Iran, Climate Change and Prediction Error

Mark Twain is famous for saying that "it is difficult to make predictions, especially about the future." My mother often predicted that I would become a bum.  She was right. As a happily retired guy I am sure that Betty would agree with my mom’s vision. 

Predicting the future is both necessary and humbling. Squirrels don’t have spreadsheets and mathematical models, but they gather nuts in anticipation of the coming winter. The playboy squirrels who don’t predict so well lose a lot of weight after winter arrives.  Clearly we learn from squirrels and we predict lots of things that improve our lives. But predicting the future is not an easy thing since the future by definition is unknowable. Those who take actions in anticipation of a specific future often make mistakes – sometimes very damaging ones.

Yet we predict and forecast. I grew up in Florida. During hurricane season we all become forecasters. Will that storm turn into a hurricane? Will that hurricane hit land? If so when will it hit? Where will it bring the most disastrous winds and lightning? Weather forecasters are almost always wrong when it comes to predicting these critical facts about hurricanes.Maybe that is an extreme example but I don’t think so. We modern folks with our math and models forecast a lot of things. It is important to do so. And we do so knowing that we are often wrong.

If you are still awake your mind might be wondering and thinking about all the ways we predict the future. My reason for writing today arises because of what I see as a very inconsistent approach by our present leaders with respect to forecasting some very important things.

The Obama administration is VERY sure that climate change is coming and that without major policy changes and a lot of investment, we and the rest of the world will be threatened. I think he said that climate change is our most important future challenge. There are some very important people and very sophisticated models supporting the urgent need to spend trillions of dollars to change and prepare for things that will happen in the distant future – some expected to arrive more than 50 years from now.

Despite the fact that the future is hard to predict and despite the huge sums of money involved, the president is laser focused on attending to these challenges immediately. In his and his supporters’ minds, this expenditure is worth the risk. His policy makes us all invested bettors on future climate.

Compare this aggressive approach to another important future challenge – nuclear weapons. The world is already in accord that countries will not produce more nuclear weapons. And that accord is for good reasons. While it seems highly irrational that any nation, even a rogue nation, would fire nuclear weapons at another country, we worry that all nations are not always rational. It is like the idea of someone yelling fire in a crowded movie theater. It seems quite irrational to yell those words – yet we have laws to prevent crazy or mean people from doing such things. The world has agreed to control nuclear weapons for similar reasons.

Yet the same administration that worries about climate change wrecking our countries is willing to predict that Iran and North Korea can be trusted to not yell fire in a crowded movie theater – or to not unload a nuclear weapon on one of the rest of us. Obama can vividly see water levels rising and shorelines being over run despite knowing that all this future information is model-driven and about the future 50 years from now. Yet the same Obama cannot imagine a religious zealot or a desperate dictator shooting a nuclear weapon. He cannot see those countries most threatened by nuclear Iran and North Korea arming themselves. He seems to minimize any real threat from a world with increasing amounts of nuclear weapons in the most unstable places. 

Kerry and Obama repeatedly say that the recent accord with Iran will prevent them from obtaining a nuclear weapon yet they also agree that within 10 years Iran will be able to manufacture such weapons freely. They publicly agree that after those 10 years it will take only one year to be ready to aim and fire. So why are we not aggressively trying to prevent that outcome? My grandson Nolan will not be 13 yet in 10 years. I am not particularly crazy about him having to worry about Iran or North Korea or some other despotic place. Clearly this is at least as important as the impacts of climate change on him. Right? 

So here is my question. In the case of global warming, President Obama is willing to forecast the absolute worst. In the case of Iran and North Korea his “models” assume the absolute best. Most economic forecasters that I know (who are not ideologically motivated) bring a “show me” attitude to forecasts. They are always skeptical about their model’s predictions. They always discount the certainty of what we think we know. They always follow their forecasts with a list of caveats longer than a drug company’s list of side-effects in a television commercial.

Why is Obama so sure about the intensity of climate change and so sure that Iran and North Korea will turn into the cutest and sweetest puppies? Why can't we apply conservative and consistent forecast approaches to policies related to climate and national defense? 

2% Inflation and the Fed

The Fed seems to have a thing about 2% milk. Or was that 2% inflation? It has become a passion with them. It’s like your mom when you were a kid. Honey, if you are good we will take you to Legoland. What is good Mom? To start with clean up your room. And then you should get straight Bs. Straight Bs? Why do I need straight Bs to be good – good enough to go to Legoland?

Mom knew that I would never get straight Bs. I could hardly sit in my school desk for five minutes let alone concentrate long enough to get a B on anything. The Fed has been singing this 2% inflation song for quite a while – and all during that time the chance of inflation reaching 2% was about the same as my getting straight Bs.

Why is the Fed so disingenuous? Mostly to take our collective eye off the ball. There used to be a time when the proper role of the Fed was to provide just the right amount of liquidity to the economy and restrain inflation. But then the Keynesians messed things up and suggested that since the government is totally inept, the only organization besides Donald Trump left to control the economy is the Fed. So instead of humbly trying to  dampen inflation and inflation expectations the Fed has turned into this multi-headed hydra doing everything from dunking basketballs to fine tuning the unemployment rate.

Janet has no troubling dunking so she and her fine fellows at the Fed (notice all the Fs) have spent the last 8 years or so telling us bedtime stories about monetary policy and the unemployment rate. Janet will not rest until every last legal and illegal fast-food server has a full time job with rapidly growing wages. She is still a long way from reaching that goal so she is even more dedicated. But here’s the rub. Aged economists like myself keep reminding her that at some point after she has poured enough money onto the smoldering economy she will have created enough economic and financial imbalances to sink a manatee.

Janet wants to please even old guys like me so she gives what we might call “lip service” to the idea of inflation. Janet wants unemployment much lower (and wages much higher) and will say just about anything so she can say she slayed the employment dragon. One thing she can say is – look dudes. I poured enough money on the economy to drown China and look – no inflation. Well – there is some inflation so she had to come up with a number for the perfect amount of inflation and that number is 2%. She keeps pointing out that inflation is less than 2% and she acts as if that is a bad thing. Is it a bad thing when your money buys more? Instead of saying she wants the unemployment rate lower – she chides us with this silly statement that inflation is less than 2% and that is a bad thing! Worse – she says – we must keep stimulating the economy until we can get inflation up to 2%. 

Up to 2%!!! Am I yelling? I spent my whole 169 year career thinking the Fed is supposed to REDUCE inflation. Where did we get this raise inflation crap??? It is just like those straight Bs. Mom didn’t want to take me to Legoland. Janet does not want to raise inflation to 2%. What Janet really wants is a gold star for employment achievement.

You say – but Larry – the Fed just raised the interest rate. Are you never happy? Did you never get to Legoland? Yes, I did get to Legoland and it was wonderful. As the Fed announced its miniscule increase in the interest rate it spent more words reassuring us that the future increases will be so gradual that no one will even notice. But even that tiny little interest rate increase isn't guaranteed. If ANYTHING comes up this year that has even the tiniest possibility of slowing growth in the US economy you can be sure that the Fed will end their attempt to restore a bit of normalcy to monetary and financial conditions.

2% inflation is a gimmick and it means nothing. What matters is the Fed’s progressive agenda and that it is riveted on the unemployment rate and economic growth. Mark my words. If the inflation rate rises close to or above 2% while the employment situation is not sufficiently solved – the Fed will explain why 2% was never a rigid target. The Fed will then explain why 3% makes more sense. Hey guys, is 4% really so bad? 

Why am I so mean about the Fed? The answer is that they don't read the handwriting on the wall. First, remaining issues with employment have nothing to do with monetary policy and everything to do with long-term structural issues. Loose money and low interest rates are doing little for growth and everything to increase imbalances. Second, we already see the worrisome bubbles developing that arise from near-zero interest rates. Third, if inflation does begin to rise despite little progress on employment, the Fed will likely ignore the inflation and will end up creating a very unstable stagflationary environment. Those of you who experienced all that in the 1970s know why that is not a desirable end. 

The Fed should stop this charade about wanting a higher inflation rate and just tell the truth. They are not going to stop this abnormal monetary policy until every last one of us has a full time job and wages are growing faster than kudzu. Domestic and global imbalances be damned. 

Junk Bond Bust by Guest Blogger Buck Klemkosky

There are problems in the junkyard. Liquidation of the largest mutual fund since 2008, Third Avenue’s $800b Focused Credit Fund, has intensified concerns about the health of the high-yield bond market.  Third Avenue had invested in high-risk illiquid bonds and as redemptions poured in the fund sold liquid bonds first but at the end could not sell the $800b of illiquid bonds and halted redemptions until assets can be sold. 

Another high-yield fund also stopped redemptions and one other liquidated. This was a wake-up call for investors who had been chasing yield without assessing the potential risk of high-yield bonds. The amount of money invested in high-yield bond funds has quadrupled since 2009.

High-yield, high-risk bonds are commonly referred to as junk bonds. People who work and invest in this area of the bond market would prefer the high-yield label but junk is used as often as not. Bonds are rated investment grade or speculative. Investment-grade bonds are further categorized into high-grade (AAA and AA ratings) and medium-grade (A and BBB ratings). High-yield bonds (rated BB or B or CCC) are considered speculative with only moderate protection of principal and interest. Bonds can be rated lower than CCC but usually not at issuance.

There are only three AAA-rated corporations left in the U.S.: Johnson & Johnson, Exxon-Mobile and Microsoft. Twenty-five years ago there were nearly 100 U.S. companies with AAA ratings so they are a dying breed. There has been a long-term downgrading of corporate bonds globally; for example, in 2015 more than $1t of corporate bonds have been downgraded and less than $500 B upgraded in the U.S. alone.

Prior to the 1980s, only investment-grade bonds could be issued. Any bonds rated lower than BBB had been downgraded. Mike Milken of Drexel Burnham fame started the junk-bond revolution by convincing investors to buy high-yield bonds at issuance. He has long since departed the industry as has Drexel Burnham but the high-yield bond market continues to thrive. High-yield bond issuance has set records the past five years as has the issuance of investment-grade corporate bonds.

One result of the record amount of high-yield bond issuance and consistent downgrading of investment-grade bonds is today $2t of global corporate bonds are rated speculative or junk. Corporations have been motivated to issue bonds because of low interest rates and tax advantages while investors have chased yield because high-yield bonds provide 4-5% annual yield more than investment-grade bonds. Recently AA-rated bonds yielded 2.61%, BBB-rated 4.27% and high-yield 8.5-8.8%, up from 5.8% earlier in 2015. In the bond markets, the higher the risk, the higher the return. If you really have an appetite for risk, the CCC-rated bonds yield over 18%. However, as junk-bond yields have increased and prices declined, they will suffer negative returns for the first time since 2008. A popular high-yield bond index has fallen 13.6% since mid-April 2015, prompting investor selling.

What is the downside of having $2t of corporate bonds rated junk? Evidence shows that the probability of default is much higher for junk bonds; over a 30-year period, 3.8% of these bonds defaulted annually. In 2015, the default rate was 2.6% versus 2.1% in 2014. The default rate is expected to be above 4% in 2016. During periods of crisis such as 2007-2009, the default rate skyrocketed to 15%. About 25% of high-yield bonds have been issued by energy, mining and commodity-based companies which are now experiencing financial stress. 111 companies have defaulted on $80b of debt in 2015, the highest number since 2009. High-yield promised returns look appealing in a low-interest rate world; returns after default don’t look nearly as attractive as promised yields. Unfortunately many investors have chased yields without fully understanding the risk that entails.

Sunny Davidsons: Glass Half-Full?

Happy New Year!

I spout a lot and spouting can sometimes have a negative tone. So I thought I would start the year off on the right foot. Glass half-full? Of course the glass is always half-full but in 2016 and the year of a Presidential election in the USA – we are going to constantly hear about everything that is wrong with this country and the world. The good things will easily get lost in all this negativity.

I am not saying that there is anything wrong with pointing out our drawbacks and challenges. This is the way we learn. Mrs. Montgomery my fourth grade teacher was pretty clear that punching and otherwise touching my classmates was not appropriate behavior. Today I am pretty much punch-less and I should thank Mrs. Montgomery for her constant help including the water-boarding. 

But we also know that too much emphasis on the negative can be counterproductive. My father’s name was Sonny Davidson.  Born in 1915 he was a young teen when the Great Depression hit and he decided he already had enough schooling and hit the streets. Later during World War II he passed himself off to the Merchant Marines as an electrician. After the war he was selling cigarettes on the Staten Island Ferry where he met my mom. Sonny was an eternal optimist despite being beaten back time and time again. He fought hard to put the food on the table and had at least the following occupations – taxi driver, entertainer with a stage name (Zonn Murray was a hypnotist, mind reader, magician), Miami Beach strip club manager, bar manager in Key West and then Havana, appliance salesman, appliance store owner, and then gift wholesaler. Both his appliance store start-ups ended in bankruptcy.

But if Sonny Davidson was optimistic his dear wife Marge was Mother Teresa.  Marge was born in Budapest and came to the US in 1929 – great timing mom! She met Sonny one day on the Staten Island Ferry and that was that. They moved to Miami after World War II and happily raised two sons there. They were the classical good cop bad cop when it came to raising children but always they were optimistic and forward looking. No wall was too high to climb. Thus my title today is Sunny Davidsons.

Inasmuch you see why it is so easy and natural for me to advance the glass half-full philosophy. As we march through the battlefield of 2016 it does not hurt to think about some things….

            If you are reading this you are alive. Smile.

            Thanks to innovation we have things available to us that we never even dreamed of 20 years ago. If mom was alive she would not be using something called a wash tub and ringer.

            While Russia is no pussycat, I am not a pimply teen walking around Miami waiting for a violent reaction by the Soviets over Kennedy’s Cuban Missile Standoff.

            While we are contemplating ground troops in Syria, we are not learning daily of casualties in a far-off place called Vietnam. Most people today do not even know the word napalm.

            Non-profits and charities are everywhere serving the needs of the less-fortunate and many of us are proud to serve on their boards and committees.

            Despite continuing worries about the future of the Social Security System, the baby boom is retiring in scores and receiving checks that make life easier for boomers.

            Radio stations continue to play Party Doll and other favorites from the 1950s.

            Despite lingering two-way racism and ensuing unrest, minorities are succeeding in education, work, and are no longer subject to obnoxious insults like sitting in the backs of buses.

            While many of us dislike a swollen national debt our government is not teetering on the brink of collapse as in Greece, Brazil, Russia, Venezuela, and several other countries.

            No one likes sub-par economic growth but if one looks around the world today a 2% growth rate is not bad. Consumer spending rose 3% last quarter.

            Gays can marry and are mostly treated as regular folk.

            While politics and elections are important and colorful – most of our days and hours are  filled with both frustrating and wonderful friends, family and neighbors.

Have an absolutely wonderful 2016.