LONDON: MODELS FIGHT IN PUBLIC!

PART 1 OF 2 PARTS

Oh, sorry, not fashion models…I meant the UK’s monetary, fiscal and pension funding models, which the “working level” geeks who manage them usually reduce to mathematical models. Only the perverse (and tabloid editors) think watching fashion models fight would be entertaining. Or so I am told.

I can just hear American geeks replying “Oh but we use the same formal thinking and math(s) model(s)! Otherwise, we wouldn’t be able to quantify what actions our boards need to take. And we’ve kind of skated around the sort of crash the British had the other week.” (The UK geeks say the problem is they weren’t consulted.)

But it’s not that the US Treasury and the Fed are any smarter than their UK counterparts.

No, it’s all about the advantage of having a military that has a budget several times the size of its key allies and adversaries put together, along with hundreds of bases around the world that also listen to over 90% of the world’s telecoms traffic, and has back door access to most of the software around the globe, which means your regional partners can publish Russian soldiers’ messages on Twitter and  possibly use people’s personal photo apps to image some of the places they want to target with precision artillery rounds, air strikes or infantry.

And that’s only a tiny part of what they can do to a major adversary without their 5000 nukes. Even though America’s political leadership and the official opposition are pretty much corrupt rubbish. What—you think the people you see on the news really run things in America?

(Apart from the Kardashians, of course, who obviously are part of the Inner Circle. Except Kim, who’s on the outs just now.)

That’s why most of the time everyone has to buy US dollars to do trade and buy US Government bonds with part of the proceeds. This “leading reserve currency privilege” is the principle reason the US can get away with deficits and monetary financing that otherwise would create Truss-Kwartung-government-like crises every week.

And also why the simplistic econometric models such as the elaborations on Dynamic Stochastic General Equilibrium gadgets used by both the UK and US governments and central banks don’t have the same consequences in both countries. The “assume a can opener” constructs of the econometrics behind their models are absurdly “reductionist”, meaning they don’t have terms that might describe essential aspects of the way the economy functions.

The UK had just as much, if not more, relative privilege for a century or so. When that happens to the US in a few decades (or years if it isn’t more careful), it will have to exchange Trumpian bluster for Proustian wistfulness, much less wealth and the requirement to pay for promises in real money. Promises such as pension schedules.

In the usual accounts of the British pensions mess, the UK’s most recent financial crash and bailout was all thanks to the libertarian ideology of Kwasi Kwartung, the country’s Chancellor of the Exchequer (translation: finance minister), and the reckless greed of the City of London financial elite. Not quite, no.

Yes, there has always been recklessness and greed in the City, as in every financial market.

But the September UK government bond crash did not have its roots in excessive risk taking by the always unpopular speculators. Rather, it was the inevitable result of a compulsive and unreflective risk aversion on the part of the country’s pension managers and bank regulators that is backed by public sentiment.

The proximate cause of the September UK crash/bailout was an attempt by pension fund bond managers to hedge against a rapid acceleration in the fall of the prices of (rise in yields) of UK government bonds (“gilts”). That came in response to the surprise increase in planned deficit spending. Gilt yields had been rising all year; from around 1% in January, they had gone up to a bit over 2% by mid-August.   

Rapid increases in government deficits are particularly risky for countries that already have high levels of debt (and no unique reserve currency privilege), and at over 96.6% of GDP the UK’s public debt is well in the red zone. At the beginning of September 10-year gilt yields had already risen to 2.91% on deficit rumors. When the mini-budget was released on September 23, yields shot up and prices cratered. By September 27 they had reached a peak of 4.53%. Massive emergency gilts purchases by the Bank of England on September brought them down to 3.77% by October 3.

And then there is the key British pension investing model: liability-driven investing, or LDI. As is often the case with magic investment ideas, it works the first time a few people (or pension funds) try it, but then when too many people do it a systemic risk is created that has to be bailed out, maybe by a central bank and taxpayers.

That’s how the 1987 stock market crash happened, due in part to a structure called “portfolio insurance”, along with “index arbitrage”. Both involved attempting to balance risk between the S&P 500 stock index futures and a basket of the underlying stocks.

And most brutally, of course, there was the Lehman crash, which had its roots in securitizing mortgage portfolios and prudently allocating different slices among various investors with clearly described and understood risk parameters. By 2008 this had reached grotesque proportions of size and corruption.

Liability-driven investing hasn’t gotten to the total disaster point yet, but the late September fiasco was pretty close. In a way, it is more like the 1998 Long Term Capital Management disaster. LTCM was also a quant-geek strategy juggling long and short positions. Towards the end of its existence, it took a large, illiquid risk in Russian bonds and attempted to catch the rate difference between those and a short position in German government Bunds.

In both the LTCM and the British LDI cases it was the “risk free” bond positions that blew up first. Both needed to be bailed out through involvement by their central banks.

LTCM was highly successful in 1995, 1996 and 1997. But by late summer 1998 they were on their way towards a final loss of $4.6 billion. By September Wall Street and Fed Governor Alan Greenspan thought the then-imminent sudden liquidation of LTCM would lead to a disastrous unwind of many other investors’ large positions and a far more serious market crash than happened the previous year.  In September 1988 LTCM received a Greenspan-brokered injection of $3.65 billion of private sector institutional money.

LTCM was unwound in an orderly way in 2000. In retrospect it would have probably been better for the crash to have happened in 1998. That would have been very bad but would have forestalled the much worse risks increased by officially sponsored bailouts in the following two decades.

On Thursday October 6, I will describe in Part 2 how the LDI crisis of September 2022 foreshadows a specific, unavoidable systemic problem in the years immediately ahead.