Things That Go Bump In The Night


Pennywise: Tasty, tasty, beautiful fear.
Eddie: Okay, so let me get this straight. It comes out, from wherever, to eat kids for, like, a year, and then what? It just goes into hibernation?
It (2017)

Even at eleven, he had observed that things turned out right a ridiculous amount of the time.

― It, Stephen King (1986)

Same with markets. Things turn out right a ridiculous amount of the time. Pennywise only shows up once every 27 years. Should we be scared about his market equivalent?

Like many children with over-developed imaginations, I was always scared of things that go bump in the night. To this day I remember vividly the events (all fictional, of course) that frightened me so badly, like this scene from the 1979 made-for-TV movie of Stephen King’s Salem’s Lot, where little vampirized Danny tries to get his friend to open the upstairs window and let him in. You see, vampires have to be invited into your house. You have to give them permission to destroy you.

Hold that thought.

Anyway … as a child, I convinced myself that I could keep myself and my family safe from these malevolent forces and evil eyes if only I surrounded myself with the proper talismans (mostly stuffed animals, arranged just so around the bed) and said the proper words to God before going to sleep.

And it worked! This was classic magical thinking, just like that used by so many of our smartest and most powerful adults to protect us from the malevolent forces of economic recession and political decay.

I’d love to say that I’ve outgrown these fears that I know are irrational, but the truth is that I still surround myself with protective talismans and carry them with me wherever I go … a couple of lucky pennies, sure, but also a lucky dime (h/t Scrooge McDuck); one of the many chestnuts that I’ve rubbed between thumb and fingers till it’s oiled black and smooth, thinking this was my uniquely private charm until I recently found a well-worn chestnut hidden away in my grandfather’s rolltop desk; fortunes from cookies I ate 20+ years ago; my half of the turkey wishbone from this Thanksgiving, where my wife and I always not-so-secretly try to let the other win; an ancient post-it note wishing me luck, scribbled by one of my kids not for any particular reason, but just because. Powerful magics, all.

I’ll bet any amount of money that everyone reading this note has their own protective talismans. Maybe not as over-the-top as me, but you have them. This has always been my can’t-miss Turing test — the question you ask of an intelligence you can’t see to determine if it’s human or machine — what’s your talisman? What’s your charm of protection or luck? Every human being has a talisman. No machine would. It’s like asking a computer what mnemonic device it uses to remember something like the colors in the spectrum of visible light … the name Roy G. Biv has no meaning to a non-human intelligence other than as a curiosity of a less-capable species.

In investment and allocation circles, we have a name for these magical protections against spooky market forces that go bump in the night. We call them hedges. Now I’m not talking about hedge funds per se. I’m talking about the ad hoc hedges used by naturally long-only allocators like foundations and endowments and pension funds and big family offices. I’m talking about the ad hoc hedges used by naturally long-only investors like everyone with an IRA. I’m talking about how everyone reading this note has, at one time or another, gotten scared about markets and decided to hedge their professional portfolio or personal account with something that will make money if markets go down. Not as part of a considered review of risk tolerances and return projections and portfolio convexity (whatever THAT means). Not as part of an intentional portfolio that might include a long-volatility manager or a dedicated short fund. But just because we’re scared of something going bump in the night, and we need a talisman to ward off the bogeyman.

The most common of these casual hedges, the investment equivalent of a lucky penny, is the put option, and its most common expression is the put spread.

Quick review! A put is an option where you’re betting on whether the underlying thing, say the S&P 500, will go down below a certain price level before the expiration date of the option. So if I buy a put option that’s “struck” at a price level 5% below where the S&P 500 is today, and that option expires three months from today, then in three months my put option will only have value if the S&P 500 is at least 5% below its current price. The farther below that 5% strike price, the more money the option is worth.

A put spread is when I both buy AND sell a put option. Slightly different put options, of course, otherwise I’d just be buying and selling the same thing, but the difference between the two options — either in expiration time or (more commonly) the strike price — is the “spread” that I’m now betting on. So let’s say I bought a three-month put option struck at 5% down on the S&P 500 and sold a three-month put option struck at 15% down. When those options expire, I’ll make money on the put I bought if the S&P 500 is down at least 5%, and I’ll make a little money on the put I sold (limited to the price someone paid me for the option in the first place) if the S&P 500 avoids being down more than 15%.

Why would I do this complicated little dance? I do it in order to reduce the net cost of the put option I’m buying (the one struck at 5% down in this example). I want to buy some “insurance” on my portfolio that will pay off if the market is down more than 5%, and I can reduce the cost of buying that more-than-5%-decline insurance policy by selling someone else a more-than-15%-decline insurance policy. I mean … yeah, I’m scared of a 5% bogeyman attacking the market, but a 15% bogeyman? In the next three months? C’mon, that’s crazy talk. I’m not THAT scared.

As you can imagine, there are a zillion different variations on the put spread theme, depending on how scared I am and what I’m scared about. As you can also imagine, selling these put spreads to naturally long-only investors is a lucrative business for Wall Street, the bread and butter of equity derivative desks everywhere.

Again, I want to make clear that I’m not talking about the Street’s interaction with professional investors where options trading is part and parcel of their particular strategy. If you’re a BMW salesman, do you make your money by selling to a guy who owns a limo service and knows everything about the car business? No, of course not. You make your money by selling (or better yet, leasing) a new vehicle every three years to the doctors and lawyers and financial advisors who love their beemers. They’re not dumb guys and you’re not fleecing them (or else they’ll try a Mercedes for a change), but it’s not their business. This is where you make your margins. It’s exactly the same thing with the Street and selling portfolio hedges to naturally long-only investors.

Here’s the other similarity between luxury car sales and portfolio hedge sales. When you step back for any sort of a long-term view, is there really a meaningful difference in the transportation utility between a new BMW and a used Chevy? Of course not. There’s a personal utility I get in driving a BMW. My dad bought a BMW 1600 (the cheaper cousin of the 2002) in Birmingham freakin’ Alabama back in 1972 when BMWs were economy cars. I learned to drive a stick shift with that car. That car would flat-out FLY. It connects me with my father, gone 20 years now, and my own youth to own a BMW. So you’re damn straight I’m going to keep driving one. But I don’t own a BMW because it improves the Sharpe ratio of my transportation portfolio. I own it because it’s a powerful talisman for my personal life story. It makes me feel better about myself.

This is the reason why so many naturally long-only investors have paid for billions of dollars in ad hoc portfolio hedges, mostly in the form of put spreads, over the years. Not because these hedges have improved the risk-adjusted returns of their portfolio — decidedly on the contrary, in fact — but because they make long-only investors feel better and more secure about their portfolio. Ad hoc portfolio hedges are a crucial part of the STORY we tell our investment committees — either an external committee or, more importantly still, that internal investment committee we all carry around inside our heads — about how we are ever-vigilant against the monsters lurking just beyond the castle walls.

And it works! Not in an economic sense, of course, but in the powerful psychic benefit it provides, like me as a child arranging the stuffed animals around my bed just so, or me as an adult driving a BMW.

But here’s the thing about our adult talismans — they’re not cheap. Sure I might not care about the premium I pay to drive a BMW when times are good, but I can tell you from experience that I care a lot if my annual income takes a big hit. Talismans and charms are great for the psychic benefit they provide, and god knows I’m all about psychic benefits, but if it’s that or paying the mortgage …

I think that naturally long-only investors are now abandoning their portfolio hedges, because they can no longer easily afford the psychic benefits of these expensive adult talismans.

The investment returns of so many naturally long-only investors have been so disappointing for so many years (in relative terms if not in absolute terms) that it is harder and harder to justify the very real cost of putting on ad hoc portfolio hedges. If you don’t keep up with the Joneses in the investment returns you provide your client, external or internal, you will be fired. If you’re a good story-teller, that will buy you more time with your client than if you’re a poor story-teller, but it’s only a matter of time. You. Will. Be. Fired. In times like this, psychic benefits go by the wayside, and I think this is creating a big shift in the behavioral structure of markets.

I don’t have any proof-positive charts to show you that naturally long-only investors (who control the vast majority of financial assets in the world, btw) are now changing their long-held behaviors by abandoning ad hoc portfolio hedges. I have plenty of anecdotes and stories, and a couple of suggestive charts, but like all big shifts in investor behavior this is a slow burn that won’t be obvious until it’s already happened. If I’m right, though, this is a sea change in the way that the game of markets is played, with important implications for anyone who cares about playing the players and not just playing the cards.

Here are two charts that suggest a behavioral shift.

First, this chart (h/t Joe Gulotta) shows the ratio of outstanding equity put options to call options on the Chicago Board Options Exchange (CBOE), the largest options exchange in the U.S. I like looking at the ratio of puts to calls because it’s not impacted by the overall level of options usage in and of itself. Whatever the overall option activity might be, this ratio is isolating how many investors are participating in negative markets bets (puts) versus positive market bets (calls). The put/call ratio is typically used by traders as a sentiment indicator (so in this case showing a bullish market sentiment), and that’s all well and good. I’m using it for a different purpose … not to judge sentiment levels per se, but to see if we can glean behavioral patterns from the path in which those sentiment levels change over time. I’m not particularly interested in measuring sentiment or even change in sentiment. I’m interested in understanding the behaviors associated with sentiment, and how those behaviors change over time.

There have been six trading days over the last eleven where there were only half as many put options held by investors as call options. Prior to this, there were six trading days with this 1:2 ratio over the past two years. Also, you can see on this chart that there have always been spikes of put buying activity every few months, when investors get scared about this or that and decide to buy some talismans for “protection”. We haven’t had that sort of spike since last summer, and it’s not like there haven’t been any well-publicized market bogeyman since last summer. It’s the put-buying behavior that’s changed.

Second, this chart  (h/t Devin Anderson and the rest of the Deutsche Bank equity derivatives team) shows the changing value of outstanding put options on the S&P 500. In other words, I’m less interested in the ratio or total number of put options out there at any given time, than in the dollar amount of hedging that those put options represent. This is what it means to show “delta-adjusted” open interest on put options, measured here in billions of dollars. So per this chart, over the past five years the maximum amount of hedging on the S&P 500 index using put options occurred in the fall of 2015, with about $230 million worth of “insurance”. Today, however, there is only about $70 million in S&P 500 index protection outstanding, the lowest amount in five years, and it sure looks to me like it’s on a path to nothing. Which would be an amazing thing.

I’m not saying that it’s a bad thing.

In fact, as someone who has a strong professional interest in encouraging allocators and investors to focus on what truly matters for their portfolios (see, of course, Rusty Guinn’s 2017 serial opus for Epsilon Theory, summary of the chapters linked here), I think it’s a good thing to stop making these ad hoc portfolio hedges. And if it’s accompanied by a conscious review of risk, reward and REGRET in our investment strategies for a profoundly uncertain world … well, that’s a really good thing.

But it is an amazing thing, with some important implications. Here’s one:

For years now, whack-a-mole vol-selling strategies, where any slight pick-up in volatility was promptly whacked on the head with a mallet of put selling and volatility futures shorting, have been extremely successful. Why? Because when volatility spiked up it meant that there was a bogeyman narrative being projected by CNBC and the like, and the naturally long-only allocator or investor got all scared and decided to “buy protection” with a put spread or some similar ad hoc hedge. And then when the bogeyman didn’t materialize, this “insurance” expired worthless, and the premiums paid were pocketed by the volatility selling strategies. If you’ve ever bought a portfolio hedge (and god knows I have), then you’ve been the counterparty to these vol-selling strategies. Time after time after time, you’ve been on the losing side of the zero-sum game that is the options market.

Today though … if that talismanic put-buying behavior is going away — and I think it is — then systematic volatility selling strategies won’t work as well going forward as they have in the past. That’s not a bold market call. It’s just a mechanistic fact of markets: sellers don’t get as high of a price for what they’re selling if you have fewer buyers. Volumes go down and margins are squeezed for traders, too.

This isn’t just an issue for hedge funds and Big Bank equity derivative desks. Systematic vol-selling strategies are everywhere these days, including the most vanilla of accounts. Got a covered-call overlay (also called a buy-write strategy) on your RIA account? That’s a systematic vol-selling strategy. Now please, I’m not saying that these are bad strategies or anything like that. Really, I’m not. I’m saying that a change in the hedging behaviors of institutional investors isn’t just inside baseball stuff. It matters for every financial advisor, every individual investor trying to figure out what to do.

And it goes way beyond the impact on this investment strategy or that strategy. What I think we’re seeing is the next necessary step in the transformation of markets into political utilities, where political institutions like the Fed are tasked in a more and more explicit manner with supporting the interests of the Nudging State and the Nudging Oligarchy. Does anyone doubt that if a vampire were truly to appear and knock on the market’s window, say a vampire in the form of a North Korean artillery attack, that the central banks of the world wouldn’t do “whatever it takes” to keep markets from falling? Why should we pay good money to buy put options as a hedge on our portfolio when the Fed will give us a put option for free? I think this is the most far-reaching and transformative effect of the extraordinary central bank policies of the past eight years — we are no longer afraid of things that go bump in the night.

But should we be?

Let’s agree (I hope) that buying ad hoc hedges in response to our fear of things going bump in the night is a poor implementation of our worries, that it’s an expensive psychic benefit that rarely moves the portfolio performance needle even if it works. But if we could implement a hedging strategy in a systematic way (not necessarily mathematical, although maybe, but always rigorous and repeatable in its process … something I’ve written about a lot, notably here and here), should we?

Are there monsters that the Fed can’t protect us from?


I think that there are two ways to think about the monsters that are immune to the central bankers’ Protection from Evil spell (sorry, revealing my OG D&D roots there).

First, there are monsters that the central bankers CAN’T control. Now to be honest, there aren’t too many of these bogeymen out there after eight years of forward guidance chants and $20 trillion of asset purchases, but the most obvious ones all come out of some unexpected turn of events emerging from China — a military coup, a hot war, a yuan devaluation (or float), a cold war on trade … something of that ilk. All very low probability events, but not totally crazy, either. If China and the U.S. are ever seriously at odds in a geopolitical sense, then it doesn’t matter how much jawboning we get from central bankers … the market is going to decline in a serious way. But I don’t get too worried about these monsters that the Fed can’t control.

Much more important, I think, are the monsters that the Fed WON’T control.

There’s an old saying that I remember liking so much when I first heard it: “Ask for forgiveness, not permission.” It appealed to me (and I suspect to most readers) because it speaks to our personal sense of independence and autonomy. By golly, I’m going forward with this smart plan of action that might not get approved in advance by my boss or my board or my significant other, because I truly believe it’s best for the team. And if my boss or my board or my significant other has a problem with my actions after the fact … well, then I’ll swallow hard, take full responsibility and ask for forgiveness.

This is exactly the opposite of how vampires behave.

Vampires ALWAYS ask for permission.
Vampires NEVER ask for forgiveness.

You get one chance to say no to a vampire. After that … well, you asked for it.

I’m not talking about Stephen King vampires. I’m talking about real-world vampires, intensely self-interested professions that have been institutionalized into destroyers. Real-world vampires aren’t knocking on the window asking for permission to come in. We’ve already given them permission. They’re already inside.

Like politicians who are invited into our White House and Capitol with our votes. Politicians who then enact policies to enrich and empower themselves, their families and their posses. Politicians who pursue these policies with absolute entitlement and zero shame.

Like police and surveillance organizations who are invited into our homes and cellphones with our tacit and explicit expressions of support for civil security. Police and surveillance organizations who then seize our property and our communications. Police and surveillance organizations who pursue these seizures with absolute entitlement and zero shame.

Like technology companies who are invited into our friendships and purchasing behaviors with our voluntary social media and online commerce participation. Technology companies who then monetize our most private habits, opinions and preferences. Technology companies who pursue this monetization with absolute entitlement and zero shame.

Like unfathomably large banks who are invited into every aspect of our lives with our insatiable appetite for debt and consumption. Unfathomably large banks who then claim a permanent and unbreakable lien on our income and our labor. Unfathomably large banks who pursue this claim with absolute entitlement and zero shame.

Each of these modern vampires has charisma. They don’t present themselves as ghouls floating outside the upstairs window. They present themselves as the Robert Pattinson equivalent for whatever group of citizens they need to open the front door wide. It is, per Anne Rice, the first lesson of the vampire: “to be powerful, beautiful and without regret.”

This is how you NUDGE.

Each of these modern vampires of the Nudging State and the Nudging Oligarchy shares a certain DNA. Not to get all Marxist here, but these vampires share the DNA of Capital, in opposition to the DNA of Labor, and this is why you will never see the Fed or any other central bank lift a finger against them. Because the Fed is also a creature of Capital not a vampiric destroyer as these modern manifestations of Capital have become — but a creature of Capital nonetheless.

Meaning what, Ben? Meaning that all of the Fed’s policies — and particularly the monetary policies that are most impactful on our investment portfolios — are in the service of Capital. Sometimes, as we’ve experienced over the past eight years, that means incredibly accommodative monetary policy to support asset collateral prices. Sometimes, as we’ve seen in the past and I think we’re about to see again, that means punitive monetary policy to crush labor and wage inflation.

I don’t know how this change in monetary policy regime plays out. I don’t know how quickly punitive monetary policy happens or how far it runs. I can’t predict it. But I know that the Fed won’t prevent it, because the Fed isn’t your protector, and that’s what you should hedge against in an intentional, systematic way.

In real life it’s never the monster that goes bump in the night that gets you.

It’s always the monster in plain sight.

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Magical Thinking



Duane Hall: Can I confess something? I tell you this as an artist, I think you’ll understand. Sometimes when I’m driving … on the road at night … I see two headlights coming toward me. Fast. I have this sudden impulse to turn the wheel quickly, head-on into the oncoming car. I can anticipate the explosion. The sound of shattering glass. The … flames rising out of the flowing gasoline.
Alvy Singer: Right. Well, I have to — I have to go now, Duane, because I … I’m due back on planet Earth.
“Annie Hall” (1977)

One of my all-time top-ten movie scenes. Of course, Duane ends up driving Alvy and Annie back to the airport that night. No one does crazy better than Christopher Walken. Except maybe the Fed’s #2, Stanley Fischer. We’re all just passengers in the backseat of the Fed-driven car.



Alvy Singer: This guy goes to a psychiatrist and says, “Doc, my brother’s crazy; he thinks he’s a chicken.” And the doctor says, “Well, why don’t you turn him in?” The guy says, “I would, but I need the eggs.” Well, I guess that’s pretty much how I feel about relationships; y’know, they’re totally irrational, and crazy, and absurd … but, I guess we keep going through it because most of us … need the eggs.
“Annie Hall” (1977)

We’re all passengers in the backseat of the Fed-driven car, and we all suspect that our drivers might be high-functioning lunatics, and we’re all terrified about what they might do next.

But we need the eggs.


“What are the stars?” said O’Brien indifferently. “They are bits of fire a few kilometres away. We could reach them if we wanted to. Or we could blot them out. The earth is the centre of the universe. The sun and the stars go round it.”

“For certain purposes, of course, that is not true. When we navigate the ocean, or when we predict an eclipse, we often find it convenient to assume that the earth goes round the sun and that the stars are millions upon millions of kilometres away. But what of it? Do you suppose it is beyond us to produce a dual system of astronomy? The stars can be near or distant, according as we need them. Do you suppose our mathematicians are unequal to that? Have you forgotten doublethink?”

Winston shrank back upon the bed. Whatever he said, the swift answer crushed him like a bludgeon. And yet he knew, he knew, that he was in the right. The belief that nothing exists outside your own mind — surely there must be some way of demonstrating that it was false? Had it not been exposed long ago as a fallacy? There was even a name for it, which he had forgotten. A faint smile twitched the corners of O’Brien’s mouth as he looked down at him.

“I told you, Winston,” he said, ‘”that metaphysics is not your strong point. The word you are trying to think of is solipsism. But you are mistaken. This is not solipsism. Collective solipsism, if you like. But that is a different thing: in fact, the opposite thing.”

George Orwell, “1984” (1949)

As O’Brien patiently explains to Winston between torture sessions, or what we would call today “FOMC meetings”, Collective Solipsism is the voluntary abdication of empirical and independent thought. But it’s not ordinary solipsism — a pathological egocentrism where reality is entirely defined by one’s own thoughts. Instead, Collective Solipsism annihilates one’s own thoughts and replaces them with state-sponsored thoughts. Your reality is just as fake. But you’re living someone else’s fantasy.

epsilon-theory-magical-thinking-september-1-2016-joan-didionGrief turns out to be a place none of us know until we reach it. … We might expect that we will be prostrate, inconsolable, crazy with loss. We do not expect to be literally crazy, cool customers who believe that their husband is about to return and need his shoes.

In the version of grief we imagine, the model will be “healing.” A certain forward movement will prevail. The worst days will be the earliest days. We imagine that the moment to most severely test us will be the funeral, after which this hypothetical healing will take place. … We have no way of knowing that this will not be the issue.

There was a level on which I believed that what had happened was reversible.

 ― Joan Didion, “The Year of Magical Thinking” (2005)

The best book I’ve ever read on the emotion of grief. Central bankers today are grieving the death of the so-called Great Moderation, and they are expressing their grief in the same way that Didion expressed hers — through magical thinking, through the pathological belief that if only the right words are said and the right thoughts are thought, then the dearly departed might walk through the front door and ask for his shoes.


 Mr. Hilsenrath: What kind of compromise would it take to get the FOMC to move in September? I mean, so the tradition is there’s some kind of — like you say, some kind of agreement. What would it take to get them there?
 Mr. Bullard: Well, I have no idea, so — and it’s really — it’s really the chair’s job to fashion that. But I will say that — I’ll talk historically about the FOMC, the kinds of things that the FOMC would do. You would trade off. You would say, OK, we could hike today, but then we’ll not plan to do anything in the future. That would be one way to — one way to go about a consensus. So that often happens on the FOMC. Or vice versa. If you read the Greenspan-era transcripts, he’ll do things like, OK, we won’t go today, but we’ll kind of hint that we’re pretty sure we’re going to go next time.
 Mr. Hilsenrath: Right.
 Mr. Bullard: And so you get this inter-tempo kind of trade-off, and that often — that often is enough to get people to sign up.
 Mr. Hilsenrath: So, hike today and then delay.
 Mr. Bullard: Yeah. (Laughs.)
 Mr. Hilsenrath: Or, no hike today and then no more delay.
 Mr. Bullard: Yeah, yeah.
 Mr. Hilsenrath: Something like that.
Mr. Bullard: Yeah, those kinds of trade-offs are, historically speaking — I’m not saying I know what Janet’s doing, because I don’t. But, historically speaking, those are the kinds of things that the FOMC has done.
Mr. Hilsenrath: I came up with my catchphrase for the — for the month. (Laughter.)
Mr. Bullard: Those are great. That’s worthy of a T-shirt. (Laughs, laughter.) You could have one on the front and one on the back.
Ms. Torry: Or a headline.
Mr. Hilsenrath: Well, that’s the St. Louis framework now, right?
Mr. Bullard: Yeah.
Mr. Hilsenrath: Hike today and then delay.
Mr. Bullard: Yeah. That’s what it would be, yeah.
Mr. Hilsenrath: But if you decide to use that, maybe you can credit — you know, include a little footnote to the Wall Street Journal.
Mr. Bullard: OK. (Laughs.)
― Wall Street Journal, “Transcript: St. Louis Fed’s James Bullard’s Interview from Jackson Hole, Wyo.” (August 27, 2016)

Reading this transcript made me throw up in my mouth a little bit. And Bullard is the best of the lot. At least he’s honest about the intellectual poverty about the whole FOMC interest rate-setting exercise. They’re just making it up as they go along, a hallmark of magical thinking.


In point of fact magicians appear to have often developed into chiefs and kings.

 ― James George Frazer, “The Golden Bough” (1890)

Frazer’s book on the history and anthropological foundations of magic was a revelation to me when I first read it, as it was to as disparate a group of writers and poets as Yeats, TS Elliot, Freud, Hemingway, Joyce, and … Jim Morrison.


Courtier T.L. — Amid all the people starving, missionaries and nurses clamoring, students rioting, and police cracking heads, His Serene Majesty went to Eritrea, where he was received by his grandson, Fleet Commander Eskinder Desta, with whom he intended to make an official cruise on the flagship Ethiopia. They could only manage to start one engine, however, and the cruise had to be called off. His Highness then moved to the French ship Protet, where he was received on board by Hiele, the well-known admiral from Marseille. The next day, in the port of Massawa, His Most Ineffable Highness raised himself for the occasion to the rank of Grand Admiral of the Imperial Fleet, and made seven cadets officers, thereby increasing our naval power. Also he summoned the wretched notables from the north who had been accused by the missionaries and nurses of speculation and stealing from the starving, and he conferred high distinctions on them to prove that they were innocent and to curb the foreign gossip and slander.

 ― Ryszard Kapuscinski, “The Emperor” (1978)

If you can only read one book on the end of an ancien regime and the magical thinking that ALWAYS takes place in its wake, this is it. Kapuscinski chronicles the final years of Haile Selassie’s reign in Ethiopia from the inside out, interviewing dozens of courtiers to paint a first-hand portrait of an entire society lost in the fantasy world of Collective Solipsism.

Selassie and his Inner Party maintained the fantasy for years after it lost all connection with reality, so that a mighty fleet consisted of a single ship with a malfunctioning engine, promotions and medals were conflated with real-world power and influence, and bad people and bad ideas were constantly lauded and rewarded to keep hard questions from being asked.

Spoiler alert: it doesn’t end well for Selassie or for Ethiopia. In the words of another famous solipsist, Louis XV, “après moi, le deluge.” After Selassie came The Dergue. Think Pol Pot in committee form.

The last years of Selassie’s rule are more than a parable for our times … they ARE our times.

Magical thinking is a term of art in both clinical psychology and cultural anthropology, and it refers to the common belief among both children and “primitive” societies (yes, intentional quotation marks there to show my arched eyebrow at the word) that thinking the right thoughts or saying the right words can control the invisible forces that shape our world.

For example, as Jean Piaget (the father of developmental psychology) noted, children from the ages of 2 to 7 tend to have very little conception of real-world causality. Tell your four-year-old son that the family dog has died, and he is likely to a) blame himself for something he did or didn’t do for “causing” the death, and b) believe that there is some combination of proper words and proper thoughts and proper actions that can make the dog come back to life. That’s magical thinking. It’s a profoundly ego-centric conception of the world, and if you’re a parent you know exactly what Piaget is talking about. Every four-year-old child is an egomaniac, in the clinical, non-judgmental sense of the word.

It’s the same thing with what cultural anthropologist Claude Lévi-Strauss called “The Savage Mind” in his groundbreaking 1962 book. Societies without a causal explanation for, say, the weather will always construct some sort of combination of words and thoughts and actions to be performed by privileged caste members like priests or kings, through which the entire society convinces itself that humans exercise some sort of control over these incredibly powerful real-world forces and that they aren’t just buffeted this way and that by the inexorable might of a big bad world that really couldn’t care less about them. In fact, that’s the literal origin of the word “inexorable”, from the Latin in (not), ex (away), orare (to pray) — something that cannot be prayed away.


In early days of any human society, this sort of magic usually emphasizes some form of sympathetic or like-for-like object … for example, you might rub a banana-shaped crocodile tooth against a banana plant to make it bear fruit (I’m not making this up). Over time, however, the spellcasting caste and society at large convince themselves that you don’t really need actual crocodile teeth, but you can instead invoke the power of a crocodile tooth by calling it by its secret name. Maybe you need to write down that secret name using the secret language of the priests in order to make the spell work, but you definitely don’t need to go out and hunt down a real-world crocodile. It’s at this point that hunter/soldier-kings are replaced by academic/priest-kings … the pen is truly mightier than the sword, or at least writing “crocodile” carries a longer life expectancy than hunting crocodiles. Over still more time, the secret names and the secret language of the priest-kings become a vast edifice of magical thinking, an edifice that provides great comfort and stability to the entire society. Because there is nothing more important to societal stability than the belief that nature is under control. That the invisible forces of nature can, in fact, be prayed away.

Until they can’t. Until all the banana plants die because of some rare nematode infestation in the roots, and all the secret words and secret languages and even the “old magic” of the actual crocodile teeth are useless. They were useless all along, of course, as the banana plants would have borne fruit for the past 50 years with or without the spells, but hey … until this year there was a 98% correlation between the spells and a healthy banana crop! And my VAR was really quite negligible!

Okay, Ben, we see what you’ve done here. Yes, yes … quite droll, really … you’ve found a clever metaphor for railing against our central banker ruling class. Again. Thanks for the diversion, but now we need to get back to planet Earth. Important work to be done, and all that. Love your quotes, by the way.

Wait! This is not a metaphor. This is not an anthropological parable for our times. This IS our times. Want to see what a magic spell looks like? Here you go:


This is the Gaussian Copula spell. It’s what you write down to make sure that your AAA-rated slice of a massive bunch of mortgages pays you 6% a year with only an infinitesimal risk of default. It’s not a metaphor for a spell. It is an actual magic spell, exactly the same in form and function as the talismanic scripts written on, say, Egyptian funerary urns in 1000 BC to make sure that your body and soul get to the afterlife with only an infinitesimal risk of default.

Secret language no one can read or understand? Check. Not really comprehensible even by most magicians? Check. Administered by a privileged caste with appropriate pomp and ceremony? Check. Reflective of an innate human desire to control invisible forces that are, in fact, uncontrollable and inexorable, like death and business cycles? Check. Highly effective in motivating human behavior and supporting status quo political institutions? Check. And mate.

The Gaussian Copula spell wishes away the possibility of a nationwide decline in U.S. home prices (if you haven’t already, please read Felix Salmon’s 2009 Wired magazine article on the Gaussian Copula — “The Formula That Broke Wall Street” — my all-time favorite piece of financial market journalism). The magical thinking embedded in this spell is that a nationwide decline in U.S. home prices is not just unlikely, it is — literally — unthinkable. It is an incantation that generated enormous societal stability and wealth, creating out of whole cloth a belief that a $10 trillion (yes, that’s trillion with a T) asset class in residential mortgage-backed securities (RMBS) was a solid thing, a triumph of Science (why, just look at all those Greek letters and the mathematical stuff!), an example of man’s mastery over the invisible vagaries of nature.

And then we had a nationwide decline in U.S. home prices. Which broke our world.

Here’s another spell:


This is the Taylor Rule spell. It’s what you write down to make sure that the inflation rate in your economy goes up or down the way you want it to go up or down. There are lots of other spells that go along with the Taylor Rule spell for “controlling” inflation, but it’s the main one, I’d say. This is the spell that has created a $12 trillion asset class in negative yielding sovereign debt. Because, you know, the lower interest rates go, the more you’re going to borrow and spend, and the higher inflation goes. Right? Right?

If the Gaussian Copula is like a funerary spell, trying to assure investors that they will get to investor heaven like dead Egyptian Pharaohs were assured of getting to dead Egyptian Pharaoh heaven, the Taylor Rule is like a weather spell. When I read this from James Frazer’s The Golden Bough:

epsilon-theory-magical-thinking-september-1-2016-scotland-witches So in Scotland witches used to raise the wind by dipping a rag in water and beating it thrice on a stone, saying:

I knok this rag upone this stane
To raise the wind in the divellis name,
It sall not lye till I please againe.

I can’t help but think of Stanley Fischer, vice-warlock of the Fed coven, saying in Jackson Hole that we need thrice interest rate raises (one last December, two more this year) to quell the inflationary winds. Or raise them. Or whatever sort of weather that Fischer is trying to manufacture. It’s really hard to tell.

But here’s the kicker. When a spell doesn’t work, no one in the magically thinking society believes it’s because spell-casting itself doesn’t work. It means that the spell wasn’t performed properly. Either the priest-kings said the words wrong or they didn’t think the right thoughts or there’s some other invisible force that we need to propitiate first. So what always happens, and I mean “always” in the sense of This. Is. Human. Nature. and has been happening in a rhyming sense for tens of thousands of years across every human society that ever lived, is this:

In phase 1, the priest-kings try harder. They seek out purer ingredients for their spells. They speak more loudly, more convincingly, more stridently. If two crocodile teeth were used in the past, now they use four. Or eight. It’s not just “more”, it’s “MOAR!”. Often there’s an internal purge near the end of phase 1.

In phase 2, the priest-kings regroup and tweak the spell. Maybe instead of “targeting” (another word for “praying for”) a 2% inflation rate, we need to “target” a 4% inflation rate. Maybe we should change the magic word “inflation” to “nominal GDP growth” and see if that works any better. Sure, why not? This tweaking process has happened, it is happening now, and it will happen all the way to the bitter end. What will never happen is that the priest-kings quit. There’s always another tweak, always another word choice, always another order in which the words can be said.

In phase 3 — and this is where we are now in the historical process, somewhere near the end of phase 2 and the beginning of phase 3 — the priest-kings are challenged by a rogue priest in their midst (rare) or an alt-priest coming out of nowhere (common). By “nowhere” I mean that the alt-priest is an Other, whether that’s a foreign religion or a foreign geography or a foreign (i.e., non-priestly) caste. The alt-priest isn’t about tweaking the spell or casting it louder. He’s about doing an entirely different spell, and he’s about accusing the incumbent priests of incompetence or worse. The alt-priest is always a populist, and populism comes easy when the incumbent spells have been failing … and failing … and failing.

So what happens? It depends on reality. It depends on whether the banana plants get better on their own or if they die. If they get better on their own (and this happens more often than you might think), then the incumbent priest-kings remain. If the banana plants give up the ghost, then the incumbents are swept away. For future reference, this is what dead banana plants look like.


Interestingly — and this was Frazer’s big point in The Golden Bough — even if the incumbent mode of magical thinking survives, it’s necessary for societal stability to perform a public human sacrifice of the primary incumbent priest-king. The king is dead. Long live the king. Fortunately for all involved, human sacrifice today is a lot less literal than it was during, I dunno, the heyday of the Etruscans. A little public shaming, a tearful interview with Anderson Cooper, a quiet hermitage in the form of a deanship at a small New England college … yeah, that should do the trick.


The way this all plays out also depends on how deeply the incumbent priest-kings retreat into their fantasy world of tweaking spells and magical thinking, and that’s where I’m most concerned. The fact is that the global economy — particularly the U.S. economy and the Chinese economy — is more robust than the alt-priests tend to let on. Amazingly enough, the U.S. can still grow its way out of the massive debt we’ve taken on. I know … hard to believe. But it’s true. The power of compounding is truly inexorable, and it’s amazing what a steady 3.5% growth rate on a huge economic base can do to make manageable even trillions of dollars in debt. The rest of the developed world? Impossible to grow their way out of debt. They’re finished. Or rather, to use the lingo of my distressed debt friends, Japan and Europe ex-Germany are now “work-out situations”. But if the U.S. could just get out of its own way … if we could stop arguing about who gets to use what bathroom and start arguing about how to increase productivity (i.e., how to make technology a tool for humans doing more stuff rather than a replacement for humans doing stuff at all) … then we could actually come out of this okay.

I know, I know … I’m a dreamer. And for all the political fragmentation and polarization reasons that I write about ad nauseam, or at least here, here, here, and here, the politics of identity are unlikely to be replaced by the politics of growth anytime soon. Not in the West, anyway. But that’s why I want to pull my hair out when I watch the Jackson Hole theatre. Guys, you’re not helping!

I was dumbfounded by the stultifying, excruciating more-of-the-sameness that came out of Jackson Hole. Oh my god, are we really saying that the entire FOMC decision-making process comes down to whether there’s a good jobs report on Friday? Why don’t we just inspect the entrails of a goat? Are we really still arguing about one-raise-or-two when LIBOR is now pushing 90 basis points? Was there any mention — any mention at all — of LIBOR during the entire Jackson Hole meeting? Do these people, and it’s not just the central bankers themselves but all the courtiers — the journalists, the academics, the hangers-on — do they even recognize that a world exists outside of their imaginations and theories? Answer: NO.

Yep, at first I was disappointed in them. But on reflection I became more and more disappointed in us.

See, the problem isn’t with the Fed. They’re going to do what solipsistic, magical thinking priest-kings have done for ten thousand years … more of THAT. More solipsism. More magical thinking. More 4 year old egomaniacal determination that their spell casting efforts are the ONLY thing that stand between us and utter ruin.

No, the bigger problem is with us. The bigger problem is that we cannot imagine a solution for our current economic and political problems that does not rely on greater and greater state-directed spell casting. Monetary policy spells not working? Well, golly, I guess our ONLY alternative is to try some fiscal policy spells. Really? That’s the best we can come up with? I understand that this is what the courtiers are going to say. But I expect more from the rest of us. I expect more from myself.

Look, I get it. To riff on Woody Allen’s famous joke, we need the eggs. We need a stock market that goes up, not down. We need financial asset price inflation. We need the eggs so badly that we’re willing to support the magical thinking crew and smile at their courtiers even though we think they’re totally out of touch with reality. We’ve become so used to getting our eggs delivered on time and without fail that our first, second, and third responses are to ask for more magical thinking from the incumbent priest-kings, not less.


This is a dangerous, myopic game. Because we will get what we ask for. We will get more magical thinking. Only it won’t come just from the status quo magicians. It will also come from the alt-priests, some of whom will represent the absolute worst impulses of humanity. There are really bad ideas lurking on the wings today — there always are — but these really bad ideas about how human society should be organized always resurface and grow more powerful at times like this. Because it’s the old magic, an old magic that the human animal is hard-wired to respond to.

Maybe we’ll get lucky. Maybe the banana plants of global growth will turn green again, and we can have a grand celebration of the particular variant of the policy spell that was coincidentally cast at the same time. That could happen. As Otto von Bismarck, the Iron Chancellor of 19th century Europe supposedly said, “there is a special providence for children, fools, and the United States of America.” Any portfolio manager with long enough tenure knows what it’s like to be bailed out by the market, and it’s a beautiful thing. Now we just need that to happen on a much larger scale.

But we should do better than just trust to luck. I’m not saying that we have to deny our human nature and stop believing in the act of spell-casting itself. I’m not (that) delusional. What I’m saying is that the more we embrace and encourage state-directed magical thinking, whether it’s of the monetary or fiscal policy sort, what we are actually doing is opening the city gates to the old evil magic and the alt-priests of fascism and totalitarianism. We don’t need the eggs that badly. What I’m saying is that we need to think less about Scottish witchcraft, a la Macbeth and James Frazer and Stanley Fischer, and more about the Scottish Enlightenment, a la David Hume and Adam Smith and Alexander Hamilton. What I’m saying is that we need to focus on empiricism and on what works in the real world, not theory and what “works” as an equation. What I’m saying is that usually the better course of state-directed action is to do less, not more, and the better course of individually-directed action is to do more, not less. What I’m saying is that the old good magic of small-l liberalism and technological innovation in the service of man rather than the replacement of man is pretty darn powerful itself, and the stories still inspire. Let’s embrace and encourage THAT as we make our way through what is still a largely inexorable world.


It matters whether or not we call things by their proper names, because the words and the spells motivate human behavior like nothing else. It matters whether or not we sleepwalk our way through our own fin de siècle, because the really bad people and the really bad ideas that periodically wreck our world can’t be wished away. It matters whether or not we become courtiers ourselves, because the courtiers always fall the farthest. The problem with magical thinking run amok and its perpetuation of a fantasy world is that sooner or later the dream of the delusional king becomes a real world nightmare for real world people. It’s time to wake up.

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