Archive for June 23rd, 2008

Central Bankers play test-match cricket under trying conditions

June 23, 2008

I was reading this piece from Tamal Bandyopadhyay:

In cricketing parlance, this is a not a dream pitch to bat on. With the inflation rate at a 13-year high, capital flows drying up and the rupee weakening against the dollar, the job of India’s chief money manager is not going to be easy.

It just struck me. When is it easy? Just a few months back we could reverse this entire thing with the same end

With the inflation rate expected to rise, capital flows rising, the rupee appreciating against the dollar and the economy moderating, the job of India’s chief money manager….

It is still not easy.

Though it was being felt that Central Banker’s job is not exciting and Mervyn King even remarked it as boring. Obviously all this was in backdrop of the Great Moderation when Central bankers felt that lower volatility in output and inflation was here to stay and central banks had little more to do.

We now know all this was nothing but true and Great Moderation is followed by Great Disruption with heightened volatility in output, inflation, financial markets etc. You name it and we have it.

I have a different analogy for Central banks and Cricket. The Central banks play a test-match in trying conditions – on slow turning wickets (Sub-continent, West Indies) where ball stays low and starts turning viciously on 4th/5th day, or in England where the ball swings substantially, or on pacy wickets like those in South Africa, Australia (Perth). First situation is Great Moderation, second and third are like today’s times where swing and pace conditions can unsettle both the sides. Those Central Bankers and Cricketers which can play under all conditions are dubbed as great/benchmarks/ideal, rest are simply known as players.

So far few Central Banks/Bankers were considered as greats, but as they moved from sub-continent to Australia their technique is being questioned. 🙂

Time for some Bogleisms

June 23, 2008

I have been a big fan of John Bogle as he shows the other side of developments in financial markets (read my earlier post here). He shows how costly and greedy this sector has become. His recent speech is on similar lines but looks at the recent buzzword- speculation.

He actually calls it a triumph of speculation over investment.

We’ll begin by talking about the difference between investment and speculation. Investing, to me, is all about the long-term ownership of businesses, focused on the gradual accretion in intrinsic value that is derived from the ability of our corporations to produce the goods and services…..

Speculation is just the opposite. It represents the short-term—not long-term—holding of instruments—not business—focused (usually) on the belief that their prices—as distinct from intrinsic values—will rise

Over a long-term you should expect both returns to be identical. But we don’t see that happening as we have transaction costs. Hence, speculation will give lower returns than investments. So, we should expect people to invest their monies as an investment, and investment strategies to gain over speculation. However, we see the opposite:

 Consider that during most of my first 15 years in this industry (through about 1966), it was not that way. Fund turnover averaged about 16 percent per year—let’s call that “investing,” a six-year average holding period—and never varied significantly from that norm. But turnover moved steadily upward, and in the past decade, has averaged nearly 100 percent per year—let’s call that “speculation,” a one-year average holding period—exactly the opposite of my expectations when I joined this industry all those years ago.

Actually, Bogle assumes people are rational and invest over a long-term. But actually people are irrational and moreover predictably irrational.  People usually look to others and rely on professional advice, advertisements etc for investing.  The speculation has increased on both the sides- investors (demand) and financial firms (supply). Former speculate as they see better returns in some fund/stock (which have been achieved in the past) and latter to earn some extra return (alpha) to justify their fees, jobs etc.

However, all this shows doesn’t mean Bogle’s concern is overstated, but actually it is understated. If people are irrational , financial sector has to become  more responsible while selling the various products and services. There are huge costs and he should be aware of the returns ex-costs. In the last section Bogle touches on these aspects and questions the various financial innovations which in his words

The incredible rise—and fall—of so many derivative instruments in the present era should raise a red flag of caution regarding the value of financial innovation to investors. The flood of complexity—and its attendant high costs—seems to have overwhelmed simplicity—with its attendant low costs. One example: Collateralized debt obligation (CDOs) have wreaked havoc among our commercial banks and our investment banks, and credit default swaps (CDS) now total an astonishing $600 trillion—speculative derivatives of credit instruments that themselves total less than $20 trillion—an amount of speculation 25 times (!) that modest amount of (risky) underlying investment. We know almost nothing about the counterparties to this boatload of CDS that embody the excesses of our financial system—innovation designed to benefit those who create these instruments rather than those who own them.

(Emphasis is mine)

Another very good speech from Bogle. Worth a read.

Ending the post with his wonderful story:

There’s a wonderful story about an investment banker addressing his colleagues: “the bad news is that we’ve lost an enormous amount of money. The good news is that none of its ours.


Assorted Links

June 23, 2008

1. WSJ Blog points Malcolm Knight leaves BIS for Deutsche Bank. I will miss his speeches for sure.

2. Nudges has a superb post on the endowment effect involving Thaler

3. TTR points it is lucrative times for financial journalists

4. IDB points to some subprime lessons for microfin

5. MR points to a Calvo article that blames SWF as a facot rising commodity prices. Krugman diasgrees with Calvo view and says:.

On a happier note, it’s great to see top-flight economists weighing in on the crucial issues of the day. It’s kind of like the Asian financial crisis of 1997-1998, which was bad for the world but a sort of golden age for policy-relevant theory

6. Krugman also points to a study which says oil prices might reduce trade

7. DB Blog points to some mighty books that stirred excitement in development

%d bloggers like this: