The “Lowdown” on Energy

a brief aside from Adam Millers, undergraduate at University of Iowa


Before the promised “lowdown” on energy, here is something about the similarities between string theory and the creation myth from Tolkien’s Silmarillion that, though completely unrelated, also completely deserves your attention.  Actually, there’s very little in that article about string theory– that’s because I came up with that idea myself (while probing into the backstory of Gandalf the Grey’s maiar roots).  Edit: as is usually the case, a quick search of Reddit revealed that I’m actually not (as close to) the first to have that idea as I thought.


So here’s a quick thought on energy…

Since oil is priced in dollars and the dollar is currently appreciating for a whole slew of reasons that should be properly addressed in a separate post, could the falling demand for oil have something to do with the falling purchasing power of the foreign countries that buy it?

By the way–

USD vs Oil Price

Might not mean anything, but if it does– well then rate hikes in 2015 should be even more interesting than they already are…


Economics a la Wittgenstein

By Adam Millers, undergraduate at the University of Iowa

Regarding a random attempt at novelty; i.e. a Wittgensteinian interpretation of US monetary policy


If you demand a rule from which it follows that there can’t have been a miscalculation here, the answer is that we did not learn this through a rule, but by learning to calculate.

-From “On Certainty,” Ludwig Wittgenstein (44.)

…and if that quote made you think “oh, like the Federal Reserve,” then congratulations– you’ve stumbled across a blog post that might actually interest you.


Wittgenstein and Language Games

First off– for those insufficiently inspired by the careful examination of semantics to carefully examine them, Ludwig Wittgenstein was a 20th century Austrian philosopher of great renown.  Much of his legacy is attributable to an incident involving Karl Popper and a poker, but he had some notable ideas as well.  Some of these were attached to what I would say was one of his central theses (and please be sure to note that I am not seeking to misrepresent myself as a serious student of Wittgenstein here); i.e. the idea that language is fundamentally arbitrary, and that the meaning we derive from it is subsequently contingent on the framework within which it is used.  Another way to put it, in Wittgenstein’s own words, is that the words to which we ascribe intrinsic meaning can only be understood as “a complicated network of similarities overlapping and criss-crossing,” and that our perception of reality, as represented by its manifestation in this language, is every bit as jaded…

Now that being said, while I do sincerely recommend reading Wittgenstein– he’s considerably more coherent than Hegel and every bit as valid a talking point in the coffeehouse –I’m sure you won’t, and so that’s probably enough on Wittgenstein and language games.  (The links should get you off to a good start if you do, in fact, find any/all of the above to be intriguing).


The Federal Reserve and Language Games

Both philosophy and economics are faced with the task of applying logic to the illogical.  Former Chairman of the Federal Reserve Ben Bernanke put it well when he responded to a question regarding his confidence going into QE with the answer: “The problem is that QE works in practice, but doesn’t work in theory.”  (In hindsight, perhaps we’ll allow him that one– but it does beg the question: why was the central bank implementing policy that it didn’t expect to work?)  Likewise, Heraclitus famously quipped that “one cannot step twice in the same river” (although he also claimed that the world is made of fire– so don’t be too surprised when ‘the same river’ allows you to take two or maybe even three steps in it).  Bearing in mind the inherent similarity of the two disciplines, it should come as no surprise that the Federal Reserve, as the nominal “center” of American economics, has taken a page from Wittgenstein in its recent approach to policy.

The policy in question is forward guidanceand the description provided on the Federal Reserve homepage would appear to provide us with our first example of a “language game” as it ironically begins with “clear communication is always important in central banking.”  So you can follow the link for more, but forward guidance is basically, well, exactly what it sounds like it would be– the Federal Reserve provides (vanishingly little) guidance as to what they intend to do going forward.  Now here’s a little tangent, but if we put on our philosopher hats for a moment, would it perhaps be possible to pose as a question for the metaphysicians the following:

If the action prescribed by forward guidance is contingent upon the satisfaction of certain as-of-yet unfulfilled criteria, then does forward guidance address the nature of the action itself or the logical fulfillment of said criteria?

(Block quotes used for dramatic effect).

By the way, that could very well mean absolutely nothing.  Sometimes we play language games with ourselves…


Anyways–

A Misplaced Preface

So everybody knows about QE, right?  Real quick– the Federal Reserve wanted to stimulate economic growth and, with its limited arsenal of tools, decided that this could be most effectively accomplished by buying trillions of dollars of Treasury securities.  The liquid money paid by the Federal Reserve for the relatively illiquid Treasury securities would then be lendable to businesses to invest in new workers and equipment (and here you may see that this post is also relevant to the ongoing discussion of TLTRO).

Now an additional consequence of this massive bond-buying spree involved the market for the bonds that were being bought.  Let’s consider these consequences by breaking it down into pieces:

  • The value of a Treasury security (security = financial instrument representative of some form of debt) can be simplified as: the interest that the security pays divided by the price of the security.

Interest paid by security / Price paid for security  = Yield (net value, more or less) of security

  • When it comes to the price of the security, think of the classic supply-demand dynamic: an increase in demand relative to supply will raise the price charged per unit supplied.  So with the Federal Reserve (artificially) increasing demand to the tune of those trillions of dollars, the price on the securities increased, and the yield decreased.

Demand up = Price up = Yield down

  • For the sake of simplicity, let us equate the reduced yield on these Treasury securities with a proportional decrease in general rates on the market.  We can refer to these “general rates on the market” in the abbreviated form “rates” from here on out.

So then the “additional consequence” was to lower rates.  Now this would seem to play perfectly into the Federal Reserve’s theory (hmm Bernanke) because:

  • Lower rates mean that it will cost the businesses less to borrow all that new money received by the banks who sold Treasury securities to the Federal Reserve.
  • Lower rates mean that investors will be more willing to invest in riskier securities because of the higher yields.

and, perhaps most importantly of all,

  • The overall effect of the lower rate environment is the facilitation of a cheap expansion of liquidity, mediated by and to some extent contained within the financial sector.

Expanded (and expanding) liquidity combined with a willingness to invest in riskier securities means that the riskier securities will effectively become less risky, as a corollary of the capital reallocation from other areas of the market into those securities.  So here is the full chain:

Demand for Treasury securities increased (Fed buys securities)

Yield on Treasury securities decreases (because the increased demand caused an increase in price)

Yield on other securities [like stocks and bonds] starts to decrease (everyone other than the Fed buys these securities)

The price on all those securities [stocks and bonds] increases

Now the key takeaway is the thread that connects Point A to Point B: the Fed buys securities and, as a result, the price of stocks and bonds increases. 

This is, by the way, a very simplified explanation.


Language Games and Rate Hikes

That was quite a tangent.

Back to the idea of forward guidance as a language game– we now know that the Federal Reserve possesses (and has implemented) the power to inflate the prices of securities on the market.  They did this by lowering rates (using QE).  But one thing that you may be asking yourself is: if the prices of stocks and bonds go up when the Fed buys all those Treasury securities, then what happens when the Fed sells them?  Good question.

(Note: for those of you who are more acquainted with monetary policy or whatever, please let “open market sale of Treasuries” suffice as a catch-all for whatever ridiculously convoluted games the Fed would likely play with repo markets and discount windows.  That is something for Taylor Beguhn to soliloquize about).

Basically, the artificially inflated asset prices should fall.  Some will fall more than others, especially long-duration bonds that don’t pay back the initial investment for a long time and are most susceptible to changes in rates.  Does that make sense?  I think it should, if you just apply the logic from the previous section in a slightly modified reverse order.  Let’s just skip to the key takeaway here and say that for investors and market participants in general, an increase in rates by the Fed will be really significant, mostly because of how significant the preceding decrease was.

And that’s why forward guidance is so important.  At least that’s my opinion.  There isn’t a convincing case for the contention that by outlining what it intends to do given certain criteria, those criteria will somehow be more likely to… I honestly don’t know the correct word here but –“do whatever criteria do.”  So then forward guidance is really directed at “the folks with lots of money” who pumped “lots of money” into the banks to buy the Treasury securities that were then sold to the Fed during QE.  Because those folks are the same ones who, on some level, want to make sure that all this expanded liquidity ends up expanding their own.

So what “clear communication” does the Fed have for these folks?  That it will wait “patiently.”

What does that mean?  There are several traditional definitions for you, but now we have this Federal Reserve language game too.  Now “patiently” is quantifiable in terms of asset pricing models and option-adjusted spreads and other financial arcanum that would make Merriam Webster renounce the family business.  Now “considerable time” means “mid-2015,” or (if you had looked to Eurodollar swap options as your oracle) in December 2014 (whoops!).


Thank You, Wittgenstein…

…for teaching the Federal Reserve how easy it is to take advantage of the human penchant for reading between the lines.  And thank you also for reminding us that whatever we find between those lines is no more meaningful than the lines themselves.  Because, at the end of the day, both the action and the criteria are language games… inflation, whether core CPI or some permutation of the Michigan consumer sentiment index, is not tangible… for all we know, Janet Yellen could be talking about blowing up 2% of a balloon.

Does it make sense to exclude changes in the price of energy and food in the calculation of the overall purchasing power of the dollar?  There is an argument that it does, I would imagine, and presumably another argument that it doesn’t– but the key here is that they are arguments.  To borrow from a long line of philosophical inquiry: there is a substantial disparity between what we can assert about the world and what we can truly know to exist in it.  This rationale is applied to justify skepticism regarding whether or not your right hand is in fact a real thing; how much less pedantic does that rationale become when applied to something as tenuous as currency value?

And, as a brief aside on inflation, shouldn’t there be some (extensive) accomodation for the historical lows in oil prices?  It’s estimated that for every decrease of 1 cent in the price of oil, consumer discretionary spending expands by $1 billion.  That means a potential $50-60 billion dollar increase in consumer discretionary spending from the recent downtrend.  Now, granted, consumer discretionary spending and inflation are both language games in the purest sense, but even within the parameters of those games (or the larger-scale game that encapsulates them both), I get this unsettling sensation that the doves aren’t quite taking the big picture into consideration; the Fed is rushing for a first down without trying for the touchdown.  And this is probably wrong, but if PCE doesn’t decline as much as the substantive net residual impact of declining energy prices, doesn’t that mean there is latent inflation embedded in some subset of the difference between the latter and the former?  Key takeaway: what is inflation?  Does the Fed know?  And how can you make inflation, as the infinite abstraction that it seems to be, the basis of your “clear communication” (i.e. language game) if you don’t even know what the former is…?

Well then what about unemployment?  We have the Phillips Curve, and sure, that’s pretty cut and dry… but not when you add in labor force participation, and cyclicality of employment, and demographic fluctuations… What about the Baby Boomer generation retiring and the paradigm shift in the US support ratio?  Let’s go full circle– doesn’t that have a massive effect on the distribution of spending habits, and thus inflation?  Context, man, it’s “a complicated network of similarities overlapping and criss-crossing” and somewhere along the line it becomes necessary to just lay down the law and establish a framework for the meaning of the things you say that doesn’t conform to the changes in the meaning of the things you’re saying those things about.


Whatever, the semantics don’t matter because we’re not inspired to examine them carefully (remember?)– that’s something you have to resign yourself to, as an economist, if you hope to have any chance of staking a claim with conviction.    I mean, doesn’t it make sense that the Fed’s forward guidance is a language game?  To answer a question I posed earlier, if we take the stance that forward guidance addresses the logical fulfillment of certain criteria, and those criteria are comprised of language games of their own– well then what do we expect from the forward guidance?

What do we expect when we try to apply logic to the illogical?


One more time (for dramatic effect)

If you demand a rule from which it follows that there can’t have been a miscalculation here, the answer is that we did not learn this through a rule, but by learning to calculate.

-From “On Certainty,” Ludwig Wittgenstein (44.)


P.S. Thanks for reading.  Consider this a supplement to the TLTRO discussion; I’m still trying to figure out what I was talking about in the first installment of the latter.  Too much coffee, I guess.

TLTRO- The Ephemeral Long-Term pt 1

by Adam Millers, University of Iowa

Regarding disjointed musings over a dark roast at Java House, Dec 13 2014

So, to begin with, I guess the pertinent question here is not the what of the ECB’s Targeted Long Term Refinancing Option, but rather the why.  I.e. why is this deus ex machina central bank intervention the answer yet again?

Now it’s European disinflation concerns, then it was the Great Recession in the US… I have no doubt that the timeline trends back to the primordial ooze of accommodative monetary policy, but when is that? what is that? is there actually any logic to the vicious liquidity cycle, and whose logic is it? (namely, who stands to gain)?  Ok, so maybe there is no single “pertinent question,” and maybe there isn’t necessarily a question at all…


 

That being said, here’s somewhat of an answer, preceded by a skeleton of the source material:

  • Ricardian equivalence theorem, primary source material by David Ricardo
    • …and relevant discussions courtesy of the Library of Economics and Liberty ([italics mine] & truly a nice pair, albeit seemingly unrelated in, like, an epistemological sense)
  • Marx, on capital accumulation and overproduction, Capital
    • …and the more or less faithfully opposed, if not generally biased, reiteration of the aforementioned by the Mises Institute
  • “After Mill: Bastiat and the French laissez-faire tradition”; haven’t read it yet, but it looks promising from a quick skim, and is also from the same Mises Institute publication on the history of economic thought
    • …and Bastiat’s witty fables regarding the ills of protectionism and statist economics
  • Various research and other stuff about TLTRO and QE, skewed as much as possible to rational, quasi-objective perspectives because: Library of Economics and Liberty [italics remain mine] and the Mises Institute are the other two perspectives (not to mention Marx)

First, three quotes:

“The superficiality of Political Economy shows itself in the fact that it looks upon the expansion and contraction of credit, which is a mere symptom of the periodic changes of the industrial cycle, as their cause.” – Marx, Capital

“The imposition of a tax directly reduces the net worth of the taxpayer, but the issue of an equivalent amount of government debt generates an equal reduction in net worth because of the future tax liabilities that are required to service and to amortize the debt that is created.” – James M Buchanan, Richard Wagner, Democracy in Deficit: The Political Legacy of Lord Keynes

“Karl Marx created […] a veritable tissue of fallacies.  Every single nodal point of the theory is wrong and fallacious.” – the Mises Institute (just for LOL’s)


 

The Targeted Long Term Refinancing Option (TLTRO) is to Quantitative Easing what a man at his bachelor party is to that same man the day of his wedding– this man, whose parents made the questionable decision to name him TLTRO, has already committed to his wife QE in spirit, but wants to experiment a little bit before he makes that kind of commitment.  The chronology is similar too; European QE (QECB lol) is waiting at the altar, pretending that the groom hasn’t seen the dress yet.

Essentially TLTRO consists of reallocating massive amounts of capital with the objective of distributing liquidity to the European money supply.  While QE achieved this through direct purchases of securities on the open market in a pretty obvious liquidity swap, the TLTRO manages to hide the same fundamental principle in a policy less likely to rekindle memories of Weimar hyperinflation and etc.  By way of TLTRO, the European central banking apparatus finances the ability of non-central banks (though in the spirit of Too Big Too Fail, the distinction becomes increasingly arbitrary) to loan at lower rates, by loaning to them at lower rates, the assumption here being that this will solve the problem of a weak economy by… creating inflation?

Well no, that’s not actually the rationale.  Let’s break it down.  Lower borrowing costs should lead to increased borrowing.  This has something to do with user cost of capital and required rates of return, I think.  But those readings are from awhile ago.  Anyway– it should go like this.  People that make things borrow more money and expand their ability to make things, which involves using the borrowed money to build new places for other people to work and more equipment for them to operate.  So the expanded ability of some people to make things actually expands the ability of other people to buy those things because now they have new jobs in new places and new equipment.  And, to quote Vonnegut: so it goes.


 

So now to tie in two new ideas.

The Ricardian equivalence theorem explains that when the government finances its operations by way of debt issuance, it is effectively imposing a future tax.  It goes on to say that this should be acknowledged in market movements, because David Ricardo actually seems to think that people intuitively understand his equivalence theorem.  I mean, I think I mentioned this already elsewhere but it’s such a convenient reference– the Dutch tulip bubble…

Karl Marx spoke extensively on the subject of capital accumulation and concentration in the hands of an increasingly small portion of the population.  There is something called the Gini coefficient, used primarily by sociologists to quickly compare the levels of inequality in different places, and it provides fairly solid empirical evidence in support of Marx’s contention.  But if you remain unconvinced, I am feeling confident that I will return to discuss that idea in greater depth after getting a few things out of the way here first.

I am also feeling confident that my somewhat of an answer is becoming somewhat more of an answer, despite there still not being much of a question.


 

So if the Ricardian equivalence theorem states that sovereign debt is really a future tax, then would it be fair to say that QE and TLTRO basically constitute two really convoluted paradoxes wherein the government pays a future tax to itself in buying back its own debt so that it will be able to sustain future taxation in the form of more debt?  Wait– is this where lower interest rates and the glorified inflation become truly useful to the economy?  Now the denominator of your PV calculations has been modified, the cost of debt is much lower, and that money that you did owe just shrunk in terms of its own relative value.  So share repurchases and M&A abound, and the government slyly reduced its debt burden, which means it cut down the future tax burden of its constituents.

Is it okay with you if we call that tax burden “the cost of financing the portion of output arranged/facilitated/intermediated by the government?”  No?  Oh well, we’ll call it that anyway, because that allows us to say the following:

If the government, by way of the central bank, is engineering growth by way of manipulating liquidity so that the cost of present solvency is a financial black hole event horizon that consumes its own future insolvency– if the government, by way of the central bank, is taxing itself with its own debt when it performs QE and TLTRO and whatever manifestation of QEternity is next in line, and expanding its own proportion of the proportion of output that it arranges/facilitates/intermediates– if the government, by way of the central bank, is facilitating economic growth by way of effectively growing itself, well then how exactly are we supposed to believe in a free market?  And how exactly are we supposed to interpret the “LT” in “TLTRO?”


 

Some fables and aphorisms from Bastiat about laissez-faire economics seem applicable here.  Like Bastiat’s candlemakers union, seeking protection from the sun– only here it is the withered market seeking to insulate itself from… itself?  And here I think it would be appropriate, or at least fun, to draw a parallel to the Copernican revolution, but we’ll do that later.  For now: the fable of the broken window.

Bastiat’s fable of the broken window demonstrates a point of contention between the Austrian proto-market and the pre-Marxist “market-market” (both terms I just made up, to be characterized further as you see fit).  A boy throws a brick through a shop window.  Regarding this event, there are three potential levels of economic analysis, arranged hierarchically according to how well they conform to Bastiat’s model: 1) the destruction is inherently bad, and that is the end of it; 2) the destruction itself may be bad, but the stimulation of the economy that stems from the need of the storeowner to hire window repair specialists, and the subsequent multiplier effect that stems from the proceeds of that repair, are inherently good; 3) the stimulative effect of the window repair is inherently good, but relative to the stimulative effect attached to the lost opportunity for the storeowner to invest in incremental capital, it is “net-inherently” bad.  Hm, very interesting.

I’ll be the first to admit that I don’t actually know what I’m talking about here.


 

So capital accumulation results in overproduction, time and again, whether it’s a bubble or whatnot– then is not the extension of credit more or less analogous to the breaking of the window by the boy?  Then, counterintuitively, the accommodative monetary policy, the QE, the TLTRO– these are not remedies.  They are, in fact, the window repair specialists hiring the boy to break the windows so that they can be hired to repair them.  Do you see what I am getting at?

Increased interest rates here equal the repair of the broken window.  It is the restoration of value to the market, which was crippled by the relative distortion of currency, the foundational unit in this random dialogue… the restoration of value to the market in terms of the same metric used in determining the relative value of the currency… i.e. liquidity breaks the window and liquidity is the window repair.  

So now, the crucial question… whose logic repaired the window, and who was the window repair specialist?


 

Well I’m out of coffee so stay tuned for part two if you thought there was anything valuable to be gleaned from all that  ^^ 

 

*this post has yet to be edited

Gamma Concepts- The Rates of Change

by Adam Millers, University of Iowa

Related to the Iowa Economics Forum discussion, dated Monday December 8th, 2014

On October 15, Treasury markets experienced an unprecedented spike in the price volatility of 7-10 year securities.  Despite the brevity of this anomaly, and the ease with which it could be identified (or at least written off) as nothing more than a statistical outlier of normal market movements, the October 15 spike provides deep insight into the changing dynamics of both financial markets and the economy as a whole.

As reported by the New York Times on October 19th, the precipitous decrease in Treasury yields (from 2.2 to 1.9 percent) was the sort of erratic behavior characteristic of flash crashes or, even worse, events like the collapse of Lehman Brothers in the heart of the 2008 financial crisis; it wasn’t the kind of instability that investors like to see in the market for quintessentially vanilla bonds.

The Oct 15 spike was the result of a confluence of seemingly unrelated events, borrowed here for the purpose of setting up a contextual framework from Matt Levine of Bloomberg View (http://www.bloombergview.com/articles/2014-12-08/levine-on-wall-street-watch-out-for-the-gamma-trap) and an article in Risk Magazine (http://www.risk.net/risk-magazine/feature/1515005/the-gamma-trap).  They are as follows:

  • The collapse of M&A negotiations between Abbvie and Shire.
  • An extremely disappointing report from the retail sector.
  • Huge, unexpected declines in energy prices.
  • Losing bets on the Federal Reserve increasing rates.

To briefly summarize the chronology, as it makes sense to me:

1) The perception of positive trends in certain underlying economic indicators had convinced a number of funds to take prominent short positions in 7-10 Treasuries, founded on the assumption that the Fed would respond to the specter of inflation embedded in credit-engendered growth by increasing rates.  (In this case, increased available returns on the market would increase Treasury yields to a proportional level by lowering their price).

2) When retail and energy stocks tanked along with the massive long positions that funds had taken in Shire (betting on the return to be earned from the share premium that would likely be paid in the potential acquisition), there was a net movement of capital into the safety of Treasuries.

3) Treasury prices therefore increased.  (The dynamic here is worth further discussion, as a number of other factors are implicated in the recent downward trend of yields, including the effects of an appreciating dollar and the relative appeal of US government-backed, dollar-denominated debt in a climate of global economic instability).  Now the short positions were in trouble…

Which brings us to the concept of gamma.

In the valuation of options, the explanation of the relationship between the contract itself and the underlying security naturally relies on derivatives.  Delta is the rate of change of the option value relative to the value of the underlying security.  In economic terms, you can think of it as the price elasticity of, for instance, an option contract on one share of Apple stock to that share itself (i.e. if one share of Apple stock increases by $1, the relative increase in the value of the option tied to that share of Apple stock is the option’s delta).

Gamma is essentially the second derivative of the relationship of the option to the underlying security, or the first derivative of delta, or – more specifically – the magnitude of acceleration of the rate at which an option increases/decreases in response to an increase/decrease in the value of the underlying security.  More comprehensibly, as the price of that one share of Apple stock gets higher and higher, the rate at which the value of the option changes in proportion to those increases (delta), also increases.  This secondary rate is gamma.

Back to the Oct 15 spike…

Funds now needed to cover their short positions, and so entered into a desperate scramble to buy Treasuries, even as the price at which they were buying them increased (due to the interplay of constant supply with rising demand).  There is a bitter irony here in that the coverage of the short positions was actually making it exponentially more costly to cover the short positions.  This, then, is the theoretical reason for the Oct 15 spike- the unraveling gamma of the short position that forced funds to buy increasingly high and sell increasingly low.

But this gamma concept is not confined to the world of esoteric financial products.  The ability to comprehend the inherent properties of change itself adds color to a world in which infinite variables evolve endlessly according to transforming rate convexities of the second, third, fourth, fifth degree (etc).  Tulip bubbles in 17th century Holland or housing bubbles in 21st century America– the underlying dynamics of change are, paradoxically, the only constant.

The ability to distinguish these dynamics from the framework in which they operate is the ability to consider life on the margin.

 

 

*article still pending editing