I won’t go into monetary theory in-depth in this post, but the need for a depreciable currency becomes quite evident as Bernstein highlights the suffering caused by severe deflations instilled via high interest rates put in place to attract gold to maintain issued currency gold parity in earlier times.

The late Bernstein had a rich background including roles at the FED during many critical times.  The role that gold plays in the necessary money illusion is highlighted here and Bernstein correctly hints at the requirements for monetary regimes to be as malleable as the metal without fixed ratios in order to minimize deflation based debt crises. The monetary component for maximizing economic growth is to maintain the money illusion with minimal value loss (inflation) and minimal volatility for extended periods.

As a sometimes teacher and perpetual student, I have a great respect for the ability to communicate clearly. The Cartoon Introduction to Economics is fantastic for this. It is like a comic book version of the Dummies Guide to series. The cartoon series of books includes micro and macro economics, statistics , calculus and physics with a clear and clean method. The graphic novel approach forces jargon reduction and clear communication. As an economics geek, I finished this in an hour, but found it a great way to brush up on familiar concepts. It also provided some novel ways of showing and explaining concepts to others.

If knowledge is the light banishing ignorance to darkness, then the Cartoon introduction series shines brightly opening many fields to offer knowledge for people who may be intimidated. I sincerely hope the author and publisher extend this series. As the saying goes, if you think education is expensive, try ignorance.

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The U.S. dollar bestrides the world. Acceptable in every country, fervently desired in most, it is a potent symbol of American economic strength and power. But it was not always so. Indeed, it was less than a hundred years ago that the U.S. Congress established the Federal Reserve Bank, the American equivalent of the Bank of England or European Central Bank.

For most of America’s history  from the English colonies established on the seaboard fringe of the continent over four hundred years ago to the early twentieth century, a wide and at times bizarre range of different types of money circulated within the United States itself. The monopoly of the dollar there is a comparatively recent event. The U.S. republic was established in 1783, but as late as the mid-nineteenth century, a tremendous array of different types of money circulated in America, with states and banks being free to issue their own notes. As late as 1860, there were some 9,000 different kinds of privately issued dollar bills circulating, around a third of which were counterfeit. On no less than six occasions in the first half of the nineteenth century, Congress passed acts allowing foreign coins-French, Spanish, British to circulate as legal tender.

Two attempts to establish a U.S. central bank, of the kind with which we are all now familiar, failed. Prosaically called the First and Second Banks of the United States, both had short lives, which ended by 1840. America then waited until 1907 (sic 1913) before the Federal Reserve Bank, with us today, was established.

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I just finished reading Paul Volcker and Toyoo Gyohten’s 1992 book, Changing Fortunes which gives first hand accounts of US and Japanese monetary policy with the regime ups and downs from the post World War II era to 1991.  The book is based on a series of lectures and reads like a long narrative.  The amazing thing one finds while reading it is how capricious seeming policy can be.

The appendix provides a chronology of events. The 1973 OPEC price shock can truly be called a Black Swan. The events unfold in 1973 in the following way: (from the book)

1973: Oct 6. Yom Kippur war

1973: Oct 16. OPEC raises the price of crude oil 70% from $3.01/bbl to $5.12/bbl. [my comment (The equivelant in late sept 2012 would be going from $92.06/bbl to $156.50/bbl.)]

1973: Oct 20. OPEC imposes an oil emabargo on the United States, and later the Netherlands. Oil companies shuffle shipments to ensure steady supplies.

1973: Nov. 12. Central bank governors, meeting in Basel, terminate the two-tier gold agreement.

1973: Dec. 23. The oil price is raised again, nearly quadrupling from its level of early October, to $11.65 a barrel. [my comment (The equivelant from late sep 2012 base would be a Dec. price of $356.07]

Now that is sticker shock. Amazingly US inflation using govt. CPI figures reported increases of only 8.86% in 1973, 12.09% in 1974 and 7.05% in 1975. GDP is reported to have only fallen 3.9% during the recession.

And for fun here is Nixon in 1971 spinning the dollars decline and blaming”international money speculators” instead of poor fiscal policy while jumping off the gold standard. Reading Volcker’s book is a great inside lesson about the machine.

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Perrow’s understanding of tight coupling, contingency, complexity and hidden paths in systems is top notch. He uses real world examples to bring these concepts to life.  One thesis posited by the paper is that as small systems integrate and become tightly coupled they form a larger discrete system which becomes prone to collapse and catastrophe than the original smaller isolated systems. Integration of this type in pursuit of economic efficiency, power and influence leads to the ultimate collapse of a large system.

The implicit argument is that decentralized (federated/discrete) systems are longer term stable and resilient than monolithic systems.  Historical and contemporary study of overly centralized homogenous governments, banking and social systems tightly coupled acting in unison provide numerous examples of this critical failure thesis.

My personal concern is the global unified banking risk system known as Basel 3.

Here is a paper Perrow posted many years ago. Some other of his papers can be found here.

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So lets pull a Charlie munger and think about the 2nd order effects of the entrants attracted to a hot product space. In a Lottery hot sector many firms are competing for the big fast growing market prize. Often times, each firm is priced to take it all. The result can be disaster as the hot sector matures and competition erodes the margins of even the fully grown survivors.

PV solar cells are an example of this effect. Each potential winning company originally competed with a $/watt product edge. They then discovered their edge usurped, margins crushed and threat of encroaching technologies still present even at large scales after years of growth.  PV solar firms were a classic case of one-trick innovations in a mostly commmodity market. Customers needed the cheapest $/watt and as long as the technology was robust didn’t differntiate between businesses.  The best manufacturer with a 10 year history was only as good as the ideas coming out of some garage or university yesterday.

Innovation is deeper than product alone, it is a profound process. Quantified research from The Doblin group, shows that innovation covers 10 seperate categories and that sustained margins are held by dominating as many capability categories uniquely as possible. Today’s great new mouse trap isn’t necessarily a business, its just a product innovation capability for some guy to riff on tomorrow. I know. I used to manage 70 science PhDs in Europe’s answer to the MIT media lab innovating in every field of science you can name.

The human desire to make it big fast often leads to disaster. I know this as well through painful personal experience as a software entrepreneur/ founder.  This innate human pattern of betting for the big payoff can be seen in studying pari-mutual horse racing odds and outcomes.  Where long shot bets are placed mostly for emotional kicks more than actual gains.  The insightful blog CSinvesting posted this article on the issue (see middle of post).

I have redacted a few graphics to give a visual summary of the paper by Eric Snowberg and Justin Wolfers.  The data shows the long-shot betting bias over 6.5million horse races. Betting the long shot is just a way to lose faster.

And for the international set, here is 50 years of data. Human nature isn’t changing any time soon.

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Bret Victor – Inventing on Principle from CUSEC on Vimeo.

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If someone can tie biology and constructal theory into the Fiegenbaum constant, that would totally rock.  It would be a nice systems theory for biology and evolutionary process. Most likely it could be incorporated with an entropy and dissipation model factor model.  Biology could become like a fuzzy form of physics both some homestatic and homeorhetic fuzzy boundaries and trajectories. Sweet!

If you dig this video, check out West’s TED talk. He definitely has a lucky “talk” shirt which serves him well in both presentations.

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This is a great document using the correct language of degraded performance, cascading failure and resiliance.  It is worth the read and highly educational.  Copyright warning, I have posted this is scribd, hoping it gets a larger audience. It is the work of Feasta.

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An excellent introduction to tight coupling, feedback and systems.  The piece also includes normal accidents, safety systems leading to normalized risk and hidden paths in systems that induce risk.

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Seth Klarman manages an estimated $23 billion for his hedge fund Buapost group. He has an excellent sense of risk and an ability to convey his thoughts. Here is an excerpt:

Nowhere does it say that investors should strive to make every last dollar of potential profit; consideration of risk must never take a backseat to return. Conservative positioning entering a crisis is crucial: it enables one to maintain long-term oriented, clear thinking, and to focus on new opportunities while others are distracted or even forced to sell. Portfolio hedges must be in place before a crisis hits. One cannot reliably or affordably increase or replace hedges that are rolling off during a financial crisis.

Risk is not inherent in an investment; it is always relative to the price paid. Uncertainty is not the same as risk. Indeed, when great uncertainty – such as in the fall of 2008 – drives securities prices to especially low levels, they often become less risky investments.

Do not trust financial market risk models. Reality is always too complex to be accurately modeled. Attention to risk must be a 24/7/365 obsession, with people – not computers – assessing and reassessing the risk environment in real time. Despite the predilection of some analysts to model the financial markets using sophisticated mathematics, the markets are governed by behavioral science, not physical science.

Full text with all 20 lessons is available here at the top notch blog, Farnam Street.

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With corporate balance sheets groaning with cash and liquidity appearing to have returned, the question remains; what next? Low rates and massive balance sheets for the next few years, or try to deflate central bank balance sheets.  Current interest rate levels and swollen balance sheets indicate central banks believe the crisis to be far from over. Or, perhaps like Japan the dominance of  central banks in the debt markets is now fashionable. It all feels quite uncomfortable and the Spanish party hasn’t even started yet.

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The more interesting graph is the one below.  It is a 60 month rolling annualized return alpha calculated by taking the last 60 months of hedge fund returns and subtracting the S&P 500 returns. This shows an annualized alpha experienced on a rolling 5 year period.  From the hedge fund index perspective it seems L/S hedge fund alpha has a negative trend and is due to hit zero by about 2019.

Now hedge fund alpha isn’t really running out, the more likely story is that over the last decade more and more managers having been piling into hedge funds recognizing them firstly as a great compensation class and then selling them to others as an asset class. The alpha hasn’t disappeared, but the number of the participants without alpha generating skill has likely grown so much as to mask the real alpha making it difficult to find the signal amongst the noise of the 2/20 crowd.

Generating long term positive returns means applying a stable allocation process over time and possessing a deep understanding of the source of value from that process. If you run a fund and want a good analyst or portfolio manager call this guy He has delivered 1,000 bps of alpha each year since starting out in 2007 without a down year and is looking for a place to put his analytical and portfolio management skills to work. Columbia University Press is publishing his book The Nature of Value later this year.

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The drawdown tool only makes sense with an ever increasing time series.  Quantitative analysts use volatility to express risk, but many decisions are made based on perceptions. Drawdown is a good way of understanding those perceptions and the patience that may be required with paper loss experience. Being a value investor helps some people to ignore price fluctuations while they focus on intrinsic value.

Plotting a drawdown series is also a good way to understand what holding an asset may feel like. 20 years can seem like a long time to get up to break even. The graph below doesn’t include dividend payments or the impacts of inflation on purchasing power of the asset.

The graph below is taken from a full article available on Seeking alpha entitled The trillion dollar trading system 1871-2011.

S&P 500 peak to trough drawdown 1871 to 2011

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“If you want to build a ship, don’t drum up people together to collect wood and don’t assign them to tasks and work, but rather teach them to long for the endless immensity of the sea.” 

Antoine de Saint-Exupery (1900-1944)

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Great video and highly entertaining ht:Paul Kedrosky. The phase space of nature is open ended which means we are part of unknown and mysterious unfolding. Enjoy the ride.

NECSI & MIT/ESD Seminar: Stuart Kauffman on “The End of a Physics Worldview: Heraclitus and the Watershed of Life” from NECSI on Vimeo.

My upcoming book will use some metaphors from ecology and adaptive systems to explain the basics of applied value investing. If anyone has special requests or areas of interest they would like to see in the book, put them in now.

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I jazzed up the model a bit to make it widgetier to play with and understand.  Just used a few cheap design tricks. I make no claims as to the integrity of the data or calculations. Caveat emptor folks as we say in Iowa don’t bet your farm on this. It is a 10 minute derivative work from the original DIY spread sheet with simple scrollbars for key variables and some charts.  Reuters has a more robust version here.

Here is an Excel Download in XLSX format. The DIY European Bank Stress Test V 2.0

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Credit is a function of the cost of money and one’s faith in the future return of that money. Credit like money is ultimately a social belief system. In 2008 the global credit market effectively had a heart attack.  The Federal reserve brought it back to life with cheaper money (low rates), trillions in swap lines and lending facilities. This was effectively like taking the paddles out and jump starting the stopped global economic heart.

The difference between an acute crisis and chronic process.

We experience the world one day at a time and for many one headline at a time.  These headlines often describe acute events or turning points.  The credit meltdown was one such event. The more important economic and political factors are chronic or process in nature. Like paint drying or a forest growing they unfold over time slowly avoiding the daily headlines that would lead to awareness of their potential impacts. These processes are right in front of us, but their slow steady monotonous motion blinds us to their potential impacts for increasing the risks of an acute crisis.

Below is the monetary base of the US showing deposits and currency in circulation.  This is near money. It is short term. You can see how the fed expanded near money since 2008 hoping that by making it more easily available things would get better. The hope was that after first saving the patient’s Lehman liquidity collapse (heart attack) the money multiplier effect would work its magic and keep the credit creation process alive and pumping.  By making near money available and cheap it was hoped far away longer term broad money would be created by the credit market.

Unfortunately it didn’t quite work out like that.  Here is the TCMDO(Total Credit Market Debt Owed) which shows all of the credit in the system including broad money.

The important factor is measuring the effectiveness of FED policy as an economic/credit stimulus is how TCMDO responds as a multiplier of interest rate policy adjustments and expansion of the monetary base.

This last graph shows that the FED is pushing on a string.

The credit market is shrinking as de-leveraging takes over and the FED’s attempts at expanding the credit market become less effective.  Less credit means, less throughput and declines in consumption etc. A central bank is merely a sometimes hand maiden for Credit creation/destruction. Ultimately credit is a free market function. When people don’t perceive opportunity or view themselves as over leveraged they stop lending / borrowing.

Each dollar of base money is stimulating less credit.

If one believes that credit expansion is required to reflate the economy and if one believes credit is generated by expanding the FED balance sheet then whatever expansion plans using multiplier of X in 2008 are likely to use a multiplier of perhaps 2X now. The danger is the likely call for a QE3 that can be justified in the trillions of dollars, the rationalization will be a cheapening of the dollar to help debt holders and domestic exporters while expanding credit supply via an expanded narrow money base.  The other side of the policy coin is of course is fiscal stimulus whereby the govt. spends money on creating economic activities, this is more akin to economic mouth to mouth resuscitation. A likely outcome will be a mix of fiscal and monetary policy over the next 3 years involving increases in federal debt which are purchased largely by the FED.

I am not advocating either policy, but rather suggesting likely outcomes based on historical precedents of fiscal policy and FED behavior. Neither of these actions is good for the dollar as a store of value, but the impacts of de-leveraging, declining GDP and subsequent deflation may give them appeal to many.

Source data is here:

Federal reserve St. Louis Adjusted Monetary Base (BASE)

Federal reserve St. louis Total Credit Market Debt Owed (TCMDO)

Ratio of debt to monetary base .XLS

All work above is property of Thoughtful Capital Group.

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