Another Line to Cross Before Reflation; Nuns and Neutrality

By Jeffrey Snider of Alhambra

Talking with my colleague Joe Calhoun yesterday, he was eager to share with me something he found in the (virtual) pages of the Wall Street Journal, a perfect sign of the times. In a story about a group of nuns in Germany taking their financial future into their own hands, Joe couldn’t help but shake his head at what surely is just another example of how “we” don’t learn.

“I started by googling what a swap is,” Sister Lioba says, referring to a derivative that allows an investor to exchange the income stream of one asset with that of another.

I’m not sure what’s the worse transgression here, the Sister’s entry into what will someday be the same kind of lore as daytraders of dot-coms gone by, or the Journal’s description of a swap that is, understandably for a media article, technically correct but still inappropriate in so many ways. Joe was right to chuckle as nothing could possibly go wrong here.

The 54-year-old then began studying the financial pages of German newspapers and her bank’s research notes.

“I now understand every third sentence instead every 10th when I started,” she says.

The chief economist (it’s always economists, isn’t it?) of the bank that services the nuns’ portfolio is bullish on the Sisters anyway, saying “they have actually proven themselves to be quite the savvy investors.” It’s not savviness that is required, a deficiency often laid bare in the aftermath of almost all prior assurances from economists, nor is technical proficiency a fastidious guard against getting in over your head. The Belgian bank Dexia was both savvy and proficient, and it still wound up like so many others in the unsteady hands of its government.

We haven’t even finished up with the last round of swaps gone awry and still we are to celebrate the fortitude of those who venture into that same unknown? As I wrote back in May:

If Japanese banks were heavily into obtaining dollars via basis swaps especially right after QQE, they would have determined not just the rate of both legs of the swaps but likely factored the expected future direction of JPY. Since it was on a multi-year down-trend that QQE was thought to only fortify, there was undoubtedly considerations as to what the future state of rollover costs would be – addressed directly through further means and hedging like swaptions or, in the likely case of JPY at that time, intentionally left completely unhedged. It’s not as absurd as it sounds when something becomes entrenched conventional wisdom; once something happens (like JPY devaluation) that is expected to happen it is not uncommon for rational humans to simply believe it will always happen. Belgian bank Dexia was bailed out for a second time in October 2011 because it was funding a “carry trade” via total return swaps that essentially shorted German bunds. Because they never thought that interest rates would decline and do so as much as they did, the bank was totally exposed when the (modeled) impossible did happen.

The problem in general terms is not acquiring knowledge; that is to be celebrated in any form or context. It is pushing boundaries without any appreciation for what is not known, or in many cases is not knowable. Appreciating the unknown, to paraphrase Donald Rumsfeld, is something they don’t do well (by definition) in modeled swaps or econometrics, largely because of these stubborn conventions that are believed to have it all figured out.

The Journal tells us that the reason the nuns of Mariendonk have entered the realm of high finance is because the ECB had ruined the conditions of their previous financial existence.

For over a century, Mariendonk financed itself by selling milk and candles, and through income on its bank deposits. After the European Central Bank began cutting rates, eventually going all the way below zero to their current -0.4%, Sister Lioba realized her convent needed extra income to survive.

Orthodox economics persists with the notion of monetary neutrality when we have any number of real world examples to refute that theoretical boundary. Neutrality asserts that changes to the stock of money will not affect real variables such as employment and consumption, affecting at most prices and rates. But the nuns as well as Dexia, Merrill Lynch, MF Global, Wachovia, Lehman, the house flippers of the 2000’s and their forerunner daytraders of the 1990’s show that there is a real effect of at least perceptions of monetary policy.

Most of the behavior that led to the events of 2008 was acting out under false assumptions, the ability of the Fed (or ECB) to extract those daring firms and individuals from trouble being the primary one. How many houses were built in the US last decade because “you couldn’t lose?” Dexia failed because there was just no way that central banks would “allow” it to get so bad that German bunds would get close to 2%, let alone 1%, and now negative. Nobody looked at the downside because it was convention that there wasn’t any, or at least not much before it would trigger the heroics of the printing press. What we got instead was central bankers standing upon the burning embers of a financial system nearly collapsed and proclaiming themselves heroic due to bank reserves because it wasn’t worse.

It’s a far different range of scenarios under that reality than what somehow survives today. Perceptions matter because they drive behavior, and behavior matters because it does have real effects. This is what central banks are actually counting on with QE and all the rest, to be “stimulus” of emotion whether or not there is actual money printing; to get people to act like the money is coming before it ever does, and therefore jump starting the process where it will. The nuns are in one way acting out the intended “portfolio effects” of monetary policy, pushing them into risky behavior that they clearly don’t fully understand because economists believe in efficient markets that said behavior proves likewise is absurd.

By relating it all back to rational expectations and thus efficient markets, economists believe that behavior drives prices and therefore reality. If the nuns buy more swaps because they can’t get a good rate on their CD’s, then the growth and prices of swaps or stocks or whatever other risky asset will be taken as real and therefore a sign of better days. From that, economic participants will act on those prices as if those better days are about to become real because markets are, under the efficient market hypothesis, never wrong – even when a German convent is on the other side of your swap.

Traditional havens such as bonds offer such low returns that Mariendonk now invests around a third of its money in stocks, which are typically more volatile than fixed-income investments. Before rates fell below zero in 2014, the nunnery invested less than a quarter of its portfolio in equity.

Though a human interest story, and an admittedly interesting one, the article was meant to be reassuring. In many ways it is reductio ad absurdum to accomplish that goal, meaning that if nuns can do it so can you, but that absurdity works in both directions; if even the formerly stoic nun portfolio is now under the thumb of “portfolio effects” then what is it that stocks are actually pricing? An actually better future or a misunderstood coping from within the current undesirable circumstance?

Again, we have to circle back to risk. These portfolio effects at least now are not even what most people believe they are. By that I mean low bank rates may be a direct consequence of Mario Draghi’s orthodox views, but the rest of the funding and credit markets are not; the interest rate fallacy driving global rates lower is a much different condition than viewing low rates as “stimulus.” It is, in fact, the same mistaken behavior as “you can’t lose” in housing during the housing mania. Low rates are low because there is everything wrong in the global economy, but stocks may be higher because so many believe in the opposite as being brought about by what already was proved a myth (and a disastrous one).

In 1998, Ben Bernanke wrote a paper with Ilian Mihov for the NBER setting out to prove empirically long run neutrality. The reason for it was that though it had been an accepted theoretical component of the orthodox canon for decades, back to the early 1970’s, many who had gone looking to prove it especially in the 1990’s had instead come to the opposite conclusion. As Bernanke and Mihov wrote:

Cochrane (1995) notes that the output response to money innovations in a VAR context is “puzzlingly protracted”, a finding he uses to motivate his argument that anticipated as well as unanticipated changes in money may affect output. Gordon and Leeper (1994) similarly find that monetary policy shocks affect output over long horizons, accounting for over 30% of the unforecasted variation in output three years after the policy shock.

Don’t worry, however, because Bernanke and Mihov find that long run neutrality does, in fact, hold and “in a robust sense.” And what money variable did they use to define this “robust” evidence? Bank reserves.

Even if President Trump were to ask for Janet Yellen’s resignation on January 21, she would be replaced by just another empty suit for whom bank reserves still count as relevant money and all that would follow from it – right down to nuns in Germany investing in ways that they never would have otherwise no matter how hard the Wall Street Journal and regular economists cheer their moxie.

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