“The products are gaining traction because the buyers don’t have to mark them to market, thus avoiding the possibility of booking paper losses.”
Japan Regulator Planning Crackdown on $67 Billion of High-Yield Loans – Bloomberg
A great article from Bloomberg on the proliferation of an increasingly popular investment product that is being gobbled up by regional banks in Japan. The article is special, not so much in the unique innovation of this particular product, but due to its simple clarity as to why these sorts of investments proliferate. The above quote lays it out clearly. These are not economic or commercial decisions. These are regulatory and accounting driven determinations.
Just a couple more quotes pulled from the article, stated ever so matter-of-factly.
“Repackaged JGB loans lack economic rationality, at least in terms of costs and risk returns,” Yashiki said. “It’s difficult to get their fair value.”
“The products hold allure for regional lenders, many of which lack expertise and scale to pursue more diversified investment portfolios like those of the nation’s largest banks.”
We love this article, such a simple and clear representation of what we here refer to as “Rational Accounting Man”.
Readers will, no doubt, be familiar with the core of traditional (Sharpe World) economic models’ concept of “Rational Economic Man”, aka “Homo Economicus”. Rational Economic Man (REM) represents the sole universal agent operating in an economy/market. Rational Economic Man has complete and perfect access to all the information needed, and all the knowledge and tools necessary, to make (expected) utility maximizing decisions across all commercial and economic choices encountered. It is one of many key simplifications to make behavior predictable (and manipulatable) in economic analysis and policy making.
Rational Economic Man (REM) is the perfect foil to the simplified parameters of finance and economic models, our Sharpe World or Taleb’s “Mediocristan”. We’ve laid this out many times over. Gaussian/Normal distributions. Linearity. Ergodicity.
The failings of the consensus premise are most clearly encapsulated in Friedrich Hayek’s Nobel Prize Lecture, “The Pretence of Knowledge”, back in 1974. We have quoted from this speech many times over the years.
“And while in the physical sciences the investigator will be able to measure what, on the basis of a prima facie theory, he thinks important, in the social sciences often that is treated as important which happens to be accessible to measurement.” Friedrich Hayek, 1974.
https://www.nobelprize.org/prizes/economic-sciences/1974/hayek/lecture
We quoted our spiritual PhD thesis supervisor, Benoit Mandelbrot, back in our September 2021 Update – “The Challenge of Measurement” Convex Strategies | Risk Update: September 2021 – The Challenge of Measurement.
“The whole edifice hung together – provided you assume Bachelier and his latter-day disciples are correct. Variance and standard deviation are good proxies for risk, as Markowitz posited – provided the bell curve correctly describes how prices move. Sharpe’s beta and cost-of-capital estimates make sense – provided Markowitz is right and, in turn, Bachelier is right. And Black-Scholes is right – again, provided you assume the bell curve is relevant and that prices move continuously.” Benoit Mandelbrot, “The (Mis) Behavior of Markets”.
Also in that September 2021 note we linked to this wonderful paper from Federal Reserve Board economist Jeremy Rudd Why Do We Think That Inflation Expectations Matter for Inflation? (And Should We?) and highlighted this wonderful opening line:
“Mainstream economics is replete with ideas that ‘everyone knows’ to be true, but that are actually arrant nonsense.” Jeremy Rudd, 2021.
Meanwhile, central planners, in the form of central bankers and other like-minded policy makers, use these models to not just try to predict economic outcomes but, even more dangerously, to try to manipulate economic outcomes. They try to play God in their own fantasy metaverse of conjured rules and participants, fiddling with their scientistic models, ala the famed Dynamic Stochastic General Equilibrium model. Obviously, in the broader world of reality, we know that markets and economies behave like Complex Adaptive Systems (CAS), where the basic assumptions undergirding traditional economic and financial models simply do not exist. In reality, there is no such thing as Rational Economic Man, so what exactly are the policy makers trying to manipulate to guide things to the outcomes they desire?
The answer to that is our “Rational Accounting Man”. If markets and economies, and the agents participating in them, won’t behave like the models say they should, the solution became to create a subset of reality that would march to the beat of the central planners’ drum – Sharpe World in the form of regulated financial fiduciaries, aka Rational Accounting Man.
While the real world may not adhere to Normal distributions, linear outcomes, and single-period ensemble averages free from ergodic breaks, the regulated financial world does, because those are the risk and accounting rules imposed upon it. It is Sharpe World brought to life as a giant lab experiment with Rational Accounting Man as the willing subject. Remove skin-in-the-game, and with it the tacit knowledge that makes humans hard to predict/model, then provide the right incentives to encourage playing along with the rules you have constructed, and your problems are solved! Rational Accounting Man will behave as the models say he should.
Rational Accounting Man is how the world gets to circumstances such as $18.44 trillion of negatively yielding bonds. The answer to the oft asked question, “who would own negatively yielding bonds?”, is quite clearly Rational Accounting Man.
Figure 1: Notional of Global Debt Outstanding with a Negative Yield. 2012-2024. Peak Dec 2020 (red line)
Source: Bloomberg, Convex Strategies
Indeed, Rational Accounting Man is the implementation tool for the guidance (manipulation) of economies by policy makers, as well as the bane of their efforts in the creation of the sandpile-esque, endogenous, imbalances. The combination is the machine by which boom-bust cycles get generated.
We believe the appropriate designation of the true participants in economies and markets, those with skin-in-the-game, are as Boundedly Rational Agents (BRA). We laid out the “Rationality Wars” in our November 2024 Update Convex Strategies | Risk Update: November 2024 – “Rationality Wars”. Our Boundedly Rational Agents function in the realm of Simons and Gigerenzer, applying satisficing decision heuristics to navigate through the real-world challenges of imperfect information, non-linear and chaotic future possibilities, and time-averaging optimizations. They function innately, navigating with a tiller of Polanyi’s tacit knowledge. We put it this way back in November:
“There are things that we just don’t know, ie. uncertainty. Things with probabilities but that are unknown or unclear to us, ie ambiguity. Things that are so complex that we have neither the means nor the time to compute them, ie. intractability. This is the world of heuristics, tacit knowledge, skin-in-the-game.”
We have long challenged central bankers to shift their focus away from trying to be great shamans, able to foresee or even direct future economic outcomes, towards being risk managers, focused on avoiding the endogenous risk accumulations that lead to extreme outcomes. We emphasized this issue in one of our personal favourite notes, the July 2022 Update – “The Pointlessness of Forecasting”.
Convex Strategies | Risk Update: July 2022 – The Pointlessness of Forecasting.
In this note we quoted from Doyne Farmer, one of the pioneers in the world of Complexity Economics (the interchange of Chaos Theory and economics), from a pre-released chapter from his, then, not yet released book, “Making Sense of Chaos: A Better Economics for a Better World”.
“Chaos combines two essential properties. The first is called ‘sensitive dependence on initial conditions’, which means that, on average, nearby trajectories separate from each other at an exponential rate. The second is endogenous motion, meaning that even though there are no external shocks – the dynamical system is deterministic – it never settles down to rest.” Doyne Farmer.
Since we quoted Doyne back in 2022, his book has subsequently been released. It is a very accessible read to get your head around these concepts and the obvious criticisms of the static models of Sharpe World economics and finance. Doyne advocates building what are known as Agent Based Models (ABM) that build bottom-up computational worlds showing how endogenous risks and emergent properties arise in complex systems.
“…our work suggests that if we properly understood how households and firms really make decisions, we might find endogenous explanations for business cycles, and better understand and predict them…My hypothesis is that the deviations from rationality are important and shouldn’t be neglected…I believe that if we make more realistic models, in which households and firms are only boundedly rational, their planning errors will cause business cycles to emerge spontaneously.”
Doyne collaborated with another giant in the realm of Agent Based Models, Robert Axtell of George Mason University, for the comprehensive review on the topic: “Agent-Based Modeling in Economics and Finance: Past, Present, and Future” Robert Axtell and Doyne Farmer, 2022.
This a fantastic resource for those wanting to understand the concept and history of Agent Based Models. A number of the sections in this note reappear as chapters in Doyne’s book. In the introduction they make this so simple comment as to the benefits of Agent Based Models in that it “permits relaxation of assumptions commonly made in theoretical models for mathematical tractability, and so provides an alternative when realism is more important than conceptual simplicity.” (Highlights are ours).
Realism over simplicity. Good idea!
As a basic premise, traditional economic models base off an assumption of ‘equilibrium’. The economy is assumed to be in equilibrium until some exogenous shock comes along to knock it off course, only for it to eventually find its way back to equilibrium (often driven by some change from policy makers). In the concept of Complex Adaptive Systems and Complexity Economics, equilibrium itself is not a stable steady-state. It is an ever-evolving potential in the form of Ed Lorenz’ strange attractor of Butterfly Effect fame. The real economy is chasing, but never quite catching, the never-stable attractor. Never catching it and coming to rest, but never spiralling off into the unknown ether.
Figure 2: Butterfly Effect: Plot of Lorenz’ Strange Attractor
Source: Wikipedia
Axtell and Farmer note many of the giants in the areas of economic complexity.
“A further motivation for ABMs lies in their ability to match the economic process of a real economy. Real economies are decentralized in deep and important way (Hayek 1945, 1964), making information not just diffuse but also tacit (Polanyi, 1948).”
“Some have claimed that the quintessential example of emergence in economics is Adam Smith’s invisible hand, and the corresponding welfare theorems of general equilibrium (e.g.Durlauf, 2012)”
We are definitely onboard with the merits of ABMs. It allows for the creation of agents that reflect elements of real-world interactions and decision making, then allows those interactions to reflect evolving endogenous imbalances over multiple iterations of time. We think a useful ABM would be one that constructs our above two broad categories of market/economic agents: 1) Rational Accounting Man and 2) Boundedly Rational Agents.
How do these two distinct agents behave? How would we, as ABM modellers, program their respective actions?
We can show that with our own favourite visualization, our frequency vs magnitude overlay of a Normal/Gaussian distribution and a Shannon Entropy curve on top of an Association football pitch. We’ve shaded the area under the Entropy curve based upon the contribution to long-term Compounded Annual Growth Rate of the S&P500 Index by percentiles of monthly frequency.
Figure 3: Frequency vs Magnitude: Normal Distribution (black) and Shannon’s Entropy Curve (yellow)
Source: Convex Strategies, Bloomberg
In our ABM, Rational Accounting Man’s behavior would be programed to follow the Sharpe World tenets as imposed on regulated fiduciaries as implied by the black Normal/Gaussian distribution. The Boundedly Rational Agents would adhere to the tacit decision heuristics implied by the greater importance of magnitude to time-averaging paths implied by Shannon’s Entropy curve, focused on what matters the most, not what happens the most.
Rational Accounting Man is easy to program, just follow the existing simplicity of Efficient Market Hypothesis (EMH) and Modern Portfolio Theory. The behavior of the Boundedly Rational Agents is a fair bit more complicated. It needs to take into account decision heuristics of Simons and Gigerenzer. The less than intuitive mathematics behind Shannon’s Information Theory. The simple genius underlying Jensen’s Inequality. And the all-important premise behind time-averages, as compared to the more familiar ensemble averages, as best elucidated by Ole Peters of Ergodicity Economics fame.
Here is a short and clear video from Ole on the subject of Ergodicity, “Random multiplicative dynamics”, from 2021.
https://www.youtube.com/watch?v=CCLtQHL-VUs
“Every trajectory decays, if we wait long enough, and the average of all trajectories always wins, if we average over enough trajectories. Imagine an economy where income behaves in this way. GDP would grow but practically everyone’s income would decline.”
Sounds a lot like the imbalances, ala wealth segregation, that are key fragilities in today’s evolving critical state. Ole explaining in his way what our football pitch picture is telling us.
Our ABM built around the interactions of Rational Accounting Man, no skin-in-the-game levering up risk on the capital of other’s based on the imposed rules by the Sharpe World masters, interacting with Boundedly Rational Agents, self-preservation focused non-ergodic path optimizers, ought to create something that looks quite a lot like reality. Rational Accounting Man marching the path as laid out by the planners, playing the game of volatility as risk, driving the boom-bust cycles, stability begetting instability. Boundedly Rational Agents there to capture the extraordinary upside of unforeseen innovation, all the while hyper focused on avoiding the unrecoverable impact of the absorbing barrier of wipe-out. One creating the endogenous risk of extreme phase transitions, the other keeping the system from spinning off into endless space. Rational Accounting Man is levering fat-tailed risks (again, with other people’s capital) and avoiding thin-tailed risks. Boundedly Rational Agents are seeking out thin-tailed risks and hedging with fat-tailed risks (the path to compounded wealth).
We like to think that this sort of ABM could aid policy makers in avoiding the mistakes of undue risk buildups in economic systems. It isn’t a model to predict what will happen but, rather, a model of what should be avoided to prevent undue risks in the economy. It is a model that would tell them that allowing natural volatility builds resilience in a system. Suppressing volatility makes the system vulnerable.
Easy enough to find a live real-world example of a central bank heavily relying on the behavior of Rational Accounting Man in order to drive forth their policy ambitions. Bank of Japan (BOJ) provides a great example of this. The below chart gives stark clarity to the current situation. It is simply a grid with the Real Policy Rate on the X-axis and current measures of inflation (eg. CPI yoy% change) on the Y-axis.
Figure 4: Real Rate vs Inflation Rate. Japan (red) vs Other Developed Economies.
A sampling of some of the respective 10yr Government Bond yields looks like this.
Figure 5: 10yr Govt Bond Yields: Japan (red), Germany (white), US (papaya), UK (blue)
Source: Bloomberg
As you can see, yields on 10yr JGBs have risen aggressively of late to now yield just over 1.50%. Meanwhile, the most recent CPI yoy% change as of January was reported at 4% and BOJ is running their policy rate at 0.50% with this explicit quote in their most recent Policy Statement:
“Real interest rates are expected to remain significantly negative after the change in the policy interest rate, and accommodative financial conditions will continue to firmly support economic activity.” k250124a.pdf
Begs our favorite question – “Who’s gonna buy the bonds?” Who is going to own bonds with a 1.5% yield over 10yrs, in a 4% inflation environment, and a policy setting whose objective is to stimulate things further. Not to mention, on an issuer that is carrying 250%-ish Debt/GDP. Obviously, only Rational Accounting Man. But, as you can see from the recent trend, even those guys are getting a bit skittish.
We can roll back the above chart by 3-years and see where the players were just before the rest of them realized that significantly tighter policy rates were the order of the day, with arrows showing the transitions to the current situation.
Figure 6: Real Rate vs Inflation Rate. Japan (red) vs Other Developed Economies. Arrows: Jan 2022 to Jan 2025
Source: Bloomberg, Convex Strategies.
All the other developed economy central banks, eventually, decided that tighter policy rates, to the point of positive real policy rates, were in order. We assume they made this determination to a) try to restore price stability back toward target after letting it run exceptionally hot, b) restore some credibility in the commitment to their mandates, and c) avoid losing control of the back end of their bond curves.
Here is a look at how the respective real rates have evolved over recent years.
Figure 7: Real Policy Rates Japan (red) vs Other Developed Economies. Sept 2018-Jan 2025
Source: Bloomberg, Convex Strategies
Nary do we hear any mention from the shaman at BOJ of the risk of (continued) overshooting of their price stability targets. As we have so often discussed, despite the “significantly negative” real rates and “accommodative financial conditions”, the seldom accurate forecasters at the BOJ continue to predict that today’s above target inflation measures will, in due course, return back down to target. As we always state, they are adamant in their conviction that their policy measures “WILL NOT WORK!”. They are always ready to assure that any adjustment in nominal policy rates will only come ever so slowly. That the accommodative stance will exist for the foreseeable future. That they, unlike all the other developed economy central bankers, won’t have to move to positive real rates to restore some sort of order in the economy and the bond market.
Boundedly Rational Agents are undoubtedly viewing this with their usual tacit skepticism.
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