Ascending and Descending

Islamists in the Sahel have vowed to drag France into a “long war”. Reuters reports that “Al Qaeda-linked Islamist rebels launched a counteroffensive in Mali on Monday after four days of French air strikes on their northern strongholds, seizing the central town of Diabaly and promising to drag France into a brutal Afghanistan-style war.”

To add insult to injury the Shebab group posted a picture of a dead French commando. “The picture showed the body of the alleged commander, dressed in a black button-up shirt, and khaki pants, lying face up on an orange surface next to presumably his combat gear. A small crucifix showed from his neck.”

Meanwhile tensions rose in the subcontinent after a Pakistani unit slipped across the border to behead Indian soldiers. Gen. Bikram Singh, the Indian Army Chief of Staff was not amused:

“The attack on Jan. 8 was premeditated, a pre-planned activity. Such an operation requires planning, detailed reconnaissance,” Singh told reporters. He said India reserved the right to retaliate at a “time and place of its choice.”

Singh urged his troops to be “aggressive and offensive in the face of provocation and fire” from Pakistan. He said the alleged beheading of the Indian soldier was “unacceptable and unpardonable” and accused Pakistan of violating the “ethics of warfare.”

You’d think the world is in trouble. But is it? To the question of whether any of this matters the answer is that it depends whether you believe you can live in a dream. Let us for a moment forget the Shebab and Pakistan and fly on the wings of fancy to the world of dollars and cents, which is stranger than even Somalia. Don’t worry, we’ll come back to Shebab in due time.

Chris Cole, a volatility trader at Artemis Capital says that the Western economy has for some time been running on “impossible objects”. The economy has now become entirely about the market and the market has become entirely dependent on its perception of itself. It’s self referential. Cole likens it to other impossible objects in the history of philosophy and art:

In the 1985 work “Simulacra and Simulation” French philosopher Jean Baudrillard recalls the Borges fable about the cartographers of a great Empire who drew a map of its territories so detailed it was as vast as the Empire itself. According to Baudrillard as the actual Empire collapses the inhabitants begin to live their lives within the abstraction believing the map to be real (his work inspired the classic film “The Matrix” and the book is prominently displayed in one scene). The map is accepted as truth and people ignorantly live within a mechanism of their own design and the reality of the Empire is forgotten. This fable is a fitting allegory for our modern financial markets.

In his view, we no longer live entirely in the real economy of loaves of bread and tons of steel. We live in the representation of it. We make more paper profits, even though in this strange economy people seem to get poorer. Cole writes:

Despite higher asset prices experimental monetary policy seems to be doing very little to support the middle and lower class. Following QE2 GDP growth actually slowed down from +2.4% to +1.6% and unemployment adjusted for discouraged workers went from 22.5% to 22.7% according to shadow government statistics. The middle and lower class do not own stocks and they cannot buy homes because they remain overleveraged. Raising bank profits has not helped the economy because credit cannot be extended to households that are in debt. For example less than 1% of all mortgages originated in the past 18 months went to borrowers with an impaired credit history, and 1 out of every 5 homes sold was purchased in an all cash deal by an investor rather than a live-in homeowner. Every $1 increase in equity prices raises consumer spending by just 3 to 5 cents so a 10% increase in stocks will add, at best, 45 basis points of GDP growth to the US economy. In addition by keeping interest rates artificially low the Fed is creating a large funding gap for pension systems and other programs leading up to what could be a demographic time bomb.

But never fear. Without the Matrix we would die. Everything Too Big to Fail perishes without it. Cole describes the contradictory effects.

The defense of quantitative easing rests largely on an assessment of what would have happened to the economy absent its support. Nonetheless we should fear the law of unintended consequences because it takes a very small shift in perception to result in uncontrollable socio-economic change. We may get higher asset prices today but at the expense of inflation, class warfare, social unrest or something even worse tomorrow.

And when tomorrow comes there’ll be some other distraction to beguile the low information denizens of the Matrix. Some new celebrity scandal; another dance craze. Another hit movie. And meanwhile the Fed will be printing money. Our commenter Josh has often called this “Bernanke magic” but Cole says that Bernanke is one of its modest practicioners. Cole believes Bernanke is well aware he is treading on absurdity. So he warns all and sundry to heed Wile E. Coyote’s advice: don’t look down.

Bernanke is more modest than his counterparts in Europe and does not publicly challenge the “Gods of Risk” to a throw down. Bernanke states more humbly regarding the threat of accommodative policy, “Whether we have the credibility to persuade markets that we’ll follow through is an empirical question… we will have created (by following through) a reserve of credibility that we can use in any subsequent episodes that occur”. … either way the fate of markets rests largely on the psychological fight between the credibility of global central banks to defend an optical illusion against the will of risk markets to test the fragile boundaries of human perception.

Because maybe if we don’t gaze at the arroyo floor then we’ll get all the way to the next limestone tower by sheer momentum alone. Perhaps the most imporant calculation in Cole’s paper is his demonstration than in our world risk-free assets have now become, properly considered, as risky as risky assets. He proposes an experimental investment, and I leave the reader to examine the calculations for himself. He concludes:

When the “bull market in fear” meets a “bubble in safety” a collateralized short volatility position and “risk-free’ UST bond have shockingly similar risk-to-reward payoffs. Of course you would rather own the UST bond in deflation or the volatility bond in inflation but we are assuming a riskneutral world. To this effect both investments suffer comparable losses to their worst case scenarios. Without endorsing either investment, when evaluated on a pure risk-to-reward framework the volatility bond (with embedded short optionality) is superior to UST bonds at current prices. What kind of world do we live in where the risk-return pay-off of short selling equity volatility is equal or better to that of a supposedly “risk-free” government bond?

His next insight is the most interesting. In a Wile E. Coyote world you also get Wile E. Coyote risks. Trains can come out of painted doors in rocks. You can fall faster than rock so that the rock lands on you.

When the market is an impossible object the price of risk can change radically as perception shifts. Hence what may be sound judgment one minute may be completely foolish the next. If two contradictory ideas can exist simultaneously then there is no such thing as “simple perception” anymore. How is it possible for safety to be risky and for otherwise calm markets to be rich in fear? Paradox is now fundamental. The investor who can adapt to shifting perspectives will endure the volatility of an impossible object. Common sense says do not trust your common sense anymore. Don’t live in a box or walk a flight of stairs that leads back from whence you came. We cannot assume that the paradigm of the last three decades of lower interest rates and debt expansion will be relevant going forward nor can we find shelter in the consensus rules formed around that standard.

By opting to live in MC Escher’s or the Matrix’s world we’ve also opted to risk encountering the impossible perils of that universe. Live in fantasy, die in fantasy.

What has this got to do with Shebab in Somalia or terrorists in Pakistan? The parallel is that for a similarly long time the political system has been constructing the equivalent of Bernanke’s Impossible Universe. It is a place where objects like Global Warming, nuclear disarmament, the need to produce more ethanol and the imperative to clamp down on jumbo soft drinks looms larger than say, the War on Terror, which is about to be declared over.

It’s worked so far because everyone has gone along with the con. Why won’t it work forever. Maybe it will. Perhaps all we really need to do is buy the world a Coke. But a word from the wise. Don’t look down. Don’t look down.