FEDERATED INVESTORS

From my perspective, the most meaningful of this week’s data was Friday’s report from the ECB showing that Spanish bank borrowings had reached a record 337bn euro ($411bn), up almost 50bn euros ($61bn) during June. Spanish institutions have now increased ECB borrowings by 204bn euro ($250bn) in only five months. There’s no mystery surrounding President Rajoy’s snappy acquiescence to EU demands for additional painful deficit-cutting measures. Spain’s banking system is suffering a run on deposits and liquidity. The euro traded to two-year lows Friday morning, before rallying somewhat to close out another losing week. 

From Friday’s WSJ Heard on the Street column (Simon Nixon): “Feeling more relaxed about the euro crisis since last month's summit? Think again. The risk of a euro-zone breakup may actually be rising rather than falling, according to Bank of America Merrill Lynch strategists David Woo and Athanasios Vamvakidis. Using game theory to consider how the situation might evolve, they believe the crisis will boil down to a game of bluff between Italy and Germany in which neither country has an incentive to back down. That doesn't mean this would be the best outcome for either side; in game theory, the most likely outcome isn't always what economists call ‘Pareto optimal,’ one that will bring maximum benefit to all players. Instead, the ‘Nash equilibrium’ for the euro zone—the situation in which no player has an incentive to change strategy because to do so unilaterally would leave them worse off—is that Italy refuses to undertake the overhauls needed to enable its economy to grow and Germany refuses to provide the bailouts to persuade it to stay.”

From Wikipedia: “It is commonly accepted that outcomes that are not Pareto efficient are to be avoided, and therefore Pareto efficiency is an important criterion for evaluating economic systems and public policies. If economic allocation in any system is not Pareto efficient, there is potential for a Pareto improvement—an increase in Pareto efficiency: through reallocation, improvements can be made to at least one participant's well-being without reducing any other participant's well-being. …In practice, ensuring that nobody is disadvantaged by a change aimed at achieving Pareto efficiency may require compensation of one or more parties. For instance, if a change in economic policy eliminates a monopoly and that market subsequently becomes competitive and more efficient, the monopolist will be made worse off… This means the monopolist can be compensated for its loss while still leaving a net gain for others in the economy, a Pareto improvement. In real-world practice, such compensations have unintended consequences. They can lead to incentive distortions over time as agents anticipate such compensations and change their actions accordingly.”

I’d prefer that this analysis was not too technical, but the “Pareto optimal” and “Nash equilibrium” concepts – and game theory more generally - are critical for analyzing both the unfolding European crisis and the extraordinary global macro Credit environment. Besides, it doesn’t hurt to ponder whether reasonable explanations exist that help explain why post-Bubble policymakers are generally cast as such nincompoops. I dove deeper into Credit theory last week, attempting to illuminate how the nature of policymaking/politics can change profoundly depending upon the evolutionary phase of the Credit Cycle. In particular, the idea of European political cooperation and monetary integration resonated during the potent upside of the global Credit boom. Credit, economic output and asset prices were expanding – the economic pie was seen as growing ever larger. Optimism and extrapolation reigned supreme – as they do.

In game theory terms, players were willing to compromise and, in some cases, “reallocate.” Politicians and central bankers recognized that individual country benefits – and gains to the integrated system overall – would greatly outweigh the associated costs. Cooperation, after all, was certain to spur system-wide efficiencies and enhanced economic wealth. Europe’s wealthier countries were willing to subsidize the poorer, confident of the overwhelming benefits to economic, financial and monetary integration. China, Asia and others were more than willing to monetize ongoing U.S. trade deficits, believing the overall benefits to growth and prosperity outweighed gradual devaluation of their dollar holdings.

But the downside of the Credit cycle radically alters rules of the game. Over time, reality sinks in that the previous prosperity was in fact an unsustainable boom-time phenomenon. The downside of the Credit cycle ensures faltering asset prices, deflating household net worth and financial sector deficiencies, along with the revelation of problematic economic imbalances and maladjustment. It’s not long into the bust before many see themselves as losers – and to have lost unjustly at the hands of an unfair system. The growing ranks of losers become an increasingly powerful political force.

The pie - recognized as having been previously inflated by excess and policy largess – is seen as vulnerable and shrinking, much to the dismay of the general public whose expectations were so inflated during the previous Bubble. The Credit cycle’s downside ushers in a period where individual players become acutely focused on ensuring that they get the largest possible share of what they view as a contracting pie. The backdrop no longer incentivizes cooperation, cohesion and integration. As has been demonstrated by political stalemates in Brussels, as well as in Washington, ‘Nash equilibrium’ dynamics prevail, “the situation in which no player has an incentive to change strategy because to do so unilaterally would leave them worse off.”

But let’s not limit game theory analysis primarily to Europe. And, importantly, the upside of the global Credit Bubble has not yet fully run its course. So, from a more global macro point of view, a ‘Pareto optimality’ mindset still holds sway. Global central bankers remain predominantly of the view that the overall benefits from cooperation, monetization and currency devaluation outweigh the costs. Ultra-low rates compensate borrowers at the expense of savers, a cost policymakers view as easily outweighed by the systemic benefits of sustained global Credit expansion. And, astutely, from Wikipedia above: “In real-world practice, such [‘Pareto optimal’] compensations have unintended consequences. They can lead to incentive distortions over time as agents anticipate such compensations and change their actions accordingly.”

“Incentive distortions” don’t get deserved attention. The conventional view holds that inflation poses the predominant risk emanating from loose monetary policy. Yet with Chinese and Asian mega-factories seemingly capable of forever saturating the world with inexpensive goods, central bankers and analysts these days easily dismiss inflationary risks. Essentially free money is, basically, costless, or so the thinking goes. And if it all seems too good to be true, it’s because no one wants to delve into the true costs associated with monetary policy incentives having so maligned global financial markets.

Previous CBBs have focused on the dysfunctional nature of the “risk on, risk off” – Roro – market trading dynamic. Instead of a fleeting fad, Roro has become only more deeply entrenched – seemingly becoming a permanent fixture. Arguably, the market backdrop has regressed only further into a casino of wagers either on or against the capacity of policy responses to incite market rallies. Risk markets have become only more highly correlated – and the bets only more fixated on red or black (or, more accurately, the flashing red or green from the Bloomberg screen). And the two biggest outgrowths from years of monetary policy incentives - the mammoth leveraged speculating community and global derivatives markets - are struggling to perform as expected. This comes as no surprise.

An era of “incentive distortions” - years of loose money and decades now of “activist” central bank market intervention – has severely distorted the underlying structure of Credit, financial market, and economic systems. Beginning back in the early 1990s, the Greenspan Fed actively “reallocated” financial returns to the impaired banking system by slashing short-term borrowing costs and orchestrating a steep yield curve (“free money” from borrowing short and holding longer-term debt instruments). Intervening in the markets to boost depleted bank capital was seen as providing extraordinary system benefits. Little attention was thus paid to the fact that this also incentivized leveraged speculation. And the hedge fund industry hasn’t looked back since, with assets exploding from about $50bn to surpass $2.1 TN. And with the Fed and the cadre of global central banks guaranteeing “liquid and continuous” markets, the derivatives and risk insurance marketplaces exploded to unfathomable hundreds and hundreds of Trillions. And the larger these Bubbles and associated risks inflated, the more confident the speculator community became that more aggressive policy measures and market interventions would be forthcoming.

I would today argue there is a momentous unappreciated cost to central bankers’ “reallocations” and “incentive distortions:” they’ve nurtured one massive, and now hopelessly unwieldy, “crowded trade” throughout global risk markets. And, as seasoned traders appreciate, once a trade becomes “crowded” the nature of how a trade – how a market – performs tends to turn highly unpredictable, erratic and, in the end, unsatisfying. Over time, fundamental developments are overshadowed by the brute force of market technicals. For example, “crowded” short positions will tend to “melt-up” into dramatic short squeezes before eventually collapsing. And crowded longs tend to turn highly speculative, yet inevitably susceptible to air-pockets and abrupt downdrafts. Locate a “crowded trade” and you’ve found a captivating place where it’s easy to lose money. In general, crowded trades fuel speculation, unpredictability, and Bubble Dynamics – along with a lot of frustration and eventual disenchantment. 

Global central bankers have ensured that way too much money now chases limited global risk asset market returns (contemporary prevailing inflation). With global short-term rates pushed near zero, hundreds of billions have flooded into more speculative instruments and ventures, certainly including the global hedge fund community. Not surprisingly, funds have struggled with performance. After a poor 2011, scores of funds have crowded into similar trading strategies and are these days under intense pressure to make money. Many are desperate not to miss a tradable market trend, while at the same time suffering from an unusually low tolerance for losses. Funds, careers, businesses and dreams are at stake – and the “tape” shows it.

It’s all created an extraordinarily mercurial backdrop. The game of seeking to extract speculative trading profits from “crowded trades,” trend-following derivative trading strategies, and generally weak-handed participants has, itself, become one massive and dysfunctional crowded trade. “Crowded Trade Squared,” a creature of prolonged policy interventions and incentive distortions, is a perilous predicament posing as a functioning marketplace. Meanwhile, the backdrop seems to ensure the type of “Roro” volatility that wears down managers, performance and investor confidence. This is the case for markets across the globe, in an era where market-based finance has never been as critical to global financial, economic and social stability. And that amounts to an incredible accumulating cost the “inflationists” will continue to disregard.