Hung, The China Boom

Ho-fung Hung, a sociology professor at Johns Hopkins University, invokes history, sociology, and economics to explain why, in the subtitle to his book The China Boom (Columbia University Press, 2016), China will not rule the world.

In the first part of the book, Hung takes the reader back to the two centuries (1650-1850) in which China had a market without capitalism, where capitalism is understood to be the use of money to pursue a larger sum of money. He outlines China’s phase of primitive accumulation (1850-1980), followed by the capitalist boom (1980-2008). The flowering of Chinese capitalism, he argues, was not a radical break with the past. Rather, it was “built on the foundation laid in the Mao period, including a large, healthy, and educated rural surplus labor force and an extensive network of state-owned capital.” (p. 10)

The second part of the book looks at the present and paints possible future scenarios.

With its rise as a global economic powerhouse China took a “great leap backward to inequality.” In the Mao era, inequality was expressed not in income but in power. But after the 1980s income inequality became “the increasingly prevalent form of inequality through which other inequalities are expressed.” (p. 91) Inequality is now manifested in class inequality, the growing rural-urban inequality, and inequality among provinces.

China’s development model led to an imbalance in the Chinese economy, “characterized by tepid household consumption, excessive investment by the state sector, and reliance on the export sector” (p. 151), complaints we have heard frequently. Wage growth is lagging far behind the growth of the economy as a whole. Corporate profits are turned into corporate and government savings, which in turn fuel a credit boom that aggravates overinvestment. “The problem of overinvestment that accompanies worsening underconsumption in China is more severe than it was earlier for the Asian Tigers owing to the decentralized nature of the Chinese developmental stage.” That is, local states in China can act independently, creating “anarchic competition among localities, resulting in uncoordinated construction of redundant production capacity and infrastructure.” (p. 155)

So far China has been able to export its excess capacity. But how long can this last? Hung believes that “the imminent and inevitable readjustment of the Chinese economy is poised to create significant repercussions throughout the world.” (p. 176) Just what these repercussions might be Hung leaves largely to the reader’s imagination. He certainly doesn’t want to be a fear monger. In fact, he concludes:

In the end, China is far from becoming a subversive power that will transform the existing global neoliberal order because China itself is one of the biggest beneficiaries of this order. It will not be exonerated any time soon for its role in facilitating continued dominance by the United States in the world through its supply of low-cost export and credit to the United States. If U.S. global dominance is going to end, it will not likely be fostered by China but by some other forces. To be sure, China has been reshaping and will continue to reshape the context of development in the developing world…. Whether China’s net impact will be beneficial or detrimental to development will vary from country to country and will change from time to time. In the short run and from the perspective of specific individual countries, China’s capitalist boom might seem like a game changer that will bring new prosperity, empowerment, subordination, or crisis. At the global level and in the long run, nevertheless, China is set to disappoint many who hail or fear the prospect of its challenging the existing global order in any fundamental way.” (pp. 180-81)

Turner, Between Debt and the Devil

Adair Turner, the former chairman of Britain’s Financial Services Authority and described by The Economist as a man for all policy crises, upends financial orthodoxy in Between Debt and the Devil: Money, Credit, and Fixing Global Finance (Princeton University Press, 2015). He argues that nothing regulators have done thus far has addressed the fundamental underlying cause of financial instability: that “modern financial systems left to themselves inevitably create debt in excessive quantities and in particular debt that does not fund new capital investment but rather the purchase of already existing assets, above all real estate. It is that debt creation which drives booms and financial busts: and it is the debt overhang left over by the boom that explains why recovery from the 2007-2008 financial crisis has been so anemic.” (pp. 3-4)

For 50 years private-sector leverage increased as “credit grew faster than nominal GDP. In the two decades before 2008 the typical picture in most advanced economies was that credit grew at about 10-15% per year versus 5% annual growth in nominal national income. And it seemed at the time that such credit growth was required to ensure adequate economic growth.” (p. 7) If that theory is in fact correct, we’re condemned to financial instability and crisis. But, Turner argues, we can develop a less credit-intensive growth model if we address the three drivers of credit intensity: (1) the increasing importance of real estate in modern economies, (2) increasing inequality, and (3) global current-account imbalances unrelated to long-term investment flows and useful capital investment.

One policy initiative we should be willing to use in moderation, although Turner admits it will horrify central bankers, is fiat money creation, “using central bank-printed money either to finance increased public deficits or to write off existing public debt.” (p. 12) This action, though reminiscent of a cautionary tale in Goethe’s Faust in which Mephistopheles tempts the emperor to print and distribute paper money, is necessary to escape the debt overhang.

Demonstrating the increasing complexity in the financial system, Turner points to the shift in typical bank balance sheets. In the U.K. in 1964, more than 90% of aggregate bank balance sheets were made up of loans to the real economy plus government bonds and reserves at the Bank of England. By 2008 “much more than half the balance sheets of many of the biggest banks in the world … were accounted for by contractual links, whether in loan/deposit or in financial derivative form, between these and other banks, or between them and other financial institutions, such as money market funds, institutional investors, or hedge funds.” This shift, he notes, reflected in part the dramatic rise in trading activity. “The value of oil futures trading has gone from less than 10% of physical oil production and consumption in 1984 to more than 10 times that of production and consumption now. Global foreign exchange trading is now around 73 times global trade in goods and services. Trading in derivatives … now dwarfs the size of the real economy; … the total notional value of outstanding interest rate derivative contracts had soared by 2007 to more than $400 trillion, about nine times the value of global GDP.” (p. 25)

I could go on and on (and in fact I have pages of notes), but there is no space here. Turner’s book is tightly argued and is packed with insights about the financial markets as well as the real economy. For example, he lists five factors that explain why market bubbles and subsequent crashes are inevitable and five features of debt contracts that make them potentially dangerous. He explains why fixing the banks will not fix the economy. He argues that, if it is to succeed, the eurozone must become a complete currency union and hence a political union and that if this cannot be done, “eurozone breakup is likely to be inevitable and is preferable to sustained stagnation.” (p. 159) He explains in what sense less liquid and less complete markets can be good. And these examples represent but a tiny fraction of the issues Turner tackles in his book.

We know that we still have a long way to go to recover from the financial crisis and that we’re slipping back into some of the practices that gave rise to it in the first place. Turner’s book is both a critique of the status quo and a set of suggestions for getting out of the morass without precipitating yet another crisis. It will, and should, be controversial, but Turner is a worthy adversary.

Lowenstein, America’s Bank

Whenever Roger Lowenstein writes a book it’s a newsworthy event in the financial media. He already has five under his belt—The End of Wall Street, While America Aged, Origins of the Crash, Buffett, and perhaps his best-known, When Genius Failed. His latest book, America’s Bank: The Epic Struggle to Create the Federal Reserve (Penguin, 2015), is yet another tour de force. As over sixty pages of endnotes indicates, he did extensive research, but he writes gracefully, as if telling a familiar story.

In its broadest outlines, the founding of the Federal Reserve Bank is a familiar story, at least to anyone who has a passing interest in U.S. financial history. But Lowenstein shows just how critical, difficult, and in the end miraculous it was.

The American financial system in the late nineteenth and early twentieth centuries was rudderless and fragile, with frequent crises and panics. Paul Warburg, who would be one of the early promoters of the Federal Reserve, likened the currency system “to that of Europe ‘at the time of the Medicis’” (p. 56) and said that “it suffered in comparison with that of the ancient Babylonians.” (p. 74)

Although monetary reform was essential if the country’s rickety banking system was to survive, there was little consensus about the form it should take. How much power should the government, Wall Street, East Coast banks, Midwest banks have? How centralized should the system be? America had already experimented with two national banks and, even though these banks were successful on balance, it didn’t want a third.

The birth of the Federal Reserve was long and arduous. Initially, the very idea of substantive banking reform seemed stillborn. Two Republican administrations (Theodore Roosevelt, William Howard Taft) came and went. One of the key advocates and framers of banking reform, Senator Nelson Aldrich, himself a slow convert to the idea of a Federal Reserve, saw his political clout erode amid scandal. Congress was splintered. The media balked. The Washington Post, responding to the Glass bill, “warily predicted that the power to be lodged in the new Federal Reserve Board could be ‘greater in some respects than the power now wielded by the President of the United States.’” (p. 214)

The Glass-Owen bill was a compromise, addressing the concerns of the time. “No onlooker in 1913 could have predicted that one day the Fed’s most well-advertised duty would be setting interest rates. The bill’s primary purpose was to mobilize reserves, the better to avert a crisis, and to modernize the banking system. … However, an intriguing clause stated that interest rates should be adjusted ‘with a view to accommodating the commerce of the country and promoting a stable price level.’ Buried in that phrase was the suggestion of what became, through a subsequent act of Congress, the Fed’s dual mandate.” (p. 218)

Woodrow Wilson, who eventually signed the Federal Reserve Act into law, had to fend off threats from bankers and deal with a revolt in the House Banking Committee. “The latter in particular upset him. Intraparty strife was the virus that had undone Taft, and Wilson was determined not to give factionalism any quarter.” (p. 224) In the end Glass-Owen passed the House 285-85, with all but three Democrats voting in favor. The Senate, after lengthy wrangling, passed its own bill 54-34, with six Republicans joining a united Democratic front. The gap between the House and Senate bills was “unusually large,” but the conferees managed to produce a conference report that was overwhelmingly accepted by both the House and the Senate. “In twelve short months, Wilson had wrung from a party steeped in devotion to Andrew Jackson, and to the crudest anti-banking stereotypes, the filaments of a central bank.” (p. 252)

Lowenstein explores the hopes and dreams of the men who were instrumental in the creation of the Fed, and he shows how the sausage was made. America’s Bank is an engrossing story.

Superforecasting: 5 master classes

If you were intrigued with Philip Tetlock’s Superforecasting, you can get a lot more at Edge.org, a wonderful site. There he offers five master classes for a high-powered group of round-table participants, including Danny Kahneman and Dean Kamen.

Sekerke, Bayesian Risk Management

Matt Sekerke’s thesis in Bayesian Risk Management: A Guide to Model Risk and Sequential Learning in Financial Markets (Wiley, 2015) is important and, even if not unassailable (just ask all the frequentists), readily defensible:

[T]he greatest obstacle to the progress of quantitative risk management is the assumption of time-invariance that underlies the naïve application of statistical and financial models to financial market data. A corollary of this hypothesis is that extreme observations seen in risk models are not extraordinarily unlucky realizations drawn from the extreme tail of an unconditional distribution describing the universe of possible outcomes. Instead, extreme observations are manifestations of inflexible risk models that have failed to adapt to shifts in the market data. The quest for models that are true for all time and for all eventualities actually frustrates the goal of anticipating the range of likely adverse outcomes within practical forecasting horizons. (pp. 4-5)

Sekerke wants to replace the normally overly complex risk model of classical statistics with a set of models, which are evaluated on their ability to generate useful predictions and which are penalized for complexity. “Though common practice routinely works exclusively with a single model, Bayes factors will always be computable for the chosen model relative to any conceivable alternative specification, so long as informative priors are used. … If one is seriously interested in knowing when models are in danger of breaking down—or equivalently, when the dynamics of markets are undergoing a significant change relative to recent history—the information contained in the Bayes factor is crucially important.” (p. 50)

Bayesian methods are superior to classical methods in numerous ways. One notable difference is that Bayesian inference not only captures the distinction between risk (measurable randomness) and uncertainty (which recognizes that randomness cannot be definitively measured) but “makes visible and quantifiable one element of generalized risk that has been deemed inaccessible to analysis. In fact, the possibility of making model comparisons between models with different discount factors makes it possible to speak of the degree of uncertainty in a meaningful way.” (p. 84)

Sekerke’s book is written for quants, with the appropriate amount of math, but even non-quants can learn something from it. In nine chapters it covers models for discontinuous markets; prior knowledge, parameter uncertainty, and estimation; model uncertainty; introduction to sequential modeling; Bayesian inference in state-space time series models; sequential Monte Carlo inference; volatility modeling; asset-pricing models and hedging; and from risk measurement to risk management.

DiPietro, Day Trading Stocks

When a book begins

“Caution! Alone, this manual will not adequately teach you my intra-day trading and swing methodology. Your mastery of my system will only come about through formal hands-on training. … This book is your introduction. It’s meant to reveal why my training program lasts for one full year. … Do not attempt to trade with this system without formal training from me.”

my first instinct is to cast it aside. I don’t use this site to promote training programs.

But in this case my curiosity got the better of me. Was there anything in Josh DiPietro’s Day Trading Stocks the Wall Street Way: A Proprietary Method for Intra-Day and Swing Trading (Wiley, 2015) worth sharing? The author himself would say no, since he stresses that the book must be read sequentially, no skipping around allowed. So if I write about something from p. 100, I will have violated his reading rules. And he is a man of many rules—primarily trading rules, of course—that are not meant to be broken.

I therefore gave up. I’ll say only that he advocates a fusion of day and swing trading, a countertrend system that endorses averaging down based on “real price levels.” One of its basic tenets is that “You need to get comfortable with being in the red.” (p. 147)

Morris, Wall Streeters

Edward Morris sets out to do for American finance what Paul de Kruif did for biology (The Microbe Hunters) and Robert Heilbroner for economics (The Worldly Philosophers). Through the stories of fourteen influential men, he traces “the development of financial innovations, the growth of financial markets, and the causes of financial crises.” For a variety of reasons having nothing to do with the quality of Morris’s book, Wall Streeters: The Creators and Corruptors of American Finance (Columbia Business School Publishing, 2015) will probably not attain the stature of the works he emulated. But it puts a human face on Wall Street as few finance textbooks do. After all, finance is not simply numbers; it’s also, and even more so, people.

Morris starts with J. Pierpont Morgan. He then profiles three reformers: Paul M. Warburg, Carter Glass, and Ferdinand Pecora. Two democratizers follow: Charles E. Merrill and John C. Bogle. Then come three academics: Georges F. Doriot, Benjamin Graham, and Myron S. Scholes. And three financial engineers: Alfred Winslow Jones, Michael R. Milken, and Lewis Ranieri. And finally, two empire builders: William H. Donaldson and Sanford I. Weill. Each chapter is about twenty pages long.

Just as history can’t be carved up into discrete periods, so Morris’s “lives” don’t always begin and end in the chapters that bear their names. Morris isn’t writing birth-to-death biographies. His focus is on the effect these fourteen people had on the financial world, and effects linger and overlap.

It’s not that he ignores personalities. Morris writes, for instance, that “Milken and Ranieri had little in common. Milken was taut and slender, with a no-nonsense, scholarly mien; except when the subject turned to business, he had little to say and his social life seldom veered from small family affairs. Ranieri, on the other hand, had a Rabelaisian personality and was loud and generally uncouth. He was infamous at Salomon as the perpetrator and subject of outrageously elaborate and sometimes profane practical jokes among his fellow bond traders—while Milken, when the Drexel traders hired a stripper to dance on his desk for his thirty-eighth birthday, simply retreated under the desk with his phone and continued trading.” (p. 252) But the bulk of the chapter on Milken deals with junk bonds; Ranieri’s chapter, with the MBS machine that he started and the rise of quantitative finance. “Mortgages are math” was one of his mantras.

Experienced Wall Streeters will enjoy this book. Students of finance should be required to read it.