"Kee" Points with Jim Kee, Ph.D.

Spanish interest rates (10-year) hit 6.5% with rising fears that Greece will make a disorderly exit from the Euro. The concern is that if Greece exited and returned to (re-introduced) the drachma, then big problems would ensue. Greek companies, banks, and citizens have debts that are denominated (have to be repaid in) Euros. A newly minted drachma issued by a defaulting government would have no credibility and would probably plummet. That means that Greek citizens couldn’t exchange it for a lot of foreign currency, like Euros, which they need to pay their debts. So Greek debt holders would have to default. Of course, all of this now worthless debt would be sitting on European bank balance sheets, and the big banks would be looking at each other suspiciously, not wanting to refund overnight loans for fear of lack of repayment (“counter-party risk”). It follows that a credit freeze or crisis could ensue (i.e., a “Lehman” event).


That’s why I don’t think it will happen. It is why the Greek people want to renegotiate the terms of austerity measures but without leaving the Euro. And it is why the European Union, European Central Bank, the IMF, and the world’s central banks want to provide a financial backstop. Interestingly, last week I saw a lot of Wall Street pieces cross my desk with titles like “Probability of Greek exit exceeds 50%,” etc. To me this calls to mind the fundamental distinction between risk and uncertainty drawn by economist Frank Knight over 90 years ago. Risk, according to Knight, was associated with events that have known probability distributions. That is, the average values of events and the dispersions or distributions of values around those averages are known. This is the domain of actuaries who can assign probabilities to events. In contrast to risk, uncertainty was a new classification of imperfect knowledge created by Knight that involves circumstances in which background knowledge or experience is lacking, which makes probability estimates of possible outcomes impossible. In my opinion, events that fall under this category (i.e. uncertainty) include just about everything people are talking about today – a Greek exit, hard Chinese landing, recessions, terrorist events, etc. So I’m skeptical whenever I see a statement like, “There is a 25% probability that the U.S. will enter recession in 2013,” or, “We’ve raised our estimates of a Greek exit from the Euro from 40% to 55%.” As an interesting aside, according to Knight, uncertainty was the only circumstance that offered the opportunity for profit.


Finally, a lot of analysts are starting to focus on the investment implications of the U.S. elections and the “fiscal cliff” that faces investors if Bush era tax cuts are not extended in early 2013. It is my opinion that, while estimating potential tax/regulatory outcomes is interesting, the only thing that really matters to investors is knowing what’s already priced in. And I don’t know of any overall equity (stock) market valuation models that are good enough to discern that (though plenty claim to). In fact, Dr. Victor Canto of La Jolla Economics recently published a straightforward analysis arguing that a Republican sweep would favor dividend paying stocks over non-dividend paying stocks, as dividend tax rates were slated to go up the most (more than capital gains taxes) under Democrat control. Interestingly, he showed a strong positive correlation between the likelihood of a Republican (versus Democratic) sweep (based upon the Iowa Electronic Market) on the one hand, and the performance of dividend paying stocks versus capital gains intensive growth stocks on the other. What this tells me is that the investment implications of the U.S. elections depends upon who wins (duh). But that means that picking winning strategies is akin to forecasting the winners ahead of time. Thinking back to Bush/Gore in 2000, that might not be possible until the night of the election! So again, uncertainty is why you have an investment plan (disciplined diversification), not the time to abandon it!