Uttin’ on the Itz


High hats and arrowed collars, white spats and lots of dollars
Spending every dime, for a wonderful time
If you’re blue and you don’t know where to go to
Why don’t you go where fashion sits,
Puttin’ on the Ritz.
– Irving Berlin

Hegel remarks somewhere that all great, world-historical facts and personages occur, as it were, twice. He has forgotten to add: the first time as tragedy, the second as farce.
– Karl Marx

Every time I hear a political speech or I read those of our leaders, I am horrified at having, for years, heard nothing which sounded human.
– Albert Camus

The structure of a play is always the story of how the birds came home to roost.
– Arthur Miller

In Young Frankenstein, Mel Brooks and Gene Wilder brilliantly reformulate Mary Shelley’s Frankenstein; or, The Modern Prometheus, a tragedy in the classic sense, as farce. The narrative crux of the Brooks/Wilder movie is Dr. Frankenstein’s demonstration of his creation to an audience of scientists – not with some clinical presentation, but by both Doctor and Monster donning top hats and tuxedos to perform “Puttin’ on the Ritz” in true vaudevillian style. The audience is dazzled at first, but the cheers turn to boos when the Monster is unable to stay in tune, bellowing out “UTTIN’ ON THE IIIITZ!” and dancing frantically. Pelted with rotten tomatoes, the Monster flees the stage and embarks on a doomed rampage.

Wilder’s Frankenstein accomplishes an amazing feat – he creates life! But then he uses that fantastic gift to put on a show.

So, too, with QE.

These policies saved the world in early 2009. Now they are a farce, a show put on by well-meaning scientists who have never worked a day outside government or academia, who have zero intuition for, knowledge of, or experience with the consequences of their experiments.

Two things happened this week with the FOMC announcement and subsequent press conferences by Bernanke, Bullard, etc. – one procedural and one structural.

The procedural event was the intentional injection of ambiguity into Fed communications. As I’ll describe below, this is an even greater policy mistake that the initial “Puttin’ on the Ritz” show Bernanke produced at the June FOMC meeting when “tapering” first entered our collective vocabulary.

The structural event – which is far more important, far more long-lasting, and just plain sad – is the culmination of the bureaucratic capture of the Federal Reserve, not by the banking industry which it regulates, but by academic economists and acolytes of government paternalism. These are true-believers in too-clever-by-half academic theories such as management of forward expectations and in the soft authoritarianism of Mandarin rule. They are certain that they have both a duty and an ability to regulate the global economy in the best interests of the rest of us poor benighted souls.

Anyone else remember “The Committee to Save the World” (Feb. 1999)? The hubris levels of current Fed and Treasury leaders make Rubin, Greenspan, and Summers seem almost humble in comparison, as hard as that may be to believe. The difference is that the guys above operated in the real world, where usually you were right but sometimes you were wrong in a clearly demonstrable fashion. A professional academic like Bernanke or Yellen has never been wrong. Published papers and books are not held accountable because nothing is riding on them, and this internal assumption of intellectual infallibility follows wherever they go. As a former cleric in this Church, I know wherefore I speak.

There’s frequent hand-wringing among the chattering class about whether or not the Fed has been “politicized.” Please. That horse left the barn decades ago. In fact, with the possible exception of Paul Volcker (and even he is an accomplished political animal) I am hard pressed to identify any Fed Chairman who has not incorporated into monetary policy the political preferences of whatever Administration happened to be in power at the time.

Bureaucratic capture is not politicization. It is the subversion of a regulatory body, a transformation in motives and objectives from within. In this case it includes an element of politicization, to be sure, but the structural change goes much deeper than that. Politicization is a skin-deep phenomenon; with every change in Administration there is some commensurate change, usually incremental, in policy application. Bureaucratic capture, on the other hand, goes clear to the bone, marking a more or less permanent shift in the existential purpose of an institution. The WHY of the Fed – its meaning – changed this week. Or rather, it’s been changing for a long time and now has been officially presented via a song-and-dance routine.

What Bernanke signaled this week is that QE is no longer an emergency government measure, but is now a permanent government program

In exactly the same way that retirement and poverty insurance became permanent government programs in the aftermath of the Great Depression, so now is deflation and growth insurance well on its way to becoming a permanent government program in the aftermath of the Great Recession.

The rate of asset purchases may wax and wane in the years to come, and might even be negative for short periods of time, but the program itself will never be unwound.

There is very little difference from a policy efficacy perspective between announcing a small taper of, say, a $10 billion reduction in monthly bond purchases and announcing no taper at all. But there is a HUGE difference from a policy signaling perspective between the two. Doing nothing, particularly when everyone expects you to do something, is a signal, pure and simple. It is an intentional insertion of uncertainty into forward expectations, a clear communication that the self-imposed standards for winding down QE as established in June are no longer operative, that the market should assumenothing in terms of winding down QE.

Think of it this way … why didn’t the Fed satisfy market expectations, their prior communications, and their own stated desire to wait cautiously for more economic data by imposing a minuscule $5 billion taper? Almost every market participant would have been happy with this outcome, from those hoping for more accommodation for longer to those hoping that finally, at last, we were on a path to unwind QE. Everyone could find something to like here. But no, the FOMC went out of its way to signal something else. And that something else is that we are NOT on automatic pilot to unwind QE. A concern with self-sustaining growth and a professed desire to be “data dependent” are satisfied equally with either a small taper or doing nothing. 

Choosing nothing over a small taper is only useful insofar as it signals that the Fed prefers to maintain a QE program regardless of the economic data. 

But wait, there’s more …

Given the manner in which inflation statistics are constructed today – and just read Janet Yellen’s book (The Fabulous Decade: Macroeconomic Lessons from the 1990’s, co-authored with Alan Blinder) if you think that the Fed is unaware of the policy impact that statistical construction can achieve, as changing inflation measurement methodology is one of the key factors she identifies to explain how the Fed was able to engineer the growth “miracle” of the 1990’s  – inflation is now more of a proxy for generic economic activity than it is for how prices are experienced. In a very real way (no pun intended), the meaning and construction of concepts such as real economic growth and real rates of return are shifting beneath our feet, but that’s a story for another day. What’s relevant today is that when the Fed promises continued QE so long as inflation is below target, they are really promising continued QE so long as economic growth is anemic. 

QE has become just another tool to manage the business cycle and garden-variety recession risks. And because those risks are always present, QE will always be with us.


In Pulp Fiction the John Travolta character plunges a syringe of adrenaline into Uma Thurman’s heart to save her life. This was QE in March, 2009 … an emergency, once in a lifetime effort to revive an economy in cardiac arrest. Now, four and a half years later, QE is adrenaline delivered via IV drip … a therapeutic, constant effort to maintain a certain quality of economic life. This may or may not be a positive development for Wall Street, depending on where you sit. I would argue that it’s a negative development for most individual and institutional investors. But it is music to the ears of every institutional political interest in Washington, regardless of party, and that’s what ultimately grants QE bureaucratic immortality.

It is impossible to overestimate the political inertia that exists within and around these massive Federal insurance programs, just as it is impossible to overestimate the electoral popularity (or market popularity, in the case of QE) of these programs. In the absence of a self-imposed wind-down plan – and that’s exactly what Bernanke laid out in June and exactly what he took back on Wednesday – there is no chance of any other governmental entity unwinding QE, even if they wanted to. Which they don’t. Regardless of what political party may sit in the White House or control Congress in the years to come, it will be as practically impossible and politically unthinkable to eliminate QE as it is to eliminate Social Security or food stamps. 

QE is now a creature of Washington, forever and ever, amen.

At least in June the Fed still projected an aura of resolve. Today even that seems missing, and that’s a very troubling development. Creating a stable Narrative is a function of inserting the right public statement signals into the Common Knowledge game. As described above, it really doesn’t matter what the Party line is, so long as it is delivered with confidence, consistency, and from on high. But once the audience starts questioning the magician’s sleight-of-hand mechanics, once the Great and Terrible Wizard of Oz is forced to say “pay no attention to that man behind the curtain”, the magician has an audience perception problem. Fair or not, there is now a question of competence around Fed policy and its decision-making process.

Sure the Monster can sing, but can it sing well?

What does all this mean for how to invest in the short to medium-term? Frankly, I don’t think that “investment” is possible over the next few months, at least not as the term is usually understood, and at least not in public markets. When you listen to institutional investors and the bulge-bracket sell-side firms that serve them, everything today is couches in terms of “positioning”, not “investment”, and as a result that’s the Common Knowledge environment we must all suffer through.

This is the fundamental behavioral shift in markets created by a Fed-centric universe – the best one can hope for is a modicum of protection from the caprice of the Mad God, and efforts to find some investable theme are dashed more often than they are rewarded.

The Narrative of Central Bank Omnipotence – that all market outcomes are determined by monetary policy, especially Fed policy – is stronger than ever today, so if you’re looking to take an exposure based on the idiosyncratic attributes or fundamentals of a publicly traded company … well, I hope you have a long time horizon and very little sensitivity to the price path in the meantime. I will say, though, that the counter-Narrative of the Fed as Incompetent Magician, which is clearly growing in strength right alongside the Omnipotence Narrative, makes gold a much more attractive option than this time a year ago.


Heeere Comes Lucky!



“It is my understanding that the Constitution of the United States allows everybody the free choice between cheesecake and strudel.”
– Sky Masterson (“Guys and Dolls”)

“One of these days in your travels, a guy is going to show you a brand-new deck of cards on which the seal is not yet broken. Then this guy is going to offer to bet you that he can make the jack of spades jump out of this brand-new deck of cards and squirt cider in your ear. But, son, do not accept this bet, because as sure as you stand there, you’re going to wind up with an ear full of cider.”
– Sky Masterson (“Guys and Dolls”)

“So long as they continued to work and breed, their other activities were without importance. … Heavy physical work, the care of home and children, petty quarrels with neighbors, films, football, beer and above all, gambling filled up the horizon of their minds. To keep them in control was not difficult.”
– George Orwell, “1984”

“If God did not exist, it would be necessary to invent Him.”
– Voltaire

“Mistah Kurtz – he dead.”
– T.S. Eliot, “The Hollow Men”

Growing up in Alabama, gambling was part of the fabric of my life. Sports and card games of all sorts were constants, but the truth is that anything was fair game for a bet, from the behavior of lightning bugs to the duration of a thunderstorm. I learned important market-oriented lessons within this particular sort of educational framework, from the power of leverage in playing gin rummy with my uncle at a penny a point and Hollywood scoring (ouch!) to the Eureka moment when I gave my father 5 points on a college football team, took 7 points from my grandfather on the same team, and realized what would happen if they lost by 6.  Maybe the most valuable lesson was one of my grandmother’s bridge dictums – “there is no such thing as a good re-double” – which has served me well time and again in a wide range of real-life situations.

Of all the gambling activities that permeated my life, however, only one was licensed and sanctioned by the state of Alabama – dog racing. I’m sure it’s hard for anyone under the age of 40 or anyone who grew up in an economically-privileged geography to understand the appeal of dog racing, but it used to be a pretty big deal. More to the point, it was the only game in town for my entire region, as the Gulf Coast casinos and even a state lottery were still decades away from realization, and horse racing might as well have been Formula I racing given the expense involved of the facilities and the animals. In fact, horse racing eventually came to Alabama in 1987 with a Birmingham-area race track, but it was an unmitigated economic disaster and was ultimately converted into a simulcast and live dog racing venue. Dog racing may not have been “the sport of kings”, but it was definitely the sport of the kings of Alabama, as the industry was controlled by Paul Bryant, Jr. – son of legendary Alabama football coach Bear Bryant – who amassed an enormous fortune by virtue of this state-sponsored monopoly over legal gambling.

Is dog racing systematically abusive to greyhounds? Yes, I believe it is, although I can promise you that there were far more gruesome “sports” going on with dogs throughout the area. Would I ever go back to a dog track? No, I would not, but I’m not sorry that I did. The truth is that as a 17-year old kid out on a Friday night with his buddies in Greene County, I was blissfully unencumbered by concerns over the training methods employed or the post-race conditions endured at the kennel. The truth is that I enjoyed the rush of gambling, the excitement of hearing the announcer say “Heeere comes Lucky!” as the mechanical rabbit sped by the gates, and I learned some important lessons about both markets and human nature from the experience.

Now supposedly it’s possible to handicap the potential risk and reward of a dog race as expressed in the odds posted at race time, but this always struck me (even at age 17) as a poor proposition. First of all, unless you are a trainer, and maybe not even then, it seems enormously difficult and costly to acquire private information. And even if you had useful private information, not only is it substantially less than a zero-sum game as the track managers take their cut, but also there is no market-maker to provide liquidity or lock-in the odds/price of your bet. You have some expectation of what the odds are likely to be, based on the tout sheets and the track’s pre-race odds estimations, but the actual pay-outs are entirely dependent on the distribution of actual bets placed by your fellow spectators and have no direct relationship to the pre-race estimations. You may correctly deduce that the pre-race odds on a particular dog are wrong and present an asymmetric risk/reward opportunity, but if everyone else makes the same calculation that asymmetry vanishes (or reverses) in a heartbeat, usually after you’ve placed your bet! Pari-mutuel betting is a wonderful example of the Common Knowledge game in action, where a dynamic assessment of what everyone thinks that everyone thinks is the most useful way to predict attractive pay-out odds, but even with perfect game-playing the enormous transaction costs and shallow liquidity make it a losing proposition. Still worse, though, is to believe that your “fundamental analysis” or straightforward handicapping of the limited public information actually provides you with an asymmetric risk/reward opportunity when everyone else is doing exactly the same thing.

Is today’s stock market the functional equivalent of a dog race, where fundamental analysis of the risk and reward associated with a security based on limited public information is a sucker’s game? No. The fundamental investor is rescued over time by the non-zero sum nature of the stock market, as well as the presence of non-fundamental investors with different preference functions.

But is there a dog racing aspect to today’s stock market that is growing in size and influence, aided and abetted by powerful institutions that want you to respond atavistically to the market equivalent of a mechanical rabbit and the “Heeere comes Lucky!” call? Absolutely.

This past Thursday, September 12th, the weekly unemployment claims number came out as usual at 8:30 AM with a shockingly low result – only 292,000 Americans had filed for initial unemployment benefits in the past week, the lowest number in more than seven years and a decline of more than 30,000 applicants from the prior week. As it turns out, neither Nevada nor California reported complete data to the Labor Department, so the data release was significantly under-reporting actual claims, but this error was not part of the initial news release. Instead, the Labor Dept. only informed a few reporters of the mistake in an embargoed fashion, which meant that the “news” of the embedded error in the filing was announced in an ad hoc fashion by private news agencies after the official release. Both the substance and the process of the error were entirely avoidable, and it was such an egregious mistake that you had past and current officials of the Labor Dept.’s Bureau of Labor Statistics (BLS), who are apparently not directly responsible for collecting this data from the states, criticizing other Labor Dept. employees with more direct responsibility. To use a sports analogy, this is like the defensive line of a professional football team holding a press conference to criticize the offensive line … it never happens.

It’s no surprise that the Labor Dept. made a ridiculously large error with the weekly initial unemployment claims, because this is a systematically biased and flawed data source, particularly under the current Administration. The chart below is a histogram (frequency distribution) of the errors made in the reporting of weekly unemployment claims during the Bush Administration from September 30th, 2005 through the 2008 election.


The horizontal axis consists of different “buckets” of errors as measured by the difference between the revisions that are reported one week later and the original report. For example, if the original report said that 300,000 people filed for unemployment benefits in a given week, but the revised report one week later said that 310,000 people filed for benefits, then that original report would fall into the 9-10k error bucket. A positive error means that the original report under-reported the true number of unemployment claims, and vice versa for a negative error. The more accurate the original reporting, the more the errors should be at or near the 0 mark on the horizontal axis, and the less biased the original reporting, the more the error bars should look like a bell curve centered on the 0 mark. In this chart, 36% of the original reports were error-free (no difference between the revised and original reports) and 47% of the original reports under-reported the actual unemployment claims by 1,000 to 2,000 people. There are a few weeks with slight over-reporting of unemployment claims and a few more weeks of more pronounced under-reporting of unemployment claims, but by and large this is a picture of a reasonably accurate and only slightly biased data report.

And now here’s the frequency distribution of the errors made in the reporting of weekly unemployment claims during the Obama Administration from September 30th, 2009 through the 2012 election.


I mean … I could go through all the statistics that show how accuracy declined and bias increased in the weekly unemployment claim reports from the Bush Administration to the Obama Administration, but this is a good example of how one picture is worth a thousand words.

In the period 9/30/2009 through the November 2012 election, original Labor Dept. reports understated initial jobless claims by 858,000 relative to initial revisions. Compared to final revisions, the original estimates look even worse, understating jobless claims by 884,000. In the period 9/30/2005 through the November 2008 election, on the other hand, original Labor Dept. reports understated jobless claims by 292,000 relative to initial revisions. Compared to final revisions, the original reports understated jobless claims by only 5,000 people! Were there more initial jobless claims in the Obama time period than in the Bush time period? Yes, but only approximately 25% more. The total errors in initial revisions, on the other hand, increased almost 300% over the comparable time periods (and almost 180x versus final revisions!), and the skew towards under-reporting actual claims is even more pronounced.

The systematic error and bias is almost certainly due to the same bureaucratic procedure that caused the most recent snafu – when individual states report incomplete or stupidly estimated data, the Labor Dept. takes the reports at face value and makes no effort to validate or correct them. The error and bias are obvious to the BLS, which is staffed with very smart people, and they could easily fix it if they wanted to. The BLS adjusts raw data all the time, and there are obvious statistical adjustments that could be applied to this obvious systematic error. But the BLS chooses not to fix it because the systematic bias favors the incumbent Administration and is embedded in standard operating procedures. Why make bureaucratic waves to fix this broken data series when turning a blind eye to its structural flaws works in your favor? Only now with this very public embarrassment and no re-election campaign ahead does Keith Hall, a former BLS commissioner, and “several” unnamed economists (i.e., current BLS commissioners) tell the WSJ that the methodology and bureaucratic oversight need to be improved.

As intriguing as this data and shifting bureaucratic Narrative might be from a political perspective (let’s just say that Jack Welch was perhaps not totally wrong in his well-publicized comments regarding the suspicious nature of labor data prior to the 2012 election), there’s a still more interesting question here from an Epsilon Theory perspective. How did this tertiary data series … a labor statistic that maybe 1 in 1,000 professional investors was aware of pre-crisis … a labor statistic that the Bureau of Labor Statistics deemed too minor to administer (!) … come to be the subject of such incredible hand-wringing and scrutiny. Why are we paying such close attention to weekly initial unemployment claims? What does it mean for today’s market that this report is treated as a useful informational signal?

Part of the answer is wrapped up in Fed communications policy and its explicit linkage of monetary policy to labor conditions. I’ve written about this at length in “2 Fast 2 Furious”, and the linkage explains both a generic market and media interest in all things labor-related as well as a very specific interest in the labor statistics that the Fed has noted in its communications. But those communications have never included weekly initial unemployment claims data as a meaningful signal, and it is inconceivable that the Fed – which is staffed with even smarter people than the BLS – would give this data series any credence or weight whatsoever, except in the very broadest sense. Moreover, there are plenty of indications of labor conditions that we know the Fed cares about – the quality or permanence of new jobs, for example – that do not receive one iota of the media attention given to weekly initial unemployment claims.

Here’s the outstanding quality of the initial unemployment claims data from a media presentation perspective – it’s weekly. The data release occurs precisely at 8:30 AM ET every Thursday. With its patina of labor-relevance it’s not an obviously stupid subject to highlight, and with its predictable timing and frequent occurrence it’s tailor-made for media scheduling. The media treatment of weekly initial unemployment claims is representative of the dog race-ification of capital markets, where artificial “events” are established and promoted in hopes of generating investor attention and activity.

In dog racing, there is no meaning to the activity itself other than to provide a context for gambling on the outcome of some pseudo-analyzable event. College football games would still take place even if no one gambled on them, but that’s not the case for dog races. They exist only to excite a gambling animus, and everything about the creation and production of the race is geared to that end. Dog racing is an artificial and constructed practice that fills the coffers of the state Treasuries and the pockets of the Paul Bryant, Jr.’s of the world by providing a regularly scheduled and officially sanctioned venue for the satisfaction of powerful human desires. So, too, are many CNBC segments and WSJ articles.

The weekly unemployment claims number is probably the most egregiously artificial or constructed data series, but it is by no means unique. For example, within the broad category of housing conditions we now have enormous attention paid to weekly data on mortgage applications, as well as monthly data on housing starts, housing permits, new home sales, existing home sales, new home prices, existing home prices, Case-Shiller, and homebuilder sentiment. In general, there has been a pronounced increase in the level of financial media attention paid to regularly scheduled macro data releases – both US and non-US – over the past few years, and it’s a trend that shows no signs of abating. Whether it’s Jobs Friday™ (discussed extensively in “What We’ve Got Here … Is Failure to Communicate”) or Bloomberg’s latest branding effort around consumer sentiment, these macro “signals” are being created and promoted at an accelerating pace, to the benefit of any institution that relies on investment activity, regardless of what that activity is. Those institutions, of course, include every sell-side and media firm, not to mention most political and regulatory bodies. The fact is, once you start looking for artifice in the data signals we are bombarded with, you will find it everywhere.

The point of this note and its identification of the constructed nature of so much of what passes for “data” these days is NOT to encourage you to ignore the reports. This is, unfortunately, what it means to live in a Common Knowledge world – even if you privately believe that much of what you hear is hokum, it is necessary and rational to act as if these are meaningful signals so long as everyone thinks that everyone thinks the signals have meaning. The point is to encourage you to recognize these data reports for what they are, to call them by their proper name, so that you limit your reaction to a rational Common Knowledge response rather than make the mistake of believing that these reports are any more analyzable in a fundamental fashion than the $5 tout sheet at the dog track in Greene County, Alabama. And the next time you hear a CNBC anchor breathlessly describe the importance of the upcoming data report, complete with a clock ticking down the seconds to its release, I hope you hear that broadcast for what it’s really saying – Heeere comes Lucky!

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It Was Barzini All Along



“Tattaglia is a pimp. He never could have outfought Santino. But I didn’t know until this day that it was Barzini all along.”
– Don Vito Corleone

Like many in the investments business, I am a big fan of the Godfather movies, or at least those that don’t have Sofia Coppola in a supporting role. The strategic crux of the first movie is the realization by Don Corleone at a peace-making meeting of the Five Families that the garden variety gangland war he thought he was fighting with the Tattaglia Family was actually part of an existential war being waged by the nominal head of the Families, Don Barzini. Vito warns his son Michael, who becomes the new head of the Corleone Family, and the two of them plot a strategy of revenge and survival to be put into motion after Vito’s death. The movie concludes with Michael successfully murdering Barzini and his various supporters, a plot arc that depends entirely on Vito’s earlier recognition of the underlying cause of the Tattaglia conflict. Once Vito understood WHY Philip Tattaglia was coming after him, that he was just a stooge for Emilio Barzini, everything changed for the Corleone Family’s strategy.

Now imagine that Don Corleone wasn’t a gangster at all, but was a macro fund portfolio manager or, really, any investor or allocator who views the label of “Emerging Market” as a useful differentiation … maybe not as a separate asset class per se, but as a meaningful way of thinking about one broad set of securities versus another. With the expansion of investment options and liquid securities that reflect this differentiation – from Emerging Market ETF’s to Emerging Market mutual funds – anyone can be a macro investor today, and most of us are to some extent.

You might think that the ease with which anyone can be an Emerging Markets investor today would make the investment behavior around these securities more complex from a game theory perspective as more and more players enter the game, but actually just the opposite is true. The old Emerging Markets investment game had very high informational and institutional barriers to entry, which meant that the players relied heavily on their private information and relatively little on public signals and Common Knowledge. There may be far more players in the new Emerging Markets investment game, but they are essentially one type of player with a very heavy reliance on Common Knowledge and public Narratives. Also, these new players are not (necessarily) retail investors, but are (mostly) institutional investors that see Emerging Markets or sub-classifications of Emerging Markets as an asset class with certain attractive characteristics as part of a broad portfolio. Because these institutional investors have so much money that must be put to work and because their portfolio preference functions are so uniform, there is a very powerful and very predictable game dynamic in play here.

Since the 2008 Crisis the Corleone Family has had a pretty good run with their Emerging Markets investments, and even more importantly Vito believes that he understands WHY those investments have worked. In the words of Olivier Blanchard, Chief Economist for the IMF:

In emerging market countries by contrast, the crisis has not left lasting wounds.
 Their fiscal and financial positions were typically stronger to start, and adverse effects of the crisis have been more muted. High underlying growth and low interest rates are making fiscal adjustment much easier. Exports have largely recovered, and whatever shortfall in external demand they experienced has typically been made up through an increase in domestic demand. Capital outflows have turned into capital inflows, due to both better growth prospects and higher interest rates than in advanced countries…The challenge for most emerging countries is quite different from that of advanced countries, namely how to avoid overheating in the face of closing output gaps and higher capital flows.  – April 11, 2011

As late as January 23rd of this year, Blanchard wrote that “we forecast that both emerging market and developing economies will sustain strong growth.”

Now we all know what actually happened in 2013. Growth has been disappointing around the world, particularly in Emerging Markets, and most of these local stock and bond markets have been hit really hard. But if you’re Vito Corleone, macro investor extraordinaire, that’s not necessarily a terrible thing. Sure, you don’t like to see any of your investments go down, but Emerging Markets are notably volatile and maybe this is a great buying opportunity across the board. In fact, so long as the core growth STORY is intact, it almost certainly is a buying opportunity.

But then you wake up on July 9th to read in the WSJ that Olivier Blanchard has changed his tune. He now says “It’s clear that these countries [China, Russia, India, Brazil, South Africa] are not going to grow at the same rate as they did before the crisis.” Huh? Or rather, WTF? How did the Chief Economist of the IMF go from predicting “strong growth” to declaring that the party is over and the story has fundamentally changed in six months?


It’s important to point out that Blanchard is not some inconsequential opinion leader, but is one of the most influential economists in the world today. His position at the IMF is a temporary gig from his permanent position as the Robert M. Solow Professor of Economics at MIT, where he has taught since 1983. He also received his Ph.D. in economics from MIT (1977), where his fellow graduate students were Ben Bernanke (1979),

Mario Draghi (1976), and Paul Krugman (1977), among other modern-day luminaries; Stanley Fischer, current Governor of the Bank of Israel, was the dissertation advisor for both Blanchard and Bernanke; Mervyn King and Larry Summers (and many, many more) were Blanchard’s contemporaries or colleagues at MIT at one point or another.

The centrality of MIT to the core orthodoxy of modern economic theory in general and monetary policy in particular has been well documented by Jon Hilsenrath and others, and it’s not a stretch to say that MIT provided a personal bond and a formative intellectual experience for a group of people that by and large rule the world today. Suffice it to say that Blanchard is smack in the middle of that orthodoxy and that group. I’m not saying that anything Blanchard says is amazingly influential in and of itself, certainly not to the degree of a Bernanke or a Draghi (or even a Krugman), but I believe it is highly representative of the shared beliefs and opinions that exist among these enormously influential policy makers and policy advisors. Two years ago the global economic intelligentsia believed that Emerging Markets had emerged from the 2008 crisis essentially unscathed, but today they believe that EM growth rates are permanently diminished from pre-crisis levels. That’s a big deal, and anyone who invests or allocates to “Emerging Markets” as a differentiated group of securities had better take notice.

Here’s what I think happened.

First, an error pattern has emerged over the past few years from global growth data and IMF prediction models that forced a re-evaluation of those models and the prevailing Narrative of “unscathed” Emerging Markets. Below is a chart showing actual Emerging Market growth rates for each year listed, as well as the IMF prediction at the mid-year mark within that year and the mid-year mark within the prior year (generating an 18-month forward estimate).


Pre-crisis the IMF systematically under-estimated growth in Emerging Markets. Post-crisis the IMF has systematically over-estimated growth in Emerging Markets. Now to be sure, this IMF over-estimation of growth exists for Developed Markets, too, but between the EuroZone sovereign debt crisis and the US fiscal cliff drama there’s a “reason” for the unexpected weakness in Developed Markets. There’s no obvious reason for the persistent Emerging Market weakness given the party line that “whatever shortfall in external demand they experienced has typically been made up through an increase in domestic demand.“ Trust me, IMF economists know full well that their models under-estimated EM growth pre-crisis and have now flipped their bias to over-estimate growth today. Nothing freaks out a statistician more than this sort of flipped sign. It means that a set of historical correlations has “gone perverse” by remaining predictive, but in the opposite manner that it used to be predictive. This should never happen if your underlying theory of how the world works is correct. So now the IMF (and every other mainstream macroeconomic analysis effort in the world) has a big problem. They know that their models are perversely over-estimating growth, which given the current projections means that we’re probably looking at three straight years of sub-5% growth in Emerging Markets (!!) more than three years after the 2008 crisis ended, and – worse – they have no plausible explanation for what’s going on.

Fortunately for all concerned, a Narrative of Central Bank Omnipotence has emerged over the past nine months, where it has become Common Knowledge that US monetary policy is responsible for everything that happens in global markets, for good and for ill (see “How Gold Lost Its Luster”). This Narrative is incredibly useful to the Olivier Blanchard’s of the world, as it provides a STORY for why their prediction models have collapsed. And maybe it really does rescue their models. I have no idea. All I’m saying is that whether the Narrative is “true” or not, it will be adopted and proselytized by those whose interests – bureaucratic, economic, political, etc. – are served by that Narrative. That’s not evil, it’s just human nature.

Nor is the usefulness of the Narrative of Central Bank Omnipotence limited to IMF economists. To listen to Emerging Market central bankers at Jackson Hole two weeks ago or to Emerging Market politicians at the G-20 meeting last week you would think that a great revelation had been delivered from on high. Agustin Carstens, Mexico’s equivalent to Ben Bernanke, gave a speech on the “massive carry trade strategies” caused by ZIRP and pleaded for more Fed sensitivity to their capital flow risks. Interesting how the Fed is to blame now that the cash is flowing out, but it was Mexico’s wonderful growth profile to credit when the cash was flowing in. South Africa’s finance minister, Pravin Gordhan, gave an interview to the FT from Jackson Hole where he bemoaned the “inability to find coherent and cohesive responses across the globe to ensure that we reduce the volatility in currencies in particular, but also in sentiment” now that the Fed is talking about a Taper. Christine Lagarde got into the act, of course, calling on the world to build “further lines of defense” even as she noted that the IMF would (gulp) have to stand in the breach as the Fed left the field. To paraphrase Job: the Fed gave, and the Fed hath taken away; blessed be the name of the Fed.

The problem, though, is that once you embrace the Narrative of Central Bank Omnipotence to “explain” recent events, you can’t compartmentalize it there. If the pattern of post-crisis Emerging Market growth rates is largely explained by US monetary accommodation or lack thereof … well, the same must be true for pre-crisis Emerging Market growth rates. The inexorable conclusion is that Emerging Market growth rates are a function of Developed Market central bank liquidity measures and monetary policy, and that all Emerging Markets are, to one degree or another, Greece-like in their creation of unsustainable growth rates on the back of 20 years of The Great Moderation (as Bernanke referred to the decline in macroeconomic volatility from accommodative monetary policy) and the last 4 years of ZIRP. It was Barzini all along!

This shift in the Narrative around Emerging Markets – that the Fed is the “true” engine of global growth – is a new thing. As evidence of its novelty, I would point you to another bastion of modern economic orthodoxy, the National Bureau of Economic Research (NBER), in particular their repository of working papers. Pretty much every US economist of note in the past 40 years has published an NBER working paper, and I only say “pretty much every” because I want to be careful; my real estimate is that there are zero mainstream US economists who don’t have a working paper here.

If you search the NBER working paper database for “emerging market crises”, you see 16 papers. Again, the author list reads like a who’s who of famous economists: Martin Feldstein, Jeffrey Sachs, Rudi Dornbusch, Fredric Mishkin, Barry Eichengreen, Nouriel Roubini, etc. Of these 16 papers, only 2 – Frankel and Roubini (2001) and Arellano and Mendoza (2002) – even mention the words “Federal Reserve” in the context of an analysis of these crises, and in both cases the primary point is that some Emerging Market crises, like the 1998 Russian default, force the Fed to cut interest rates. They see a causal relationship here, but in the opposite direction of today’s Narrative! Now to be fair, several of the papers point to rising Developed Market interest rates as a “shock” or contributing factor to Emerging Market crises, and Eichengreen and Rose (1998) make this their central claim. But even here the argument is that “a one percent increase in Northern interest rates is associated with an increase in the probability of Southern banking crises of around three percent” … not exactly an earth-shattering causal relationship. More fundamentally, none of these authors ever raise the possibility that low Developed Market interest rates are the core engine of Emerging Market growth rates. It’s just not even contemplated as an explanation.

Today, though, this new Narrative is everywhere. It pervades both the popular media and the academic “media”, such as the prominent Jackson Hole paper by Helene Rey of the London Business School, where the nutshell argument is that global financial cycles are creatures of Fed policy … period, end of story. Not only is every other country just along for the ride, but Emerging Markets are kidding themselves if they think that their plight matters one whit to the US and the Fed.



Market participants today see Barzini/Bernanke everywhere, behind every news announcement and every market tick. They may be right. They may be reading the situation as smartly as Vito Corleone did. I doubt it, but it really doesn’t matter. Whether or not I privately believe that Barzini/Bernanke is behind everything that happens in the world, I am constantly told that this is WHY market events happen the way they do. And because I know that everyone else is seeing the same media explanations of WHY that I am seeing … because I know that everyone else is going through the same tortured decision process that I’m going through … because I know that everyone else is thinking about me in the same way that I am thinking about them … because I know that if everyone else acts as if he or she believes the Narrative then I should act as if I believe the Narrative … then the only rational conclusion is that I should act as if I believe it. That’s the Common Knowledge game in action. This is what people mean when they say that a market behavior of any sort “takes on a life of its own.”

For the short term, at least, the smart play is probably just to go along with the Barzini/Bernanke Narrative, just like the Corleone family went along with the idea that Barzini was running them out of New York (and yes, I understand that at this point I’m probably taking this Godfather analogy too far). By going along I mean thinking of the current market dynamic in terms of risk management, understanding that the overall information structure of this market is remarkably unstable. Risk-On / Risk-Off behavior is likely to increase significantly in the months ahead, and there’s really no predicting when Bernanke will open his mouth or what he’ll say, or who will be appointed to take his place, or what he or she will say. It’s hard to justify any large exposure to public securities in this environment, long or short, because all public securities will be dominated by this Narrative so long as everyone thinks that everyone thinks they will be dominated. This sort of game can go on for a long time, particularly when the Narrative serves the interests of incredibly powerful institutions around the world.

But what ultimately saved the Corleone family wasn’t just the observation of Barzini’s underlying causal influence, it was the strategy that adjusted to the new reality of WHY. What’s necessary here is not just a gnashing of teeth or tsk-tsk’ing about how awful it is that monetary policy has achieved such behavioral dominance over markets, but a recognition that it IS, that there are investment opportunities created by its existence, and that the greatest danger is to continue on as if nothing has changed.

I believe that there are two important investment implications that stem from this sea change in the Narrative around Emerging Markets, which I’ll introduce today and develop at length in subsequent notes.

First, I think it’s necessary for active investors to recalibrate their analysis towards individual securities that happen to be found in Emerging Markets, not aggregations of securities with an “Emerging Markets” label. I say this because in the aggregate, Emerging Market securities (ETF’s, broad-based funds, etc.) are now the equivalent of a growth stock with a broken story, and that’s a very difficult row to hoe. Take note, though, the language you will have to speak in this analytic recalibration of Emerging Market securities is Value, not Growth, and the critical attribute of a successful investment will have little to do with the security’s inherent qualities (particularly growth qualities) but a great deal to do with whether a critical mass of Value-speaking investors take an interest in the security.

Second, there’s a Big Trade here related to the predictable behaviors and preference functions of the giant institutional investors or advisors that – by size and by strategy – are locked into a perception of Emerging Market meaning that can only be expressed through aggregations of securities or related fungible asset classes (foreign exchange and commodities). These mega-allocators do not “see” Emerging Markets as an opportunity set of individual securities, but as an asset class with useful diversification qualities within an overall portfolio. So long as market behaviors around Emerging Markets in the aggregate are driven by the Barzini/Bernanke Narrative, that diversification quality will decline, as the same Fed-speak engine is driving behaviors in both Emerging Markets and Developed Markets. Mega-allocators care more about diversification and correlations than they do about price, which means that the selling pressure will continue/increase so long as the old models aren’t working and the Barzini/Bernanke Narrative diminishes what made Emerging Markets as an asset class useful to these institutions in the first place. But when that selling pressure dissipates – either because the Barzini/Bernanke Narrative wanes or the mega-portfolios are balanced for the new correlation models that take the Barzini/Bernanke market effect into account – that’s when Emerging Market securities in the aggregate will work again. You will never identify that turning point in Emerging Market security prices by staring at a price chart. To use a poker analogy you must play the player – in this case the mega-allocators who care a lot about correlation and little about price – not the cards in order to know when to place a big bet.

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