Time Travel in the Minsky Moment

Time Travel in the Minsky Moment Bill Miller Legg Mason Capital Management

Source: CALVIN AND HOBBES © 1995 Watterson. Used by permission of UNIVERSAL PRESS SYNDICATE. All rights reserved.

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“There are decades where nothing happens; and there are weeks where decades happen.�

Vladimir Ilyich Lenin LMCM 3

Risk versus Uncertainty Risk- we don’t know the outcome, but we know what the underlying distribution looks like • incorporates the element of loss/harm

Uncertainty- we don’t know the outcome, and we don’t know what the underlying distribution looks like • need not incorporate loss/harm Source: Frank H. Knight, Risk, Uncertainty, and Profit(Boston: Houghton and Mifflin, 1921).

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First Financial Crisis 33 A.D. “The destruction of private wealth precipitated the fall of rank and reputation, till at last the emperor interposed his aid by distributing throughout the banks a hundred million sesterces, and allowing freedom to borrow without interest for three years, provided the borrower gave security to the State in land to double the amount. Credit was thus restored, and gradually private lenders were found.�

Tacitus, Annals Book 6 LMCM 5

“We have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the workings of which we do not understand.”

John Maynard Keynes, Essays In Persuasion “The Great Slump of 1930” LMCM 6

Irving Fisher’s Cross-Currents of a Depression (7) Mild Gloom and Shock to Confidence VII. (5) Decrease in Profits (8) Slightly Reduced Velocity of Circulation (5) Increase in Losses (1) Debt Liquidation (7) Increase in Pessimism II. (9) Money Interest on Safe Loans Falls (8) Slower Velocity (9) But Money Interest on Unsafe Loans Rises (1) More Liquidation III. (2) Distress Selling (6) Reduction in Volume of Stock Trading (7) More Gloom VIII. (6) Decrease in Construction (3) Fall in Security Prices (6) Reduction in Output (1) More Liquidation (6) Reduction in Trade (3) Fall in Commodity Prices (6) Unemployment IV. (9) Real Interest Rises; REAL DEBTS INCREASE (7) More Pessimism (7) More Pessimism and Distrust IX. (8) Hoarding (1) More Liquidation (8) Run on Banks (2) More Distressed Selling (8) Banks Curtailing Loans for Self(8) More Reduction in Velocity Protection V. (2) More Distress Selling (8) Banks Selling Investments (2) Contraction of Deposit Currency (8) Bank Failures (3) Further Dollar Enlargement (7) Distrust Grows VI. (4) Reduction in Net Worth (8) More Hoarding (4) Increase in Bankruptcies (1) More Liquidation (7) More Pessimism and Distrust (2) More Distress Selling (8) More Slowing in Velocity (3) Further Dollar Enlargement (1) More Liquidation I.

Source: Irving Fisher “Econometrica”, 1933 p. 343

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“Then we have the great paradox which, I submit, is the chief secret of most, if not all, great depressions: The more the debtors pay, the more they owe. The more the economic boat tips, the more it tends to tip. It is not tending to right itself, but is capsizing.�

Irving Fisher, The Debt-Deflation Theory of Great Depressions LMCM 8

What We Need is a Paradigm Shift in Economic Thinking

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The Old Paradigm • Classical Economics • Hydraulic Metaphor • Efficient Markets

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The New Paradigm • • • •

Complex Adaptive System Agent-based Modeling Emergent Properties Multidisciplinary Analysis

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From Physics to Econophysics Classical Mechanics

Classical Economics

Einstein and Relativity

Keynes/Minsky

Quantum Mechanics

Economy as an Evolving Complex System LMCM 13

“A door like this has cracked open five or six times since we got up on our hind legs. It's the best possible time of being alive, when almost everything you thought you knew is wrong.�

Tom Stoppard, Arcadia

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“The idea that austerity measures could trigger stagnation is incorrect.�

Jean-Claude Trichet, June 2010

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Dimon: “Has anyone bothered to study the cumulative effect of all these things? Do you have a fear, like I do, that when we look back, they will be a reason that it took so long that our banks, our credit, our businesses, and most importantly, job creation started going again?”

Bernanke: “I can’t pretend that anybody really has. . . . We don’t really have the quantitative tools to do that.”

June 2011

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The Leverage Cycle

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The Leverage Cycle

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“Countries differ in their economic success because of their different institutions, the rules influencing how the economy works, and the incentives that motivate people.�

Daron Acemoglu and James Robinson, Why Nations Fail March 2012

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Problems for Policy Makers • Fallacy of Composition • Ergodic Fallacy

http://www.columbiatribune.com/news/commentary/darkow

http://intoverflow.wordpress.com/2008/05/27/what-is-a-hidden-markov-model/

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Sustainability • The level of short term real rates maintained by the monetary authority • The real growth rate of the economy • The growth path of the real stock and debt incurred by the fiscal authority is determined by real fiscal deficits as a share of real GDP LMCM 23

“The question is not whether a bank has enough capital for the type of assets which it now holds and the risks which it now appears to face, but whether it has enough capital to enable it to assume the proper and reasonable risks of participating in the financing of business enterprise.�

FDIC, 1944 LMCM 24

“The facts of life do not penetrate to the sphere in which our beliefs are cherished; they did not engender those beliefs, and they are powerless to destroy them; they can inflict on them continual blows of contradiction and disproof without weakening them.�

Marcel Proust, Swann's Way LMCM 25

“To perceive the world differently, we must be willing to change our belief system, let the past slip away, expand our sense of now, and dissolve the fear in our minds.”

“New facts burst old rules; then newly divined conceptions bind old and new together into a reconciling law.”

William James, The Will to Believe LMCM 26

The Way Ahead What the Euro-Zone governments need to do: • Bring about greater fiscal integration through a common Treasury • Bank stabilization and/or recapitalization • Structural reform must continue • Programs to promote sustainable debt levels • Balance the imbalances LMCM 27

The Way Ahead What the ECB needs to do: • Lower the target rate to zero • Depreciate the Euro • Provide adequate liquidity

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A Market Based Approach

“Stock rally might be the best economic stimulus.”

Alan Greenspan, USA Today “I think we underestimate the impact of equity values on the level of economic activity.”

Alan Greenspan, Bloomberg

“Higher stock prices will boost consumer wealth and confidence, which can spur spending.”

Ben Bernanke, Washington Post “WSJ: What’s the first statistic you look at in the morning? Draghi: Stock markets.”

Mario Draghi, Wall Street Journal

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The Five Fold Way Out • • • • •

Economic growth Fiscal adjustment/Austerity Restructuring of default and debt Inflation Financial repression The Mix is Key LMCM 30

"When we think about the future of the world, we always have in mind its being at the place where it would be if it continued to move as we see it moving now. We do not realize that it moves not in a straight line‌ and that its direction changes constantly."

Ludwig Wittgenstein

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“The history of humanity is a progressive triumph of cooperation over conflict, driven by simultaneous genetic and cultural evolution.�

Mark Pagel, Wired for Culture: The Natural History of Human Cooperation LMCM 32

Sources for Photos: Slide 1- http://www.impactlab.net/2011/07/25/scientists-prove-time-travel-is-impossible/ Slide 2- CALVIN AND HOBBES Š 1995 Watterson. Used by permission of UNIVERSAL PRESS SYNDICATE. All rights reserved.

Slide 3- http://www.wallpapermaven.com/cat/people/Vladimir-Lenin-4.html Slide 4- http://www.wikiberal.org/wiki/Frank_Knight Slide 5- http://www.nndb.com/people/875/000087614/ Slide 6- http://questioningwithboldness.wordpress.com/2011/08/09/random-quote-of-the-day-john-maynard-keynes/ Slide 8- http://en.wikipedia.org/wiki/Irving_Fisher Slide 10- http://www3.dbu.edu/mitchell/kuhnpostscript.htm Slide 13- http://www.amazon.com/Economy-Evolving-Complex-System-Institute/dp/0201156857 Slide 14- http://woldcnews.com/30907/bernie-mccains-suggestology-the-origin-of-wealth/ Slide 15- http://www.financialcentresinternational.com/FCI500/Jean-Claude_Trichet Slide 16- http://www.time.com/time/specials/2007/article/0,28804,1733748_17 33758_1736192,00.html; http://kudlowsmoneypolitics.blogspot.com/2012/02/ bernanke-right-on-taxes.html Slide 17-http://www.traders.com/documentation/FEEDbk_docs/2009/04/Interview.htm Slide 18- http://www.zoo.ox.ac.uk/staff/academics/may_r.htm, http://www.princeton.edu/~slevin/, http://www.universityofcalifornia.edu/news/article/16978 Slide 19- http://news.yale.edu/2011/04/12/professors-probing-forces-make-economy-tick Slide 20- http://www.english.ucsb.edu/grad/student-pages/sdeng/Eng_105A/class3notes.html Slide 21- http://stochastictrend.blogspot.com/2011/11/dron-acemoglu-on-publishing.htmll; http://www.bbc.co.uk/programmes/b01cvp9d Slide 22- http://intoverflow.wordpress.com/2008/05/27/what-is-a-hidden-markov-model/; http://www.columbiatribune.com/news/commentary/darkow Slide 24- http://www.personalfinanceanalyst.com/fdic-you-go-me-worried/ Slide 25- http://en.wikipedia.org/wiki/Marcel_Proust Slide 26- http://www.nndb.com/people/569/000087308/ Slide 29- http://en.wikipedia.org/wiki/Alan_Greenspan; http://kudlowsmoneypolitics.blogspot.com/2012/02/bernanke-right-on-taxes.html; http://www.financialcentresinternational.com/FCI500/Mario_Draghi Slide 31- http://gunnarbjursell.blogspot.com/2011/04/ludwig-wittgenstein.html Slide 32- http://www.bathlitfest.org.uk/wiredforculture.aspx

The views expressed in this presentation reflect those of Legg Mason Capital Management (LMCM) as of the date of this presentation. These views are subject to change at any time based on market or other conditions, and LMCM disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for clients of LMCM are based on numerous factors, may not be relied upon as an indication of trading intent on behalf of the firm. The information provided in this presentation should not be considered a recommendation by LMCM or any of its affiliates to purchase or sell any security.

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