Monday, November 24, 2014

The Celtic Tiger Falls Into A Trap

The 2006-2011 Irish economic and financial crisis must certainly go down as one of the most dramatic collapses of recent years, despite a litany of strong contenders. Few other crises have highlighted so painfully just how quickly specific problems can morph into Hydra-like catastrophes. In the Irish case, a real estate crisis turned into a banking and financial system crisis, which turned into a fiscal crisis, leading to a sovereign debt crisis and contributing to a regional currency crisis.

I recently finished "The Fall of the Celtic Tiger" by Donovan and Murphy (henceforth D&M). I found it very enjoyable and informative on the specifics of the Irish crisis. The book does an excellent job of laying out the series of events that led to the Irish state guaranteeing the liabilities of its banking system in 2008 and the request for a Troika bailout in 2010. It also comprehensively highlights the role played by different actors in this tragedy, ranging from the property developers and banks to Irish politicians, regulators, media and the public. Few escape the book's critical but balanced gaze.

Somewhat unfairly, I'm going to focus on the book's few weaknesses. There is one actor that gets off too lightly in the book's treatment, in my view. That entity is (no surprises) the ECB. D&M describe ECB banking and credit policy, as well as its role as financial regulator and crisis manager. The narrative, however, gives insufficient due to the ECB's monetary policy decisions - surely the institution's most important function.  

We can break these decisions down into several phases. First, we turn to the pre-crisis period in which the gigantic property bubble was inflating. D&M agree that the ECB's monetary policy did not suit Ireland for much of the 2000s, leading to higher than average inflation, and a sharp loss in external competitiveness. However, they insist that "to "blame" the ECB's monetary policy for the Irish property bubble is to misunderstand entirely the concept of a currency union" since monetary policy should be run for the Eurozone as a whole, not any specific country or region. Furthermore, D&M argue that "it is noteworthy that most of the other Eurozone countries, particularly those in northern Europe, did not borrow on the unprecedented scale that Ireland did. Were their central banks and regulatory authorities more aware of the potential dangers involved and did they discourage it? Or was it a case of different cultural approaches?" D&M seem to settle on "the accentuation of the traditional fixation of the Irish psyche on property" as the key to Ireland's particular mania. 

I agree wholeheartedly that ECB policy should be run for the zone as a whole (even if the reality is that decisions are asymmetric with respect to Germany). But D&M seem to take as a given that Ireland belongs in the Eurozone, despite noting that "this is the second time in twenty-five years that Ireland has faced major economic and financial difficulties. Bernard Connolly's excellent "The Rotten Heart of Europe" reveals the paucity of reason behind Ireland's decision to join the currency union. Rather than resorting to cultural reasons, D&M seem to have underplayed the fact that Irish nominal GDP was running far, far too high from 2001-07. 

You can look at the Google Data visual depiction on your own if interested. I concede that Ireland's deviation from a healthy NGDP trend was not the ECB's "fault" per se, but rather the inappropriateness of a one-size-fits-all monetary policy, which D&M underplay.

We next turn to 2008. Few central banks covered themselves in glory in understanding the interaction between tight money and economic and financial collapse. The ECB, of course, was particularly culpable in raising rates in July 2008.

As a financial regulator, the ECB compounded this mistake. As D&M note, "while not prepared to embark on any specific rescue package for a country in difficulties, [the ECB] opposed strongly any suggestion of the country in question allowing its banking system to default." It is particularly curious that European authorities such as the ECB are very keen on protecting domestic banking structures despite moral hazard risk. Yet they spew jeremiads about that risk when dealing with sovereigns.

2008-2010 offered another phase of the Irish crisis, after the banking guarantee. D&M correctly note that "periodic upward revisions of the extent of the banking disaster contributing to an underlying erosion of market confidence". Yet the ECB seems to escape any criticism for this state of affairs. Its overly tight monetary policy did little to assuage the effects of a broad deterioration in European banking. What's worse, the correspondence between Finance Minister Brian Lenihan and ECB President Trichet shows the ECB's deep and unhealthy involvement in Irish political economy. It is laughable that some "sound money" types in the US have praised the ECB for its rigid adherence to (if unsuccessful achievement of) its inflation targeting mandate. The ECB, as I have underscored before, is an intensely political beast - far more so than the Federal Reserve. 

Finally, we come to the post-2010 period. D&M rightly state that "the absence of any significant GDP growth has rendered the achievement of deficit/GDP and debt/GDP targets that much more difficult", but do not point to the ECB for its role. The infamous 2011 rate rises are the worst example of the ECB's performance, which has compounded Ireland's difficulties. Again, in highlighting the ECB's mistakes, I do not want to exonerate the other actors who D&M do such an excellent job of identifying. There would have been a collapse in Irish property prices even without the ECB's raft of mistakes. But these errors - and the general inadequacy of the Euro for its members - must surely be cited.

To end, I want to draw one major lesson from D&M's generally excellent treatment of this crisis, namely that understandable emotions are the enemy of good economic policy. First, the decision to join the European Monetary System in December 1978 led to the breaking of the one-to-one parity of the Irish pound with sterling in March 1979. The breaking of parity "was perceived as representing a symbol of success as a nation."  Yet this desire to be free of the UK's influence led eventually to the property bubble by yoking Ireland to the ECB. And of course, this unfortunate manifestation of nationalism was equally apparent when the bailout occurred. In Nov 2010, the Irish Times asked whether the men of 1916 had died for "a bailout from the German Chancellor with a few shillings of sympathy from the British Chancellor on the side... the shame of it all." As D&M write, "The loss of sovereignty was palpable."

If national pride is a bad guide to economic policy, empathy is equally to blame. D&M write that "The roots of the Irish fiscal disaster were initiated by a political decision, implicitly shared by all political parties, that the fruits of the boom should not be confined to those involved directly in property." An understandable desire to share the bounty of good fortune (or perhaps the opportunism of politicians) led to disastrous fiscal decisions, weakening the government's finances right when they were needed the most.

All in all, D&M do a superb job of explaining the Irish economic and financial catastrophe. While there is a human tendency to want to blame individual actors or identify specific causes, D&M show cogently how the Celtic tiger fell into a trap that it is still struggling to escape.

Monday, November 17, 2014

Serenity, Insight and Investing

I've been reading Bhikku Bodhi's "In the Buddha's Words", which is an anthology of discourses from the collection of Buddhist scriptures known as the Pali Canon. The message is simple but powerful: "From development of the mind arise happiness, freedom, and peace." He goes on, "Development of the mind... means the development of serenity (samatha) and insight (vipassana). Both serenity and insight are considered necessary to achieve true development. "The cultivation of serenity requires skill in steadying, composing, unifying, and concentrating the mind. The cultivation of insight requires skill in observing, investigating, and discerning conditioned phenomena...While meditators may [approach the two aspects] differently, eventually they must all strike a healthy balance between serenity and insight."

While these precepts form the foundation of one of the world's major philosophical traditions, one does not need to be a Buddhist to see their broad applicability. Stoic philosophy conveys similar ideas. Closer to the current day, Jonathan Haidt's "The Happiness Hypothesis" presents another metaphor, that of the elephant and the rider. The mind is divided between conscious/reasoned processes and automatic/implicit processes. These two parts are like a rider atop an elephant. The rider's inability to control the elephant explains many puzzles about our mental lives. Haidt posits that learning how to train the elephant is key to self-improvement.

Unsurprisingly, I think these ideas provide a useful philosophical basis for the tiny sliver of life that is investing. I've written before about Robert Hagstrom's view of investing as the last liberal art. Investors need a grasp of (in order of least controversial to most controversial) finance, microeconomics, macroeconomics, psychology, history and sociology. All these contribute to insight, i.e. seeing the financial markets as they really are, and being humble enough to create a risk management framework that deals with the uncertainty inherent in investing. Developing insight is certainly more than just being knowledgeable, particularly in this era of Information. It's about trying to develop wisdom. To quote T.S. Eliot, "Where is the wisdom we have lost in knowledge? Where is the knowledge we have lost in information?" It's easy to mistake information for knowledge, and knowledge for wisdom. 

That said, even wisdom seems to only be part of the equation. One can be a brilliant analyst but lack the equanimity and humility required to translate good ideas into successful investments.Serenity allows the investor to actually implement an investment, and to maintain an even keel whether things are going particularly well or particularly badly. Anyone observing financial markets comes to realize that they just another medium conveying the vicissitudes of human life. Fear and greed are rightly identified as two emotions that drive much of how we act in financial markets. But market participants experience other emotions too: for example, they experience anger, disgust and shame when taking losses, trust and pride when things appear to be going well, and confusion when market action goes against expectations. The skilled investor therefore needs to be master of his own emotions. Despite his homespun image, Warren Buffett too merges investing acumen with a steely constitution, and the combination has led to his stellar record. Stan Druckenmiller is more of a trader than a value-oriented investor, but my former boss Scott Bessent, in "Inside the House of Money", describes Druckenmiller's toolkit as such: "Stan may be the greatest moneymaking machine in history. He has Jim Rogers' analytical ability, George Soros's trading ability, and the stomach of a riverboat gambler when it comes to placing bets." 

The emotional component to investing is well-recognized these days, with books like Kahneman's "Thinking Fast and Slow" popularizing behavioural economics. Kahneman uses the terms System 1 and System 2 to represent fast, unconscious thoughts and slow, effortful thoughts respectively - analogous to Haidt's elephant and rider respectively. But despite Kahneman's literary success, my guess is that investors still pay far less attention to this side of investing than they should. While there are numerous mainstream avenues to develop the analytical tools of investing (again, just one part of insight, in my analogy), such as going to business school or getting the CFA qualification, these tools are not worth very much without a sound emotional grounding. In fact, they can even be harmful, creating the illusion of certainty where none exists. 

Sadly, there aren't schools devoted to helping investors gain the type of serenity they need. Most investors (retail and professional) succumb to those old enemies, fear and greed, far too often, leading to sub-optimal investment performance. Perhaps we all need to take a step back to learn from Druckenmiller and Buffett - and maybe even the Buddha.