top of page

Good Reading -- June 2012 (part 2)


  • "Former Treasury Secretary Henry Paulson said the U.S. will emerge relatively unharmed from the debt crisis in Europe as efforts by Greece, Spain and other nations to stabilize their economies persist for the long-term. 'Although Europe is a drag, the U.S. will continue to muddle along with growth that really isn’t enough to make a dent in employment,' Paulson...said at a [June 19] biotechnology industry conference in Boston. Europe will eventually stabilize and avoid a 'catastrophic outcome,' he said, [but] under the best circumstances, 'this will drag on over time.'” (Source: Bloomberg)

  • Regarding the outlook in Europe: "I'm sure of three things. I don't know what's going to happen; nobody else knows what is going to happen; and all the experts are predicting different outcomes so 90% of them must be wrong, if not 100%. It is a folly to listen to anyone who says they know what is going to happen and make investments on that basis." -- Howard Marks*

  • * Remarks delivered at a conference in New York on June 12, 2012. Any misattributions or mistakes are my own. Further comments are paraphrased as follows: Europe will probably get by, with the governments -- namely Germany -- doing the bare minimum. But there is certainly a non-zero chance of of something very bad happening. Either way, Europe in general is a huge mess and will likely remain so for years. The wall of worry in today's market is well deserved; the litany of macro concerns prevalent today may be the most extreme in my or anyone's career, but they also have existed for years -- we just weren't focusing on them. The riskiest thing in the world is a lack of belief in the presence of risk in the market; that is certainly not the case today. Act cautiously; insist on value and safety. Low-priced, well-capitalized corporate assets are -- as always -- the best options in this environment.

Facts and Figures

  • In the past six years, the balance sheets of the world's eight largest central banks have more than tripled (in dollar terms) from $5.4 trillion to $15+ trillion. (Source: Bianco Research)

  • Coca-Cola will return to Myanmar (Burma) for the first time in 60 years. The only two countries left in the world without Coke will then be Cuba and North Korea. (Source: Bloomberg)

  • "From 1985 through 2011...for every dollar spent in [capex, M&A, dividends and buybacks], roughly $0.55 went to capital spending, $0.27 to M&A, and $0.18 to dividends and buybacks." (Source: Michael Mauboussin -- see attached; note: dividends and buybacks were about equal at ~9% each)

  • In the past 10 years, dividends and M&A have remained about the same (~9% and ~26%, respectively), while capex has fallen to 50% and buybacks have climbed to 14%. In the last five years, the trend is even clearer: still almost 9% in dividends, only 43% in capex, 16% in buybacks and 32% in M&A


  • Reading List -- A couple of friends asked for this recently, so I thought I'd send it around in case you're looking for some good reading material this summer. The "top 100" and groupings are just my opinion -- there should be something for everyone on this list, and hopefully some new or overlooked books or articles. Please let me know if you have any suggestions or corrections to the list.

  • "Share Repurchases from All Angles" -- An excellent article from Michael Mauboussin offering some clear-headed thinking on share buybacks.

  • "Bearish on Brazil" -- A great debate about Brazil's economic prospects. The attached is an essay in Foreign Affairs adapted from the author's new book Breakout Nations: In Pursuit of the Next Economic Miracles. I haven't read the book yet, but the essay is interesting. The author, who is head of Emerging Markets and Global Macro at Morgan Stanley Investment Management, explores Brazil's lofty reputation as a growth market and attributes most of the successes to a heavy reliance on rising commodity prices driven by Chinese demand. The author also believes Brazil has a "hidden cap" on growth -- due to high interest rates, inflationary feedback, uncompetitiveness, an overvalued currency, chronic government overspending and misinvestment, lack of productivity growth, and a lack of investment in anything other than a welfare state -- that will be exposed as commodity demand/prices weaken.

  • Here is a series of rebuttal essays, including a response by the author, with many excellent points and counterpoints.

  • For more on Brazil's horrendous education system see here, here and here.


  • Hedge Fund Market Wizards -- Jack Schwager has just released the fourth book in his Market Wizards series. I've read the others, which began more than 20 years ago, and this one is the best yet. They're all focused more on "trading" than "investing," and some of the trade-y stuff really makes me cringe, but even the staunchest Grahamite still has something to learn here. In particular, Schwager's interview with Edward Thorp is excellent -- that material alone would make a great book.The only overlap with The Alpha Masters is a chapter on a Ray Dalio, which is longer and more detailed in Schwager's book. And if nothing else, Schwager's interview with Joel Greenblatt gives this book all the credibility it needs. Highly recommended.

  • An interview with the author by Opalesque (via a great blog) is here.


  • "Debunking the Myth of Intuition" -- A great interview with Prof. Kahneman on a range of topics.

  • Julian Robertson Interviewed on Bloomberg TV -- A rare interview with Julian Roberston. Topics include hedge funds and investment strategy, Europe and the debt crisis, and American politics.

  • "The Five Mega-trends Shaping Tomorrow's Customers" -- An op-ed by Coca-Cola CEO Muhtar Kent about the key forces driving the world's consumers.

  • "The Formula That Killed Wall Street? The Gaussian Copula and the Material Cultures of Modelling" -- Don't let the title scare you.

  • "Why I'm Betting Big on Europe" -- A profile of David Herro and his investments in European banks. Regardless of an opinion on the merits of these investments, this is certainly not a mutual fund manager with any fear of a little tracking error!

  • For another contrarian, check out this guy investing solely in Greek equities.

  • "The State of the Nation's Housing" -- The latest annual report from The Joint Center for Housing Studies of Harvard University. I've always found this report to be one of the very best ways to understand the conditions in the housing industry (and it's free!). This year's press release reads: "“While still in the early innings of a housing recovery, rental markets have turned the corner, home sales are strengthening, and a floor is beginning to form under home prices. With new home inventories at record lows, unless the broader economy goes into a tailspin, stronger sales should further stabilize prices and pave the way for a pickup in single-family housing construction over the course of 2012.”

  • "This is Your Brain on Bargains: JC Penney and the Curse of Discounts" -- An interesting look at consumer behavior, the history of coupons and discounts, and the potential impact on JCP's strategy.

  • "Shatel Q&A: Friendships are Buffett's Sport Riches" -- Speaking of Michael Lewis (see below), I thoughtMoneyball was a pretty good book. In this interview, which is more of a curiosity than anything else, Buffett said in response to a question about sports figures asking for advice from him: "I get a lot of them that just want to talk. Billy Beane called. He's a Berkshire shareholder. He was running the A's. He was running them like Berkshire, he thought. There's a fair number of them who are shareholders."

  • "In Insider and Enron Cases, Balancing Lies and Thievery" -- I think this is a really interesting debate. And this essay is amazing --- the lead Enron prosecutor walks through a very honest assessment of the case; admits that it had "fundamental weaknesses" and that Skilling "took steps inconsistent with alleged criminal intent"; and states that his trial strategy breakthrough came after watching the movie based on Bethany McLean's outstanding book The Smartest Guys in the Room (which is highly recommended, by the way).


  • Remarks at the Festival of Economics -- A recent speech by George Soros in which he outlines his theory of reflexivity and his thoughts on the euro/EU crisis. It's long and a little dense -- and the reflexivity stuff certainly isn't new -- but there are worthwhile thoughts and analysis in here if you wade through it. And here and here are other Soros articles on the topic.

  • "Don't Eat Fortune's Cookie" -- Michael Lewis's recent speech to the graduating class at Princeton. I have mixed emotions on his articles and books -- I love some of them, others not so much -- but in the spirit of the recently passed graduation season, this is worth a quick read. Other commencement links:

  • Dr. Michael Burry at UCLA -- Burry's commentary on his career and investments, including "the big short," and his overall outlook for the future (which is largely pessimistic). It starts slow but is very worthwhile.

  • Failure and Rescue -- A commencement address by Atul Gawande of The Checklist Manifesto fame.

  • Cory Booker at Stanford -- transcript and video. Future President?

  • For another angle, I thought this was great: Wellesley English Teacher To High School Graduates: "You Are Not Special."

  • "Unequal Shares" -- A look at dual-class share structures and public company governance in light of the recent Facebook IPO. A recent issue of The Economist also looked at the possible demise of the public company, which obviously a bit of hyperbole but has some worthwhile thoughts behind it.

  • "Not So Expert" -- A column in The Economist about psychological biases and financial decisions. "The need for financial advice may be more psychological than practical."

  • NYSE CEO: Public Has Lost Trust in Market -- I think there is something to the NYSE's side of the argument. And much like the move from private partnerships to publicly-traded corporations, I would view the exchanges' decisions to IPO as a seminal moment in the evolution of the environment we have today.

Remarks at the Festival of Economics, Trento Italy

June 02, 2012

Ever since the Crash of 2008 there has been a widespread recognition, both among economists and the general public, that economic theory has failed. But there is no consensus on the causes and the extent of that failure.

I believe that the failure is more profound than generally recognized. It goes back to the foundations of economic theory. Economics tried to model itself on Newtonian physics. It sought to establish universally and timelessly valid laws governing reality. But economics is a social science and there is a fundamental difference between the natural and social sciences. Social phenomena have thinking participants who base their decisions on imperfect knowledge. That is what economic theory has tried to ignore.

Scientific method needs an independent criterion, by which the truth or validity of its theories can be judged. Natural phenomena constitute such a criterion; social phenomena do not. That is because natural phenomena consist of facts that unfold independently of any statements that relate to them. The facts then serve as objective evidence by which the validity of scientific theories can be judged. That has enabled natural science to produce amazing results.

Social events, by contrast, have thinking participants who have a will of their own. They are not detached observers but engaged decision makers whose decisions greatly influence the course of events. Therefore the events do not constitute an independent criterion by which participants can decide whether their views are valid. In the absence of an independent criterion people have to base their decisions not on knowledge but on an inherently biased and to greater or lesser extent distorted interpretation of reality. Their lack of perfect knowledge or fallibility introduces an element of indeterminacy into the course of events that is absent when the events relate to the behavior of inanimate objects. The resulting uncertainty hinders the social sciences in producing laws similar to Newton’s physics.

Economics, which became the most influential of the social sciences, sought to remove this handicap by taking an axiomatic approach similar to Euclid’s geometry. But Euclid’s axioms closely resembled reality while the theory of rational expectations and the efficient market hypothesis became far removed from it. Up to a point the axiomatic approach worked. For instance, the theory of perfect competition postulated perfect knowledge. But the postulate worked only as long as it was applied to the exchange of physical goods. When it came to production, as distinct from exchange, or to the use of money and credit, the postulate became untenable because the participants’ decisions involved the future and the future cannot be known until it has actually occurred.

I am not well qualified to criticize the theory of rational expectations and the efficient market hypothesis because as a market participant I considered them so unrealistic that I never bothered to study them. That is an indictment in itself but I shall leave a detailed critique of these theories to others.

Instead, I should like to put before you a radically different approach to financial markets. It was inspired by Karl Popper who taught me that people’s interpretation of reality never quite corresponds to reality itself. This led me to study the relationship between the two. I found a two-way connection between the participants’ thinking and the situations in which they participate. On the one hand people seek to understand the situation; that is the cognitive function. On the other, they seek to make an impact on the situation; I call that the causative or manipulative function. The two functions connect the thinking agents and the situations in which they participate in opposite directions. In the cognitive function the situation is supposed to determine the participants’ views; in the causative function the participants’ views are supposed to determine the outcome. When both functions are at work at the same time they interfere with each other. The two functions form a circular relationship or feedback loop. I call that feedback loop reflexivity. In a reflexive situation the participants’ views cannot correspond to reality because reality is not something independently given; it is contingent on the participants’ views and decisions. The decisions, in turn, cannot be based on knowledge alone; they must contain some bias or guess work about the future because the future is contingent on the participants’ decisions.

Fallibility and reflexivity are tied together like Siamese twins. Without fallibility there would be no reflexivity – although the opposite is not the case: people’s understanding would be imperfect even in the absence of reflexivity. Of the two twins, fallibility is the first born. Together, they ensure both a divergence between the participants’ view of reality and the actual state of affairs and a divergence between the participants’ expectations and the actual outcome.

Obviously, I did not discover reflexivity. Others had recognized it before me, often under a different name. Robert Merton wrote about self-fulfilling prophecies and the bandwagon effect, Keynes compared financial markets to a beauty contest where the participants had to guess who would be the most popular choice. But starting from fallibility and reflexivity I focused on a problem area, namely the role of misconceptions and misunderstandings in shaping the course of events that mainstream economics tried to ignore. This has made my interpretation of reality more realistic than the prevailing paradigm.

Among other things, I developed a model of a boom-bust process or bubble which is endogenous to financial markets, not the result of external shocks. According to my theory, financial bubbles are not a purely psychological phenomenon. They have two components: a trend that prevails in reality and a misinterpretation of that trend. A bubble can develop when the feedback is initially positive in the sense that both the trend and its biased interpretation are mutually reinforced. Eventually the gap between the trend and its biased interpretation grows so wide that it becomes unsustainable. After a twilight period both the bias and the trend are reversed and reinforce each other in the opposite direction. Bubbles are usually asymmetric in shape: booms develop slowly but the bust tends to be sudden and devastating. That is due to the use of leverage: price declines precipitate the forced liquidation of leveraged positions.

Well-formed financial bubbles always follow this pattern but the magnitude and duration of each phase is unpredictable. Moreover the process can be aborted at any stage so that well-formed financial bubbles occur rather infrequently.

At any moment of time there are myriads of feedback loops at work, some of which are positive, others negative. They interact with each other, producing the irregular price patterns that prevail most of the time; but on the rare occasions that bubbles develop to their full potential they tend to overshadow all other influences.

According to my theory financial markets may just as soon produce bubbles as tend toward equilibrium. Since bubbles disrupt financial markets, history has been punctuated by financial crises. Each crisis provoked a regulatory response. That is how central banking and financial regulations have evolved, in step with the markets themselves. Bubbles occur only intermittently but the interplay between markets and regulators is ongoing. Since both market participants and regulators act on the basis of imperfect knowledge the interplay between them is reflexive. Moreover reflexivity and fallibility are not confined to the financial markets; they also characterize other spheres of social life, particularly politics. Indeed, in light of the ongoing interaction between markets and regulators it is quite misleading to study financial markets in isolation. Behind the invisible hand of the market lies the visible hand of politics. Instead of pursuing timeless laws and models we ought to study events in their time bound context.

My interpretation of financial markets differs from the prevailing paradigm in many ways. I emphasize the role of misunderstandings and misconceptions in shaping the course of history. And I treat bubbles as largely unpredictable. The direction and its eventual reversal are predictable; the magnitude and duration of the various phases is not. I contend that taking fallibility as the starting point makes my conceptual framework more realistic. But at a price: the idea that laws or models of universal validity can predict the future must be abandoned.

Until recently, my interpretation of financial markets was either ignored or dismissed by academic economists. All this has changed since the crash of 2008. Reflexivity became recognized but, with the exception of Imperfect Knowledge Economics, the foundations of economic theory have not been subjected to the profound rethinking that I consider necessary. Reflexivity has been accommodated by speaking of multiple equilibria instead of a single one. But that is not enough. The fallibility of market participants, regulators, and economists must also be recognized. A truly dynamic situation cannot be understood by studying multiple equilibria. We need to study the process of change.

The euro crisis is particularly instructive in this regard. It demonstrates the role of misconceptions and a lack of understanding in shaping the course of history. The authorities didn’t understand the nature of the euro crisis; they thought it is a fiscal problem while it is more of a banking problem and a problem of competitiveness. And they applied the wrong remedy: you cannot reduce the debt burden by shrinking the economy, only by growing your way out of it. The crisis is still growing because of a failure to understand the dynamics of social change; policy measures that could have worked at one point in time were no longer sufficient by the time they were applied.

Since the euro crisis is currently exerting an overwhelming influence on the global economy I shall devote the rest of my talk to it. I must start with a warning: the discussion will take us beyond the confines of economic theory into politics and the dynamics of social change. But my conceptual framework based on the twin pillars of fallibility and reflexivity still applies. Reflexivity doesn’t always manifest itself in the form of bubbles. The reflexive interplay between imperfect markets and imperfect authorities goes on all the time while bubbles occur only infrequently. This is a rare occasion when the interaction exerts such a large influence that it casts its shadow on the global economy. How could this happen? My answer is that there is a bubble involved, after all, but it is not a financial but a political one. It relates to the political evolution of the European Union and it has led me to the conclusion that the euro crisis threatens to destroy the European Union. Let me explain.

I contend that the European Union itself is like a bubble. In the boom phase the EU was what the psychoanalyst David Tuckett calls a “fantastic object” – unreal but immensely attractive. The EU was the embodiment of an open society –an association of nations founded on the principles of democracy, human rights, and rule of law in which no nation or nationality would have a dominant position.

The process of integration was spearheaded by a small group of far sighted statesmen who practiced what Karl Popper called piecemeal social engineering. They recognized that perfection is unattainable; so they set limited objectives and firm timelines and then mobilized the political will for a small step forward, knowing full well that when they achieved it, its inadequacy would become apparent and require a further step. The process fed on its own success, very much like a financial bubble. That is how the Coal and Steel Community was gradually transformed into the European Union, step by step.

Germany used to be in the forefront of the effort. When the Soviet empire started to disintegrate, Germany’s leaders realized that reunification was possible only in the context of a more united Europe and they were willing to make considerable sacrifices to achieve it. When it came to bargaining they were willing to contribute a little more and take a little less than the others, thereby facilitating agreement. At that time, German statesmen used to assert that Germany has no independent foreign policy, only a European one.

The process culminated with the Maastricht Treaty and the introduction of the euro. It was followed by a period of stagnation which, after the crash of 2008, turned into a process of disintegration. The first step was taken by Germany when, after the bankruptcy of Lehman Brothers, Angela Merkel declared that the virtual guarantee extended to other financial institutions should come from each country acting separately, not by Europe acting jointly. It took financial markets more than a year to realize the implication of that declaration, showing that they are not perfect.

The Maastricht Treaty was fundamentally flawed, demonstrating the fallibility of the authorities. Its main weakness was well known to its architects: it established a monetary union without a political union. The architects believed however, that when the need arose the political will could be generated to take the necessary steps towards a political union.

But the euro also had some other defects of which the architects were unaware and which are not fully understood even today. In retrospect it is now clear that the main source of trouble is that the member states of the euro have surrendered to the European Central Bank their rights to create fiat money. They did not realize what that entails – and neither did the European authorities. When the euro was introduced the regulators allowed banks to buy unlimited amounts of government bonds without setting aside any equity capital; and the central bank accepted all government bonds at its discount window on equal terms. Commercial banks found it advantageous to accumulate the bonds of the weaker euro members in order to earn a few extra basis points. That is what caused interest rates to converge which in turn caused competitiveness to diverge. Germany, struggling with the burdens of reunification, undertook structural reforms and became more competitive. Other countries enjoyed housing and consumption booms on the back of cheap credit, making them less competitive. Then came the crash of 2008 which created conditions that were far removed from those prescribed by the Maastricht Treaty. Many governments had to shift bank liabilities on to their own balance sheets and engage in massive deficit spending. These countries found themselves in the position of a third world country that had become heavily indebted in a currency that it did not control. Due to the divergence in economic performance Europe became divided between creditor and debtor countries. This is having far reaching political implications to which I will revert.

It took some time for the financial markets to discover that government bonds which had been considered riskless are subject to speculative attack and may actually default; but when they did, risk premiums rose dramatically. This rendered commercial banks whose balance sheets were loaded with those bonds potentially insolvent. And that constituted the two main components of the problem confronting us today: a sovereign debt crisis and a banking crisis which are closely interlinked.

The eurozone is now repeating what had often happened in the global financial system. There is a close parallel between the euro crisis and the international banking crisis that erupted in 1982. Then the international financial authorities did whatever was necessary to protect the banking system: they inflicted hardship on the periphery in order to protect the center. Now Germany and the other creditor countries are unknowingly playing the same role. The details differ but the idea is the same: the creditors are in effect shifting the burden of adjustment on to the debtor countries and avoiding their own responsibility for the imbalances. Interestingly, the terms “center” and “periphery” have crept into usage almost unnoticed. Just as in the 1980’s all the blame and burden is falling on the “periphery” and the responsibility of the “center” has never been properly acknowledged. Yet in the euro crisis the responsibility of the center is even greater than it was in 1982. The “center” is responsible for designing a flawed system, enacting flawed treaties, pursuing flawed policies and always doing too little too late. In the 1980’s Latin America suffered a lost decade; a similar fate now awaits Europe. That is the responsibility that Germany and the other creditor countries need to acknowledge. But there is no sign of this happening.

The European authorities had little understanding of what was happening. They were prepared to deal with fiscal problems but only Greece qualified as a fiscal crisis; the rest of Europe suffered from a banking crisis and a divergence in competitiveness which gave rise to a balance of payments crisis. The authorities did not even understand the nature of the problem, let alone see a solution. So they tried to buy time.

Usually that works. Financial panics subside and the authorities realize a profit on their intervention. But not this time because the financial problems were reinforced by a process of political disintegration. While the European Union was being created, the leadership was in the forefront of further integration; but after the outbreak of the financial crisis the authorities became wedded to preserving the status quo. This has forced all those who consider the status quo unsustainable or intolerable into an anti-European posture. That is the political dynamic that makes the disintegration of the European Union just as self-reinforcing as its creation has been. That is the political bubble I was talking about.

At the onset of the crisis a breakup of the euro was inconceivable: the assets and liabilities denominated in a common currency were so intermingled that a breakup would have led to an uncontrollable meltdown. But as the crisis progressed the financial system has been progressively reordered along national lines. This trend has gathered momentum in recent months. The Long Term Refinancing Operation (LTRO) undertaken by the European Central Bank enabled Spanish and Italian banks to engage in a very profitable and low risk arbitrage by buying the bonds of their own countries. And other investors have been actively divesting themselves of the sovereign debt of the periphery countries.

If this continued for a few more years a break-up of the euro would become possible without a meltdown – the omelet could be unscrambled – but it would leave the central banks of the creditor countries with large claims against the central banks of the debtor countries which would be difficult to collect. This is due to an arcane problem in the euro clearing system called Target2. In contrast to the clearing system of the Federal Reserve, which is settled annually, Target2 accumulates the imbalances. This did not create a problem as long as the interbank system was functioning because the banks settled the imbalances themselves through the interbank market. But the interbank market has not functioned properly since 2007 and the banks relied increasingly on the Target system. And since the summer of 2011 there has been increasing capital flight from the weaker countries. So the imbalances grew exponentially. By the end of March this year the Bundesbank had claims of some 660 billion euros against the central banks of the periphery countries.

The Bundesbank has become aware of the potential danger. It is now engaged in a campaign against the indefinite expansion of the money supply and it has started taking measures to limit the losses it would sustain in case of a breakup. This is creating a self-fulfilling prophecy. Once the Bundesbank starts guarding against a breakup everybody will have to do the same.

This is already happening. Financial institutions are increasingly reordering their European exposure along national lines just in case the region splits apart. Banks give preference to shedding assets outside their national borders and risk managers try to match assets and liabilities within national borders rather than within the eurozone as a whole. The indirect effect of this asset-liability matching is to reinforce the deleveraging process and to reduce the availability of credit, particularly to the small and medium enterprises which are the main source of employment.

So the crisis is getting ever deeper. Tensions in financial markets have risen to new highs as shown by the historic low yield on Bunds. Even more telling is the fact that the yield on British 10 year bonds has never been lower in its 300 year history while the risk premium on Spanish bonds is at a new high.

The real economy of the eurozone is declining while Germany is still booming. This means that the divergence is getting wider. The political and social dynamics are also working toward disintegration. Public opinion as expressed in recent election results is increasingly opposed to austerity and this trend is likely to grow until the policy is reversed. So something has to give.

In my judgment the authorities have a three months’ window during which they could still correct their mistakes and reverse the current trends. By the authorities I mean mainly the German government and the Bundesbank because in a crisis the creditors are in the driver’s seat and nothing can be done without German support.

I expect that the Greek public will be sufficiently frightened by the prospect of expulsion from the European Union that it will give a narrow majority of seats to a coalition that is ready to abide by the current agreement. But no government can meet the conditions so that the Greek crisis is liable to come to a climax in the fall. By that time the German economy will also be weakening so that Chancellor Merkel will find it even more difficult than today to persuade the German public to accept any additional European responsibilities. That is what creates a three months’ window.

Correcting the mistakes and reversing the trend would require some extraordinary policy measures to bring conditions back closer to normal, and bring relief to the financial markets and the banking system. These measures must, however, conform to the existing treaties. The treaties could then be revised in a calmer atmosphere so that the current imbalances will not recur. It is difficult but not impossible to design some extraordinary measures that would meet these tough requirements. They would have to tackle simultaneously the banking problem and the problem of excessive government debt, because these problems are interlinked. Addressing one without the other, as in the past, will not work.

Banks need a European deposit insurance scheme in order to stem the capital flight. They also need direct financing by the European Stability Mechanism (ESM) which has to go hand-in-hand with eurozone-wide supervision and regulation. The heavily indebted countries need relief on their financing costs. There are various ways to provide it but they all need the active support of the Bundesbank and the German government.

That is where the blockage is. The authorities are working feverishly to come up with a set of proposals in time for the European summit at the end of this month. Based on the current newspaper reports the measures they will propose will cover all the bases I mentioned but they will offer only the minimum on which the various parties can agree while what is needed is a convincing commitment to reverse the trend. That means the measures will again offer some temporary relief but the trends will continue. But we are at an inflection point. After the expiration of the three months’ window the markets will continue to demand more but the authorities will not be able to meet their demands.

It is impossible to predict the eventual outcome. As mentioned before, the gradual reordering of the financial system along national lines could make an orderly breakup of the euro possible in a few years’ time and, if it were not for the social and political dynamics, one could imagine a common market without a common currency. But the trends are clearly non-linear and an earlier breakup is bound to be disorderly. It would almost certainly lead to a collapse of the Schengen Treaty, the common market, and the European Union itself. (It should be remembered that there is an exit mechanism for the European Union but not for the euro.) Unenforceable claims and unsettled grievances would leave Europe worse off than it was at the outset when the project of a united Europe was conceived.

But the likelihood is that the euro will survive because a breakup would be devastating not only for the periphery but also for Germany. It would leave Germany with large unenforceable claims against the periphery countries. The Bundesbank alone will have over a trillion euros of claims arising out of Target2 by the end of this year, in addition to all the intergovernmental obligations. And a return to the Deutschemark would likely price Germany out of its export markets – not to mention the political consequences. So Germany is likely to do what is necessary to preserve the euro – but nothing more. That would result in a eurozone dominated by Germany in which the divergence between the creditor and debtor countries would continue to widen and the periphery would turn into permanently depressed areas in need of constant transfer of payments. That would turn the European Union into something very different from what it was when it was a “fantastic object” that fired peoples imagination. It would be a German empire with the periphery as the hinterland.

I believe most of us would find that objectionable but I have a great deal of sympathy with Germany in its present predicament. The German public cannot understand why a policy of structural reforms and fiscal austerity that worked for Germany a decade ago will not work Europe today. Germany then could enjoy an export led recovery but the eurozone today is caught in a deflationary debt trap. The German public does not see any deflation at home; on the contrary, wages are rising and there are vacancies for skilled jobs which are eagerly snapped up by immigrants from other European countries. Reluctance to invest abroad and the influx of flight capital are fueling a real estate boom. Exports may be slowing but employment is still rising. In these circumstances it would require an extraordinary effort by the German government to convince the German public to embrace the extraordinary measures that would be necessary to reverse the current trend. And they have only a three months’ window in which to do it.

We need to do whatever we can to convince Germany to show leadership and preserve the European Union as the fantastic object that it used to be. The future of Europe depends on it.

"Don't Eat Fortune's Cookie"

Michael Lewis June 3, 2012 — As Prepared

(NOTE: The video of Lewis' speech as delivered is available on the Princeton YouTube channel.)

Thank you. President Tilghman. Trustees and Friends. Parents of the Class of 2012. Above all, Members of the Princeton Class of 2012. Give yourself a round of applause. The next time you look around a church and see everyone dressed in black it'll be awkward to cheer. Enjoy the moment.

Thirty years ago I sat where you sat. I must have listened to some older person share his life experience. But I don't remember a word of it. I can't even tell you who spoke. What I do remember, vividly, is graduation. I'm told you're meant to be excited, perhaps even relieved, and maybe all of you are. I wasn't. I was totally outraged. Here I’d gone and given them four of the best years of my life and this is how they thanked me for it. By kicking me out.

At that moment I was sure of only one thing: I was of no possible economic value to the outside world. I'd majored in art history, for a start. Even then this was regarded as an act of insanity. I was almost certainly less prepared for the marketplace than most of you. Yet somehow I have wound up rich and famous. Well, sort of. I'm going to explain, briefly, how that happened. I want you to understand just how mysterious careers can be, before you go out and have one yourself.

I graduated from Princeton without ever having published a word of anything, anywhere. I didn't write for the Prince, or for anyone else. But at Princeton, studying art history, I felt the first twinge of literary ambition. It happened while working on my senior thesis. My adviser was a truly gifted professor, an archaeologist named William Childs. The thesis tried to explain how the Italian sculptor Donatello used Greek and Roman sculpture — which is actually totally beside the point, but I've always wanted to tell someone. God knows what Professor Childs actually thought of it, but he helped me to become engrossed. More than engrossed: obsessed. When I handed it in I knew what I wanted to do for the rest of my life: to write senior theses. Or, to put it differently: to write books.

Then I went to my thesis defense. It was just a few yards from here, in McCormick Hall. I listened and waited for Professor Childs to say how well written my thesis was. He didn't. And so after about 45 minutes I finally said, "So. What did you think of the writing?"

"Put it this way" he said. "Never try to make a living at it."

And I didn't — not really. I did what everyone does who has no idea what to do with themselves: I went to graduate school. I wrote at nights, without much effect, mainly because I hadn't the first clue what I should write about. One night I was invited to a dinner, where I sat next to the wife of a big shot at a giant Wall Street investment bank, called Salomon Brothers. She more or less forced her husband to give me a job. I knew next to nothing about Salomon Brothers. But Salomon Brothers happened to be where Wall Street was being reinvented—into the place we have all come to know and love. When I got there I was assigned, almost arbitrarily, to the very best job in which to observe the growing madness: they turned me into the house expert on derivatives. A year and a half later Salomon Brothers was handing me a check for hundreds of thousands of dollars to give advice about derivatives to professional investors.

Now I had something to write about: Salomon Brothers. Wall Street had become so unhinged that it was paying recent Princeton graduates who knew nothing about money small fortunes to pretend to be experts about money. I'd stumbled into my next senior thesis.

I called up my father. I told him I was going to quit this job that now promised me millions of dollars to write a book for an advance of 40 grand. There was a long pause on the other end of the line. "You might just want to think about that," he said.


"Stay at Salomon Brothers 10 years, make your fortune, and then write your books," he said.

I didn't need to think about it. I knew what intellectual passion felt like — because I'd felt it here, at Princeton — and I wanted to feel it again. I was 26 years old. Had I waited until I was 36, I would never have done it. I would have forgotten the feeling.

The book I wrote was called "Liar’s Poker." It sold a million copies. I was 28 years old. I had a career, a little fame, a small fortune and a new life narrative. All of a sudden people were telling me I was born to be a writer. This was absurd. Even I could see there was another, truer narrative, with luck as its theme. What were the odds of being seated at that dinner next to that Salomon Brothers lady? Of landing inside the best Wall Street firm from which to write the story of an age? Of landing in the seat with the best view of the business? Of having parents who didn't disinherit me but instead sighed and said "do it if you must?" Of having had that sense of must kindled inside me by a professor of art history at Princeton? Of having been let into Princeton in the first place?

This isn't just false humility. It's false humility with a point. My case illustrates how success is always rationalized. People really don’t like to hear success explained away as luck — especially successful people. As they age, and succeed, people feel their success was somehow inevitable. They don't want to acknowledge the role played by accident in their lives. There is a reason for this: the world does not want to acknowledge it either.

I wrote a book about this, called "Moneyball." It was ostensibly about baseball but was in fact about something else. There are poor teams and rich teams in professional baseball, and they spend radically different sums of money on their players. When I wrote my book the richest team in professional baseball, the New York Yankees, was then spending about $120 million on its 25 players. The poorest team, the Oakland A's, was spending about $30 million. And yet the Oakland team was winning as many games as the Yankees — and more than all the other richer teams.

This isn't supposed to happen. In theory, the rich teams should buy the best players and win all the time. But the Oakland team had figured something out: the rich teams didn't really understand who the best baseball players were. The players were misvalued. And the biggest single reason they were misvalued was that the experts did not pay sufficient attention to the role of luck in baseball success. Players got given credit for things they did that depended on the performance of others: pitchers got paid for winning games, hitters got paid for knocking in runners on base. Players got blamed and credited for events beyond their control. Where balls that got hit happened to land on the field, for example.

Forget baseball, forget sports. Here you had these corporate employees, paid millions of dollars a year. They were doing exactly the same job that people in their business had been doing forever. In front of millions of people, who evaluate their every move. They had statistics attached to everything they did. And yet they were misvalued — because the wider world was blind to their luck.

This had been going on for a century. Right under all of our noses. And no one noticed — until it paid a poor team so well to notice that they could not afford not to notice. And you have to ask: if a professional athlete paid millions of dollars can be misvalued who can't be? If the supposedly pure meritocracy of professional sports can't distinguish between lucky and good, who can?

The "Moneyball" story has practical implications. If you use better data, you can find better values; there are always market inefficiencies to exploit, and so on. But it has a broader and less practical message: don't be deceived by life's outcomes. Life's outcomes, while not entirely random, have a huge amount of luck baked into them. Above all, recognize that if you have had success, you have also had luck — and with luck comes obligation. You owe a debt, and not just to your Gods. You owe a debt to the unlucky.

I make this point because — along with this speech — it is something that will be easy for you to forget.

I now live in Berkeley, California. A few years ago, just a few blocks from my home, a pair of researchers in the Cal psychology department staged an experiment. They began by grabbing students, as lab rats. Then they broke the students into teams, segregated by sex. Three men, or three women, per team. Then they put these teams of three into a room, and arbitrarily assigned one of the three to act as leader. Then they gave them some complicated moral problem to solve: say what should be done about academic cheating, or how to regulate drinking on campus.

Exactly 30 minutes into the problem-solving the researchers interrupted each group. They entered the room bearing a plate of cookies. Four cookies. The team consisted of three people, but there were these four cookies. Every team member obviously got one cookie, but that left a fourth cookie, just sitting there. It should have been awkward. But it wasn't. With incredible consistency the person arbitrarily appointed leader of the group grabbed the fourth cookie, and ate it. Not only ate it, but ate it with gusto: lips smacking, mouth open, drool at the corners of their mouths. In the end all that was left of the extra cookie were crumbs on the leader's shirt.

This leader had performed no special task. He had no special virtue. He'd been chosen at random, 30 minutes earlier. His status was nothing but luck. But it still left him with the sense that the cookie should be his.

This experiment helps to explain Wall Street bonuses and CEO pay, and I'm sure lots of other human behavior. But it also is relevant to new graduates of Princeton University. In a general sort of way you have been appointed the leader of the group. Your appointment may not be entirely arbitrary. But you must sense its arbitrary aspect: you are the lucky few. Lucky in your parents, lucky in your country, lucky that a place like Princeton exists that can take in lucky people, introduce them to other lucky people, and increase their chances of becoming even luckier. Lucky that you live in the richest society the world has ever seen, in a time when no one actually expects you to sacrifice your interests to anything.

All of you have been faced with the extra cookie. All of you will be faced with many more of them. In time you will find it easy to assume that you deserve the extra cookie. For all I know, you may. But you'll be happier, and the world will be better off, if you at least pretend that you don't.

Never forget: In the nation's service. In the service of all nations.

Thank you.

And good luck.

Unequal Shares

by James Surowiecki May 28, 2012

A couple of weeks ago, when Mark Zuckerberg wore his trademark hoodie to meetings with potential investors in Facebook’s I.P.O., not everyone was impressed. Michael Pachter, an analyst at Wedbush Securities, said that it was a “mark of immaturity” and Zuckerberg’s way of “showing investors that he doesn’t care that much.” Pachter sounded like a cranky geezer telling the neighborhood kids to stay off his lawn, but he was right about Zuckerberg’s view of investors. Zuckerberg has been careful to make sure that investors don’t interfere with the way he runs his company. Before Facebook went public, it created two classes of shares, and Zuckerberg’s shares have far more voting power than the ones sold to outside shareholders. After Friday’s I.P.O., he will own eighteen per cent of the company but will control fifty-seven per cent of the voting shares, putting him in total command.

Dual-class share structures used to be rare and confined largely to family-run enterprises or media companies, such as the New York Times, where they could be justified as protecting the company’s public mission. The received wisdom was that active investors are good for companies and for the market as a whole, and that companies need to put shareholders first. But Google bucked convention when, in 2004, it adopted the dual-class structure for its I.P.O., and the arrangement has become popular among technology companies. All the big tech I.P.O.s of the past year—LinkedIn, Groupon, Yelp, Zynga—featured it, and Google’s recent stock split took things to a new level and sold shares with no voting rights at all. Whereas the C.E.O.s of most public companies have to spend time kowtowing to investors, Zuckerberg and his peers are insisting on the right to say, “Thanks for your money. Now shut up.”

There’s reason to be concerned at the spread of the dual-class structure. One study that examined a large sample of dual-class firms from 1994 to 2001 found that they notably underperformed the market. And few people would say that the problem with corporate America is that C.E.O.s have too little authority; the recent travails of Rupert Murdoch are a testament to the problem of a monarchical executive. Yet when the right person is in charge the dual-class structure can help companies avoid one of the problems besetting modern business—the short-termism of big institutional investors. In the postwar era, most shareholders were individual investors who held on to stocks for ages and exerted little pressure on companies. Executives didn’t have to worry about quarterly earnings and had the freedom to invest in long-term research and development. In today’s market, by contrast, investors are far more aggressive in pressuring companies to hit their numbers. This has its benefits—companies are more efficient in using shareholder money, and underperforming C.E.O.s are more likely to be shown the door. But investors now have very short-term horizons. The average annual turnover of a mutual-fund portfolio is a hundred per cent, and for a hedge-fund portfolio around three hundred per cent. When shareholders reckon in months (or weeks) rather than in years, it’s harder for companies to take the long view.

Still, even if there are potential virtues in a dual-class share structure, it turns investors into mere spectators. So why do they put up with it? The simple answer is that they don’t have much choice. Investors these days are hungry for any kind of return: the stock market as a whole has barely risen in the past decade; bond yields are unusually low; and, thanks to the so-called global savings glut, much of it driven by China, there is just too much capital out there chasing too few worthwhile investments. This makes investors willing to accept terms that they would once have found intolerable. On the flip side, companies like Facebook don’t really need the money that an I.P.O. raises. Thanks to things like open-source software and cloud computing, the cost of starting and expanding a technology company has fallen dramatically, and Facebook’s operating profit is more than enough to fund its growth. (Its I.P.O. prospectus is up front about the fact that it envisages no “specific uses” for the sixteen billion dollars it just raised, most of which it will park in U.S. treasuries, like an aging retiree.) Investors, in other words, need potential highfliers like Facebook more than the companies need them.

Compounding this problem is the fact that being a public company is no longer as alluring as it once was. The hassles of dealing with Wall Street and manic-depressive investors have arguably never been worse, even as a whole infrastructure has sprung up to make it easier for companies to stay private while still giving their owners and employees a chance to cash out. That’s partly why the number of I.P.O.s has dropped sharply in the past decade, and why the number of public companies in the U.S. has fallen by more than forty per cent since 1997. For many start-ups, staying private or selling yourself to a bigger company—as Instagram did when it sold out to Facebook for a billion dollars—has never looked more appealing. Public companies aren’t going to disappear, but we are witnessing a significant shift in power from shareholders to entrepreneurs and managers, one that may make the stock market less central to American capitalism. Facebook’s I.P.O. was the biggest tech I.P.O. the U.S. has ever seen. It also seems likely to be the biggest it will ever see. ♦

Not so expert

The need for financial advice may be more psychological than practical

ASK enough people for advice, they say, and you will eventually find someone who will tell you what you want to hear. But the need for advice burns so strongly that people become blind to its quality. There is a remarkable tendency to trust experts, even when there is little evidence of their forecasting powers. In his book “Expert Political Judgment”, Philip Tetlock shows that political forecasters are worse than crude algorithms at predicting events. The more prominent the expert (ie, the more they were quoted by the news media), the worse their records tended to be. There is also an inverse relationship between the confidence of the individual forecaster and the accuracy of their predictions.

The remarkable tendency for individuals to rely on expert advice, even when the advice clearly has no useful component, was neatly illustrated in a recent academic paper* about an Asian experiment. Undergraduates in Thailand and Singapore were asked to place bets on five rounds of coin flips. The participants were told that the coins came from fellow students; that these would be changed during the process; that the coin-flipper would be changed every round; and that the flippers would be participants, not experimenters. Thus there was a high likelihood that the results would be random.

Taped to the desk of each participant were five envelopes, each predicting the outcome of the successive flips. Participants could pay to see the predictions in advance, but they saw them free after the coin toss had occurred.

When the initial prediction turned out to be correct, students were more willing to pay to see the next forecast. This tendency increased after two, three and four successful predictions. Furthermore, those who paid in advance for predictions placed bigger bets on subsequent coin tosses than those who did not.

Paying for financial advice might not seem quite as bizarre as paying for coin-toss predictions, but there are some similarities. Nobody can reliably forecast the short-term outlook for economies or stockmarkets; Warren Buffett, the world’s most successful long-term investor, thinks it is not worth trying to do so. But plenty of economists and strategists earn a good living doing just that. The average active-fund manager fails to beat the stockmarket index; no reliable way has been found for selecting above-average managers in advance. Yet investors are still willing to pay for the services of active managers.

The sheer complexity of modern financial markets and the torrent of information that is published each day are a boon to the providers of financial advice. Investors may feel that they simply do not have the time to analyse all the data, and they therefore need to rely on the advice of professionals. This is true even if they think the markets are a “rigged game” played for the benefit of insiders; it still makes sense for them to pay for an insider’s view.

There may be another, psychological, reason why investors want to pay for advice: the avoidance of regret. If you choose to put all your money into technology stocks on the back of your own research, and such stocks collapse, you only have yourself to blame. But if you have listened to the advice of an expert, then the decision is not your fault.

Some financial advice may be extremely useful. Many advisers steered their clients away from Bernie Madoff’s fraudulent funds. Investors also need to be made aware of the benefits of diversification and of the effect on their portfolios of tax rules and regulations. There is also evidence that market valuations revert to the mean over the long term, so pointing out when markets look historically cheap or dear can help.

The problem for the industry is that such advice will not be needed very often, and that limits the potential fees. So instead investors are bombarded with endless research on why stock A is better than stock B, why one currency is bound to outperform another and so on. Clients end up churning their portfolios, even though the costs erode their returns.

Perhaps the financial-advice industry survives because the idea that the future is unknowable is just unsatisfying. Some forecast—any forecast—is therefore comforting. Mr Tetlock suggests that “we believe in experts in the same way that our ancestors believe in oracles; we want to believe in a controllable world and we have a flawed understanding of the laws of chance.”

* “Why Do People Pay for Useless Advice? Implications of Gambler’s and Hot-Hand Fallacies in False-Expert Setting”, by Nattavudh Powdthavee and Yohanes Riyanto, Institute for the Study of Labour, May 2012.

NYSE CEO: Public Has Lost Trust in Market


The New York Stock Exchange's top executive told lawmakers Wednesday investors have lost faith in a financial marketplace that has evolved to prize speed and complexity over long-term investing.

The byzantine, technology-dependent nature of the markets' trading venues has given an edge to sophisticated financial firms over individual investors and stock-issuing companies, according to Duncan Niederauer, chief executive of NYSE Euronext .

"The public has never been more disconnected [and] has never had less confidence in the underlying mechanism," Mr. Niederauer said at a hearing convened by a subcommittee of the House Financial Services Committee. "What used to be an investors' market is now thought of as a trader's market."

Mr. Niederauer blamed a blurring line between the functions of brokers and exchanges for helping encourage trading in shares to flow away from exchanges and into private markets run by financial firms, reducing the amount of buying and selling behind publicly available prices.

The debate over whether markets favor the biggest and fastest traders at the expense of smaller retail investors provided some of the most pointed contrasts in comments by exchange and trading executives during the first two hours of a hearing about the structure of securities markets.

"There's never been a better time to be an investor," whether big or small, fast or slow, said Thomas Joyce, chief executive of market-making firm Knight Capital Group Inc.

Mr. Joyce urged lawmakers not to vilify technological developments for problems in the markets, saying "high-speed computers, dark pools, etcetera, are not the problem," but rather they are the "culmination of competition" that has driven down costs for investors across the market.

Dark pools are private, off-exchange, computerized-trading platforms that in recent years have eaten into the market share of formerly dominant U.S. public exchanges.

Mr. Joyce said retail investors have experienced a "huge benefit" from the rise of off-exchange trading services, which Knight provides.

"I think we need to be careful when we talk about leveling the playing field," Mr. Joyce said. "An exchange has responsibilities that are decidedly different than a broker-dealer."

The issue strikes at the heart of a years-long debate in the financial-services industry. Exchanges have evolved beyond the private, member-owned utilities they were a decade ago to become for-profit, publicly traded companies. The transformation has pushed them to develop services typically offered by brokers and technology companies.

At the same time, broker-dealers have taken advantage of regulations designed to maximize competition in stock trading, setting up dozens of private platforms for trading shares that have lured away approximately one-third of all share volume from exchanges, particularly that of retail traders and institutional investors.

While exchange executives like Mr. Niederauer have objected to what they say is a lighter regulatory regime enjoyed by so-called dark pools and other private stock venues, broker-dealer officials retorted that exchanges enjoy their own benefits due to their unique regulatory status.

Dan Mathisson, head of U.S. stock-trading for Credit Suisse Group AG, told lawmakers Wednesday exchanges ought to be stripped of legal immunity from liability for some trading losses suffered as a result of system outages. Nasdaq OMX Group Inc. is seen enjoying some protection from lawsuits over losses in the glitch-ridden Facebook Inc. stock-market debut due to exchanges' status as self-regulatory organizations.

Robert Greifeld, Nasdaq's CEO, had declined an invitation to appear at the hearing, according to a subcommittee spokeswoman. A Nasdaq spokesman declined to comment on Mr. Greifeld's decision.

"You should not be able to be a for-profit and a not-for-profit at the same time," Mr. Mathisson said Wednesday.

Featured Posts
Recent Posts
Search By Tags
Follow Us
  • Facebook Basic Square
  • Twitter Basic Square
  • Google+ Basic Square
bottom of page