Look Out Below

The Wall Street Journal wrote a story today on the signs that deflation might be on the horizon for Spain and other Euro Zone countries:

Spain became the first country using the euro to post an annual decline in consumer prices in the current slowdown, underlining concerns about the potential for deflation in parts of Europe, as an important research institution reported that the entire euro zone has been in recession since January 2008 -- just a month after the U.S.

You might wonder why people worry about deflation. Lower prices seem pretty good, right? Not quite.

A deflationary economy contains too many goods and too little money. To adjust, prices fall, meaning every dollar you have can buy more stuff. In other words, in Year X $1=1 apple, but in Year Y, with deflation, $1=1.1 apples.

Although this seems good, it can be disastrous for an economy. If you know that your money will have more purchasing power in the future, you will have an incentive to hold onto it instead of spending. When everyone in an economy does hoards cash instead of spending, its contracts the overall demand for goods, which leads firms to fire workers, which further contracts demand for goods, which leads more firms to fire workers, and so on. A classic deflationary spiral.

Deflation also increases the burden on people with outstanding debt, because if you have a fixed-rate interest payment, it remains the same, while the money you use to pay it is worth more. Let's say you have a 7% car lease that costs you $500/month Year X. Even with deflation, it will cost you $500/month in Year Y. But, whereas that $500 was only worth 500 apples in Year X, it's worth 550 apples in Year Y. The actual dollar amount of the payment remains the same, but it's really costing you more*.

So although falling prices might seem good for your pocketbook, somewhat counter-intuitively, they would actually be terrible for this economy.

* If you want to know the math behind this, just take a look at Fischer's equation, which tells us that the Nominal Interest Rate = Real Interest Rate+Inflation Rate. Using algebra, we can show that the Nominal Interest Rate-Inflation Rate=Real Rate of Interest. Therefore when the the inflation rate is negative (which it is under deflation), we will actually get a higher real interest rate.

Blaming BSchools

As a graduate of a business school myself, I've taken great interest in reading about the current crisis will shape how these educational institutions operate. However, I've had some problems with how I've seen the story approached.

First, I'm pretty sure I remember seeing a few of stories that imply that focusing on shareholder value encourages managers to make immoral decisions that harm society. To most people, I'm sure, that vague concept of shareholder value does conjure images of a company fattening its profit margins by destroying rainforests and exploiting foreign workers. But the situation is really much more complex.

Let's take, for instance, the case of a company that wants to tear down an historic building for a new factory. Management expects the plant will be wildly profitable, but locals have been protesting the demolition of the existing structure. Manager A might indeed forge ahead, salivating at the double-digit profit margins he expects the factory will produce. But Manager B might not, realizing that the bad press, boycotts and lawsuit that will no doubt ensue will cut into those profits and lead to a loss. Contrary to the typical characterization of the term, the company would actually maximize shareholder value by NOT building the factory.

I argue that part of the crisis is actually attributable to the fact that management didn't focus enough on maximizing long-term shareholder value. Instead, as has been well documented, bankers and traders at Wall Street banks enriched themselves at the expense of shareholders thanks to a bonus system that encouraged short-terms gains. They reaped rewards creating and investing in products that have led to billions in shareholders losses in the long-term. A quick look at the stock charts tells you that, if anything, these people have minimized shareholder value.

And I'm not sure there is an easy fix to that selfish behavior. Business schools are obviously going to attract people that want to make money. Not all these people are bad people, but for the ones that are, taking an ethics class or two, as some have suggested, isn't going to stop them from making self-serving decisions in the future.

That said, there are parts of the business school curriculum that must be reassessed. Schools continue to teach the financial theories responsible for the Crash of 1987, the downfall of Long-Term Capital Management and the current crisis. As Nassim Taleb -- one of the most vocal critics of business schools* -- points out, for some reason, people still take the word of people like Nobel Prize winner Myron Scholes as gospel despite his role developing the theories that have gotten us into the mess we're in:

First, [Taleb] says, we have to unmask the charlatans of risk like Myron Scholes. To Taleb, Scholes is the Great Oz in this Emerald City because his work on options and derivatives allowed the whole of the financial system to adopt poorly understood products-like the ones that brought AIG down-that hide risk. To Taleb, Scholes' academic work, which enabled the widespread use of complex derivatives, was like "giving children dynamite."
"This guy should be in a retirement home doing Sudoku," Taleb says. "His funds have blown up twice. He shouldn't be allowed in Washington to lecture anyone on risk."

To me, schools continuing to teach these theories seem like a much bigger issue.

* Here's a sample from Fortune:

I worked on Wall Street for close to two decades in trading and risk management of derivatives. I noticed that while portfolio models got worse and worse in tracking reality, their use kept increasing as if nothing was happening. Why? Because in the past 15 years business schools accelerated their teaching of portfolio theory as a replacement for our experiences. It looks like science, and they have been brainwashing more than 100,000 students a year. There is no way my experiences can be transmitted to the next generation because of these schools. We've had fiascoes in finance that they need to neglect because they contradict their models. The problem may also be the Nobel in economics that gave a stamp to these junky theories. Someone needs to make the Nobel committee account for this, for the damage to society - and I hope to do so.

Also see this interview from Bloomberg.

Worth Reading 3/27

• Those Persistent Anonymous Sources (The New York Times): "The Times has a tough policy on anonymous sources, but continues to fall down in living up to it."
  


• Goodbye, Homo Economicus (The Prospect): "What the “madmen in authority” heard this time was the distant echo of a debate among academic economists begun in the 1970s about “rational” investors and “efficient” markets. This debate began against the backdrop of the oil shock and stagflation and was, in its time, a step forward in our understanding of the control of inflation. But, ultimately, it was a debate won by the side that happened to be wrong. And on those two reassuring adjectives, rational and efficient, the victorious academic economists erected an enormous scaffolding of theoretical models, regulatory prescriptions and computer simulations which allowed the practical bankers and politicians to build the towers of bad debt and bad policy."
  


• Richard Rorty and the efficient markets debate (TheMoneyIllusion): "It is widely assumed that the 2006 housing bubble was irrational, and perhaps in part it was. But again, let’s not get too overconfident. In fact irrational overconfidence—the same psychological trait that may generate bubbles, also generates an excessive level of confidence that we can spot bubbles. We all tend to remember when we make a correct prediction, or even have a correct hunch. But how often do we remember our failures? And if we forget the failures, do we grossly overestimate our batting average?"
  

Whither the BSDs?

Wall Street honchos like to fancy themselves as Masters of the Universe. As Michael Lewis hilarious chronicled in Liar's Poker, traders and salesmen, in particular, like to roam the floor considering themselves BSDs. Which is why I always find it funny when these business big shots are too cowardly to go on the record for stories, such as John Heilemann's anonymous source-filled piece in this week's New York on Obama's economic team.

Check out all these at least somewhat-critical quotes:

On Wall Street, meanwhile, where Geithner’s stock has been falling precipitously for weeks, a prominent Democratic banker (and Obama backer) told me, “It’s not that everyone here thinks he should be fired. It’s just that there’s no one who would stand up right now and publicly throw their support behind him.”

“Tim and Barack might have been able to get away with ‘Trust me on the details’—except that they were following Paulson, who asked to be trusted so many times and then changed directions that no one was going to trust any Treasury secretary on the details,” remarks a senior executive at one of Wall Street’s biggest banks. “And then here comes Tim and says, ‘Trust me on the details.’ Oy vey.”

The situation was exacerbated by the paucity of senior staff at Treasury, which has made it nearly impossible for Wall Street to talk to Geithner’s shop: “There is no one there to answer the phone,” says one executive. “Literally.”

To some in the White House, the sight of the financial world turning hard against Geithner is curious, even baffling. What the Obamans thought they were getting in him was Wall Street’s guy. “They don’t get it,” says one name-brand Democratic banker. “Geithner was a $500,000-a-year guy. He was the regulator. People knew him, liked him fine, but he was never a member of the club.”

Back in New York the following day, I related that story to a CEO pal of mine who is a big Obama backer. “What are they, smoking crack down there?” he replied. “Find me one CEO who likes what they’re doing. Seriously, find me one!”

“I heard [Obama budget director] Peter Orszag on TV saying health care is the biggest problem affecting the economy,” says one Democratic CEO. “No, it’s not. Right now, of the top ten things they should be focused on, it’s like, No. 11; the first ten are the banks.”

Obama has made this argument on several occasions now, but it made its debut when he addressed the Business Roundtable earlier this month. It was one of those occasions where the venue for the message mattered nearly as much as the message itself. “What it said to me was, they know they have a problem with business, that they’re not in la-la land about that any more,” explained another Obama-friendly executive in the city. “But unless they fix the banks, nothing else matters. That’s what everyone is waiting for.”

I don't believe in the old saying that if you don't have anything nice to say, you shouldn't say it all. But if you're going to say it, at least have a big enough SD* to put your name behind it**.

*Yes, I realize some of these could be women, but the blog works better this way.

** To be fair, the political types quoted were just as bad in hiding behind anonymity (although not all the quotes were critical).

When the financial crisis hit in September, Furman put Summers in charge of doing the opening presentation on Obama’s economic conference calls, which took place daily (at least) during that pivotal time. “Larry was just brilliant on those calls,” recalls one regular participant. “And not just brilliant but inclusive and generous—he was very rarely as assholic as he had a reputation for being.”

Obama also heard from many Summers opponents. “The problem was, 50 percent of the people Obama asked about Summers said no fucking way—between the confirmation hurdles and the arrogance problem,” says this person, who was asked. “But everyone said he had to have Larry at the table. And Obama had really come to respect him. The funny thing is, Barack barely knew Tim; they’d only met a couple times, there was no relationship there.”

“I went through battle after battle with Tim, and he’s quite remarkable,” says a former Treasury official from the Paulson era. “He’s a very strong leader. He’s smart, he’s tenacious, he works harder than anyone. There were countless times when Paulson and Ben Bernanke were focused on academic discussions and Tim was the one who brought things back to reality.”

(Some suggested putting former Fed chairman Paul Volcker in the job for a year, with Geithner as his deputy and successor in waiting.) “I have great respect for Tim,” says one of them. “But I thought he lacked the gravitas for the job, the ability to be a commanding figure, to get on TV and have people take one look at him and say, ‘Yeah, he’s the man.’ ”

A longtime Geithner ally in Washington comes to a different conclusion. “A lot of the pushback he’s getting from Wall Street is about their lack of self-awareness about how the world has changed, how they’re not the Masters of the Universe anymore,” this person argues. “They feel marginalized and put-upon by the administration’s rhetoric about the greedy bankers. They are way behind the curve about where the public is and how much pressure the administration is feeling. They don’t like what the new environment means for how they run their business. They see their taxes going up and their compensation going down. And what they don’t do is go to the New York Times and say, ‘My feelings are hurt. I don’t like what the new president is saying about our character and our competence.’ What they say is, ‘These guys are incompetent, we need a real policy, the Treasury secretary has got an unsteady hand—he’s not up to the job.’ They’re thinking one thing and saying something quite different.”

When I was at the White House recently, I jokingly asked a senior Obama official if the team was having fun turning the country into a socialist state. “What are you talking about?” this official replied. “Business loves what we’re doing!”

Was Volcker placated? Maybe only momentarily. “He wants to have a real role,” says someone who knows him. “If they’re gonna call him an Obama adviser, he wants to really advise. He has no interest in just being window dressing.”

“All I can tell you,” says one administration official, “is that Larry seems quite happy with this part of the policy portfolio being known as the Geithner Plan.”

The truth, in the end, is that whatever emerges will be perceived as the Obama plan. And the president is apparently deeply uncomfortable with nationalization. “Barack’s perspective is, if you do one bank, what happens to the next weaker one and the next one and the next one?” explains someone with his ear on economics. “Where do you draw the line? How far do you end up going? What are the repercussions?” Obama, notes this person, is risk-averse in his decision-making. “He wants to know in advance the likely outcome. So he’s saying to Tim and Larry, let’s play it out—and there is no solid answer. If you do Citi, you can’t be sure what that means for B of A. You’re not sure whether Goldman and Morgan can survive as just investment banks. That level of uncertainty is something that, for them, is really hard to swallow.”

If you have about 40 free minutes ...

It's worth watching the following video of Larry Lessig speaking at Google. Lessig, the Stanford Law School professor that founded Creative Commons, has decided to return to Harvard Law School to work on his newest project Change Congress, which is pushing to reform the political system by supporting "a hybrid of small-dollar donations and public financing, to keep big money out of politics". I found the speech below thanks to a link on the blog of Northwestern b-school professor Sandeep Baliga, who attended a similar Lessig presentation that he called the "best talk I have ever witnessed in person".

Check it out for yourself:

I Like It, But Will They?

As a reader, I really like what I think is a new feature Esquire magazine has added to its front cover: The page number for the table of contents. It's a minor issue, but I always found it a bit frustrating to have to flip through a bunch ads the magazine has packed up front to get to what I'm looking for. Really, I wish more magazines would do this.


That said, I'd be pretty upset if I were an advertiser. Isn't this basically just inviting readers to skip through ads*? The only reason I could even see the magazine deciding to do this is if there were a bunch of people like me complaining about all the ads that stood in the way of the table of contents. I know there's a wall separating editorial content and ad sales, but given this is magazine that sold an ad on its front cover, that's not quite as clear as it's been in the past. I'm surprised, then, they'd let this sort of a thing happen.

* The cover has page numbers for many feature stories, too, but they've done that in the past.

A few thoughts...

At this point, pretty much everything that one can say about the bonus bill has been said. It's way too broad a piece of legislation, doesn't actually fix the problems underlying the compensation models at these firms, will only encourage firms to shift a bigger portion of pay to salary (if it actually gets passed), etc. That said, there are a few things I did want to point out:

• A number of people have suggested that part of the reason people are upset about the bonuses* is that they simply don't understand how salaries and bonuses work on Wall Street. The "public", the argument goes, equates a bonus with a reward for good work, so it's easy to see why they're upset. But surely, if the public knew that a majority of a banker's pay came from his bonus and not his salary (therefore making a bonus like a de facto salary), people would be more sympethic, the people sticking up for bankers say.
  

  I'm going to go out on a limb and say people would be just as upset if the banks were spending millions to pay salaries instead of bonuses. Average people are pretty shocked to learn you can make so much money simply moving pieces of paper round-and-round.

• There are also a number of people (such as Nate Silver, for instance) who have pointed to examples where bankers/traders might actually deserve the money they make, especially in cases where they better the public good. I'm fairly certain these are the exceptions rather than the rules. Certainly -- like all professions -- there are people that are very good bankers, but most are mediorce or just plain bad. Remember their motivations for getting into the business -- to make a lot of money, not to save the world. My sense is that if you could really rank most Wall Street banker's priorities when doing a deal, they'd go something like this:

1.) Banker
2.) Banker's friends at his firm
3.) Banker's firm
4.) Banker's friends at other firms
5.) Other Wall Street firms
455.) Banker's neighbor
956.) Banker's pizza delivery guy
1875.) Banker's client

* When at Yale for a quiz bowl tournament in high school, a Yale quiz bowl team member made a big point about saying the plural of bonus was boni. Apparently, that is incorrect.