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A Nobel Prize in Economics a Climate Change Denier Might Love

It has been a scary month in climate science. Hurricane Michael and a frightening report from the U.N. Intergovernmental Panel on Climate Change underlined the potential costs of human-caused global warming. Then to add insult to injury, William Nordhaus won the economics Nobel Prize. Nordhaus wa...

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IN A WORLD OF UNDERPRICED RISK, WHAT COULD POSSIBLY GO WRONG?


Monday September 17, 2012

 
EUGENE LINDEN
 
On a recent conference call, the strategist of a major international bank (it was an off-the-record call for clients only) laid out the bare bones of what he called the world’s “giant experiment” in debt and interest rates. Never before have so many countries maintained such low base rates for so long; never before in peacetime have so many countries had such huge deficits and debt burdens; never before in U.S.  history had long term rates been so low; never before has the U.S. gone so many decades without deflation following inflation. Because we live in these unprecedented times, it’s easy to lose sight just our strange they are… and how dangerous.
 
Consider just one small piece of this brave new world: What happens when the huge preponderance of the global financial market under prices risk?  To add to the list offered by the strategist: Never before has so much debt been referenced to benchmarks that price debt too low for their inherent risks. The distortions of this unique situation have been well-documented – underfunded pensions and impoverished retirees for instance -- but reversion to the fair pricing of risk would almost certainly crater the global financial system and governments around the world.
 
This leaves us in an exquisitely cruel predicament. An underpinning of any sustainable financial system is the proper pricing of risk. If I am going to loan you money, the interest rate I charge will reflect what kind of return I can fairly demand (assuming that the borrower can turn to someone else if I charge too much) given all the different factors that might prevent me from being repaid in full.  For any given financial instrument, these factors might include the quality of collateral, inflation expectations, the character of the borrower, and a host of other factors including the political stability of the borrower’s home country. To the degree that I charge too low an interest rate I am subsidizing the borrower, assuming a portion of risk that the borrower is not paying for, and increasing the likelihood that I will not be repaid in full.
 
That’s where we are right now, with every lender, depositor and investor in the developed world (which includes most of us when we consider pension funds and insurers) blithely assuming much more risk than we are being compensated for. This has allowed, actually encouraged, the entire developed world to pile on debt at levels without precedent. When events force a settling of this world-wide mispricing, we risk the mother of all financial crises. Will it be hyperinflation as governments try to devalue debt burdens, a deflationary spiral and credit freeze as floating rates soar to try and catch up, or all of the above?
 
Naturally, all of this has been done by design. On the one hand, central banks around the world have for years been pursuing policy rates at or near zero (nicknamed ZIRP or Zero Interest Rate Policy) since 2008 (and long before in the case of Japan), ostensibly to encourage profitable lending in order to restore vigor to economies. Through programs such as Operation Twist in the U.S. and the LTRO (Long Term Refinancing Operation) in Europe, central banks have also sought to supply liquidity and bring down long-term rates. Thus the vast universe of both high yield and investment grade bonds, priced more to their spread from treasuries than for nominal yield, underprices risk to the degree that fed actions underprice the risk in U.S. sovereign debt.
 
Then, as we discovered this year, LIBOR, an unofficial rate inaugurated in 1986 to reflect the price that the biggest banks pay to borrow from each other, also has been manipulated to understate the risks bank see in lending to their peers. LIBOR is the benchmark for many trillions of dollars in debt and financial instruments (estimates range up to $800 trillion, a truly ridiculous number that underscores what a monster LIBOR has become). Central bankers in the U.K. and the U.S. have known for at least five years that LIBOR was being manipulated to understate what might constitute a true interbank rate. Mervyn King, a governor of the Bank of England, witheringly described LIBOR in 2008 “as the rate at which banks don’t lend to each other.”
 
The authorities tolerated this manipulation because they feared then, and still do today, that the real interest rate at which banks would actually lend to each other would be so high as to cause a global panic given the impossibly huge amount to debt benchmarked to LIBOR.Between them, ZIRP and LIBOR affect financial instruments that cover most of the credit waterfront. To paraphrase Jim Grant, much of the developed world lives in a world of return free risk.
All this de facto philanthropy by investors has been a windfall some governments – including the U.S. and Japan -- allowing them to pile on debt without having to commensurately increase the amount they budget for interest. For banks ZIRP has been a mixed blessing. On the one hand, big banks have access to extremely cheap money, but, on the other, the risks of lending in a debt-burdened and bruised economy often don’t justify the meager nominal returns that can be achieved. Also, the tiny margins at the zero bound mean that the short-term collateralized lending that supports money market funds and much of the shadow banking system can become unprofitable in the blink of an eye. Thus, ultralow rates, historically associated with the risk of inflation, can actually withdraw liquidity from the market, and produce a deflationary spiral.
 
This is just one of the paradoxes of this strange new world. Another is that even as rates suggest that risk has been banished in the 21stcentury, the number of governments and corporations deemed risk free by the rating agencies continues to shrink. According to the New York TIMES, the number of AAA rated corporations in the U.S. has dropped from in the 60s in the 1980s to just four today. The number of Triple A-Rated sovereigns shrinks apace. One reason for the parsimony in handing out AAA ratings today comes from barn-door closing by the rating agencies after the heady days of the housing bubble when any loan had a bright future as part of a AAA-rated financial instrument thanks to the alchemy of securitization. The continuing global hangover from this historic mispricing (and miss-rating) underscores the misery that follows the misunderstanding of risk.
 
Why then do financial authorities persist in underpricing risk so soon after that near-death experience? Simply put, we can’t do otherwise. ZIRP and a low low LIBOR push the day of reckoning off into the future, and allow governments and investors to retain the faint hope that some yet to be identified engine of growth will save the day. If, however, interest rates were to rise to discount actual risk, debt service would soar to consume tax revenues for the U.S., Japan, and other profligate governments, a flood of insolvencies would ensue, what little mortgage lending that remains would shrink further (pushing home prices down and further impoverishing households that have seen their net worth plummet since 2008), and economic activity would shrivel throughout the developed world.
Central bankers do have one lucky break that gives them breathing room in this ultimately unsustainable situation: inflation remains far over the horizon. All the money printed around the world really isn’t going anywhere (except to buy up the too-cheap debt issued by governments and agencies). It certainly isn’t going to wages – outsourcing has killed that legacy of the bell-bottom era – and there is plenty of slack capacity that needs to be filled before any developed world economy overheats. Nor is it going into consumption -- most households are still drowning in debt, which limits their desire to spend, even if people could qualify for additional credit. 
 
So, the Federal Reserve continues to push out the date, currently 2015 and counting, at which they say they will wean the economy from ZIRP, and LIBOR remains surreally below a level at which banks might actually lend to each other. Given the alternative, however, who can blame the financial authorities? The only choice seems to be to hold our breath, and hope that no event or mistake causes the ping pong ball to fall on to the table full of mouse traps that now constitutes the global financial system: 

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Short Take

In Memorium: Koko the Gorilla

Koko the gorilla died on June 19. She and a female chimpanzee named Washoe (who died in 2007) played an outsized role in changing how we view animal intelligence. Their accomplishments inaugurated deep soul-searching among us humans about the moral basis of our relationship with nature. Koko and Washoe have made it much more difficult for us to treat animals as commodities, in any way we wish.

I knew the two great apes when I was young and they were young, and I”ve closely followed the scientific, philosophical and moral upheavals they precipitated over the last five decades. In the 1960s and ’70s, they learned to use American sign language, and they came to understand that words could be combined to convey new meanings. It threw the scientific world into a tizzy, implying that sentience and languagewere not ours alone, that there was a continuum in higher mental abilities that linked animals and humans.

The problem for science remains unresolved: 3,000 years into the investigation of signal human attributes and we still don’t have rigorous ways to define language and intelligence that are agreed on and can be empirically tested. There remain a number of scientists who don’t think Koko and Washoe accomplished anything at all. Even if a scientist accepts one of the definitions of language that do exist, it’s nearly impossible to test it in animals because what is being examined is inherently subjective, and science demands objective, verifiable results.

Consider how hard it is to prove a lie beyond a reasonable doubt in court. Then consider trying to prove lying in an animal in accord with the much stricter standards of science.

As difficult as proving it may be, examples of apes lying abound. When Koko was 5, I was playing a chase game with her. When I caught her, she gave me a small bite. Penny Patterson, Koko’s lifelong foster parent and teacher, was there, and, in sign language, demanded, “What did you do?”

Koko signed, “Not teeth.”

Penny wasn’t buying it: “Koko, you lied.”

“Bad again Koko bad again,” Koko admitted.

“Koko, you lied.” But what was Koko’s intent — a central issue when it comes to proving a lie. What was actually going on in her head when she made the gestures for “not teeth?” As if that weren’t inscrutable enough, one of the guiding principles of scientific investigations of animal intelligence is what’s known as Morgan’s Canon: Scientists must not impute a higher mental ability if a behavior can be explained by something more primitive, for example, simple error.

Analogously, about 50 years ago, on a pond in Oklahoma, Washoe saw a swan and made the signs for “water” and “bird.” Was she simply noting a bird and water, or was she combining two of the signs she knew to describe an animal for which she had no specific word? The debate continued for decades and was unresolved when she died.

Since Washoe made those signs, there have been many more instances of apes combining words to describe something, but these examples still don’t prove they can combine words to arrive at a novel term, even if it seems obvious that they can. Faced with these ambiguities, many scientists have moved to studying whether animals can accomplish specific cognitive tasks, and a welter of credible findings show sophisticated abilities in animals ranging from crows to elephants.

Although science struggles with questions of general intelligence, language and intent, the public is in the “it’s obvious” camp, readily accepting evidence of animal sentience. The latest objects of fascination are the octopus — a relative of the clam! — and fish. Stories of cephalopod escape and problem-solving regularly go viral, and to the consternation of sushi lovers , John Balcomb’s book, “What a Fish Knows,” provides copious evidence that fish know a lot.

We tend to see animals as either personalities or commodities, or sometimes, both. When I wrote about octopus intelligence, I was amused by one octopus-oriented website that divided its space between stories of smart octopuses and recipes for cooking them. Perhaps the most extraordinary example of our schizophrenic view of animals occurred some years back when a chimp colony that included sign-language-using apes was disbanded and many of these onetime celebrities were shipped to a medical research lab to be used in Hepatitis B and AIDS drug testing.

I knew these chimps too, and visited them in their new environment. They were desperate to communicate with their human captors, but the staff didn’t know sign language. So insistent were Booee and Bruno with their signing that one handler put up a poster outside the cages showing some basic signs to help the humans respond. When I was there, three days after Booee had arrived, he was signing agitatedly for food and drink. But what I think he really wanted was reassurance: If the humans would respond to “gimme drink,” things were going to be OK.

Teaching Koko, Washoe and other animals some level of human and invented languages promised experimenters insight into the animal mind. But the animals seemed to seize on these languages as a way to make their wishes — and thoughts — known to their strange, bipedal wardens, who had no ability or interest in learning the animals’ communication system. For Koko, I believe, sign language was a way to make the best of a truly unnatural situation, and so she signed.

Science doesn’t know if great apes can invent terms or if they tell lies. And the tension between whether we view and treat animals as personalities or as commodities lives on. The truth is, Koko, Washoe and many other animals who have had two-way conversations with the people around them shatter the moral justification for the latter.



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