#85 In hindsight we all need umbrellas

There is no better time than Christmas to look back and reflect. Given the spectacular market recovery, the gifts under the tree will no doubt have recovered. As has confidence on Wall Street, where "God's Work" is paying off profitably. In hindsight, not the wisest of comments by the CEO of Goldman Sachs (need I mention any names?).

Christmas is a time for humility and reflection, if not to ask forgiveness for those we have neglected inadvertently (tax payers anyone?). Obama was elected partially to give that message to the "fat cats" of Wall Street. Despite his television appearance, a generic hallmark Christmas card probably made more of an impression.

Instead of focusing on banker's bonuses, the real focus should be on the economy. Markets are supposed to reflect the barometer of the economy, with economic weather men telling the masses wether we are in for rain or sunshine. Whether it be sun or rain, umbrellas seem to be in short supply. But then again who needs an umbrella when you can rely on the weather forecast. After all, the representatives of God's work are always right in hindsight. And yet in hindsight we all needed umbrellas.

Many claim they saw storms coming. Why did we all go outside without an umbrella then? I've got one now, but I am tempted to trade it in for sunglasses with the market looking so upbeat. No need to stay indoors. Take a little gamble, the masters of the universe sell on NBC & Bloomberg; buy gold, time for value investing, just look at those juicy p/e ratios, etc, etc. One compliment to the financial weathermen; they sure know how to sell compared to those weight loss exercise gear that one sees advertised on television. I guess that is the real difference between no education and a Harvard education.

Lose 20 pounds in 2 weeks for sixty dollars, or balance your portfolio the right way and see it all evaporate in front of your eyes in a matter of months. "Results in the past are no guarantee for future expectations." If you want to sell dishonestly, turn off someone's common sense. You can fool anyone if you turn off their common sense. That's why you always have to Quaerere Verum: seek the truth. Instead of our human flaws, easily exploitable through suggestion, insecurity and plain old greed.

Truth is, all you need is common sense. When you're leaving the door, do you ask yourself if you have your keys, wallet, umbrella, etc? Consciously or subconsciously you do. That's common sesne. Now when checking the weather, do you have blind faith in the prediction of sunshine when you see clouds outside? Probably not 100%; not having blind faith is also common sense. So why do you let someone turn off your common sense when reading or watching the financial tell-sell on the TV, Internet or newspapers? I don't have an answer to that right now but let's not do it again. The rain makes you wet faster than the it takes the sun to dry you. That too is common sense.

So when cheap money pours in again to inflate asset prices beyond the sun., think about Icarus and your umbrella. You don't need an MBA for that.

And remember, better grumpy and prepared, than insanely unprepared.

#84 Wall Street Socialism

Who would have thought that the collapse of the American housing market would signal the end of an era for the world's most prestigious investment banks? The U.S is in-between a rock and hard place to rescue the financial sector of the world's largest, most important and most competitive economy. At what cost? We are, according to Nassim Taleb, the prolific black swan visionary, socializing losses and privatizing profit. That is the world of capitalism turned on its head.

The crisis goes fundamentally deeper than the interconnected failure of banks and other financial institutions in an increasingly interlinked and globalized world. We need a collective re-examination of leading economic, finance and management theory and practice in order to evaluate where and why it has gone wrong.

It is far too easy to blame greed on Wall Street. Greed is healthy; without it we do not have the Darwinian economic animal spirit of capitalism. Without greed we would not have banks, health insurance or even mortgages for that matter. Greed is a force for innovation, hard work and ambition. The blame lies in the sharing of risk and reward. Institutions have become too big to fail. Without economic Darwinism, the rotten survive, and with it bad practices and empty suit risk/reward models.

The problem is that greed and risk management do not mix well with current investment banking models. They are in fact creatures whose interests, even though they pretend to speak the same language, are juxtaposed. Risk management in itself is almost an impossible venture because:

a) Risk is too complex and interconnected in a globalized world for any human being to comprehend accurately and effectively, b) Unknown and unexpected events with previously unrecognized connectivity spring up from places where we never saw them coming (black swans), c) Risk managers are rarely appreciated or understood, and d) Assessing the correct value, impact and occurrence is almost pseudo-science.

Some so-called gurus claim that risk management (in hindsight) should have given investment banks the knowledge (foresight) to steer away from the iceberg of doom. Risk Management is always a science that relies on (biased/faulty) hindsight in order to attain foresight that we can never accurately interpret or understand. Furthermore, us mortal humans lack the objective internal stochastic instruments to judge the real-life world in terms of potential/real events/impacts.

Banking in the future will inevitably be increasingly socialized and/or nationalized at a higher cost, with potentially the same risks and (moral) hazards if we fail to learn from the past. I think it's time we start teaching students and practitioners the history of finance and financial economics. Let's start with Financial Meltdown Economics 101.

#77 The Perils of 'Risk Free' Debt

The recent (ongoing) crisis in the so-called subprime market has highlighted the immense difficulties of managing an economy that relies heavily on borrowing in order to create spending. The US and, perhaps even more so, the global economy is seemingly in fine shape. In the States, however, this is in great part due to increased spending made possible through the use of debt. People have had easy access to borrowed money thanks to the historically low interest rate of the past few years.

As the interest rate gradually began to rise, however, paying back these loans has become increasingly difficult. The subprime mortgage crisis is not a sub - as the name might suggest - but rather a prime example of this. Since a subprime loan is a loan that is given to people with a bad credit record, who therefore don't qualify for market interest rates and must pay a much higher rate, it is naturally mostly the poorer people who make use of it. The large number of people with subprime mortgages suddenly found that with the decreasing value of their houses, they were unable to pay the mortgage. And if you can't even pay your mortgage, you surely won't be able to spend on much else, which would cause a problem for the economy.

This poses a dilemma, as the economy must continue to be boosted through spending, but not at all costs. People need to understand that borrowed money needs to be paid back; it is not free money. This should serve as a wake up call to American consumers that relying too heavily on debt is too great of a risk. Sadly, there are always - including now - strong voices advocating debt forgiveness. Surely it cannot be so that consumers are taught that accumulating debt to the point of being unable to repay it comes without consequences? The message that big trouble will arise with too much debt must be hit home hard, once and for all. Better now, while the economy is reasonably stable, than later, when debt will only accumulate further, causing a potentially cataclysmic economic downfall of unknown proportions if China's possible bubble were to collapse.

There is some good news on the horizon, however, in the Fed's failure to take serious steps (i.e. have the central bank lower its benchmark federal funds rate from 5.25 percent) to help those affected by the crisis. It appears that Federal Reserve Chairman Ben Bernanke is trying to "teach investors a lesson," namely that the Fed will not bail out their poor decisions. This is not to say that there is no help whatsoever. The Fed has already injected tens of billions of dollars into the banking system and lowered its discount rate (the charge on its loans to commercial banks). Furthermore, President George Bush announced a plan to help struggling subprime mortgage borrowers to keep their homes via changes to the tax code.

Let's hope that a fair balance is found between the honest need to help those hardest hit and teaching a very wrong and dangerous lesson. Sometimes it is best to set an example to future potential defaulters by acting very harshly (though some would say justly as well) towards those involved now.

#71 Europe’s Unequal Siblings: Monetary Economics in Central Europe

The great experiment that is Europe still needs to overcome a number of obstacles until it truly becomes an economic entity. Especially when looking at the integration of new member states to the economic, political and cultural entity that Europe seeks to be. Central Europe can be seen as a collection of younger siblings in the family of European states. In many ways states such as Hungary, Poland, Slovakia and the Czech Republic are like restless teenagers on their way to adulthood.

Current president of the Czech Republic, Mr. Václav Klaus, is known to be a vivid enthusiast of Milton Friedman and his dogmatic free markets. You might therefore think it would only be natural for this liberal economic fervor to wash over to the lower political echelons. But this is not the case, because these badly needed fiscal reforms hurt those people in the economy who need government protection the most. Leftist and Populist parties make good use of this and find great support from the disadvantaged, disenfranchised and elderly sections of the electoral masses. In "old" Europe these type of factions do not enjoy the same level of support because the West has already gone through many of these transitions over the last several decades, albeit one small step at a time.

Europe’s Central European siblings want to take larger steps on the road to economic prosperity and future European economic integration. Fiscal discipline is an important prerequisite, but Central Europe's budget deficits are not heading in the direction of 2-3% of GDP. In fact, they are actually showing a widening trend. This, coupled with inflation, is not going to strengthen currencies and reduce the purchasing power parity gap. Yet, there are some unique forces at work. Skilled labor is much more mobile in Europe than unskilled labor. Wages of highly skilled laborers are even on a road to parity, while if they work abroad they are often already in parity. But for the majority of laborers in Central European countries such as Hungary, the Czech Republic, Poland and Slovakia, the question remains how long it will take until there is a true convergence of per capita income.

The good news is that there is actually downward wage pressure in countries such as Germany and Austria as a result of this imbalance between per capita income differentials. This is inherently a good thing because it makes the rest of Europe more competitive.

When visiting the capitals of Central Europe such as Budapest and Prague, one can definitely observe a boom. Low interest rates, economic vitality, wage growth and speculation are driving new real estate development and pushing property prices up. This boom is to a large extent a local driven phenomenon, at least when looking at the residential market. Most of residential housing stems from large Communist residential development; giant, dated and somewhat drab apartment complexes still form the mainstay of housing of Central European residents. But with a growing segment of the population being upwardly mobile and flush with cash, they are driving a residential building boom. People want to move out of their dated Socialist housing arrangements into new housing and apartments. An increase in interest rates could bring some much needed revaluation into the property market and blow off some steam.

This seems unlikely to happen in the short term as central banks are keen to keep the economy going. Inflation doesn’t appear to be at the forefront of their worries. Economists and central bankers should keep their eyes on the horizon because there are some worrisome circumstances. Some of the currencies such as the Hungarian Fórint have been quite volatile compared to the relative stability of the Euro and the Swiss Frank. Additionally, many Central European Economies have fallen behind in their fiscal reforms and will find pushing painful reforms through in the various parliaments a difficult task to say the least. Sure, bumps on the road to maturity are imminent and even unavoidable for the Central European teenagers. Some central bankers also argue that the type of inflation we are witnessing is completely natural and to a certain extent outside of their influence.

EU taxes on regulated goods such as alcohol and tobacco is an important inflationary presence, especially is Central Europe, where alcohol and tobacco consumption tends to be larger. My final worry lies in the close correlation between Central European currencies, which tend to move fairly together, even though political and economic circumstances are rather different between Poland, Hungary and Slovakia. There is the fear that we could be oversimplifying those dynamics, assuming too much and questioning far too little. Undeniably the dissimilarity of growth is as much an opportunity as it is a threat to the economic entity of Europe as a whole. Nonetheless, if Central European governments do manage to get their fiscal responsibilities together, there is little to fear besides a few bubble bumps on the road. Projected rate increases in Euroland should inspire the central banks in Central Europe to do the same.

#62 Economic Darwinism in the Market Place through Hedge Funds and Private Equity

The notion of "survival of the fittest" is not only something attributable to the development of species, but, in a more contemporary sense, to world markets as well. The defragmentation process of regional markets that has been set in motion by the followers of those who advocate closer integration of global markets is a force to be reckoned with.

In the past regulation created barriers that protected regional and national firms from the more efficient and competitive adversaries that operate in more capital efficient and less regulated environments, where capital is allocated to the most productive parts of the economy. This is increasingly changing today, with hedge funds and private equity groups jumping at the new found opportunity to take advantage. Hedge funds and private equity are in fact the aquarium algae eating fish that take out the dirt and keep the water clean for the other fish. This is not to say that firms targeted by private equity directly equate to fish guano. No, these firms are simply more able to asses the true value of a firm, albeit like a skeleton being sold off bone by bone to piecemeal investors.

When firms perform less than optimal, the question amongst shareholders - which can include private equity groups or hedgefunds - is whether management resources have been utilized optimally to achieve maximum utility in comparison to capital market benchmarks. As hedge funds often operate with long-short positions, performance or under-performance is crucial. It is no surprise, therefore, that hedge funds are perhaps the most shortsighted investors in terms of their investment horizons. They often propagate and support the shedding of assets, business, or other holdings if it contributes to short term operational results.

With hedgefunds as shareholders, it becomes essential for the firm to not only "know thy self" but also "know thy shareholders." Shareholders are not a homogeneous group; a pension fund, for instance, may have a longer term perspective and subsequently influences firm management in that direction. Hedgefunds have a different investment and return horizon. By their very nature they are required to give high returns in a relatively short time period. This can create a conflict of interest with regards to the strategy and horizon between firm management and a disparate group of shareholders.

This makes the concept of value difficult to grasp for the management of firms, as they have to deal with a heterogeneous group of investors with different time horizons. This destroys any homogeneous expectations of value and allows for arbitrage based on different views on time, value and strategy. The key word, really, is arbitrage: a key pricing component in the pricing of assets. By means of shareholder activism, buyouts, long-short strategies and others, hedgefunds and private equity improve market efficiency through re-pricing. Hedgefunds reprice through long-short strategies and private equity reprice via financial engineering and other management strategies. Technically hedgefunds can do the same by pressuring management. Either way, the end result is the same.

The power of shareholders in efficient, unconstrained capital markets is a key component in the arsenal of hedgefunds and private equity groups alike. Without transparency and various takeover and management defense mechanisms, shareholders would not be entitled to the influence they deserve as owners of a firm. Yet for years many firms in the Netherlands enjoyed the benefit of various defense constructions against hostile takeovers. This in the end suppressed the value of firms so notably that the phenomenon became known as the Dutch discount.

What empowers private equity and hedgefunds even more is the world of cheap capital that we live in. Low interest rates and low spreads on many forms of debt (excluding subprime market) is stocking the weapons arsenal of hedge funds and private equity alike. The bitter reality of this low interest world in which we live in consequentially empowers the lashes of capital and market efficiency through the empowerment of hedge funds and private equity. In terms of the functioning of markets, I would argue that it is a good thing.

Unfortunately, hedge funds and private equity do not spend much time on press relations, and whenever there is talk of hedge fund activity or private equity, it is equated with some evil power bent on selling off assets and mass firings. The truth is that if management of firms under question such as ABN-Amro had performed more adequately, the scenario we are seeing today would have been less likely. In the end the question is often whether a company is worth more as a whole than the sum of its parts. If the sum of its parts is more valuable than the whole, then management must have failed its shareholders in creating significant value.

Furthermore, management could be accused of empire building and not shedding assets that would be to the benefit of its shareholders. Management has the same tools available as private equity; the difference is the perspective on value. The time window for performance delivery has also narrowed in recent decades, in part due to increased accounting transparency that enables more financial performance benchmarking. This, in tandem with increased integration with global markets, has helped to create enormous "peer" pressure to perform.

This should by no means induce us to feel sorry for management, as performance is more than handsomely rewarded. It is the common employee of the firm who stands to lose the most in this hyper-competitive world. Employees bear the burden of under-performance and often gain, relatively speaking, little when performance is good. Except perhaps for the continuation of job security and perhaps performance. This is not a picture that top management would adhere to. It is a bitter reality. I can imagine ABN-Amro employees being more than a little disgruntled if the management leaves with a nice big bonus due to a hostile take over and all they are left with is uncertainty. ABN is in that regard comparable to the titanic: the only rescue vessels available are for the captain, the shareholders and a select group of officers. The bulk of the crew are left behind in an ocean of uncertainty. This is not entirely fair, as a good captain should go down with his ship, instead of being rewarded for steering the ship into an ocean of icebergs.

#56 Peer to Peer Finance: Threat or Opportunity?

Micro finance - associated with financial empowerment in developing countries - is making a commercial comeback in the developed world. This time in the form of peer to beer banking, albeit without banks as intermediaries. Peer to peer banking uses the Internet as a virtual marketplace where lenders meet borrowers. Taking out the bank as the middle man creates both a more personal and a more competitive business model.

Taking out large, powerful and influential institutions such as a banks may seem an unconventional move at first. There is a valuable logic behind the idea, however. Proof of its success lies in the growing popularity of peer to peer financing enterprises such as Prosper.com, the British Zopa and the Dutch Boober. With relative success, they have proven that their "bankless" model has merits capable of attracting a growing community of borrowers and would-be debt speculators.

Peer to Peer financing groups attain their strength by working together with credit rating and credit collection agencies, much in the same way that traditional banks do. Would-be borrowers are registered and receive a credit score, based upon which they get a rating. This is similar to the world of corporate and institutional borrowing and lending, where the credit scores of firms and institutions are rated by agencies such as Moodies and Standard & Poor. This rating, in the same way as in the corporate world rating, gives insight to the level of risk that a loan bears.

It is important to note that, even though peer to peer financing at first glance appears rather informal, the lending contracts are in fact legally binding contracts. This means that borrowers pay by direct debit and, when borrowers miss payments, the same recovery/collection process that banks rely on are used to recover the face value of the loan.

From the perspective of a lender, the most attractive and interesting aspect of peer to peer financing is that it allows lenders to take small positions in a large number of different loans. This allows lenders to diversify risk by spreading a lending position among a large group of borrowers, while at the same time earning competitive returns.

There is a dark side to peer to peer financing, however. For the most part peer to peer financing is a by product of the consumer debt era in which we live. Credit card debt is one of the largest contributors to the disease that American consumer debt has become. Nearly 2.5 million Americans are currently in debt counseling, creating a large demand for consumer credit. Much of this demand is fueled by out of control credit card debt. Americans often own multiple credit cards and in many cases use one credit card to pay off another, creating a downward spiral of debt.

Credit card companies take advantage of the situation and earn considerable returns on high interest rate credit card debt. It is no surprise therefore that most loan or consolidation requests are instrumental in paying off expensive and out of control credit card debt. The sheer amount of refinancing actually underscores the true scope of of the cancer that has become credit card debt in America.

When investigating some of the Peer to Peer financing companies, one also sees that the level of riskiness is by no means uniform either. When correcting for U.S. and European interests rates, the American Prosper.com has much higher interest rates than the Dutch Boober.nl, suggesting that Peer to Peer financing does come with considerable risk, comparatively speaking.

For EU or other non U.S. citizens this means that the personal debt market is out of bounds, both in terms of the supply and demand of credit. This is a pity, as it is quite lucrative for European suppliers of credit to invest in American investment grade loans. For similar levels of risk, Europeans earn much lower returns.

In any case Peer to Peer finance is still very much in its infancy. The American Prosper.com, one of the largest Peer to Peer finance groups, claims to have more than 240.000 members and 49 million in loans. This would result in about 204 dollars worth of loans per member. Based on the 240.000 member base, that still amounts to a relatively low amount of loans spread among members. Nonetheless, the promise off Peer to Peer finance is one to be followed with close attention. Traditional banks would be wise to analyze what the development of Peer to Peer finance products means for their business models: is it a threat or an opportunity.

#49 The Social Science of Economics Part 2

Be sure to read The Social Science of Economics Part 1 first!

Entering the twilight zone…

In part one I hinted at the idea of computers and complex quantitative models taking over from humans as active market makers. We are definitely going to see rapid further growth of quantitative financial modeling, computer run portfolios and computer market management based systems. Before you feel completely obsolete, however, keep in mind that there are still a number of factors involved that should, at least for a while, guarantee jobs for those beings with emotions and mortality.

There remain limiting factors to quantitative perfections, as computers and models require data. And there are many different types of data, such as trading volumes, stock prices, volatility, interest rates, Gross Domestic Product, consumer spending, job growth, inflation, etc. The problem with data is that some of it may not be a true reflection of the economy. Think again about our definition of the economy as a common denominator of human interaction.

Traditional economic approaches fail to capture the true scale and complexity of the global economy and therefore so do our data. In fact, there is a shadow economy, be it a twilight zone, completely untouched by the bias of our standard quantitative approaches to economics. For example, to what extent does GDP truly reflect the sum of economic behavior of a country? GDP only contains that what we measure and unfortunately (or fortunately depending on your profession) not everything is measured. Why not? Because the real world contains aspects that cannot be measured. In development economics this is partly captured by the notion of the "informal economy." The informal economy contains activity that is neither taxed nor monitored by a government and is subsequently not included in that government's Gross National Product.

The informal economy can encompasses everything from money laundering, drug trade, prostitution and bartering of goods and services, to mowing the lawn for grandpa, writing a blog and downloading or uploading content from the internet. With that in mind, the informal economy probably says much more about human behavior than does the formal economy. Although the informal economy is notoriously unquantifiable, it is probably a grossly understated element driving GDP.

Coming back to the idea that economics is a social science: exchange does not have to be monetary. In fact, most exchanges between people do not directly involve money. Inherently it means that value is actually arbitrary and, analogously, the value of money is arbitrary as well. Just as purchasing power parity can explain why an American middle class salary lets you live like a king in Vietnam, the arbitrary value of money explains how people value an X amount of money irrespective of the differences in their environment.

So now the twilight zone is complete: there is a world with arbitrary value, one where there are different modes of transaction – monetary and non-monetary. Monetary exchanges include informal monetary transactions (think about prostitution, micro finance (e.g. mini loans, transactions within families or farm cooperatives) and mafia practices). In terms of non-monetary alternative exchange based transactions, think of media exchange on the internet, bartering goods and services, etc. This twilight zone should encompass economics. But it doesn’t, because it presents a nightmare scenario of elements that are by their nature difficult to quantify and analyze in a traditional economic sense.

A common thread and constant within this twilight zone is human behavioral aspects. This is not saying that human behavior is constant (in fact it is probably highly variable and scenario driven), but it saying that, although the basis of exchange and circumstances is variable, there is perhaps a common thread (keeping in mind bounded rationality) that can accurately describe human economic behavior more accurately than traditional restricted economic models. So conclusively, if we accept that economics is a social, behavioral science, it needs to extend the breadth of analysis by drawing from disciplines it criticizes as soft or irrelevant. Finally, if we are to use economics to accurately model the aggregate of human behavior and exchange, it is imperative that we explore closer integration with fields such as behavioral finance, psychology and, in the future, neuroeconomics.

#48 The Social Science of Economics Part 1

When you think of economics, traditional concepts such as of supply demand, interest rates, inflation and GDP all come to mind. These are relatively abstract notions that do not seem very important on a gloomy, cold and rainy morning in March. Nor do they provide a natural gust of excitement in your body the way tabloid pop culture news might. Arguably, the problem with economics is that we have lost sight of what it really is: A common denominator of human interaction.

You might say that my definition appears far removed from economics. Well, the opposite is actually true. It's nothing more than common sense re-rationalized. Economics is really about human interaction; more specifically about exchange and the conditions of exchange. Human interaction, be it on a micro or macro level, is really a behavioral science. So, in fact, when we are studying markets we are really studying aggregate psychological behavior: the sum of all interactions.

Currently mathematics is used to study economics and finance by constraining the "human" elements prevalent in the exchange. Common assumptions such as “risk neutral”, “risk averse”, “homogenous expectations” and “rational actors” are all foundations upon which many economic and financial models are based. To give credit where credit is due, it has to be said that by constraining human behavior, we are able to examine how perfect markets would work and this has contributed greatly to our understanding of economics and financial markets.

However, humans are far more than merely rational, utility maximizing robots. We have feelings, emotions, memories, a conscience, and are often absorbed by greed. So, in fact, human rationality is a biased rationality, if not a flawed rationality. Human rationality is different from the machine-like rationality upon which clever mathematicians and econometrists build their assumptions models. This begs the question of what this means for markets?

Behavioral finance is a relatively new field that draws on heuristics, cognitive biases and bounded rationality. The basic premise is that behavioral biases play an important role in markets. Even more interesting is the study of neuroeconomics, which studies how the brain makes choices in combination with psychology, economics and neuroscience.

Imagine modeling the neuroeconomic behavior of macro market movers such as hedge fund managers. A computer model with A.I. (artificial intelligence) capabilities would be able to predict and model the market scenarios and move against them accordingly. Since economics as a social science destroys the concept of ‘perfectly perfect’ markets anyways, the neuroeconomic models could create tremendous arbitrage opportunities. There are some limitations that lie at the core of not only this idea, but general economic modeling that need to be considered first.

Read The Social Science of Economics Part 2 as we enter the twilight zone of economics!

#41 Making Money From Hot Air

Ever since the implementation of phase one of the Kyoto Protocol, the right to release CO2 into the air has become commodified. In Europe alone, there were 24 billion dollars worth of CO2 deals; indicating a booming trend.

Traditional banks and brokerages have been relatively quick to follow suit, albeit with mixed success. For one, the dynamics of the CO2 market are not as straightforward as they are in other markets. CO2 prices have been volatile, arguably for the reason that these markets are not by definition efficient and mature. One major factor in CO2 pricing is weather; when the cold sets in, energy consumption goes up, and with it the need for emission rights.

The mild winter resulted in lower energy consumption, which in turn resulted in both lower energy and CO2 emission prices. CO2 prices are actually fairly correlated to a basket of fuel indexes such as Coal, Oil, Gas, etc. The relationship between coal consumption and CO2 is one of the strongest, as it produces the most CO2, thus requiring more emission rights. With Kyoto in place, there is finally a financial incentive to move towards reducing CO2 emissions. Furthermore, with CO2 pricing, there is a benchmark that can be used to calculate returns on investing in alternatives that reduce the overall CO2 emissions exposure.

There remain some issues to be worked out; notably the pricing of emission contracts remains a tricky endeavor. Part of the problem lies in the fact that the CO2 trading platform remains a young market in its adolescence, meaning there remain considerable arbitrage opportunities. Academically and professionally there is no real simple uniform pricing model for CO2 emission in the way that the financial world has embraced the Black & Scholes option pricing model or the Capital Asset Pricing Model.

Other factors bringing uncertainty to the whole affair (excluding energy dynamics) are the different political organs and processes that determine the emission ceilings of different countries. When emission ceilings move arbitrarily - for the most part downward - this creates much volatility in the market. With CO2 allowances set to tighten in Europe as we move towards phase 2 of the Kyoto Protocol, it is expected that prices are set to rise once again. Looking at the future, there is definitively money to made from hot air and, in doing so, arguably stemming global warming.

Kyoto opponents, for whatever reason or motivation, may laugh at the whole "pseudo" CO2 market phenomenon. Nevertheless, its significance (aside from scientific debate on global warming) can by no means be ignored. Non-Kyoto signatory countries are going to face significant pressure in the near future. French President Chirac was already bold enough to suggest putting an import tax on countries that have not signed Kyoto. This sends a clear message to the U.S., Australia and China, who, even without signing and accepting environmental responsibility, will face a steep price to pay for their environmental desecration.

#19 Technology, Demographics and Lay Trading

After the boom and bust around the turn of the century, it seemed that small discount brokerages would be hard pressed to survive. Many professionals and amateurs alike got burned as the markets retreated after 9/11 and the bursting of the tech bubble. In recent years we are witnessing a clear uptrend in the use and popularity of discount brokerages. "Amateur" investors are once again rushing to the market place and there is some hefty wooing going on to attract those flushed with enough cash.

We are now witness to the rise of a new kind of investor. This new kind of investor is an active trader that has become known as a "day trader." These are mainly amateurs and semi-professionals who play the short term markets in various ways, be it by trading in commodities, currency markets, using leveraged products, futures or options. Often it is a retired professional with some knowledge of financial markets. Then there are also the "early" retirees (late 40's, early 50's) who are using day trading to supplement their income and financially secure their retirement. The new day trader community is a mixed bag of complete amateurs, gamblers and semi-professionals alike.

The recent upswing in US and Global markets has provided ample money making opportunities for this group of day traders, which has lead to an increasing number of amateurs joining their ranks. By sheer word of mouth, the success of Joe the neighbor, who sits at home making "easy" bucks, is a fairy tale concept that is capturing the imagination of many. We could coin a new term for this growing class, namely "lay traders." This is a play on the words "layman" and "trader," put together in the same way that the term "day trader" is. Lay traders are amateur traders who try their luck on short term market fluctuations.

It is true that even aspiring lay traders can make money in bullish markets. But what will happen to these traders when markets turn bearish? The democratization of trading is not going to be a blessing for everyone. In fact, there is a significant risk that these new lay traders could overexpose themselves to risks that their financial situation does not allow for. The smell of easy money is one that has the potential to blind even the most experienced and confident investors. The end of the tech bubble has shown the devastating effect that declining markets can have on traders. Significant financial damage was caused to countless traders who lost their entire savings, sometimes in a matter of months. The threat of losing all they own is a serious reality for today's bullish day traders.

Technology has been a critical aspect with respect to providing near professional real-time trading tools for the aspiring lay trader. The technology transfer from the professional market makers to the amateur trader has the same potential as what blogging offers traditional media. The paradigm in creation has the potential to create a small hurricane in the traditional brokerage and trading community.

However, discount brokerages always expand in boom times, only to sound a hasty retreat when markets go down. The same could very well happen to the growing "lay trading" community. On the other hand, when the market goes down, only the most able and skilled traders will remain, weeding out the amateurs and speculators blinded by easy money. Perhaps this is nothing more than a healthy, Darwinist example of "survival of the fittest." Either way, "laytraders" are here to stay, driven in part by demography, technology as well as a human hunger for more than it can safely devour.

#17 A Spoonful of Sugar Makes the Medicine Go Down

"A Spoonful of Sugar Makes the Medicine Go Down." If Mary Poppins were an economist, this is what she would be saying to the American Economy. She would also have said "do not be fooled by the temporary upswing of the dollar (rebounding back to 1.30 this Friday)." Unfortunately, even fundamentals such as employment cannot change the direction in which the American economy is heading in the long run. The spoonful of sugar is in fact the cheap money supply, which after moderate tightening is still plentiful to sustain investments that reap positive effects to American labor statistics.

Investors were desperate for good news and the results came as a mild surprise. It is even rumored that the fed may not decrease its short term rates. Is this a reason for celebration? No. The market often overreacts to both gloom and positive news. Investors have been warned of a forthcoming recession for many months. The signal by the economic weatherman is hardly a prediction of blue skies for the coming time period. The minute cheap oil is hampered by a cold surge or other disruptions from the world's incurable hot spots; the short honeymoon is surely to end with a migraine.

As economists, we are often trained to treat investor reactions to news with a certain degree of reservation if not pessimism. Economists like to focus on the analysis of indicators such as housing, trade imbalances, GDP, fiscal strength, growth et al. And economists are quite aware of the temporary emotional fickleness of investors who think that a patch of blue sky spells out summer.

I, however, am not afraid to stick out my neck and say that even though the forecasted rain is somewhat postponed, it is definitely not the time to plan a picnic just yet. Furthermore, your best investment right now is an umbrella such that your tasty dollar assets do not get watered down by the rain. The temporary rebound may be the perfect opportunity you need to strategically relocate that picnic basket of yours.

And yes, a spoonful of sugar does make the medicine go down.

#12 About Dollars, Euros and Uncertain Times

With the Dollar at yet another unprecedented low (1.32 Dollars to the Euro on January 2nd, 2006), we are living in uncertain times. This uncertainty is not necessarily a bad development and for economists it is a very interesting time indeed. For one, we are going back to more fundamental aspects of monetary policy, economic strength et al.

It is very possible that we are witnessing the end of an era known as the dollar era. As the American economy stutters, the rest of the world is feeling the pinch. And this pinch is fueling a growing demand for Euros and Euro based assets and derivatives.

The Dollar originates from the German coin the Thaler, or, according to the Dutch, the Daalder. While the US Dollar has a European heritage, it soon became hegemony when in the post-war world the American Economy blossomed, bloomed and spread over the world. In international trade the Dollar had become the main standard of trade across the world. Practically all commodities are today still traded based on dollars. This means that as people trade on the global market, a Dollar surplus or deficit is created based on trade. This dollar is then, if desired, traded back into a local currency or asset. However, when the basic exchange metric (the Dollar in this case) starts to rapidly depreciate, so does that what you are exchanging if the underlying goods do not equally appreciate.

In these circumstances a lot of activity and volatility quite naturally occur in the exchange and commodity markets. Furthermore, it creates a large demand for hedging for those firms, enterprises or countries with considerable exposure. This hedging activity explains the rise of Euro or Gold assets vis a vis the Dollar.

In the future we must consider several scenarios which include a possible change in the Dollar as the exchange metric. This would be very bad news for America and Dollar based economies, as the change could worsen the anticipated American Economic downturn, which in today’s global economy affects nearly everybody. US demand for foreign goods is set to decrease with further Dollar depreciation, which will also dampen global growth elsewhere.

American consumer markets are an essential motor for the global economy. China has long realized this and has been very willing to provide credit for American consumers. However, with so much excess foreign provided credit, the already “maxed” out credit card consumer is expected to dramatically cut consumption. The end of the American Dollar hegemony is going to be bitter pill not only for Americans but for all of us in the global economy.

As the economic axis begins to swing away from America towards a Eurasian (with the emphasis on Asian) powerhouse, we can expect a vastly different economic and political paradigm to unfold. Maybe it is not such a bad idea to learn Mandarin after all.