Wednesday, August 29, 2007

From risk to uncertainty and back again (I hope)

The facts of life in this regard are in a superficial sense obtrusively obvious and are a matter of common observation. It is a world of change in which we live, and a world of uncertainty. We live only by knowing something about the future; while the problems of life, or of conduct at least, arise from the fact that we know so little. This is as true of business as of other spheres of activity. The essence of the situation is action according to opinion, of greater or less foundation and value, neither entire ignorance nor complete and perfect information, but partial knowledge. If we are to understand the workings of the economic system we must examine the meaning and significance of uncertainty; and to this end some inquiry into the nature and function of knowledge itself is necessary.
Frank Knight: Risk, Uncertainty and Profit

When I was 11 my father decided to go back to school and study the Liberal Arts; specifically Philosophy. Thus I had the good fortune, at an impressionable age, to browse through the views of many of the noted Philosophers, in particular Locke, Berkeley and Hume.

I remember the first time I browsed (read would imply greater understanding than was evident) Hume's essay on Human Understanding. It was a humbling experience. While the book was written in English, and, according to my public school educators, I could already read at a college level, I couldn't understand the arguments. Fortunately I was young enough to not write off the essay as "unintelligible," instead realizing I needed more study to grasp the, as I later learned, important arguments therein.

I get the sense that others have encountered similar difficulty grasping complex arguments in literature, although, it seems to me, without recognizing the fact. Take President Bush's recent statement about Graham Greene's novel, The Quiet American:

The argument that America's presence in Indochina was dangerous had a long pedigree. In 1955, long before the United States had entered the war, Graham Greene wrote a novel called, "The Quiet American." It was set in Saigon, and the main character was a young government agent named Alden Pyle. He was a symbol of American purpose and patriotism -- and dangerous naiveté. Another character describes Alden this way: "I never knew a man who had better motives for all the trouble he caused."

After America entered the Vietnam War, the Graham Greene argument gathered some steam. As a matter of fact, many argued that if we pulled out there would be no consequences for the Vietnamese people.

It has been a while since I read the book but I don't recall any of Greene's characters arguing that an American pull-out would have no consequences for the Vietnamese- the book's focus was on the naiveté of going in and expecting positive results. Further, although this is a small point, Greene's argument didn't "gain steam," it became self-evident. The naive Alden Pyle's of America's ruling class had self-inflicted a wound on American prestige in international circles by opting to intervene in IndoChina. The Iraqi analog also seems self-evident, but that is just my opinion.

And opinion, personal opinion, and its effects, is the theme of this essay.

President Bush, it seems to me, assuming he read the book and is not relying on his speech writers' understanding thereof, views Greene's arguments through the self-imposed lens that American military intervention is, in both Vietnam and Iraq at least, wise. Greene's arguments fell on deaf ears in that case. One must be open to the possibility that contrary arguments might be correct, i.e. be able to entertain them, to understand those arguments. Aristotle's quote that it is the mark of an educated mind to be able to entertain an idea without accepting it comes to mind.

But I digress.

The notion of Knightian uncertainty is making the rounds again in the aftermath of recent credit and equity market volatility. In reading some of the comments referencing Knight's views, I get that same sense that the arguments of Frank Knight's Risk, Uncertainty and Profit often fall on deaf ears. This is perhaps not surprising as Mr. Knight was first a philosopher before he became an economist and understanding his views requires an understanding of epistemology, the study of what it means to know something. As he put it: If we are to understand the workings of the economic system we must examine the meaning and significance of uncertainty; and to this end some inquiry into the nature and function of knowledge itself is necessary.

If you read Knight's views without a fair bit of grounding in epistemology you may well find yourself at the impasse I found when I first read Hume, or when I try to read an advanced book on Organic Chemistry.

Alternatively, you might think you understand epistemology as, apparently, ex-Fed Chairman Greenspan did, through his familiarity with Ayn Rand's Objectivism. In that case, Knight's arguments would, unbeknownst to you, be falling on deaf ears. Greenspan's view (see below) that one never knows whether one is dealing with uncertainty or risk seems to me evidence of a lack of understanding of Knight's arguments. If you keep discovering, through the emergence of surprising outcomes, that what you thought was risk was really uncertainty, you aren't assessing risks, but fumbling in the dark.

The Federal Reserve's experiences over the past two decades make it clear that uncertainty is not just a pervasive feature of the monetary policy landscape; it is the defining characteristic of that landscape. The term "uncertainty" is meant here to encompass both "Knightian uncertainty," in which the probability distribution of outcomes is unknown, and "risk," in which uncertainty of outcomes is delimited by a known probability distribution. In practice, one is never quite sure what type of uncertainty one is dealing with in real time, and it may be best to think of a continuum ranging from well-defined risks to the truly unknown.

Enough prologue though, let's move on to Knight's views.

As the opening quote states, the difference between risk, which Knight defines as measurable uncertainty and uncertainty proper, i.e. unmeasurable, is a matter of personal opinion, or as I like to put it, one man's risk is another man's uncertainty. A well grounded sense of the world transforms a good deal of uncertainty to risk and vice versa.

Perhaps then, one can understand Greenspan's statement that uncertainty is not just a pervasive feature of the monetary policy landscape; it is the defining characteristic of that landscape as an (I suspect unintended) indictment of Central Banking. Perhaps accepting the view that Central Bankers can make the world a better place- a view I suspect most Central Bankers accept, turns what could be defined as risk, in their minds, to uncertainty. If monetary policy rarely creates better outcomes but monetary policy makers assume it does, they will, from time to time, be surprised at the outcomes which follow their actions, that is learn that they were operating in an environment of Knightian uncertainty. Alden Pyle's naiveté might not only be evident in military interventions but economic ones as well- let's call it The Quiet Central Banker.

And these Central Bankers and other economic officials would like you to share their uncertainty. They wish to mold investor expectations through commentary and intervention such that you see the world through their lens.

Thus, it seems to me, they turn what might be apprehended as a clear risk of financial disaster into uncertainty of its probability in the minds of many and thus engender the very volatility they claim to wish to curtail . If you accept, or more cynically, believe that many others will accept the views of Henry Paulson, presented on March of this year that; We have a very strong global economy. We have a global economy with low inflation, high levels of liquidity and I feel very comfortable with the global economy, then the recent market gyrations were surprising. Equally, if you adhere to the views of those like Jim Cramer that additional Fed liquidity, which, in my view, are a cause of the problem, is likely to fix things, you may well be surprised at the outcome. If you believe that financial deregulation, which allowed banks to securitize mortgages and let derivatives grow unchecked, is an unalloyed good, you too might be operating in uncertainty, but be ignorant of that fact, and thus be surprised at the outcome.

For Frank Knight, the difference between a successful entrepreneur and a failure lies in their differences in opinion. The former operates, more or less, in an environment of risk while the latter operates, ignorantly, in an environment of uncertainty. Transforming a good deal of uncertainty to risk can be done by adopting more accurate opinions of how the world works and how we, through the medium of consciousness, interact with it..

So, in this case, to transform uncertainty to risk one should "fight the Fed." To the extent our current problems were foreseeable, and many predicted them, they are a result of risks transformed into uncertainties by faith in false doctrine.

I'll close with another excerpt from Knight: But in economics a distrust of general principles, fatal as it is to clear thinking, will be inevitable as long as the postulates of theory are so nebulous and shifting. They can hardly be made sufficiently explicit; it is imperative that the contrast between these simplified assumptions and the complex facts of life be made as conspicuous and as familiar as has been done in mechanics.

The present essay is an attempt in the direction indicated above. We shall endeavor to search out and placard the unrealities of the postulates of theoretical economics, not for the purpose of discrediting the doctrine, but with a view to making clear its theoretical limitations. There are several reasons why the approximate character of theoretical economic laws and their inapplicability without empirical correction to real situations should be especially emphasized as compared, for instance, with those of mechanics. The first reason is historical and has already been indicated. The limitations of the results have not always been clear, and theorists themselves as well as writers in practical economics and statecraft have carelessly used them without regard for the corrections necessary to make them fit concrete facts. Policies must fail, and fail disastrously, which are based on perpetual motion reasoning without the recognition that it is such.

Friday, August 24, 2007

FT's Lex forgets: investors drool too

The credit hullabaloo is toppling many perceived truths. Triple-A means safe, for example. And terrified investors rush into gold. If there was ever a time for gold to demonstrate its safe-haven status, it was Monday. Yields on three-month Treasury bills plummeted almost 200 basis points as investors scrambled for government paper. Surely, this dramatic flight to quality should have pushed gold through the roof. Yet the price of gold did not shift from exactly $657 per troy ounce from Friday to Tuesday.

Either all bullion traders holiday together or investors prefer to trust the US government with their money more than they do gold. That is not as silly as it sounds. Gold is, after all, just a metal, and sentiment can be as irrational as for a high-risk asset. It is not even scarce. Nearly all the gold ever mined is still above ground. Only about 10 per cent of 2007 demand is for industrial use, whereas three-quarters of demand is for jewellery. It also provides no yield – although the way Treasuries are moving, that may not be a relative disadvantage for long
. FT

Many readers are likely familiar with the experiments of Pavlov with dogs. Pavlov would ring a bell each time the dogs were fed and then he found that the dogs would salivate (drool) after hearing the bell even when they weren't fed.

One feature of the black boxes used to make trading decisions is to make those traders like Pavlov's dogs. They have no sense of fundamentals, like if they are getting fed (i.e. buying low), but simply react blindly to stimuli. Investors have bought US bonds during the past few crisis, therefore, Pavlov's dogs are sure these are the things to buy.

This process is aided by timely intervention with this effect in mind.

Further experimentation by Pavlov showed that the dogs eventually stopped drooling after a period of just hearing the bell without getting fed.

I suspect the conditioned reaction to financial crisis will also wear off. Meanwhile, I advise one to think twice when hearing a bell.

Wednesday, August 22, 2007

Learn from RISE of Ancient Rome, I say

Last week's warning from David Walker, comptroller general of the US, to learn from the fall of Rome led me to reconsider, by which I mean go back and re-read a few books, the utility of that oft used comparison. After further reflection I think a far more apt analogy to our (i.e. the United States) situation is the rise of Rome from effective city-state to Empire, rather than its fall. I believe a study of the rise of Rome teaches more useful lessons because the US, as currently constituted, more closely resembles the Roman Republic after the Punic Wars than it does the Empire prior to its fall.

Prior to the wars with Carthage (the Punici in Latin, i.e. Phoenicians) Rome had managed to expand its domain in the Italian peninsula, in the main, without changing its Republican government. For the most part the conquered states within the peninsula adapted well to the Roman modes of government and language. Indeed, all the Latin tribes spoke some form of Latin.
The growth of the United States within what are now the contiguous states between Mexico and Canada followed a similar path in that each expansion was able to be added without changing the form of government or language.

Once Rome had gained control of the peninsula, as when we gained control of the contiguous states, attention was turned to growth across the seas- growth which, in Rome's case, eventually led to the demise of the Republican forms and which, in our case, seems to be leading us down the same path, which is why I find that earlier period a more apt analogy than the fall.

Consider this view from J. A. Richards' The History of the World Vol IV: Now the system which worked while the city was self-contained, while it was actually a city within a domestic area of adjoining territory, proved itself defective as soon as the dominion of the city expanded, but not at first conspicuously. The Latin and Italian allies had their grievances, but they were of a fixed and therefore of a tolerable kind. Through the great wars the Senate and the nobles maintained their high character for public spirit in spite of many blunders. But the mere fact that war was being conducted on a large scale brought into prominence the impracticability of a system which annually changed its generals and disbanded its armies.

In other words, as we are currently learning, the Republican model of reasonably frequent elections and thus changes in leadership which had proven effective (in Rome and elsewhere over the centuries) in maintaining domestic support by giving the people a "say," however limited, in government proved ineffective when conducting large scale wars of long duration. Remember this the next time you hear some politician on TV, from either side of the aisle, speak of the long term War on Terror. Long wars and Republican forms of government do not mix.

Rome "solved," in a manner, this problem much as we have, although we tend to use local governors, by adopting a provincial system, which Richards' explains: The next step [in the provincial process] was the reduction of the whole [recently conquered by Rome] area to the form of a province, the "command" of a Roman governor exercising the imperium [i.e. absolute rule]. It was his business to preserve order and to collect the revenue for which his province was responsible. A constitution was laid down for the province, adapted to its special conditions, and the governor was supposed to act in accordance with the provisions of the constitution.

The position of provincial imperator became a much sought after prize- many Romans looked on Roman political office as a stepping stone to such appointments, as it came without the conditions imposed by the Roman constitution. Having tasted absolute (in many ways) power, Roman governors, like Julius Caesar, saw that form of government as a better model for Empire.

Julius Caesar and his adopted son Augustus led Rome through the last stages of the demise of the Republic and birth of the Empire.

Some (many) of you might be wondering if my choice of the rise of Rome as Empire as more apt analogy for our current situation implies the view that we will be as successful as Rome in making a similar transition. I don't think we will be as successful as Rome in that endeavor.

The first and foremost reason I don't see us following that path is the difference between our military expansion and Rome's. Rome proved quite capable, even while Hannibal was causing problems within the peninsula, of fielding sufficient men to fight on multiple fronts. Rome fought and won the Macedonian War, thus gaining a foothold in the heart of the Hellenic world, while the Second Punic War was ongoing.

The two centuries which followed the destruction of Carthage were, admittedly with quite a few setbacks, years of Roman military success- years which eventually led to Roman dominion over the entire Mediterranean.

By contrast, and, I believe, fortunately, we have proven to be less adept at bringing foreign powers to heel. It has been more than 5 decades since we last "won" a war against a major power. Korea, Vietnam, and more and more obviously Iraq, are demonstrating the limits of our military power in a world where human rights for peoples of all colors are valued and news travels around the world in the blink of an eye. The sensibilities of the modern world and speed of communication are, at least thus far, far less amenable to Empire than was the case two millennia ago.

The second reason I don't see us following Rome to Empire lies in the expanded "say" of US citizens in our Republican government and the enforced indoctrination of our young in the virtue thereof. We have, I believe, many more Cicero-like characters around these days.

Wars of foreign conquest over the past 5 decades of our history have fomented more or less peaceful domestic rebellion. Anti-War politicians find their way to power much easier than was the case in Rome.

Certainly things could change. There are those who seem as prepared to discard the old forms of government as were the Caesars, but, thus far, they have not been of the same quality as those two. Had Julius and Augustus been less successful militarily their attempts to lead Rome from Republic to Empire might well have ended differently. Rome, in that scenario, might have collapsed back on its Republican forms much as Britain did after its Empire proved too difficult to maintain.

George Bush, in my view, is, in a sense, correct when he warns of the consequences of Iraq becoming another Vietnam. Given our reliance on imported oil to fuel both our economy and military expansion- an Achilles heel which Rome did not have, I doubt we will get another bite at the apple of Empire if we lose "our resolve," to quote the President, in Iraq.

It seems to me that it is either now or never for Empire. Losing Iraq likely means a fall back to the old forms, i.e. a true conservatism.

We will see what the future holds.

p.s. I'm still working on the Knightian uncertainty essay

Thursday, August 16, 2007

Central Bankers take toys and go home

If you don't have children peer back in your memory and try to recall a time when a group of you were playing a game. Then when the game wasn't progressing the way one child, who happened to own the toys, wanted, he upends the game board, or simply takes the toys away and leaves.

If you have children you most likely see this from time to time.

Watching the gold market trade the past few days, I get the same sense. It is as if a group of guys decided that if we don't play by their rules, they will destroy the game for all. The global financial system becomes Hotel California, you can check out any time you like, but you can never leave.

When did finance become an all-or-nothing proposition? When Central Banks took the place of a gold standard. Prior to that time, gold was the preferred place to store value during imbalance resolution phases. Now, we are all, apparently, stuck on the Titanic and all warning bells have been disconnected.

Heck, even Dennis Gartman sees things that way, although he views the policy with agreement.

But this policy has consequences, most notably, it transforms risk into Knightian uncertainty- a transformation I will explain in my next post.

Tuesday, August 14, 2007

Carlo Ponzi - Fed Chairman, and the current crisis

Central banks around the world have been injecting funds into markets in response to an undesired and unwelcome spike in short-term rates suggested that demand for reserves was outstripping supply. The following is a rundown of the totals and excerpts from any statements issued Friday by the regulators. WSJ

Federal Reserve
Thursday: $24 billion
Friday: $38 billion (tranches of $19 billion, $16 billion and $3 billion)

European Central Bank
Thursday: €94.84 billion ($130 billion)
Friday: €61.05 billion ($83.56 billion)

The Bank of Canada
Friday: 1.64 billion Canadian dollars ($1.55 billion).

Bank of Japan
Friday: one trillion yen ($8.39 billion)

Swiss National Bank
Friday: two to three billion Swiss francs ($1.68-$2.51 billion) [estimate]

The Reserve Bank of Australia
Friday: 4.95 billion Australian dollars (US$4.18 billion)

The Monetary Authority of Singapore

Friday: 1.5 billion Singapore dollars (US$986.1 million)


FRANKFURT/SINGAPORE (Reuters) - Central banks in the world's leading economies pumped money for a third day into the financial system on Monday, but in smaller amounts as investor nerves steadied over the dangers of a credit squeeze.

The European Central Bank lent out an extra 47.67 billion euros ($65.29 billion) in overnight funds, its smallest amount since lending rates shot up last Thursday on fears European banks faced huge exposure to risky U.S. mortgage debt. The ECB noted that markets were beginning to return to normal.

While the Atlantic Hurricane season has been slow (so far) it appears that a whale of a storm just hit the financial markets. You know things are grim when the sedate FT prints articles that seem more at home on a blog. Jeremy Grant's Learn from fall of ancient Rome, official warns US reads like something I would write. Of course crisis periods usually evoke crisis warnings and we are experiencing a crisis, aren't we?

We don't need no st-ee-nking crisis

Judged solely by the actions of the world's Central Banks a credit crisis seems obvious. Yet, having been around the financial block for a few decades I'm a bit confused. Crises ain't what they used to be.

I was an economic consultant out in SE Asia during the 97-98 crisis and remember it well. By the time the Fed decided to act, in September of 98, most Asian equity indices had lost at least half of their value, and many, much more. For instance, Singapore's Straits Times Index had fallen from Jan-97's 2216.8 to 826.93 by Sept of 98.

In the US, the Dow Jones Index had fallen from a spring 98 peak of just over 9000 to around 7500 when the Fed eased in September of that year- roughly a 17% decline.

Meanwhile Russia was defaulting on its foreign debt and Brazil was on the brink.

Now that's a crisis.

The current crisis, at least judging by equity indices, seems much more tame.

Asian equity indices have fallen, but only by 10% or so from early year peaks. European equity indices have fallen by similar amounts of 10% or so. The Dow Jones Index is down about 850 pts from it's peak of 14K or just over 6%. That's 1/3 of the 98 equity decline that got the Fed into action a decade ago. And I am unaware of any Russian style sovereign debt defaults this go round.

If the current crisis is, judging by equity indices, orders of magnitude less severe, than what's the deal? What makes this a crisis?

The wrath of the Derivative's God

The most glaring difference between the 98 crisis and the current period is the growth of derivatives in general and credit derivatives in particular.

According to the OCC, the total notional value of derivatives for US banks in Q2 1998 was US$28T, of which interest rate derivatives totalled some US$20T and credit derivatives totalled some US$129B.

As of Q1 2007, the total notional value of derivatives for US banks was US$144T (a quadrupling over 10 years), of which interest rate derivatives totalled some US$119T (6 times the 98 amount) and credit derivatives totalled some US$10T (an almost 10 fold increase over the decade).

Another difference is the concentration of exposure into fewer banks. In 1998 derivatives exposure was spread across 8 big banks, while currently (again according to the OCC report) Commercial bank derivatives activity is heavily concentrated in the three largest dealers, which hold 89%of all contracts.

Back when I was trying to explain derivatives to Asian Central Bankers I used to tell them to think of derivatives as leverage- more derivatives equals more leverage. So in the 10 years since that last crisis, leverage has increased dramatically AND been concentrated into fewer and fewer hands.

Increased leverage means that it takes less unanticipated price action to create a crisis. A decade ago, equity indices could fall 20-30% before Central Bankers warned of a crisis while now a mere 10% move evokes the same warning.

Increased concentration of exposure into fewer and fewer institutions also decreases the amount of unanticipated move necessary before alarm bells ring. A tremendous amount of leverage concentrated into three institutions, which, as an aside, was just the type of situation Glass-Steagle and the other post depression financial regulations were trying to avoid, is a recipe for disaster- when one goes the market goes with it. Good thing those regulations were repealed.

In other words, increased leverage and concentration makes our financial institutions much less resilient to unanticipated shocks. As any leveraged futures trader who has been burned can tell you, the more leverage you use, the better speculator you need to be, or as we will discover, the better placed your friends need to be

What if Robert Rubin had founded LTCM?

I see more than coincidence in the recent actions of Central Banks and the news that Goldman Sachs' Global Equity Opportunities Fund just got a US$3B shot in the arm. Financial industry consolidation and the seeming revolving door between high level Wall St. executive positions (most notably Goldman Sachs, from whence came Hank Paulson) and the US Treasury should set collusion alarm bells ringing.

I wonder if the LTCM fiasco would have been resolved differently if one of their founders had taken the job as US Treasury Secretary. In the event, LTCM was liquidated, while Goldman Sachs' Global Equity Opportunities Fund will likely continue operations.

Carlo Ponzi, Fed Chairman

Most press stories explain the recent liquidity additions as a concerted attempt by the world’s central banks to restore confidence in the global financial system.

How does the financial industry lose confidence? by losing other people's money.

How can the financial industry maintain confidence? Let's go back to the early 20th century and inquire as to the actions of one Carlo Ponzi (thus the eponymous scheme) whose Securities Exchange Company advertised a 50% return in 90 days:

as news of the audit hit the street, the whiff of insecurity began to work its magic, creating a run on the Securities Exchange Company. But it seemed as though Carlo had an inexhaustible supply of cash: all of the investors who that lined up to withdraw their deposit each received their cash plus 50 percent.

And as the audit progressed, the auditors were stumped. The company kept meticulous records of all deposits and withdrawals. No one was being cheated, and no law had been broken. The only thing that they couldn't find was how the company made its fantastic profits. When asked, Carlo indignantly replied that that was a company secret.

Carlo Ponzi maintained confidence in his scam by ensuring that depositors were able to withdraw funds. That is, so long as he was able to survive the run on his bank, i.e. seemed to have an inexhaustible supply of cash, he could stay in business.

I assume that one use of Central Banker liquidity will be to ensure that Hedge Fund investors get their money back, i.e. that redemptions will be allowed. Nothing kills confidence more than finding out you can't get your money back, just ask California or Florida real estate flippers.

I guess it's good to be a high net worth individual these days, as opposed to an average Joe who took Greenspan's advice and took out an adjustable rate mortgage a few years back, eh.

But Carlo Ponzi did not have the deep pockets that our financiers have. Let's go back to the early 20th Century again:

The feds responded to this [ being told that investment methods were a secret- exactly what Hedge Funds say today] by placing a restraining order on the company, prohibiting it from accepting any further deposits while the investigation was proceeding. Carlo, glimpsing impending doom, hired the well-respected William McMaster to handle public relations until the investigation blew over. This move didn't turn out so well for our friend Carlo. Shortly after being hired, McMaster issued a statement to the press that the Securities Exchange Company had never--not even once--conducted a single foreign financial transaction.

Again, investors created a run on Carlo's company, and again, Carlo appeared to weather the storm, even serving coffee and donuts to depositors as they waited. But eventually the toll of the investigation and revelations took their course, and more and more investors showed up to withdraw their money, until eventually the money ran out. On August 9, 1920, Carlo's bank issued a statement that it could no longer honor checks from the Securities Exchange Company. Two days later, Carlo's criminal record was released to the public.

Back when Carlo was being forced to repay investors, a dollar was worth something- about 1/20th of an ounce of Gold. Carlo couldn't just print Ponzi money and give it out.

Now the banks can, in essence, do just that. When they are faced with the modern form of a bank run- hedge fund redemptions, Central Banks can just inject liquidity into the system (Ponzi money) and the problem is solved, sort of.

What price confidence

The effect of bail-outs like these, as opposed to the liquidation forced on poor Carlo Ponzi, is a devaluation of the currency, inflation.

Back in 1998 much of the inflation was masked by the dire straits faced by Russia and other emerging economies. Their need to acquire US$s to repay debt and build up sufficient reserves to avoid a repeat of the crisis acted to drain much of the added liquidity from the system.

The situation now could not be more different. If the problem of 98 was a lack of US$ reserves among emerging market nations, the problem now is too much. Moreover the people short of $s are not emerging market nations, but western hedge fund managers and those who supplied them the leverage, a few western banks.

Aside from location, another difference between the emerging market nations that were short US$s a decade ago and the hedge funds and money center banks short US$s now is productive capacity. Emerging market nations could (and did, the swing from emerging market current account deficits in 97-87 to surpluses now has been well documented) produce goods to earn $s and repay their debts, the hedge funds and banks will not.

In other words, the increased liquidity a decade ago tended to finance, inter alia, increased productive capacity. I doubt the same will follow this time round.

So, what price confidence? Inflation, and lots of it. Financial industry consolidation guarantees that liquidations will be few and far between and bail-outs, more and more common.

The limits of Arbitrage

Who knows, we might even reach the point where investors realize that an ounce of Gold in hand might just be worth quite a bit more than US$666 of Ponzi money invested in a hedge fund.

The reason being, one cannot guarantee, in a real sense, investments that are too good to be true, particularly investments that don't finance productive capacity. There's only so much real money to be made arbitraging, which is what a fund that doesn't invest in productive capacity does. Parasites that outgrow their hosts, kill them, and then die themselves.

When the universe of arbitragers was small, real positive returns were possible, but as that universe has grown at much faster rates than that of productive capacity, real returns are getting harder and harder to come by. The only thing Central Bankers can guarantee is currency, not value- a lesson which will become more and more obvious as the next few months pass.

Wednesday, August 08, 2007

Apocalypse Now for the US$

The truth happens to an idea. William James

"Apocalypse" is but one of many words whose meaning in the minds of many
, due to oft repeated misuse, has drifted from its origins.

A literal translation of the Greek is "lifting of the veil" or simply, the revealing. It does not refer to the end of life or the end of the world, but rather to the end of deception and the unveiling of the truth- noticing and discussing the once ignored elephant in the room...perhaps those barbarians will over-run Rome, perhaps that volcano will get the picture.

Of course, if you have bet on a deception being true, or at least being able to be maintained and milked, then apocalyptic times when deceptions are revealed as such might well seem like the end of the world.

How fittingly ironic (for those with a hint of schandefreude) to think that the many fundamentalist sects who have been praying for the "end of the world" as prophesied in the Book of Revelations, i.e. The Apocalypse, in hopes of being swept out of the mess of the earth, leaving the rest of us behind, may well have their apocalypse, the truth- that we are all going to have to make due with this little planet.

Who knew ancient Greek would come in handy?

But it is not with the broader sense of the apocalypse in mind that I write, rather it is with a narrower sense of an economic apocalypse
in mind that I write today - an unveiling of the inherent risks of the current dollar based international exchange rate system.

In today's UK Telegraph, Ambrose Evans-Pritchard writes, China threatens 'nuclear option' of dollar sales.


And what is the 'nuclear option'?

Two officials at leading Communist Party bodies have given interviews in recent days warning - for the first time - that Beijing may use its $1.33 trillion (£658bn) of foreign reserves as a political weapon to counter pressure from the US Congress.

Shifts in Chinese policy are often announced through key think tanks and academies.

Described as China's "nuclear option" in the state media, such action could trigger a dollar crash at a time when the US currency is already breaking down through historic support levels.

Remember the Frank Capra movie, Mr. Smith goes to Washington? I think we're seeing the first act of Mr. De Gaulle goes to Beijing.

Former Federal Reserve Chairman Alan Greenspan recently tried to assuage fears of Chinese sales (and we know how prescient Mr. "variable rate mortgages are a great deal" is) of US bonds because, China would not have anyone to sell the securities to.

When the London Gold Pool collapsed in 1968 and the US began quiet negotiations with European $ holders to stop them from trying to convert their $s to gold, De Gaulle, in a sense, didn't have any one to sell his US$s to either...but that didn't keep their value up.

The reason being that prices aren't set in the market, but in market participants' minds. The market is merely a medium in which such changes become manifest. To wit, as many a suburban home owner is becoming painfully aware, your house doesn't need to be "on the market" for its value to fall. Nor does China have to sell bonds for people to realize that they aren't worth as much as previously thought.

When I think of the opening quote from William James, the truth happens to an idea, I think of an apocalypse. The quality of "truth" or "reality", if you prefer, is applied, in the minds of many, to an idea to which it previously was not. Even though the idea may have always been, from some perspective, "true" it is only when "truth" is applied to the idea in each individual mind that change occurs.

And so, I believe, it will.

When De Gaulle asked for his Gold in the late 60s he pointed to the elephant in the room of the Bretton Woods system- that US$s are worth only what you can get in trade for them. Even though Nixon denied his request Pandora's Box had been opened and inflation accelerated out of control.

China, in my view, just pointed to the elephant in the room again- the value of the US$ is by statute "elastic" and only retains value to extinguish US$ based debts, public and private. It has no guaranteed exchange value with anything real. This is printed on every $ bill, of every denomination, which is why these $ apocalypses are so nasty. Once you get it, you do a Homer Simpson.... Doh!

Let the mad rush for value in the great game of financial musical chairs commence.

ps These things take time...first the apocalypse then the period of upset (or tribulation in the vernacular) then action...but once the apocalypse happens the action becomes inevitable

Tuesday, August 07, 2007

Freedom's March - My chat with President Bush

The trend is clear: In the Middle East and throughout the world, freedom is on the march. President Bush

I agree with President Bush, freedom is on the march. Of course, freedom, in a sense, has been on the march for many centuries - freedom, that is, from nonsense, from deceptions, intentional and inadvertent, and from modes of behavior both individual and cultural that no longer work.

Of course, my sense of freedom may not be shared by the President. At least, according to this article, he has been thinking about it- freedom, that is, and history, and how the world works (better late than never):

At the nadir of his presidency, George W. Bush is looking for answers. One at a time or in small groups, he summons leading authors, historians, philosophers and theologians to the White House to join him in the search.

Over sodas and sparkling water, he asks his questions: What is the nature of good and evil in the post-Sept. 11 world? What lessons does history have for a president facing the turmoil I'm facing? How will history judge what we've done? Why does the rest of the world seem to hate America? Or is it just me they hate?

You might be surprised to learn that your author, The Dude, was NOT invited to the White House to shoot the breeze with the Prez (then again, if you know me you wouldn't be surprised at all, lol).

The tragedy is I had a little talk all prepared for him, as I expected to get the call. So as to not let the thoughts go to waste, I'll share with you what I would have told the President if he had but asked my opinion.


Mr. President, I'm going to begin with a crucial question;
Do the times make the individual, or do great individuals make the times?

Yes, I assumed you believed the latter. Let me try, using some examples from history, to persuade you to the former view.

Let's go back to the latter half of the 18th Century when freedom's march was accelerating through the western world and examine the paths of two nations; France, and the United States (a title, by the way, which more appropriately captures the sensibilities of freedom than the more monolithic "America") and two individuals, George Washington and Napoleon Bonaparte.

Sir, as you are a lover of freedom, a love I share, you most likely look back at wonder at the latter half of the 18th Century. In 1750, Monarchical systems of government, with greater or lesser degrees of absolutism, were the norm, and had been for many centuries. A mere 50 years later;

  • the United States had declared its freedom from the crown of King George- a declaration which was, in a sense, an external manifestation of Britain's domestic drive for freedom from monarchy which began with the Magna Carta
  • the absolute monarchy of the House of Bourbon in France was destroyed through revolution

There were many principal actors on these stages during this momentous era. I'm going to argue that those actors who pursued the cause of freedom found the wind filling their sails, so to write, until, and this is the important part, they stopped pursuing that cause- conflating their own desires with grander ideas.

In other words, believing that great individuals made the times, or as the thought has been framed, created their own reality, was usually the downfall of those great individuals.

As you have mentioned him lately, I'll begin with our first President, George Washington, to whom you refer as No. 1.

The great virtue of George Washington was not his military mind; he lost more battles than he won and was not an active participant in the two significant Colonial victories at Saratoga and Yorktown; but his overriding sense of the importance of stepping down from power, which he did twice- first after winning the war as Commander in Chief, and secondly after serving two terms as President.

While Washington was not immune to the temptations of power, at pivotal moments, the manifestation of his republican sensibilities saved these United States from the convulsions experienced by France.

Sadly, for the French, instead of George Washington, they had Marat, Robespierre, and Napoleon leading them to freedom- three men who found the ring of power too seductive to give up voluntarily.

And yet, while they were ending the tyranny of others they found the winds of freedom filling their sails.

While Marat, Robespierre and the Jacobins were destroying the advantages of the old aristocracy, the people were, in the main behind them, and fortune favored them. But, as they consolidated power in their persons, fortune turned against them.

How odd to think that Marat would survive agitation against the absolute power of the House of Bourbon only to be stabbed in his bath tub by Charlotte Corday- a scene which became a foil for one of the chief propagandists of the time, Jacques-Louis David, in his Death of Marat.

That's right, sir, the Jacobins had their own version of Fox News.
Jacques-Louis David painted, you decided. As a noteworthy aside, David narrowly escaped the guillotine when the reign of terror ended and the blame therefor was being apportioned.

Napoleon, I believe, offers a wonderful counter-point to George Washington, and is a great example of how the winds of freedom can fill one's sails one moment, and then blow against you the next.

Napoleon carried the spirit of the enlightenment throughout continental Europe, destroying the entrenched aristocracy so effectively that they never recovered. Fortune smiled on him as he stormed through Italy and Austria and weakened Ottoman control of Egypt, although he failed to wrest control of the Mediterranean from the British.

His triumphs in the Continent were also immortalized by David in the famous Napoleon Crossing the Alps.

After a coup, he seized control of France, having himself named First Consul for life. Many of the reforms he instituted in the early part of his reign still remain, and for a moment, after signing the Treaty of Amiens, Europe was almost ready for peace.

History might view Napoleon as a promoter of Freedom instead of merely a great General who overstepped if he had chosen differently, but, in the event, ambition got the better of him and he declared himself Emperor- a declaration that evoked powerful forces against him.

People, it seems, love liberators, but hate dictators and it is possible for one person to be a liberator one month and a dictator the next.

The winds of freedom which had aided his rise did not fill his sails against the Haitians, the loss of which likely led him to sell French holdings in North America to the United States for a pittance. While he managed to retain control of Continental Europe for a decade, he was never able to gain control of the seas.

In 1812 Napoleon invaded Russia. He entered Moscow hoping to be declared the new ruler only to find the city deserted and soon burning. Perhaps Napoleon's drive to be Emperor in the mold of Augustus was not in accord with the spirit of freedom and victories which had seemed so easy a few years earlier became impossible. As the aura of invincibility left him, his opponents grew in number and boldness.

And the rest, as they say, is history.

Napoleon was exiled to Elba, escaped, and led a successful coup only to lose the final decisive battle at Waterloo. He was a prisoner the rest of his life.

The point I'm trying to make, sir, in comparing Washington to Napoleon is that if one wishes to be a great man on the world stage AND enjoy a full and free life, the path of Washington is much preferable to that of Napoleon. Washington manifested a deep understanding and appreciation of freedom, the rule of law, and the place of any individual within a political system espousing those ideals.

Napoleon did not.

Fortunately, for you, your part as actor on the world stage is not yet complete, there are choices still to be made.

Let me close with another anecdote from the life of No. 1.

It was summer of 1781, French Count Rochambeau had been trying for almost a year to convince George Washington to drop his sense of honor lost over his defeat in New York. Washington, according to his letters, was almost obsessed with getting New York back, striking a decisive blow against tyranny, so to write.

If No. 1 had "stayed the course" history might well be different. In the event, he dropped his honor, listened to reason and set sights on the South. Cornwallis' defeat at Yorktown which soon followed effectively ended the war.

Here's an excerpt from Ellis' His Excellency George Washington: In his diary entry for July 30 [1781], Washington confessed his concern about "my obstinacy in urging a measure [driving the British out of NY City] to which his [Rochambeau's] own judgment was oppos'd." Three days later he wrote Robert Morris to request delivery of thirty transport ships in Philadelphia as soon as possible, observing that New York had been "laid aside" and that "Virginia seems to be the next object."

Food for thought.

Thursday, August 02, 2007

Whew! It's not terrorism II

The U.S. Department of Homeland Security in Washington said there was no indication of terrorism in the disaster. Six killed in Minneapolis road bridge collapse

Perhaps we ought to think about initiating a war against these pesky infrastructure gremlins who are, at least these days, far more lethal than al-Qaeda.

One interesting quote I found on the tragedy:

Catherine Yankelevich tumbled into the Mississippi River. "Cars started flying and I was falling and saw the water," she said. She climbed out the driver's side window and swam to shore uninjured.

"It seemed like a movie, it was pretty scary," said Yankelevich. "I never expected anything like this to happen here."

I don't know anyone who has fallen into a river while watching a movie.