john rutledge,cgu lecture february 14, 2012

Rutledge Capital, LLC (203) 313-4000 [email protected] www.rutledgecapital.com

Dr. John RutledgeClaremont Graduate University

February 14, 2012

Far From Equilibrium Economics: Network Failure, Credit Crisis, and Optimal Portfolios


Our Fragile Island Economy

Capital$200 trillion

GDP/Work$15 trillion


Earth’s Thin, Fragile Crust


Hayek Neural Networks

• Price system as information network– Neural network (Sensory Order)

– System of telecommunications

– Price as a kind of symbol

– Prices coordinate actions of different people

– Solves division of knowledge problem

– One of the great triumphs of the human mind

• Division of knowledge– the really central problem of economics

– Only the most essential information is passed on…only to those who need it

• Perfect markets, equilibrium are tautologies– Change in knowledge disrupts equilibrium

– Economic problem, rapid adaptation to change

• Suggests 2 states (regimes), phase transition– Price clearing vs. Non-price clearing regimes

– As in Edward Lorenz (1963) weather model

Lorenz Attractor

Lorenz EquationsDeterministic Non-periodic flows


Evolutionary Economics

• Early work: Malthus-Darwin (1869), Marx (1867), Marshall, Veblen (1898 Why is Economics…?), Schumpeter, Hayek, von Mises

• Nelson, Winter (1982). Carrier of information, knowledge, rules as genes.

• New models of agent behavior: behavioral, experimental, neuro

• New models of interaction: complex adaptive systems, dissipative structures, directed graph theory, percolation theory, de Donder, Schrodinger, Prigogine, Haken, Mandelbrot, Lorenz, Barabasi, Arthur

• Empirical work: Farmer, Lillo, Geanakoplos, Lo, Allen, Gale, Chen, Cont

• Synthesizers: Schweitzer, Sornette, Foster, Witt, Dopfer, Metcalfe, Potts, Hodgson

• Results: both agent behavior and interactions lead to cascading failures, power law signatures of far from equilibrium phase transitions between regimes

• Applications: – Macroeconomics: financial crises, contagion, recession, depression

– Finance: Portfolio Theory


Debt, Deflation Theory of Great DepressionsIrving Fisher (1933)

• Cycle theory creed--Booms and Depressions (1932)

• “Equilibrium…seldom reached and never long maintained.” p. 339

• Disequilibrium…delicately poised…beyond certain limits instability ensues…breaking of many debtors constitutes a crash, after which no coming back to original equilibrium (sound familiar?)

• Two dominant factors, over-indebtedness (debt disease) to start with and deflation (dollar disease) following soon after. (debt is a network property)

• Debt starters…new opportunities…easy money cause of over-borrowing. Crises 1837, 1873, 1893 (2001?, 2007?)

• Public psychology for going into debt…lure of future income…hope of immediate capital gain…reckless promotions…scandals, frauds…always real basis


Fisher’s Key Result: Liquidating Debt Defeats Itself

• Debt liquidation leads to distress selling…All fluctuations come about through a fall of prices

• Liquidation defeats itself…the more debtors pay the more they owe…the very effort of individuals to lessen the burden of their debts increases it because of the mass effect of the stampede to liquidate in swelling each dollar owed

• 1929 debt greatest known to that time…by 1933 liquidation reduced debt by 20% but increased the dollar 75%...real debt increased 40%

• Vicious spiral many years…universal bankruptcy…natural way out of depression…needless cruel bankruptcy, unemployment starvation…political revolution…reflation

• Controlling price level new importance…those in drivers’ seat will be held to a new accountability


Portfolio Theory

• MPT, CAPM, APT– Return distribution– Fixed mean, variance, covariance– Efficient frontier, optimal portfolio– Risk free rate, market portfolio– Asset allocation industry, Pension Act of 2006

• MPT Does an Adequate Job in Normal Market Conditions

• MPT Fails During Credit Market Crises– Credit markets fail, banks call loans– Volatility jumps, clusters– Correlations converge on 1.0– Asset prices fall across the board– Optimal investors have little cash– Forced asset sales at deep discounts– Contagion between portfolio, businesses

• Makes financial crises worse


Correlations Approach 1.0 During Credit Crises

• Correlations are transitory by nature

• Correlations are not fundamental parameters of nature

• Secular increase in correlations

• Correlations approach 1.0 in times of crisis

• Diversifications benefits not realized

• Optimal portfolios lead to forced selling


Evolutionary Economics and Portfolio Theory

• Random distribution rules out big changes (exponentially small), mean, std dev

• Actual time series frequent big changes• Power Law: N(x) = x –• N(x) is number of movements of size x• DJIA data Log N(x) = -3.96x -3.3 R2=.97• Random OK small, hopeless for large changes

– P(3%) = random 718 per century, actual 780.

– P(6%) = random 1 per century, actual 57

– P(8%) = random 1 per 106 centuries, actual 11

– P(10%) = power law predicts 6, actual 8.

• Fat tails, clustered volatility signatures• Implications: non-equilibrium, phase transition

between two states (regimes)– Equilibrium regime

– Non-equilibrium regime (cascading failure)


Credit Crisis – 2 Period Model

• Credit Crisis– Non-price credit rationing– Reduction in Lending– Reported interest rate falls– Unreported shadow price (Rcc) rises– Opportunity cost of cash soars

• Optimal portfolio - credit crisis– Opportunity cost of cash > r(E)– All cash corner solution

• But 2 period model unsatisfying– Does not allow return to equilibrium state

• View as statistical problem?– Opportunity cost of cash distribution

• R(credit crunch) = 20%, r(equil) = 2%• P(credit crunch) = 0.3• Expected value = 7.4%• Standard deviation = 8.4% (no risk free asset)• Correlation with risk asset? (certainly < 0)

• Conclusion: 2 period model unsatisfying


Credit Crisis - Optimal Investor3 period model


Credit Crisis – Cash-Rich Investor3 period model


Summary

• Opportunity cost of cash– Higher than risk-free rate on average

– Much higher than risk free rate during credit crises

– There is no risk-free (zero variance) asset

– Negatively correlated (-0.8%) with other risky asset returns

• Casualties:– Cash-rich portfolios are optimal with credit crisis regimes

– Corner solutions possible/likely

– Tobin separation theorem no longer holds

– There is no longer a unique market portfolio of risky assets

• Extensions:– Forced liquidation of business operating assets

• Collateral (Geanakoplos), credit channel, employment and output effects

– Empirical tests using mezzanine data• Separate return distribution into equilibrium, non-equilibrium regimes

• Hypothesis: Equilibrium regime distribution Gaussian; non-equilibrium regime power law, fat tails

– Recognize that phase transition (network failure), not standard deviation, is key risk-return tradeoff

– Incorporate phase transition risk into portfolio theory


Next Project: Value InvestingIntrinsic Value, Intrinsic Risk Tradeoff


Dr. John RutledgeClaremont Graduate University

February 14, 2012

Far From Equilibrium Economics: Network Failure, Credit Crisis, and Optimal Portfolios

john rutledge,cgu lecture february 14, 2012

Documents

portfolio

credit crisis

phase transition

credit crunch

rutledge capital

agent behavior

network failure

fat tails