Sunday, December 18, 2011

Europe - no disasters in the waiting but little hope after that!

There are two parts to the Europe question.
1. Will the Euro survive?
2. What happens to Europe in the medium term in case it does?
The caveat in the second question is because it is terribly difficult to predict what happens to Europe if Euro does not survive. Predictions range to as much as 25% loss of output across Europe.

To me, the first question seems moot, especially in the light of the rather widely known fallout of Euro's failure and the fact that the near term survival of Euro is actually pretty much on tap for the policymakers in Berlin, Paris and Frankfurt (where ECB is based out of). I believe that contrary to popular belief and most scenarios of doomsday, Euro as a currency is far from failure. Sure it is under threat and is beseiged from many sides. However, for Euro to fail, Germany and France will have to lose market access or the cost of saving Euro in terms of bailouts has to go way beyond their current and future bond market-funded balance sheets. Either of these is remote scenario.

What is Germany upto really? Angela Merkel has been painted black and grey and white in the last few weeks by analysts around the world. But what the Germans are really trying to get out of the rest of the Eurozone is actually a commitment to lead fiscal lives similar to Germany's. This in turn is based on a more productive workforce, longer hours, higher retirement age, less state doles and so on. In the bargain the peripheral countries get to enjoy being part of the Euro - certainly a privilege in the times of crisis. Italy would have lost market access long back had it not been for its currency i.e. Euro. Of course one can argue that it might not have been lent to as much as it has been if it had not been for the Euro. Very true. Precisely the sort of thing that Germans want to avoid in future. They seem to have correctly concluded that bond market investors are not as well informed and choosy as they are made out to be. They will lend to seemingly sound but actually bad credit in much the same way American banks lent to sub-prime individual borrowers. Greece was a major case in point for this. Post facto, it seems ridiculous that anyone lent to Greece - Euro-denominated bonds or otherwise! Presumably everyone was counting on the rescue or explicit underwriting by Germany and France - which was never really there and which never happened when the time came. Having seen the inability of bond investors to rein in fiscally imprudent countries, Germany has correctly understood that the future of Euro depends on a "no-bailout covenant". And hence, if the suppy of money is going to be there in the lax times (from over-enthusiastic investors), Germany wants the demand curbed at the source - through fiscal deficit limits and gross public debt limits. Prudent if you ask me!

Why do I believe that Euro does not have that much of survival threat? For one, rescue is one round of QE away! Very much as the Americans have been shouting from the rooftops to the Eurozone leaders for a while now. Eurobonds have been talked about enough by now for even an implicit acceptance of the same by Germany to send the bond market investors into risk-on mode! Lastly the leaders of the rest of the peripheral countries seem to be complying with the demands of fiscal prudence - which most realize are in their own interest even if Euro does not survive. Germany and Euro-saving are good outside factors to blame to overcome any internal resistance for most of these countries. Push is unlikely to come to shove and even if it does, a combination of ECB, IMF, EFSF and maybe even the Fed will figure out a good way forward. It is in Germany's interest to keep things muddling through rather than conclude them very positively in a sudden stroke of brilliance. The most that sort of heroism will achieve is massive risk-on trades around the world, positive sentiment all round and in effect loss of another chance for the well managed economies of Eurozone to establish some displine amongst the rest. Since it seems more or less coordinated brinkmanship, the only danger is that of an unforeseen financial accident. In absence of that Eurozone worries will eventually go but probably drag on for another couple of quarters - as the economies sort out the fine print of greater fiscal union and iron out inevitable differences.

Disaster hence is unlikely. That does not mean that the proverbial "aaaal" is well though! The reason Eurozone went into this crisis is fiscal profligacy of its peripheral economies and the loss of confidence amongst bond investors for the debt issued by those countries. The confidence may slowly return to make investors take some cautious bets. However, the fundamental productivity challenges of Euro-area economies will not go away. If anything the battling with the crisis has only diverted the attention of the economic policy makers from them. Last but not the least the unfavorable and worsening-by-the-year demographics of most of European countries is not helping at all in boosting productivity. While Spanish unemployment may come down and Irish banking sector may after all be restored to half decent health and the clouds over most of Europe's banks may go away, the painful process of adjusting to a new economic environment where money is neither cheap nor abundant, governments are not the welfare states they used to be and where everyone is required to work longer and more productively will take its toll on growth. Europe may lose its own decade a la Japan. That is a far bigger disaster - however slowly it bites!

Tuesday, December 06, 2011

Behavioral Economics and Finance - Waking up to reality!!

I had always wanted to read more about behavioural economics and finance but had been putting it off till recently. Owing to some generic stimuli as well as a real potential use in my professional life I have started reading up quite extensively on the topic. This area is indeed like the proverbial rabbit-hole – one does not know how far it can take us and what all it can open up.

An actual account of what behavioural economics is probably for later. Here is a good link to start with. A useful paper covering the background can be found here. A good lecture series - here - is also available on youtube. What is more interesting right away is the potential this domain has for reforming economics as well as finance as we know it. There are many way in which it can do so. I have summarized the following. These are not extensive.

1. There has been an appalling lack of reliance on the use of scientific method in evaluating candidate models and theories in economics. Data is used but it is historical and probably selected with a bias. In fact considering that most theories are designed to explain past observation, it is no achievement that the theory at least partially explains what was observed. It is like in-sample optimization. There is rarely an equivalent of out-of-sample optimization. Unlike theories of physics and chemistry, those of economics do not necessarily pass by predicting things that can then be verified. There are of course many reasons for that – most important being the inability to recreate precise conditions of testing theory. But there is no serious attempt to work around this limitation.

The results are obvious. Many theories are worshipped in the face of consistent contradictory evidence against them – efficient market hypothesis being the commonest example. Behavioral school of thought starts from the actual nature of human beings and then goes to construct its theories. This is not fool-proof nor does it have a certainty of producing results. But at least in the spirit of common sense as well as robust scientific process it seems like a good idea!

2. Rational economic agent is a foolish concept. It is probably the worst part of the theoretical foundations of the neoclassical economics and modern finance. The metanarrative of the REA is one where there is perfect and symmetric knowledge, no emotional interference from the actors’ minds, perfect coherence between the mathematically right answer and the appealing-to-real-human answer. The attempt is laudable to explain human choices. However, it is fundamentally wrong in so many of its assumptions that it explains almost nothing relevant and predicts even less. The most damaging characteristic of the metanarrative however is its treatment of what is not within its purview. When human beings do not follow the predictions of the REA school of thought, it is termed “irrational”, “inefficient” and some such term. This treatment itself smacks of a rather narrow thinking process which is quite dogmatic and terms everything outside of it (almost the whole real world) as some sort of anomaly. There is some intellectual hubris here. More damagingly, there is a naïve hope that the “anomalies” only await some refinement of theory and can then be “explained away” while preserving the grand narrative of the rational economic agent!

3. Considering the complex nature of macroeconomics and the problem it deals with there is a serious lack of multi-disciplinary approach. Sociology and psychology have a lot to teach economics in terms of the behaviour of its key decision makers. Physics has a lot to teach in terms of experimental method as well as some models of collective behaviour.

All in all, post the recent crises through last couple of decades, economics as a discipline is anyway due for an overhaul. Being able to predict bubbles, having the ability to explain the complex interactions amongst global consumers, producers, investors and investees and in general creating a coherent thinking framework which does not keep relying on the proverbial “other hand” of the economist is certainly the need of the hour.

Sunday, November 27, 2011

Redefining volatility

Volatility should be redefined to actually reflect the evaluation by clients. Just because something has higher variance does not mean that it is at once worse than something else which is steadier. Also there is no directly observable relationship between variance of returns and expectations of returns by clients.
Real clients in real world look at risk very differently. A measure like standard deviation hence does not quite do the job well. Also sharpe ratio based on this definition of volatility is thus too flawed.

I dont know the right answer just yet. Nevertheless, in a bid to get there, let us start with some simple questions. What do investors really look at while defining risk?
- loss of capital (there is special value loss in losing part of capital; 110 going to 105 is not the same as 100 going to 95); maybe drawdown captures this in a generic sense
- horizon is relevant: investors look at their investments every so often - monthly or daily or quarterly or annually or on every publication of nav. It is the variance in this horizon that is most important. High daily variance coupled with steady monthly returns hence might not be so bad for investors reviewing their portfolio every month.
- downside variance is more important than upside variance. Seeing value fluctuate to go down is worse. If assets appreciate it matters less whether they appreciate with high variance or low variance.

Some other observations can also be added to this. Volatility as a representative of risk then needs to be redefined to include the impact of above parameters. The idea is to match what we call risky in a mathematical sense and what investors perceive as being risky. That then might be useful in creating really client centric products.

Wednesday, November 23, 2011

My recent presentation at the Terrapinn conference on ETFs

I recently presented at the Terrapinn conference on exchange traded funds. I spoke on the relevance of these funds for investors and the core and satellite approach to using them.

I will post the contents and presentation soon.
Here is a link to the terrapinn website.

Saturday, November 19, 2011

My presentation at The Economist conference

Recently i presented at a conference organized by The Economist on theme Ideas for Asia's Century. My essay was based on the idea to pre-empt a possible war in asia as it grapples with geopolitical rivalry in the absence of an asia based international forum like the UN.

This is the link to the content on the website of The Economist (go to the tab the next big idea)
The video is also available here.
(on the right hand side there is a link under the title "the next big idea finalists"

Monday, October 24, 2011

The mighty tide of demography

The recent issue of economist (india inc) has a very important article - we are 7 billion now. Amongst some useful inisights on how we are nowhere close to the proverbial population doom, it highlights a very important trend in terms of demography in the current world.
The rich countries are aging fast but they are rich. China on the other hand has a race with time on its hands. It needs to grow rich enough benfore it ages to an order similar to that of the richer countries. Interestingly india ad sub saharan africa are aging much less speedily than china and will be quite young as a population even in 2050 while china would have reached the average age of the rich world by then. This means the vigor of economic growth may last longer in these regions than in china if they get their act together in governance and avoidance of civil wars.
I dont know about sub saharan africa but for india it is comforting to know that it has a fair shot at prosperity of the sort enjoyed in today's rich world. China is less lucky in this matter owing to its current age profile and also sex ratio. How did this happen? Simple answer is - effectiveness of its one child policy. That policy worked quite well when launched and is now coming back to hurt china.
I look back at india's own obsession with population control in the 80s (the forced sterilizations in the indir gandhi era being a case in point). Two good things about india's push for the population control were its focus on two children as against one and its democracy which avoided a very tight implementation of the initiative. Over time most parents acted smart enough anyway and had only two children. Of my three siblings two have two children each and one has one. Of all my cousins only two (out of 20) have more than two childern. All my uncles had more than 4 children. I guess within a generation much of india moved from having 3 to 5 children as a matter to routine to having 2 and in some cases even 1. This has helped control the population grow rate without creating the worry china has i.e. aging too fast as a society.

What india makes of this demographic dividend is of course another question but having the strong tailwind of demography when the society embarks on its quest for prosperity sure does help!!


Sunday, October 02, 2011

Metanarratives - what do I make of them?

I have been reading some stuff on the meta-narrative lately. Had read the “postmodernism - a short introduction” sometime back with rather patchy takeaways. Couple of good things that did come out of that though were this slowly dawning understanding of the metanarrative and the postmodern condition for one and purchase and reading of “History of the World in 10 ½ Chapters” for two.

I have always been aware of the concept of metanarrative – though with other names. In short it is the big story – story behind all stories – in a given ideology, way of thinking, value system etc. Capitalism, Christianity, Gay Rights Movement, Portfolio theory, Evolution are all examples of metanarratives. A metanarrative need not be internally consistent or logical. It needs to be credulous and believable by human beings. Hence many seriously followed cults are metanarratives – however questionable their premises and practices might be for the average thinking person.

Why are metanarratives important? Primarily to understand the biases or thought processes of those using them. In fact the leading philosopher of postmodernism Jean-François Lyotard defined postmodernism as incredulity to all metanarratives. The book I read on postmodernism is also quite explicit in its suspicion of all grand theories. The general thought process (another metanarrative?!) of the postmodern proposal is that anything which has an overarching ideology, value system and thought process is already inconsistent with reality, freedom and individuality (all three of these are distinctly relevant and non-trivial claims.) If we are to believe the postmodern proposal, any metanarrative will introduce (sometimes obvious and sometimes deep-rooted and subtle but powerful) biases in one’s thinking – thus taking away personal freedom as also compromising on a fair/true representation of reality.

I believe this to be half true. However, considering the distance we have gone in oversimplifying things and over-generalizing the world, the emphasis on incredulity of the meta-narrative might be a welcome respite. But let us leave the timing and “intellectual marketability” of the proposal for a while and focus on whether it truly says something accurate.

I had written another blog on the human obsession with easy generalities. I had inadvertently touched upon the possible human trait to create/follow meta-narratives. In opposing meta-narrative we might be trying to transcend our limited human cognitive toolkit by merely wishful thinking. In other words, it might be that we are limited in our mental faculties in a way that makes us long for meta-narratives. If so, merely declaring incredulity towards meta-narratives follows the same path that theories of justice, peace, equality and universal empowerment take. The path of utopian and ignorant modelling of human beings – leading one to think that what seems “good” and “right” automatically also becomes “feasible” and better still “optimal”.

Why do I say that? It is because I have a fundamental belief in what Neils Bohr referred to as the limitation of human mind. I believe that our minds are shaped by various forces of nature – and are by brute force of evolution, optimized for thinking in a certain way. This way did not involve abstraction of the sort that calls for the ambiguous construct of justice, being right and so on. On the other hand, what we think is likely to be best for us or someone else need not be an accurate prediction either. Combine these two and one is likely to feel rather worried about creating any master narrative – but unfortunately including that of calling master narratives incorrect.

So, I share the incredulity of postmodernism about most meta-narratives. However, I am keen to explore if I could use them as models of reality which help me organize my life. Insofar as the “absolute” truth is anyway off-limits for me, I might as well start making some sense of life around me to get ahead. If I take the models to be what they are and avoid falling in love with them (a big if admittedly) I could hope to navigate the world a little better than starting from scratch at all points of time.

Or is this oversimplification? Is this obsession with navigating life with the help of models (loved and obsessed on or caveated and unloved) a limitation of my mind that I can work to overcome and I am giving up the chance of? If I abandon all meta-narratives, can I still continue living and achieve another level of being – which does not require such modelling? Will that open some other dimension of understanding of the world to me? Or is it meant more to be a more fulfilling life? Or is it meant to be a more intellectually-at-peace-with-oneself-but-forever-disturbed-otherwise sort of life?

Whatever I may choose on the personal front, the society that I am a part of will have its own plan (or a collective outcome of individual choices which might be simplified as the society’s plan!) In here being suspicious of meta-narratives is probably a much better attitude on the balance. Meta-narratives are seductive – owing to their simplicity and ability to make sense of the world. A common person feels lost in absence of these. In fact meta-narratives can be thought to be the mass-produced versions of abstract philosophies. With all due respect to everyone, that is probably all the abstraction that most human being can handle (or more probably – want to handle!) It is almost like getting the big thinking out of the way by subscribing to a ready-to-go, credulous and locally optimized construct of the meta-narrative on offer (and focusing on earning livelihood, having sex and drinking beer).

That of course does leave the individuals rather vulnerable to vested interests and power structures. In the era of mass media this danger is even more acute. As it turns out the vested interests themselves are not quite almighty and in charge of creation and perpetration of the meta-narratives (in general; however, notable and rare exceptions exist). However the awareness of the malleability of the society’s mood in light of the meta-narrative gives these elements the ability to construct their convenient versions of truth – sometimes going all the way to manufacture them. Noam Chomsky’s "Manufacturing of Consent" is probably a similar realization.

Sunday, September 25, 2011

In Praise of Quantitative Easing!

Is quantitative easing the right solution to the problems presently plaguing US and Europe? Are the central banks recreating the loose monetary policies that in part led to the crisis in the first place? What role does monetary policy play in economic growth anyway? Is there a lesson we should learn in India from this?

Before I attempt answering these questions, I must briefly state a story I had read long back about a village where a general sense of gloom is pervading everyone and there is general despondency and pessimism among the villagers. The farmers, the bakers, the wood-cutter and all the rest of them go about their daily work with reluctance and eke out a rather modest living - always wishing they could have more.
One fine day a gentleman from a far off place visits the village goldsmith and tells him that he would like a very beautiful necklace made - for a rather princely sum. The goldsmith agrees and tells the fellow that he can make this masterpiece in a couple of months. The gentleman agrees to return after two months. The goldsmith is rather amazed at his fortune and decides to celebrate by finally ordering that new cart he had been dreaming about all this while. Thus he in turn visits the cart-maker and places an order for the cart. The cart-maker is in turn becomes quite happy with the turn of events and suggests to his wife that they put their presumably bright daughter for private tuition with the maths teacher. The maths teacher decides to stock more grain for her son's wedding and the farmer in turn..... and so on. In the next couple of months, the village is abuzz with a lot of activity and everyone seems to be happier - and most notably, better off!
Unfortunately the gentleman who ordered the necklace perishes in a ghastly accident (the original story did not mention the ghastly accident, I have added it for appealing to the sensationalist within us!!). He thus is not able to collect the necklace nor pay for it. As it turns out though, the village is now quite well-off even without this dosage of income. The goldsmith has other orders to attend and so does everyone.

The above story is an oversimplification but it does carry a very important and powerful message. As much as the economic activity is a function of size and productivity of various resources (capital, labour, land and entrepreneurship) in an economy, in shorter terms, it depends in large measures upon the confidence of various market participants. This can work to everyone's detriment (as it did in the village of earlier) or benefit (as in the village later on). Unlike other market determined inputs, this factor is largely psychological and built on expectations, fears, aspirations and such fuzzy stuff. Hence as much as the purists may hate to bring about subjectivity in their analysis, an economy (especially in turbulence) cannot be properly assessed without these factors.

This is partly what the central banks in the developed world are trying to do. The great depression was in part owing to genuine economic slowdown but was significantly exacerbated due to spiraling effect of the vicious cycle of lower confidence, lower investments, more employment, lower consumption and further lowering of confidence. Ultra-loose monetary policies and massive fiscal stimuli (never thought I would use plural of stimulus in economics!!) of today in the advanced economies are intended to break this vicious circle. In fact the biggest mistake of the then administration during the great depression was a premature belt-tightening by the government - which further depressed economic activity. Japan followed a similar course through its lost decade when it tried to maintain low fiscal deficits in the face of falling economic growth. Unfortunately the political deadlock in the US may force a similar move there as well - though the first dose of fiscal stimulus and still persisting loose monetary policies seem to have successfully averted a depression.

Whats the downside to quantitative easing? To answer that we should revisit the nature of paper currencies and what happens when a central bank prints money recklessly. One can read up on hyperinflation - Poland, Brazil, Zimbabwe all suffered from it in recent decades. Then how is it that US is not seeing any of this?

The answer lies in size and status. All the countries that suffered hyperinflation were trying to print money when the market for their bonds was non-existent (at least outside the home country). There is no use printing money if nobody is going to value it. Another vicious circle can strike such economies when outsiders refuse to convert the currency at any rate and eventually the country simply loses access to outside world - financially speaking. That is clearly not likely to happen to US or the Eurozone. In terms of status, the US occupies a special position as the country that issues the Dollar. That gives it far more leeway in printing more money than a Poland or Brazil.

In summary hence, quantitative easing and loose monetary policy have probably already served their purpose of averting depression. They seemed to have had only partial success though in pump-priming the economies into action through easy credit. That is when the central banking alchemy runs into the genuine problems of indebtedness of the average household and a true lack of the ability to consume as much as they used to till 2007! 

Sunday, September 04, 2011

Stumbling on Happiness - review; and Next Steps

I recently finished reading the book "Stumbling on Happiness" by Daniel Gilbert (psychology prof in Harvard). The title is a little misleading - in that it sounds like a self-help book. In a way it is - but for the very scientific and left-brain sort of reader. In that sense, it might put off a lot of intelligent reader. I thought ten times before buying it myself (but then read a couple of pages to make sure).

The book makes two starting points
1. We feel happy about thinking about the future and controlling our path to future
2. Our happiness is independent of the destination we reach

Of this the first is assumed to be an agreed on hypothesis. The second is explained through the book. The idea is that we don’t know what makes us happy. However we continue to believe that we do. The first of this – that we don’t know what makes us happy is due to the following
1. The limitations of imagination – filling in details in our picture of the future, without us consciously knowing it; and more importantly leaving out details without us consciously knowing it
2. The tendency of human mind to construct the view of the future in the light of the present.
3. The ignorance of human mind of its own strength to rationalize – which makes a person suffer less than expected due to a negative event

The author then goes on to claim with supporting evidence from experiments that human beings are very unlikely to learn from their own experience – since memory is a very unreliable guide to how one “felt” in each event.

The final recommendation from the author’s side then is to rely on the experience of others who are currently in the state that we are expecting to be in future. Adequate explanation is given to deal with the claims of uniqueness of human experience (we are not really that different from each other).

There is a small excursion into why we continue to believe in the eternal truths of more wealth being better and children being a source of joy. This is quite important. The theory of super-replicators in the domain of ideas/beliefs is the same as that of suitable genes in the domain of biological evolution. The simple idea is that false beliefs can last long and grow in societies since these make those societies as a whole stable, prosperous and long lasting. At the individual level though, these beliefs may not be (and often are not) happiness-maximizing.

Next steps?!

In the context of my project of “The Handbook of Happiness”, where does this leave us? A few random lines of thoughts emerge as below
1. Planned happiness seems like an oxymoron after all. A linear program to “get” to happiness is oversimplification and delusive
2. There is one area covered in the book about human beings being prone to inaction rather than action – while still subsequently regretting inaction rather than action. This might then be translated into a bias to action (a la “Yes-Man” the movie) which also ties in well with the chaos view (not a part of this book) of life – one needs to expose oneself to a lot of experiences, some of which might make one happy after all.
3. Can we pre-empt our tendencies mentioned above? Or are they given? If we can pre-empt these, we can get a decent handle on our expectations of future happiness (or the lack thereof)
4. Can we optimize our pursuit of money and its uses such that the happiness is maximized?
5. The book still does not talk about chronic happiness – call it contentedness or state of bliss or so on. It is mostly about happiness from an activity limited in space and time. How does one translate that into planning a career or place of stay and other such long term decisions?
6. Is there not a separate line of enquiry into avoiding the traps of where we spend our energies? i.e. we do not actually always pursue happiness. Every now and then we are caught up in firefighting, dealing with jealousy, politics and so on. For some, these become protracted pursuits – often overshadowing the pursuit of happiness. These traps may also be self-perpetrating and hence difficult to get out of. It might sound too simplistic – but can one do a energy-spent audit every so often and thus find out if one is really consciously choosing to spend energy on some pursuits or it is happening through inertia (of motion in this case as against rest).

I have a bit of a confession to make here: every time I take up the thought of studying this in some detail, I come up against the following “retorts” from myself
- this is pointless; one can’t really plan such effervescent thing as happiness.
- this is all for well-off people with enough food, shelter and freedom, what about the large multitude of human beings which struggles to make ends meet?

However, I must reply to myself regarding the first above that while a grand program to be forever happy is a delusion, thought-through handling of the subject is not. It’s a bit like practicing for a race even when one has the talent/strength. One can’t produce a winner through practice alone but given everything else similar, the one that practices with more plan and thought has higher chance of winning. Hence while someone else may be happier without going through all the thinking through; the process of thinking constructively about better organizing our lives to orient them towards happiness can’t possibly harm us.
As regards the second point, it is really driven by the need to be politically correct (in my own eyes). While one should seek to make the poorer lot better, that is no reason one should not actively think about how to better organize well-provided-for lives for making them happier. It is almost like creating two different “offerings” for two different socio-economic classes. As long as this does not make the poor poorer still, it is harmless from their point of view. In fact, a few decades hence when the poor are middle class they might look up to the higher-ups in the socio-economic ladder for ideas on how to best use their new-found economic freedom!

Onwards then!!!

Sunday, August 28, 2011

Modern Global Economy - Wither currencies?

Very few realize the depth of the changes Nixon brought about in 1971 when he depegged dollar from gold thus creating the modern currency markets as we know them. One of the most profound change was the paperization of currencies. This one move made all currencies into paper currencies - delinking them from any hard/real asset and thus allowing central banks everywhere to choose to print money at will!
In theory this was a good thing. (and no, I am far from an enthusiast of gold standard, this is not about that anyway). This allowed countries much higher degree of flexibility in managing their fiscal, monetary and economic  policies. In practice though, the world very quickly witnesses several cases of hyperinflation including Poland, Russia, Zimbabwe, Brazil and so on. Part of this was because the central banks of these countries sort of ignored the linkage of inflation with printing money (and thus money supply).

Till date though, it was thought that the currency systems after the abovementioned demise of Bretton-Woods-II was largely a positive thing - especially for the governments whose central banks were more responsible about printing money. The recent fall-out of the 2008 crisis however raises serious doubts about this.

There are three major contributions of the present currency system to the development, deepening and furtherance of the crisis.
1. Status of Dollar as a global currency - despite the freedom that the US central bank has in printing money
2. Manipulation of Yuan by China and their respective currencies by the East Asian governments to promote exports at the cost of domestic demand - thus creating long lasting global economic imbalances
3. Emergence of Euro - a monetary union which works in good times but complicates life significantly during bad ones.

I have detailed the first two in my book. The funny thing about the present currency system is that the fiscal and monetary policy independence enjoyed by individual countries is not entirely reflected in the interlinkages of their respective currencies with each other. The presence of central banks of all the leading governments - as active players in bond and currency markets globally - makes the matters even more complex. These are no more simply rational economic agents trying to maximize their risk adjusted returns - their behavior is far more complex and hence lends itself to rounds of second, third and higher order guessing by other market participants! (Imagine the recent anticipation ahead of Ben Bernanke's address at Jackson Hole!)

For a moment if we were allowed the "flight of rationalistic fancy", what would we wish for as regards global monetary system?

Tough question. I would think of a global currency backed by reserves held by all major economies with a central authority - in the form of guarantees or claims on hard assets. This currency to have tooth will also need some compulsory use in global trade - almost like a quote each country has to finish before starting to use any other currency for trade. This is half-return to gold standard. Half in the sense that there is no gold backing any one currency. However, the relative values of different currencies are not entirely in the hands of the respective central banks! That might solve the problem of uncoordinated monetary policy pushing the world into worse state every day. This needs more work! 

Thursday, August 18, 2011

The Anomaly of US Credit Rating Downgrade!

The credit rating downgrade of US Govt. seemed like an exercise in signalling alone. In fact funnily enough the flight of safety that will ensue thus will push up the prices of US treasuries thus reducing the yields on them. Hence the US treasuries would probably become the first security ever to increase in value after a credit rating downgrade!!
That of course is only half the story. The price of a security is mostly about its economic value. However, there are some overlays such as liquidity, special currency status and home country bias that may produce a fundamentally opposite outcome to that on account of inherent economic value alone. This is indeed the case with US Govt debt. Owing to the special status of dollar as the global currency, the unmatched depth and liquidity of the US Treasury bond market and the fact that US in indeed the home to a large proportion of global investors, the treasuries can indeed rally despite (and in fact because of) the credit rating downgrade!

Where do we go from here? Will the US go into long-lasting recession (or even depression)? Will the Euro survive? Will China slow down? Will India slow down? Will global inflation lead to continued tight money policy in emerging economies thus leading to a period of anaemic growth even amongst the BRIICS?

Whatever be the ultimate diagnosis and the result thereof, I often think that the worries as well as enthusiasm get played up significantly in our times - thanks largely to media, social networking and the presence of highly liquid markets for assets. While that may sound like a nuisance to some, it also smells like an opportunity - if only one can keep one's head when everyone around is losing theirs!

Sunday, July 17, 2011

The Problem of Induction

I have been reading Fooled by Randomness lately. What got me interested was of course the fact that my newest career choice requires me to pay a lot of attention to the risk of rare events and the fact that much of the book is drawn upon the author's experience as a trader - a valuable guide for my new line of work.

Currently i am reading the section on the problem of induction. In IITB during the course on introduction to philosophy, we were introduced to the Karl Popperian philosophy of falsification and how no theory is true. We used to have a lot of long discussions on this problem in our hostel rooms then (curiously on only thursday nights!) While the business of finishing an MBA (or PGDM as they call it) subsequently and earning livelihood post that put the whole topic of epistemology far at the back in my mind, this book brought it all back with a bang!

If you observe two events occuring back to back several times, can you make a statement of the type
1. This thing Y always happens after that thing X
Even more strongly, can you ever make a statement
2. This thing Y is caused by that thing X
The problem of induction is that we can say neither 1 nor 2. Science is carried out with better and better approximation to the reality "out there" in nature while never claiming either 1 or 2. It does provide us with technology which does help in making our lives more comfortable and less painful. However heart of heart, every scientist knows that s/he will never find THE truth. Every theory is an approximation - an elegant one, a massively accurate one (to the nth decimal) - but is precisely that, an approximation.

As Taleb observes, the practitioners in humanities as well as trading floors do not seem to share that humbleness. Most people in these fields make ludicrous claims of x following y ALWAYS and worse still X CAUSING Y. Curiously, mathematics seems to have made matters a bit worse! Elegant modelling often creates a sense of comfort amongst its creators as well as audience - which is akin to believing that a fortress is safe because its small clay model is butressed with concrete!
Unlike Science the problem with humanities and by extension most of our day to day lives is that of lack of repeatability. We can never really test a hypothesis, we can never rerun an event and no two situations are alike. Hence we are forever doomed to be fooled by randomness. As the victors write history, the lucky few businessmen that survive will have vision pasted onto them post facto and the lucky individuals will talk of their grit, perseverance and fortitude!

I dont know if there is a reliable sum over histories approach possible in the humanities, day to day life, running of businesses and countries. Maybe some of the intellectual energies of our generation need to be redirected towards that rather elusive but potentially paradigm shifting goal!

Sunday, June 19, 2011


No country has the confluence of cultures and religions like Turkey does. Its a country at peace with its own religion but also its place in the world. It is fond of its culture. But it is very forward looking. It is secular but proud to be Muslim. It has wide roads and disciplied traffic but its cities have a lot of life!

I believe that geography defines history in the long term. Nowhere is it as visible as it is in Turkey. The strategies location it had in the ancient as well as medieval times kept it at the global centrestage - initially as the eastern roman empire (Byzantines in Constantinople) and later as Ottoman Empire (Turks with their capital in Istambul - new name for Constantinople). Over time as the centre of action shifted to Western Europe, Turkey became a backwater of sorts econo-politically speaking. However, post World War 1 and its battle for independence from Greeks (after a brief 3-4 year period of occupation) the country broke away from its Arab peers in its orientation. Under the visionary leadership of Mustafa Kemal Ataturk, Turkey embarked on a path of modernization. Like the proverbial two paths of Robert Frost, Turkey could have gone the way of the European countries or the Arab countries. After all, it is slotted right between the balkans and Greece on one side and Syria and Iran-Iraq on the other!!

As Ataturk thought fit, Turkey chose the path of secular growth. Its choice is most obviously visible in the way it chose to shun the Arabic script for Turkish launguage and instead went for the standard Eurpoean letters. In a similar vein, in other walks of life as well, Turkey chose to follow a primarily western model of growth and governance. The rest is History! Today Turkey is attempting to enter EU - however on its own terms.

The country is a great place to visit for its history as well as the beauty of its sites. Istambul, Konya, Ephesus, Troy all have their own character. Istambul is one fifth of Turkey in terms of population - and I guess it might be larger in terms of share of the economy. It was in its heydays the equivalent of today's New York in terms of its relevance to the world. While far lesser today in terms of significance the city does not strike as a yestercentury's city at all. It owns its culture with a lot of pride but has moved on to a modern existance in general. Hence for most parts the city is a nice friendly place to move about in once you are done with the historically significant tourist attractions.

The war memorial at Ankara is quite a magnificent piece of architecture as also representation of history. While it is relatively more recent, the respect it signifies for the heroes of the country makes one thoughtful. Capadokya is a world in itself. A very queer place in terms of its geography, it is beautiful as it is distintive. The cotton terraces at Pamukkale are a case in point! Come Ephesus and one starts to realize the melting pot nature of Turkey as a country. This western side of the country has deep Greek and Roman influence in its architecture and perceptibly in its day to day life today as well. Much of Troy is destroyed. However, as our tour guide told us, if one has good imagination a lot can be experienced in Troy as well. Especially the story of Trojan war!

All in all, 21st Century Turkey is a place which in a way stands testimony to the power of positive governance just as its previous century Avatars stood for the importance of Geography in History!

(I have not written much on the site seeing etc since the purpose of this piece was to summarize my thoughts about Turkey as a country as against Turkey as a vacation destination.)

Sunday, May 08, 2011

The unbearable lack of influence for the Indian Middle Class!

The recent debate about the Lokayuktas goes back to the perennial tension between the movers and shakers and the powerless. A recent article in Business Standard mentioned that the movement by Hazare and the support it gathered came from the middle tier between the influencing few and the utterly powerless mass. Another article sometime ago mentioned a worry that all kudos aside, Hazare's movement represents an extra-constitutional arm-twisting of the elected representatives.
At the heart of it is the worry about the creation and sustainance of institutions to uphold the interests of the majority. Indian democracy is increasingly becoming hostage to smaller and smaller group of very wealthy and mostly unscrupulous politicians. What is more, it is a vicious circle in that this class seems to self-select similar elements in its ongoing inclusions as well. The picture of the hardworking and people-oriented politician is at best a utopian dream. Most of those aspiring to get into politics have no major dreams of chaging anything for people they represent. It is mostly a race for power - which is then to be abused to amass wealth. To what end, one often wonders!!

The issue is that if and when Lokayuktas become powerful enough to take on the vested interests in the society, they will get politicised. They are left alone now because they are toothless. Give them teeth and we will soon see very questionable elements becoming lokayuktas!!

A society gets what it deserves. Indian society is 80% masses, 19.95% middle class and 0.05% ruling lot! The masses and the ruling class seem to have gotten into a seemingly unbreakable system of electing to office the most powerful and wealthy. The middle class has no influence but a fair degree of intelligence and bandwidth to comment to things. Which is pretty much what they end up doing! The angst represented in all the media is the voice of this powerless but intelligent middle class.

What's the way out? For selfish reasons as well as for the betterment of the masses, the middle class and its thinking constituents need a way to influence the polity. But the supertanker argument about the polity would tell us that small nudges will get mostly ignored in the massive structure of the influencers manipulating the masses for their personal agendas.

It almost seems like the Indian freedom struggle, which in 1920s or thereabouts might have looked fairly hopeless! The masses did not care about who ruled them, the few thinking men and women took the struggle to the massive empire. What eventually gave was a combination of the struggle, historical forces acting against the imperialists and the second world war. One does not know how the impasse of potential oligopoly in Indian politics will be broken and how soon!
There is a weak hope of sorts. Often small nudges at the right place and time act as a very strong influencer in the medium term to bring about massive change. The lightly powered middle class can hope to keep giving numerous small nudges some of which post facto might turn out to be pretty decisive. The key word here is post facto!

Tuesday, April 12, 2011

Statistical arbitrage

Lately I have been doing some reading on statistical arbitrage - largely for my work. Several interesting ideas exist in the domain. The practitioners in the advanced markets have explored various aspects of this idea and have in fact implemented a large variety - with varying degree of success. What interested me at a diffent level though was the curious fact that it exists.

It is quite debatable whether statistical arbitrage is arbitrage in the true sense of the term. Most practitioners anyway declare that it is not. Unlike "regular" arbitrage, the returns and success of a trade are not guaranteed. However the idea is that one is looking for an edge - success ratio of 70% will do excellently in most cases!!

Let us assume it exists and the total monies deployed in statistical arbitrage are making returns which cannot be explained by noise or randomness a la Taleb! The very existence of this sort of arbitrage is quite intruiging though. Why does it exist? Pattern theory may have some insights. Behavioral finance may have some ideas to throw at the question too!

My own limited thinking on the matter has reached thus far. It exists because there are not enough market paerticipants chasing it! Unlike the more visible movement in spot markets, the movements in the spreads between different underlings and in some cases even real and synthetic assets is not visible to a screen watcher. If and when sufficient automation spots these opportunities in time and exploits them at the very onset, the easy returns will go away. Something already underway in the developed markets!

Sunday, February 27, 2011

The human obsession for easy generalities

I have often wondered how much the talking heads on CNBC and the experts waxing eloquent on various issues really understand about the full context of what they are talking on. (disclaimer: i don't understand much myself and i am not offering myself to be someone with better understanding of a given topic than some X or some Y. This post is about a more fundamental epistemological issue.)

Lately I have come to realize a few things - which has led me to a general conclusion. The observations first.
1. The devil is always in the details. Generalities sound enticing and are often intellectually quite seductive. E.g. consider the following: "The debt to GDP ratio of India is already 60% (or some similar number) and that of the worst hit economies in the developed world is 105% (or something similar) and hence continued fiscal deficit in India is a sign of slowdown in future growth and crowding out of private investments, worst still it may bring about fiscal crisis of the sort Greece is facing."
The details put a huge question mark on the relevance of this gross oversimplification. For one, debt to GDP is a ratio and in India's case the denominator is increasing (and no, not at 8-9% but at 15-17% since these are nominal number not real). While the numerator also is increasing, the rate of growth is lower and is likely to go down further.
Secondly, the debt to GDP ratio of X or Y is not behind the fiscal ills of the western economies. Translating a ratio that general into an assessment of fiscal health of a country is a tall order.

2. Most often a given generality gets repeated often enough to make majority of the lay people as well as the 'experts' believe in its accuracy. That the crude oil products in India are subsidized is an example of the same. What Indians pay for a litre of petrol is higher than what Americans or most other developed countries' citizens pay. The subsidy then is simply payback from the higher taxes and duties.
If one follows a given generality to its logical end, one would realize that most of these are drawn from a vast array or general statements and ideas stated everyday by hundreds and thousands of sources. Collectively by choice or through active propaganda, some of these get picked up. Truth or accuracy is not the deciding criteria for what gets picked. Its mostly a matter of what the source is, how palatable that statement is and how intellectually or emotionally titilating it is. Through the life of the generality, it grows stronger, weaker or dies depending on the public sentiment and/or active money and energy spent in the propaganda. This life of the generality is also fairly divorced from its degree of truth.
(disclaimer 2: this is not meant to be a cynical view of the world. I am only trying to assess how we as humanity behave. That then may have some learnings of academic interest as well as of interest to those looking to actually do some good for the humanity)

3. The story of the the blind men and the elephant for me is the most profound epistemological allegory. It shows the fundamental limitations of what we claim to be our knowledge of the world. This ties in partly with observation 2 above. Since subconsciously all of us are aware of this limitation of the 'truth', we are (again subconsciously) ok not looking too hard for it if what is presented as truth is entertaining enough, satisfactory enough and not outright ridiculous.
However, at a conscious level we do not seem to be particularly perturbed by this limitation. Most of the conduct of our affairs (especially when dealing with decisions involving large number of self-conscious entities like humans e.g. large company affairs, macroeconomics, investment decisions etc) is carried out as if the blind men are either not blind or they are dealing only with a tree trunk - thus making all their observations and inferences identical and non-contradictory.

Now the general conclusion: this is more of an answer to the following question - if 3 above is true, why do we engage in 2 and routinely ignore 1? Or stated in English - if our knowledge of the world is fundamentally limited, why do we create and sustain quasi-true generalities and almost actively avoid getting into details that might contradict the generalities?
For one, it is simply the mis-match between the amount of information on one hand and the ability in a single human mind to grasp and appreciate it to draw useful general conclusion on the other. There is simply too much stuff known to us at the first level to handle for a single person. Compartmentalization helps, use of computers helps - but only so much. The higher levels of general conclusions cannot be automated and cannot be segregated into smaller tasks or disciplines.
Secondly, the remoteness of the decision and the sheer intractability of the cause-and-effect relationship between one decision and its effects in isolation from everything else make us almost jaded when dealing with our pursuit of truth. There is almost a resignation to the fact the it is all so very complex that even if we knew the exact truth and we acted on the basis of it, the outcome may not be as expected. So why bother?

An interesting aside is one specific tendacy amongst the investors and their asset managers - this bunch is is almost hypersensetive to decision oriented information. Take a look at the variation in the GDP growth of the Indian economy and the variation in its assets markets - be it equity, debt or real estate. The sharp ups and downs in the asset market are significantly exaggerated vis-a-vis the same in the underlying economy which is what these assets are supposed to be based on!
One tends to think that this bunch (which includes me!) is always looking for something to react to. This can be a small downward revision of GDP forecast, some issue of governance in a given company amongst 500 of them and so on. This lot is all the more prone to the above mentioned generalities!

Sunday, February 20, 2011

G20 summit - a very small baby step (of sorts!)

The latest G20 Summit has managed to reach consensus on - hold thy breath - the indicators which will be tracked to measure global economic imbalances! It seems public debt, fiscal deficit, private debt and current account deficit will be used to track the state of imbalance. No points for innovation there! Sarcasm aside, this is a start, however small it might be. Hopefully it would least get the world leaders to start to have some faith in dealing with economic imbalances in a multilateral manner.
As Dominique Strauss Kahn is rightly worried, the belief that the worst has passed in terms of global financial and economic crisis has made many governments too complacent to invest energy into the tedious and circuitous processes and rounds of multilateral efforts to deal with the imbalances. The worry is not alarmist. The shock has passed, the crisis has not. Recovery in emerging economies and reaction of developed economies to a unprecedented stimulus is not a sure sign of long lasting global economic recovery. It is not that things will come to the same scary pass again in a short while. However, one should not see the crisis as a one-off shock which came and went after everyone scrambled together to deal with it. It happened due to some fundamental reasons - including the global economic imbalances - which are not yet fully gone away. The next crisis may not be as severe. It may just sap the vitality of global economy over a decade. That is the scary part. It is not shocking scary, it is just scary when one puts everything down in detail. Unfortunately humanity is not known to respond very well to such subtle - even if highly potent - threats!

Sunday, February 06, 2011

Inflation - some preliminary dissection

Inflation has been spooking everyone - from housewives to prime minister and from retail investors to FIIs. Two numbers have been doing the rounds - the headline (WPI) inflation and the food inflation with the latter taking most of the limelight.

RBI duly increased interest rates in its latest monetary policy - thankfully by only 25 bps. I wonder if it is doing so out of ideological belief or out of the need to be seen doing something. Here's why I wonder so.

Data on the finance ministry website shows the nominal and real growth in three sectors of the economy.
                         Nominal         Real           Inflation
Agriculture             25.4%           4.4%      ~21%
Industry                 15.5%           8.9%        ~6%
Services                 18.7%           9.8%        ~9%

This means that industrial output and services have become costlier by a much more modest 6-9%. Food has been the only source of sustained high inflation. In this scenario, how is interest rate likely to reduce it is difficult to see. It will of course bring about a reduction through further decrease in industry and services inflation. However, I think the agricultural inflation is largely immune to interest rates and will continue to remain stubbornly high unless some other policies work or we get lucky. The sad part of this story is that monetary tightening will end up hurting growth anyway.

What can the policy makers do to contain food inflation in a targeted manner? Tax-sops? Imports? Increasing supply through Food Corporation Stock?

There is a much neglected another angle to this story - full of political implications. High food inflation in turn is income re-distributive - it takes money from rest of the agents in the economy and puts it in the hands of the farmers. I have no value judgment in the matter. It is noteworthy though. And this can be helpful to create a positive sentiment amongst farmers before the near term elections after all.

Sunday, January 02, 2011

Quant, Fundamental or Technical?

Several approaches for generating alpha have been proposed and practiced by investment professionals in equity investment. A book I have been reading has confronted the age-old debate between the proponents of fundamental analysis and technical analysis, and has in fact added a third dimension - quantitative analysis. A very well informed and thought provoking set of ideas I must say!

As per the author, the three approaches focus on three different characteristics of the stock market. The fundamental analysis has depth but is narrow in its coverage, it relies on the ability of human brain to process diverse set of qualitative and quantitative factors simulatenously while still accounting for the effect of the general economic context on stock market performance. The technical analysis relies on the behavioral interplay amongst market participants - reflected in the price movement of various stocks and indices. It has the brevity of parameters - i.e. just the price of the stock over time - and can claim to deal with what ultimately matters - the demand for and supply of each stock in the market, as indicated by the price movement. The quantitative analysis is entirely backward looking, highly scientific and thus replicable and has the advantage of breadth. It can claim to look at the widest set of opportunities since it is not limited by the bandwidth of any one human being.

Is there a winner? I guess not. Investors have made and lost money while investing with each of the three approaches on a standalone basis. Each has some flaws and some advantages.

Fundamental analysis is intellectually appealing at the surface. It directly asks the question - what is the value of a stock and how does it compare with its price. However, as one delves deeper, one realizes that the estimate of value of the stock is as good as the assumptions made in arriving at it. The model can be tweaked in so many different ways to arrive at a given 'value' that the error term in estimation is often larger than the supposed gap between the 'value' and the 'price'.
Technical analysis captures the moods of the decision makers quite accurately. One can claim that whatever be the value of a stock, if the market participants agree on a different level for the price of that stock and stay there, one can never make money using the concept of value. The only way out is to let the story play out over a number of years through which the dividends paid by the company actually make up for the price paid for it as per the value model! That can be over 10 years in most cases. The problem with technical analysis however is that it is oblivious to the factors causing the prices to move. Analysing the chart of any stock price movement can never help one predict an improvement in its margins owing to say a regulatory change. The technical analyst will often be the last one to join the party in case of shifts in valuation driven by factors like this. Technical analysis then works only in still waters - not a good limitation when one is looking to generate market beating returns.

Quantitative analysis is too generic a term to be evaluated as a single strategy. However, if one assumes that a mathematical model based on historical data and analysis is used to predict the attractiveness of stocks or points of entry into the markets, the limitations of quant strategies become clear. In a manner similar to the technical strategies, quant strategies cannot account for the shifts in valuation. They also suffer from overgeneralization of certain trends. The benefit of quant strategies however lies in their ability to beat the market in terms of returns. In this respect they are better than fundamental or technical strategies which are in some sense trying to generate high positive returns. Their focus is typically not as much to beat the market as it is to generate good returns. When one restricts the mandate to beating the markets, one can start seeing the advantages of the quantitative strategies. Ultimately, as I have argued in another post ("Index Investing and Quantitative Strategies") on this blog, market returns as reflected in the performance of an index, are a special case of an oversimplified quant strategy. If one were to take some identifiers of good stock market performance from both technical and fundamental analysis, one can hope to beat the markets more consistently than either of the other two strategies.

One can almost go back to the Hegelian dialectic of thesis, antithesis and synthesis in the above debate. The thesis is 'fundamental analysis'. The anti-thesis is 'technical and quantitative analysis'. The synthesis then is a integrated approach which combines best of all the three! Something I have started working on thesedays.