Notes From Underground: 2+2=5 is more beautiful than all the models in the universe

An interesting piece appeared in the Wall Street Journal yesterday by Zachary Karabell. Its basis of the piece is that the Fed will return to their models in search of some answer to prevent the return of the crisis from which we are beginning to emerge. Karabell maintains that the Fed did their best work when they abandoned the models to do crisis management. We are always happy to read when others criticize the models that reduce the world to a simple formula.

As many people have pointed out for many years, the Fed models have been flawed and that is where the credit saga begins. Model builders are like bad traders for they become so in love with their models that they cannot admit that their results are wrong–very much like a trader that says he doesn’t use stop losses for she is in it for the long term. In a similar vein, Binyamin Applebaum and David Cho in yesterday’s Washington Post bring to the fore in vivid detail how Bernanke made several mis-statements prior to and in the midst of the sub-prime crisis. Why? Because he depended on the faulty output of the Fed’s beloved models. When questions about the problems in California, Bernanke said he had heard it all before. However, the Fed’s models did not concur. The entire financial system rests upon badly flawed models and that is why we have systemic risk.

We will heed the advice of the smartest man who is not listened to by the movers and shakers of Wall Street: Paul Volcker. The savior of the global financial system in the early 80s is pushing for the seperation of lending banks from trading banks. We couldn’t agree more and below is a letter we wrote to the FT on August 30th, 2002.We don’t often blow our own horn at Notes but this time we have to join the battle.

LETTERS TO THE EDITOR – Profit centres too big to fail.
30 August 2002
Financial Times

(c) 2002 The Financial Times Limited. All rights reserved

From Mr Yra Harris.

Sir, John Plender (“How banks got in a mix”, August 21) correctly identifies the systemic dangers that accompanied the passage of the Graham-Leach-Bliley act. The repeal of Glass-Steagall has pushed the US banking system to the brink of “moral hazard”. The conglomeration of all financial services under one roof has entangled banks in numerous ethical conflicts. Additionally, Graham-Leach-Bliley has made several institutions so large that the Fed cannot allow them to fail.

A single institution’s deep involvement in every facet of financial dealings does not create greater synergy but greater risk. These large, private profit centres know they are too big to collapse. This realisation adds great uncertainty to the entire financial landscape. Rewarding private profits while socialising the risk is a pathway to disaster. Glass-Steagall should never have been repealed without a bank forfeiting its right to Federal Deposit Insurance Corp insurance.

The DOLLAR and equities continued rising together today, confounding the pundits yet again. The market now appreciates the convergence of low rates with a potential growth story which is causing the short term unwinding of the powerful DOLLAR carry trade. The stress in the European debt markets eased a bit as the German/Greek spread eased to 246 basis points from 276 yesterday. This did not give a bid to the EURO though giving more credence to the power of the carry trade unwind.

Chinese Central Bank Governor Mr. Zhou commented on the need for China to raise reserve requirements to curb incipient inflation. This strategy is not new for the PBOC (People’s Bank of China) as they have repeatedly used the reserve requirement tool to curb speculation. It is interesting that the Chinese are talking about inflation after the PBOC failed to buy the IMF gold that went to INDIA. The Chinese are trying to squeeze the long gold positions that raced in and drove the market away from the Chinese–we really believe that central Banks have become educable.

The fact that central banks have become traders supports our views on the importance of being nimble and flexible when operating in the investment world. The buy and hold strategy is being called into question, due to the fact that S&Ps are lower over the last decade. This is a main theme of ours and will be repeated ad nauseam. Again we caution to watch the Chinese closely for their actions will be far more important than words. The Chinese forward market was bid today as Mr. Zhou also alluded to the power of the International Balance of Payments to cause inflation. Some interpreted this to be a hint by the bank to curb the inflows of hot money.

Will the Chinese allow the Yuan to appreciate to put an end to some of the inflows? This has not been the Chinese way but we will be on the alert for any policy actions directed that way. If we listen to the FED’s concern of a negative output gap, we have to wonder what the Chinese are thinking about with their huge amount of excess capacity funded by foreign money and  the forced lending habits of Chinese state-directed banks.Inflation—hmm, we will have to wait to see with that unused capacity overhang.

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2 Responses to “Notes From Underground: 2+2=5 is more beautiful than all the models in the universe”

  1. Steve Wollack Says:

    You couldn’t have been more right in 2002 and your letter is certainly right on today.

  2. ray mckenzie Says:

    great blog today as usual Yra.

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