Thursday, April 18, 2013

The Lion Kings

By Robert H.

Matt Yglesias has really pioneered doing cutting edge policy analysis on Westeros, but I think his latest posts have been way too skeptical about house Lannister's power base.  The argument, in short, is that the main Lannister assets are gold and people owing them money.  House Tyrell, on the other hand, is rich in fertile land.  Fertile land feeds people and armies; unleashing stores of gold just inflates the money supply, so House Tyrell for the win.

It's an interesting argument, but far too modern.  He even uses an early modern example -- The Hapsburgs -- when he should be thinking along medieval or classical lines.  In the world before 1453, the race was not always to the swift, nor political power to the highest NGDP.  Some reasons House Lannister has real power and a real chance to win the throne:


1. Medieval and Classical armies foraged.  Caesar, a logistical genius, sent his legates *ahead* of the army to negotiate grain supplies, he didn't amass grain *behind* the army and ship it to the front (with rare exceptions).  Shipping food to armies is just too hard with medieval or classical technology (especially organisational technology).  So in that context being relatively rich in fertile land is sort of bad -- it makes it easier to fight on your land, where the foraging is good, and harder to fight on the other guy's land, where the foraging is bad.

2.  It is easier to defend gold than grain.  Build a big castle on a big rock, station a big army there, and put the gold under it.  Defended!  Grain wealth, on the other hand, is tied up in diffuse, hard to defend fields. You can store some of it but

3. Medieval crop yields were not the best.  Much of your grain has to be reinvested in planting the next year's harvest or in feeding the peasants.  Which makes being a super populous region a mixed blessing: more people to enlist, but also more people to feed.

4. And can you enlist them?  For one thing, if you march your people away to fight they can't plant or harvest the next crop and you starve.  This is one of the reasons nomadic societies (or people who can afford to pay nomadic societies) were often so much better at conquering.  For another, Westeros seems to have a pretty primitive sort of feudalism in which lords call on vassals to produce troops in times of war.  The actual power of House Tyrell to mobilize its people hinges on convincing dozens of minor lords to honor feudal obligations to the house.  But the Lannisters can make competing offers to get them to change sides -- possibly even with some moral force behind them, if the Lannisters occupy the iron throne.  So who do people choose?  This gets us to point five:

5. Medieval and classical societies often didn't have super-strong institutions, meaning that PEOPLE mattered a lot more.  Like, individual dudes.  King Richard is king and everything in England is relatively fine.  Then John is king and French armies are marching all over English soil and barons are revolting and magna carta and the Pope now owns England and it is a mess.  Then Henry III is king and everything goes back to being fine again (for a bit).  The lannisters being rich helps them in the person power dimension along several fronts:

A. "A lannister always pays his debts."  Their gold has let them make and keep an enormous number of contracts, building a universal reputation for keeping their end of bargains.  In contrast, their money lending and easy attitude towards debtors has ensured that countless houses have publicly made and *failed* to keep contracts them.  In other words, the Lannisters have the most important thing you can have in an anarchic environment where you can't count on good institutions to make people abide by a contract: you can trust them to keep a deal.  Even better, they've worked hard to make sure you can't trust anyone else.

B. Their wealth is liquid.  In an anarchic free-for-all war, the guy who can pay you gold *now* is a lot nicer to work with than the guy who can promise to pay you grain *later*, when it gets here/is grown.  Later the promissor may be dead or change his mind.   And while, sure, paying everyone in gold can lead to inflation, that will take a bit of time to become apparent.  In the meantime, you are negotiating with medieval sell-swords and minor lords firmly enchanted by that most powerful of spells, the money illusion.

C. Gold is much more practical for making ransom payments.  Combat in Westeros often involves poorer houses taking richer lords hostage.  The minor lord then has a choice -- will they execute the prisoner, ransom him back to his house, hand him over to their liege  what?  Ransoming a Lannister is easy and attractive: you hand him over, you get gold gold.  Not so much with ransoming a Tyrell: moving vast sums of wheat in exchange for a body would be a much more complicated transaction (and harder to hide from your lord).  Indeed, Lannisters throughout the books are often eager to get captured and confident of the likely outcome (though equally often they are disappointed by their hosts lack of greed.   This is less for socioeconomic reasons and more for "having what the character expects to happen happen is boring" reasons).  People matter, keeping your best people alive and active matters, and having the gold to pay any ransom makes that happen.  Have I mentioned Richard I and John yet?

6. Think of all this in terms of Yglesias's own model for politics in the seven kingdoms: A. most of the time things are stable and everyone agrees on a king.  B. Occasionally the king loses legitimacy or there is a succession dispute and everything goes haywire.

Being able to store your wealth through the good times and quickly mobilize it in the bad times is key.  Being able to build a reputation that will make people trust you when society is falling apart is key.  Worrying about the long term inflation rate is not key.  It took the Hapsburgs decades to seriously disrupt Europe's prices, it only takes a few years to win the iron throne.  Especially when

7. In an anarchic war type environment, the demand for gold will skyrocket -- food is maybe more valuable, but durable and easy to hide wealth in the form of gold is more valuable than your home, your fields, your clothes, and all your other stuff with a "loot me" sign on it.  You'd gladly trade that loot-able wealth for hide-able gold.  Sure, if your city is actually being besieged food prices will skyrocket.  But everywhere, prices for things that aren't food will plummet as the market is flooded with sellers (people who looted wealth and people looking to sell wealth before it is looted).    The lannisters unleashing a river of gold in that environment might just counteract deflationary pressure and not be inflationary at all. 

Hear me roar!

8.  The Lannisters can sell the chance to slap Joffery.  That is more valuable than food, even to a starving man.

Warning: I am only about half way through the third book.  Some of this may be silly and wrong if I am missing key facts.

Thursday, April 11, 2013

Inflation Expectations in Japan

by Charlie Clarke

I have been frustrated with not being able to find economically interesting data on Japan, so I decided to fire up our Bloomberg terminal for the first time.  It was amazing!  Expect more data to come.

First, the five year Japanese breakeven rate:

Japan issues inflation indexed bonds, which means they pay real rates of returns.  If inflation goes up, you get more money.  They also issue regular nominal bonds that don't adjust for inflation.  If you take the five year nominal bond minus the five year inflation indexed bond, you get a market estimate of expected inflation.  Above is expected inflation over the last two years.

Looking at the graph, we see that inflation over the next five years is expected to be 1.43% right now.  Also, The expected inflation rate has risen quite a bit over the year.  In September of 2012, the Prime Minister Shinzo Abe was elected, the expected inflation rate has more than doubled since then.  The BOJ didn't do anything until last week, but markets are forward looking.

On announcement last Thursday, the BOJ said that they intended to move to two percent inflation within two years.  I wanted to see the time path of that change.  Currently, the inflation in Japan (last reported Febuary) was -.6%.  What is it expected to be over the next
year?  Let's look at the 1 year break even rate:

So over the next year inflation is expected to be .35%.  So the market is not optimistic that inflation will pick up right away, nor did the BOJ say they were targeting that.

What about over two years?

Over the next two years, the market expects inflation to be 1.34%.  So we can figure out the inflation expected next year with (.35 + I2)/2 = 1.34, which gives 2.33% [we could be more careful with geometric averages, but this will be very close with small inputs].

I'm struck by the rapid increase from .4% to 1.2% in the two year.  This is the market rapidly adjusting up its estimate of when inflation will rise.  The date March 19th is the date Kuroda took over the BOJ: "Haruhiko Kuroda took the helm at the Bank of Japan on March 19, vowing to do whatever necessary to break Japan's economy out of deflation and attain a 2 percent inflation target."

So, is Japan in a deflationary trap?  Or do they have exactly the 2% inflation within two years they decided they wanted?  The expected future path of inflation changed, before they even did anything.

*There are some risk premium issues in interpreting the breakeven rate as the market expectation for actual inflation, but it is a nice quick a dirty picture from the market.

P.S. - There is something interesting, in that if you compare the two year to the five year, you see that the five year is only 1.43%.  So, inflation between year two in year 5 is expected to be about 1.5%.  That is, it will be .35%, 2.3% then start falling average 1.5% those last 3 years.  If the BOJ is serious and the market starts learning that over time, the five and ten year breakeven rates should rates should rise.  Right now, the markets appear to be pricing in a substantial risk that the BOJ tightens eventually and misses their longer term target.

UPDATE:  A commenter a Scott Sumner's blog points out that the Japanese market for inflation protected bonds is small and relatively illiquid.  This is the "risk premium" problem I mentioned.  If there is a liquidity premium on these bonds then the expected inflation rate is smaller than we estimated.



So the inflation rate, may actually be understated by the Japanese inflation protected bond market.  On the other side of the coin, there may be an inflation risk premium.  Maybe investors may want to be compensated in real terms more, in high inflation states of the world.  That would push the other way.

More here.

Wednesday, April 10, 2013

Why I Wake Up and Google Japanese Bonds Every Morning

As an outward proponent of monetary expansion from central banks around the world, my eyes have been fixed on Japan.  I have pretty strong views on monetary policy, but I'm not sure I'm right.  At least, I want to be open to the idea that there are plenty of people smarter than me that disagree with me.  Well, last Thursday the Bank of Japan set out to do what new Prime Minister Shinzo Abe had been promising.  Raise the rate of inflation in Japan to 2% from zero.

This was promised in the campaign, but there were plenty of people that didn't think he was serious.  And the truth is we are still learning how committed they are.  They are committed to raising the inflation rate "to 2% within two years."

I talked my class through some basic monetary theory earlier in the year, and since none of them had been watching Japan.  I got them to walk me through what we talked about.

What should happen to stocks if the central banks commit to printing money, buying bonds and raising inflation?

They said, go up pretty quickly, which is pretty clear.  Even if you don't think it will raise growth, the inflation rate alone should make stocks rise.  [If growth is expected, future dividends will be higher and future discount rates lower, which will both increase stock prices.]

What should happen to the yen against other currencies?

They got that pretty fast.  It should be devalued.  It will weaken.  

What should happen to bonds?

Silence...  I said, this is good, because we gave too stories for the effect of the central bank on interest rates.  I talked them through the easier one.  The central bank has decided to buy a bunch of bonds, what should happen to bond prices?  "They should go up..."  If the price of a bond, goes up, what happens to the yield?  (this relationship is still tough for first year students, but some have it down)  "The yields are down..."  Good that's one story.  

Now the other story.  Remember what we said the components of an interest rate were, the real rate and the inflation premium.  What did I just tell you the BOJ had promised to do to inflation?  "Raise the inflation rate..."  So what has to happen to the required interest rate, which is also the yield?  "It goes up..."  But if the yield goes up, it means the price goes down. The BOJ can buy so many bonds, bond prices go down... At some level I always new this was true (or I used models in which it was true), but a series of Scott Sumner posts and the experience of teaching an intro finance course made me realize how nuts it is (in a good way).  Something both true and not obvious.

So I asked my class, we told two stories, what do you think has happened to Japanese bonds?  ....(Silence)   They've gone nuts!  Volatility has been insane and the futures market has been shut down twice due to volatility linked circuit breakers.  Though, on announcement they were down.  I also said, if the BOJ succeeds in raising the inflation rate, I think yields have to rise and the second story holds.

So every morning, I wake up and check Bloomberg or the BOJ website for  yields on Japanese bonds.  The day before the BOJ announcement, the yields were .56%.  The day of the announcement they fell to .44%.  The next day, yields rose to .53% the day after announcement (remember the BOJ was still buying a bunch of bonds and yet prices started falling!).  Today, they are at .58% and above the day before announcement.  

Let's say the real interest rate in Japan is 0%.  Then even if the real rate doesn't budge, if the BOJ is serious and can create inflation over time the 10 year should rise to 2%.  Now, its plausible the real rate is even negative.  The U.S. Inflation Adjusted bond yields -.6%, which would mean a rise to 1.4%.

Further, if I'm right and the BOJ does hit their target, employment should rise, the economy should grow and the real rate should rise (eventually)...  But I also respect that markets are pretty efficient, so there is some chance that the BOJ caves and contracts prematurely as they have in the past.

But for quite awhile, I will likely wake up and look for news about Japan...

Aggregated Posts by Sarah M.

By Sarah M.

It's been a while, but it's not you, blog, it's me. I've been seeing other blogs. I'm taking a double course load this quarter so my posts might become random, unpredictable outbursts for the next couple of months. Fortunately, one of my classes requires a blog/vlog project where you can find me talking about YouTube, and coming soon, talking into YouTube!

We'll have a group assignment video channel, details forthcoming, so I will be producing content this quarter. I'm happy to share, if anyone seriously wants to watch videos made for a class about making videos. You never know, they could be good. My classmates are creative people. Odds are against a military theme, but whatever we do, I'll share an occasional round-up here as well.

I've also taken a larger role with one of my official program blogs, Flip the Media, where we chat about the internet, apps, anything with a digital media takeaway.

That's about it for the update. I'm not ignoring you, blog. What we have is special. I'll be back soon.