it is not at all appropriate to call PMs a store of value.  So what?  Well if gold isn't a store of value, and gold isn't used as a medium of account then central banks can force inflation buy buying gold.*

The irony here is delicious on all sides.  If central banks started buying gold to push inflation they would be making it more and more like a store of value, making it more like money, after decades of fighting to make it less like money.  On the other hand gold bugs (in recovery myself) look at purchases of gold by central banks and say "look at Russia/China buying gold" they are going to create a stronger currency that can someday compete with the US dollar. 

*Why gold and not something else?  Anything else would do (like oil, wheat or silver) but those things are either far less practical to store or are used heavily in industry or both.  Purchasing them in large amounts would not only drive up prices but also limit supply which would cause negative shocks to the economy.

Monday, January 19, 2015

Great News!

Scott Alexander thinks that

I was originally confused why they published this result instead of heading to online casinos and becoming rich enough to buy small countries, but it seems that it’s a very simplified version of the game with only two players. More interesting, the strategy was reinforcement learning – the computer started with minimal domain knowledge, then played poker against itself a zillion times until it learned everything it needed to know. Everyone who thinks that AI is nothing to worry about, please think very carefully about the implications of a stupid non-generalized algorithm being able to auto-solve a game typically considered a supreme test of strategy and intellect. (Bold mine)

He also says in the comments

The problem is that in forty years, someone will be saying “Yes, conquering Europe used to be seen as a supreme test of strategy and intellect, but now that computers can do it the real test of original thinking is something less tractable. Like Go.”

Lets talk a little rational behavior.  If poker is "solved" and you can't win anymore then the best thing to do is not play poker online anymore.  Pretty straightforward right?  How about for computers?  Well if it is solved then playing online should mean you only play against other near perfect computers and you will both lose to the rake- which means computers also shouldn't play online unless they are for sure playing against people.

Lets extend it- if war in Europe is "solved" by a computer logically no human should ever start a war in Europe again.  Peace in our time!  Ok, so a computer could win a war in Europe, but with a computer on the other side it should be very wary of starting war since war carries an extremely high rake- way higher than an online casino.  In fact it is so well established that trading > war as an economic fact that turning war over to computers that had figured it out should lead to peace in our time!

Honestly this analysis is pretty weak sauce since winning and losing are defined by the rules of the game.  If you define winning as "no Jews left in Europe" then war would go from no chance to 100% chance really quickly, so you have a framing question still to worry about.  Still the optimist can present an incredibly strong case- once computers have solved all games and are pitted against one another the only games that they would choose to participate in are positive sum games.... you know, like trade and technological advancement!  Given a choice between a game neither can win or a game you both can win the only immediately obvious reasons to pick the former are things like xenophobia or ego. 

I, for one, welcome our new robot overlords! 

Saturday, January 17, 2015

A silly/scary thought experiment on the Swiss Franc

The ECB is generally expected to launch a QE program sometime next week (late Jan 2015), last week the SNB dropped its price ceiling relative to the Euro.  What would happen if the SNB had retained the peg and the ECB started a large QE program?

1.  QE should devalue the Euro
2.  The Franc then rises vs the Euro
3.  The SNB steps in and prints Francs to buy Euros and maintain the peg.

Simple, right?  But we totally skipped WHAT the ECB is buying.  What if they decided to pursue QE by purchasing Francs?  What kind of mad world do we live in if that happens?

1.  ECB prints Euros to buy Francs
2.  Francs rise double fast (purchases increase the number of Euros AND decrease the number of Francs availible)
3.  SNB steps in, prints 2X (more than 1X as many, not necessarily 2X) as many Francs to maintain peg.
4.  SNB purchases pull Euros out of the market sterilizing their QE.
5.  ECB prints Euros and buys Francs
Repeat steps 2-5

If both banks honor their commitments and react reasonably quickly to price changes we would (expect) to see the Franc hit 1.20 and stick like glue.  With both sides having infinite ammunition in this fight there is no logical end in sight.  What should happen to those currencies compared to other currencies?  Other than some froth early on I think you can make a case for nothing (I think you could also make a case for nothing followed by complete collapse).  No new Euros will functionally hit the market before being snapped up by the Swiss and no new Francs will enter flows, they will be stocked up by the ECB. 

Is the effect really neutral though?  I think perhaps not.  In the end the banks will lose some control over their own currency and gain some control over the other parties currency.  If these two entities were of equal size then the effects would be a wash, but because the ECB represents a much more massive economic conglomerate than Switzerland the relative number of Francs it would have to put on the market to alter the value of the Swiss currency is much smaller.  In this game of chicken the Swiss would be giving up sovereignty (conservatively) ten times as quickly as the ECB would be. 

Don't believe me?  Imagine the ECB initiates QE equal to 100% of Swiss GDP (lets pretend everything ends up 1:1 nicely for simplicity) by buying Francs- the SNB expands its balance sheet by 100% of GDP by purchasing Euros to sterilize this action.  Now the ECB turns around and uses those Francs to buy US dollars.  What happens to the value of the Franc with around 800 billion newly minted ones hitting the market and 800 billion dollars getting soaked up?  Unless the Swiss want massive inflation (not 2-5% inflation but double and maybe triple digit inflation) they have to dump some of their holdings- which are overwhelmingly Euro denominated- to soak up those Francs and the Euro should depreciate vs the Franc (and also vs the Dollar). 

There is a lie floating around the ether that a CB can control its own currency with enough gumption.  That may be true (its probably not) but it immediately becomes false when a country pegs to another currency, and becomes false and really dangerous when it comes to pegging vs a much larger currency. 

If we combine this post with one from earlier today we have a rational explanation for the Swiss abandoning the peg.  That little (ie 20-30 billion francs) increase in late 2014 in SNB holdings indicate that the Swiss had not convinced the market of its commitment to maintain the peg.  To match a big QE program from the ECB the Swiss would be giving up substantial autonomy for future moves.  Even if the ECB wasn't specifically buying up Francs it would still be the major buyer of paper when Francs were flooding the market.  Either directly or indirectly the ECB would be major players in the Franc's future. 

Dude, where's my credibility? Swiss bank edition

having in effect thrown away its credibility – in today’s world, the crucial credibility central banks need involves, not willingness to take away the punch bowl, but willingness to keep pushing liquor on an abstemious crowd – it’s hard to see how the SNB can get it back.- Paul Krugman

 It’s stupid to throw away 3 1/3 years of credibility.  I won’t even say “hard-earned credibility,” as it was pathetically easy to peg the SF for 3 1/3 years. - Scott Sumner

There is a school of thought, and its the mainstream one, that a central bank can manage its currency on expectations and credibility alone.  The theory goes basically like this- if the Swiss Bank promises to prevent the Franc from appreciating above the 1.20 mark against the Euro then you would be a fool to sell your Euros for 1.19 Francs since as soon as the SNB gets wind of this transaction they will print Francs and buy Euros until the exchange rate hits 1.20 again.  Armed with perfect knowledge of future price moves (in this case only in one direction) exchanges should never threaten the peg.  The single obstacle to overcome then is to convince the market that you are truly and surely going to stick to that peg, come hell or high water.  Once the market believes you you just sit back and listen for the accolades. 

The SNB set a ceiling to its value relative to the Euro more than 3 years ago, in that time it has basically doubled its balance sheet in nominal terms in moves that exceed (again nominally) the amount it expanded its balance sheet from 2006 to 2010 when the world was in some serious fucking turmoil.  I don't want this blog to have tons of cursing in it (I need my supply for every day life) but I want to stress what so many seem to gloss over.  2006-2010 was absolutely craziness at times.  The "recovery" of the last few years has been extremely tame in terms of volatility, and yet the Swiss bank has added more "assets" to its balance sheet than during the most economically stressful time in the past 80 years.

In fact as of late 2014 the SNB was STILL expanding its balance sheet, sure that little spike looks pidley in comparison to the other moves but it represents tens of billions of dollars (or Francs, or Euros) worth of purchases.

So here is my question- if for 3 years the Swiss has pumped seemingly unending amounts of Francs into the system to defend its half-peg why didn't they have any real credibility?  If a CB is truly in control of its own currency then how freaking long does it take and how many HUNDREDS OF BILLIONS OF currency units does it have to go through to generate the mythological track where markets don't even test their resolve?  This is a rhetorical question, this post is simply to point out that everyone who says the Swiss have given up "credibility" have frankly failed to establish that they every had any, and are simply working on the assumption.  Their models are suspect, their predictions are suspect and their analysis is suspect. 

Things are happening in this world (I didn't even mention the negative interest rates) that have never been tried before, we cannot coast on old assumptions that sounded right, the evidence that they are wrong is small, but growing. 

Friday, January 16, 2015

What's in a name? Bubbles.

This is more in a back and forth between this blog and Idiosyncratic Whisk.

First we have to discuss definitions of a bubble before we can move on to talk about if housing in the 90s through aughts qualifies.  Most people take for granted that housing was a bubble so I appreciated that there are (apparently quite bright given his blog) dissenters like Kevin questioning some huge assumptions.  For my money something is a bubble not because it deviates from historical norms, or because its price increases are "to large"-  I think what makes a bubbles is the fact (or threat) that a change in the sign of growth (not only from positive to negative, but also from positive to zero, or from zero to negative) causes a feedback loop that pushes prices down.  Ponzi schemes are classic bubbles- once new investors cannot be corralled into keeping payouts high the whole thing disappears as one person pulling out their money causes lower returns which causes others to pull out their money.  The fact that a person cannot pull their money out of Social Security (at least not easily) prevents it from this Ponzi like collapse, even though the other fundamental aspects are the same. 

I will summarize Kevin's position here- he has written a ton about it so I won't do it justice in nuance but the general gist is that with very low nominal rates of interest it makes sense to borrow large amounts (to lever up) in exchange for the cash flow (in this case the implied rent).  This is similar- but definitely not identical- to the idea that was floated during the boom that house prices were being supported by lower interest rates because lower rates meant lower costs of purchase and so a person could purchase "more house" (ie a higher prices house) for the same monthly payment.  Kevin also provides a timely quote in the comments of one of his recent posts

I prefer to begin analysis of homeownership by thinking of home values as an all-cash investment. There are ways that mortgages might effect market prices, but those are tweaks from the all-cash intrinsic value.

 This is a major point of disagreement for me.  By treating home ownership as an all-cash investment he eliminates the roles of banks, and banks and homeowners have very different risk profiles, and it is this risk profile where his analysis falls short.

Banks have two risks when they loan, interest rates and default rates.  Because they borrow short and lend long an increase in interest rates freezes the majority of their income at lower rates while increasing their operating costs.  Default risk is simply the risk that the borrower cannot pay back the loan, in which case the bank seizes the house and sells it off to recover as much of the loan as they can.  All banks use models that assume some default rate and some reduced sale price (frequently around 80% of market value) to calculate expected losses on loans.  This creates a potential double whammy if interest rates increase as banks face stiffer costs to keep their capital requirements up to snuff while also having to raise more to cover larger losses on defaults (higher interest rats -> lower prices -> lower recovery %s).

What can happen on the other side of the ledger is very interesting.  In the case of a fall in interest rates, and subsequent rise in house prices, is an apparent decrease in the risk of bank loans.  This happens because most of a bank's book (at least economy wide) is based on loans already made.  If prices increase 5% then a banks recovery rate (if it stays stable at 80% of market value) will now be 84% of the original purchase price for all previous purchases.  Lets say a bank's book is 10% loans made recently and 90% made in the past, then every price increase reduces a bank's default risk by 9 times that of the risk new loans carry at the higher price.  Every new marginal borrower can be riskier than the previous average in the bank's eyes.

Here we can describe a positive feedback look pushing prices higher in which banks appear to be acting sanely.  Higher prices mean a lower risk profile for the bank, which allows slightly riskier loans, this pulls more home buyers into the market which increases demand and should then push up prices and/or interest rates.  For a visual here is home ownership rates in the US
No matter the explanation for 30 years years banks rated between 63 and 66% of the population as acceptable risk as homeowners.  From 1995 to 2005 we go from ~64% (roughly the 30 year average) to 69%- more than 3 percentage points higher than the previous high shown.  The US had between 105-110 million households in 2005 so that 3-5% rise over the historical average means that over 10 years there were 3.1-5.5 million more homeowners than you would have predicted in 1995.  This HO rate increase roughly matches when price increases started to take off in earnest

Going back to my (quick and dirty) definition of a bubble is a feedback loop once we have a change in the sign of prices.  First I want to say that banks are not run by idiots, and the people writing models that project things like default risk and recovery rates are not idiots, but the way most models are written is based on historical data.  If default rates have hovered around 1% for 50 years, a number close to 1% is going into your model, if recovery rates are 80% over that span, and number close to 80% is going into that model.  Models like these tend to break down around historical anomalies, not just because of different dynamics at those points but because the data leading up to those points is usually incorporated into their models.  When loans were made in 2004 the price increases of 1995-2003 were going to be a natural part of estimating risk.

In my narrative we have moved the price of housing up and the quality of homeowners in terms of default risk down.  Implied in that second part is the fact that the remaining pool of potential homeowners is of lower quality than the historical average.  Also implied is that the lower quality a homeowner you are (if you have bought a house) the closer to the peak purchase price of was the timing of your purchase.  Now a change in the price signal- even just from positive to no growth- will cause a spiral.  Defaults will be at the high end of historical averages (and maybe higher) and the cost of those purchases will also be the highest of those on the books.  Recovery rates fall because the pool of available buyers is at an all time low as well.  Now banks do some combination of raising capital and slowing loan origination to fill these losses that are on the edges (and sometimes over the edge) of their estimates and we have the potential for a spiral without a recession kick starting or amplifying it.

There are still lots of missing pieces in the puzzle, but to return to the topic- if you treat a home purchase as a cash transaction you will fail to see how a bank's risk profile changes in response to price changes. 

Now you can tell a different story with the data shown- but it basically requires the claim that either a substantial portion of the population (3-5% percent of households) went from being a poor mortgage risk to a good one, or that banks were leaving billions on the table from 1965-1995 and then suddenly came to their senses. 

Thursday, January 15, 2015

I guess I will start an econ blog

I got some sleep the past three nights, and crazy stuff is happening in the world- so lets start an econ blog that will get way off topic and degenerate into petty sniping (assuming I even get a reader) before disappearing into the ether 2 months from now. 

Kevin Erdmann at Idiosyncratic Whisk has some posts which basically argue there was no housing bubble.  Instead of arguing in the comments of Marginal Revolution I started this blog to argue across them. 

Here is a graph from IW*-

 Kevin (to familiar?) argues that there is a stable trend line of real estate value in the US- at roughly 8% annual growth.  Visually it appears stable, conceptually it is clearly not stable.  Why?  Because its a log graph, which smooths what is an exponential curve into a straightish line.  An 8% growth rate in an economy doing under 5% is probably* not going to be stable over a long period of time.  To illustrate this we can pull another graph from a different post of Kevin's on housing

Look at the blue line- that is mortgage debt to GDP.  This line is clearly not stable from around 2000 to 2006/2007. 

Kevin Asks about the 1st graph- "What looks more out of line?  The 2000's or the 2008-2014 period?"- the second graph clearly shows that "something" was out of line in the 2000s, we can disagree on what, but I can't see an argument for calling perpetual 8% growth in housing "stable" in the US.

"I argue that frictions in home supply were creating a supply shock in the 2000s, which was creating supply-based inflation."- Ok lets explore that with the data you provide plus a little context.

Housing starts

Ok- So eyeballing this chart we have much higher housing starts in the 70s/80s than we had in the 90s, but that doesn't mean a supply shock- that could just as easily mean a demand shock.  Here is a graph that points in that direction. 

Average household size in the US

The green line (US average household size) shows a leveling off after a long (60 year) decline.  Now you could argue this two ways- one is that the supply shocked limited the number of houses available and stopped the decline, but I think that is a very weak position to take given how family structure tends to work it seems pretty unlikely that the average household size should be only a hair above 2 people (and still falling). 

* I'm just linking directly to his blog instead of posting my own image, I have serious doubts that my viewership will ever reach a point where this is a problem.
**you can come up with scenarios, but they don't appear realistic in my view.