Poland then(30's) and now(00's)

This chart is from Barry Eichengreen and Kevin O’Rourke column comparing today’s global crises to the Great Depression. Although the general conclusion of the comparison is rather grim (i.e. no signs of green shoots in hard data) but Poland in that comparison is doing relatively well. The fall in the industrial output is relatively soft. What is than the receipt for success? I think Poland is weathering the storm so well (in relative terms) because of several factors : 1) Underdeveloped banking system 2) less leverage 3) smaller gaps /macro imbalances 4) regulations/constrains for domestic households to borrow in foreign currencies. Only if Poland would use good times (2005-2007) to reform state budged then it could be a clear winner of the crises

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S&P 500 - critical time

It is fair to say that the global economic system is one of the most complex systems known in the biosphere. Compared to physics, economics differs in the important fact that the basic constituents, or “particles”, are already quite complex: human beings. So macroeconomic knowledge is insufficient tool to predict market trends as not only hard data are important but also how human beings think about macroeconomic reality.

John Maynard Keynes made a famous observation that much of individual economic behavior is due to “animal spirits” rather than long-term rational calculus so beloved by economic theorists and fundamental analysts.

That’s why I don’t want here to discus macroeconomic picture (i.e most recent US job readings) because it’s rather trivial task as we are still in negative feedback process (i.e. banks continue to tighten credit standards –> less credit available means lower demand -> lower demand means higher unemployment -> higher unemployment undermines creditworthiness -> banks continue to tighten credit standards etc)

What I would like to focus here on fact that series generated by some complex systems (i.e. financial markets ) are characterized by periodic or nearly periodic behavior. In these cases, the dynamics can be characterized by scaling laws. Such dynamics are usually denoted as fractal or multifractal, depending on the question if they are characterized by one scaling exponent or by a multitude of scaling exponents. Sierpinski gasket is one fine example of fractal




Some times its necessary to conduct series of tests to find the scaling factor but in case of S&P 500 the self similar pattern is clear at the first glance.

I simply repeat the analysis which I done last year and I got very similar scaling factor 2.7. In words it may indicate that S&P 500 is around critical time and that in August we may test the March lows.

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Irrational Exuberance. LPPL signatures in EUR/PLN

People like to go to excesses. I think that what started out with a tulip, maybe four-hundred years ago, and continued through the South sea bubble and all of those sorts of things ( Tronic bubble in 60’s, new economy bubble in 90’s). I’m not saying here that that all human choices are orthogonal to rational ones but in human nature is to heard. Herding can result from a variety of mechanisms, such as anticipation by rational investors of noise traders strategies, agency costs and monetary incentives given to competing fund managers, sometimes leading to the extreme Ponzi schemes, rational imitation in the presence of uncertainty, and social imitation. Many financial economists recognize that positive feedbacks and in particular herding is a key factor that can push prices upward (downward) faster-than-exponentially which if unchecked can lead to bubbles.

Roughly 10 years ago Johansen and Sornette proposed model that attempts to incorporate those ingredients into a traditional rational expectations model of bubbles proposed by Blanchard.

The Jochansen-Sornette model assumes the financial market is composed of two types of investors: perfectly rational investors who have rational expectations and irrational traders who are prone to exhibit herding behavior. The noise traders drive the crash hazard rate according to their collective herding behavior, leading its critical behavior. Due to the no-arbitrage condition, this is translated into a price dynamics exhibiting super-exponential acceleration, with possible additional so-called “log-periodic” oscillations associated with a hierarchical organization and dynamics of noise traders.

A+B*(t-tc)^C*(1+D*COS(w*LN(t-tc)+O)

This so-called log-periodic power law (LPPL) dynamics given by has been previously proposed in different forms in various papers. The power law A−B(t−tc)_ expresses the super-exponential acceleration of prices due to positive feedback mechanisms. The term proportional to cos(w ln(t-tc)+o) describes a correction to this super-exponential behavior, which has the symmetry of discrete scale invariance. This formulation results from analogies with critical phase transitions (or bifurcations) occurring in complex adaptive systems with many interacting agents. The key insight is that spontaneous patterns of organization between investors emerge from repetitive interactions at the micro-level, possibly catalyzed by top-down feedbacks provided for instance by the media and macro-economic readings, which are translated into observable bubble regimes and crashes.

In previous posts I fit the LPPL formula into several financial time series. This time I fit LPPL into EUR/PLN exchange rate. As it is seen on the chart the formula fits remarkably well into the data. Even more surprisingly the LPPL model explains not only the periods when the positive feedbacks let to the zloty overvaluation but also it fits well to the period when zloty was depreciating (2001-2003). This confirms the universality of the process described by LPPL formula which describes well not only bubbles but also antibubbles.

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the global fiscal outlook is somber

IMF has released a Staff position note: Fiscal implications of the global economic crisis. Conclusion of the note is simple the global fiscal outlook is somber. Present fiscal cost of the crises + aging populations in advanced economies will strongly contribute to increase in DEBT/GDP ratios in the future. Also this momentum may raise the question of fiscal solvency. What is then the next big thing?
a) rising inflation
b) fiscal insolvency
c) a+b
or c) (put here something optimistic)

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Risk appetite remains low

Surprisingly the net average positioning index remains almost flat despite recent rally. (The shot description of the index you may find in one of the previous posts). It may indicate that portfolios still remain underweighted. So it looks like this rally has still room to go

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Polish language version of the bubble hunter

I just created Polish language version of the bubble hunter link here. “Łowca Baniek” blog will be rather focus on the Eastern Europe, bubble hunter will remain my main conceptual notepad

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Reflexivity and Eastern Europe (or can Ukraine be a Lehman Brothers of Eastern Europe?)

I was expecting this article to come sooner or later but when I read it this morning in FT I cannot say that I’m happy because for the time being I’m still living in Eastern Europe.

Not so long ago the consensus about Eastern Europe economies was that they are FUNDAMENTALY sound and those economies should decouple from global slowdown. At that time I wrote that this is not sustainable process and that the decoupling will be followed by the recouping to the rest of the world . Now after the first wave of debt/currency crises went through the Eastern Europe the consensus story has been changed somehow into more doom and gloom story. But now some say that Eastern Europe is almost FUNDAMENTALY cheep (i.e. here)
I think this way of thinking is FUNDAMENTALY wrong as markets are not efficient pricing machines Some/Most market participants believe that the markets tend toward equilibrium but equilibrium is just only first approximation how the market works.



My critique is not new. Milton Friedman said that idea of fully efficient market is inherently contradictory. In order to remove market inefficiencies we must have traders who are motivated to exploit them. But if the market is perfectly efficient there is no possibility to make excess profits. While efficiency might be true at first order, it cannot be true at second order: There must be on-going violations of efficiency that are sufficiency large to keep traders motivated. The misconception of efficient market is even obvious now than ever before, because it was the intervention of the authorities that prevented financial market from the total meltdown, not the market themselves. Indeed non-equilibrium nature of the markets is especially visible in the sharp price movements occurring at the booms and (especially) crashes which are accompanied with massive price jumps. Question is how in first place the market gets to “critical” point. The Eastern Europe decoupling story was based on the fact that economic growth in recent years was strongly based on domestic demand. Domestic demand was continuously stimulated by credit growth and budget deficits. At the beginning of the process the credit growth was limited and its impact on the price assets was limited. However lending usually stimulates economy. A strong economy tends to enhance the asset values, increases country creditworthiness and also often tigers local currency appreciation. As the asset prices grows the banks are more willing to lend because (i.e.) the value of the collaterals is growing the more credit is available the stronger economy grows. This positive feedback process continues until a point is reached where credit cannot grow fast enough to stimulate economy. By that time the asset value strongly depends on the credit growth and as the credit growth fails to accelerate further the asset values starts to decline. At the “critical” point the process reverses. Declining prices of assets/collaterals decreases the banks willingness to lend which has depressing impact on economy. Since creditworthiness/collateral has been pretty fully utilized at that point, a decline may precipitate the liquidation of loans which in turn may make the decline more precipitous.

This is very, very simplified vision of the process which leads to asset bubbles. However one of the features of the process is that Economic FUNDAMENTALS ARE NOT EXOGENOUS to the process. Unfortunately is not my idea but George Soros reflexivity which he defines as a “two-way feedback loop, between the participants’ views and the actual state of affairs. People base their decisions not on the actual situation that confronts them, but on their perception or interpretation of the situation. Their decisions make an impact on the situation and changes in the situation are liable to change their perceptions”
(Unfortunately Soros is not good at math but it’s easy to show that his reflexivity idea is a system of differential equations. More formal model definition and solution to the systems of “Reflexivity” differential equations you can find here in excellent V.I. Yukalov D.Sornete paper).

But let’s come back to the main subject and let’s try to find out what may come next. Financial linkages/Interlinkages in Eastern Europe are very tight. With the increase in the foreign ownership of the banking system in Eastern Europe the degree of financial interlinkages among Western Europe and Eastern Europe has also grown substantially i.e. Austria’s lending exposure to Eastern European countries top 80% of GDP ( IMF Paper with the statistics you can find here). As the economy slows the processes which lift asset prices is in full reverse as investors starts to withdraw the money. The liquidation of the loans takes time: the faster it has to be accomplished, the grater the effect on the value of the collateral . In the bust the reflective interaction of the loans between collateral becomes compressed within very short time of period the consequences can be catastrophic (reflexivity works both ways)

For several years Ukraine economy was flying on cheep credit and high steel prices now both engines has been lost which is not only the case of Ukraine but also for several countries in the region (i.e. Romania, Bulgaria). And now we are in self reinforcing process of loans liquidation which reinforces the drop of asset prices. Because of the size of Ukraine and close financial interlinkages acrros the Europe the comparison of Ukraine potential default to Lehman Brothers bankruptcy and its implications for the whole financial system makes sense for me

End of Part ONE

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