Monday, December 12, 2011

[Economy] Markets

Over the last few days I have had a few discussions about the latest attempt to 'fix the Euro'.

Let's see what happened: All European countries, except for the British, agreed to restrict how much public (government) debt they are allowed to add to their existing debt in the future. That surely is good news for the debt crisis, isn't it?
After all the debt crisis means that some investors have doubts about some European countries and the probability that they will pay back their debt in the future. Why would these investors be opposed to an agreement that said that the debtors do not want to issue much more debt in the future?

Well, if things would only be so simple.

Right now the US is able to issue 30 year debt at about 3% interest rate. That means that the US promises that it will give you back all your money in 30 years plus 3% per year if you give them some of your money now.

At the same time the inflation indexed 30-year debt has a 2% interest rate. That means that if you give the US money right now they promise to give it back in 30 years in addition to a 2% annual interest and also make sure you won't suffer from inflation. Consequently investors seem to think that the average inflation in the US for the next 30 years is going to be about 1%.
These are the historical inflation rates in the US. Apparently a grand new time has dawned.

On the other hand .. isn't the FED printing money like crazy since 2008 to prevent a credit crunch and other nasty things?
Ask any investor on the planet whether the average inflation rate in the US over the next 30 years will be 1% and he will consider you stupid. Significant inflation (maybe after some period of deflation) is highly probable in the US - and all over the world - at this point in time; and most every investor agrees.

So what the hell happens? Well, irrational markets happen and that is neither new nor necessarily a big problem. How many investors, do you think, who buy 30-year bonds today, intent to hold them for 30 years? How many of the people who bought Yahoo shares in 1999 intended to hold them indefinitely? When I buy shares, do I think that when I die they will have been worth it?
No. In fact, I have no idea. I never even thought about that. I don't intend to hold any shares or bonds that I buy today for any significant amount of time. I'm pretty sure that among global warming, peak oil, wars, and generally unpredictable events, some stuff will happen in the coming 30 years.

Google has said explicitly that they do not intend to pay dividends in the foreseeable future. Yet, you can give them your money and many people do. Why? Because they think that other people think that other people think ... that other people think that the shares might rise.

In the perfect rational market the story would be this: The guy who buys the 30-year bond after 29 years will not do this if he thinks that he will make a loss. That's why he will force the seller to agree on a price that includes all what he thinks will happen during the 30th year.

The guy who intends to buy the 30-year bond after 28 years and will sell it after 29 years (one year later) will consider this and therefore also consider the whole next two years when he makes the decision to buy something.

The guy who intends to buy the 30-year bond after 27 years ...

This whole process works about as well as Chinese whispers.

In reality I don't care so much about the future if the other investors don't. And the other investors don't care so much about the future if they don't think that the other investors do. And so on.

The reason the investors are reluctant to buy European bonds right now - except for German ones - is not that they think that Europe might go broke. Instead, they think that other people might think that other people might think that ... other people might think that Europe might go broke - or at least act like it.

Are German shares a good investment if you think that France will go broke? Of course not. That would be a global catastrophe. You'd be much better off buying weapons and storing them under your bed. Consequently, German and French bonds should have similar interest rates. But they don't. Are US bonds a good investment if Europe breaks up? Well, I'm reasonably certain that you'll get your money back, but it might not really be worth much anymore.

Are Japanese bonds a good investment right now even though their debt/gdp ratio is about 200%? If you manage to sell them before they lose their value: yes.

Should you buy French bonds now that they are undervalued? That depends on how much you believe in self-fulfilling prophecies. If the markets stopped giving money to the French right now, France would be broke. But so would any other country on the planet including, of course, the US, if investors stopped giving money.

In the aftermath of the latest global financial crisis many people came to realize that markets are sometimes irrational. Well, they have been wrong. Markets are irrational all the time. In fact, it doesn't even make much sense to call them rational or irrational. Markets simply are. They are a tool to accomplish things within a society. They work predictably unpredictably and can be used for great things.

Markets are not some godly wisdom of the many or a harsh judge or whatever picture some people allowed the press to print into their minds after the fall of the Berlin Wall. Markets simply are. They are often useful and should be used. But they should not be confused with some omniscient or even moral authority.

Now to answer my initial question:
"Why would these investors be opposed to an agreement that said that the debtors do not want to issue much more debt in the future?"

Because investors think that other investors might think that other investors might think that other investors might think ... that countries that spend less will achieve less economic growth in the short term (which is quite probably correct). This will produce negative headlines in the press and these headlines will cause the bonds to drop in value. Why would you buy something today if you expect its value to drop in the future?

In a perfect world this very fact would be 'in the price' already. But Chinese Whispers aren't perfect. And everybody knows that they are not.


  1. Your very last sentance is of course correct. But it implies there is a better moral authority, which there isn't. In fact there is no moral aauthority as each individual dictates their own moral authority.

    What markets do is put a current price on each individuals perspective of the world, but only at this very moment in time.

    It might be wrong to bail out banks (and being capitalist I abhore the bail out ides). But if investors believe that their money would be repaid through a bailout they will then buy that bond. After all what is the risk?

    Too big to fail in my opinion has hurt the world's economy more then true capitalism could ever have. And in my opinion lots of these negotiations revolve around bailoputs and how much and who gets them. They are still picking winners and losers instead of letting pure capitalism do it.

  2. No, it doesn't imply that, Goodmongo :).

    Other than that, tea party, occupy wallstreet and almost everybody* agree that bailing out banks is about as bad as it gets. Unfortunately it can still be the lesser evil and that's the problem.

    (*except for lobbyists)

  3. I'm not convinced that bailouts are really the lesser evil. There have been some studies that if the banks weren't bailed out in 2008 the US economy would be in a better position today.

    There might have been a more sever drop and more pain at that time but the recovery would be much stronger.

    It relies on the theory that all bubbles need to deflat. You can pop a bubble getting a massive deflation or let the air out slowly trying for a gentle landing. But the slowly delfating bubble also takes longer to accomplish.

    Unfortunately we don't have simutaneous worlds to experiment with so we'll never know for sure. But it is fair for me to say that these bailouts are not proven to be the best way to handle situations like this.

  4. Actually Goodmongo, we do have simultaneous worlds to look at. Iceland did not bailout their banks and faced unemployment and recession like everyone else but did so to a lesser degree than any other country of comparable size that followed the German plan of austerity now and forever. The recent German plan to impose what is essentially a conservative fiscal government for all EU countries in their own image will ultimately fail. What Germany offers is pain for everyone but themselves.

  5. Icelandic banks could go broke without any other (major) bank going broke. Not saving any banks in the larger economys of this planet, however, would have caused exactly this problem: A chain reaction.

    I sometimes wish all participants of these discussions would first agree that there are no super-simple solutions. ;(

  6. One way to think of the consensus is the rating. Today, I was watching CNBC. Their European reporters were saying that after the failure to achieve anything significant in the recent summit (one quote was the market wanted a bazooka not a peashooter), the bond rating agencies were going to devalue and the French President was downplaying the expected loss of AAA credit rating. Even if you feel that France will be solvent for millennia, the same bond rated AA next week is worse less than when it was rated AAA.

    Currency expectations also drives interest rates. If I have Euros and get paid x% then big investors will buy higher interest foreign (e.g. USA) bonds if the higher rates more than offsets the cost to hedge the currency.

    Another quote about recent strong US bond sales was the US was the cleanest shirt in a pile of dirty laundry.

  7. Nils, I never said no bailouts was a super simple approach. I even said that we won't know which route was the best. In fact that is my whole argument.

    The powers that be in the US said bailouts were the ONLY option and solution. I felt that there were other options. But since we don't yet have time machines we'll never know. And I clearly stated that this was 'my opinion'.

  8. I should have stated more clearly that I was replying to DSJ ;)

  9. I'm with Goodmongo on this one. Resisting the bailout option would be the most severe and painful decision in the short term, but the least painful in the long term. Not to mention, from a capitalist view, it is the "fairest" way to go about things.

    The moral hazard is, in my opinion, the most costly part of the whole bailout fiasco that resulted from the financial crisis. This can't be confirmed until we see how it pans out in the long term of course. The financial industry likes to downplay this fact, but you need to realize they were the ones that had the most to lose from a lack of a bailout. They were also the ones on the phone with the fed and the treasury on a constant basis while the crisis was unraveling.

  10. If I had any kind of decent credit rating at the moment I'd start a bank with myself as CEO.

  11. I've read many articles over the last two days from Uk sources, French sources, German sources and US sources.

    What is clear that the various sides are fighting an all out war in the papers. It is also clear that both sides are staying contradictory things and one or the other has to be misleading us. The problem is I have no clue who that might be, or if some of the points they are making even have any direct bearing to the issue at hand.

  12. Nils,

    The comment I made above was based on the evidence presented by Krugman / Delong and others on the clear trends in the economic data collected after 2008. Bailing out banks or not bailing out banks is not a simple decision but everyone should be clear about one thing. The thing to be clear about is that a cost has to be paid by someone --- in lost time, productivity, profits, and capital to clean up the problems. The debates over bailout or not are covers for a larger issue of who gets to pay? Bailouts are using taxpayer funds to make whole investors who ran their businesses poorly and rewards the bad management that created the crisis within the firms. Right now the US taxpayer is on the line through the FED and Treasury for literally over 1 trillion of what could be bad US housing loan debts. The fast majority of the money hasn't gone into economic recovery but to essentially pad the capital being held by the largest banks in the country for the purpose of keeping them solvent on paper. Not bailing them out would have created a huge problem of a different nature with different costs.

    The fact that this discussion takes place after trillions of dollars have been spent on the bailout simply demonstrates the extent to which political power is largely held by a class of wealth that simply would not allow discussion of any options that would undermine the status quo.

    Who profits by the German plan being put up? Identify who gets to keep what they have and who has to give something up and the reasons for the plan announced become clear. Core countries give up nothing ... The periphery nations give up sovereignty and taxes to pay off debts to foreign banks. What makes that worse is the fact that the structure of the interest rates versus the growth rates guarantee that an entire generation outside Germany will be in debt essentially forever, like a mob/payday loan the rates charged won't ever allow the debts to be paid --- only serviced. Some times you have to clear the books and allow people to declare bankruptcy. It not only punishes the debtor it also has the effect of making creditors far more careful about the loose lending practices that led to this mess. Both side of those loans have to pay a price. I believe the current European plans and US bailouts guarantee only one side takes a hit.

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  14. Goodmongo, drop me a mail if you want to talk to me, k ?