Federal Reserve Chairman Ben Bernanke first achieved fame with a November 2002 speech in which he repeated Milton Friedman’s assertion that the Fed could “drop money out of helicopters” if deflation or a credit crunch occurred. The Fed and the European Central Bank now appear to be doing this, having injected $300 billion into the world monetary system in the last two business days. What Bernanke didn’t tell us in 2002 was that his helicopter would hover only over Wall Street.
Friedman and Bernanke were quite right that dropping money from helicopters would provide reflation, although since 1931-32 the United States has not had an economy in which such an action would have been remotely appropriate (fiat currency central banks, being political creatures, universally err on the side of too much, not too little money in the system.)
One can indeed imagine in a difficult economy the welcome whirr of chopper blades as the Bernanke helicopter carried out its mercy mission. It would hover lengthily over the rusting steel towns of Ohio and Western Pennsylvania, would circle twice over the wasteland of downtown Detroit, would avoid the major farm states, already excessively subsidized by the U.S. taxpayer, but would provide welcome relief to the ghettoes of Watts and the South Bronx.
What it wouldn’t do, in a world of even reasonable equity, is spend any time over Wall Street.
The injection of money by the Fed and the ECB feeds directly into Wall Street. It’s huge in amount — $215 billion by the ECB and $58 billion by the Fed – and it consists of short term loans granted by the central banks to banks and investment banks which had been unwilling to make interbank deposits except at a substantial premium over the central bank’s target short term interest rate. Admittedly the injections are only loans – but if they are not quickly removed they will have added around 2% to the US and EU broad money supply. This will worsen the already serious global inflation problem, thus exacerbating the difficulties the world economy already faces. They will however bail out Wall Street and its European competitors.
The level of panic in financial markets is quite extraordinary. Stock prices are down less than 10% from their all time peaks, and still up on the year, while bond yields have retreated substantially from their recent highs and are well within their trading ranges of the year. The only general market factor that has changed significantly is that volatility has increased, in other words instead of going up and down 50 or 100 points each day the Dow Jones index is now zooming up and down 200 or 300 points, even though at the end of the week it has gone nowhere very much.
The increased volatility is key to the entire market turbulence, because of what can only be described as a gross misuse of mathematics in the trading rooms of the world.
In the capital markets of the 1960s and earlier, banks would no more have considered hiring mathematicians than they would have bet their entire capital in short term speculation. With the valuation methods of that period, mathematicians were superfluous – any reasonably numerate accountant could understand them. However, after the invention of the Black-Scholes options valuation model in 1973, mathematicians came into fashion.
The model offered the enormous benefit of providing a “value” however spurious for any option position. This allowed banks to offer their clients options both direct and disguised while ”marking to market” their trading positions at the close of each business day. The model was however completely incomprehensible to non-mathematicians. Bank managements therefore decided to import some mathematicians to interpret it and act as risk managers. This proved a sensible move; Barings tried to run a modern trading desk with large options positions with only Old Etonian liberal arts majors to manage the traders, with catastrophic results
Having imported mathematicians, and recognized that if they were going to take on these huge risks they needed to be able to manage them, bank managements then asked the mathematicians to produce a risk management metric. Unfortunately bank managements did not suspect mathematics’ most closely guarded guilty secret: only a tiny minority of possible equations are solvable using currently existing mathematical techniques.
Rather than confessing failure and losing their jobs, which were paid beyond the wildest dreams of mathematical academia, the mathematicians therefore bent the reality to fit the equations they could solve, and came up with the “Value at Risk” methodology. By assuming that securities prices move continuously with no jumps, that they are random and normally distributed, and that market trends don’t exist, mathematicians were able to produce a risk management model that was convincing to top management and worked most of the time. The occasions on which the models didn’t work were dismissed as market anomalies, although in reality it was the models not the markets that were anomalous.
Value at Risk suffers from two main defects. One is that it breaks down in times of market turbulence; the theoretical maximum “value at risk” can be an arbitrarily small fraction of the true risk when things go wrong.
The other is the way VAR deals with volatility. Under VAR, the risk of a position depends on its volatility, so that if volatility changes suddenly the risk changes also. Banks measure volatility either based on the past average over a 30 day period, or from the prices of some widely traded option contracts (these two methods can produce widely different estimates of volatility.) When volatility changes – either very volatile days are introduced into the average or options prices jump – the VAR of the position changes also.
If as in the last few weeks markets suddenly become more volatile after a lengthy period of calm the VAR of every position held by a large bank suddenly jumps, generally to a multiple of its previous level. In such cases, even if markets don’t overall move that much (as they haven’t in equities markets, down less than 10% from their peak) the bank has to reduce its positions. Since all participants are looking at the same volatilities, every bank and hedge fund is forced to unwind its trades and reduce its positions at the same time. Needless to say, this produces highly unstable markets, which themselves increase volatility and exacerbate the problem.
This is the first time the markets have done this since the introduction of VAR in the early 1990s, with the limited exception of the Long Term Capital Management crash in 1998. In 2000-2002, the equity bear market was not accompanied by any increase in volatility in other markets and was fairly orderly. This was a sign that the cathartic effect of the bear market, aborted by Fed Chairman Alan Greenspan’s massive injection of liquidity into the US economy, did not go nearly far enough to wipe out the over-optimism and gullibility of the late 1990s bubble.
Needless to say this bizarre effect of current risk management techniques has now resulted in a market panic, quite unjustified given the modest movements in the stock and bond markets themselves. The ECB and the Fed have reacted to the panic rather than the markets, and have bailed out European and US banks with oceans of additional liquidity. This of course has introduced moral hazard into the system in large amounts, if we are unlucky and the central banks’ liquidity injections stabilize the market and allow unjustified speculation to resume. Hopefully the liquidity injections won’t work and the long overdue corrective market crash will overwhelm the speculators.
Whether this somewhat artificial panic will cause the Fed to abandon inflation control altogether and drop interest rates remains to be seen. If it does so the rest of the world will suffer from a 1970s style stagflation in which savings, jobs and above all retirement incomes become highly insecure. At that point we can reflect gloomily upon the second rate mathematicians hired by Wall Street and the second rate central bankers whose helicopters never assist the middle class or the poor.
Contrary to populist theory, it is fiat money, controlled by politicians and unaccountable central bankers, and not the deflationary but mechanistic Gold Standard, that is the true instrument of Wall Street.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)