- Macro and Credit – Overshooting creates spillover effects onto other markets.
- ELV Model ? Civil unrest is a rising global trend.
“Now I believe I can hear the philosophers protesting that it can only be misery to live in folly, illusion, deception and ignorance, but it isn't -it's human.” - Desiderius Erasmus
Looking at the violent protests rocking the “civilized” world in general and the United States in particular, in conjunction with the fastest recovery on record for financial markets, in effect pushing again “Gini coefficients” to dizzying 1929 levels, when it came to selecting our title analogy we reminded ourselves of “the Exit, Voice and Loyalty Model”. The Exit, Voice and Loyalty Model aka EVL is another application of the Nash equilibrium in game theory.
The ELV model is used in the fields of comparative politics and organizational behavior. It is an extensive form game used to model interactions typically involving negative changes to one player's environment by another player. These concepts first appeared in Albert Hirschman's more broadly focused 1970 book, Exit, Voice, and Loyalty: Responses to Decline in Firms, Organizations, and States. The framework presented in Hirschman’s book has been applied to topics such as protest movements, migration, political parties, and interest groups, as well as to even personal relationships. The basic concept are as follows: members of an organization, whether a business, a nation or any other form of human grouping, have essentially two possible responses when they perceive that the organization is demonstrating a decrease in quality or benefit to the member: they can exit (withdraw from the relationship); or, they can voice (attempt to repair or improve the relationship through communication of the complaint, grievance or proposal for change). For example, the citizens of a country may respond to increasing political repression in two ways: emigrate or protest. Similarly, employees can choose to quit their unpleasant job, or express their concerns in an effort to improve the situation. Disgruntled customers can choose to shop elsewhere, or they ask for the manager.
As well the ELV model can be used to explain relationships between nation states and their citizens. The model predicts that when citizens have a credible exit threat and states are dependent on their citizens, states are less likely to take actions that the citizens would object to. For the case of increased taxation by the state, examples of credible exit threats include having the economic resources to flee or the ability to easily evade taxes. States are said to be dependent on their citizens if they value citizen loyalty more than they value the benefits that would result from a policy change. When both of these criteria are met, the model would predict that the state would not pursue a policy that would encourage citizens to exit or to use voice.
Also, “loyalty” is an essential force for Hirschman, shaping both “voice” and “exit” especially when it is difficult to join an organization:
“In the case of the newly-created Chinese middle class, which is mostly employed by the state, loyalty to the authoritarian government is very high. Their loyalty is bought through the difficulty in being admitted to their positions of relative financial prosperity and because emigration from China would result in losing significant status and income. These middle-class citizens are not completely voiceless, however, as they will protest the regime's choices through a process of remonstrations where they blame the failure of a policy on implementation by lower-level officials rather than criticize the policy directly. The regime is also aware that loyalty is bought at the price of financial stability; financial instability because of harmful policies would result in the same kinds of widespread protests that happened in 1989.
Hirschman postulated that contrary to the Hotelling–Downs analysis of political participation, those with "nowhere else to go" instead of being marginalized, their voices would become amplified. The rise of modern communications' amplifying effects has backed up Hirschman's position on voice, as seen by the rise of the Tea Party. When citizens can easily mobilize, the cost of mobilization is low for the citizens but the impact of using voice in a mobilized manner can lead to a large cost for the state.” – source Wikipedia
The French “yellow jackets” movement comes to our mind when taking into account the large cost for the state as posited by Hirshman.
The EVL game is solved differently whether the Government is dependent or autonomous from the Citizen, whether the Citizen has or does not have a credible Exit option, and the cost of using Voice:
“The EVL Model with the Citizen as player 1 and the Government as player 2. E is the value the citizen gets from exiting, L is the value the Government gets from the Citizen's loyalty, and c is the cost the Citizen using their voice. In this model, the benefit up for grabs between the Citizen and the Government is worth 1.
The EVL model shows that the only time a Government will Respond to the Citizen using their Voice is when the Government is dependent on the support of the Citizen (L > 1) and when the Citizen has a credible Exit option (E > 0). With all other combinations of E and L the Government will choose to Ignore the Citizen if they decide to use their Voice and so the Citizen will choose to Exit or remain Loyal instead rather than bear the cost of using Voice. Although, if the cost of using Voice (C) becomes high enough (E > 1 - c) then even a dependent Government can prevent a Citizen with a credible exit threat from using their Voice.
When the Citizen has a viable Exit option and the Government is dependent on the Loyalty of the Citizen (i.e. E > 0, L > 1) the Government would not try to take away the benefit to begin with as the game would end with as it knew it would have to Respond. A parallel can be drawn to the structural dependence of the state on capital within Structural Marxism where the state is seen as being dependent on capital for its existence and the capitalists have viable Exit options through their easily mobile assets while labor does not.
In cases where the Citizen has no viable Exit option and the Government is dependent on the Loyalty of the Citizen (i.e. E < 0, L > 1) the Citizen exercises Loyalty in the face of the environmental change. Real world examples can be drawn to the Financial crisis of 2007–2008 in the United States regarding the financial bailout of the financial and automobile sectors. Within a week of Lehman Brothers declaring bankruptcy the United States Treasury drafted the Troubled Asset Relief Program which planned to spend $700 billion to buy assets from struggling banks and was passed two weeks later.
One of the most obvious ways Citizens can use Voice is by protesting. The EVL Model predicts that the Citizen will only use their Voice if they have a viable Exit option and the Government is dependent (E > 0, L > 1). However, if the Government knows the Citizen will use Voice and force it to respond and revert the change it made, the Government would not enact the change in the first place. The EVL Model explains that the only time protests or other forms of Voice would be observed is when the Government does not know whether the Citizen has a credible Exit option (i.e. the Government does not know E > 0) but knows it's dependent, or when the Citizen does not know that the Government is autonomous (i.e.the Citizen does not know L < 1). ” – source Wikipedia
Once again, we saw a clear application of the model due to the COVID-19 economic and financial crisis and the French “yellow jackets” movement. As well we think the ELV Model might become more and more handy as it seems we are again moving towards some sort of Fourth Turning à la Neil Howe and William Strauss hence our chosen title analogy but we might be rambling again.
In this week's conversation, given the extremely significant rally seen in “high beta” in particular and financial markets in general, we would like to revisit Rudiger Dornbusch's famous overshooting theory which we mentioned in our post “The Worship of Mammon” given it set a milestone for explaining "irrational" exchange rate swings and shed some light on the mechanism behind currency crises but, can as well be used to describe the genesis for a credit crisis as well as looking at the rise of civil unrests, being a global trend.
- Macro and Credit – Overshooting creates spillover effects onto other markets
Looking at the euphoric mood in recent days in many segments of the market such as the post bankruptcy strong rally in the likes of Hertz, JC Penney and others as illustrated by Joe Weisenthal’s comments on twitter:
“I’ve seen a lot of unusual micro-bubbles over the years. Cannabis. Blockchain. Fuel cells. Space. Electric cars. Etc.
But I don’t think I’d have ever guessed before that *bankruptcy* itself would be an exciting investment theme.”
- source Twitter – Bloomberg
As we mentioned in the title of our bullet point, we think at this juncture of the markets it is important to revisit the theme overshooting from our post “The Worship of Mammon”:
A credit crisis can be the trigger point of overshooting in other markets. This is exactly what we have observed during the subprime turmoil of 2007.This is a crucial point, especially from the perspective of monetary policy makers. Providing additional liquidity would mean that there will be further distortions. Healing a credit crunch at the cost of overshooting in other markets. Consequently liquidity injections can be understood as a final hope rather than the "silver bullet" in combating crises. In the context of the overshooting approach, liquidity injections could help to limit some direct effects from credit crises, but they will definitely trigger spillover effects onto other markets. In the end, the efficiency of liquidity injections by central banks depends on the benefit on the credit side compared to the cost in other markets. In any case, it proved not to be the appropriate instrument as a reaction to the subprime crisis in 2007" - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis
Providing additional liquidity like the Fed did only means to us that there are further distortions. Healing the economic damage of the COVID-19 pandemic is exacerbating the cost of overshooting in other markets. Also, as we repeated on so many occasions, providing “liquidity”, does not resolve “solvency”. With the ECB now contemplating buying High Yield bonds (*ECB'S REHN SAYS `CAN CONTEMPLATE' BUYING HIGH-YIELD DEBT), this is yet another cause for concerns as it seriously distorts the “price discovery mechanism” in these markets and we doubt the “wealth effect” will rain down on the “real economy”. This will lead for sure to more usage of the EVL model rest assured as the trend is clearly one of rising protests.
The massive liquidity injections we have seen have created yet another overshooting phenomenon and while glancing at our much appreciated twitter feed, we came across a very good illustration of this phenomenon in terms of “speculative endeavors”:
- All traders Call Buys to Open – source Sundial Capital Research.
In terms of “speculative endeavours” thanks to the “overshooting” phenomenon caused by massive liquidity injections, we had an interesting exchange via twitter with Cullen Roche when he stated:
“Asset price inflation" is a term created by people who were wrong about hyperinflation, remained permabearish about the economy and now feel better about missing the stock market rally by convincing themselves it's all a fake asset bubble.” – Cullen Roche
When it comes to our economic stance, in terms of “economic camp”, we tend to cherry pick, what we think is the right theory. As far as we are concerned, if economy is a "religion" then we are agnostic, but, we do believe that, there are some points which are valid in some theories, Austrians included.
By no mean, we would like to enter into endless economic arguments. We have no point to prove, just common sense to display. Back in September 2013 in our conversation “The Cantillon Effects” we argued the following:
“Classical equation of exchange, MV = PQ, also known as the quantity theory of money. Quick refresher: PQ = nominal GDP, Q = real GDP, P = inflation/deflation, M = money supply, and V = velocity of money.
-Endogenous money, PQ => MV (Hume, Wicksell, Marx)
-Exogenous money, MV => PQ (Keynes, Monetarist)
In our Cantillon Effects, we get:
Δ M => Δ Asset Prices” – source Macronomics, September 2013
A we also posited in January 2013 in ourconversation "If at first you don't succeed...":
"Arguably the strategy of our "Sorcerer's apprentice" has been to try to induce a rise in velocity, but, we have shown in our post "Zemblanity" that the "relationship" between US Velocity M2 index and US labor participation rate over the years is clearly indicative of the failure of the theories of Friedman and Keynes because central banks have not kept an eye on asset bubbles and the growth of credit and do not seem to fully grasp the core concept of "stocks" versus "flows." - source Macronomics, January 2013
We pointed our to Cullen Roche another illustration of the cumulative effect in the change of money leading to asset bubble has been clearly illustrated by Commercial Real Estate in the United States:
- graph source Wells Fargo from their April 2020 Commercial Real Estate Chart Book.
Overshooting phenomenon? No “asset prices inflation”? You decide...
“Monkey Musings” on twitter also added to our CRE concerns:
“As Macronomics pointed out, CRE is big beneficiary post GFC of excess fed liquidity and asset inflation. You have $16-18 trilllion in assets on bank insurer & fund balance sheets that Green Street says are down 11% YTD whose cash flows are likely to be permanently impaired. That’s the asset class that becomes worrisome, given Trepp CMBS as a gauge has 7%+ delinquency (office still sub 3% Visage souriant avec la bouche ouverte et une sueur froide for now) + ProPublica pointing out that the asset values are dubious, an unspoken relatively assumed part of that market : “Whistleblower: Wall Street Has Engaged in Widespread Manipulation of Mortgage Funds” – source Twitter
In our return to posting, in our post “The Worship of Mammon” we pointed out that recent CMBX price action indicates that a growing number of have begun to short it since it is a liquid, levered way to voice the opinion that CRE is considered to be a good proxy for the state of the economy and that in the past, this type of activity began by investors shorting tranches that were most highly levered to a deteriorating economy and could fall the most if fundamentals eroded. This includes the lower rated tranches of CMBX.6-8 heavily exposed to retail but now it also includes office buildings through CMBX12 as indicating by Trepp in their article entitled “CMBX 12 spotlight: If shorting office is your thing”:
“CMBX 12 happens to be the index with the heaviest exposure to office collateral. The index has 31.6% of its loans backed by offices. All CMBX indexes starting with CMBX 10 have office exposure of more than 30%. That compares with an average of 23.6% for CMBX 6-9, including a low of 18.1.% for CMBX 7.
The cost of protection of the CMBX 12 BBB- class is about 750 basis points (as of late May). That spread was a little over 300 basis points at its recent low in February 2020. So, there has been about 450 basis points of spread widening over the last 90 days or so
As of the May remittance, the loans backing the index show 5.5% of the collateral is 30 days or more delinquent. Another 7.1% of the collateral missed the May payment but is not yet 30 days delinquent.
20.5% of the loans by balance were on servicer watchlist as of May. ” – source Trepp
To add more to the debate we have been involved in, we read a very interesting comment in the comment section fo Gavekal’s research which we think also adds to our “asset inflation views”:
“The Quantity Theory of Credit proposes that increasing the allocation of credit money for non-GDP transactions (transactions that do not increase GDP (gross domestic product)) will have no impact on economic growth, and will instead promote asset price inflation (Lyonnet & Werner, 2012, p. 95; Werner R. A., 2005). Credit growth for non-GDP transactions must be increasing, if total credit growth exceeds GDP growth (Werner R. A., 2013, p. 366). When lending for non-GDP transactions grows faster than the growth in GDP transactions it can produce asset price bubbles that create the potential for a future financial crisis. Non-GDP transactions are associated with the purchase of existing financial (for example, bonds, shares, and derivatives) and property assets that are sold in secondary markets. Secondary markets transact products previously sold within markets, such as previously issued financial assets (for example, company shares, bonds, and derivatives), and the transfer of ownership of property that has previously been purchased. Whilst primary markets trade newly created financial assets (for example, initial placing of shares by companies, rights issues of shares, and newly issued bonds) and the sale of new properties. The majority of financial and property assets are being resold, and so are traded within secondary markets.” – source anonymous comment
While we pointed out in the past, that when it comes to the omnipotence of our deities aka central bankers, it has its limit in the form of “stimulating/creating” Aggregate Demand (AD) as posited in November 2014’s conversation “Chekhov’s Gun”:
“If domestic demand is indeed a flow variable, the big failure of QE on the real economy is in "impulsing" spending growth via the second derivative of the development of debt, namely the change in credit growth.
QE will not be sufficient enough on its own in Europe to offset the lack of Aggregate Demand (AD) we think.
In textbook macroeconomics, an increase in AD can be triggered by increased consumption. In the mind of our "Generous Gamblers" (aka central bankers) an increase in consumer wealth (higher house prices, higher value of shares, the famous "wealth effect") should lead to a rise in AD.
Alternatively an increase in AD can be triggered by increased investment, given lower interest rates have made borrowing for investment cheaper, but this has not led to increase capacity or CAPEX investments which would increase economic growth thanks to increasing demand. On the contrary, lower interest rates have led to buybacks financed by cheap debt and speculation on a grand scale.” – source Macronomics, 2014
To repeat ourselves credit growth is a stock variable and domestic demand is a flow variable. Also the marginal impact of an increase in wealth to translate into consumption is lower for the richer brackets of the population as a reminder.
The same recipe of “wealth effect” lead us to think that indeed the ELV Model should be an additional tool in your “macro unrest” monitoring screen.
- ELV Model ? Civil unrest is a rising global trend
Also in our November 2014’s conversation “Chekhov’s Gun” we touched on what the rise of “inequality” thanks to the wealth effect would lead to:
“Our take on QE in Europe can be summarized as follows:
Current European equation: QE + austerity = road to growth disillusion/social tensions, but ironically, still short-term road to heaven for financial assets (goldilocks period for credit)…before the inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…).
“Hopeful” equation: QE + fiscal boost/Investment push/reform mix = better odds of self-sustaining economic model / preservation of social cohesion. Less short-term fuel for financial assets, but a safer road longer-term?
When it comes to the Current European equation, we note with interest that civil unrest is a rising global trend as indicated by Nomura by Alastair Newton on the 11th of November in his note entitled "Civil unrest: Going global - More economies look prone to protests":
The (largely) common factors remain those I identified last year, ie:
-A high level of economic inequality (using the World Bank’s assessment of individual economies’ Gini coefficient);
-A high level of perceived corruption (using Transparency International’s (TI) index);
-A 'local' – sometimes minor and often hard to anticipate – issue sparking widespread protests rooted in general unhappiness with the regime;
-Increased 'middle-classing' of civil society, often confirmed by a ‘core’ of the protestors being in or having had tertiary education;
-Effectively leaderless protests organised primarily over social networks, ie, in common with the 'Arab Spring';
-A shared sense among the protestors of not being listened to by allegedly corrupt and self-serving elites;
-Widespread protester use of mobile phone cameras in the 'propaganda war'; and,
-Allegations of police brutality escalating, rather than deterring, the protestor numbers.
As the recent demonstrations in Hungary underline, we should not assume that civil protest is limited to emerging markets. Notably in many EU countries we are increasingly seeing what are essentially protest parties capturing a significant share of the popular vote in elections. In 2015, look out in particular, therefore, for UKIP in the 7 May UK general election and for Podemos in Spain’s December elections (not forgetting the – related, in my view – drive towards independence in Catalonia)." - source Nomura
We added at the time that our "Hopeful" equation had a very low probability of success even after the "whatever it takes" moment from our "Generous Gambler" aka Mario Draghi which had in some instance "postponed" for some, the urgent need for reforms, as indicated by the complete lack of structural reforms in France thanks to the budgetary benefits coming from lower interest charges in the French budget, once again based on phony growth outlook (+1% for 2015 at the time of our musing). And today, yes, our country France is in a bind, we remain, negative on France in particular and Europe in general not from an asset price perspective for the moment given the liquidity injections made so far with the ECB doubling down, but, rising antagonisms is what makes even more valid the ELV approach from a game theory perspective.
So while the ELV model is definitely back in our toolbox, we still see “short-term road to heaven for financial assets (goldilocks period for credit)…before another inevitable longer-term violent social wake-up calls (populist parties access to power, rise of protectionism, the 30’s model…). This we think is still the ultimate outcome so please do not call us “permabears”, just call us “realists”.
“If we wait until income inequality is much more severe, we will have a whole class of new superrich who will probably feel entitled to their wealth and will have the means to defend their interest. That's already gone far enough. We shouldn't let it become more extreme.” - Robert J. Shiller
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