Banks Still in Negative Vega Zone

Recent increases in the monetary base have all gone into excess reserves, and so inflation has remained low, and monetary stimulus isn't stimulating. This puzzles many people, but I have a theory for it. The idea is that while equity owners--management--are like owners of call options on the assets of a firm (aka the Merton Model), banks are like down-and-out call option owners, because if their book equity goes down too far they will be forced into a fire-sale or liquidated by regulators.

 This is a barrier option, and has the interesting property that its vega--the derivative of the value of the equity with respect to asset volatility--is negative when it gets close in value to its barrier. A standard call option loves volatility, the greater the better. This can be shown by noting that an option is worth something like max(0,x), where x is a random variable; the higher the volatility of x the more an option is worth.  With a down-and-out constraint, a loss can cause the equity to forever extinguish, and this causes the vega to actually go negative when close to the absorbing barrier.

 That is, consider the difference in vega in the graph below.

If you have negative vega, adding risk or volatility hurts your equity value, so you turtle in, and wait like the 1990 Japanese banks for inflation and retained earnings  to cure your precarious position. Banks are still in their negative vega zone currently, afraid to do anything that will either get them into legal trouble, or generate any losses that would force them into liquidation. So, they aren't lending their new cash balances but rather hoarding them as protection.

 Bank of America recently paid a $2.4B fine to settle claims it misled investors about the acquisition of troubled brokerage firm Merrill Lynch. That brings its total fines since 2010 to $29B with no end in sight (eg, the Libor fixing scandal). Banks get fined for not lending enough to minorities, and lending too much.  If the government would stop treating the banks like the Knights Templar circa 1307, the economy would recover much faster. A modern economy needs banks, ones that want to take risks and grow.

Games People Play

I just read Eric Berne's book 1964 book Games People Play and it's a fascinating piece of psychology. The author is an expert on human self-deception and the real meaning of rituals. For example, he gives this example of a typical American ritual:

1A: "Hi" (hello)
1B: "Hi" (hello)
2A: "Warm enough for ya?" (How are you?)
2B: "Sure is, Look's like ran, though." (Fine, how are you?)
3A: "Well, take care of yourself (Okay.)
3B: "I'll be seeing you.
4A: "So long."
4B: "So long."

 The exchange is not intended to convey information. Indeed, it's polite to not exchange information. Rather, it's simply a ritual of exchanging 'strokes' that build trust and convey interest and empathy, that is all. There are all sorts of such rules that are culture dependent, why it is so important for children to learn 'how to be polite', which means, how to engage in everyday banter that isn't about what it's superficially about.  I remember as a child finding the phrase 'how are you?' to make little sense (no one wanted to know!), and wish I read this at 13.

There are many rituals and pastimes where people don't mean what they say and Berne's book is geared towards cases when people engage in repetitive behavior where both parties appear to having a continued struggle, but really are in a rut that is at some level satisfying to both, as when an argument between family members always ends with doors being slammed.

I think Freud's a quack, as his childhood sexuality thesis is absurd and his convoluted diagnoses cribbed from reading too much Sherlock Holmes (see Sebastiano Timpanaro's essay in Unauthorized Freud). But he's was on to something, and and all such talking cures (such as Scientology's auditing) rely on uncovering people's hidden motives, the ones that underlie the games outlined in Berne's book. When enlightened people are forced to confront these they are better off.

 It's always interesting to notice people you understand better than they do themselves, sad sacks who make similar mistakes over and over, and seem totally oblivious to their bad habits of thought. They rely on a strange cognitive dissonance that keeps them from really seeing themselves. I noticed it once in myself when I met an old college friend and he said, 'remember when you did X because Y!' I don't want to go into it (X and Y weren't that shocking), but in any case I had remembered my reason for X as being more reasonable. I then realized it was obvious I had lied to myself for decades.

We all lie every day, usually about inconsequential things. It's important to understand how often and easy it is to lie to ourselves, a theme in Jonathan Haidt's The Righteous Mind, and Michael Gazzaniga's work on split brains (the inarticulate part of our brain guides our thoughts more than our inner narrator). Indeed, the most unethical person I ever hope to know emphasized to me several times that 'honesty' was the most important thing to him, and he was probably unaware at a conscious level this was precisely because he knew how much he lied about important things. And so it is with many experts who not only lie to themselves, but do so about things they are expert at, or prioritize. Consider that active portfolio managers lie about their alpha, partisan intellectuals distort their opponent's arguments to make them easier to dismiss, and politicians lie about being leaders rather than slavish followers.

Back to Freud, he was always the smartest, most articulate person in the room, and coming up with clever solutions like Arthur Conan Doyle for personal problems using allusions to Greek literature and sex, all very impressive.  It allowed him to believe he was like a Newton for the human soul. He was lying to himself that he had discovered such laws in our thoughts.  This is not a paradox, it's the human condition, because for many of us clarity on the things most important to us is depressing.  It takes courage to see oneself objectively because we are all fallible and imperfect, and prefer not to think about our faults but rather the faults of others.

My kids are young and learn a lot every day.  I like to think I too am learning as much about life, even if not at their frenetic pace. I notice many adults adopt habits of thought and behavior that go pretty unchanged after a certain point.  It's as if they tire of the grief that comes with learning we are going about things sub-optimally because this causes us to re-evaluate all sorts of things about ourselves. Thus, wisdom seems to flat-line as opposed to increase throughout life like for Plato. I definitely want to avoid being one of those people others know better than I know myself.

 As Feynman said in his Cargo Cult lecture, "the first principle is that you must not fool yourself--and you are the easiest person to fool." He was talking about science, but this virtue of self-honesty is not compartmentalized, but rather a virtue you practice every day on things great and small.

Volatility Risk Premium

One of the more alluring investor myths is that you can get paid a premium for having the patience to withstand risk. It's like getting paid more for working at a smelly job rather than a job surrounded by wonderful smells: in equilibrium, the bad thing no one likes (risk, smells) are compensated via an extra return. You can formalize this and it forms one of the pillars of finance under the rubric of 'risk premiums'.

 Yet, as I point out in my book The Missing Risk Premium, to a first approximation the risk premium has a negative sign. Using Popperian logic, the profession should have moved along a long time ago, but it persists for several interesting reasons that I discuss in my book (eg, it's beautiful if true, it's a key fallacious assumption that underlies so many other threads, etc.).

Now there's PIMCO writing about how to capture the 'Volatility Risk Premium' by selling vol. They correctly note that on average, implied volatilities are a couple percentage points higher than actual volatilities, so 2% higher. Thus, it seems clear that writing options, collecting premium on 22% and paying on 20% generates a straightforward premium.

 Consider what may appear to be a great example of their argument: the VXX. it has lost 97.8% of its value since inception in January 2009, while the VIX has only declined by 66.8%. Win for risk-taking volatility sellers!

This phenomenal extra 8% annualized negative return drag (underperformance of VXX vs. VIX) comes from two sources.  One is the fact the VXX tries to match the daily return, and in sample that have negative autocorrelation, this strategy will underperform its benchmark over long periods.  This is best shown by this piece by Cheng and Madhavan at Barclays.  The other is the contango in this market, so that trying to maintain a fixed forward volatility position causes one to lose money riding down the VIX futures curve which has been very steeply sloped since the inception of this stupid product.  

That gets to the bottom line, which is that the premium of going short the VXX has little to do with risk--it's negative return is much bigger than any estimate of the equity risk premium--but rather technical issues within the contract.  You can try to capture this by trading yourself or becoming a short seller, but this highlights that to capture a return premium you need to actively educate yourself and put on positions that take at least a little work (eg, shorting the VXX is more complicated that simply going long the VXX), not passively invest in a fund that has 'risk' and does this all for you.  

If a fund purports to give you a risk premium for simply giving them money it's a classic sucker's pitch.  Consider that after 50 years there's no agreement on what the risk factor is: originally it was a beta with the broad market, now it's a covariance with something, though interestingly things correlated with well-known risk factors like 'size' or 'value' don't exist outside of the characteristic-based portfolios that actually create these factors.  That is, if you find a currency, or low book equity/market equity stock that has a high value loading, these assets don't generate higher-than-average returns as theory suggests they should. So, if you magically discovered the risk that underlies risk premiums, it would be in your best interest to keep it to yourself, not give it away to investors, and call it alpha, because no one would know. 

It simply isn't plausible people are finding risk premiums and giving this to passive investors, and naive investing is just what underlies all those fools going long the VXX in hopes of making money off Black Swans. While selling vol (shorting the VXX) is in a certain way selling Black Swans, the similarity is that some 30k foot metric like improbability is something you get paid for, whether you are buying or selling it.  You have to roll up your sleeve and earn it, taking out those pesky middle-men.  

US Corporate Tax Rates High

A new study on corporate tax rates makes the point that US corporate tax rates are rather high. I didn't realize this, so I thought it was interesting. There study is here, but like all good empirical research, the gist is in a simple graph:

Leverage Aversion and Portfolio Optimality

There's a strange article, Leverage Aversion and Portfolio Optimality,  by Bruce Jacobs and Ken Levy in the FAJ. It's not clear what their paper is trying to explain. That is, a theory should either predict something new, integrate two seemingly separate results, or explain a paradox to standard theory. This paper seems to merely show that if people explicitly take into account leverage, then portfolio holdings will be different. They don't even reference Asness, Frazzini and Pedersen (2011), the most recent piece on this subject.

But their piece is strange in several ways. First, they implicitly have people maximizing 'relative returns', what they call 'active return' (with the leverage constraint added on).  On one hand, this is great, because is consistent with my thesis in The Missing Risk Premium, that this is what most people actually are maximizing.  Yet, they propose this as if it is de rigueur. This highlights that 1) this utility function is so intuitive people generally don't even think about justifying it on more general grounds and 2) they blithely ignore the many contradictory implications of this assumption applied generally (eg, a zero risk premium).  Yet, if the utility function is relevant it can't exist parochially in one asset class without a massive arbitrage opportunities.  I know a foolish consistency is the hobgoblin of small minds, but this parochial-general distinction as applied to equilibrium returns is not foolish.

 Secondly, their model seems to imply that with 200 and 300% enhancement funds available via leveraged ETFs (Ultras, UltraPro), does this then imply the expected return on these sectors is now lower because people can buy a 200% allocation to these sectors without direct leverage (ie, you 'only' lose 100% with an ETF)? Do stocks with options have lower expected returns because of these outlets (options are levered positions that, when long, 'only' lose you 100%)?

Lastly, they imply that everyone should be leveraged somewhat.  Now, on one hand this is obvious because if they are maximizing relative return, and they presume some alpha, there's some non-negative allocation regardless of how risk-averse one is. This was proven back in the 1960s via the symmetric problem of how much of an allocation one should apply to a risk portfolio when you have absolute utility. If your theory says 'everyone' and the data say much less than half, the theory's wrong. It's a much bigger disagreement than the theory saying 80% and data saying 40%.

All Good Ideas Go Too Far

Willie Stark (aka Huey Long) in All the King's Men:

"Im going to build a hospital, the biggest that money can buy, and it will belong to you. Any man, woman, or child who is sick or in pain can go through those doors and know that everything will be done for them that man can do. To heal sickness, to ease pain, free - not as a charity but as a right. And it is your right, do you hear me? It is your right. And it is your right that every child should have a complete education.

The Chinese are currently willing to subsidize our plethora of economic rights, but I wish they would stop so we could adopt a truly sustainable balance between rights and revenues. Alas, Romney's latest Kinsley gaffe has set off a firestorm of outrage because it hits home: many people are sustained by perpetual forced charity. Clearly charity is good in some situations--temporary help, even permant help for those truly disabled--but the system is now out of control.

No one likes to think of themselves as parasites so their benefits are redefined as rights, or no different than social security or those taking advantage of tax breaks. Yet taking food stamps and avoiding federal taxes through muni bonds, are fundamentally different. Many would like us to believe that all these omnipresent mandatory transfers (social security) and tax incentives make us all equal recipients of government aid (argued as well as can be by Mark Schmitt here).

 The bottom line is that Arthur Brooks is right when he says people only gain satisfaction via earned success, not charity. This is why, if you want to gain someone's affection, you should ask them a favor as opposed to doing one for them, because the former implies they are truly valued for something they can do, whereas anyone can receive charity. Those who advocate redistribution therefore are strongly incented to convince others and themselves these cases are not charity, but no different than a tax break on muni bonds, or simply a human right that exists via natural law. In a similar way affirmative action supposedly doesn't mean targeted groups are on average less qualified, but you can tell no one really believes this because people get so very emotional if you ever mention this to an affirmative action supporter (people don't get excited when you say 2+2=5).

The Easiest Way to Make Money

Former UBS banker Bradley Birkenfeld won $104m for exposing the giant Swiss bank’s efforts—illegal in America but not in its home country—to help American taxpayers hide money in offshore accounts. I think the take-away is that any organization involved in large-scale illegalities should realize that the incentive to turn over insider evidence is huge now, and this should dissuade law-breaking of this scale, which is a good thing. However, a huge organization will necessarily have many gray areas because bidding is strategic, and so could always be seen as conspiratorial by some, or have disparate impact. Thus, this probably massively increases the amount of bureaucracy that already weakens these companies.

 But it does create jobs. Here's The Economist on the whistle blower's lawyer:

His lawyer, Dean Zerbe—who wrote the relevant legislation on informants in 2006 while serving as tax counsel to the Senate Finance Committee, and with other lawyers will share in an estimated 10-33% of the reward—says he has two dozen other cases pending, two of them bigger than Mr Birkenfeld’s. His phone has rung incessantly since the settlement.

Writing complex legislation has its advantages.

Utilities and Low Vol

I spoke with Ben Levinsohn last week, as he's a pretty good guy for the WSJ who writes about low vol on occasion.  He took this snippet out of our conversation:

"If you want low volatility, you should get utilities and not worry about it," says Eric Falkenstein

Alas, that's not exactly what I meant, though I did say it.

What I was trying to say was that while a low volatility strategy has more of a utility weighting than the S&P, your average low vol investors should not to worry about it. A low volatility focus dominates the indices, which dominate active portfolios, which dominate picking individual stocks. So the 'low vol' focus should be encouraged.

Here's the weighting of the Russell 1000 by industry sector, by value-weighting and count:

Now, if you apply a filter so you grab the bottom 20% of stocks with the lowest beta or volatility, here's the allocation you get, both by count (equal weighted), or market cap (if you allocate via market cap), where the percents are relative to the Russel, so that 20% would be neutral (because I'm choosing the bottom 20% of stocks):

There are several ways you can make low vol better, and utilities, historically, don't seem to be the secret sauce of low volatility. Below is the total return index for 10 major indices since 1927, and utilities are near the bottom in total return. As low vol has historically out-returned high volatility, this clearly suggests utilities are a drag on the strategy.

Yet, if you get worried about this nuance, you probably will get led down the path of gilding the lilly, making things worse in an earnest attempt to do things better. I mean, if you restrict utilities, what next? Value (because that overlays one's value allocation)? How about industry caps in general? While I think there are better ways to play low volatility than SPLV, for most people this is their best play.

I don't talk about tactics I think really add alpha because really good specific ideas are better kept off the web: the masses will dismiss them, and smart people will steal them without attribution. Big strategies are useful to discuss in public because they are interesting and too big to be a secret anyway.

As most people screw things up doing it themselves, usually by adding a signature flare (most new ideas are bad, after all), most people will ruin the benefits of low vol by noting that utilities detract from low vol.  In practice people don't stop with just one refinement, to their detriment.

If you can afford or know someone really good (ie, in the top decile), do it fancy, but otherwise, simpler is better.

A Bad Way to Fight Bears

Sometimes I hear that you can't trust everything you read on the internet. The following 'Interview Questions' cheat sheet doesn't help:

Q: How would you fight a bear? 

A: Climb on its back and grab it by the neck so its paws can't reach you.

Failure of LVOL Highlight Theoretical Flaw

Russell Investmests recently announced is shutting down its ETFs due to lack of demand: 25 funds with only $300MM in assets. A signature fund was LVOL, which actually was one of its more popular funds with $70MM, and was primed to pick up the hot low volatility investing trend.

It took a factor approach to the low volatility focus, first creating a 'volatility factor proxy', and then choosing 100-200 stocks from the Wilshire 1000 that load up on this factor. As the 'volatility factor proxy' selects stocks itself, this approach is too convoluted, and investors rightfully don't trust black boxes, which given weasel word language about momentum and beta. Their LVOL overview page is completely unhelpful, with just about every tab containing either the same pie chart of sector weightings, or regulatory boilerplate and irrelevant data. Indeed, the regulatory language clearly gets in the way of communication, highlighting that financial regulations are generally the opposite of helpful.

 In contrast, SPLV says on its home page

The Fund will invest at least 90% of its total assets in common stocks that comprise the Index. The Index is compiled, maintained and calculated by Standard & Poor's and consists of the 100 stocks from the S&P 500 Index with the lowest realized volatility over the past 12 months.

It's clear what they are doing, and they aren't trading too much (eg, monthly as with LVOL). If you spent time learning advanced financial theory, you would learn that LVOL did it right, SPLV did it wrong, because factor loadings are the measure of risk, not mere characteristics like volatility. That the whole field has a big flaw is a theme of my new book( available in paperback and Kindle!).

 Too much schooling is a bad thing. Recently I was working with my publisher, a subsidiary of Amazon, and their structure was clearly created by an MBA: I had a team with specialists who handled very narrow tasks but somehow were never the right person to comprehend any of my specific questions (eg, β should be different than b?). They all spoke as if they were reading from a script, and often I would find their unhelpful verbal answers on their website's FAQs. The fact the actual typesetters were in India, and I could never talk to these people, I'm sure made sense to the top guys at Amazon, who are traditional Harvard-educated efficiency experts. I have a feeling monks from 12th century Ireland were more accurate and faster.

 It's bad enough grad school costs too much, but it makes you less efficient.

Why I'm a Fama Fan

Aaron Brown was gracious (and insightful!) enough to give a rather nice review on Amazon for The Missing Risk Premium (paperback here, Kindle version here) and at Minnyanville. You can read it there. One point I made he found irksome was where I noted my Northwestern professors considered Fama a 'lightweight'. This was back in the early 1990s. Unfortunately, he inferred something I didn't intend, namely that I too considered him a lightweight in the way many opinion columnists will write 'some say welfare reform is a racist dog-whistle', so they can say and not say it simultaneously. I replied via a comment on Amazon and to him personally, and he accepts my explanation as no mere tendentious parsing of that statement (though clearly, when people don't infer what I imply, I'm guilty of not saying things as well as I could).

My point was not that my professors were uniquely wrong, just that conventional wisdom then thought the best research was examplified by the rigorous work of people like Jay Shanken, Michael Gibbons, or Stephen Ross. These papers emphasized rigor, issues such as jointly estimating betas and alphas, or whether to use Lagrange Multiplier or Likelihood Ratio Tests. The thought was that the theory was basically correct, where expected returns are a linear function of a covariance with something, and so the really important insights would be found via ever more sophisticated econometric techniques.

 It wasn't a dumb idea, but it was wrong. CAPM betas couldn't be saved, and rejecting them via these tests didn't really point to what was wrong. Fama is now one of the most respected names in finance because he has championed a model that seems to work, and part of his persuasion involved simply cross-tabbing average returns by size, then beta. This showed that the standard CAPM betas were untenable as measures of risk, because when one does this beta is unrelated to average returns, and these average returns are our best estimates of expected returns. He not only changed the focus from covariances to long-short portfolios that (conceivably) proxy a risk factor, but from abstruse statistics to cross-tabbing.

 I admire Fama for his clear arguments, his intellectual integrity (he changed his mind on the CAPM betas, he didn't jump on the momentum bandwagon and merely said 'it's a puzzle') and also his defense of efficient markets, which is often maligned by to my mind remains a pillar of finance. That is, a healthy respect for the default assumption that it simple profit rules are rare is valuable disposition, otherwise one chases all sorts of overfit will-o'-the-wisps. So, my mention that Fama was once considered a lightweight was meant to give some color to how finance has changed in methodology, which is reflected by what kinds of research and academics are considered top shelf.

 Rigor is a good thing, but it should never be more precise than the data allow, and as most of our tenable theories are simply about whether certain coefficients are zero, positive or negative (eg, for CAPM betas), not what the 11th digit is, the distinction between Wald, Likelihood ratio, and Lagrange Multiplier tests is moot. Unfortunately, there is still a rigor bias in financial theory, why so many important results are in lesser tier journals like the Journal of Emerging Markets, the Pacific-Basin Finance Journal, or the Journal of Empirical Finance. If the finding only arises from a GMM estimate of parameters of a stochastic discount function, but don't generate a scatter-plot or total return chart, it almost surely doesn't exist.

While I agree with 90% of Fama's weltanschauung, he strongly believes in risk premiums, and I don't, and that is an important disagreement. Nonetheless, I still greatly respect the man and read almost everything he writes.

Where Risk Taking Really Hurts

Sports Illustrated has a cover story on dementia and NFL players. They mention Ray Easterling, played for 8 years in the 1970s. They note:

Ray, who'd had a successful career in financial services, began making impulsive and risky decisions, a hallmark, some scientists say, of chronic traumatic encephalopathy...

If risk were positively related to return, one effect of this would be for many very wealthy people to be morons who took more risk than they realized. Sure, many would fail, but there should be vast riches to those who succeed. Indeed, in De Long, Shleifer, Summers, and Waldmann (1990), this is indeed the implication: wealth becomes concentrated among deluded investors who took excessive risk.

 This clearly does not describe wealthy investors. Many successful investors are lucky, and many aren't extremely bright. But very few of them are stupid, that is, have dementia or an IQ below 85. This is just another datapoint supporting my argument that risk is not positively related to return. Risk taking without intelligence is a sure path to financial disaster. If it were all factor loadings derived from covariances, it would be too easy.

What We Hate

I found this riff on David Foster Wallace interesting:

A lot of what he disliked in other people, and much of what concerned him about contemporary culture was a reflection of something that discomfited him in himself. ... he wanted, in his life and his art, to be a great deal better than he often was. (As a teacher he was hard on clever students who reminded him, either in their work or their personalities, of his younger self.)

This really rings true, but with a twist. Personally, I sympathize with those who display my pet peeves about myself, because I understand the good-faith origin of these faults (I know I mean well, and can extrapolate). In strangers, I only loathe those vices where I never feel any temptation. Yet I also loathe vices I find in myself in my immediate family because I really want them to succeed, and so feel compelled to shake these bad habits out of them out of an overbearing love only appropriate for family.

Any self-aware person knows their faults, and is especially observant of these faults in others. Yet, I'm not sure such self-knowledge is truly advantageous. Perhaps, like overconfidence, self-awareness is best done in moderation.

New Momentum Fund

Moment is a strange factor. Historically its magnitude is comparable to value and size in Ken French's data, yet clearly less popular. Yet unlike size, value and more recently low-vol, hardly any products out there attempt to specifically harvest the momentum premium in an efficient manner. The problem is that momentum peaked in November 2008, and has not recovered (graph below using French's data).  Many think it may never recover, which perhaps is why the main momentum fund, HMTM, trades only ten thousand shares a day.

Nonetheless, my friends at Robeco launched a fund designed to capture the momentum premium (led by Willem Jellema, right). They think it will be attractive because momentum tends to do particularly well when low volatility and value fails (e.g. late nineties was horrible for value and low-vol, but great for momentum). More importantly, their fund has some secret sauce.  I can't say what that is, but I can vouch for the fact that there is a way to play momentum that works much better than the standard approach used in academic papers.

Update: I should add that AQR runs momentum funds, and Cliff Asness has been actively researching  momentum for well over a decade (see Value and Momentum Everywhere), so he probably has some special sauce too.

Economists Love The Spread

The spread is a debating tactic where you present a set of supporting arguments so wide and particular your opponents are unable to rebut them all because 1) they have day jobs and 2) they have limited space or time to address them in any particular forum.  A champion spreader is Noam Chomsky, who selectively recites facts of world history from Indonesia, Russia, to El Salvadore and 200 places in between, which no one but a professional in Comparative Economic Systems would be familiar with (indeed, comparative economic systems was a flourishing economic subdiscipline precisely because it couldn't be easily refuted because those communist countries didn't have a free press and made up their production data, but after 1989 it was obvious this field was simple wishful thinking dominated by deluded Marxists-note:of the ones I knew!).

So, a paper by Michael Woodford calling for NGDP targeting is a case study of a good type of argument for this kind of thing. As it is doubtful that less than 1% of his readership understands all the strengths and limitations of the model he presents, it makes for a great spread argument by Paul Krugman, because he can be sure that most readers won't have the time, inclination, or ability to assess the credibility of this paper. As with most spread arguments, they can be used by those with the opposite conclusion (eg, John Cochrane here), because a small tweak makes it support an opposite view, and who's to say what is minor when references are really recondite.

The model used by Woodford is from an older paper by Eggertsson and Woodford (2003). Kids Prefer Cheese notes this following set of quotes from that paper:

For simplicity we shall assume complete financial markets and no limits on borrowing against future income. 

Our model abstracts from endogenous variations in the capital stock, and assumes perfectly flexible wages (or some other mechanism for efficient labor contracting), but assumes monopolistic competition in goods markets, and sticky prices that are adjusted at random intervals in the way assumed by Calvo (1983), so that deflation has real effects.  

We assume a model in which the representative household seeks to maximize a utility function Real balances are included in the utility function, following Sidrauski (1967) and Brock (1974, 1975), as a proxy for the services that money balances provide in facilitating transactions.

In other words, the basic workhorse of this model was created decades ago and has been available to thousand smart economists trying to forecast the macroeconomy. If some metric of monopolistic competition, sticky prices, inflation, and real balances, predicted future investment and consumption, we would know it because there's a model that targets these variables directly, and whether a parameter is 7 or -0.3 is simple enough to change after the fact: if some parameterization worked, the model could rationalize it. There isn't such a model, as evidenced by the fact that all recessions have surprised macro economists in real time.

 Now, these are smart people, so they are very good at explaining the past, but that's really unimpressive, and reflects the degrees of freedom available relative to the target variables of quarterly GDP aggregates. It's like finding a trading rule for last year's daily S&P moves.

Don't be fooled by The Spread in economics.  All macro models are no more precise than the infamous Laffer curve, which while true at extremes and useful for some intuition, says very little about your average policy change and intermediate forecasts. Outsiders can't critique such models directly, but they can say, "what did this model say in 2007?  In early 2009?"  That is, not what does the model now say about 2008 given 2007 data, but what did it actually say in 2007?