Cookies and Zilch

By: Michael Ashton | Sun, Dec 11, 2011
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One of the frustrations of the Christmas season, for someone trained in basic mathematics, is the tradition of the holiday cookie exchange. In this tradition, a collection of friends and/or acquaintances comes together for a night and exchanges cookies they have prepared for cookies that others have prepared. This results in every person who came with cookies of one type leaving with a rainbow of cookie types. And thus, we illustrate the gains from international trade" to the masses.

One of the reasons the cookie exchange tradition is frustrating is that there are always several participants, and often the organizers, who seem never to understand a basic principle: cookies are not created in the exchange. I remember an incident a few years ago when an exchange participant was enthusiastic about one particular event because she said 'this way I can get so many cookies!' How many cookies are you bringing? I asked. Two dozen, came the answer. How many do you expect to leave with? 'I don't know...maybe three, four dozen!'

This obviously can't work, and it's easy to illustrate. Suppose only one person comes to the cookie exchange, and he brings 10 cookies. In that case, he obviously leaves with 10 cookies. Suppose two people come to the cookie exchange, and they each bring 10 cookies. Then they switch cookies, and each person leaves with 10 cookies. Suppose four people come with 10 cookies. Each hands 5 cookies to the person on his left and 5 cookies to the person on his right. They all receive 5 cookies from the person on the left and 5 cookies from the person on the right, and they all leave with 10 cookies. We can generalize this: if n people bring q cookies to a cookie exchange, then on average (assuming no one eats any), each person will leave with q cookies. The n doesn't matter.

Which brings us to Europe.

What Europe has is the cookie exchange, but they don't understand how it works. Each country is showing up with 5 cookies and expects to leave with 10 cookies. It doesn't matter if they route the cookies through the IMF: the number of cookies is fixed. You either need someone to bring a truckload of cookies which are distributed to everyone else (with Germany the driver of the cookie bus), or else everyone gets roughly the cookies they came with. There is no cookie leverage." Now, if some people show up with just a few cookies, and some with big bags of cookies, but they all leave with the average amount, then obviously some participants will enjoy this socialism and some will not (in the real-world cookie exchange, this takes place when all cookies are treated as equally valuable. The person who showed up with three dozen macaroons leaves with chocolate-chip, peanut-butter, snickerdoodles, ginger snaps...and the person who brought chocolate-chip cookies goes home with at least some macaroons. Where is the justice? Shouldn't macaroons trade at a discount?[1] Those who bring great cookies end up losers while those who bring lame cookies end up winners.)

Strip away all of the structuring, and that's fundamentally the problem. There is not enough money to service all of the debt, and no amount of shuffling money will solve that problem. And Germany's decision to make is whether to bring dozens of chocolate-chip cookies and leave with macaroons, gluten-free rice-crispy treats, and that nut-flan-custard thing Grandma developed during the War.

So it wasn't a huge surprise when on Friday there was nothing of substance announced to come out of the European summit. There were lots of statements given to the press. There was nothing there. Equities rallied (S&P +1.9%) because investors couldn't really believe that was it. All we got from the summit we've been promised for weeks is a decision to move the ESM forward, although we don't know how, and a reassurance that maybe some of the Eurozone will effectively cede fiscal sovereignty to the big guys, although we don't know why?

When Monday comes, with no more headlines (unless the rating agencies go ahead and start downgrading sovereigns, as is almost assured now), I think there will be some selling pressure in the European equity and bond markets, and probably some spillover here in the equity side.

The other news on Friday was not good. Moody's downgraded the French banks, and the ECB announced that it would limit its sovereign bond buying at €20bln per week (although it is still not clear they can do that for very long and continue to sterilize the purchases effectively).

I don't think I am the only one who ended the day on Friday shaking my head in disbelief that there was no earth-shattering announcement. I didn't expect any substance, but I thought they would make a better show of it. This is going to get ugly, and I have seen nothing that truncates the possibility that it could get epically ugly.

I guess that's the way the cookie crumbles.


[1] I always thought this would be a great trading game - a tote board with bids and offers for, say, the gingersnap-snickerdoodle exchange rate.



Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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