In continuing the discussion of the concept of fairness, lets now look at lotteries. Lotteries are different; we don’t seem to demand fairness to participate. In a series of fair lotteries below the gross proceeds are evenly distributed among the participants. (For a review of my definition of fairness see my previous post).

Mean is the average payout: (total payout/ number of players). For all the three lotteries above the mean is 1, or your money back. Though this doesn’t describe what we see in the chart very well. For all lotteries above, mean returns look okay, no matter the payoff distribution or skew.

Median is the middle value of a series; the median is useful when distributions have extreme values which skew the mean value. In this example the median return for series 2 and 3 is zero. Median is a better approximate of the probable payout for those games.

Lottery payoffs are best represented by series 3 – one winner of all the money. It is unlikely that anyone would be motivated to play game 1, since simply getting you money back plus a little is not a very exciting proposition.

If we had our lottery promoter hat on, it is likely that we would prefer to sell tickets for lottery two or three rather than one. My take is that random large rewards are viewed as exciting.

In 2006, average proceeds for all US state lotteries were distributed as follows:

• approximately 65% in winnings payout
• 4% Sales General and Administrative expenses
• 31% retained by the state treasury.

Perhaps the old line “you can’t win if you don’t play” should be modified to “they can’t win if you don’t play.”

This is why economists refer to lotteries as a form of voluntary tax. In the case of all US State lotteries, initial government take of 35% compares favourably to regular income tax rates since most lottery participants pay less than 35% in average tax rates. In many instances, the proceeds are also taxed for an additional win for the sponsor state, when they receive essentially a double taxation dip of more than 50% of the bets.

So why do we suspend our sense of fairness to play these games? In the case of charity lotteries it is perhaps the excuse we need to give to a good cause. For regular lotteries, it appears that lottery operators are successful at building excitement by focusing on the mean and highlighting skewed results. This is how lottery tickets are sold. In our example more tickets will be sold for the next draw if a picture of player 10 appears in a newspaper advertisement with the proceeds check, smiling for the camera. The advertising campaigns are celebrations of non-probable random events. We don’t expect fairness in this type of game; we are satisfied with buying the excitement.

Unfortunately, we can draw many parallels to financial services from lottery marketing schemes. Instead of focusing on the plentiful returns available to market indexes, and building portfolios to capture those profits, financial service companies focus on the excitement of beating the averages. The incentives appear unbalanced. High fees paid to capture random large rewards don’t work in your investment accounts, though it may be more exciting.

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The economics of a fair game are intuitive. Even very young children understand the rules. In aggregate the participants get out of the game the resources they put in. There is seen to be an equitable arrangement between participants.

Adult bargaining games designed to test understanding of fairness, reciprocity and altruism can be helpful to clarify our understandings of these concepts. Two of these games are the ultimatum game and the dictator game.

Ultimatum game: In this game there are two players, a proposer and a responder. The proposer offers any amount of a given total stake to the responder and the proposer keeps the remainder of the stake. If the amount is accepted, both receive the agreed upon amount. If rejected, neither player receives anything.

In this game participants have to consider the concepts of reciprocity and fairness.

Dictator Game: In the Dictator Game, the responder must accept any offer by the proposer. The proposer’s stake remains constant so they don’t have to give anything to the responder.

In this game altruism motivates the proposer to give.

Game results are consistent across western cultures. In the ultimatum game, proposers offer, on average, 40% of the stake. They usually keep 60%. Offers of less than 20% are rejected half the time.

In the dictator game, an average offer is 20% of the stake, though the proposer has nothing at risk and is offering more than is necessary.

These results support the idea that people are perhaps genetically wired to be co-operative. They will also exhibit altruistic tendencies when there is no cost to them. The results also show that children have an innate propensity for fairness, reciprocity and altruism. There is a tendency for these traits to moderate as we age, perhaps from learned behaviours. In general these studies paint a positive view of basic human wiring. We expect and tend to benefit from a fair game.

Several studies are available on these games, both for adults and children. For a good review see A fair Game: Intuitive economics of Resource Exchange in four-year olds, Lucas, Wagner, Chow. Journal of Social, Evolutionary, and Cultural Psychology www.jsec.com – 2(3):74-88.

Tags: behavioral finance
Posted in: Economics |
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Final Instalment of the Review of the US Monetary System

Economists assume we all want more money. This makes analysis of their data easier. It seems to me this simplifying assumption creates misunderstanding. Money is important to the extent that it provides the things we want. While some may want the largest accumulation, most users of money don’t see simple accumulation as satisfying a higher order need. However they are concerned that they may run out. They want to ensure that their lifestyles are protected. They would like to have some financial flexibility if events don’t unfold as expected. Hording and having “the most” is usually not top of mind for consumers in general.

Users of money are concerned with purchasing power and therefore, perhaps indirectly, inflation – and rightly so. The rate of US inflation in the past 50 years has averaged about 3.3% per year. Today’s dollar has the same buying power as 8 cents in 1929 money. In the past 15 years, purchasing power of the dollar has dropped to 67 cents. By comparison, Canadian inflation has been higher in the seventies and eighties, somewhat lower since. But how have consumers generally faired in North America?

Behavioural finance is increasingly interested in relative personal consumption expenditures (PCE). The chart below suggests a strong relationship between real disposable personal income (DPI) and real consumption. This chart illustrates an inflation adjusted income of $5,000 in 1929 continues to be worth $5,000 today. Currency in this example is held constant at year 2000 levels so that the average gain in consumption to 2008 for an American is a real $22,000 (27,000-5,000). This equates to a 2% real gain in spending power each year. If you simply kept up with inflation, you would be able to consume only 20% of the amount of your neighbours and keeping up with the Joneses would become impossible.

Per Capita Real Disposable Personal Income (DPI) and Personal Consumption Expenditures (PCE) 1929-2008

North American consumers have done very well. But what has been the source of the excess buying power? Some of the gains are the result of increased wages. The attribution of wage increases can include such things as better labour participation rates and higher education levels leading to better paying jobs. Investment gains have also contributed to higher disposable incomes. Below is a review of excess returns to the public investment markets. These are positive returns after removing inflation and PCE changes of about 2% per year.

Improvements in living standards are a good thing. But people who don’t fully participate in the growth can quickly start to feel left behind. Fully diversified fixed income investments have generally reduced disposable income. An investment in a fully diversified stock portfolio has added to disposable income.  Taxes, fees and concentrated portfolios with higher volatility have probably reduced the benefits to consumers of this affect. Since diversification reduces volatility a sensible approach would include both stocks and bonds in the mix.

Patrick

Tags: diversification, Inflation, Personal Finance, US Monetary system, wealth management
Posted in: US Monetary system |
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A review of the US monetary System – Suppliers, Dealers and Users

As Children, we should all be taught to aspire to own a commercial bank (dealer). Dealers have a very interesting and sustainable business model. Essentially, they lend money they don’t have, which creates money in the hands of the borrower. This “miracle of capitalism” is created by the fractional reserve system of the Federal Reserve. The interest paid on these loans is earnings for the commercial bank. The leverage to assets is big; the Fed requires a 10 percent reserve so that a commercial bank can loan up to ten times its asset base.

In the US, commercial banks and investment banks were divided by the Glass-Steagall Act of 1933.  After the depression is was thought that risky investment banking activities needed to be separate from the Fed-backed activities of commercial banks. Glass-Steagall also introduced deposit insurance on deposits (FDIC), further protecting the interests of depositors. The act (not FDIC) was repealed in 1999 in an effort to allow US dealers to compete on a level field with Great Britain. Margaret Thatcher’s “big bang” deregulated the UK financial system in 1986. Canada followed in the late 1980s and dissolved the restrictions for commercial and investment bank mergers. Trust companies were also deregulated. Insurance companies maintained some of their independence though Canada’s big 6 retail banks are finding ways to capture market share in the insurance business as well.

Given the extremely low cost of capital and advantaged position banks share with respect to the Fed, it is difficult to compete with dealers as a group.

The promise of Big Bang and deregulation was reduced cost of capital for customers. In addition, reduction of regulatory involvement was seen as a method of increasing competition and innovation by combining access to debt and equity capabilities. Stanley Hartt, deputy Minister of Finance for Canada 1985-88 summarizes the view at that time as “the banks felt they had to grow to survive”.

These conclusions have been greatly challenged by the financial crises of 2008-09.  Leading up to the Fall of 2008, one stop financial supermarkets were able to securitize debt, selling it off to institutional investors to raise additional cash assets. This in turn allowed for more leverage to earnings and more risk assumed. The system was clearly out of equilibrium. In September 2008, perhaps precipitated by the collapse of Lehman Brothers, the system froze. Banks would no longer lend to one another for fear of undisclosed liabilities (non-visibility) reducing the real credit worthiness of the borrowing parties and increasing the likelihood of default.

Big isn’t better, and in some cases as we have recently experienced, it is much worse. Canadian banks have faired better than most. A major contributing factor is that they didn’t get their wish about eliminating foreign ownership restrictions.  Canadian banks are limited to 10% foreign ownership. It seems to me that as a group they should be grateful for the failure in their lobby effort to have that restriction eliminated. It saved their asset base and our banks and protected them from much more of the downside of the credit crises of 2008-09. Instead, in 2009 the Canadian economy and financial system has experienced strong relative growth compared to the international competition.

Commercial banks are too big to fail because of the unique arrangement they have with taxpayers. FDIC (CDIC in Canada) insures assets to 250k (100k). If they default, the government, backed by tax revenues, guarantees the liability. This call on tax dollars creates an incentive to accept more risk, in an effort to maximize shareholder profit, since Banks are credited with the positive return to risk but are insured for losses.

For banks it is very unlikely if not impossible to reorganize under bankruptcy protection. Unlike other corporations like airlines, for banks bankruptcy is equal to liquidation.

Clearly there is something wrong with this system. The old idea of building scale to eliminate the competition appears to be in conflict with the best interests of the economy as a whole.

We could try to use a 1930s solution and disentangle commercial banks and investment banks or perhaps more realistically, the consequences of bank failures could be minimized. To my thinking the latter approach is more likely. New regulation can be introduced to reduce potential claims on taxpayers.

A group has been formed to provide recommendations on just that line of thinking. The Squam Lake Working Group on Financial Regulation is a group comprised of 15 leading academics who want to bring the system back into equilibrium. The thinking is that if the incentives of scale are reduced and the costs to society of banks failures are minimized, then a better equilibrium will be established for the financial system and by extension, the economy as a whole. The group had developed several practical solutions to improve the systemic problems. It appears the US administration is listening.

Tags: credit crisis, financial markets, financial regulation, US Monetary system
Posted in: Economics, Federal Reserve, Leadership, financial markets, investing |
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Forgive me; it has been six months since my last confession…oops I mean posting.

Since April all major investment markets have rallied. This is true of both stock and bond markets. Much of the rally is due to the coordinated policies of central bankers, especially the US Federal Reserve. Toxic assets (TARP, TALF) were purchased from commercial banks and insurance companies dramatically reducing risks, visible and hidden, of commercial bank asset bases. The twin policies of de-risking and improving disclosure provided the needed incentive for those investors looking for a reason to buy.  A return to risks assumed has been re-established across the globe. Few would argue with the assessment that these efforts have resulted in the desired policy outcome of bringing order and stability to a global financial system that was unable to function in the last half of 2008.

The mandate of the Federal Reserve Bank is to use monetary policy to promote “maximum employment, stable prices and moderate long term interest rates.” Money supply is the major lever the Federal Reserve has to control the negative effects of inflation. This past year saw a unique policy response by the Fed. The unorthodox monetary policy that ensued presents many challenges today and especially in the future timing of unwinding the current position. The question remains: Will high levels of inflation result from the measures implemented by the Federal Reserve in 2008-09?

Money is created by the Fed in two ways: directly and indirectly. In the direct route, the government can print it or mint it. This is sometimes referred to as central bank money and includes net money assets of the government. This money is backed by market confidence in the ability of the issuer to meet its obligation through future tax revenues.

The indirect method is creating money through a fractional reserves system. The Federal Reserve controls the reserve of capital commercial banks are required to maintain in their operation. Today, Commercial Banks must deposit 10% of their assets in a reserve account with the Fed. From the perspective of the commercial lender, they can lend up to 10 times their asset base. This leverage creates money in the economy. This is commercial bank money also known as check book money.

Money supply has several definitions. For our purposes I will define Money supply as MB or monetary base which includes currency in circulation and demand deposits, minimum reserves and excess reserves held by the central bank.

The Fed enters into open market operations buying and selling t-bills, notes and bonds to principal dealers. The effect of a sale of bills or notes is to reduce the money supply by retiring money back to the fed. Alternatively, the when the Fed buys notes (or other assets) money supply increases. These operations also reduce or increase the leverage available further affecting the overall money supply.

Prior to October of 2008, increases in bank reserves ended up as currency in circulation. However in the fall of 2008 the fed began paying interest on excess reserves providing incentive for commercial banks to leave the money on deposit and out of circulation. This rate is equal to the upper limit of the fed funds rate of 25 basis points. The result is the increase in monetary base has had little impact on currency in circulation but has resulted in a dramatic increase in the Feds excess reserves account. This account increased from about 2 billion in mid 2008 to more than 750 billion in June of 2009.

University of Chicago economist Milton Friedman and others observed a long term relationship between money supply and inflation: (The quantity theory of money)

MV = PY

Where;

M= quantity of money

V = velocity of circulation

P = price level

Y = level of output of the economy

Friedman and other monetarists pointed out that change in money supply control the level of nominal output of the economy. Furthermore, in the long run, changes in money supply determine changes in prices or inflation. For Friedman “inflation is always and everywhere a monetary phenomenon, in that it can be produced only in a more rapid increase in the quantity of money than in output”.[1]

Inflation erodes purchasing power. This is how it affects the average family. For the US market, in the past 15 years the purchasing power of a US dollar has dropped to 67 cents. So a consumer needs fifty percent more dollars to buy the same basket of goods. Consumer Price Index (CPI) is the common measure of inflation along with the Core CPI which excludes the prices of food and energy. In the past 50 years the average annual change in CPI has been 4.2%, 4.1% for Core CPI. There has been a big range of values for CPI; greater than 14% in 1980 and -1.2% in June of 2009 (deflation). The Fed is believed to have a target for inflation of 2%. The Bank of Canada has an explicit target of 1-3% for Core CPI.

In July of 2008, prior to the default by Lehman Brothers in October of that year, US inflation levels were relatively high at 5.4%. US money supply was about 850 billion and had been stable at that level for several quarters. By June of 2009 CPI was -1.2% and money supply had doubled to more than 1.6 trillion dollars. In addition, through large scale purchases of agency debt and mortgage backed securities, the Federal Reserves assets base increased from about 900 billion to more than 2 trillion, though this was done in such a way as to avoid increasing money supply. The Federal Reserve funded the purchase of toxic assets through a special t-bill issued by the US Treasury. The deposit accounts of the Treasury are not part of the monetary base.

The challenge for the Federal Reserve is to shrink their balance sheet and reduce the money supply before inflationary expectations rise above their target. Moving too early will delay the economic recovery. Waiting too long will result in inflation. The incentives line up behind waiting too long.

Paying interest on reserves is a temporary solution. In the long run it adds to the monetary base. As well, commercial banks will find more profitable alternatives for the money. This is a big problem. 750 billion in the hands of commercial banks can result in as much as 7 trillion in additions to the money base.

Some options for the Fed to curb future inflation – exit strategy

1. The fed could use its powers to limit the leverage for commercial banks.

2. They can enter into reverse repurchase agreements (REPO) with commercial banks for the toxic assets on the feds balance sheet. If commercial banks enter into these agreements the monetary base will decrease through a reduction in the excess reserves account.

3. Treasury could issue debt and deposit the proceeds with the Fed.

4. Fed could issue its own debt directly reducing the monetary base, in competition with the Treasury.

5. Fed could let assets mature, or sell them into the markets.

Finally, the fed must be able to conduct monetary policy independent of political pressure. To avoid inflation there must be a shift from propping up credit institutions to one of price stability and oh yes they must get the timing very right.

We should probably get ready for inflation.

Milton Freidman, “The Counter—Revolution in Monetary theory,” Wincott Memorial Lecture, Institute for Economic Affairs, London, 1970.

Posted in: Economics, Federal Reserve, Inflation, financial markets, international marketing, money |
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US stocks represented by S&P500 were up 8.44% for the month of March. The Canadian S&P TSX60 grew by 7.99%. Morgan Stanley’s EAFE was 3.74% higher. While we are still 49% lower than the high in November of 2007, we have rallied 8% off the low point earlier in March.

While most of the worries and economic turmoil persists, there has been some measure of relief to the stock markets. We are at a point of growing divergence between wall street and main street. More evidence is expected of shrinking economies in North America and overseas yet these backward looking measures were not reflected in the recent buoyant return to stocks across the world.

The short term return to investment returns is random but momentum trends do make themselves known. For this positive return environment to continue investors will have to ignore the results from main street. They will have to ignore the fact that consumers are saving more and deferring large purchases. The market will have to rally in the face of lower earnings reports from companies and yes more bankruptcies and higher unemployment figures. There are no assurances, risk is pervasive even from these price levels. If this is the beginning of a turnaround in fortune for the stock markets then it would be consistent with the beginning of other bull markets, shrugging off the bad news and climbing higher in spite of the evidence.

Tags: market timing, portfolio management
Posted in: financial markets, investing, portfolio |
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We are learning more about the US Feds efforts to improve securitized mortgage markets. Specifically, the legacy loans program and the legacy securities program are designed to entice private investment involvement in turning around the credit crises. There is a good review of the Toxic-asset proposal in today’s Wall Street Journal.

The incentives have to be generous enough so as to attract private investors but not so generous that a risk free return is funded by tax dollars to the benefit of private interests. So what is a reasonable return for assuming this risk? How will these prices be established?  The public purse will be best served by a wide and broad market with many participants. Some will get better deals than others but on average many participants will serve to get the prices right and move the market to an equilibrium position, balancing risk assumed and return yielded. If we end up with a closed shop -where access is limited to a few players, then the likelihood of a subsidy from taxpayers to a small number of market dominant players is enhanced.  PIMCO spokesman Bill Gross has already voiced his firm’s intention to support the program.

Joint ventures between government and private investors are complex and rightly the subject of increased scrutiny by all interested parties. If you are a tax payer then you are a stakeholder. There is a big cost to focusing on limiting return through regulation.  There have been a series of announcements from AIG that executives will return some bonuses. These relatively small victories act as a dis-incentive to those that are considering participation. There is a view that so called excessive future gains may be clawed back by government after the fact. Increased perceived risk (regulation) will require an offsetting increased future return.

In my view, well executed programs will result from a large number of independent private interests bidding for these assets. More participants results in better asset pricing. Better asset pricing will reduce the likelihood of subsidies to private interests from taxpayers.  It is in all of our interest that the program become accessible to all parties willing and able to assume the risk. We need many participants and we should encourage bidders. We have had enough focus on punishing executives and managers of financial firms. It will not help to discourage their participation. We need to get past the need to find and punish the  parties responsible for this mess and instead focus on the task at hand. Increased effort to identify and pursue manager bonuses is an unnecessary additional cost to the bailout.

Tags: AIG bonuses, Credit Markets, financial regulation, legacy loans program, legacy securities program, portfolio management
Posted in: Economics, financial markets |
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Well as the above math indicates, the markets have improved so now they are  fully half of what they once were.

There are so many opinions/recipes/predictions for fixing the financial system:

Do Mark to Market assets on company balance sheets to improve visibility and certainty about earnings; or

Don’t mark to market assets as these add to volatility in earnings and in the end are estimates only

Buy equities, the recession is ending in 2009; or

Do nothing, the recession is deeper than expected and mid 2010 is the earliest relief point

Since the public purse is bailing out AIG (Citigroup, Bank America…) the new owners should protect us by reneging on employee bonuses. The principle is one of fairness to those who are preventing these companies from disappearing entirely; or

Pay the bonuses, keeping the companies whole will pay off in the future as a more valuable asset is sold. These bonuses represent insignificant dollar values

New expanded monetary policy is helpful in the short term and disastrous later; or

The US economy is expected to drive world recovery, the reasonable  cost of this effort is more US dollars in circulation

I expect many of you find all of these conflicting views compelling even as they are source of argument. I  usually find both sides of the noise plausible and somewhat meaningless as a result. The loudest opinion is unlikely to be the most helpful, or best considered. In times as these, we need to have some reasonable basis for  making investment decisions.

There seems to be a quest to define the moment of inertia, when the economy begins to grow instead of shrink.  If we could guess the day what would we do exactly? Search for a new job… buy an investment property? Maybe we could pick that exact moment to buy stocks in our retirement accounts.

Unfortunately,  we would probably be late to the party for stock markets.   If we look at the most severe recessions in the past 40 years for Japan, UK, US and Germany at the official end of each recession the local stock market had rebounded from a low of 31% in US markets in March of 1975 to a high of 137% in the UK in December of 1975. Of course the end of recessions are defined by looking back 6 months. Not helpful if you are trying to time a stock entry point or major purchase.

Good judgement starts with clearly understanding your unique situation. Investment activities should be added to after accounting for and funding cash requirements and perhaps reducing debt. In this way you will not be forced to turn what should be a positive into a negative investment experience.

Tags: behavioral finance, portfolio management, timing the market
Posted in: Asset Allocation, Economics, financial markets |
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The term ‘credit crisis’ seems to imply that we can expect a resumption to normal market conditions, and economic growth, as a direct result of increased lending by banks…maybe, but things haven’t worked out that way before.

Much of the recession fighting efforts by central bankers and global political administrations is focused on a forced expansion of credit. In 2007-2008, a ceasing of credit markets was crippling to economic activity. De-leveraging of global markets resulted in a sharp reduction in economic output and a pervasive global recession. The reaction by central bankers was to create conditions where bank-to-bank lending was possible again. To a great extent, and at incredible expense,  this has been accomplished. Indeed in the past few weeks we have seen credit market spreads expand. A positive indicator, since banks are probably using their own capital to lend to clients rather than simply passing on the fire hose of cash flow from the Fed.

While resumption of a normalized credit market is a precondition to ending this recession, the evidence suggests that credit expands only after the economy has rebounded. The effect is to further fuel an already expanding economy. In every recession since 1960 real bank credit didn’t peak until several quarters after the end of each recession. While this time may be different, it is likely that the same economic principles apply today as they have the past 50 years. Banks typically tighten credit as a result of loan losses. This is a reasonable response to limit losses and participate less to the downside of an economic cycle. These normal incentives operate to limit the expansion of credit prior to some clear evidence of economic expansion. When the economy begins to expand lenders expand their efforts to capture the growing market shares. It is unlikely that policy makers will be able to engineer conditions where lenders will lead a meaningful expansion in the economy. At some point incentives should switch in favour of the consumer and creating conditions for expanded demand to replace liquidity concerns as the primary focus of economic leaders.

Here is  a related short essay by Kevin Kliessen, Economist with the  Federal Reserve Bank of St. Louis  http://research.stlouisfed.org/publications/mt/20090301/cover.pdf

Tags: credit crisis, Credit Markets, money, portfolio
Posted in: Economics, Leadership, Uncategorized, financial markets |
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Today’s  Opening Value

We posted new lows last week and the S&P 500 is priced at less than half of the value in November 2007.  The recent investment experience has been brutal. Last week was one of the worst in terms of stock market performance that we have seen in the past couple of years and just about everyone is looking for the misery to continue.

Last Thursday Bank of Montreal economist Douglas Porter, suggested the worst was over and we should begin to consider the prospects of a better economy by the end of 2009. His opinion wasn’t appreciated by those that offered comment. Practically no one agreed with his point of view. The average opinion was outright critical and many dismissed his thoughts as someone who is shilling for a bank, his opinion therefore bought and paid for. I don’t know Douglas Porter other than by his reputation as a good economist.  I do have some respect for his decision to release information to the hostile crowd. He was, I think,  aware of the probable feedback. So what is going on here? Is everyone so sure that they know the future will be a continuation of the recent past? Is Porter simply rolling the dice with other people’s money (risk) to generate profit for his bank? It seems to me that investors understand there is higher risk in the investment markets. Their recent experience is bad and they look for this to continue. The idea that economists or financial analysts can predict the bottom for investment markets is a source of irritation bordering on anger.

For the sake of clarity here are some basic financial principles in which we can rely:

• Higher return comes with higher risk. The risk premium or compensation for risk is higher when things are not going well.
• Investment decisions should be made on a forward-looking basis not by looking at the recent past as prologue.
• It is improbable to predict or time the turn in the investment markets.
• Short term returns from a trough, or market low,  is very high.
• Selling after a significant drop in prices means you will probably give up significant short term return when the market recovers.
• Some short term traders will correctly predict the turn in the market but only by chance.

Tags: financial markets, investing, market timing, porfolio management
Posted in: Economics, financial markets, investing |
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