Low Probability Catastrophes

I was basically writing this exact same thing: economics as a science is a poor excuse for science (hat tip to Kedrosky... again.)

Economics is fascinating, because no one knows anything. Greider, in his excellent Secrets of the Temple said, in 1987:

The ultimate test for soundness for any science was the ability of its rules and theories to predict outcomes, and by that standard, economics was a crude and underdeveloped discipline.

Twenty years later, still as true as it was then. Why are economics and medicine, where our ignorance daily cause huge hardship and lost lives, still relatively medieval in their development while physics and chemistry have been so dynamic? Why can we put people on the moon but we can't cure cancer? Why can we make fabrics that are breathable and waterproof but we can't mitigate the business cycle?

Economics has this virtue over medicine regarding the scientific method: there is a huge amount of experimental data being generated all the time. While it occasionally shows the theory to be correct (for example, Zimbabwe), it usually shows the theory to be completely wrong (for example, the, um, economy.)

The question is, why is this so? Inventing a better economic theory would provide much more in the nature of public or private rewards than, say, inventing a better explanation for why the universe is expanding at the rate it is. Discovering the Higgs boson may win you the Nobel prize, but being able to reliably predict the fluctuations of our GDP would give you some nifty trading profits.

In fact, you don't need to predict GDP very well, you just need to predict it better than the other guys. So, why doesn't somebody? "Cargo cults" aside, I can think of only one reason: we're just not smart enough. Or, same thing, it's just not possible. One thing's for sure: we need to admit how much we don't know. The essence of crisis management is minimizing the damage from low probability catastrophes. As we bounce from one of these to another, we should think about admitting that more than leaping without looking, we're actually blind. Building some slack into the system seems the least we can do.

A Bet on Red

Okay, last post for a while on the economy. Macroeconomics fascinates me, mainly because I think it's about as well-developed as psychohistory, so Monday morning quarterbacking is possible as in no other discipline. But other commentators comment better; if you're really interested, you've found them. This post is simply a long rant aimed at getting it all out of my system so I can go back to prognosticating on marketing.

I have been told there are four virtues: compassion, joy, friendliness and equinamity. Of these, I suppose only equinamity comes naturally to me. Maybe that's why finger-pointing over the current mess seems so completely uninteresting.

If Wall Street borrowed too much and made too risky bets with their money, then they committed the same sins that Main Street does. Complaining that they were well paid to make these mistakes merely points out their customers rewarded those who made these common errors--something that can hardly be blamed on the bankers themselves. Saying, on the other hand, that they were professionals and should have known better shows, in my opinion, a certain lack of self-awareness.

I think Wall Street should have known better. I think everyone should know better. I think anyone who handles money at any point in their life should be taught this:

There's No Free Lunch.

1. If you're borrowing money, you have come under the watchful eye of someone who but for the sake of the law would break your knees as an object lesson, or just for fun. Borrowing money--including using (or even applying for) a credit card or getting a mortgage or a student loan--is a big deal. A BIG deal. You would think that as a movie-going nation we would understand the dire consequences of falling behind on paying off a debt (Get Shorty, American Gangster, The Big Lebowski... need I go on?). Borrowing money is a bad idea. But borrowing money is also a good idea. Buying a car or home or college degree costs more than almost anyone can afford to pay all at once. And, since you use your purchase over the course of time, paying for it over the course of time makes sense. So, good idea, bad idea, what to do? Approach borrowing with the same legal firepower and accounting self-knowledge that you would when making a deal with the devil. And the same expectation that, even if you've thoroughly done the legal and accounting thing, you're probably about to be totally screwed in a completely unforeseen way. (If you haven't done the legal and accounting thing, you'll be totally screwed in a completely mundane way.)

2. I referenced a graph last week showing the growth in per-capita GDP. It's 1.8% a year; not year-in, year-out, but over any medium-term period of time. If you're investing money and expect to earn more than 1.8% a year before tax, ask yourself why you deserve that. Why do you deserve it? What did you do to earn it? You're probably investing in the US economy, which grows at 1.8% per year per person. Why would your investment grow more than that? If you're thinking of buying shares of some stock, are you going to earn more than 1.8% because you are smarter than the scores of people who spend 147 hours a week, 51 weeks a year relentlessly investigating and modelling nothing but that particular stock? Or are you planning to contribute your brainpower and sweat to making the recipient of your investment more successful? If not, then why do you deserve a better return than 1.8% per year, before tax? You know what you do to deserve it? You take a chance. You take some risk. This is a good thing... a wonderful thing. It could be viewed as a joyousness about humanity's potential, a friendliness to your fellow strivers, or compassion for someone trying to lift themselves up. But it shouldn't be. It should be viewed as a bet on red. So next time black comes up, please don't whine.

Aieeee! Redux

I read today that the market is at its lowest level since 2003. As a percentage of GDP (which calculation has the benefits of automatically adjusting for inflation and actual economic growth) it's at its lowest level since 1995. I've updated the graph to show today's change as well as focus in on 1982 to today. At end of Q2-1982 total stock market cap was 37%, its lowest level that I have data for (so, since at least 1952.) It reached 210% end of Q1-2000, went to 107% Q1-2003 and I now estimate it at 94%, a level last seen Q2-1995.


If we return to 37%, the Dow would be at... wait, you do the math: I don't want to know.

Investing in the Real Economy?

I thought this was going to be more comforting than it turned out to be. Although, I have to say that it's a lot more comforting now that I've added today's market close.

GDP and Total Stock Market Capitalization in Real Billions of Dollars

This is a lot less comforting.

Total Stock Market Capitalization as % of GDP

Total market cap as a percent of GDP has reached its lowest level since 1995. But 1995 seems to mark the beginning of some different valuation paradigm. Why? What changed? Is it a real change, or the beginning of what's now ending?

GDP data from the BEA, total stock market capitalization is from the US Census Bureau, except for today's number which I extrapolated from the end of Q2-08 amount using the change in the Wilshire 5000 index.

Output is Welfare

"The US average growth rate of real per capita incomes over the last 190 years has been 1.8% a year, and the same rate over the last 10 years has been…. 1.8% a year."

(Hat tip to Chris Blattman.)

The Fundamental Impossibility of Banking

I was just reading Nassim Taleb's claim that

with ... the costs of the 2007-2008 subprime crisis, the banking system seems to have lost more on risk taking (from the failures of quantitative risk management) than every penny banks ever earned taking risks.

And it occurred to me that due to the no arbitrage condition of modern finance, borrowing short at market rates and lending long at market rates while entirely managing risk away is axiomatically an unprofitable business. Since banking is in fact profitable, then it must be that every dollar of profit and every dollar of every bankers salary that is not paid for by reduced rates to depositors or increased rates to borrowers will be paid for by the taxpayers.

There's no free lunch: a safe, free-market bank is impossible.

(Aren't my Saturday nights exciting?)

Start a Company. Now.

My fundamental strength as a venture investor is having a clear view of what the future will look like (at least as regards my little niche of the industry.) My fundamental weakness has always been not being entirely sure how we get from where we are today to that future. I suppose there's a name for that, my type of goal-oriented thinking.

I am thinking about that today because Niki Scevak over at Bronte Media uses the other type of prediction (path oriented thinking?) to predict an entirely different future for startup financing than I do. He makes a convincing argument that the inevitable deleveraging at the major financial institutions and the resulting (relative) scarcity of credit will trickle down to a freeze in VC investment over the next 12-18 months.

As mentioned, I don't have truck with this type of argument. Partly because I don't think that way, but also because I'm not sure it leads to accurate end-states. As one of my smarter mentors once said to me--regarding financial modelling--"if you make 100 assumptions, and each is 99% likely to be true, you have a very convincing argument for something that's almost certainly wrong."

Populist probability calculations aside, I think it's clearly true that errors compound at each step in the path, making the resulting end-state much less likely than a naive reading of the path implies. I prefer to gauge the economic desirability and stability of the various potential end-states and assume that we eventually end up in the best of them.

But, while I assume that all of my predictions will come to pass, I am still waiting for some of them. The most valuable lesson I've learned in the past 15 years as an investor is that if you invest in real, economically substantial change, you'd better be pretty damn patient. The healthcare industry comes to mind.

Back to venture funding: I am more optimistic than Niki.

I believe--with Warren Buffet--that the deleveraging at the banks has to be balanced by money creation elsewhere*. I also believe that the "easy" money to be made in derivatives has crowded out investment in productive assets, such as businesses. As proof, I'll point to the change in the marginal product of capital. (The following relies on a blog post by Casey Mulligan; if anyone knows where to find the underlying data Mulligan used, please let me know.)

The marginal product of capital is a measure of how much profit a unit of capital returns. In the non-financial sector of the US economy, the marginal product of capital has averaged between 7% and 8% a year since World War II. The rate just before the 2001 dot com bubble popped was below this. The rate in late 2007 and early 2008 was about 10%. 10%! 10% is huge. I suggest (without any proof) that investors were buying MBSs and CDOs and the like instead of investing in non-financial businesses. Lack of demand for equity in non-financial businesses caused prices to drop/returns to rise.

If these two propositions are true--that (1) there will still be large amounts of investable capital, and (2) that the returns to be had by investing in non-financial businesses are much higher than average--then I expect investors to find, en masse, new glamor in putting money to work in equities.

Maybe I'm just an optimist, but I predict the return of good old company building as the primary fascination of our financiers over the next two years.

(Hat tip for the Casey Mulligan link to Greg Mankiw.)

* Buffet said that the deleveraging is not possible without someone else levering up, and that someone else has to be the government. I don't assume the mechanism, I just note that bank lending is where the vast majority of our money supply comes from and that if money is not created somehow to offset the disappearance of bank lending, then we will suffer a massive deflation. This would be disastrous, and won't be allowed. Since the government can reinflate the money supply in various ways--including firing up the printing presses and buying back government debt with trillion dollar bills (we could put George Bush's face on it!) if need be--they will.