Tuesday, January 31, 2006

Sophocles says it's a war when...

It's a recession when your neighbor loses his job. It's a depression when you do.

It's a bug when your neighbor catches a cold. It's the flu when you do.

It's profit taking when stocks you don't own decline. It's a crash when your stocks decline.

It's terrorism when foreigners kill us. It's collateral damage when we kill foreigners.

It's putting down the last throes of an insurgency when kids from Missouri, Iowa and Kansas are getting maimed and killed. It's a War when the ABC news anchor gets maimed.

The older I get the more often I think to myself, there but for the grace of God go I.

I see Jim Cramer doing his carnival barker/stock broker thing on TV and I think it.

I see home owners starting at what once was their home and I think it.

I see some political shill on TV selling a program in which they clearly don't believe and I think it.

I see an American soldier home in a wheel chair and I think it.

I see a dead Iraqi insurgent and I think it.

I see mothers and fathers crying over children dead and maimed because they are viewed as nothing more than pawns on a chess board and I think it.

It's too bad that Freud buried alternates views of Sophocles' Oedipus Rex under a mountain of his peculiar brand of psycho-sexual babble. Thus the Oedipus Complex became a perverse desire instead of, among many other possible interpretations, an inability to see one's self in all men and one's nation in all nations.

The closing lines:

CREON. Thou must not think
To have thy way in all things all thy life.
Thou hadst it once, yet went it ill with thee.

CHORUS Ye men of Thebes, behold this Œdipus,
Who knew the famous riddle and was noblest,
Who envied no one’s fortune and success.
And, lo,! in what a sea of direst woe
He now is plunged. From hence the lesson draw,
To reckon no man happy till ye see
The closing day; until he pass the bourn
Which severs life from death, unscathed by woe.

Monday, January 30, 2006

Don't know much about history....

We learn from history that we never learn anything from history. Georg Hegel

I get the sense, from reading, inter alia, Stephen Roach's missive from Davos, that the globalization gang at the World Economic Forum (WEF) is beginning to realize they were wrong. Beginning to realize, I write, not realized. The full scope of their mistake has yet to dawn on those who would remake the world of men.

Conservatism, as I understand the term, refers in part, to the view that
there is nothing new under the sun - man is man, much as he was when the Pharaohs ruled, albeit with a few more tools. By the definition I am a conservative. Liberalism, again, as I understand the term, refers to the view that man, the species, can be improved (perhaps forcibly evolved might be a better choice), poverty can be erased, and material well being shared more or less equally. The WEF gang, on balance, were, by that definition, a liberal organization.

As Mr. Roach puts it: The World Economic Forum is the cradle of the modern-day globalization debate. The motto of the organization says it all, “Committed to Improving the State of the World.” The win-win endorsement of globalization -- that the development of poor countries is a huge plus for rich, developed countries -- was first coined in Davos. There have been anti-globalization protests associated with this event for years. But this year is different. The debate has moved from the outside to the inside. Serious challenges to globalization are now being openly aired in the rooms and corridors of Davos’s fabled Congress Centre.

Was it but 5 years ago that the WEF was the talk of the economic town? A benevolent capitalism, we were told, would lift all boats. In its most radical variation, the new economy, scarcity would be all but banished. So much for that idea.

To be clear, this is not an anti-capitalism rant. I believe, on balance, that a system of private property and rules of exchange are more beneficial to man than other organizational forms. In a sense, capitalism can be thought of as a regimen of diet and exercise. It can improve the material well being but whether that makes one more or less benevolent seems to me a dubious proposition.

Returning to Mr. Roach and the globalization gang, The reasons behind this shift are not hard to fathom. One of the “wins” in the win-win of globalization has failed to materialize. Job creation and real wages in the mature, industrialized economies have seriously lagged historical norms. It is now commonplace for recoveries in the developed world to be either jobless, or wageless -- or both. That this shortfall has occurred in the midst of accelerating globalization and surging global trade is all the more disconcerting.

This shouldn't, I contend, have been much of a surprise.
The break down of national sovereignty is one aspect of globalization. Yet it was at the level of the nation state that the rules of exchange were enforced. Thus the current mess. The rules of exchange are not being enforced. It reminds me of the stories of the wild, wild west. Except that in this case, the lawlessness was confused with lawfulness for many years.

Thus the dawning realization, returning to Mr. Roach, that the toughest part of this story is that there may be no easy way out.....For generations, we harbored the belief that while it was painful, it was also understandable for rich countries to lose market share in tradable manufacturing activities. This was never viewed as a serious threat because the developed world was blessed with a growing profusion of highly-educated knowledge workers toiling in nontradable services -- workers that were effectively sheltered from the tough pressures of global competition. It was win-win because rich countries would be able to buy cheaper things from poor countries, thereby expanding the purchasing power of an increasingly knowledge-based workforce. And as producers in the developing world turn into consumers, a proliferation of new markets would provide nothing but opportunity for the industrial world. This positive-sum outcome was the true hope of globalization. Alas, it is rarely easy to recover from years of misplaced faith in matters of material import.

It also apparently takes a long time to grasp the enormity of error. Consider the closing from Mr. Roach: Yet protectionism may not be the real risk in all this. I don't believe that the world would be so foolish to repeat the tragic mistakes of the 20th century. The more likely danger is that the powerful countries in the industrial world now view the Chinas and Indias of the developing world with a growing sense of distrust -- more as economic adversaries than as strategic partners. A world of distrust may well squander the greatest opportunities of globalization.

This, in my view, is the great flaw of liberalism, as defined above, exposed - the faith that man, the species, will not repeat his mistakes. Man, the species, the collective, it has been often written, learns little from history, although, man, the individual, can. In my view, the greatest opportunities of globalization were but a pipe dream. Rising distrust is an unavoidable consequence of misplaced faith.

All of which brings me back to my faith in real goods. The vast web that is the world's financial system of promises was built on the very shaky foundation of win-win globalization. Now comes the hard part, resolving the gulf which separates the world as it is with the world assumed by our financial markets. As always, it is the map that will need to come to the territory, not the other way round.

Thursday, January 26, 2006

A tip on TIPS

One of the US Treasury's key initiatives is the promotion of inflation indexed securities, TIPS for short, and after reading some of the details I can see why they are so inclined. I too would love to sell inflation indexed securities, assuming, of course, that I was the only one who produced the inflation index nor could that index, once published, ever be changed.

According to the Treasury TIPS are good food...no that's a different ad....TIPS taste great, no they're less filling...er...I'll just let the Treasury tell it like they wish it was:

Benefits to Investors of a Unique Asset Class

Unique asset class (dollar-denominated, inflation-protected, full faith and credit of the United States).

* Asset for investors focused on the future real purchasing power of their savings.
* Low volatility and attractive returns.
* Higher long-run correlation with inflation than real estate, commodities, or other real assets.
* Deflation floor, i.e., won't receive back less than nominal principal value at maturity.
* Potentially increases portfolio diversification.

What makes TIPS different from normal bonds is the inflation adjusted principal upon which the coupon payments will be based. As the CPI rises, so too will the principal, although that will only be turned into hard cash at maturity. As a bonus, purchasers don't have to worry (too much) about deflation. TIPS purchaser will receive at least par value at maturity, although if the CPI starts to measure deflation than for interest calculation purposes only your principal will decline, which is what has been happening as the CPI declined the last two months.

Of the benefits noted above I found the claims of low volatility and higher long run correlation with inflation than
real estate, commodities, or other real assets difficult to swallow. Let's first touch on some of the theoretical problems and then take a look at a real world example for the empirically minded.

The first aspect of TIPS which springs to mind is the map territory problem. Inflation, the concept, refers, in many schools of thought, to the loss of purchasing power of a currency, i.e. crudely, rising prices. Inflation, the measure, is an index, compiled, by the way, by the very people who will be paying you.

That is to write, the security is not indexed to inflation, as experienced, but rather inflation as measured by the government. I can think of few things more volatile than what a group of vested individuals think about a phenomenon and what that phenomenon might actually be. I can imagine a world in which the prices of these securities become very volatile indeed.

As a theoretical matter I found the claims of TIPS higher long run correlation with inflation than the elements, the price increases of which supposedly comprise the measure, to be downright silly. As a practical matter, it can be measured.

Imagine you purchased, at auction, $100,000 of the 3-1/2% 10-Year TIPS, CUSIP #: 9128276R8, on Jan. 15, 2001. As of Feb 1, 2006, the adjusted principal amount would be $113,534 and your received coupons would total just under $19,000, the total of which is about $132,500. If you went to sell the bond the current price (thanks to a friend with a Bloomberg) is 107-10 and the auction price was 99-26 which equates to less than the inflation adjusted principal amount so to cast this in the best light let's stick with the $132,500 figure for comparison.

Imagine instead that you had bought the imaginary average house whose price change is measured by the Office of Federal Housing Enterprise Oversight for $100,000. According to their data, through Q3 2005, your house would be worth a shade under $149,000.

Imagine instead that you had purchased $100,000 of the Commodity Research Bureau's Commodity Index (which I chose to be fair, due to its inclusion of the grain complex). At last check your investment would be worth a bit above $155,000.

I won't do oil or natural gas but how about Gold and Silver. $100,000 invested in Gold or Silver on January 15, 2001 would be worth roughly $207,000 or $201,000 respectively.

In other words, the only thing that TIPS returns will have a high correlation to is the government's sense of inflation, which, thus far at least, has been much less than other "traditional" inflation hedges. But hey, I guess if you're into that kind of accuracy go ahead, buy some TIPS.

My tip on TIPS, sell them and invest the proceeds elsewhere, apparently almost anywhere..

Education in Democracy

Our commitment to democracy is also tested in the Middle East, which is my focus today, and must be a focus of American policy for decades to come. In many nations of the Middle East -- countries of great strategic importance -- democracy has not yet taken root. And the questions arise: Are the peoples of the Middle East somehow beyond the reach of liberty? Are millions of men and women and children condemned by history or culture to live in despotism? Are they alone never to know freedom, and never even to have a choice in the matter? I, for one, do not believe it. I believe every person has the ability and the right to be free. President Bush Nov 6, 2003

Bush says won't deal with Hamas - Jan 26, 2006

When I first heard the Bush Administration sing the praises of Democracy, I thought they would come to regret it. Now, in the sixth year of their reign they are getting a little education about one of Plato's least favorite forms of government.

To be charitable to the Bush team, they wanted to stick with slogans in public and words like "freedom" and "democracy" evoke feelings amongst the masses they wanted to evoke.

Yet, grand policy is implemented in public. When the words, that have been so forcefully projected into people's minds, and deeds don't match, political power, the sense that a leader's words are true and carry weight, ebbs.

Moreover, or so I believe, it is better to initially deal with the confusion of a complex policy in the open rather than try to argue that you meant this or that all along. If for no other reason than dealing with the complexities in public demonstrates an understanding of the complexity of the task itself. Propaganda works on both the listener AND the speaker. Even if one is aware on some level of the "truth" propaganda can make one a prisoner of rhetoric.

When President Bush asserted in the speech linked above, the roots of our democracy can be traced to England, and to its Parliament, he was caught in an error of oversimplification. It wasn't democracy per se that America carried with it from England but a democratic impulse within a Constitutional framework, itself contingent upon a certain view of man's place in the universe.

As Shakespeare might have put it, there is more in heaven and earth than is dreamt of in your political philosophy. Bringing democracy to the Middle East has so far, in Iraq and today in Palestine, only served to give voice to the anger of the oppressed. It is a turn I think only a die hard dispensationalist, one who years for the final battle between good and evil and the second coming, could cheer.

So now the Bush team will try to escape from their rhetorical prisons. Democracy alone, they are now asserting, is insufficient to justify a rise to power and the political manifestation of a view of the world. This strikes me as very perilous ground.

To me, the democratic impulse that is part of the western form of government is important in its legitimizing effect, within our aforenoted, but often ubiquitous sensibility of the world. If a democratic vote no longer provides that effect, what does? Plato had an answer, tyranny.

Wednesday, January 25, 2006

The other hand of Bill Gross

I was just finishing reading the last paragraph of Bill Gross' (PIMCO) January Investment Outlook when my left, that is, other, hand suddenly began moving of its own accord. I tried to hold it back but it went straight for the keyboard, typing furiously. The following is the result of that possession.

Santa was so good to me this year that I began to stop questioning my assumptions in public. No more wasting time trying to induce from past conditions to suggest the path of the future, I would now simply deduce backward from the "conclusion" (that's according to my right hand) that bond yields were perpetually going lower. Induction is, after all, quite a difficult exercise, fraught with uncertainty and never proved until the event, while deduction is what everyone else seems to be doing - finding evidence which supports their already concluded conclusion.

Was it but 14 months ago that I wrote, with both my hands, the following sentences: It’s an uncertain world these days, with the polls split down the middle and Heisenberg long ago having declared that something can be here or not here at the same instant. And for those of you who have no idea what I’ve just said I can only offer you congratulations on your blissful certitude
. How I long for such days when, on the one hand, we had this, and on the other hand we had that.

Alas in the age of empire only the meek can speak their mind and think of various possible forward scenarios. As Einstein wrote, to punish me for my contempt for authority, fate made me an authority myself. Now I must do what authorities do, stay on message, but sometimes I'll let my left hand out for a walk, or a type.

In my latest IO I revealed one of my bond market timing tools, my holiday gift to you as my right hand put it. I'll let my right hand explain the model, that is what he does best. You can see the graph here (new window works best).

Imagine, if you will, purchasing (receiving) a 5-year interest rate swap at some time over the past few years. For those of you who don’t spend 12 hours a day in bond trading rooms, that means owning a 5-year fixed rate bond and financing it (paying) with 3-month Libor which increases in yield every time the Fed raises its benchmark. Instead of mark to market changes in the 5-year swap price, what I would like to promote here is the concept of an increasingly more expensive "cost" to owning this 5-year swap as its financing rate (3-month Libor) increases. A 5-year swap purchased when short rates were much lower and the yield curve more positive, produced positive carry and therefore generated "profits" for anyone holding this longer dated maturity when viewed from an income statement perspective. But if you narrow or eliminate that carry via higher short rates (and a flat yield curve) those "profits" disappear.

This 5-year swap concept is important because the U.S. economy operates in much the same way. With close to a 5-year average life, the entire U.S. bond market can be compared to a 5-year fixed swap. That means that companies, homeowners, and consumers that have borrowed money in recent years - (and purchased assets such as a home that are akin in my example to a 5-year swap) - are now being squeezed in a flat yield curve environment. Visualize a real life example in which you have "financed" a home with an adjustable rate mortgage (in my example you finance a 5-year swap with floating 3-month Libor). As the cost of the ARM increases with higher short rates, your excess income available to spend on discretionary items begins to shrink. If that ARM rate goes too high, you hunker down even more by not eating out, going to movies, or taking a vacation to exotic destinations. The economy in other words slows down.

How does this translate into a bond market timing tool? Chart I shows but one of a series of graphs PIMCO uses to indicate when enough is enough - the point at which adjustable short rates rise sufficiently to make the owner of a home or a 5-year swap, or more importantly the economy, cry "no más!" That point comes in this example when Fed Funds rise to meet the average cost of intermediate Treasury financing issued over the past 5 years and the spread between the two disappears.

As my right hand goes on to relate in that IO, the above could mean that bond yields have peaked because monetary conditions are now restrictive enough to dampen consumer demand. BUT, this is only one of many reads of this data and but one possible scenario going forward.

As my right hand casually noted, in brief, Much will depend on the future condition of the U.S. housing market and of course global economies - primarily of the Asian variety. Since even my right hand had to admit that "much will depend on ...
global economies - primarily of the Asian variety" let's spend a bit of time reflecting on what Bastiat might have called that which is unseen.

Let's consider a few reasons for the Fed's decision to not cross the "no mas" line in the graph above for the past 2 decades. My right hand noted that previous violations of that line were due to accelerating inflation, which my right hand suggested was not happening today by contrasting that experience with current conditions. I guess you now know that I keep my wallet in my left pocket and it is with my left hand that I pay those increasing costs.

But there may be other concerns staying the Fed's tightening hand. A scan of US Treasury data on the percentage of foreign holdings of total US marketable securities which rose from 12% in 1978 (when the debt to GDP ratio was roughly 33%, i.e. we're talking about 4% of GDP) to 35.2% in 2000 and to 52% in June 2004 (when the debt to GDP ration was roughly 63% so now we're talking about 33% of GDP, actually more as it has been another year) suggests a link.

Back when the US self financed, easing and tightening were exercises in shifting the internal flow of funds mainly by rewarding or punishing the financial sector's bond market exposure. It was, at times rancorous, but still a family affair. While some US institutions might post losses on their Treasury holdings, other US institutions which had been more cautious, gained.

As foreign holdings of US debt rose, however, tightening became an international issue. Suddenly the question arose, who will buy these securities if the Fed does what it used to and raised the cost of carrying the debt to punitive levels? After all the reason they sold the debt to foreign bidders in the first place was because US buyers couldn't be found. What happens if we scare off the foreign buyers altogether? Lefty here has another question, what happens if we don't scare them off and they keep financing us? That's right, Warren Buffett answered that one, sharecropper society.

But let's stick to the first question, what happens when the Fed punishes US Treasury debt holders? Firstly the American consumer slows down fairly quickly. This in turn means that Asian exports to the US slow and they will have fewer $s with which to buy Treasuries, even though their purchases are far more important now than ever before. Additionally, Asia will be sitting on a pile of securities which are losing value but which act as their reserve base. Are you getting the sense that this would not be an "orderly market" event? Think Thailand mid 1997 for a possible model.

Anyway, perhaps now you can see why we haven't had a real bear market in bonds since the early 80s. We would be biting the hand that feeds us and forcing ourselves to face an even bigger problem than the one we ignored in the late 70s.

Yet, despite the freedom from convertibility, and thus ability to extensively manipulate markets gained with the adoption of the second amendment to the IMF's articles of agreement, which, according to the IMF, eliminated the use of gold as the common denominator of the post-World War II exchange rate system and as the basis of the value of the Special Drawing Right (SDR), (I call it Humpty Dumpty finance, words mean whatever I want them to mean, nothing more and nothing less) we seem to have something of an inflation problem, albeit one that has
escaped detection by the BLS (gotta make sure Social Security recipients and TIPS holders don't unbalance the budget you know).

What we are left with are the Emperor's New Bonds. Everyone, including me, (with my left hand tied behind my back) will buy them and we will claim they are getting ever more valuable and yet they won't be. The currency devaluation the BLS can't quite seem to find will be eroding their true value, but we will all be too polite (and scared) to say so.

Tuesday, January 24, 2006

On the Great God Money

I'm in the midst of building an ice rink for my son today so I've published an old musing from my collection of not ready for publishing stack of scribblings.

Give me control of a nation's money and I care not who makes her laws
. Mayer Rothschild

I remember the first time I came across the opening quote from Rothschild, thinking, wow, that is a profound insight. At the time I was working as a currency trader so I felt that I was playing the game of life at its highest level. I have since come to reconsider that view.

All people who believe in anything, and that includes just about everyone, believe in God although they define the attributes thereof differently. God being the word humans use to define the first and ultimate cause.

Some, the scientific, empirical crowd, believe that the universe of our senses is real and permanent. Of these there are steady staters who believe the universe has always been what it is and the big bangers who believe the universe exploded into existence from a primordial soup.

Some, like myself, believe in creation, by which is meant the stuff of consciousness, derived from the firmament of unchanging nature and the divine spark of the word.

Some, like the fundamentalists, merge the two faiths above. God, they say, created the material universe out of nothing and can and does change that universe when the divine will feels the need.

Some, like the early Christian Gnostics believe that the material universe is some sort of evil joke played on purely spiritual beings.

Many may not believe they believe any such thing but few of these can read David Hume's famous excerpt:

These two propositions are far from being the same: I have found that such an object has always been attended with such an effect, and I foresee, that other objects, which are, in appearance, similar, will be attended with similar effects. I shall allow, if you please, that the one proposition may justly be inferred from the other; I know, in fact, that it always is inferred. But if you insist that the inference is made by a chain of reasoning, I desire you to produce that reasoning. The connection between these propositions is not intuitive. There is required a medium, which may enable the mind to draw such an inference, if indeed it be drawn by reasoning and argument. What that medium is, I must confess, passes my comprehension, and it is incumbent on those to produce it, who assert that it really exists, and is the origin of all our conclusions concerning matter of fact.

without being shaken in that view. The question why, ubiquitous in every culture, begs assumptions about the working of the universe and how we humans have come to understand it, if at all.

The Rothschild quote above can be read in many ways. A charitable read might lead one to argue that the quote means that one who controls money within the confines of superior hierarchical assumptions, some of which are noted above, controls the path of mankind.

A less charitable read might lead one to argue that the quote means that he who controls money, controls the world.

This recalls Nietzsche's quote:

As long as a man knows very well the strength and weaknesses of his teaching, his art, his religion, its power is still slight. The pupil and apostle who, blinded by the authority of the master and by the piety he feels toward him, pays no attention to the weaknesses of a teaching, a religion, and soon usually has for that reason more power than the master. The influence of a man has never yet grown great without his blind pupils. To help a perception to achieve victory often means merely to unite it with stupidity so intimately that the weight of the latter also enforces the victory of the former.

Arguments like mine, that forecast the collapse of the current system of international exchange, presuppose that money only works, with lags, within the proper hierarchical belief structure.

Arguments that the current monetary system can be perpetuated indefinitely take Rothschild at (and beyond) his word. Those who control money are like Gods on earth, or at least the emissaries thereof, able to direct the path of mankind at their whim.

Choosing amongst these various faiths is not, I contend, an exercise in logic or deductive reasoning, which are merely tools for working within belief structures, but rather, leaps of faith as to the working of the universe.

To me, the 90s was the decade when faith in money, bolstered by the lack of a US economic collapse in the late 70s, led some, like Daedalus with his new wings, to fly where their predecessors had feared to go.

Throughout history, many have worshipped variously defined Gods. Most of these Gods have proven to be false. The causal relations which had been assumed, by virtue of faith in a God of certain attributes, to be constant through space and time ceased to work.

Will the great God Money prove to be equally false? Stay tuned.

Sunday, January 22, 2006

Credit where credit is due

International organizations can serve the cause of peace, but they can never serve as a substitute for, or exercise a veto over, principled American leadership. Republican Platform 2000

I don't believe in world government in large part because I believe the main impetus behind growth of the state is "us" and "them" thinking. If we are all us, and there is no them of whom to be afraid why have government at all? In that regard I think the the Bush administration has been doing a great job emasculating international organizations. I wish they might have chosen different means towards that end but that's another story.

To wit, here's an interesting note about Paul Wolfowitz over at the World Bank. Apparently the talent is leaving in droves. If only Dick Cheney could be persuaded to run the IMF.

I had a few chuckles reading the rest of the Republican platform for election 2000.

Here's a few highlights:

Energy: What happened? Eight years ago, the nation was energy confident. Our standing in the Middle East was at its zenith. The oil cartel was in retreat; gasoline was affordable, even as automotive progress reduced emissions from cars. Today, gas prices have skyrocketed, and oil imports are at all-time highs. Foreign oil now accounts for one-third of our total trade deficit. (I'll bet somebody will be using this talking point again.)

Free Trade: But free trade must be fair trade, within an open, rules-based international trading system. (yes, that would be nice.)

Privacy: Government also has a responsibility to protect personal privacy, which is the single greatest concern Americans now have about the Information Revolution. Citizens must have the confidence that their personal privacy will be respected in the use of technology by both business and government. That privacy is an essential part of our personal freedom and our family life, and it must not be sacrificed in the name of progress. (I agree, neither should it be sacrificed in the name of political victory )

Friday, January 20, 2006

On the super-criticality of Financial WMDs

Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal. Warren Buffett

The War with Iran has begun in earnest, with Iran firing a precise strike into the heart of the West, the financial system. The headline announcing this radical change simply read, Iran said moving assets. The article explained that Iran was moving assets out of European Banks to shield them from possible UN sanctions but that is not the only effect which flows from this action.

One of the stated aims of Central Banking in particular and the Federal Reserves specifically is to fend off the spread of any panic induced bank runs. This is necessary, assuming, of course, you opt for a system of fractional reserves, because the inherent leverage of said system leaves it vulnerable to collapse in the event of withdrawals which exceed its reserves.

This vulnerability rises if the liquidation prices of the assets on the bank's balance sheets are
less than their "marked to market" value. That is, the effects of leverage, which has two faces, the inherent leverage of the fractional reserve system AND the leverage of the portfolio itself which is usually much higher, and market over-valuation are additive, hmmm, perhaps multiplicative is a better choice.

In the event of one bank's collapse, due to some combination of adverse market move and depostor withdrawal, depositors at other banks can become nervous and withdraw their funds, potentially sparking a chain reaction of financial default.

In a sense, you can think of a fractional reserve, or more generally, leveraged, bank as an unstable atom, and a highly leveraged bank exposed to over-valued markets as a highly unstable atom, for instance Uranium 233.

Both the Uranium and the highly leveraged bank have the potential to transform into a more stable state by releasing the energy that makes it unstable. Both the Uranium and the highly leveraged banks have the potential to ignite chain reactions, where such energy releases in one atom or bank creates instability in the next. In the case of Uranium, however, the medium through which such chain reactions occur is the proximate material universe while in the case of the financial system, the medium is the minds of men, which is why financial managers are always tempted to intervene in markets or otherwise obfuscate the facts.

In the patois of Nuclear Physics, criticality refers to a state where each nucleus that fissions induces on average one additional fission, i.e. it is self sustaining. This is the reaction used in Nuclear Reactors. Sub-criticality refers to a state where, while there are fissions they aren't inducing enough additional reactions to perpetuate the self sustaining energetic release.

This somewhat complex subject can sometimes be made easier to contemplate if instead of nuclear reactions you think of building a camp fire. Sub-criticality then refers to the state where you keep lighting matches and getting the kindling going but the fire keeps going out. Criticality then would refer to a nice camp fire that keeps you warm.

Super-criticality is the stuff of Nuclear Bombs. It refers to a state where there are more than enough fissions to keep the reaction going, indeed, the chain reactions grow exponentially over time. In our camp fire metaphor, your fire is supercritical when it ignites the tree under which you foolishly started it.

Getting back to the world of finance, it is the job of the Central Bankers to keep the inherently unstable leveraged institutions at sub-criticality. They perform this function by ensuring that the banks can survive a run by pooling reserves and directing them, at least in theory, where needed most.

To use Chairman Greenspan's favorite expression, pooled reserves are much more productive in that a much smaller quantity, relative to the amount that would be needed if each bank carried its own reserves, is needed to produce the desired effect - creating the impression of financial system solvency in the minds of depositers. Please note that I didn't write, be solvent, the aim here is to create the impression of, in fact, few banks could survive total depositor withdrawal.

The greater the systemic leverage the more difficult this job, of creating the impression of solvency, becomes as the effects of small price changes
on the financial sector's portfolios are greatly magnified, exposing the whole industry, in the event of a significantly adverse price change, to a loss of its entire reserve base. Let's go over that again to be clear, Central Banks pool reserves, making them more productive, at a cost, which rises with systemic leverage, of the implosion of the entire system.

Thus national asset markets under Central Banking become strategically important. A "crash" won't just impoverish speculators, it can cripple intermediation entirely for weeks, months or even years.

"But," you might be thinking, "don't all the banks mark their books to market. Surely the financial sector can liquidate at roughly its current value."

One of the experiences which led Warren Buffett to his view on derivatives was the unwinding of Gen Re Securities' derivatives book. He notes in his 2003 Letter to Shareholders:

When we began to liquidate Gen Re Securities in early 2002, it had 23,218 outstanding tickets with 884 counterparties (some having names I couldn't pronounce, much less creditworthiness I could evaluate). Since then, the unit’s managers have been skillful and diligent in unwinding positions. Yet, at yearend – nearly two years later – we still had 7,580 tickets outstanding with 453 counterparties. ......

The shrinking of this business has been costly. We’ve had pre-tax losses of $173 million in 2002 and $99 million in 2003. These losses, it should be noted, came from a portfolio of contracts that – in full compliance with GAAP – had been regularly marked-to-market with standard allowances for future credit-loss and administrative costs. Moreover, our liquidation has taken place both in a benign market – we’ve had no credit losses of significance – and in an orderly manner. This is just the opposite of what might be expected if a financial crisis forced a number of derivatives dealers to cease operations simultaneously.

This comports with my experience managing currency option portfolios for Chase Manhattan, unwinding derivative portfolios is an expensive affair, at the best of times. Thus you can see the trigger mechanism for the financial weapon of mass destruction right there, a financial crisis which forces a number of derivative (which might be better understood as EXTREMELY LEVERAGED) dealers to liquidate. Recalling yesterday's whimsical digression of euphemisms, we might wonder just what "financial crisis" means.

Well, the Asian Crisis occurred when international investors withdrew enough capital from asian markets to create financial super-criticality. So, to induce financial super criticality all one needs to do is withdraw enough funds, or sell enough Treasury Bonds or whatever, to force liquidations. The same can happen in any leveraged financial system, even that of the US.

I'm a bit spooked to consider the coincidence of Osama bin Laden warning of more attacks and Iran withdrawing funds. The intricate web of financial obligations mushroomed during the 90s based on the expectation of the whole world adopting western finance. The "Peace Dividend" in a sense, was wagered.

Yet, If enough key countries decide not to play, and by virtue of their oil reserves this means Iraq and Iran, the expectation on which this vast financial web is based becomes Soros' trend whose premise is false. It is the Achilles Heel of the west in general and the US, by virtue of its inability to self finance, in particular.

Hopefully this eventuality will be avoided. Although I am critical of US economic policy with regards to financial system leverage, specifically because it leaves the nation vulnerable to such attacks, I have no interest in being proved right in this way any more than one wants a friend, who happens to smoke despite your best efforts to get him to stop, to get cancer. If I was a politician I might argue something like, President Reagan told Mr. Gorbachev, Tear Down This Wall, and I tell Mr. Greenspan, Defuse the Bomb, Unwind this Portfolio. "Whew," you might be thinking, "don't quit your day job."

One final point if I may. It seems to me as if the only way that the US$ can continue as global reserve currency is if it brings all nations, especially oil exporting nations within its system. A Cold War style detante is no longer possible without significant financial disruption by virtue of the aforenoted massive expansion of leverage in the financial system, the bet on US$ global hegemony has been placed. It is an all or nothing, a binary proposition, which does not lend itself to hedging, the essence of derivatives valuation. I think this is going to be ugly either way.

Thursday, January 19, 2006

Euphemisms 'R' US

I remember watching George Carlin on Saturday Night Live in the 70s and howling at his plays on words- plastic glass, jumbo shrimp and military intelligence; but as with all tools there are good word plays and bad word plays.

The, according to Carlin, oxymoronic, military intelligence, is one of the leaders in the field, with such dissimulations as smart bombs, surgical strikes and everyone's favorite, collateral damage. Two other industries, if you will, which are leaders in the field of dissimulation, finance and politics have recently been caught joining forces again and you guessed it, the english language ended up being tortured and twisted in the process. If we don't watch out people will end up running away from this language like they did with Latin.

Remember when day trading used to refer to some guy wearing pajamas, working from home and trading off of his CNBC screen. Some people hope you still have that image in mind when the new charges of "day trading" Washington DC style hit the mainstream. In the new, new jargon, day trading refers to the practice of passing "political intelligence" from the Capitol to Wall St.

What's "political intelligence"?, you ask, another Carlin-esque oxymoron? Now that you mention it....but seriously folks, "political intelligence" refers to stuff like congressional vote results before the vote is actually taken. Wouldn't it be nice to know, for instance, that some new aero-space venture was about to be approved, before it actually was approved? Well then, get ye some "political intelligence" or as they used to call it, "inside information" before they make it illegal again.

ps When is a security breach a welcome event?

Wednesday, January 18, 2006

Speculative Bubbles and Gold

First of all, that was written 40 years ago, and I was mistaken in part. I expected things that didn’t happen. And, nonetheless, my general view toward the type of gold standard effect remains to this day. My forecast of what was going to happen subsequent to that period has proved, fortunately, wrong. And as I have said to you in the past, we have tried to manage the Federal Reserve over the years, really since October 1979—because, remember, up to that point we were in some very serious inflationary trouble. Since then I think we have been remarkably successful, in my judgment. Alan Greenspan, House Financial Services Committee Q&A Feb 17, 2005, in response to a question by Ron Paul about Greenspan's views on Gold expressed in Gold and Economic Freedon

With the $ price of Gold dropping some $20 over the past few sessions the question, was Gold's recent rally a speculative bubble?, is likely to be a topic of concern. While the question cannot be definitively answered except through the passage of time, in the following paragraphs I'm going to argue that the recent rally was not a "speculative bubble", first by qualifying what the phrase, "speculative bubble" means to me and then examining what I believe to have been previous speculative bubbles in Gold.

The trading maxim of George Soros, find the trend whose premise is false and bet against it, comes to mind as a fine starting point in defining "speculative bubble." The key feature is, as both Soros' maxim and Greenspan's comment above allude, false expectations. In the case of the Nasdaq bubble, the false expectation was that un-or-marginally-profitable companies would nonetheless make money for shareholders. The second element of a speculative bubble is that the false expectation drives capital flows sufficiently to significantly influence the price. That is, there are two features of a speculative bubble, a false premise and a substantial departure from historical price relationships of the asset in question.

In the case of Gold I watch, among other relations, that with crude oil because I don't see the $ becoming a second class currency so long as it is the currency of choice for trading the world's key commodity, oil. When Gold's price in relation to crude is high and rising it seems to me that the cart, the $ collapse trade, is ahead of the horse, the $'s utility as mediator for international commodity exchange, specifically oil.

Since the price of Gold was floated in 1971 there have been a number of Gold price spikes both with respect to US$s and oil. The, in hindsight, false expectation behind some of these spikes is that the US$ would cease to be the world's reserve currency. Most followers of Gold are familiar with the Watergate inspired fears of a $ collapse in late '74 that took Gold above $200 and the now infamous, at least in Gold Bug circles, early 1980 spike that took Gold above $800.

In both of these cases, the ratio of oil to Gold rose dramatically, in late '74 exceeding 40 barrels of oil per ounce of Gold and in early '80 exceeding 23 barrels of oil per ounce of Gold. For reference purposes, the Bretton Woods era ratio was roughly 19. The lesson I take from this is that it seems a silly bet to assume that the US$ is failing as a reserve currency when oil exporters are willing to exchange oil for it. Thus when the Gold/oil ratio is high (above 20) and rising, and investors are piling into Gold as a safe haven in the event of a $ collapse, as in '74 and '80, history teaches us that this bet is riding on a false premise.

This measure also rationalizes the failed break-outs during the '87 through '90 phase when the US was unwinding the 80s equity and then real estate bubbles. During this entire period the Gold/oil ratio was well above 20, in some moths spiking to 30 barrels of oil per ounce of Gold. I remember trading during that period and fears of a US economic and by extension US$ collapse were quite real, if, in hindsight, unfounded at the time.

As Greenspan's response to Ron Paul above suggests, he and many others had assumed that the US$ would collapse and when it didn't they felt they learned something new. In Greenspan's case I think he "learned" that a fiat currency regime could work. I would argue that they were just early to the game. The US, at least with respect to external accounts was in far better financial shape in the 70s than it is now
, i.e. it could finance itself.

And it is now that concerns us here. Currently, the Gold/oil ratio is just under 10 which is quite low historically. This tells me that, unlike past periods of $ system stress, few, measured in terms of $s committed, are running for the golden exit door, despite the rise in the $ price of Gold. Yet, it is only now that one could justifiably, at least as I see things, consider the US a financial banana republic. In other words, despite the deterioration in US external account balances, Gold is still trading by my metrics as if the US$ based system was just fine.

Given the continued deterioration in external accounts, and lack of policy response, so long as oil prices remain high, suggesting stress in the US$'s role
mediator for international commodity exchange, while the ratio of Gold to oil stays under 15, I wouldn't consider Gold a speculative vehicle at all but rather a low risk investment.

I'm not arguing that Gold will rally $20 tomorrow, next week or next month, this isn't a short term trading recommendation. I'm merely arguing, to the extent I've correctly identified some of the features of previous Gold speculative bubble tops, that this doesn't qualify.

Tuesday, January 17, 2006

Do the words legal, popular and right mean the same thing?

just some scribblings today, nothing that seemed to cohere together well but in lieu of nothing....

Readers of the comic strip, Dilbert, are likely quite familiar with the Peter Principle, a phrase coined by Lawrence J. Peter which means, in a hierarchy, every employee tends to rise to his level of incompetence. The phrase was the title of a book which aimed to answer the question, why do things always go wrong, at least in a hierarchy? In general, I think the skills necessary to rise to the top of an organization are opposite to the skills necessary to see the world clearly and respond correctly. Consider how difficult it would have been to get an established investment group to dump Nasdaq shares in late 99 or early 2000. Ah the madness of crowds, as Charles MacKay put it.

Of course, this is not a new phenomenon. Plato's analogy of the cave notes the distinction between popularly held "truths" and real truths. That the Nasdq would continue to rise was a very popular idea that was, unfortunately for its adherents, quite false.

Perhaps this seeming peculiarity of humanity was one of the reasons Plato thought of Democracy as the worst form of government in that it was based on a clear falsehood, that popular ideas are necessarily true.

Plato's view, with which I agree, is that discerning the truth is a tricky thing made almost impossible be close association with any hierarchy. To the extent readers find clarity in my perspective, you should know that my current views are formed in almost total isolation and were far more muddled when I previously worked in an organization.

Getting back to the Peter Principle, imagine an ambitious guy who wants to climb the old corporate ladder. His concerns will mainly center on how certain people perceive him, which in many jobs may have little to do with how well one performs their function. Yet, once this guy gets to the point where he is beyond those concerns, once he is, in truth, in charge, he needs new skills. To wit, to get to the top you need to make people believe you are clever, once there you must actually be clever. Yet, harking back to the Nasdaq crash, the guys who were proven right were, until after the fact, thought to be silly.

The early 18th Century French diplomat Charles Maurice de Talleyrand famously observed, C’est plus qu’un crime, c’est une faute, which, in English, means, this is worse than a crime, it’s a blunder. The famous American Justice Oliver Wendell Holmes, in his The Path of the Law, wrote, If you want to know the law and nothing else, you must look at it as a bad man, who cares only for the material consequences which such knowledge enables him to predict, not as a good one, who finds his reasons for conduct, whether inside the law or outside of it, in the vaguer sanctions of conscience. Here again we see the distinction perhaps more easily seen when observing Monarchical/Dictatorial political systems that one can be within the law but totally wrong, or conversely doing something illegal but moral.

These thoughts have been bumping around my head lately as I contemplate Supreme Court Justice nominee Alito's support for a "unitary executive" or a President who is in some senses above the law. It is an idea which elicits horror from some quarters but not much from me. Far more important than being legal, in my view, is being right. Hitler, Stalin, Mao and Napoleon were above the law yet this did not stop them from making mistakes with horrible effects. To the contrary, I think the sense of being above the law invites error in all but the most disciplined minds.

I get the sense that in the coming months the distinctions between legal, popular and right will become a bit more clear, to some at least.

Friday, January 13, 2006


Remember the 1981 Jane Fonda film, Rollover, about a diabolical plot by Arabs to withdraw their oil export money from western banks and crash the world's monetary system? In reading a few reviews of the film on the internet, I've discovered that I must be one of those finance geeks, because I, unlike the reviewers who neither enjoyed it nor found it plausible, remember enjoying it, not in the theater run but later, after working in the field a few years. The premise of the film was, to me, quite plausible, which perhaps explains my uneasiness after reading of the US Treasury's funding needs this quarter (US$171B).

Beginning in the Clinton administration, by virtue of their preference for paying off high interest, longer dated bonds during the "surplus" years, the average maturity of US debt has been declining. This process was accelerated when the Bush team stopped issuing 30 year bonds in 2001.

To give some sense of the change, it has been 20 years since the average maturity of US marketable securities has been less than 55 months (under 5 years) as it is currently. Moreover, unlike 20 years ago, when the average maturity of issuance
(1 year moving average) was much higher (roughly 6 years and higher), over the past 3 years the average maturity of issuance has been less than 3.2 years.

As one would expect, when the average maturity of the debt you issue has been 3 years or less for the past 3 years, you likely have a growing stock of short term debt that needs to be rolled over. As the US has been running substantial trade deficits through this period, not only is there a substantial amount of short term debt that needs to be rolled over, a good portion of that debt is foreign owned, or as they call it in emerging market (or banana republic to old Aussie Treasurer Keating) lingo, the dreaded short term external debt.

As of 9/30/05, the US had US$546B of under 1 year external debt maturing. You can check out the amounts and maturities yourself here.as they should be updated soon.

For the past few years, the US has dodged quite a few financial bullets in that they (actually it should be we) found very cheap finance borrowing in the short end while the Fed was easy. Now as the Fed has tightened the front end, interest charges are beginning to bite. That is where things get interesting. The long end of the bond market has remained fairly stable in part because the Treasury hasn't been borrowing there. Will the Treasury being to extend the average maturity of issue? Will foreigners prefer to stay in the front end and earn the higher rates should the curve invert?

More troubling, when you have half a trillion in short term external debt and another few hundred billion in projected primary borrowing, who is in charge of the budget process, Congress, the President or those foreigners who may or may not roll our debt over?

Who knows, maybe the film critics will have greater insight into this film in coming years.

ps Gold, unlike Federal Reserve Notes won't lose lots of value in the event the US has troubles rolling its debt over.

Thursday, January 12, 2006

Greenspan's Legacy

When Alan Greenspan was appointed as Chairman of the Federal Reserve, in the summer of 1987, there were already rumblings and grumblings about the obscene money being made in finance, even before the stock market crash that fall. Who knew that the shift towards financial glorification was just getting started. That, to me is the great achievement of the Greenspan Fed - keeping the obscenity going.

In 1966, in an oft quoted speech, Greenspan raged against deficit spending as a scheme for the confiscation of wealth. Many people then and since see in the speech, as Paul Simon sang, what they want to see, a call for honest money and fair trade. But, I contend, Greenspan's cause was not honest money, per se, which was but a means to an end. Rather, he wanted the rich, particularly those who owned firms (financial industry employee compensation as a percentage of total domestic compensation has only risen 1.5%) in his chosen field of finance to get richer. In that regard, he succeeded in his goal.

In 1987, less than 19% of total domestic corporate profits were earned by financial firms, while just under 27% were earned by manufacturing firms. In 2004, 33% of total domestic corporate profits were earned by financial firms while just over 12% were earned by manufacturing firms. In 1987, the US had a slightly positive net international investment position. In 2004, the net international investment position was -$2.5T, which is to say that under Greenspan's Chairmanship,
the US sold the family jewels to keep up appearances and the guys who served as middlemen in the process, the owners of the financial sector, got rich doing it. (all data: BEA)

It is only fitting, I believe, that in this last year of his reign, Wall St. bonuses hit a new record of $21.5B, surpassing that of 2000. Greenspan not only tilted the table, so to write, in the direction of finance, his obscurantism led many a great many people to assume he was working for them. This is his legacy.

Wednesday, January 11, 2006

2005's Word of the Year - Truthiness

From the American Dialect Society

In its 16th annual words of the year vote, the American Dialect Society voted truthiness as the word of the year. Recently popularized on the Colbert Report, a satirical mock news show on the Comedy Central television channel, truthiness refers to the quality of preferring concepts or facts one wishes to be true, rather than concepts or facts known to be true. As Stephen Colbert put it, “I don't trust books. They're all fact, no heart.” Other meanings of the word date as far
back as 1824.


Would that make truthiness the mental precursor to hubris?

Tuesday, January 10, 2006


Iraqi leaders are also beginning to make the tough choices necessary to reform their economy -- such as easing gasoline subsidies. Until recently, government subsidies put the price of fuel in Iraq at artificially low prices -- really low prices. President Bush Jan 10, 2006

Twice in my life I've witnessed riots following the imposition of a substantial oil price increase; in Indonesia in 1998 and in Jamaica in 1999. Neither experience was pleasant but as tends to happen in such instances, not without its lessons, if you take the time to reflect.

Although I'd remembered seeing video of the Rodney King riots in Los Angeles, its one thing to see it TV and quite another to realize that you could be the next Reginald Denny, the truck driver dragged from his cab at a traffic light and beaten in view of helicopters with TV cameras. In addition to highlighting to me how thin the veneer of civilization can be, I also learned that substantially raising the price of one of the now staples of modern life, oil, is a dangerous political act.

While Jamaicans, who import virtually all their oil, do, as I can attest, get upset by the price increases, Indonesians, who had been substantial exporters, get more than upset. Although the 3 decade reign of Indonesian strong man Suharto was already on thin ice as 1997 drew to a close, the agreement his government made with the International Monetary Fund, with the "quid" of US$43B for the "quo" of, among other things, reducing Indonesian government subsidies for oil was the proverbial straw that broke the camel's back of his adminstration.

Why, asked the Indonesian man on the street, should I pay more for my cooking oil, which is produced here in Indonesia, just because the guys running the nation's finances ran afoul of international bankers? It was a question I answered reflexively in 1998, certain of the wisdom of the IMF.

The Indonesians, by contrast, took such a dim view of the agreement that Suharto was soon removed from power. A few years and a few governments later, with the IMF still pushing Indonesia to cut oil subsidies, Indonesia ended its credit arrangement with the IMF.

I recalled this bit of personal history while reading of the recent IMF agreement with another oil exporting nation, Iraq. In this instance, the loan is quite small. Relative to Indonesia's US$43B, Iraq is only getting US$685M to remove, among other things, domestic oil subsidies. To be precise, the government of Indonesia got the US$43B. To be even more precise, Suharto's cronies got the money and I'd guess that the flow of funds in Iraq is similar. How amusing to see that convicted fraudster and neo-con darling Ahmed Chalabi recently was put in charge of Iraq's Oil Ministry.

It was no big surprise to me to see an escalation in violence in Iraq following the oil price increase. I don't suppose the average man on the street in Iraq today would think much differently about the end of oil subsidies than the average man in Indonesia did in 1998, with the exception that he might be even angrier. After all, Iraq's oil reserves dwarfed Indonesia's.

One big difference between the riots I saw in Indonesia and the increasing violence in Iraq that stands out to me is that the Indonesians were angry first at their government and only tangentially at the IMF. The IMF had no tanks in the streets, nor had they been bombing the countryside.

The Iraqis, on the other hand, seem to see the real culprits through the illusion that is their government. The idea that the Americans are coming to steal their oil is probably ringing a bit more true to any Iraqi paying 2-3 times more to fill his car, or cook his meal. However the information is mediated, the fact of an occupying military presence combined with a price increase of this magnitude of a commodity in plentiful supply in Iraq, but in severe deficit in America leads to obvious conclusions.

What I wonder though is why? Surely I have no special vision to see that such actions lead to such outcomes. This IMF imposed condition seems to me like throwing gasoline on a fire you claim to be trying to extinguish. Looking at the issue from a smaller perspective, let's say I am a lawyer. Should I charge my child, my wife or my friend the same price for my time as my clients?

Insanity has been defined as doing the same things and expecting different results. Getting the IMF involved in this way was sure to anger the public, and in this instance it isn't domestic soldiers trying to keep the peace but foreign, mainly American soldiers. It is also sure to once again raise the issue of western financial vultures in the Islamic world and in this instance there will be a bunch of western faces at which to direct their anger.

The rallying cry of radical Islam which is officially derided from the President of the United States on down is that the West is looting Islamic nations. I guess it depends on what the definition of "looting" is.

The American people know the difference between responsible and irresponsible debate when they see it. They know the difference between honest critics who question the way the war is being prosecuted and partisan critics who claim that we acted in Iraq because of oil.
President Bush Jan 10, 2006

Friday, January 06, 2006

Busy signals

When men of a certain age and spirit look back on their lives, they see long periods of continuity separated by a few key decisions. One such man awoke early one morning and reflected on some of those decisions. He remembered that day 21 years ago when his eldest son was born. As always, the memory brought a smile to his face. And now, after 21 years of feeding, housing, clothing, washing and nurturing this man's son was now ready for a centuries old family tradition.

The man remembered the day of his 21st birthday, when his father woke him up and took him for a surprise walk to the old town spring. On that walk his father emerged as a person to him for the first time, a man who was telling his son that from now on they were equals-from now on the son would become a man, responsible for his own actions, good or ill. To help him in that quest, members of the family had come up with a set of rules which, if followed, created the best chance of being a good man. The list had not been changed in 150 years.

The rules on the list weren't unique in that they could be derived by careful study of the great religions' primary texts. Yet when the man thought of his ancestors, those without whom he would not be, writing the rules down for posterity, they came alive for him. Although he had been too caught up in the magic of the moment to notice it when he received the list, the coming of age tradition sanctified the words. As he had matured as a husband and father, the magic of the rules faded but their wisdom was, by then, clear.

Today, he would give this precious gift to his son, now ready to become a man. So he quickly dressed and went to his son's room. Through the partially open door he could see his son's body slowly rise and fall in the rhythm of deep sleep.
On a desk near the bed a computer screen flickered, a prize his son had won in a math competition.

Mixed emotions passed through the man's mind as he looked at the computer. Pride at his son's almost innate skill with symbolic logic fought with a nagging sense that the copious praise earned by that skill had kept him from discovering the literature most family members loved. Yet those skills had already landed his son a job as a programmer, a model builder to be precise, as the man had been proudly announcing to his friends around town

His son awoke as the door creaked in its hinges. "What's up, Dad?" he asked.

"I'd like to take a walk with you this morning, son. I have something to give you," his father responded.

"OK," the son replied but with a look as if he would just as well sleep a few more hours.

Once outside in the country air, the man and his son walked together on the same path to the spring he had walked with his father. Years ago the path had been well worn but lately the grass was fighting its way back as fewer and fewer visited the spring.

After a few minutes of walking in silence, wondering how to begin, the man was almost startled to hear himself using the same words his father used those many years ago. Lost in the comfort of tradition the man didn't notice his son's expression at first. He was looking at the parchment of family rules, now covered in plastic for protection, as if he didn't want to touch it.

"Why didn't you just email it to me?" he asked, not noticing, as 21 year olds are wont, the seriousness of his father.

The man stopped short, almost stunned. "But..but..these are rules our family has tried to live by for years," he said, confused.

"You know, Dad," the son interjected, "you've been talking most of my life about being a good man and I have my own solution."

"Really," his father answered, torn between pride of his son's mathematical skills and his long held faith that the rules worked.

"Yes," the son answered, "I call it a goodness index. You see," his son went on, "I'll just keep track of what happens to me, good or bad, and change my behavior whenever things start going bad, just like I've done around the house."

The man thought about all the electronic meters his son had installed around the house. He had to admit, it was great to find out that he needed new light bulbs, or that his furnace was operating with decreasing efficiency without checking on these things by hand but something nagged at him.

"Are you sure you don't want the rules?," he asked again.

"Just email me a copy and you keep the paper, I know you like old stuff like that," the son responded with a smile. "Let's go back to the house, I don't really want to walk all the way to the spring."

They walked back in silence at first. The son, formerly dragging his feet was now in the lead and the father's sure, steady gait had become halting.

Without turning back to look at him the son told his father, "you really need to get into the 21st century, Dad."

His father replied, "I'm not so sure," but the son was too far ahead to hear.

Thursday, January 05, 2006

The Paradigm Problem (or why Brad Setser ain't wrong)

In the beginning the earth was without form, and void. And the economists said, let there be GNP based quantitative macro-economics and there was GNP based quantitative macro-economics. And the economists saw the GNP based quantitative macro-economics, that it was good: and the economists divided the GNP based quantitative macro-economics from the darkness.

Gene-money $1.01

It is the mark of an educated mind to be able to entertain an idea without accepting it. Aristotle

There I was on Tuesday night, with keyboard as chisel, trying to bring forth a word sculpture of a good idea. I read it this morning and what had been a fine word sculpture now became an exercise in pedantry (a wonderful word, see definition 2, although I wonder if using the term makes one a pedant?). "Dude," I thought, "nobody but a wing nut like you is going to want to read three pages of ancient Greek mathematics and astronomy to get to the punch line." "Dude," I said back to myself, "I don't even want to read it." OK then, enough showing off, or demonstrating my ignorance, depending upon your perspective, lets go for the cheap laughs, bathroom humor, and get to the punch line quick.

You ever wonder how a bunch of guys can sit in a small room filled with the overpowering smell of stale beer and the farts thereof, watching a game on TV? Simple, after a while the smell just fades into the background. It becomes absent from one's mind by its continuous presence. Of course, if you leave the room for a while and then try to come back, watch out. Let's leave the room, ideologically speaking.

You ever wonder how a culture could cling to an idea like Aristotelian-Ptolemaic geocentrism even when the evidence against it was overwhelming. (how that idea became mainstream is another interesting story, Aristarchus and Pythagoras proposed heliocentric models) Simple, once an idea is entrenched in a culture it fades into the background. Moreover, leaving the room was and still is a very difficult proposition, (channel Giordano Bruno if you doubt me) unless you practice the art of skepticism, quietly that is.

Just recently I discovered a new, to me at least, feature of the NYTimes web site, a search function which accesses a database going back to 1851. So I search "gross national product" and the earliest instance is in 1942. I search "gross domestic product" and the first instance is 1959. Why does this matter? Pick up an undergraduate macro-economic textbook, go on, it won't hurt you, just bore you to tears. I have Dornbusch and Fischer's Macroeconomics but Samuelson's is similar. These texts are based on the primacy of National Income accounting- the classic formula Domestic product = C+G+I+(X-M). GDP, the measure or map IS, according to these texts, the economy or territory and everything from the financial markets to public policy is supposed to be decided accordingly. The concept isn't introduced as one way to consider the issue but rather as the only way, like the geocentric view of the world was 5 centuries ago.

It wasn't always that way. Less than a century ago students of economics or rather political economy might read Keynes' General Theory, Mises' Human Action, or Ricardo or Smith as primary texts. Now these studies, if they are ever pursued, occur after indoctrination into national income accounting. A century ago students of political economy might debate the relative virtues of differing media of exchange, now they simply sing the praises of the US$. Indeed, it seems to me as if that is a good chunk of what economists do now, they sing the praises of a measure (GDP) whose relation to the real world seems an exercise that best recalls the old joke about Scholastics debating how many angels could dance on the head of a pin. Sillier than the joke about the Scholastics is the reality of economists debating dark matter. As Ptolemy might put it, more epicycles anyone?

In theory, it all seems nice. The state would produce a quantitative measure of economic progress, or the lack thereof and policy would be changed accordingly. Ah the seductive siren's song of public policy as science. It's a great idea unless you are the guy or party that has to take the lumps. Guys like George Washington and Cincinnatus who are willing to hand over power are the exceptions not the rule. Most guys who attain power are loathe to reliquish it, or even admit error.

As I noted a few days ago, I'd read Brad Setser's humble Things I got wrong in 2005 with interest. I had read and agreed with the sense of his paper co-authored with Mr. Roubini predicting tough times ahead for the current system of international exchange. But while I was reading his humble admissions of error I wondered if he had really considered the scope of his forecast. It is one thing to argue that Thailand's GDP will fall, as that idea fits within the current paradigm, but quite another to argue that the basis of the whole system is flawed. Just as the language of geocentrism isn't much use when describing a heliocentric system, so too will the language and metrics of national income accounting be of little use when the medium of exchange, on which that accounting is based, is failing.

Looking through his list of self-described errors I see exchange rates, interest rates, yield curves, reserve accumulation and an implicit nod to GDP in the sense of a lack of stress. This leads him to, in my view, confuse a sign of stress, $60 oil, as a sign of strength, in that, according to the metrics currently is use, this price rise hasn't caused problems. To me, the lack of measured stress in the data suggests they are measuring the wrong thing. Of course, having decided in the 70s that GDP must always be rising, except for the odd hiccup, this should come as no surprise.

When Schumpeter wrote about the ground giving way underneath the economists' feet, he was, I contend, referring to this confusion of the map and the territory. While the financial markets, by which I mean to refer to the paper kind, and the GDP based data to which they refer paint a wonderful picture, rising commodity prices, Wars, preparation for more Wars, energy shortages and threats of embargo, and even the rising price of Gold suggest an escalating problem.

Brad, if you read this, I think you and Mr. Roubini are more right that your writing suggests. The only error I see is an expectation that the powers that be would be as humble as you in admitting their error.

Addendum: Winston Churchill famously said, Men occasionally stumble over the truth, but most of them pick themselves up and hurry off as if nothing had happened. In similar fashion to Mr. Setser, Stephen Roach of MSDW has nagging doubts-things aren't going the way they should. Yet, within a few sentences of this report, he quickly picks himself up and hurries off. The idea that the statistics are so massaged as to be meaningless in any quantitative model and the markets so managed as to forestall any outcome that might suggest weakness is perhaps too scary for him. The question, in my mind, isn't, when are things going to get bad but rather when will our dire economic condition be admitted, i.e. when will the financial map better represent the economic territory.

ps I was talking to my friend Stephen Plant and he repeated an idea of his that seems pertinent to this argument. He noted that the door to get into Gold was too small for the big money. This has been a problem for the big money guys for years, but not decades. If you manage a few billion $, putting on a commodity trade that will meaningfully impact your bottom line risks moving that market substantially. One could think that this means that the Gold market is too small for the hedge funds. Steve thinks it just means that prices will need to find a level at which the hedge funds can play. I agree. Too much liquidity and too few goods and services.

Cue Gollum, stage left

But the climate of those years was so grim that half the Washington press corps spent more time worrying about having their telephones tapped than they did about risking the wrath of Haldeman, Erlichman and Colson by poking at the weak seams of a Mafia-style administration that began cannibalizing the whole government just as soon as it came into power. Nixon's capos were never subtle; they swaggered into Washington like a conquering army, and the climate of fear they engendered apparently neutralized The New York Times along with all the other pockets of potential resistance. Nixon had to do everything but fall on his own sword before anybody in the Washington socio-political establishment was willing to take him on.
--Hunter S. Thompson, The Great Shark Hunt

When I first read Tolkien's Lord of the Rings at 11 I found the climax a bit odd. "Aren't the good guys supposed to defeat the bad guys?," I thought to myself, "this ending has the bad guys, who should win, losing by their own actions." Later in life I came to understand and agree with Tolkein's worldview, evil destroys itself, eventually, which is why we call it evil.

Consider the case of Jack Abramoff and his partner Michael Scanlon, which is apparently making quite a few public officials nervous. Was this case cracked by a virtuous detective like on TV? No. It appears that the real break came not from the efforts of law enforcement but by virtue of the actions of the players themselves. According to this article, the case broke open when Mr. Scanlon's jilted fiancee called the F.B.I. What a surprise, someone who was willing to defraud people out of millions of $ wasn't faithful to his fiancee. Free will, what a drag. It always seems to screw up the best laid plans.

Yet the Scanlon snafu may not be the "gollum" moment. Yesterday, NBC's Andrea Mitchell asked James Risen, who broke the NSA spying story in the NYTimes if the NSA was taping journalists and then specifically asked if the NSA had eavesdropped upon Christianne Amanpour.

David Hume once opined; The soldan of Egypt, or the emperor of Rome, might drive his harmless subjects, like brute beasts, against their sentiments and inclination: But he must, at least, have led his mamalukes,° or prætorian bands, like men, by their opinion. That is, you can drive the unwashed masses at whim but you must be careful with the nobles-you must get them on your side. If the press corps in Washington, and their significant others, like James Rubin (Amanpour's husband) or Alan Greenspan (Andrea Mitchell's husband) begin to worry about being taped, things could get really interesting.

Cue Gollum, stage left.

Wednesday, January 04, 2006

Wanting to believe

What does the Nasdaq bubble and the tragic error in reporting the condition of the trapped miners have in common? They are both examples of what can happen when the wish to believe overpowers sober reflection of and patience in obtaining the necessary evidence. In my view, the real onus to get the story right rests on the teller of the tale, particularly with respect to the families of the miners.

This is not, I believe, an uncommon phenomenon. What seems uncommon is for the hard evidence to the contrary to be found so quickly. What a tragedy.

Marshall McLuhan coined the phrase "the medium is the massage" and in this case, and others, the massage exemplifies, nay, generates Baudrillard's simulacrum. Yet to all things there are limits as the myth of Daedelus and Icarus warns, though perhaps the boy who cried wolf might be more apt. I wonder how many stories the mass media can get very wrong in a short period of time before the public turns it off.

thin ice

Tuesday, January 03, 2006

Timing is everything

Abramoff will also agree to cooperate in any ongoing federal investigations in Washington, said his Miami attorney Neal Sonnett. Prosecutors there are investigating several members of Congress who allegedly received favors from Abramoff or his clients. AP

Back in the '92 election campaign, Bill Clinton's team came up with the slogan, "it's the economy stupid", the sense of which was that as the economy went so did the fortunes of those in Washington. For Clinton, emphasizing economic woes was his ticket to the White House, while an aversion to any noticeably meaningful deterioration allowed him to maintain control. This articulation though overstates the degree of control I believe the powers that be have over the economy. Clinton found himself in an economic sweet spot.

The Bush team has not been so lucky. All the spin in the world is not going to do much good when gas prices double, heating oil prices triple and natural gas prices...ouch!. Yes, Clinton's 92 election slogan still seems apt.

Recalling my days in corporate land, the lesson that timing is everything comes to mind. If, as a trader, you are on a roll, raking in profits, you can do (almost) anything and management will look away. But, if you are losing, you had better get to work early, leave late and be helpful. You could likely crash your car into the Sr. VP's car in a drunken stupor and have him ask you, with all the feigned concern he could muster, if you are OK after posting a few million $s of profit in the past month but get fired for merely parking in his spot after losing US$100k.

As the winter begins to bear down on the US, while crude oil, it's products and natural gas prices begin to rise again I listen the drumbeat of scandal out of Washington DC with interest. There are good times and bad times to get caught bribing, perjuring, outing and obstructing and this winter may be one of those bad times.

I dwell on this issue for the 40% of my 3 readers (yes I know, just go with it) who come here for financial opinions. The world of fractional reserve banking is built on faith and unfortunately for those in charge, it isn't faith in the afterlife, but faith in something quite tangible, material well being. I know it's an opinion I've given before but perhaps now it seems a bit more possible, a bit closer to reality. I suggested the Watergate scandal as possible model for current times but things seem much more dire now than then, at least to me if for no other reason than that we have, in a sense, already sold many of the family jewels. In the 70s the US still had a positive net investment position.

My next post will focus on the paradigm problem, i.e. how do you speak of a collapsing paradigm using the lexicon developed therein? It is in response to Brad Setser's post, What I got wrong in 2005. I think Mr. Setser got far less wrong than he thinks.

Monday, January 02, 2006


I do most of my writing, typing actually (I tend to contemplate the ideas and formulate the articulation lying in bed at night, driving without music and walking by myself) in my barn/office a very short walk from my home. After publishing yesterday's piece I didn't even make it into the house without the urge to edit hitting home. "Dude," I said to myself (talking to one's self seems to me an occupational habit of philosophers) "you too played at being an expert in the 90s. Had you risen to Bandow's stature would you have turned down the money?" I thought of a few instances which suggested no, but then many others which suggested otherwise. I wouldn't do it now, but I think differently about money and words now than I did then. In general I took money more seriously than words, a view that doesn't fit comfortably in my mind any longer.

1600 years or so ago, in a book which inspired this post, a man recalled his own episodes of linguistic a$-kissing for money.

I recall from the incident of the day on which I was preparing to recite a panegyric on the emperor. In it I was to deliver many a lie, and the lying was to be applauded by those who knew I was lying. My heart was agitated with this sense of guilt and it seethed with the fever of my uneasiness. For, while walking along one of the streets of Milan, I saw a poor beggar--with what I believe was a full belly--joking and hilarious. And I sighed and spoke to the friends around me of the many sorrows that flowed from our madness, because in spite of all our exertions--such as those I was then laboring in, dragging the burden of my unhappiness under the spur of ambition, and, by dragging it, increasing it at the same time--still and all we aimed only to attain that very happiness which this beggar had reached before us; and there was a grim chance that we should never attain it! Augustine of Hippo Confessions Book 6 Ch. VI

Like Augustine the African, I too played the game and wondered, at rare intervals, why. But mostly I just played the game. My critique is not meant to be from on high but from the trenches-been there, done that (whew!, glad I escaped). I understand the drive if I don't now agree with it.

I've been on TV and spoken at conferences around the world and as I recall my talks much of what I said seems to me now silly rhetorical nonsense packaged with enough of the received dogma to fool others whose studies were of equal depth as my own (lots of those) although at the time I was sure it was quite clever, though crafty seems more apt. In other words, the first person I fooled was myself. Looking back, I assume I was picked to stand as "expert" because of my ignorance, ambition and skill as rhetor. Ironically, I feel far more qualified to speak on economics now yet have almost no desire. I guess there is a difference between wanting to be thought of as someone who knows and actually learning.

As I was writing, almost as soon as I finished my last post, I felt the urge to edit but didn't, deciding instead to post a follow-up confession. I then watched a bit of TV and was almost embarrassed to recall myself doing what I was seeing on the tube. Ah, to be on TV. To have one's opinion begged. To laugh overloud at the host's jokes in order to be called on again, only to prove the wisdom of Mark Twain: it is better to remain silent and have people suspect you are a fool, than open your mouth and remove all doubt. Ah the human condition, better learn to love it, because leaving it is so terminal.

In the end I share Augustine's sense that if I could come to see how silly I was (and may still be, I'll let you know in a decade, if I'm still kicking around) there is always hope for the world.