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Why Do Economists Sometimes Assume Away Reality?

I’ve never really understood the way many economists think. For instance, take the latest from Paul Krugman in which he tries to explain why his model of the economy helped him to predict some things in recent years. What’s so strange is how he assumes away reality:

“What I did in my old analysis was to radically simplify the dynamics by imagining an infinite-horizon model in which all the action takes place in period one.

I also, as a first pass, assume that there is no investment, just consumption.

Well, if we have rational expectations and frictionless capital markets — which we don’t, but let’s see what would happen if we did”

I know what he’s trying to do here. He’s just trying to simplify the model to control the experiment in essence. But this isn’t like an experiment in a lab. You see, in a real-world scientific experiment you might control the experiment to remove any outside variables that would produce a false conclusion. By controlling the experiment you can be more precise in your experiments before you apply them to the real-world. But the kicker is that the science still has to be applied to the real-world. All of those variables that you removed from the lab have to still be put back in when you actually apply the results in real-life.

What economists do is control their experiments in a fake setting and then just assume that the same thinking applies in the real-world.  Except it doesn’t because you’ve created a fictional world in which you established your conclusion and then forgot to actually apply it to the real-world, which would have actually required you to put all those assumptions back into the model.

This just makes no sense to me. And it’s why I keep saying no one needed the ISLM model or anything like it to make the same predictions Paul Krugman made.  After all, I made every prediction he did without using that model. I just looked at the real world for what it is and performed my own experiments in that real-world.  No one needed fake models to understand why QE didn’t cause high inflation.  All you needed was to understand the operational realities of how it actually works in the real-world.

Weekend Q&A and Open Forum

It’s been too long since I did a Q&A and open forum here so feel free to use the comments to let me know what’s on your mind and if I can help with any questions then feel free to ask away. Poetry and love making questions have priority as always. But since I know little about both topics you will get what you deserve in the answer.

Are Foreign Bonds Worth the Risk?

Excellent piece here by Michael Batnick on foreign bonds. Michael and I both agreed that John Bogle was wrong to say that an investor should shun foreign stocks, but what about foreign bonds?  There’s a lot to like about foreign bonds.  Russell Investments laid out a good case here.  For instance, if you look at most of the major developing trends in the world emerging markets look like a must own portion of the world:


Remember, the USA was once an emerging market and shunning emerging markets now is the same as looking at the USA in 1850 or 1900 and saying that it’s not developed enough. Of course, that’s not the point of investing. When you’re investing for growth and protection of your purchasing power you want to skate to where the growth is going to be, not where it’s been. John Bogle likes to demean forecasters, but I’d argue that he is just suffering from recency bias which leads to his home bias. In fact, his insistence on non-forecasting is what leads to his incorrect conclusion about foreign stocks.

Anyhow, I wanted to elaborate on Michael’s point because I think there’s some sound thinking to support his conclusion (and mine). The main reason you add bonds to a portfolio is because you want to diversify the risk of owning stocks. The way I usually describe this is by using a simple example. If Apple Corp raised funds by selling $100 in 5% 10 year bonds and $100 in stock which would you want to own? Would you prefer just $100 of stock or $100 of bonds? Well, it depends of course, but the instruments are both functions of profits. That is, if Apple goes bankrupt both instruments will be worthless (though stockholders are subordinate and will certainly be wiped out). So, if you wanted to take a lot of risk you’d just buy the stock which might generate a better return, but will likely have a higher degree of risk. If, on the other hand, you wanted to create a more steady return you might blend your holdings. The bond steadies the portfolio return because it has embedded guarantees. You know, as long as Apple stays solvent, that you will get your principal plus 5% annual interest back after 10 years. Who knows what the stock will be worth in 10 years though? The point is, you own bonds because they stabilize a portfolio.

That brings us to government bonds. The reason you own government bonds is also for stability. But not all government bonds are stable. In fact, some can be quite unstable. If we look at the performance of emerging market bonds during the financial crisis they added little stability to a portfolio:



This makes sense. If you own bonds for protection against permanent loss risk then you want to own the highest quality bonds. Now, this doesn’t mean you have to own US government bonds. But I would argue that you want to own high quality developed market bonds of some sort.  The reason why is simple – if you want to diversify your portfolio so you have exposure to the growth in emerging markets then use an instrument that actually takes advantage of that growth by owning stocks. But owning emerging market bonds just doesn’t complement this slice of stocks with the stabilizing component that many should expect from fixed income. And that means that in order to help stabilize that growth component of your portfolio you likely need to diversify into high quality developed market bonds of some sort because emerging market bonds and many other foreign bonds just won’t provide the stability when you most need it.


Buffett and Munger on Being a Hack

By Ben Carlson, A Wealth of Common Sense

“I believe in the discipline of mastering the best that other people have figured out. I don’t believe in just sitting down and trying to dream it all up yourself. Nobody’s that smart.” – Charlie Munger

I have a confession to make — I’m a hack. That’s right. I’m consistently stealing ideas from people that are smarter than me and using them to my advantage.

I used to think that having my own unique opinions about everything single thing was the way to go. Why be a conformist? Slowly, but surely, I learned it’s a waste of time to constantly try to create your own ideas just for the sake of being different. It’s an uphill battle against people that are much smarter than you are. Most of us will get much more out of destroying our own wrong ideas than coming up with new ones every day. Reinventing the wheel is over-rated.

Luckily, I have some good company in this line of thinking. Even brilliant people look to use the best ideas from others to find their way. Here are Warren Buffett’s thoughts on standing on the shoulders of giants:

I’ve mainly learned by reading myself. So I don’t think I have any original ideas. Certainly, I talk about reading [Benjamin] Graham. I’ve read Phil Fisher. So I’ve gotten a lot of ideas myself from reading. You can learn a lot from other people. In fact I think if you learn basically from other people, you don’t have to get too many new ideas on your own. You can just apply the best of what you see.

In The Warren Buffett Portfolio, my all-time favorite book about Buffett, Robert Hagstrom sheds some more light on how Buffett and Munger think about learning:

“It’s extraordinary how resistant some people are to learning anything,” Charlie once said. “What’s really astounding,” Buffett added, “is how resistant they are even when it’s in their self-interest to learn.” Then, in a more reflective tone, Buffett continued, “There is just an incredible resistance to thinking or changing. I quoted Bertrand Russell one time, saying, ‘Most men would rather die than think. Many have.’ And in a financial sense, that’s very true.”

I used to assume that being the first one to a piece of news was the key to sucess in the markets. But timely information is just not that important when market reactions and movements happen so quickly. I’ve never felt more informed because I was the first one to read a piece of breaking news. But I’ve always felt more informed when I’ve read a piece of advice that I can use over and over again to apply to different situations.

It’s not only important to learn from those around you, but also those who came before you. The most useful learning I do usually comes from older material. One of the best books I read this year was over 2,000 years old (On the Shortness of Life by Seneca). The best advice is timeless because it focuses on understanding and perspective over action and tactics.

Of course, it doesn’t matter how much you read or how many good ideas you latch onto if you can’t put your own spin on them and apply them to your own situation. Ideas without application are useless.

Being able to pick and choose the best ideas from some of the greatest minds out there is something not enough people take advantage of.

The Warren Buffett Portfolio

“Do you Want to be Right or do you Want to Make Money?”

I can’t remember the first time I saw the quote in the title of this post (maybe this Barry Ritholtz post), but it always stuck out to me. I will never forget the emotion I had following the financial crisis – that gripping fear. I went about 6 months in late 2008 and early 2009 without doing anything in the markets. I was paralyzed with fear. At points it was the right emotion, but as it ceased to wane I realized that the fear was no longer a productive part of my life. And as the markets and the economy healed in late 2009 I made a promise to myself that I would never let fear dictate my life the way it had in 2009.

In my book I describe fear as “the most destructive emotion”. Fearful people are easily manipulated, don’t take the right risks, easily fall in line with conventional thinking and never experience their full capabilities because they let their own emotions hold them back. And while this emotion is destructive in our personal lives, it can be even more destructive in our portfolios.

I’ll never forget 2009 because it was the year where I vowed to start thinking objectively rather than emotionally. This was the period when I began to obsess over the specific operations of the monetary system. It was when I realized that I needed to understand the world for what it is rather than what my emotions want it to be. That was the only way I could make objective decisions about the future.

As someone who writes a moderately popular website I’ve had to resist the urge of alarmist and “eye catching” commentary. I know exactly what works in the field of finance. If you want to have a wildly popular website you write about the following topics consistently:

  • The Federal Reserve is a big scam out to screw us all.
  • Government debt and spending will be the end of us all.
  • The next big market crash is always right around the corner.
  • High inflation is going to destroy the financial world.
  • Gold is the best thing since, well, anything, ever.

The reason those topics garner so much attention is because they feed on people’s emotions. They feed on people’s fear. Of course, most of the articles about those topics are totally misleading. And I hurt my own popularity by not writing about them. In fact, I tend to write about incredibly boring stuff and often say precisely the opposite of the aforementioned topics.  It’s amazing any of you are even reading anything I write. But the objective and pragmatic view is usually a boring view. It doesn’t reside in extremes. It resides somewhere in the middle. The beauty is, I’ve noticed that a more objective and practical approach leads to far better results.  And ultimately, that’s what we’re all after. Someone who sells you fear is trying to separate you from your savings by selling you a scary story. And fear will always end up being “right” at some point because the markets are always in flux.  But that won’t necessarily help you make money.

It took me a long time to overcome my behavioral biases and stop viewing the world through a fear based lens. It took me even longer to develop my understandings of the monetary system and the financial system. But there’s no looking back for me. Irrational optimism and irrational pessimism are emotions that are no longer part of the way I live my life. Living on the extremes of your emotions creates too much risk in too many different ways. And in this business you can’t afford to let your emotional extremes get the best of you.

Rail Traffic Trends Hanging Strong Despite Oil Collapse

Oil prices are collapsing, but trends in rail traffic are hanging in there.  The latest weekly reading on rail traffic came in at 4.5% on a year over year basis and brought the 12 week moving average down to 3.6%.  That’s the lowest reading since March of this year, but still solidly growing.  It will be interesting to see how things pan out in the coming weeks/months, but for now this indicator appears to be hanging in there.





This is rather impressive:

“Cash still exists in rather surprising quantity – about a trillion dollars, or more than $3,000 per capita, 77% of it in hundred-dollar bills. But you and I, corporate businesses, and financial markets use trivial amounts of cash. The legal, and especially corporate and financial economies, have moved to electronic, interest-bearing money. Almost all of us pay by credit cards or debit cards, linked to accounts that will, when interest rates rise, pay interest, and are mostly settled by netting between our banks –an essentially electronic accounting system. Cash really is only used in any substantial quantity for illegal transactions, undocumented people, and store of value in foreign mattresses.

For this reason, as a modeling approximation, it seems wiser to think of cash holdings as disconnected from nominal (legal) GDP, than to found control of nominal GDP on control of cash balances not used for most of GDP. Empirically, cash holdings just trundle with little apparent connection to the economy and, especially, the financial system. Unredeemed coupons, unused subway cards, sock-drawer change, that stack of receipts you’ve been putting off submitting for reimbursement, and, more seriously, invoices and some trade credit are also non-interest paying claims. But they’re not tightly connected to output or price level determination. Controlling the inventory of unredeemed coupons would not control the price level.

Furthermore, the Fed does not control the quantity of cash, as Fama prescribes. For MV = PY to control PY, the Fed must control the M, as well as V being determined and stable. The Fed allows banks freely to exchange cash for reserves.

For these reasons, it makes more sense, I think, to abstract from cash –along with unredeemed coupons and the rest of my humorous list of non-interest-bearing claims – and think of a monetary system based entirely on interest-paying reserves, and consisting entirely of interest-paying electronic money. Reserves, not cash, are really our fundamental numeraire and means of final payment. We certainly don’t want to embark on the alternative abstraction –that the functioning of monetary policy and the control of inflation centrally revolves around the demand for cash, almost all of which is held for illegal purposes.

More generally, some monetary frictions do remain. There are tiny spreads between treasuries and reserves. There are on-the-run and other small liquidity spreads in treasuries. But I think it would be a mistake to base our basic analysis of big questions of monetary policy – can monetary policy affect GDP and the price level, and if so how – on these ephemeral frictions, using models that, if those frictions were to disappear, would not be able to describe monetary policy and price level determination at all. Instead, it seems more sensible to base our analysis on a theory that is valid in a world with no monetary frictions at all, and then add frictions as necessary to understand second-order effects.

This discussion about money may seem quaint, because our Federal Reserve explicitly targets interest rates rather than monetary aggregates, and obviously will continue to do so. So, the central class of theory needed is a theory that describes how Fed manipulation of interest rate targets, not M, controls the price level.”

The source for the piece just quoted is John Cochrane’s paper “Monetary Policy with Interest on Reserves”, reviewed in this previous post:

The Achilles heel of monetarism is its undifferentiated concept of the monetary base. Leaders of the theory refer to it reverently as “the base”.

The regime of interest paying reserves is one window into this traditional conflation. Cochrane incorporates this perspective as part of the fiscal theory of the price level.

Within the framework of a controversial theory, he offers clarity on several aspects of monetary operations:

a) Interest paying reserves are a form of government debt. That is not new, but it is a foundation for his seamless application of FTPL.

b) Currency is almost irrelevant for any useful version of a monetary theory.

Yes, that’s right.

Read point b) and the quoted piece again.

Useless. He rejects it outright as being helpful to the analysis. Done away with.

Cochrane’s paper is amazing not just for this but for a number of other realistic observations offered as background to the FTPL theme.

But there is a larger point that overarches the subject and the paper.

Which is that understanding the previous (Fed) regime of scarce bank reserve balances that paid an interest rate of zero also required a differentiated analysis of the functions of bank reserve balances and currency.

Deconstructing this traditionally consolidated view of the “base” is essential in understanding monetary operations. But monetarism has never seemed to put much value in such operational details.

Are Bonds Really Less Risky than Equities?

By Patrick Rudden, AllianceBernstein

It’s practically an investing axiom that government bonds are much less volatile than equities. But that depends on how you look at it. In fact, our research suggests that income streams from stocks are actually much less volatile than those of government bonds.

This counterintuitive point raises interesting observations for investors. Namely, the less sensitive you are to price volatility, the more attractive the yield from equities may become.

Over the long term, global equities have had an annualized volatility of nearly 17% versus about 8% for government bonds.1 This analysis is based on a century of data from 1900 to 2000 from the London Business School. By this measure, equities have clearly been riskier than bonds.

However, the picture looks very different looking at real returns, i.e., adjusted for inflation—especially if you decompose the total real return of equities into two components: the contribution from capital appreciation and the contribution from dividend yields. This analysis shows that share prices (capital appreciation) have been quite volatile over 10-year holding periods (Display). Dividend yields, though they have fallen somewhat over time, have been much more stable.


Comparing the real return of bonds over the same period with the dividend yield from equities also paints an interesting picture (Display). Bonds did very well in the 1980s and 1990s (and, for that matter, also over the most recent decade) as interest and inflation rates fell. However, bonds struggled during decades in which inflation and interest rates rose. In contrast, the real return from dividends was positive every decade. In other words, seen through the lens of producing an income stream to meet an investor’s purchasing needs, equities don’t look quite so risky after all.


Why might these observations matter? Most investors have assets because they have liabilities. Liabilities often take the form of a series of inflation-linked payments that need to be made over several years. So owning real income streams that meet those expected payments is the essence of asset-liability matching, in our view. And for investors without explicit liability matching needs, generating stable streams of real income is becoming increasingly important in a world of volatility. Yet the common perception that equities are more volatile than bonds often creates a barrier for investors to consider stocks as a reliable source of income.

In a recent blog, our colleagues pointed out that an equity income approach is probably more appropriate for investors with long-term goals. While the shares are likely to appreciate over time, stock price volatility means the value of the initial investment will fluctuate (see upper display). But of course, an investor doesn’t necessarily have to choose to be exposed to either equity or bond income.

In fact, there are good reasons to have a bit of both, in our view. Income streams between equities and bonds are not perfectly correlated. For example, we measured that the percentage yield from the Barclays Global Treasuries Index has had a negative correlation of –0.6 with the percentage yield from the MSCI World Equity Index since 2001. So by combining income streams from a range of asset classes, we think investors should be able to generate more consistent income and, importantly, income growth.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.AllianceBernstein Limited is authorized and regulated by the Financial Conduct Authority in the United Kingdom.

Patrick Rudden is co-manager, Dynamic Diversified Portfolio at AllianceBernstein (NYSE:AB).