Understanding the Market

Charles Ponzi (actually Carlo Ponzi, from Lugo, Italy, in the province of Ravenna) was living in Boston in 1918 and looking for a way to make money.  Then he discovered an apparent arbitrage possibility.  He could buy an international postal reply coupon (an IRC) in Italy that allowed him to buy a US stamp for less than the price of the stamp in the US. (See Ponzi’s Scheme: The True Story of a Financial Legend for a good biography.)

The mechanics of the transaction were (1) to send money to Italy; (2) convert the money to Italian lire , a currency that had depreciated after the end of World War I; (3) purchase IRCs in Italy; (4) ship the IRCs to the US; (5) use the IRCs to obtain postage stamps; (6) sell the stamps for cash. According to this account by the author of the biography noted above,  sending $1 to Italy would generate $3.30 worth of stamps in Boston. Ponzi offered his friends the opportunity to earn a 50% return in 45 days.

By February 1920, Ponzi took in $5,000 and Ponzi quickly grew famous.  By July millions of dollars were coming in to Ponzi every week; a careful financial analyst noted that if Ponzi was actually doing what he said (buying IRCs) he would own roughly 5000 times the number of IRCs in circulation.  By November 1920 Ponzi had pleaded guilty to mail fraud and he spent much of the next 15 years in prison.

Ponzi’s secret was the continuing arrival of new investors.  It is not obvious that he ever actually bought an IRC, but if he attracted enough investors, he could pay off the initial investors.   Some people were foolish enough to leave their money with Ponzi (allowing him to “reinvest” their funds); others actually mortgaged thier homes in order to invest money with Ponzi.  Of course when Ponzi’s scheme was finally ended, there was not enough to pay off those who had given Ponzi their money, as he had sent some to earlier investors or spent it on an extravagant lifestyle.

As a footnote

, IRCs are still available today.  If you want someone to write back to you, you can enclose an IRC in your letter and they can use the IRC to obtain an international airmail stamp. See here for current US rules on IRCs and here for recent news of Italian IRCs.   The Italian post office does not heavily promote IRCs

, but according to the article cited, an IRC costs 1.29 Euros.  Unfortunately for current day arbitrageurs, a US international airmail stamp costs $0.94 today, and an IRC would cost over $1.70.  But if the Euro dropped sharply, to around $.70, and if the price of the Italian IRC remained the same, then it would once again be possible for someone to buy an IRC and get the stamp and then sell the stamp.

To earn the return that the author cited above calculated

, the Euro would have to drop to around $.22/Euro.  Starting with $1, you would get 4.5 Euro , buy 3.5 IRCs (at E1.29/IRC) and get three and a half 94 cent stamps worth $3.30.  But the Euro is well above $.22 (around $1.39 as I write today) so this transaction is not profitable.

But to make real money the Italian Posta would have to sell thousands of IRC and you would have to find someone to buy thousands of US international airmail stamps.

Current day Ponzi schemes have used other methods but the principal is similar.  Bernard Madoff apparently promised steady returns (10% with very little risk); instead of buying IRCs he allowed his clients to believe that he had special market expertise

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, possibly related to his large and apparently legitimate market making business.

The primary monetary policy tool of the Federal Reserve is the Federal Funds rate (see here for a description of the package of tools the Fed can use).  This article briefly describes the nature of monetary policy

, the idea of targetting a rate and how the Fed actually conducts open market operations (for a fairly technical article about what the Fed does, written by the Fed, see this pdf).

The Fed is supposed to do many jobs (see here) that it tries to accomplish by changing the amount of money in the economy.  In the short run, the more money that is in the system, the more economic activity; but over longer horizons , more money results in more inflation.  The Fed has two policy choices: they can choose to either target the quantity of money or its price. These are two ways of targeting the same goal, but the difference is the feedback link.  A brief example may illuminate the distinction:

One can compare the Fed’s problem to the problem of maintaining a reasonable weight.  Someone who wants to maintain a particular weight could target their weight or the number of calories they eat every day.  If you target your weight, you could weigh yourself every day and on days when your weight is too high you could eat less and on days when your weight is too low you would eat more.  If you target calories , you would set a daily level of calories that you consume and adjust the number or calories that you consume when you see your weight rising or falling.  The idea is that if you target weight, you change your calorie levels more often, while if you target your calories, you allow your weight to vary before changing the number of calories you consume.  In principle these two strategies should lead to identical outcomes, but in practice there may be situations where one strategy leads to less variation than the other.

The Fed has experimented with both methods and has found that using an interest rate target works better than using a money supply target.  So the Fed sets an interest rate and then sees what is happening; if the economy is growing too quickly, they raise rates and if the economy is growing too slowly they cut rates.

The specific rate they target is the Fed Funds rate

, “the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight” (see here for a recent history of Fed Funds rates).  Without getting into too much detail (and if you want more detail, see the pdf cited above) the Fed can buy and sell Treasury securities to add or withdraw reserves from the banking system.  The Fed does not buy Treasury securities at auction , but instead buys them from Treasury dealers, being careful not too own too much of any particular issue.

Fed Funds rates are not a fixed price and vary throughout the day (like the price of stocks or commodities) changing as traders buy and sell.  The range of Fed Funds rates is available here; the Fed decides on the size of their daily transaction by observing the market and estimating how much is necessary to keep the Fed Funds rate around the target rate set by the FOMC.  There is a reasonable amount of daily volatility in the Fed Funds rate; from the pdf article (table 5), the standard deviation was around .20% per day and the range between the high and low daily Fed Funds rate was over 100 basis points.  In recent days (late November and early December 2008 that I found here) the standard deviation and the range were similar.  So while the Fed targets a particular rate, most Fed Funds transactions are within 20 basis points either way, occasionally ranging to 50 or more basis points above or below the target.

The Fed will ask dealers for the price at which they are willing to buy or sell certain Treasury securities and then execute the transactions.  These transactions can be outright (permanently changing the Fed’s position) or temporary (unwinding after a certain number of days).  When the Fed executes a purchase, it writes a check to the dealer that is deposited creating more reserves in the financial system; when the Fed executes a sale, there are less reserves in the system. The effect on the economy depends on how the reserves are used.  When there are more deposits in a bank (after a Fed purchase of Treasuries), the bank has to decide what to do with the extra cash.  The bank can make more loans (expanding the economy) or the bank can allow the cash to sit in its account at the Fed.  During normal times, banks use these additional deposits but during crises banks may prefer to allow the money to sit in their accounts.

On December 16, 2008 the Fed announced a target for Fed Funds rates between 0 and 0.25% (see here); the Fed will add reserves to keep rates very low until the economy shows signs of recovery.  In the context of the weight target example above, the subject has lost much weight and is being offered a huge amount of calories every day.  If the patient is fundamentally healthy

, then weight should return to normal and the daily calorie allotment will be cut.  If not…

[Updated as of November 26 data; on December 1, 2008, the NBER announced that in December 2007 a recession started.  I will no longer update this article with but I will write more about the recession here.]

Many market analysts (e.g., Warren Buffett, Martin Feldstein and Alan Greenspan), have argued that the U.S. economy is in a recession. These pronouncements are relayed to the public without a clear definition of what a recession is and who actually determines whether the U.S. is in a recession. The common definition of two negative quarters of GDP growth is not correct, despite its widespread acceptance in the financial press.

This essay will explore the precise definition of a recession and provide a regularly updated view of the data that the committee that determines recessions will look at.

The NBER business cycle dating committee makes the official determination of when a recession starts (the peak of the previous economic cycle) and when one ends (the trough). On their site they write:

“The NBER does not define a recession in terms of two consecutive quarters of decline in real GDP. Rather

Additionally

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, a recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.”

The committee track four specific indicators:

(1) personal income less transfer payments, in real terms and (2) employment. In addition, we refer to two indicators with coverage primarily of manufacturing and goods: (3) industrial production and (4) the volume of sales of the manufacturing and wholesale-retail sectors adjusted for price changes.

The committee also looks “at monthly estimates of real GDP such as those prepared by Macroeconomic Advisers” but notes that “there is no fixed rule about which other measures contribute information to the process.”

Here are the most recent data for the four key series that the NBER follows:

Source: Department of Commerce, Bureau of Labor Statistics, Federal Reserve Board and author’s calculations; real personal income in billions of chained 2000 dollars, employment in thousands, and sales in billions of chained 2000 dollars.

__________________

Here are the same data expressed as a percentage of September 2007 values (some analysts have claimed that September 2007 represented a peak in the economy; in any event , values can be compared with January 2008 levels, claimed by others as a peak). The drop associated with the average of the last five recessions prior to 2001 is indicated at the bottom of the table in red.

Source: Department of Commerce , Bureau of Labor Statistics, Federal Reserve Board and author’s calculations; all data expressed as percentage of September 2007 values.

———————————-

Then NBER has described the typical recession:

A recession involves a substantial decline in output and employment. In the past 6 recessions

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, industrial production fell by an average of 4.6 percent and employment by 1.1 percent. The Bureau waits until the data show whether or not a decline is large enough to qualify as a recession before declaring that a turning point in the economy is a true peak marking the onset of a recession.

As noted above

, data as of October 2008 (industrial production and employment) are very close to recession levels and a recession is likely to be declared by the NBER in the next month or two.