Felix Salmon

Why we won’t build a stock-market simulator

Felix Salmon
Dec 30, 2011 04:12 UTC

A year ago, I spoke to the University of Pennsylvania’s Michael Kearns about whether we might be able to do something to help prevent a much worse reprise of the May 2010 flash crash. The short answer is that no, we can’t — or won’t, in any case. But the longer answer is that there is something we could do, if we just had some will and a lot of money:

You can imagine trying to build an ambitious, reasonably faithful simulator of our current markets. You’d have high-frequency algos, shorter-term stuff, dark pools, multiple exchanges, etc. A giant sandbox.

If you do a simulation and you try some perturbation or stress, and it tells you that a disaster happens, then it’s worth thinking hard about our current markets. But if you don’t find a disaster, that’s not reassurance that some other disaster won’t happen.

I’m proposing a quant version of the stress tests that were proposed for banks.

A car company, before they roll out a product, have a lab environment where they put it through tests. And in reality problems which weren’t tested for get discovered. We’d be much better off with a simulator.

We have no such lab for our financial markets. This strikes me as a little off.

People on Wall St think about simulation, but not for catastrophe prediction, just for their own trading purposes.

Kearns’s idea didn’t get anything like the traction it needs, and it’s not going to happen. But now a new paper from the UK’s Government Office for Science, written by Dave Cliff and Linda Northrop, lays out the case for building such a simulator over the course of 47 very interesting pages.

First of all, they write that the whole global economy “dodged a bullet” on May 6, 2010: if the Flash Crash had just happened a couple of hours later — and there’s no reason it couldn’t have done so — then the US markets might well have closed before the Dow had a chance to recover. The US sell-off would have triggered big market swoons in Asia and Europe, with very nasty consequences for, among many other things, Greek debt dynamics.

More generally, they write,

The global financial markets have become high-consequence socio-technical systems of systems, and with that comes the risk of problems occurring that are simply not anticipated until they occur, by which time it is typically too late, and in which minor crises can escalate to become major catastrophes at timescales too fast for humans to be able to deal with them.

Cliff and Northrop say that we should do exactly as Kearns suggested:

The proposed strategy is simple enough to state: build a predictive computer simulation of the global financial markets, as a national-scale or multinational-scale resource for assessing systemic risk. Use this simulation to explore the “operational envelope” of the current state of the markets, as a hypothesis generator, searching for scenarios and failure modes such as those witnessed in the Flash Crash, identifying the potential risks before they become reality. Such a simulator could also be used to address issues of regulation and certification. Doing this well will not be easy and will certainly not be cheap, but the significant expense involved can be a help to the project rather than a hindrance.

There are many reasons why this is not going to happen, starting with the fact that no one, right now, can afford to do it. Cliff and Northrop rather hopefully say that if this market simulator is expensive enough, then lots of Wall Street players will pay up to have access to its results — but in reality they’re much more likely to do everything they can to stop it from being built in the first place. Because if it is built, the certain consequence will be more regulation:

It may also be worth exploring the use of advanced simulation facilities to allow regulatory bodies to act as “certification authorities”, running new trading algorithms in the system-simulator to assess their likely impact on overall systemic behaviour before allowing the owner/developer of the algorithm to run it “live” in the real-world markets. Certification by regulatory authorities is routine in certain industries, such as nuclear power or aeronautical engineering. We currently have certification processes for aircraft in an attempt to prevent air-crashes, and for automobiles in an attempt to ensure that road-safety standards and air-pollution constraints are met, but we have no trading-technology certification processes aimed at preventing financial crashes. In the future, this may come to seem curious.

Even if regulators don’t have to sign off on trading strategies on an algo-by-algo basis, there’s really no point in building a hugely expensive and complex market simulator if the results of the simulations don’t result in constraining market participants somehow. And I can assure you that no amount of “you’ll all be safer” pleading with banks will persuade them that more regulation and constraint is ever going to be welcome.

Gillian Tett, too, is skeptical that anybody’s going to go ahead with a project of this magnitude:

Most regulators still prefer to forget May 6 rather than admit in public that they are struggling to understand how modern markets really work. And that, sadly, is unlikely to change, unless there is another flash crash.

And there’s a bigger reason, too, why it’s not going to happen: for all its ambition, a financial-market simulator wouldn’t actually address any of the causes of the financial crisis we just had, and probably wouldn’t address any of the causes of the next one, either. As Cliff and Northrop write,

The concerns expressed here about modern computer-based trading in the global financial markets are really just a detailed instance of a more general story: it seems likely, or at least plausible, that major advanced economies are becoming increasingly reliant on large-scale complex IT systems (LSCITS): the complexity of these LSCITS is increasing rapidly; their socio- economic criticality is also increasing rapidly; our ability to manage them, and to predict their failures before it is too late, may not be keeping up. That is, we may be becoming critically dependent on LSCITS that we simply do not understand and hence are simply not capable of managing.

We could try to spend hundreds of millions of dollars simulating and examining the fine-grained architecture of securities trading and high-frequency algorithms; and even if we were incredibly successful in that endeavor, there would still be hundreds if not thousands of other large-scale complex IT systems which can and probably will fail catastrophically at some point. We can’t simulate them all. So why pick on the stock market?


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Posted by kaylabi | Report as abusive

There’s no reason why stocks are down today

Felix Salmon
Sep 22, 2011 15:48 UTC

There’s a lot of uncertainty in the global economy, and that’s the kind of thing which makes stocks volatile. This morning, we’re seeing that volatility express itself, with global stocks all falling and US stocks down about 2.5% from where they closed yesterday.

But let’s not kid ourselves that there’s any particular reason why global stocks are falling. And especially, let’s not try to invent some spurious reason for the fall, be it broad and inchoate (“global economy fears”) or weirdly specific (“Federal Reserve pessimism”).

It’s may or may not be helpful, here, to check out the price-and-volume chart of the S&P 500 over the past few days.


You see that little wobble in the mid-afternoon yesterday, before the high-volume sell-off at the end of the day? That was the immediate reaction to the release of the FOMC statement at 2:30pm. The big plunge, on unusually high volume, started about an hour later. And the big drop at the open today was much more notable in price terms than it was in volume terms.

It’s silly to think that the decline in stock-market prices was a rational reaction to the FOMC statement. If the FOMC is more pessimistic than the market expected, that’s normally a good sign for markets, since it implies that monetary policy will remain looser for longer. The market cares about the Fed because the Fed controls monetary policy. And so Fed forecasts are important because they help drive that policy. No one revised down their growth expectations as a result of the FOMC statement.

As a general rule, if you see “fears” or “pessimism” in a market-report headline, that’s code for “the market fell and we don’t know why”, or alternatively “the market is volatile and yet we feel the need to impose some spurious causality onto it”.

This kind of thing matters — because when news organizations run enormous headlines about intraday movements in the stock market, that’s likely to panic the population as a whole. They think that they should care about such things because if it wasn’t important, the media wouldn’t be shouting about it so loudly. And they internalize other fallacious bits of journalistic laziness as well: like the idea that the direction of the stock market is a good proxy for the future health of the economy, or the idea that rising stocks are always a good thing and falling stocks are always a bad thing.

Or, most invidiously, the idea that the most interesting and important time period when looking at the stock market is one day. The single most reported statistic with regard to the stock market is where it closed, today, compared to where it closed yesterday. It’s an utterly random and pointless number, but because the media treats it with such reverence, the public inevitably gets the impression that it matters.

Here’s a more useful stock market chart, for the vast majority of people for whom the stock market only matters as a long-term investment:


I’m not going to try to read any great narrative into this chart. But if you want to explain stocks to the broad population, this is the sort of thing you should be showing them. Rather than useless and irrelevant news about what happened to stock prices this morning.


Good point. The long-term chart shows a key point that the stock market has not generated a positive return for about a decade, since the peak around 2000.

This is why it is critical that folks own stocks than pay a nice dividend. Examples are AEP, D, RDS-B, MCD, KMB, LLY, etc.

Posted by Farcaster | Report as abusive

E Pluribus Nemo

Mark Dow
Sep 19, 2011 17:19 UTC

By Mark Dow
The opinions expressed are his own.

While Felix is away, I will be posting off-and-on, as my day job permits. I hope to be able to put out at least a couple of posts more thoughtful than a market update, but let me at least start with an update for the time being.

The market had been hoping there would be some cohesion coming out of Europe in the wake of the Geithner meeting; but none materialized. The grands lignes of what could be a plan are there, but the political hurdles in Germany seem still too high.

One, as various surveys suggest, Germany, in the aggregate, supports the notion of an integrated Europe, but also strongly opposes dedicating more resources to it. Yes, this is an excellent example of cognitive dissonance, but it is where we are. Two, in a profound and visceral way, Germans want to defend the purity of the ECB’s single mission. For them, the ECB is the Bundesbank, in thinly-veiled drag. And Germans don’t seem to be in a compromising mood.

These views, unfortunately, are incompatible not only with a permanent fix, but also with basic crisis management. Market participants know this. Secretary Geithner knows this. The IMF knows this. And all parties (except, it seems, a good number of European policymakers) are very worried. This is much of what markets are responding to today.

Moreover, markets will likely remain under pressure until Germany finds a way to overcome the moralistic, rule-bound, penny-wise-pound-foolish policymaking that has characterized the approach so far. Concretely, they need to lead the EU into cutting losses. And, as immoral and unjust as it will no doubt seem when the moment comes, they will have to dedicate resources to the peripheral countries if they want to minimize the collateral damage to Germany and other core countries that will flow from Europe’s restructuring.

The other element driving the market this morning is the continued unwind of risk in emerging markets. There has been a significant outflow over the past two weeks from emerging markets local markets (local bonds and currency). This sector has probably received more inflows relative to the size of the asset class than any other over the past 2-3 years. If risk appetite doesn’t resume soon, the EM outflows will almost certainly intensify. Fundamentals won’t matter. Valuations won’t matter. Secular convergence (more on this in the coming weeks) won’t matter. Only flows and liquidity will.

There was some easing in the outflows late last week, as equity markets rallied and hope that the FOMC might try and shock the markets took hold. However, due in part to the article last night by the Wall Street Journal’s influential Jon Hilsenrath, today market participants are abandoning the hope of a deus-ex-machina Fed. In consequence, the unwinds are accelerating.

Here’s a graph of the DXY, 2006 through today, to give you a rough indication of how far things could go:

True, it could well be that the Fed is using Hilsenrath to dampen expectation so as to surprise the market come Wednesday. After all, Chairman Bernanke understands the centrality of psychology in all of this. But to me it seems the divisions within the FOMC are too great to bridge at this one meeting. My guess would be that the FOMC meeting tomorrow and Wednesday will be used to prepare the groundwork for more aggressive action at a later date. As for where we go on Wednesday, anything up to and including Operation Twist will most likely be taken as a disappointment by the market, result in another leg up in the dollar, and an accelerated unwind of emerging market local currency positions. Of course, in markets, unlike in economic punditry, it pays to never get too comfortable with your own views.


@Curmudgeon, thanks for your contribution.

Posted by Woltmann | Report as abusive

The markets are falling, not panicking

Felix Salmon
Aug 18, 2011 17:26 UTC

Allan Sloan says that today is “scarier than 2008-09″ — and looking at the markets, he doesn’t seem far off. Yes, stocks are still much higher than they were at the height of the crisis, but relative to earnings the improvement isn’t all that impressive. Meanwhile the 10-year Treasury hit a new all-time low yield of 1.97% today, inflation figures notwithstanding, and gold too is hitting new highs above $1,825 per ounce.

To be honest, though, I’m not seeing fear or panic right here. For one thing, we’re in the middle of August — the time of year when traders and institutional investors go on vacation, volumes tend to dry up, and market moves can get magnified for no good reason. Today stocks fell as much as 5% and the VIX broke above 40 — moves which are indeed reminiscent of what was happening in those panicked days of 2008-9. But having experienced those days and come out the other side, I feel that the investing public as a whole has been toughened up a bit, inured to volatility in a way they weren’t back then. Plus, of course, they’re much richer, on a mark-to-market basis, than they were when the S&P 500 was below 700.

What I’m not seeing here is deep-seated existential fear — the idea that certain companies might well wind up seeing their stocks go all the way to zero, and then defaulting on their debts. During the crisis, we had the worst possible flavor of that fear — that it was banks which were insolvent. Now, by contrast, bank stocks are low, but the famous TED spread, for instance — one of the best indicators of the degree of faith that financial institutions have in each other — is still less than 30 basis points. It spiked to more than 400bp at the height of the crisis.

If we were genuinely in a period of panic and turmoil, we wouldn’t see multi-billion-dollar deals being done for companies like Morotola and Autonomy; we certainly wouldn’t be seeing extreme equity capital markets deals being mooted like the idea that Manchester United might list its shares on the Singapore stock exchange. The markets are clearly finding it difficult, this August, to determine what the right and proper price is for various financial assets. But that’s not panic. In fact, it might just be a perfectly rational response to an increasingly uncertain world.


I think the current behavior of the market is reflection of people’s attitudes vis-a-vis the economic and political outlook more than anything else.

The economy is stuck in neutral, the employment picture is bleak, and the political system is dysfunctional. Is it any suprise that people are starting to wonder where the increased corporate profits which would support a market upturn are going to come from?

Let’s not forget that until the recent correction, the market had more than doubled from it’s March 2009 lows without a single pullback of at least 10% along the way. It’s not like you needed to be a genius to see that the market was due for a correction sometime soon.

Posted by mfw13 | Report as abusive

Lessons from stock-market volatility

Felix Salmon
Aug 10, 2011 08:55 UTC

Didja see? Stocks went down, and then they went back up again. If you just spent the entire period lying in blissful ignorance on a beach, then you would have saved yourself a lot of stress and panic. And there was very little in the way of actual news, either. The scandal isn’t that S&P might have told banks and hedge funds it was going to downgrade the US: the scandal is that S&P told everybody, repeatedly, that it was going to downgrade the US, and the markets ignored the news until it actually happened. Similarly, there’s precious little actual news in the FOMC statement — certainly not enough to move the market by 5%.

So as ever, the best thing to do, if you’re saving for the long term, is to just keep on putting a small amount of money into the stock market every time you get your paycheck — and to ignore short-term stock-market gyrations. The stock market, at some point in the future, will be lower than it is now. And at some other point in the future it will be higher than it is now. We mere mortals can’t hope to time such things.

All we can really hope to do is put our money somewhere where it’s more likely to earn a decent real return over the long term than it is to get eroded away. And there’s simply no way that bonds or cash are superior to stocks on that basis, given their current yields of zero.

Obviously, the stock market is a dangerous place for short-term speculation — and if you can’t afford to see a 5% drop in one day, or a 20% drop over the course of a few weeks, then you shouldn’t be investing in stocks at all. It’s not a place for money you’re likely to need to spend any time soon. But if you’re a long-term investor, the one advantage you have over the big institutions is that you don’t mark to market, and are therefore less likely to be forced to puke up liquid and valuable stocks when markets fall. Take advantage of that, stay calm when markets get volatile, and over the long term you’ll be glad.


hsvkitty, it really depends on whether you expect “slow growth” or “no growth”. If you expect “slow growth” in the global economy (not necessarily the US and Europe), then there are already bargains on the table. If you expect the global economy to shrink, or to completely stagnate, then we should expect prices to fall further.

I started buying again yesterday, and will continue to buy as money comes in as long as the market stays in its present range.

Buffett also claims to be buying.

Posted by TFF | Report as abusive

Felix TV: Time to chill out

Felix Salmon
Aug 5, 2011 17:26 UTC

Jason Varone was not impressed by this video. “I guess you don’t know anyone trying to retire?” he tweeted in response.

Actually, I do. But retirement isn’t — or shouldn’t be, in any case — a day on which you suddenly liquidate your entire stock portfolio and go from risky stocks to safe cash. As we get older and more risk-averse, we should hold fewer risky stocks and more safer bonds. (Although the idea that bonds are particularly safe is something you might want to reconsider, these days.) Retirement is the point at which you stop putting money into your retirement account — and therefore the point at which you stop buying more stocks. But not-buying isn’t the same as selling.

What’s the optimal asset allocation for someone who’s retiring right now? The answer there depends on a huge number of variables — whether you own your own home, what kind of a mortgage you have, what your monthly expenditures are, what kind of Social Security income you have, etc etc etc. But one thing I can say: the amount of stocks you have the day before you retire shouldn’t be vastly different from the amount of stocks you have the day after you retire.

Yes, there’s always a small number of people who are genuinely hurt by a big stock-market sell-off — people who for some reason have to sell now and who would in hindsight have been much better off selling a few weeks ago. But I don’t see a lot of forced selling in the market right now, and I don’t think there are all that many people in that position: while unemployment is still at very high levels, the amount of new unemployment — people being laid off, and forced to live on their savings — is quite low, and the economy is gaining jobs, not losing them.

As for the rest of us — the employed majority — we should just continue to dutifully put aside a chunk of money every paycheck, and invest it in the broad stock market. Sometimes our retirement account will go up, and other times it will go down. But over the long term, simply putting money in every month is the most important thing of all — that and not panicking when the market gets volatile.


“You have a lot more faith in companies’ reported earnings than I do.”

Depends on the company, JayCM, but I suppose I do…

Posted by TFF | Report as abusive

How stocks react to the macroeconomy

Felix Salmon
Aug 5, 2011 12:22 UTC

Mohamed El-Erian has the best explanation of what happened in the markets yesterday. First and foremost, there were “technical factors”. This doesn’t mean lines on charts and head-and-shoulders patterns and similar astrological nonsense, but rather the dynamics of where investors’ money was being held and the amount that the market would fall given a modest downward nudge. Sometimes that number is tiny, but it can fluctuate a lot, and yesterday it just happened to be huge.

Then there are four long-term factors which conspired to give the markets their current bearish outlook.

First of all are concerns about a double-dip recession and broad weakness in the US economy; Floyd Norris has a good column on this today.

Secondly there’s the end of QE2, with no indication that QE3 might appear any time soon. In English, the Fed isn’t pumping money into the stock market and sending prices upwards any more.

Thirdly, there’s a distinct lack of faith that the federal government might be able to step in where the Fed fears to tread. Indeed, the base-case scenario at this point is that the government is going to make things worse rather than better. QE2, at heart, was a monetary response to a problem much better addressed with fiscal policy; right now we have no more help on the monetary side of things, and the fiscal response has been — astonishingly — to cut spending rather than raise it.

Finally, ever and always, there’s Europe:

By failing to act decisively, policymakers have allowed the Euro-zone’s crisis to morph from the outer periphery (Greece, Ireland and Portugal) to also include much larger (and, therefore, harder to solve) countries (Italy and Spain), as well as the continent’s banking system.

Now none of these factors are exactly new, which is why it feels a little bit silly to use them to explain a stock-market drop on Thursday August 4. They were there on Wednesday, they’re there today, and they’ll be there tomorrow too. I very much doubt that some large number of institutional money managers all woke up yesterday morning in synchronicity and decided that they were worried enough about US economic growth that they should sell a significant part of their stock portfolios.

But the stock market is far from efficient at reflecting economic expectations. Remember 2007, when we were in the midst of a brutal credit crunch, the housing market was imploding, and bond markets were all but frozen solid — the stock market continued to set new all-time highs. Stocks tend to lag bonds when it comes to pricing in macroeconomic pessimism, and when they do start pricing it in, they tend to do so violently. Stocks rise slowly and steadily; they fall dramatically and with great violence. Over the long term, the slow-and-steady tortoise wins the race. But in the short term, anybody who bought stocks in the past few weeks is very unhappy right now, and has no appetite to buy more.

It’s instructive to take a step back, here, and look what happened to stocks since that 2007 high. For about a year, they slid back slowly to roughly their current levels. Then, when Lehman Brothers collapsed, stocks imploded, and kept on falling through the first quarter of 2009. That violent sell-off was followed by a super-strong year-long recovery, to, again, roughly current levels.

Think about it this way: if the S&P is trading at around 1,200, that’s an indication that the economy is going to be reasonably healthy going forwards. Nothing special, but nothing disastrous either. We got ahead of ourselves in 2007 and fell to about 1,200. Then came the financial crisis, stocks plunged, and subsequently rebounded back to about 1,200. Over the past year or so we’ve traded at 1,200ish; momentum trading and QE2 helped to push us up, and now economic pessimism is pulling us back.

If you think that we really are going to enter a double-dip recession, then stocks are not remotely attractive at these levels: they have a ways further to fall. If you think that wise and proactive economic policy in the US and Europe can help prevent such a thing, then likewise it’s a good idea to stay on the sidelines right now: there’s no chance of that happening any time soon. On the other hand, if you genuinely believe that less government is better government and that the private sector, left to its own devices, will create jobs and economic growth, then maybe what you’re seeing right now is a buying opportunity.

For most of us, however, I can only reiterate that the volatile expectations market known as the the stock exchange is really nothing to get too excited about. Over the long term, stocks are a good place to place savings — and right now they’re cheaper than they were quite recently, which is good news for any long-term savers. In the short term, stocks are unpredictable and volatile, which means that only the very brave or the very idiotic attempt to time the market and do the buy-low-sell-high thing.

Every so often, we get reminded of that unpredictability and volatility with a massive stock-market swoon. It’s probably a helpful reminder, just so long as you don’t let it worry you too much. If you want to be really worried, look at the things we’ve known for ages: that unemployment is stubbornly high, that governments in both the US and Europe seem powerless to help, and that the entire developed world is burdened with far more debt than it can ever comfortably repay. It’s the global economy which matters, not the vagaries of intraday stock-market moves.


The house always wins.

Posted by silliness | Report as abusive

What does the stock sell-off mean?

Felix Salmon
Aug 4, 2011 18:59 UTC

At 8:30 tomorrow morning, the July jobs report will come out, and it’s almost certainly going to be pretty miserable, with headline employment growth of maybe 100,000 new jobs, significantly less than needed just to keep up with population growth. The jobs report is rightly renowned as the most market-moving of all economic indicators, and so market action in the immediate wake of its release is closely watched.

What’s going on here? If anybody tries to tell you we’re seeing “fears of a double-dip recession,” or somesuch, ignore them. Fears of a double-dip recession do not appear overnight, and do not send markets down 3.5% in the course of a morning. When vague “fears” are cited as the prime reason for a sell-off, you can be sure that in fact there’s no reason at all. Markets are volatile things, and sometimes this kind of thing happens. If you can’t stand it, you shouldn’t be invested in stocks in the first place.

One thing you can be sure of: all tomorrow’s reports about how markets have reacted to the employment report should be taken with an enormous pinch of salt. At this point, it’s impossible to know what’s priced in and what isn’t, and in any case this kind of volatility would normally last a second day in any case. Whatever markets do tomorrow, they might well have done anyway even if the employment report hadn’t come out.

If markets hadn’t moved much today and instead this sell-off had happened tomorrow, it’s certain that everybody would blame the employment report, no matter how good it was. It’s one of the basic tenets of market reporting: if markets move on the day that non-farm payrolls are released, then there’s always a direct causal relationship between the move and the report.

So it’s worth remembering, on days like this, that sometimes we don’t know why markets have moved, and sometimes there simply is no reason.

But that said, a couple of things are worth noting.

Firstly, this is not necessarily a Bad Thing. If you’re saving for retirement, stocks are cheaper now, and your 401(k) contribution goes further than it did a few weeks or months ago. That’s good.

Secondly, if there ever were serious doubts about the USA’s creditworthiness, they’re gone now. The 10-year bond is yielding less than 2.5%: there are no worries in evidence there.

Put those two things together, and you can even be quite happy about today’s sell-off. If you’re a debtor rather than a saver, then falling interest rates are good for you. If you want to buy a house, then falling mortgage rates — not to mention falling home prices — are also good news. And if you want to invest in some wonderful future income stream, then money’s cheap right now to do so.

Still, the future of the global economy is very uncertain, and southern Europe in particular is still far from any kind of sustainable resolution. The US economy has no particular exposure to Greece — but Italy is another matter entirely. This is a global sell-off, with European markets down just as much as those in the US; Asia’s sure to follow suit when it opens. Now that the Fed has stopped dropping dollar bills on the US economy, it’s hard to see where confidence and optimism are going to come from in the coming months.

In general, I’m not a fan of extrapolating broad macroeconomic hopes and fears from the first derivative of the S&P 500. We’re at 1,220 right now: that’s low compared to the 1,350 of a few weeks ago, but it’s high compared to the 1,120 we saw a year ago — and certainly compared to the 735 we saw at the depths of the sell-off in 2009. If you look at levels rather than deltas, there doesn’t seem to be any big reason to worry — the stock market is showing a reasonably healthy optimism about future long-term growth.

Which, of course, just means that there’s a lot further to fall if we are indeed headed into a double-dip recession.


Why is it a “SELL-OFF” and not a “BUY-UP”?
Which is the glass-half-full view?
Just curious…

Posted by isaiah53-6 | Report as abusive

The damage already done by the debt ceiling debate

Felix Salmon
Jul 14, 2011 17:55 UTC

Listen to anybody on Capitol Hill, and they’ll tell you that the debt ceiling debate is turning into a complete disaster, with the Republican rank and file such an inchoate mess that it increasingly seems as though no deal will get done at all. Look at the Treasury market, however, where the 10-year bond currently yields something less than 3%, and it looks decidedly sanguine; short-term debt maturing shortly after the drop-dead date of August 2 is similarly unaffected by the news from Washington.

Megan McCardle thinks this shows a “giant disconnect” between Wall Street and Washington — things which Wall Street thinks are easy turn out in reality to be extremely hard, and things which any Wall Streeter would just do as a matter of course can be de facto impossible when political posturing starts getting in the way.

I’m not sure the disconnect is all that huge, for a couple of reasons. For one thing, US default risk is impossible to hedge. US default is an end-of-the-world event, and markets by their nature can’t price such things. Conceptually, there’s no point in buying something which pays off if the world ends, since the world will have ended at that point, and in any case your counterparty won’t be able to make good on the contract.

On top of that, remember that we already hit the debt ceiling on May 16two months ago. Since then, the amount of outstanding Treasury securities — a number which normally rises steadily — has been stuck at $14.3 trillion. The fact that supply of Treasuries has been artificially constrained by the debt ceiling has surely, at the margin, helped to support prices.

And more generally there are still a lot of individuals and institutions who want to buy Treasury bonds. That number might have been falling in recent weeks, but it’s still large. The U.S. is not facing the kind of emergency we’re seeing in the eurozone, where countries want to borrow money but no one’s willing to lend to them. If Treasury asks to borrow money from the markets, the markets will always lend it money; the only question is how much interest they will charge.

This is where McArdle goes awry, incidentally: she’s worried that any new debt issued after August 2 won’t be able to find buyers if Congress doesn’t raise the debt ceiling. But there will always be buyers, and there will always be buyers at yields very, very close to the secondary-market price for Treasury bonds. Treasury bonds are fungible, and to underscore that fact Treasury could easily just reopen old bond issuances instead of creating new ones. That would ensure that there was no way of telling the difference between bonds issued “legally” and bonds issued after the debt ceiling was breached.

Even if Treasury can still sell bonds, however, that doesn’t mean for a minute that breaching the debt ceiling is something which should be considered possible for the purposes of the current negotiation. Tools like the 14th Amendment or even crazier loopholes like coin seignorage would be signs of the utter failure of the US political system and civil society. And that alone could mean the loss of America’s status as a safe haven and a reserve currency. The present value of such a loss? Much bigger than $2 trillion. (Coin seignorage, if you’re wondering, is the right that Treasury has to mint a couple of one-ounce, $1 trillion coins and deposit those coins in its account at the New York Fed. It could then withdraw cash from that Fed account to make all the payments it wanted.)

This is one reason why I worry a lot about clever ideas like Mitch McConnell’s plan to get the debt limit raised through a novel use of the Presidential veto — or, for that matter, Matt Yglesias’s even cleverer plan for Democrats to game the McConnell scheme. McConnell is one of Congress’ foremost tacticians, but cunning tactics on either side of the aisle are the last thing that anybody needs right now.

When Bob Rubin did a nifty sidestep around Congress and magicked Mexico’s bailout billions from some dusty account no one knew about, he was playing a dangerous game. When Hank Paulson and Ben Bernanke stretched the limits of their powers almost beyond the legal breaking point during the financial crisis, their actions were understandable but also set yet another precedent. And so now, when there’s no immediate emergency at all, people are looking to the executive branch to find a way to do the right thing, and thereby giving Congress implicit permission to play out and generally behave with all the maturity of a group of rampaging destructive adolescents.

The base-case scenario is, still, that the debt ceiling will be raised, somehow. But already an enormous amount of damage has been done: the US Congress has demonstrated clearly that it can’t be trusted to govern the country in a responsible manner. And the tail-risk implications for markets are huge. Think of the speed with which the Egyptian government collapsed earlier this year, or the incredible downward velocity of News Corporation right now. When you build up large stocks of mistrust and ill will, nothing can happen for a very long time. But when something does happen, it’s much quicker and much worse than anybody could have anticipated. The markets might not be punishing the US government at the moment. But the mistrust and ill will is there, believe me. And when it appears, it will appear with a vengeance.


Salmon isn’t much of a negotiator and I wouldn’t want him anywhere near crucial negotiation. I could see his palms sweat and his eyes twitch in between sentences.

The big problem with this piece is it isolates out the debt ceiling from the debt. That wrenches the current negotiations out of the context of federal government spending and taxation. That’s a killing mistake and makes this piece worthless.

Let me add some of that back in and maybe Salmon can start to make sense of what’s going on.

The USFG is projected by everyone to take rapidly increasing shares of the US GNP under even very optimistic assumptions. That’s a certain catastrophe for this economy: economists estimate that 25-35% of GNP for all levels of government maximizes growth. Under Democratic proposals and baselines, the USFG takes at least that amount, just for itself, for decades to come. That is a catastrophe for economic growth: it entombs our economy in a permanent rotting decay.

That problem isn’t solved with more tax revenue, it is exacerbated. Because it is certain that politician-weasels will spend every penny of revenue and use more revenue to leverage even more spending. There is NO prospect that Obama or the Democrats would make any substantial spending cuts in the foreseeable future. The Obama budget that was unanimously defeated this Spring increased spending across the board, in fact.

The debt is a related, but distinct issue from the total portion of the economy that politicians take to hand over to their cronies. And escalating debt also crushes the future by undermining economic growth. More importantly, my son is 1 year old and unless we take action, his life chances will be substantially undermined. He and your sons and daughters will be handed massive debt that they will have to pay back. That is, by my account, evil. What sort of moral disaster thinks its ok to consume today and force their children to pay for that consumption the rest of their lives? Evil.

This moment is a chance to do something meaningful about both of those problems. To scale back the size of the federal government and to meaningfully lower federal debt. Felix Salmon, Megan McCardle, Harry Reid, and Barack Obama need to think things through, this one time, and do the right thing, this one time. Instead of what they are doing.

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