Monday, April 27, 2009

Time, Power and Money

When you are courting a nice girl an hour seems like a second. When you sit on a red-hot cinder a second seems like an hour. That's relativity. Albert Einstein

Late in the 16th Century, Pope Gregory XIII stole 10 days, declaring that October 4, 1582 would be followed by October 15, 1582. After 12 centuries of use, the extra 11 minutes per year relative to the vernal equinox cycle assumed by the Julian Calendar had pushed the date of the spring equinox back about 10 days. The Vatican wanted the vernal equinox to occur on the same calendar date as that of the First Council of Nicea in 325, Mar 21, thus the decision to "steal" 10 days.

This Gregorian Calendar and its intercalations has (not without dissent, e.g. the British didn't adopt it until 1752) become the (for the most part) global standard for commercial purposes.

As you might surmise, such a significant change caused great consternation. Some thought the reform a plot by landlords to cheat them of 10 days rent- no doubt some clever insiders bought property to capture this free rent prior to the calendar's adoption in each country. A counter argument that, relative to the new calendar, renters had been cheating landlords out of 11 minutes of rent per year for centuries would likely have fallen on deaf eras.

Fortunately the Julian Calendar Year wasn't 11 minutes less than the vernal equinox cycle, thus requiring an addition of days. Stealing days from the poor and padding the accounts of landlords was a much easier "sell" than the reverse would have been.

The word, time, as Einstein reminds us, refers to an idea. It is one of man's greatest conceptual tools to impose order on our sometimes chaotic perceptions. Seconds, hours, days and years might feel alternatively long or short but the choice to apply- perhaps "submit to" would be more apt- real world standards of time keeps us on the same page. Were we not all on the same temporal page, modern finance, given its reliance on time based interest, would never have been developed.

Imagine, perhaps in an attempt to ameliorate the effects of the current financial crisis, a government loosening the standards by which time was measured. Adding days to a few months would certainly make debt service easier, assuming one's income flow was based on a non-monthly standard.

Financiers, correctly, in my view, would argue against loosened standards of time. "How," they might ask, "can we calculate asset worth, determine net present value, or estimate risk in a world where the month of April refers to this amount of time today and a radically different amount of time tomorrow?"

Given current conditions, however, one could respond by noting that despite rigid standards for time, such calculations are obviously difficult for the financial world. "It wasn't," the imagined retort might be formulated, "a change in any temporal standard that destroyed the value of my retirement investments or that of US mortgage securities."

Indeed, it wasn't a change in temporal standards that led to the current financial disorder. Rather, inter alia, it was, I believe, a loosening of monetary standards. If standards of time are crucial for accurate financial calculation so too, it seems, should be standards for money. These standards for money go beyond the basic decision to, for instance, set a fixed exchange rate to specie or some other method to ensure that no more money is created than there are goods and labor to buy with it. They would include restrictions on securitization and credit, and procedures for liquidation. The idea of unrestricted finance seems to me about as absurd as unrestricted time....how many seconds in a hour?...however many you prefer.

The calendar reform noted above can perhaps be seen as a lesson in compounding- error, that is. Eleven minutes is but 0.002% of a year, yet, over time such a seemingly trivial error- certainly one that went unnoticed by most people on earth- eventually pushed back the date of the vernal equinox by 10 days.

At least the error was constant. What if temporal standards had been "elastic?" Imagine the confusion that would result from days being 25 hours one year and 23 the next. Imagine, instead, the increased confusion that would result if the elasticity of temporal standards varied per individual. Tax payers might wish for years of 500 days while mortgage bond holders might wish for months of 10 days. Such mortgage bond holders, if they were able to implement this "short month" policy, would see the value of their assets, at least on paper, rise dramatically.

Of course, under such conditions, it wouldn't be long before the whole system of temporally based payments collapsed. If the desired changes in standards were less radical- call it the Fabian approach to loosened standards- the collapse would take longer to manifest. In any event, the lesson is clear, standards that vary over time and individual (or group) inevitably create confusion and discord. In the highly ordered modern world my month must be the same as everyone else's month.

Equally, in the modern world, my money must be the same as everyone else's money. There must be some standard of reference if calculations today are to have any merit tomorrow.

To illustrate, let's return to our mortgage bond holders wishing for a short month to increase the value of their assets. How many mortgagees, once the short month policy was adopted, would be able to make payments after 10 days? or after 3 short months? In the event, the paper gains mortgage bond holders loudly proclaimed as their path to permanent prosperity wouldn't manifest, for they would be but an illusion. No doubt those who expected to benefit from such a scheme would consider both the scheme, and those who devised it, brilliant. Expected beneficiaries would quickly become mesmerized by the proverbial "pies in the sky" and give these brilliant people the benefit of the doubt and more.

And so they were, and so they have.

As former IMF Chief Economist Simon Johnson recently wrote:

A whole generation of policy makers has been mesmerized by Wall Street, always and utterly convinced that whatever the banks said was true. Alan Greenspan’s pronouncements in favor of unregulated financial markets are well known. Yet Greenspan was hardly alone. This is what Ben Bernanke, the man who succeeded him, said in 2006: “The management of market risk and credit risk has become increasingly sophisticated. … Banking organizations of all sizes have made substantial strides over the past two decades in their ability to measure and manage risks.”

Of course, this was mostly an illusion. Regulators, legislators, and academics almost all assumed that the managers of these banks knew what they were doing. In retrospect, they didn’t. AIG’s Financial Products division, for instance, made $2.5 billion in pretax profits in 2005, largely by selling underpriced insurance on complex, poorly understood securities. Often described as “picking up nickels in front of a steamroller,” this strategy is profitable in ordinary years, and catastrophic in bad ones. As of last fall, AIG had outstanding insurance on more than $400 billion in securities. To date, the U.S. government, in an effort to rescue the company, has committed about $180 billion in investments and loans to cover losses that AIG’s sophisticated risk modeling had said were virtually impossible.

Wall Street’s seductive power extended even (or especially) to finance and economics professors, historically confined to the cramped offices of universities and the pursuit of Nobel Prizes. As mathematical finance became more and more essential to practical finance, professors increasingly took positions as consultants or partners at financial institutions. Myron Scholes and Robert Merton, Nobel laureates both, were perhaps the most famous; they took board seats at the hedge fund Long-Term Capital Management in 1994, before the fund famously flamed out at the end of the decade. But many others beat similar paths. This migration gave the stamp of academic legitimacy (and the intimidating aura of intellectual rigor) to the burgeoning world of high finance
.

"Hang on a second, Dude," you might be thinking, "I get the bit about time, but you haven't explained how variations in monetary standards caused the current confusion. Mr. Johnson doesn't mention it."

True. I haven't and he didn't.

Let's begin with a review. We use conceptual standards to ground our ideas through time and space and thus make them useful. We improve the utility of our ideas by choosing the best standard available.

While lunar cycles seem to have been the first choice of temporal standard some cultures- the early Egyptians and Britons are two that come to mind- discerned that annual rhythms more closely matched solar rather than lunar cycles. These "sun worshipping" cultures tended to outperform their moon worshipping, a.k.a. "lunatic" rivals because their expectations of the future, grounded by wise standards, tended to be more accurate.

The idea of time is regulated- in ancient times it was regulated by priests. The modern world, however, having settled on temporal standards, and having reduced the mysteries of time to a science no longer worships the sun, or moon. We self regulate using accepted technology- modern governments have no ministries of time.

We do, however, have ministries of money and "priests" whom, we hope, understand this new mystery. In a sense, we worship money. Sadly the priests of the new temple have gone pagan, by which I mean forsaken the old teachings, and the Great God Money is angry.

Like time, the word, money, refers to an idea- one that measures value and thereby facilitates trade and projections thereof through time and space. In our highly ordered modern world with its complex division of labor, my plans of the future are based on my trade of labor for, initially, money, and then the share of goods and labor produced by the cooperative effort it represents. It is vital, given our increasingly complex division of labor, that my work is productive. If it doesn't add to the cooperative effort I'm diluting the value of money- not just mine, but everyone else's.

Pause, if you will, and reflect on this idea a moment.

Each day hundreds of millions of people spend hours typing, talking, thinking, planting, calculating, transporting, managing, and building to cite a few jobs. This cooperative effort produces the things we need to survive (or would just like to have). In certain occupations, such as farming, productivity is easy to measure. In others, such as government or finance, productivity is usually much more difficult to measure because it tends to flow from labor freed for more useful purposes.

What's a good government or stable financial system worth? Ask those from a country in crisis, like Iraq. Productive governments, inter alia, maintain civil order and thus reduce fears of loss of life and goods that would otherwise increase the labor burden on others. Productive financial systems allow savings to be channeled to productive uses. Although these 2 occupations add nothing directly to the stock of available goods, when they are working well, by facilitating cooperation they add to total output.

This last point is key. The economic value of government and finance, among other occupations, can only be calculated indirectly as some segment of total output of the economic unit in question. It then follows that the value of an existing government and financial system can never be greater than total output. It also follows that neither government nor finance are the sine qua non of economic output.

Because their economic value is a function of total output, during periods of increased productivity in the rest of the economy, government and finance may overstate their contribution in somewhat similar fashion, I imagine, that the Egyptian Priests of Ra sometimes overstated theirs. Productivity increases flowing from, for instance, the use of iron had little to do with the rites of the Priests of Ra.

As Simon Johnson notes: From 1973 to 1985, the financial sector never earned more than 16 percent of domestic corporate profits. In 1986, that figure reached 19 percent. In the 1990s, it oscillated between 21 percent and 30 percent, higher than it had ever been in the postwar period. This decade, it reached 41 percent.

What did the financial world do such that its share of corporate profits should nearly triple? It didn't invent the computers and networking technology that gave rise to Greenspan's tech boom, although it did use them to reduce its labor force and improve their bottom line. It didn't optimize manufacturing techniques or improve mine or oil drilling extraction rates, although it helped finance the research and implementation. Outside of asset securitization, most of the "innovations" in finance, like futures and options, would have been familiar to early 17th Century Dutch Bankers- yes, the one's who fomented the Tulip Mania.

Finance, despite numerous attempts to enforce the label, refuses to accept that it is a mature industry, in the main, because mature industries, like electricity production, aren't growth industries- they are expected to provide their service flawlessly and get paid a regular but small profit for their efforts.

As a student of the physical sciences I find electricity generation and transmission fascinating. It must have been a marvel for the late 19th Century man to witness a machine creating and harnessing the power of lightning. Fortunately, we do not worship electricity. Thanks to Science we realize that a generator transforms mechanical energy into electrical for ease of transmission, inter alia. The process is not seen as mystical, it is considered a natural process that follows laws which can be understood by any reasonably competent person who cares to study. The industry is considered mature and its leaders not irreplaceable. Bankruptcies in the industry are, correctly, in my view, seen as management failures. Electricity generating CEOs could not go to Congress and ask for 100s of billions of $s with no questions asked. There is no mystique to the process.

A few years ago, however, one natural gas mining company got into the electricity generating and transmission business and created a mystique about its practices. Enron became a financial industry favorite by posting profits far in excess of similar companies in the field- profits which came, as time passed, less and less from its core businesses and more from arcane financial transactions. As we now know, these profits were fiction. When the fraud was exposed, shareholder equity was wiped out and management was prosecuted. Enron's attempt to mystify the utility industry and thus justify higher profits failed. Their failure was only a catastrophe for their shareholders and workers. Electricity and natural gas continued to flow.

Where Enron failed, finance has succeeded. Modern finance, which has been around longer than electricity use, has, I believe, mystified its procedures- think Greenspan speak. Banking, which had, in the 50s and 60s, been a boring business for older, sober men, became, as monetary restrictions were cast aside, exciting, new and mysterious. General Electric, the company founded by Edison, and which still builds electricity generators, doesn't have a TV station devoted to the marvels and mysteries of electricity, it has one devoted to the marvels and mysteries of finance- CNBC. This mystique stands in the way of finance receiving the Enron treatment. We do not fear a stoppage in the flow of electricity if large utility companies are bankrupted but we do fear a stoppage in the flow of funds if large finance companies are bankrupted.

A child who wished to radically increase the flow of electricity (amperage) in a wire would rightly by admonished by an adult who knew the wire would heat up and fail. Yet there are seemingly no adults to admonish the children who radically increased the flow of credit thus halting that flow.

China's Vice Finance Minister recently called for reform of the world's monetary system. Like Pope Gregory XIII, this minister sees that our ideas are not working as we wish, but with money instead of time. Reforming the world's monetary system means, to me at least, stripping the subject of its mystique. There is a science of money as there is a science of electricity and it seems to me man would be well served by remembering this. This isn't, as Jon Stewart remarked to Jim Cramer, a %&$#% game. Money is the tool which allows our complex division of labor to work.

4 comments:

Hombre said...

Dude, I really like the electricity/economics analogy. And it seems to me that until 100 or so years ago the average citizen had a reasonable idea that economics was more of a science like electricity than a God -- gold-based dollar, etc. Yet at some point it switched from science to religion, which the creationists have yet to achieve w/r/t evolution.

I guess I'm wondering how that happened -- was it central bankers, de-linking fiat currencies from a store of value, the proliferation of credit, Keynes, Greenspan? And what sort of event will we need to see in order to end the faith/fear in the Great God Money, and turn it back into the dismal science?

Dude said...

The last time the scientific became mysterious was the fall of Rome. Declining educational standards as a result of, inter alia, economic decline was the culprit then.

Hopefully the still unfolding economic/financial crisis will provide sufficient impetus to demystify finance.

Charles Butler said...

Hombre,

Try the combination of a utopian society that believed that anything could be done now that history had been put a stop to, and the tool to do the job - the computer.

Great post.

sustento said...

Welcome the world of monetary reform.

My father was a banker for 42 years. My first job post-university and backpacking was reconciling swaps transactions (back in 1989). Although I'd studied capital market theory at Uni I hadn't heard of a swap so I called him up and he gave me a book on foreign exchange forwards!! He lived in a world of personal banking and letters of credit. There was risk but you always knew who you dealt with.

Overnight his sons were making more moolah in a year than he made in 10.....trading options, futures..credit? Buying expensive houses, flats, cars...pass the tulips :-)

But now the time has come to put our technology and skills to work. Peer to peer lending, basic incomes, public interest free money supply....

We can rebuild it (not the $6m man but the $6trln screw up!)