The Enlightened Despot

Yesterday, pundits and bloggers got to play one of their favorite games: Stock Exchange-Pathetic Fallacy Madlibs. The rules are very simple: start by assuming the stock market is a living, opinionated being that reads the newspapers, pick a recent movement in stock prices and a fun, more-or-less coeval news item, then write a few sentences explaining how the market chose to do the former because of its feelings about the latter. So a few weeks back we had ongoing debates about whether the Dow was terrified of our first socialist president or sulking in its room because Republicans weren’t playing fair.

To be fair, what went on yesterday wasn’t quite as silly as this. For the most part, analysis of this sort shows every sign of just being made up after the fact. The markets do something dramatic, and a fable explaining why is created out of the news of the day. This sort of analysis is generally worthless, as I’ve written before. There are, however, some events which everyone expect will have a noticeable, very short-term effect on markets ahead of time. The most common examples are Fed meetings - everyone waits with bated breath to here what the new interest rate targets will be, and, whatever decision comes down, traders go nuts. In these cases, it at least makes sense (usually) to say that there is a causal connection between the news and the market activity; the release of details about Geithner’s plan was certainly such an event.

But the fact that we can reasonably assume stocks have risen at least in part as a reaction to the Geithner plan, it doesn’t at all follow that that market activity tells us anything interesting about the plan or whether it will work. For starters, investors don’t become more bullish about stocks when they get good news, they become more bullish about stocks when they get news that is good for the companies in question. If Congress were to pass legislation promising trillions of dollars to banks to round up and drown puppies, bank stocks would no doubt soar. But this wouldn’t be evidence that the market thought the puppy-drowning scheme was brilliant; it would be evidence that the market responds predictably to the transfer of trillions of dollars.

Secondly, consider this, from King Felix:

I had a brief discussion with Jesse Eisinger yesterday about the stock market reaction to the Geithner plan. The central question: do you look at the level of the index, or do you look at the amount that it moved over the course of the day? Geithner’s first attempt at introducing the plan resulted in the Dow falling 382 points to 7,889; Geithner’s second attempt saw a 497-point rise to 7,776.

If you ignore the direction and just focus on the Dow as a snapshot of how the market feels about the prospects for the economy, you could make a case for investors being more optimistic the first time round than than they were yesterday. That’s true even if you look at a sensible index like the S&P 500, which closed yesterday at 823, down a smidgen from its February 10 close of 827, rather than looking at the silly but ubiquitous Dow average.

Ultimately, Felix is simply trying to make the point that “it’s ill-advised to use day-to-day movements in the stock market as much of a barometer of anything.” But in his example, looking at the price rather than the short-term performance makes things even worse. As discussed above, the entire exercise is nothing but hand waving unless we are looking at extremely short-term movements in the immediate aftermath of a major announcement where we can confidently assert a straightforward causal connection; once you start looking at even slightly longer-term (and more meaningful!) trends, you can’t really talk about the market reaction to, in this case, Geithner’s plan, because there are too many other factors affecting stock movements.

Ultimately, though, what really makes these market jumps useless as a means of evaluating Geithner’s plan - or anything else - is that we actually shouldn’t expect the stock of, say, Citi to go up if investors think the plan will help Citi and down if they think it will hurt the bank. Rather, we should expect Citi stock to go up if the plan that is announced is more helpful to Citi than they expected it would be. Investors knew that a plan would be announced - just as they know when the Fed is going to make an announcement about target rates. So their expectations should already be priced in to the relevant stocks before the announcement is made. Good news should lead to a drop in prices if investors expect great news. Bad news should lead to short-term gains if investors expect terrible news. So unless we’re very sure that the market was optimistic about Geithner’s plan before the details were announced, we really can’t know what to make of what happened immediately after.

This chart, based on Census Bureau data, comes from Nate Silver, and shows the growth of real income for each decile of earners during the past seven presidencies. It’s a neat graphic, and another piece of evidence, as if one were needed, that the Bush years have not been kind to America. But, with all due respect to Silver, who did terrific work during the election, his analysis of the data presented is really quite awful.

The conclusions he draws are actually all perfectly sensible, though I would have thought most of them went without saying. For instance:

Manifestly enough, as we see under Reagan/Bush, the government has some capacity to allocate income to one class to another with its economic policy. In general, however, the fates of different economic classes are linked. Since 1967, the correlation in the change in year-over-year income between the 10th and the 90th percentiles is .63.

This latter characteristic is something that I think a lot of liberals tend not to have a good appreciation of. There is sometimes a tendency among liberals to see the economy as a zero-sum game, but this is not really the case. When the economy is doing well, everyone tends to do well, unless the President is trying really, really hard (as Reagan did) to steer that growth only toward certain income classes. And when the economy is doing poorly, everyone tends to do poorly. The poor did awfully under George W. Bush, but the wealthy didn’t perform all that well either.

It’s certainly true that liberals care a lot more about inequality than do conservatives, who are generally more interested in the bottom line for the economy as a whole. But if liberals really tend to “see the economy as a zero-sum game” then they desperately need to do their homework. Adam Smith (and David Hume before him!) did a very good job of explaining why it was foolish to think of economies this way, and I’m not aware of any serious thinker who has challenged him on the point. (One more instance in which the search for correctness leads to 18th century Scottish thought.)

But if the above graphic helps people understand this, God bless. My objection is to the premise - absent from the conclusions, but prevalent throughout the preceding discussion - that macroeconomic trends should generally be attributed to the actions of the current president. Consider:

Also, the data omits transition years — for example, 2001 is a transition year between Clinton and Bush, and it’s not clear who to credit/blame for the economy’s performance in that year, so I’m skipping it.

…

There’s a lot to look at in this little chart. Under Nixon/Ford, the very wealthiest did reasonably well, but oddly enough, so did the very poorest (this may have been LBJ’s Great Society programs belatedly kicking in rather than anything Nixon/Ford did).

Here we have two exceptions that prove the rule. (From the ‘begs the question‘ file of near-fatally abused phrases.) Though Silver never makes the connection explicitly, the two examples of cases where we can’t reliably say which president is responsible for the economy strongly imply that, as a general rule, the health of the economy is a function of presidential activity.

This is hardly a theory unique to Silver. Indeed, there is strong evidence to suggest that most people buy into this theory , at least implicitly. The state of the economy leading into an election year is a good indicator of how the incumbent party will fare. But as fashionable as it is to caution against underestimating the American voter, he is no economist.

It is inarguably true that the president can have a very powerful impact on the economy; he can start a major war, for instance. And it’s almost certainly the case that the actions of the president usually have a significant effect on the macroeconomic picture. But it is equally certain that there are many other factors at work, some of them entirely outside any president’s control. It could be the case that the causal power of presidential activity so far outweighs all other factors that we should expect the health of the economy to track the wisdom of the president’s economic policies most of the time, but this is a massive assumption. It’s an interesting psychological fact that most people make this assumption, but it doesn’t have much place in serious discourse without an argument.

I just found a new term to tuck away in my super-senior tranche of economic buzz-words: ’super contango’. The market for a non-perishable commodity is said to be in contango when futures for that commodity are trading for more than the current ‘now price’. (The reverse situation is called ‘backwardation’, which means that no matter what is going on in the market for a commodity, you can’t describe it with a straight face.) This is a fairly natural state of affairs, as commodities have a quality that is rare in finance: they actually exist in space and time. This means you have to keep them somewhere, and storage space costs money.

‘Super contango’ is a term currently popular to describe a situation in which futures are trading for more than the cost of storage and transfer; that is, I can sell you a promise to deliver $2000 worth of oil next month, buy that oil right now for $1000, spend $500 storing it and shipping it (generally to Cushing, Oklahoma, which, it turns out, is where crude oil deals go down), and walk away with $500 risk free. This, supposedly, is the situation we are in now.

You don’t have to be a hardline efficient markets theorist to think there is something wrong with this picture. Sometimes there is a free lunch, but it’s seldom well-advertised, and there’s never adequate parking. Kevin Drum mulls over a few possibilities:

So what’s going on? One possible explanation is that most of the easy storage is already full, so it’s not really possible to make a quick buck on this even if you want to. But even if that’s the case, there’s yet another option: oil producers can pump less oil now (essentially “storing” it in the ground) and then pump it out in July for delivery at the higher price. But apparently they’re not doing that. John Hempton figures there are two possible explanations: (1) they’re already pumping at full capacity, so they can’t promise to pump extra oil in July even if they want to, or (2) oil producers are so desperate for cash that they’re willing to take money now even if it’s way less than they could get for the same stuff six months from now.

#1 doesn’t seem to be true. So that leaves #2: thanks to plummeting oil prices, OPEC countries are in serious economic turmoil and desperate for any cash they can get their hands on right now. Either that or else there’s an option #3 that’s not obvious.

Let’s back up a bit. Screw OPEC, why aren’t you making free money off this? There are a number of reasons, but most of them come down to the inconvenience of trading in real objects. As KJ points out, there may be a shortage in storage capacity, meaning that hanging on to oil is going to cost you a lot more than what economists think it should cost you when they claim we’re in a super contango. If you do find a place to store your oil, it’s going to be a big place - the storage and transport costs won’t work out unless you’re dealing with a whole lot of oil. A year or two ago, perhaps you could have raised a few hundred million in mortages on your mobile home, but credit is a lot harder to come by these days. And nothing is really risk free: if Somalia is inbetween Oklahoma and your oil vendor, you might have some explaining to do a month from now.

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As reported by Felix Salmon, Nassim Taleb thinks not:

Nassim Nicholas Taleb is angry. Not in the YouTube clip of the same name, but rather at Nobel laureate Bob Merton, whom Taleb attacked in a paper he co-wrote with Emanuel Derman of Columbia.

In the wake of that paper appearing, Merton sent Taleb a detailed and equation-filled eight-page note, dated December 2005, taking issue with the paper. “His argument was that my argument was not compatible with portfolio theory,” says Taleb, who says that Merton assumed, in his paper, the very constructs — things like beta — which Taleb criticized; which are as meaningful for him as astrology; and which have no place in the world of financial economics.

The article is actually pretty amusing, as it details the thoroughly childish interaction of these two heavyweight economists. But, as Salmon points out, the substantive disagreement between the two is a pretty big deal:

For the record, although I’m sympathetic to Taleb’s side of the debate, I have no reason to believe that Merton is waging some kind of deliberate proxy campaign against him.

The interesting thing for me about this particular academic feud, however, is that that for all its viciousness, the stakes really aren’t low at all. Taleb is working towards nothing less than the outright dismantling of Black-Scholes, portfolio theory, and the enormous financial edifices which have been built upon them; if he’s successful, essentially all the quants on Wall Street would be out of a job. Which I think is probably reason enough for many people to defend Merton right there: the man himself doesn’t need to direct anything at all.