Thursday, March 27, 2008

Prerogative power and the death of "free markets"

Remember Friday March 14 2008: it was the day the dream of global free-market capitalism died. For three decades we have moved towards market-driven financial systems. By its decision to rescue Bear Stearns, the Federal Reserve ... declared this era over. ... Deregulation has reached its limits. - Martin Wolf, FT

Martin Wolf makes, I believe, an important point in declaring the death of "free market" capitalism (although I would have added, "for this cycle" and good riddance). To the extent financial institutions become dependent on government for survival, using the same arguments which justify intrusions into the lives of welfare recipients, these institutions should be regulated by the government.

Robert Rubin, one of the prominent supporters of financial deregulation during the Clinton years has, according to Paul Krugman, "seen the light:" If Wall Street companies can count on being rescued like banks, then they need to be regulated like banks.

Not to be outdone by one of his predecessors, current Treasury Secretary, Hank Paulson, joined the chorus yesterday: Historically, commercial banks have had regular access to the discount window. Access to the Federal Reserve's liquidity facilities traditionally has been accompanied by strong prudential oversight of depository institutions, which also has included consolidated supervision where appropriate. Certainly any regular access to the discount window should involve the same type of regulation and supervision.

This approach- using the might of the state to effect change- is in keeping with the Bush administration's philosophy- the state is not a reflection of the mood of the times, it creates the mood.

If it were only so easy.

For, as Mark Thoma notes at Economists' View in An Absence of Oversight: As the philosophy of both parties has drifted toward a hands off approach over time, and as appointment after appointment to this or that agency has reflected that changing philosophy, the accompanying regulatory oversight has changed along with it. The changes have been more dramatic under Republican administrations, and the current administration strongly prefers a hands off approach on all matters involving economic policy (with the exception of tax cuts for the wealthy), so it's no surprise that the same philosophy has, over the last several years, filtered into the offices charged with regulatory oversight more so than in the past (and appointments based upon how much someone contributed and the strength of their ideology rather than their competence hasn't helped). To change all of this and reign in the excesses, it will take more than just changing the rules, it will also be necessary to change the people interpreting and enforcing the rules,

I wouldn't go as far as Mr. Thoma in urging that people go, but rather, and more simply, that they change their views.

Unfortunately, such changes often require a peek into the abyss, so to write, particularly when many have been indoctrinated into an unfeasible point of view . "Too big to fail" has no place in free market ideology.

Just as the right wing, justifiably in my view, bemoaned the middle of the 20th Century Marxist shift in leading Universities- the preaching of the virtues of communism, as if the problem was the "ism" rather than the views of the people in charge, so too will we regret the more recent embrace of the free market philosophy to which Mr. Thoma refers.

Am I, you might be wondering, against "free markets?"

No, my issue lies in the definition thereof. The current conception of "free markets," it seems to me, borrows more from the New Deal view that the state should maintain income flow to a preferred economic sector, than it does from the idea of freedom which drove the Revolution that created this country. As an example, Greenspan was all for instituting a Gold standard as a means to expose welfare spending as confiscation- but seemed to have no problems inflating the money supply, while suppressing the price of Gold to create welfare for financial corporations.

Both policies have the same effect, they insulate a sector of the economy from failure and thereby engender moral hazard. If welfare to the poor is believed to remove incentives to work, why don't we believe that welfare to the financial sector has the same effect- and the current crisis seems to demonstrate that the financial markets "don't work." Either we believe in the virtuous effects of competition, and driving force created by the fear of failure or we don't- or so it seems to me.

What has been apparently lost is the desire for freedom- freedom, that is, to both succeed or fail on one's own merits- to find the notion of prerogative power abhorrent however directed. As Bernard Bailyn argues in The Ideological Origins of the American Revolution, our revolutionary leaders were "eighteenth-century radicals concerned, like the
eighteenth-century British radicals, not with the need to recast the social order, nor with the problems of the economic inequality and the injustices of stratified societies but with the need to purify a corrupt constitution and fight off the apparent growth of prerogative power."

Sadly, it seems to me, debate on US economic policy for much of the past century has been on which sector to favor with prerogative power, not whether such is useful or not. As the power of the state has grown, faith in its omnipotence has followed. Thus the still apparent faith in the ability of the state to "fix" our economic ills- a faith, recalling the "Greenspan put," et. al. which allowed the causes of the ills to persist for decades.

Methinks we are soon to see an anti-King Canute event. The state will tell the tide- the tide, that is, of which Warren Buffett speaks when he talks about discovering who's been swimming naked- to stay as it is, but it will recede anyway. The abyss will become very visible.

A few weeks ago, in Power Outage on Enlightenment, I bemoaned the turning away from Enlightenment ideals- the ideals which informed our Revolutionary leaders. These leaders, in stark contrast with the men currently proposing a "unitary executive," believed in themselves, in man, not the state. They wrote of "self-evident truths," not imposed views. They were very un-revolutionary, revolutionary leaders.

As Gordon Wood argues in The Radicalism of the American Revolution: The American revolutionary leaders do not fit our conventional image of revolutionaries- angry, passionate, reckless, maybe even bloodthirsty for the sake of a cause. We can think of Robespierre, Lenin and Mao Zedong as revolutionaries, but not George Washington, Thomas Jefferson, and John Adams. They seem too stuffy, too solemn, too cautious, too much the gentlemen.....They made speeches, not bombs; they wrote learned pamphlets, not manifestos.

In sum, they believed in persuasion, not coercion. They were cautious because they were aware not only that they might fail, but also that if they did so, they would not be "bailed out." They were pragmatic before the term was coined as a philosophy- they believed the truth had a "cash value," as William James put it. The use of prerogative power, then, would only obscure the search for truth.

As Thomas Jefferson put it, It is error alone which needs the support of government. Truth can stand by itself.

Sadly, our financial system cannot.

Tuesday, March 25, 2008

Thoughts from a burning theater

We admit that in many places and in ordinary times the defendants in saying all that was said in the circular would have been within their constitutional rights. But the character of every act depends upon the circumstances in which it is done. The most stringent protection of free speech would not protect a man in falsely shouting fire in a theatre and causing a panic. It does not even protect a man from an injunction against uttering words that may have all the effect of force. The question in every case is whether the words used are used in such circumstances and are of such a nature as to create a clear and present danger that they will bring about the substantive evils that Congress has a right to prevent. It is a question of proximity and degree. When a nation is at war many things that might be said in time of peace are such a hindrance to its effort that their utterance will not be endured so long as men fight and that no Court could regard them as protected by any constitutional right. Schenck v. U.S. , 249 U.S. 47 (1919) Oliver Wendell Holmes Jr.

Someday, I find it fun to imagine, Philosophy students might study a issue from the distant past- the idea that use of the term "recession" (in this case "impending $ collapse") causally effects the economic outcome MORE than the policies of the government in charge of regulating it. Conversely, if current policies and past practices had been such as to maintain an external surplus, would shouts that "the US$ is crashing" cause it to happen?

Luxuriating in the metaphor (a phrase I borrowed from the late William F. Buckley) these days I feel as if I am caught in a crowded theater (today's showing: Titanic), which has caught on fire- a fire, mind you, that was the result of too much dry paper hidden away by the theater owners. Yet, the theater owners have sent men to vent out the smoke, and hide the flames from those within. The illuminated sign on the exit door- the golden exit door- has been turned off and armed men are dissuading people from leaving (but not, as yet, forcibly preventing their exit). Those who shout "fire" are quickly drowned out by the refrain of "the US has a strong $ policy" broadcast ludly over the, very Hi-Tech, sound system

On second thought, I don't feel as if I'm in the theater. I'm outside the theater, but live in the neighborhood, and know many people on the inside. I'm concerned that a burnt theater in the center of town will be a drag on commerce until it is rebuilt. I've given up, however, on trying to put out the fire, it is already too big, and I was always too small regardless.

Now, I'm concerned about my friends still inside. I'm calling them on my imaginary cell phone (in real life I haven't owned one this century) and suggesting they use the golden exit door. But most are dissuaded by the armed men- the interveners- who ask that they go back to their seats.

The line from Hotel California comes to mind: you can check out any time you like, but you can never leave.

Except you can. Get real, leave the theater of paper- a very flammable substance- that leaves nothing but ash.

Monday, March 24, 2008

Question for the morning on Gold

In 1964 Bertrand Russell wrote Sixteen Questions on the Warren Report which aimed to point out glaring contradictions in the official narrative, e.g. If, as we are told, Oswald was the lone assassin, where is the issue of national security?

Along that line of pondering contradictions, I wonder, if, as most economic officials tell us, they can't recognize a "bubble" until after the fact, why, then, do they always seem comfortable intervening in the Gold market?

After last week's substantial commodity market declines, the term "bubble" in reference thereto, seems to be more frequently applied.

But, was it a bubble?

My answer (which, to slightly paraphrase Michel de Montaigne, is by way of discourse, and not by way of advice. I should not speak so boldly if it were my due to be believed) is that if the commodity markets were bubbles then I wouldn't want to own any equities or bonds. Conversely, if the economic authorities continue to view equity and bond price levels as "normal," the commodity markets still have a long way to run.

.....more later

Thursday, March 20, 2008

Busy today

so here's a little humor until tomorrow: The Sub-Prime Primer

Wednesday, March 19, 2008

True Believers hiding Black Swans

Before the discovery of Australia, Europeans thought that all swans were white, and it would have been considered completely unreasonable to imagine swans of any other color. The first sighting of a black swan in Australia, where black swans are, in fact, rather common, shattered that notion. The moral of this story is that there are exceptions out there, hidden away from our eyes and imagination, waiting to be discovered by complete accident. What I call a "Black Swan" is an exceptional unpredictable event that, unlike the bird, carries a huge impact. Nassim Taleb

One of the books I read during my absence from the screen was Nassim Taleb's, The Black Swan: The Impact of the Highly Improbable. I enjoyed the read, and found it thought provoking, but felt the theme of the book, expressed above in the author's words, a bit too blameless.

True ignorance, to which Taleb refers, while as disastrous in effect as the more pernicious ignorances, seems rarely to be man's problem these days. It isn't, it seems to me, what we truly don't know that bedevils us, but what our forefathers once knew, which we have forgotten, or simply not learned.

That is, to work within Taleb's analogy, the problem is not that we don't know there are black swans, but rather that we used to know of their existence, but no longer believe because that belief stands in the way of the promised land, be it peace on earth or permanent prosperity. The black swans are not waiting to be discovered in some far off land. They are here, but hidden. Their existence is denied.

Who would hide a black swan, and leave others to believe the improbable, impossible? The true believer, who, as described so well by Eric Hoffer, interposes a "fact-proof screen between him and reality."

A recent revistation with Hoffer's The True Believer: Thoughts on the Nature of Mass Movements reminded me of an exchange between Ron Suskind and a senior advisor to President George W. Bush:

......he told me something that at the time I didn't fully comprehend -- but which I now believe gets to the very heart of the Bush presidency.

The aide said that guys like me were ''in what we call the reality-based community,'' which he defined as people who ''believe that solutions emerge from your judicious study of discernible reality.'' I nodded and murmured something about enlightenment principles and empiricism. He cut me off. ''That's not the way the world really works anymore,'' he continued. ''We're an empire now, and when we act, we create our own reality. And while you're studying that reality -- judiciously, as you will -- we'll act again, creating other new realities, which you can study too, and that's how things will sort out. We're history's actors . . . and you, all of you, will be left to just study what we do.''

"It is," Hoffer wrote more than half a century ago, "the true believer's ability to shut his eyes and stop his ears to facts which in his own mind deserve never to be seen nor heard which is the source of his unequalled fortitude and consistency." The new reality to which this aide referred is not a larger or grander vision of the world, but, as time seems to have made clear, a lesser one, a diminution of the world as it is, with the negatives removed, with the black swans hidden away.

Alan Greenspan exhibits characteristics of true believer thinking in The Age of Turbulence. Commenting on Bill Clinton's dalliance with an intern, Greenspan writes, As the scandal unfolded and details of their alleged encounters appeared in the press, I was incredulous. "There is no way these stories could be correct," I told my friends.

Talk about hiding black swans from one's eyes. Not only did Greenspan forget about the tendencies of powerful men, he forgot about Clinton's own past. Did he forget about Gennifer Flowers, whose tale of an affair with Clinton almost cost him the Presidency? Did he forget about Paula Jones, whose lawsuit led to the unveiling of his dalliance with Ms. Lewinsky?

In the words of Dick Morris, "You had to be a moron to believe this guy after his past record."

But the past, for Greenspan, is but something to be paved over by "creative destruction" as he relates by way of a dialogue with his wife, Andrea Mitchell, while visiting Venice:

I asked Andrea, "What is the value-added produced in this city."

"You're asking the wrong question," she replied, and burst out laughing.

"But this entire city is a museum. Just think of what goes into keeping it up."

Despite noting that Venice was for centuries a center of commerce, the lesson that being such a place comes and goes, was lost on Greenspan. Managing that reality is what men like Greenspan should do, but don't because they'd prefer such reminders to be forgotten.

I'll close with another excerpt from Greenspan's book that may be viewed in the future as quite ironic:

Korea's central bank was also sitting on $25B in dollar reserves- ample protection against the Asian contagion, or so we thought.

What we didn't know, but soon discovered, was that the government had played games with those reserves. It had quietly sold or lent the dollars to South Korean commercial banks, which in turn had used them to shore up bad loans.

I wonder how much Gold the Fed actually has, and whether this will be the next hidden black swan to emerge.

Tuesday, March 18, 2008

The last hurrah for the "strong dollar" policy

The Federal Open Market Committee decided today to lower its target for the federal funds rate 75 basis points to 2-1/4 percent.

Recent information indicates that the outlook for economic activity has weakened further. Growth in consumer spending has slowed and labor markets have softened. Financial markets remain under considerable stress, and the tightening of credit conditions and the deepening of the housing contraction are likely to weigh on economic growth over the next few quarters.

Inflation has been elevated, and some indicators of inflation expectations have risen. The Committee expects inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization. Still, uncertainty about the inflation outlook has increased. It will be necessary to continue to monitor inflation developments carefully.

Today’s policy action, combined with those taken earlier, including measures to foster market liquidity, should help to promote moderate growth over time and to mitigate the risks to economic activity. However, downside risks to growth remain. The Committee will act in a timely manner as needed to promote sustainable economic growth and price stability. FOMC

The Fed eased dramatically this afternoon, taking real rates, even using the lowest "official" measure of consumer inflation, the St. Louis Fed's median CPI, into negative territory.

You'd think that such an action would lead to a US$ sell-off. But it didn't. Toto, I've got a feeling we're not in Kansas anymore.

Despite lower rates, firmly negative against any measure of inflation, with even the Fed noting inflation has been elevated, the US$ rose, modestly against foreign currencies and strongly against Gold.

Why the substantial fall in the price of Gold? More selling than buying, as we used to quip on the trading desk.

"Why more selling than buying, smart A$$?," you might be retorting.

I have a few ideas.

1) The Sunday night melt up in Gold got the attention of finance officials, who either through jawboning or intervention, leaned on the price. The last thing those who wish to maintain the current system of exchange want is for Gold to rise dramatically with news of large financial firms going bust on the TV. As Kevin Bacon's character in Animal House put it, Remain Calm. All is well!

2) As one who has seen official intervention fail miserably, the point above is not sufficient, to my mind, to explain the decline. During a call with my friend Stephen Plant yesterday, I expressed my uneasiness, as a long term holder of Gold, with the rapid gains Gold had been making. Although I believe Gold is still dramatically undervalued here, it usually takes time for markets to adjust. Speculative froth creates its own restraining forces, and invites official responses, like increased margins for futures trading, et. al.

3) I suspect that part of the policy approach flowing from the recent meetings of the President's Working Group on Financial Markets is to flog the dead carcass of Bob Rubin's "strong $ policy." Yesterday, after briefing the President on the group's findings, Treasury Secretary Paulson, in response to a question about FX intervention had this to say:

We have a strong dollar policy. It's very much in our nation's interests.

Our economy has ups and downs. The long-term fundamentals -- and I'm very confident about this. When we look at our long-term fundamentals compared with other major countries around the world, we have strong long-term fundamentals. That will be reflected in our currency markets.

And so our whole focus here is on policies that are going to -- going to increase the confidence in our economy. And this is open trade, open investment, working through this capital market's turmoil in a way so that we minimize the impact on our economy.

4) tying the above points together, I suspect that the major banks are willing to see if the "strong $" narrative still holds water.

Over the short term, given the recent rapid advance before today, the narrative might gain credibility and Sorosian reflexivity might come into play.

Over the medium term, however, (and potentially even over the short term, and if so, Gold will really pop) I think this is the last hurrah for this approach. If, after the short term specs are flushed, the narrative begins to lose its magic, the Fed will have to get serious about defending the $ with more than jawboning and intervention. Having rapidly reduced rates deep into negative territory, with inflation rising, in sharp contrast to the post 9/11 easing, future capital gains on US bonds will be hard to come by. Reasons to buy the $ are becoming quite scarce.

As I see things, either the Fed realizes its error and gets in front of the market, which might keep the dollar decline somewhat graceful or the market begins to tighten for the Fed, and then the game is over, in a most ungraceful manner.

Either way, I don't think we'll be hearing too much more of the "strong $ policy" after the short term, except as part of some Daily Show/Colbert Report skit.

ps. I guess I was wrong in my earlier post. It appears the PWGFM still has a bit of mojo left.

Imaginary Productivity and WMDs...and their fruits

The crisis will leave many casualties. Alan Greenspan

Five years ago the global media machine was promoting the view that Iraq had WMDs and therefore the US needed to invade. As it turned out, this was not true. The question arises; was the Bush team deceitful or incompetent? What is not in doubt; hundreds of thousands have paid the price of this error.

The last thing I'd want to see at this point is a key member of the Bush team warning about the unfolding disaster without some sort of mea culpa.

With that in mind, consider the latest warning from Alan Greenspan; The current financial crisis in the US is likely to be judged in retrospect as the most wrenching since the end of the Second World War.

His warning concludes with this face saving view; But we cannot hope to anticipate the specifics of future crises with any degree of confidence.

Can we not? And could we not have seen this one coming?

I can't speak for anyone but myself, but I saw it coming. Judging by what I read, I'm not alone in seeing it coming either.

Returning to the subject of non-existent Iraqi WMDs, do you remember reading Paul Wolfowitz's view; For bureaucratic reasons, we settled on one issue, weapons of mass destruction (as justification for invading Iraq) because it was the one reason everyone could agree on.

I wonder if, for bureaucratic reasons, US economic official-dumb settled on one issue, increasing US economic productivity (as justification for allowing the US external imbalance, and coincidentally, US domestic imbalances, to grow unchecked) because it was the one reason everyone could agree on?

In Greenspan's, The Age of Turbulence, he describes the thought process that led him to revise US productivity data upwards:

I'd zeroed in on the primary riddle of the technology boom: the question of productivity.

The data we were getting from the Commerce and Labor Departments showed that productivity was virtually flat in spite of the long-running trend towards computerization. I could not imagine how that could be.......

It seemed that the government had been underestimating productivity growth for years.

In the words of George Tenet, increased productivity was a "slam dunk." And so the seeds of the current financial crisis were sown under cover of the darkness created by Greenspan's imagination- an imagination, mind you, which not only failed to see this crisis coming, but also asserts that we cannot hope to anticipate the specifics of future crises with any degree of confidence.

That is, the man who couldn't imagine a crisis imagined a productivity boom that was as apparent as Iraqi WMDs.

Let's help Greenspan imagine how US government stats showed flat productivity growth in spite of the long running trend towards computerization. Perhaps the data was right, and the productivity gains of technology application were getting swamped by other forces. Perhaps it might be more apt to argue that a reduction in competitive forces, in the form of increased external imbalances without pressure to repay, allowed profits to rise (the "sign" that led Greenspan to think that productivity was rising) without increased productivity.

It seems to me the practice at which we became quite "productive" was creating an illusion of the US$s value (the now, decade old "US has a strong $ policy" dogma). The Asian Crisis led many Asian governments to dramatically increase their US$ inflows, and, importantly build their reserves. The missing inflation Greenspan cited as sign of increased productivity can be explained, in part, via this mechanism. We exported inflation to Asia, while, in part, in response to their crisis, they, not us, became more productive, in the real sense.

Lately, the missing inflation Greenspan hung his "productivity" hat on is returning to our shores. Despite the Bernanke Fed's policy of fairly dramatically reduced growth in the monetary base, inflation continues to rise. When US economic officials were loathe to bail out financial firms last year, owners of those exported $s were ready to fill the Fed's shoes, so to write.

Thanks, in part, to Greenspan, foreign Central Banks, and foreign official investment funds, filled with our exported $s, are usurping the Fed's power. As Bernanke seems to be learning, the Fed couldn't deflate gracefully if it wanted to. The old trading mantra; "Don't Fight the Fed" may soon be replaced by; "Don't Fight the SWFs."

The man who replaced "Don't Fight the Fed" with "Don't Fight the SWFs," seems a fitting epithet for Mr. Greenspan. As the Maestro he allowed the US economic symphony to lose rhythm and harmony. Perhaps he should have smoked some of that dope his fellow musicians were enjoying and stuck with his clarinet.

Sunday, March 16, 2008

Initial conditions and the virtues of Free Trade

In Beyond the Noise on Free Trade, Greg Mankiw asserts the virtues of free trade using the conclusions of Smith and Ricardo- Trade between two countries creates winners and losers, but it leaves both nations with greater overall prosperity. Disagreement with this assertion leaves one, according to Mankiw, in the apparently unenviable position of a distinct minority- only 12.5% of Ph.D. members of the American Economic Association thought the US should not eliminate remaining tariffs and other barriers to trade. Adding insult to injury, Mr. Mankiw labels dissenters mere muggles.

Well call me a muggle (but not within arm's reach)!

While the high priests of the dismal science may see opportunity in free trade, this muggle thinks they are misunderstanding the views of Smith and Ricardo on one of the necessary preconditions of virtuous free trade, a mechanism to keep that trade balanced between nations over time.

To wit, from Ricardo's Principles of Political Economy: Thus, cloth cannot be imported into Portugal, unless it sell there for more gold than it cost in the country from which it was imported; and wine cannot be imported into England, unless it will sell for more there than it cost in Portugal. If the trade were purely a trade of barter, it could only continue whilst England could make cloth so cheap as to obtain a greater quantity of wine with a given quantity of labour, by manufacturing cloth than by growing vines; and also whilst the industry of Portugal were attended by the reverse effects.

He concludes the chapter on Foreign Trade with: The nations of the world must have been early convinced, that there was no standard of value in nature, to which they might unerringly refer, and therefore chose a medium [Gold], which on the whole appeared to them less variable than any other commodity.

To this standard we must conform till the law is changed, and till some other commodity is discovered, by the use of which we shall obtain a more perfect standard, than that which we have established.

The idea that the US could import goods and services whose value was far in excess of US exports for a considerable length of time, in this case, decades, would, I assume, lead Ricardo and Smith to use the proper word for such exchange; tribute, not trade. The difference, it seems to me, between trade and tribute is balance- trade assumes some equivalent (albeit in the eye of each party) value on both sides while tribute is one-sided.

I do not, however, wish to imply that the Joe Six-Packs of the US have not benefited from reduced barriers to exchange, just the opposite. The average man has benefited greatly from the US system of exchange as have many nations who have extracted tribute.

So, you might be wondering, if you think the average man has benefited from the current system of exchange, aren't you agreeing with Mr. Mankiw?


Mr. Mankiw is not referring to the past but to the future- and a future of more Ricardian free trade. The closer the world moves to a Ricardian system of free trade, the worse off will be the average man because a system of balanced trade, as opposed to the current system of de facto tribute, will mean the US needs to produce and export more to maintain our level of imports.

Ricardo's thought experiments on foreign trade, through which the phrase comparative advantage entered the Economist's lexicon, assumed a shift from a system of autarky to a system of increased exchange. China, then, given its recent shift from a fairly autarkic model to a system of increased foreign trade seems a more apt nation to fit in Ricardo's model, albeit with the proviso that they are still sitting on hundreds of billions of $s whose value sinks by the day.

The US, by contrast, is not autarkic. The virtues of comparitive advantage have been enjoyed for some time. Indeed, more virtues have been enjoyed than imagined by Ricardo, for we haven't repaid the exchange. In a system of free and balanced international trade, the US, in my view, would be worse off.

I'll conclude with an old adage for the Wizards of Economics; be careful what you ask for, you might get it. In a system of free and fair trade, the US will need, as noted above, to produce and export more, or import less. In other words, jobs of relative leisure, such as is enjoyed by these wizards, might become quite scarce.

Friday, March 14, 2008

Secret is out: PWGFM has no mojo

I'll go back to the '60s, recharge my mojo, defeat Dr. Evil, and be back in time for tea. Austin Powers (wav)

Late in 2005, in response to an article by Bloomberg's Caroline Baum, I am not now, and have never been, a PPT member, I opined, it becomes quite clear that one of us will look the fool in the medium term. Our bone of contention was the notion that the President's Working Group on Financial Markets (PWGFM), or, as per Brett Fromson of the Washington Post called it, the Plunge Protection Team (PPT) "conspired" with major banks to shore up financial markets- a notion she thought preposterous.

Yesterday I learned that the PWGFM had been asked by the President, in August of 2007, to "review the underlying causes of developing financial market turmoil" (a.k.a. plunging markets) with the aim of "mitigating systemic risk, restoring investor confidence, and facilitating stable economic growth." The PWGFM, which includes the Treasury Department, the Federal Reserve, the Securities and Exchange Commission and the Commodity Futures Trading Commission working with the Office of the Comptroller of the Currency and the Federal Reserve Bank of New York- the lobbying group, if you will, for the major banks in NY, then discussed the problems the banks were facing to try and get the markets "back on track."

So, would this count as a "conspiracy?" It depends on how one defines that term. Leaning on my rusty Latin, to conspire is to breath, or whisper, together, denoting a degree of secrecy. To conspire is not to give orders. Those on the inside of a conspiracy know something those on the outside do not- in this specific case, that the group was meeting to "mitigate systemic risk, restore investor confidence, and facilitate stable economic growth." I think it shouldn't strain credulity to imagine that knowledge of the whispers might induce people to buy some of the plunging markets.

I suspect this may have happened a few times in the past; PWGFM gets called, they speak to the NYFed, who speaks to the banks, while the general public is unaware, and the next thing you know the plunging markets reverse. Note that, in my imagined scenario, nobody gives anyone orders, rather, the mere knowledge that a powerful group is working behind the scenes is enough to induce action.

While this might be a secret to Ms. Baum, it is not the secret to which the title of this post refers. It seems to me a far more interesting observation is that the PWGFM has lost its mojo- despite the "behind the scenes" action, plunging markets continue to plunge.

Before offering a few possible causes of this loss of mojo, let's check on the PWGFM's diagnosis of the problem:

The global market turmoil has not yet abated, so any diagnosis is necessarily incomplete. Nonetheless, it seems clear from experience to date that the principal underlying causes of the turmoil in financial markets were:

  • a breakdown in underwriting standards for subprime mortgages;
  • a significant erosion of market discipline by those involved in the securitization process, including originators, underwriters, credit rating agencies, and global investors, related in part to failures to provide or obtain adequate risk disclosures;
  • flaws in credit rating agencies. assessments of subprime residential mortgagebacked securities (RMBS) and other complex structured credit products, especially collateralized debt obligations (CDOs) that held RMBS and other assetbacked securities (CDOs of ABS);
  • risk management weaknesses at some large U.S. and European financial institutions; and
  • regulatory policies, including capital and disclosure. requirements, that failed to mitigate risk management weaknesses.

Their diagnosis also contains this sentence: Following many years of benign economic conditions and plentiful market liquidity, global investors had become quite complacent about risks, even in the case of new and increasingly complex financial instruments.

What seems missing from the diagnosis is the sense that the Fed and Treasury, by embracing the "free market" dogma, which included successfully lobbying for the termination of depression-era banking regulations, like Glass Steagle, tenaciously defending the "rights" of the major banks to grow their derivative exposure (i.e. the "new and increasingly complex financial instruments" referred to above) without any regulations, and habitually adding liquidity at any sign of significant market decline, may have fostered the environment which led us to this pass.

So now that the horses have bolted from the barn, they aver, let's close the door and make things right again.

So why has the PWGFM lost its mojo? Here's a few guesses. One, just as has occurred many times when official support becomes swamped by economic reality; remember, for example, the BoE and BoI attempts to keep the GBP and ITL within the ERM in 1992, the inevitably magnetic "pull" of intrinsic value cannot be ignored any longer. Two, there may be an, at this point, small, nagging sense among the major banks that the Fed and Treasury might, after yet another attempt of the same medicine, actually have to do what they should- better police the game, and stop adding liquidity which only serves, after years of habit, to put off the problem until tomorrow.

That is, the "conspiracy" worked to reverse market plunges so long as all members therein had the same goals, and the "pull" noted above hasn't begun to work its magic.

As an analogy, on the second point, a shift in focus by the official financial sector might, at this point, be akin to a corrupt police department that had decided to enforce the laws fairly. The once symbiotic relationship becomes antagonistic. This, in the inimitable words of Austin Powers leads to a situation wherein, I started to work my mojo, to counter their mojo; we got cross-mojulation, and their heads started exploding.

Who knows, maybe the PWGFM might actually act to liquidate a large, mismanaged financial institution instead of propping it up- the cops might do their job.

I'd write more, but I think I just saw a black helicopter outside my window.

Wednesday, March 12, 2008

Power Outage on Enlightenment

Enlightenment is man's emergence from his self-imposed nonage*. Nonage is the inability to use one's own understanding without another's guidance. This nonage is self-imposed if its cause lies not in lack of understanding but in indecision and lack of courage to use one's own mind without another's guidance. Dare to know! (Sapere aude.) "Have the courage to use your own understanding," is therefore the motto of the enlightenment. Immanuel Kant, What is Enlightenment

*Nonage: the condition of "not [being] of age."

In The Dumbing of America, Susan Jacoby explores a concern dear to my heart, the self-imposed closing of the American mind as successive generations opt more and more for, in her words, video culture over print culture.

It's a point made previously by, inter alios, Jacques Barzun in From Dawn to Decadence and Neil Postman in Amusing Ourselves to Death.

At the core of the Protestant Revolution was a belief that man could learn about the world in which we live, in a sense, by himself. This, I believe, is true. Whether man is willing to do the work is another matter. Perhaps our material successes, or, maybe better stated, the material fruits of the ingenuity of those who came before has led many to the view that they needn't do the work- that such work is beneath them.

For, as Ms. Jacoby notes: the third and final factor behind the new American dumbness: not lack of knowledge per se but arrogance about that lack of knowledge. The problem is not just the things we do not know (consider the one in five American adults who, according to the National Science Foundation, thinks the sun revolves around the Earth); it's the alarming number of Americans who have smugly concluded that they do not need to know such things in the first place. Call this anti-rationalism -- a syndrome that is particularly dangerous to our public institutions and discourse. Not knowing a foreign language or the location of an important country is a manifestation of ignorance; denying that such knowledge matters is pure anti-rationalism.

Sometimes populations can be "scared straight," or in this case literate, and who knows, such a scare could be right around the corner.

Kurt Vonnegut may have hit the nail on the head in answering this question.

Int: you have any ideas for a really scary reality TV show?

Vonnegut: “C students from Yale.” It would stand your hair on end.

But hey, I've go to run. There's an episode of Law and Order starting in a few minutes.

Copernicus and Monetary Policy

Arthur Schopenhauer famously opined: All truth passes through three stages. First, it is ridiculed. Second, it is violently opposed. Third, it is accepted as being self-evident. In the battle between heliocentrism and geocentrism one could argue that the second stage lasted more than 17 centuries. In the case of monetary policy, specifically the choice to define money in real terms, I hope we see a modification of Schopenhauer's path. For thus far, assuming specie money is a better choice, first it was accepted as being self-evident, then it was subverted.

Long before Copernicus drew his first breath, Aristarchus of Samos, in the 3rd Century BC, hypothesized that the earth revolved around the sun. Contemporaries argued that he should be indicted "on the charge of impiety" for disputing the work of Plato, Aristotle and others.

Four centuries later, Claudius Ptolemaeus (Ptolemy), systematized the geocentric hypothesis in the Almagest and Hypotheseis ton planomenon, the latter of which presents the view of the universe, later to bear his name, as a system of tightly-packed nested spheres with the earth at its center.

And so the matter rested for another 13.5 centuries. Fortunately, in this case, faith in the wrong model did not cause economic hardship for the people.

The impetus for this trip down Astronomical History was a read of Can monetary policy really be used to stabilise asset prices? by Katrin Assenmacher-Wesche and Stefan Gerlach.

Their view concludes: Whatever merits such a stabilisation policy has in theory, our research suggests that in practice, monetary policy is too blunt an instrument to be used to target asset prices – the effects on real property prices are too small, given the responses of real GDP, and they are too slow, given the responses of real equity prices. In particular, there is a risk that setting monetary policy in response to asset price movements will lead to large output losses that exceed by a wide margin those that would arise from a possible bubble burst.

My mind flashed to Copernicus while reading their view because it reminded me of the need to add more and more epi-cycles to the Ptolemaic System to make it work right. That is, it was not impiety to note that Ptolemy's system wasn't working right, just as it is not impiety today to note that monetary policy isn't working right. Those who opt for piety simply make the existing system more complex by adding epi-cycles, in the case of astronomy, or ever more arcanely derived rules, in the case of monetary policy. Impiety lies in challenging the basic assumption of the system, in the case of Copernicus, geocentrism and in the case of specie money proponents today, fiat money.

Why, I ask, should we assume that "monetary policy" refers only to the adjustments made within a system of fiat money? Is not specie money a "monetary policy?"

In the preface to Copernicus' seminal work, De Revolutionibus, Andreas Osiander argues:

There have already been widespread reports about the novel hypotheses of this work, which declares that the earth moves whereas the sun is at rest in the center of the universe. Hence certain scholars, I have no doubt, are deeply offended and believe that the liberal arts, which were established long ago on a sound basis, should not be thrown into confusion. But if these men are willing to examine the matter closely, they will find that the author of this work has done nothing blameworthy. For it is the duty of an astronomer to compose the history of the celestial motions through careful and expert study. Then he must conceive and devise the causes of these motions or hypotheses about them. Since he cannot in any way attain to the true causes, he will adopt whatever suppositions enable the motions to be computed correctly from the principles of geometry for the future as well as for the past. The present author has performed both these duties excellently. For these hypotheses need not be true nor even probable. On the contrary, if they provide a calculus consistent with the observations, that alone is enough. Perhaps there is someone who is so ignorant of geometry and optics that he regards the epicycle of Venus as probable, or thinks that it is the reason why Venus sometimes precedes and sometimes follows the sun by forty degrees and even more. Is there anyone who is not aware that from this assumption it necessarily follows that the diameter of the planet at perigee should appear more than four times, and the body of the planet more than sixteen times, as great as at apogee? Yet this variation is refuted by the experience of every age. In this science there are some other no less important absurdities, which need not be set forth at the moment. For this art, it is quite clear, is completely and absolutely ignorant of the causes of the apparent nonuniform motions. And if any causes are devised by the imagination, as indeed very many are, they are not put forward to convince anyone that are true, but merely to provide a reliable basis for computation. However, since different hypotheses are sometimes offered for one and the same motion (for example, eccentricity and an epicycle for the sun's motion), the astronomer will take as his first choice that hypothesis which is the easiest to grasp.

As humanity experiences the economic tumult that resulted, in part, from a system of undefined value money that allowed such massive imbalances to grow unchecked, that the virtues of specie money will become clearer.

Specie money, as history shows, won't stop the formation of asset bubbles, but this policy not only attenuates the excesses, but, far more importantly, provides a base to which the general price level can return. In the event of a global hyper-inflation, I suspect the virtues of such a feature will be clear.

Tuesday, March 11, 2008

Eliot Spitzer and the forgotten "if"

An 'efficient' market is defined as a market where there are large numbers of rational, profit-maximizers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants. In an efficient market, competition among the many intelligent participants leads to a situation where, at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future. In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value.

Eugene F. Fama, "Random Walks in Stock Market Prices," Financial Analysts Journal, September/October 1965

What a surprise we New Yorkers got yesterday afternoon. It wasn't the news that a high ranking public official had enjoyed (we assume) the services of practitioners of the "oldest profession," but rather that a totally unregulated market, at least here in the US, could be so inefficient.

$5,500 an hour! C'mon Mr. Spitzer, haven't you heard about the virtues of globalization, specifically outsourcing (perhaps in-sourcing is a better fit), i.e. labor market arbitrage? With that kind of cash he could have flown to Asia or Eastern Europe, enjoyed the services of multiple women for days, and may well have avoided the prying ears of the FBI to boot. I guess some high ranking public officials aren't rational, profit maximizers.

Sadly, it seems to me, given the massive and continuing shift in control of global wealth from private sector hands into the official sector, the irrational, non-profit maximizing habits of public officials (and even private sector officials of big firms) is becoming a real drag on the global economy. Sadder still, this deterioration in market efficiency is, in a sense, invisible because of a forgotten "if."

To what forgotten "if" do I refer? The implied "if" in Eugene Fama's definition of an efficient market- for he did not argue that all markets ARE efficient, but rather that markets are efficient IF participants exhibit certain qualities. It then follows that the fruits therefrom, notably that market prices will be good estimates of intrinsic value, are not guaranteed but instead conditional.

Nietzsche argued, 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.

The true masters, it seems to me, are aware of the necessary conditions to achieve the desired benefits while their more powerful apostles promote the simpler views- man IS rational (not that he can be) and markets ARE efficient (not that they can be).

Thus the conundrum we seem to be facing.

Having assumed that markets are efficient, the idea that, for instance, market interest rates, in the US at least, are far from their "intrinsic" value makes no sense. Thus the sense that officials can "tinker around the edges" and fix things still seems credible.

Trillions of $s are managed in "trust" by the few, who, as the example of Mr. Spitzer makes (facetiously) clear, are irrational non profit maximizers, for the many, who will pay and are paying the price of market inefficiency in the form of a credit crunch, et. alia. Stupid people with lots of money not their own can distort any market, even the oldest one there is.

The cause of the crunch, it seems to me, is not, as Central Bankers, who also rarely exhibit profit maximizing behavior (think BoE gold sales under $300) a lack of credit, but a mis-pricing thereof. The supply of true (as opposed to the Central Bank variety) credit will rise, as with every other market, when its price rises, or so elementary supply-demand curve analysis argues.

As an example, I have a house to sell (yes, I know, this isn't a good time) and I'd love the write the mortgage. Yet, the rate I want would seem usurious to anyone who thinks that the current 6.07% 30 year mortgage rate is the result of an efficient market, i.e. an good estimate of "intrinsic" value. So both my house and my credit will stay off the market for a while.

On the plus side, market inefficiencies have a way of working themselves out spontaneously, recalling my last post on entropic processes. The greater the inefficiency, the worse the outcomes. The worse the outcomes, the easier it becomes to accept radical solutions and the more likely that radical change will simply erupt.

Or so I believe.

Until then I'll just sit back and enjoy sun rises like these from my new office window.

Sunday, March 09, 2008

Inflation as entropic process

Paper money eventually returns to its intrinsic value ---- zero. Voltaire

A friend recently asked me when is a day or so longer than a few weeks? When the Dude says he'll write again within that time.

Another friend of mine, and all around bright fellow, has, through a few days of debate on the causes of rising prices, inspired me to finally start posting again.

I find it fascinating how different minds think about the same issue. The "bones of contention" in any debate, assuming (and this is a big IF) the issue has been properly defined, reveal the differing underlying beliefs.

After going back and forth on the issue of the necessary causes of rising prices, I saw his underlying assumption: some force, such as might occur if a market was "cornered," a la the Hunt's silver play of a few decades past, must come into play in order for prices to rise. Thus he kept, quite reasonably, under that view, asking for the mechanism that drove prices higher.

Throughout the exchange I found myself at something of a loss for words. It seemed obvious to me that prices should be rising, yet I couldn't explain the basis of my view to an inquiring mind. Finally, having spent a few days pondering why I thought higher prices were so obvious but he didn't, the answer came to me- he was assuming that the unit of account and medium of exchange was of stable value, while I had accepted Voltaire's view, above, as true- paper money, such as the US$, was returning to its intrinsic value, zero.

In my next response to him, I inverted the arrow of causality: The better question to ask is how the price (which is simply the relation of a good/service to a unit of account of minute intrinsic, but some implied value) of any good stays the same over time instead of rising. That seems to me a more difficult question to answer.

That is, in a fiat money system, price stability is a low entropy configuration requiring some enforcement to maintain, inflation, i.e. a shift in a currency's perceived value towards its intrinsic value, is a shift to a configuration of greater entropy.

For those unfamiliar with the concept, entropy can be thought to rise as potential dissipates. A state of higher entropy is, in a sense, more disordered than a state of lower entropy. The second law of thermodynamics states that the world acts spontaneously to minimize potentials- tends to a state of higher entropy. For instance, an ice cube placed on a table at room temperature will melt without being heated or a concentration of gas, perhaps enclosed in a chamber under the same pressure as the surrounding room, will diffuse through the room over time after the chamber is opened.

Voltaire's view, which I share, implies that some ordering force must be applied to maintain the value of paper money. Remove the ordering force and paper money will begin losing value just as the ice cube on the table in your room (assuming you can afford heating oil these days) will begin to melt if heat is not constantly drawn from it.

This line of thought reminded me of my recent read of Greenspan's The Age of Turbulence- particularly his oft expressed sense that a well functioning, efficient economy (however one might define such terms) was a "natural" occurrence, at least in the west, due, as he notes in relating his observations of Russia's shift to Capitalism, to our long standing traditions of valuing private property, etc. An inefficient economy in the US, according to Greenspan, is a result of restrictions or rules which impede the transition to its natural state. Free the markets, and, he avers, things will sort themselves out.

This runs counter to the second law of thermodynamics. Of course, we are not bits of ice or molecules of gas, thus this law should only be assumed to operate on our physical beings (for instance the entropic process by which every ordered biological entity is always tending to death and disintegration, mitigated only temporarily by regular additions of energy (food), water and air).

Yet, it seems to me one can imagine this law operating on cultures as well. As the fall of myriad cultures over history seems to attest, humans, barring organizing forces, (which might be internal, such as simple faith that "the system" is working, or external, such as the imposition of sanctions on certain behaviors, what we call the justice system) are always tending towards the "noble savage." Our current state of, despite the occasional war, and other atrocities, high level cooperation is the "un-natural" or low entropy state, always pregnant with a return to barbarism.

Returning to the topic at hand (I need to force myself to stop digressing, or expressing my natural mental entropy) it seems to me that Central Banking in America at least, has forgotten its primary function by assuming that zero inflation under a fiat money system was a "natural" result. The Fed or Treasury would need to "do something wrong" to ignite inflation.

Au contraire, say I, the natural value of these colored, variously numbered pieces of paper in my pocket is almost nil. The Fed needs to "do something right," i.e. enforce the view that paper money has value, in order to stop inflation from occurring. Acting as if external imbalances never need to be resolved, blocking the mortgage market from clearing, and cutting interest rates ever closer to zero (etc.) don't seem to me to be policies that will stall the now accelerating entropic process of the US$ finding its intrinsic value.

p.s. I'm not arguing that restrictions are necessarily a good thing, the fewer the better, so long as the really important ones, like maintaining a stable unit of account, are enforced.