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We’re Fighting the Wrong War

Posted on February 28, 2009

“Generals are always fighting the last war.” Certainly this was true in Vietnam for many years. More recently we tried to refight Desert Storm in Iraq, without understanding that we were headed for another Vietnam.

But what about the economists? Are they subject to the same failings? Most certainly the answer is yes. We have now spent the last year fighting the Great Depression, when the current problem results from a very different cause. True the Great Depression followed the pricking of a stock market bubble, much like the worldwide equity bubble we experienced from 2002-2007. Yet there is one factor in the current market that is materially different from the conditions of the late 1920’s that precipitated the Great Depression of the 1930’s.

You have likely seen the chart below from Ned Davis Research sketching the history of leverage in the United States economy.


Leverage (Total Debt/GDP) peaked in the 1930s at ~2.6 x Gross Domestic Product. Leverage in the current economy peaked at 3.6 times GDP in 2007-2008. So what’s the difference? The difference is that there is no indication that, in the aggregate, the boom of the late 1920’s was caused by a massive leveraging of the economy. From 1923 through 1930, leverage ranged from 150% to 170% percent of GDP. On the other hand, in the current era from Q3 1998 to Q2 2008, a period similar in many ways to the boom times of the 1920s, leverage increase from ~2.6x to almost 3.6x. The massive spike in leverage to GDP from ~1.6x in 1930 to ~2.6x in 1934-36 resulted not from a credit bubble, but from the rapid decline of incomes and output while debt remained relatively constant.

The current down cycle is being driven by a phenomenon different from the forces that led to the Great Depression, i.e. … read the rest

Categories: Banks, Economics

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What Does a Bonus Cost?

Posted on February 15, 2009

Consider this fable.

You’ve decided to invest $5 million in backing a champion at the new World Champion Poker Standoff. The rules are simple. Two players will play a winner takes all game of Texas Holdem. Each player will come to the table with a $5 million stake. You might ask why you would consider such an “investment”, but this is not all that different from the game the big banks have played in recent years.

Once in the game, you win a flip of a coin and are given first choice on hiring one of the two champions who will play in the tournament. The only information you are given is the following:

  • Player A wants an upfront cash salary of $400,000 plus a bonus equal to 50% of salary.
  • Player B requires no salary, but demands a bonus equal to 20% of his winnings.

Admittedly you’re missing some fairly important information such as who has the better track record and whether one of the players is a drunk or cocaine addict. But this is a fable after all so you’ve got to play by fable rules.

Given no more information than this, which player should you choose and how much will each player cost you if chosen. I would posit the following:

Player B is the only rational choice. Player A doesn’t have the courage of is convictions. Player B does. While this could be based on a totally unrealistic optimism on Player B’s part, it is more likely based on Player B’s realistic confidence that he will win. Assuming this is the case then the odds favor Player B and the likely cost of each player is as follows:

  • Player A costs $5,400,000 (Salary plus 100% loss of capital)
  • Player B generates a net profit of $4,000,000 ($5,000,000 winnings less $1,000,000
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Categories: Bailouts, Banks, Business Turnarounds, Economics, Uncategorized

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