CHAOS-ONOMICS: Strangely Attracted to the Truth
May 7
chaos-onomics.com
I’d love to be the historian who writes the story of how this small group of eight or nine people made the case [to attack Iraq] and won.. - Unnamed Pentagon Advisor
William James famously argued, "A great many people think they are thinking when they are rearranging their prejudices." This thought may help explain one of the more perplexing things to those who have, in a sense, left Plato's cave to see things for themselves, to wit, why don't markets adjust to the new realities. Recasting the notion of reflexivity popularized in financial circles by George Soros in light of James views leads me to argue that in a sense the financial markets will tend to validate their prejudices. This is to argue that the market is not only not immune from normal human foibles but due to the effects of fear and greed, more likely to behave irrationally than not.
One of the running debates in financial commentary of late has concerned itself with the issue of market intervention. The plunge protection team, exchange stabilization fund, price keeping operations, etc. are all terms used to refer to official support schemes. The objects of these schemes are variously the US$, the US equity market, the US$ price of Gold, etc. As the more radical variants of the theory goes, whenever markets of concern reach certain levels, officials, either on their own or through proxies, place orders to reverse market direction. According to these more radical variants of the theory, interventions may take place daily.
As I have little direct knowledge of dealings of this nature by the US government I cannot speak with certainty on the issue. The following is thus speculation based on a thesis of financial market action consistent with the notions of James, Plato, et. al. I think holders of the more radical variants of the theory are unlikely to find that the state has directly intervened in markets as often as they seem to think. I also think, however, that the markets often reflexively act "as if" the state is intervening and that outside of interest rates, the true tool of intervention is propaganda.
Before moving to the issue of propaganda, let's touch on the centrality of interest rates in financial calculation. Embedded in value calculations of all paper assets is the risk free rate, which in the US, according to FASB, is the US Treasury rate. These rates are indirectly controlled by the Fed through the normal open market operations and should bond arbitrageurs fail to adequately adjust the curve, the Fed can directly control these rates. This control of the basis of calculation for all other paper assets is a powerful tool in that, in theory, the risk free rate represents market discounting expectations. The lower the rate, the less one needs to discount projections. Thus when the Fed eases they are forcing the market to accept their estimate of the proper discount.
This calculation link between the Fed influenced rate of discount and other paper assets inspires a great deal of arbitrage and it is this arbitrage which in the main, I contend, keeps the market cohesive. Indeed, I sometimes wonder just how much cohesiveness has been added via the introduction of spreadsheets in banks. Consider that right now, in dealing rooms around the world, millions of computers are analyzing price data in search of theoretical identities. As example, one can arbitrage between the cash bond market and the bond futures market because in theory the two securities are identical, in fact, however, they are not due to differing credit risks.
Lets return now to the propaganda, or perhaps it might be more illuminating to use the phrase creating and managing prejudices. The Greenspan put or the faith the Fed and/or Treasury won't let the market crash has proven to be an enduring bit of dogma from the late 90s bull market. Certainly the public pronouncements of the Fed have tended to include more discussion of the interplay of equity market levels and the real economy over time, to wit, the wealth effect. Does that, however, mean that Greenspan intends to buy equity futures whenever the S&P drops below 800? I contend that this would be akin to a world leader dropping a nuke on any other state that disagrees with it, a sure sign of a loss of control.
Rather, I think what tends to happen is that the securities houses and certain hedge funds impute equity market levels which suggest, via the wealth effect, deteriorating consumer demand and then "arbitrage" the expected decline in the rate of discount into these prices. As an example, when the DJIA was falling prior to the onset of hostilities, I imagine that as the 8000 level was breeched, certain houses concluded that the Fed would inject sufficient liquidity to keep discount rates falling and thus entered long futures positions. These imputations may also be assisted by phone calls from senior members of the securities houses and government officials. After all, Bob Rubin has probably made more calls to the Treasury and the Fed than just the infamous query about Enron's credit rating.
This is not, however, to argue that the state does not intervene, or even in rare occasions doesn't intervene often. Rather, this is to suggest that intervention can be thought of as military action, a direct brutish way to adjust the behavior of the masses when the established reflexive trends aren't coalescing as those in power would like. Far more often that that, I contend, market reflexes do the job. Intervention in the market process of discounting money is a powerful tool which brings to bear the army of spreadsheet arbitragers rearranging their financial prejudices, like the one about Treasuries being "risk free".
On a quick closing note, the graph of the day depicts the deterioration of Japan's public finances. I picked the graph after reading about the ¥10,000B bank bailout, which comes to some 2% of GDP. With the debt stock to GDP ratio well over 120% and with the revenue to GDP ratio over 14, I can see why the Japanese are turning to Gold.
==========
Fed says, FULL SPEED AHEAD
Imagine the tensions over at the Fed, "how do we hint we might ease without implying a weak economy?" or "how do we inspire confidence without implying the need to tighten?" maybe even, "should we mention the dollar?" Perhaps Greenspan and his cohorts are beginning to understand the Sisyphusian nature of the game they play. No matter how hard you try to make paper wampum perform the function of money, in the end, all the work is wasted as people slowly, and by bitter experience, come to realize that wampum shorn of its anchor to the real world is a fetish inspiring a reflexive response reminiscent of money which diminishes over time. Recalling yesterday's discussion of Mr. Iguchi of Daiwa Bank, William Leith reported in the Guardian; "Iguchi says that he suffered from a sense of unreality - he felt that there was no difference between $100m and ¥5. Money lost its meaning." Yep, a sense of isolation from the ramifications of one's actions concerning money might just lead one's ideas of money to lose meaning.
Turning to the substance of the Fed statement, they still fear deflation ahead and given the decline in the US$ of late, the easing bias will make Gold suppression efforts that much harder. Indeed, without the Iraq conflict as scapegoat, and Greenspan's earlier rah-rah testimony envisioning better times ahead, economic policy making in general is going to be pretty dicey in the months ahead. With Greenspan and the boys manning the printing presses, one wonders how long it will take before the Chinese and Japanese follow the lead of the Mexicans and sell a few US$. Perhaps the selling will commence as soon as the Congress passes the next debt limit extension, or when they don't and the US defaults sometime after May 15. |
