Tuesday, October 4, 2016

Martingale Strategies and Central Banks

You've got to know when to hold 'em
Know when to fold 'em
Know when to walk away
And know when to run
--Kenny Rogers

Bill Gross discusses Martingale gambling strategies in the context of modern central banking policy. Gamblers who use Martingale strategy increase the size of their bets as they lose more. The intuition is that if you, say, double the size of your subsequent bet after each loss then at some point you are bound to recover your previous losses and then some when the cards, dice, etc. finally do turn in your favor.

The Martingale approach is bound to appeal to many people because it legitimizes the idea of taking more risk when you are behind. Aversion to loss is a core tenet of decision-making under risk as elaborated by Prospect Theory.

Bill Gross suggests that Martingale strategy appeals to central bankers, as it seems like they increasingly turn to more extreme and riskier monetary policy solutions after each preceding bet does not jump start the economy as hoped. Witness for example the NIRP strategies being implemented in Europe and Japan.

One obvious problem with Martingale strategy is that gamblers may run out of capital before their 'double down' bets hit. But wait, don't central banks run the printing press, permitting them to print an endless supply of money from which they can fund their next round of bets?

Not exactly, as Gross observes. One problem that central bankers face is the prospects of Big Inflation stemming from their money printing. If the size of their losses get big enough and those printing dollars make their way to markets for goods and services in sufficient quantities, then prices explode higher. The printing press, i.e, the funding source of central bank Martingale bets, shuts down when that happens.

Because they center on distorting interest rates lower, central bank Martingale strategies also threaten the lifeblood of capitalism--i.e., savings that serve to fund productivity improvement projects that advance prosperity. When capital is consumed, then the goose that lays the golden eggs of prosperity is dead, and there is no standard of living to wager on.

At that point, all bets, as they say, are off.

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