Sunday, October 18, 2015

The Fed has created a Prisoner's Dilemma

Game theory is generally regarded as a science that seeks to understand how intelligent, rational humans cooperate and compete with each other during the decision making process. One of the more well known game theory models is called "The Prisoner's Dilemma". What makes this particular game theory model noteworthy is that under the construct of the prisoner's dilemma, the rational actors are compelled to behave irrationally and therefore end up making decisions that are not in their own best interests. This odd outcome given the specific framework of the prisoner's dilemma results in the model being looked upon as a paradox.

I believe that the Great Financial Crisis created some very problematic situations that have forced the Federal Reserve (and all other Central Banks) to create their own version of a "Prisoner's Dilemma" within the stock market. One primary issue that I feel required the Fed to use this unorthodox approach (as it continues to hold back a full scale economic recovery) is that most of the developed world is mired in a "Balance Sheet Recession". While not a mainstream and widely accepted economic view, Nomura economist Richard Koo has been talking about this phenomenon for decades. Initially he used the term to describe the economic conditions in Japan starting in 1990, but expanded his view to include the United States in 2008.

Wikipedia describes a balance sheet recession this way,

"A balance sheet recession is a particular type of recession driven by the high levels of private sector debt (i.e., the credit cycle) rather than fluctuations in the business cycle. It is characterized by a change in private sector behavior towards saving (i.e., paying down debt) rather than spending, which slows the economy through a reduction in consumption by households or investment by business. The term balance sheet derives from an accounting equation that holds that assets must always equal the sum of liabilities plus equity. If asset prices fall below the value of the debt incurred to purchase them, then the equity must be negative, meaning the consumer or business is insolvent. Until it regains solvency, the entity will focus on debt repayment".

Unfortunately many people (including most economists, analysts and Central Bankers) still do not appreciate that the United States (and indeed ALL of the advanced economies) are mired in a balance sheet recession.

One key difference between a balance sheet recession and a 'normal' recession is that when a central bank lowers interest rates in response to an economic slowdown, the increase in borrowing that normally occurs (in a regular recession) is not forthcoming. This is because as the definition above states, in a balance sheet recession the consumer is focused on deleveraging their balance sheet, not expanding their debt loads. .

It is this unique phenomenon that occurs only within the parameters of a balance sheet recession that I believe required the Federal Reserve to create their own "prisoner's dilemma" within the stock market. I believe they are attempting to fight one economic paradox (consumer deleveraging in the face of low interest rates) with a paradox of their own. In the Fed's prisoner's dilemma model, they are forcing rational, normally risk averse actors to behave "irrationally" and against their own best interests by forcing them to embrace higher and higher levels of risk. This decreases risk premiums which in turn raises equity prices (and high yield bonds as well).

I believe the Fed hopes that as asset prices increase, a significant wealth effect will be created that will work to counteract the economic contraction created via on going consumer deleveraging.

Unfortunately, I think the Federal Reserve has slowly realized that their grand experiment is rife with flaws and they now have no idea how to reverse the process without a) significantly damaging the stock market and b) throwing the economy into an even deeper and more painful recession than we saw in 2008.

I have attempted (as best as I can) to discuss a few of the larger and more glaring flaws that are holding back the recovery within the pages of this blog - specifically:

1. While Wall Street is acting in its own self interest (which should expected) it is achieving much of this success through increasingly abusive, predatory and illegal actions. Contrary to popular belief, Wall Street has not 'learned it's lesson' after the Great Financial Crisis, and the fines that were subsequently imposed have done nothing to resolve the problem. They will not stop because they can't help themselves. As such, these abuses continue to come at a very large cost to the rest of the economy.

2. The wealth effect is a myth, which is why income inequality gets worse even as the economy sputters.

3. Moral Hazard - Since the Great Financial Crisis "ended" in 2009, the Federal reserve and other Central banks have created an environment that has gradually become very complacent with regards to risk. In an economy (and market) where there is no real threat of downside risk, malinvestment persists - unfettered and unappreciated. It is only when risk is normalized and reintroduced back into the system will these issues begin to surface and be better understood.

4. The Great Financial Crisis of 2008-09 was a symptom of a bigger, more complicated problem - I laid out these bigger trends in my "The View from 30,000 feet" thesis.

Obviously there are many more flaws that could be holding back the economy from a full recovery - but these are the ones I've chosen to write about over the years.

What concerns me the most is that by creating this kind of extended prisoner's dilemma, the Fed is creating a dangerous environment where distortions are slowly becoming embedded into the system. It is important to remember that in the original Prisoner's dilemma scenario, the rational actors were only put in a position where they had to made an irrational decision ONCE. Once the decision was made, the consequences were immediate. The Fed model has been running non-stop for 7 years (and counting), which means rational players in this environment have been compelled to make irrational decisions against their best interests every single day. It's hard to imagine how that environment will work out without any unintended consequences.

A good example of a dangerous semi-permanent distortion that the Central Banks created via their prisoner's dilemma model is the phenomenon of people paying huge premiums on homes purchased in Vancouver (I discussed the issue in a post here). While paying a premium for a property may not be an unheard of event, it is slowly becoming the norm in the Vancouver area.

Unfortunately, since people are unaware that they are making decisions within a prisoner's dilemma it follows that they do not know many of the decisions they've made are "irrational" and not in their best interests.

What I find interesting is that when the Fed is tried to communicate their desire to normalize and END the prisoner's dilemma - the market responded quite negatively. It was as if people were starting to realize that irrational behavior was once again going to be subject to risk.

The market only started to improve when the economic data was so poor that it became glaringly obvious that the Fed would NOT be able to normalize rates and stop their prisoner's dilemma. This highlights yet another possible problem created via an excessive duration of a prisoner's dilemma within the financial markets: addiction.

There are four accepted states of addiction

1. Experimentation

2. Social use, regular use

3. Problem Use, Risky Use

4. Substance Abuse

If you look at where we are now, I think it's safe to say (after 7 years of on going Fed intervention into the markets via a prisoner's dilemma construct) that we are well on our way to stage 4 where we

"use a psychoactive drug (or in our case financial intervention) to such an extent that its effects seriously interfere with health or occupational and social functioning"

I have no idea how we normalize from where we are now without having a negative impact on the market AND the economy, but think we need to make those moves now before the addiction to our irrational behavior gets even worse.