High Finance in 'The Newsroom'

Near the end  of fifth episode in the second season of The Newsroom entitled "News Night with Will McAvoy" we are whisked into the world of high finance. Or consulting. With AIG? About macroeconomics? INT. UNIDENTIFIED MIDTOWN SKYSCRAPER - CONFERENCE ROOM- NIGHT

Consultants love Macbooks and Pilot G2s.

CONSULTANT 1: You're not making a rational expectations argument.

CONSULTANT 2: I am. Expectations insofar as they're informed by predictions are essentially--OK, look: if the the prediction in..

CONSULTANT 1: (interrupting) Alright you're making a rational expectations argument but you're not being rational.

CONSULTANT 3: There's no risk here. What're we talking about?

CONSULTANT 1: It's not pure frictionless arbitrage.

 To be sure, those are all words. Here's another version with other, equally meaningful words:

CONSULTANT 1: According to my model using Angus Maddison's data, we could expect a 47 basis point shift upward in our growth trajectory if...

CONSULTANT 2: (interrupting) Excuse me? Your model? You mean your two-column Excel spreadsheet right?

CONSULTANT 1: No--it has pivot tables, too. Trust me on this one. I tinkered with the assumptions for hours until the results made sense. Plus this time series goes back to 11 AD.

CONSULTANT 2: But what about  Knightian uncertainty?

CONSULTANT 1: But. (pause) This one goes back to 11.

CONSULTANT 2: You can't have frictionless arbitrage if prices are sticky!

CONSULTANT 3: What're we talking about? If my ten years in this business have taught me anything it's there's no risk here. Now let's leverage up and do this thing.

This dialogue would have also worked.

The Real Real, Pounds and Pounds

This past week's This American Life podcast is called "The Invention of Money," tackling what host Ira Glass calls the "stoner-ish question" of what money is.

In the prologue, the discussion revolves around the confusion a reporter feels when during the peak of the financial crisis in 2008 he heard news reports of billions and trillions of dollars disappearing from the stock market. How could money just disappear, he wonders; where did it all go? His answer, which he receives from a businesswoman aunt, is that the money never existed because money is "fiction." Cue soundtrack from The Social Network.

The podcast proceeds from this conclusion, and while the episode is entertaining the content fell short for me as a result. The main mistake is to think of money in terms of a) only coins and bills, and b) only as a medium of exchange. The reason billions of dollars can disappear from the stock market is not because the physical currency was "fictional" but because money in this case is serving as a measurement of value (the economics term is the not-so-descriptive unit of account). And value, like beauty, is measured subjectively. If I intended to buy 5 pounds of potatoes but only went home with 3 pounds because the grocer's scale was off, it's fair to say 2 pounds of my potatoes have become fiction. If I go home with £5 of potatoes today and discover that I can only sell them for £3 tomorrow, however,  the two pound difference is reality.

In Act One, the fiction line is cast to Brazil, where its currency switch in 1994 to the real is framed as grand scheme that successfully duped the people into thinking the new money had value. This misses the real magic, which is something more akin to the food fight scene in Hook:

The real had value not because folks believed in a lie, but because they trusted the government and each other that the new currency could be used to exchange for things they wanted. When the people acted as though the bills and coins were money, they became so; the real became real.

Act Two, which is my favorite segment of the bunch (and not just because of the title), does a good job of explaining the Federal Reserve vis-à-vis the financial crisis. I especially liked how they avoided the typical journalist mistake by explaining that the Fed works with the money supply, and not interest rates directly. My quibble here is that they give listeners the impression that only a central bank can create money,  when in fact any bank in the world that loans out some of its deposits (i.e. fractional reserve banking) is doing the same thing, just on a smaller scale.

For the non-pedantic non-economists among you who nonetheless find interest in the inscrutable nature of money, do give it a listen. You may also enjoy revisiting this short but content-packed interview with Niall Ferguson on the Colbert Report from a couple of years ago.

A Growing Problem

In times troglodytic, folks had to barter to get what they wanted. This form of economy was more efficient than doing it all yourself, but it was still considerably constrained by the coincidence of wants. That problem was solved by using money as a medium of exchange, which made transactions far more efficient by freeing them from the need to match up wants. Money also loosed exchange from the bonds of time: those with extra money today lend to those with too little, with interest as the compensation until the principal is repaid. This last component came to mind often in several meetings I attended last week. Rwandan coffee output is lower this season partly because growers are having difficulty securing loans. The growers incur large costs at the start of the season, but can only afford to pay the costs at the end of the season when they've sold their harvest. Bridge financing would solve this mismatch between expense and revenue, but because the exchange in this case must be limited in time, the coffee grows unsold.

Walker, Texas Banker

Today Felix Salmon highlighted some Chuck Norris facts pertaining to his experience in banking:

# Little-known Chuck Norris Fact: Chuck Norris does not mark to market. The market marks to Chuck.

# More: Chuck Norris does not go bankrupt. Chuck Norris ruptures banks.

# Source of hedge fund survivorship bias?: Funds that pay Chuck Norris 2 and 20 survive; others don’t.

# Private equity: Chuck Norris does not believe in leverage. Chuck Norris believes in crowbars.

# Investment banking: No-one defers Chuck Norris’s compensation.

# Capital structure: No-one subordinates Chuck Norris. All his equity is preferred.

# If Chuck Norris devised the bank stress tests, not even the Treasury Department would survive.

Felix then invited readers to submit their own in the comments, so I gave it a shot and came up with these:

  • Chuck Norris’ tears would solve all the banks’ liquidity problems. Too bad he’s never cried. Ever.
  • Chuck Norris is too big to fail.
  • Some think deposit insurance is what prevents a run on the bank. It’s not–it’s the fear that Chuck Norris is lurking in the vault.
  • Basel rules stipulate that if Chuck Norris is within 100 feet of a bank, he can be counted as Tier 1 capital.
  • The risk-free rate is not computed using US treasuries, but the length of time it takes Chuck Norris to complete a roundhouse.
  • Chuck Norris doesn’t target interest rates, he pummels them into submission.
  • Whenever Chuck Norris visits a country, yields on that government's debt fall 150 basis points.
  • Only Chuck Norris can issue secured debt. The rest is at his mercy.
  • Beta is just a measure of Chuck Norris’ mood.

They are admittedly geeky, but they were funny enough to get a shout-out by Felix. My 15-minute joy was tempered, however, when a banking friend forwarded along this article from September 2007:

A famous series of jokes uses the actor Chuck Norris, martial artist and star of ``Walker, Texas Ranger,'' as a paragon of masculinity and omnipotence. ..

Similar thinking can be applied to the current state of financial markets. Here, then, is the world of money recast in Chuck Norris terms.

Chuck Norris doesn't target inflation. He roundhouse-kicks it until it begs for mercy.

(...)

The tears of Chuck Norris would supply enough liquidity to solve the credit crisis. Too bad he never cries.

I'm pretty sure I never saw this article before, so I plead innocent to plagiarism. The real sting comes from realizing that my humor wasn't quite as original as I thought it was. Of further humiliation is that the tears I'm crying now are good for nothing. *Sniff*.

Mental Exercises

After running about 25 miles a week for my last few months in Germany with only minor physical problems, my left knee gave up the ghost on just my second American jog in late July. Since then, and much to my consternation, I've only been jogging a few times and even then just for two or three miles before my knee began hurting and gave me grief for the rest of the day. Since jogging is not an option until my knee is rehabilitated, I decided to join a gym for my fitness jollies, but only got around to it today when I started a free week-long trial. At the end of the week, I must decide on a pricing plan, and am confronted with several options (Yes, the gym is pricey, but it's my only choice given my preferences):

Plan 1- A 12-month contract consisting of a single $99 program fee and a monthly payment of $59 Plan 2 - A 3-month contract consisting of a $225 payment ($75 per month) Plan 3 - Pay a month at a time for $85

Plan 1 can be immediately eliminated since I won't be in Columbia for another year. I will most likely be here for at least three months, however, so Plan 2 seems a good choice as it is $30 cheaper than Plan 3 (85*3=255). Problem solved?

No!

Though the calculation above is where most folks would stop, my finance professors would be insulted if I ignored the structure of the payment! A lump sum payment of, say, $100 today is only equivalent to 10 monthly payments of $10 in a world with no interest, and this is not the world in which we live; money has a time value.

Thus, I must reevaluate Plans 2 and 3. While Plan 2 is cheaper on a monthly basis, it requires me to pay out the money up front. Plan 3, on the other hand, affords me the ability to make smaller monthly payments, which in turn allows me to earn interest on the cash I would have already spent if I had opted for the lump sum. How much interest I expect to earn thus become the key to making a wise decision.

Assuming I could earn 5 percent annually (somewhat heroic, given current conditions), the sums would be as follows (I’m also assuming monthly compounding):

Plan 2 - Since I’m spending all the money up front, there’s no time component here; the plan will cost $225 Plan 3- 85 + 85/(1+(.05/12)² + 85/(1+(.05/12)³ = $ 253.25

Yikes. With a five percent annual rate, the interest I earn on Plan 3 would only defray $1.75 of the cost. Under these circumstances, Plan 2 remains the best bet.

An interesting question remains: How much interest would I have to earn to defray the extra cost of Plan 3? I’ll spare you the calculation, and simply tell you the answer is about 97 percent, or 8 percent per month. If I could earn that rate, the interest earned would defray exactly the extra costs of Plan 3, and I’d be indifferent between it and Plan 2.

Of course, if I were earning a 97 percent annual return, I probably wouldn’t be poring over the minutiae of gym membership plans.