Wednesday, November 17, 2010

John von Neumann: Playing for Keeps

It should be noted that children at play are not playing about; their games should be seen as their most serious-minded activity.   Michel de Montaigne

According to Lewis Straus, one of the original five Atomic Energy Commissioners, when John von Neumann, eminent mathematician and co-author of Theory of Games and Economic Behavior (available at, lay dying of cancer in 1956-7, “gathered round his bedside, and attentive to his last words of advice and wisdom, were the Secretary of Defense and his deputies, the Secretaries of the Army, Navy and Air Force, and all the military Chiefs of Staff.” That’s quite a bit of attention being paid to one man and I can’t think of another person since who has been held in such high regard by the US’ Military Industrial Complex’s power elite. 

Ironically enough, he earned this high regard from such serious people, in part, by preaching that life was (heuristically) a game.  The irony fades when one discovers that Johnny, as he was universally (according to the biographies I’ve read) known, thought of both poker and nuclear deterrence as different forms of similar games.  Moreover, the sense of “game” to which von Neumann referred was consistent with the opening quote- a serious endeavor to which good players bring their full attention.  Life lived as a game, in my view, is life lived aware, with a focus on constant improvement, or as Socrates put it, a life examined.

Reading von Neumann's analysis of the complexities involved in trying to model economic behavior- the theory behind the symbols- was, for me, a window into the mental process of a true genius.  The process, for me, was the "meat", far more mentally nourishing than the "conclusions" which might be construed by some as useful economic strategies.

But, I digress.  Onward to the perspective. 

For von Neumann (leaning on the work of Austrian Economists) the quantum of modern economics was an exchange, or in game-speak, a move.  The sum of all such moves, and their effects on production, distribution, etc. comprise the game we call economics.  In that sense, von Neumann’s sale of the book was a move, and a pretty good one at that.

Importantly, within that perspective, there are no disinterested umpires, although some players do “double duty” just as a poker player will, from time to time, both deal and play.  Such “double duty” demands extra scrutiny from the other players whether the game is poker or international finance.  If you wish to assume simple selection of a player as Treasury Secretary or dealer guarantees righteousness, I want to deal a few hands of poker to you and your friends.

There are a few other “sacred-cow-slaying” passages of the book which caught my attention.

 Beware of Omniscient EconomistsFirst let us be aware that there exists at present no universal system of economic theory and that, if one should ever be developed, it will very probably not be during our lifetime. The reason for this is simply that economics is far too difficult a science to permit its construction rapidly, especially in view of the very limited knowledge and imperfect description of the facts with which economists are dealing. Only those who fail to appreciate this condition are likely to attempt the construction of universal systems.

On the Ideal of Free Competition: The classical definitions of free competition all involve further postulates besides the greatness of that number.   E.g., it is clear that if certain great groups of participants will for any reason whatsoever act together, then the great number of participants may not become effective;  the decisive exchanges may take place directly between large "coalitions," few in number, and not between individuals, many in number, acting independently. Our subsequent discussion of "games of strategy" will show that the role and size of "coalitions" is decisive throughout the entire subject.

The Futility of “Maximizing Utility”: A particularly striking expression of the popular misunderstanding about this pseudo-maximum problem is the famous statement according to which the purpose of social effort is the "greatest possible good for the greatest possible number." A guiding principle cannot be formulated by the requirement of maximizing two (or more) functions at once. Such a principle, taken literally, is self-contradictory, (in general one function will have no maximum where the other function has one.) It is no better than saying, e.g., that a firm should obtain maximum prices at maximum turnover, or a maximum revenue at minimum outlay. If some order of importance of these principles or some weighted average is meant, this should be stated. However, in the situation of the participants in a social economy nothing of that sort is intended, but all maxima are desired at once by various parties.  (see also: Fed mandate of maximum employment with minimal inflation)

Finally (for this essay, I think the book is well worth a read, no summary of mine would suffice) von Neumann raises the issue of economics as a non-zero-sum game, i.e. a game in which the sum of all payments equals the sum of all losses.  As we’ve been slaying sacred cows, let me join the fray.

The apparently widespread assumption of perpetually rising GDP can be thought of as the apparently equally widespread assumption of non-zero-sum games always increasing the pot of winnings.  I think this is a dangerous assumption.  “Moves” by big players, “double duty” players, and coalitions, and their effects on others’ moves can increase as well as decrease the pot of winnings.  To wit, it seems likely to me that continued social distribution of losses and privatized winnings (bank coalition bail-outs being a case in point) will (and, in my view, has already) decrease the pot of winnings.

In all games, cooperation is key, especially in games like economics, that are played for keeps.

Wednesday, November 10, 2010

US Bonds: Waiting for the First Rat

US 10yr Notes have had a tough few days with yields rising some 15bp.  Irish Bond traders might be wondering, if a few days yield rise of 15bp can be described as “tough” what word would one choose to describe government debt trading in Ireland lately.  Yields on Irish 10yr government debt rose by more than 60bp today, making the total yield gain since May more than 400bp.  I think “crisis” seems most apt.

What’s the difference between Irish Debt and US Debt trading besides currency denomination?  That is, why are Irish yields rising dramatically and US yields not?  After all, both nations have a large stock of government debt, a not insignificant portion of which was necessitated by bail-outs of highly leveraged banks and are running substantial continued deficits (admittedly the expected Irish deficit is roughly 3 times the US relative to GDP).  Why are Irish yields so sensitive to news of additional deficits while US yields remain stable?

The French refer to this conundrum as the “exorbitant privilege” of the US.  If Ireland were to announce a policy of Irish Central Bank monetization of the next 9 months of debt issues, Irish Debt would, I suspect, crash more severely than it has.  Yet, this is just what the Fed announced last week.  It’s good, it seems, to issue the world’s reserve currency.

Press coverage of Irish debt trading speaks of investors demanding ever-higher yields as risk compensation given Ireland’s fiscal woes, while the fear in the US is just the opposite, i.e. of another asset bubble being created, despite, it seems, the US’ fiscal woes. 

Perhaps the answer to the query, “what’s the difference between Irish and US debt trading?” is simply time.

At some point in all markets, the metaphoric rats leave the sinking ship.  In the Irish 10yr, it seems 6% was the yield of no return.  Leveraged owners of the debt started to flee (sell) while Ireland’s financial needs grew (due to, if for no other reason, higher borrowing costs) and debt sales begat more debt sales. 

To repeat, at some point in all markets, the metaphoric rats leave the sinking ship, even, I believe, US debt markets. 

Of course, when the feasting has been very good for a long time and when a rat might fear repercussions from leaving early, a wise rat might wait until other rats left safely before leaving himself.  A wise bond trading rat might watch US yields and flee when they rose above some level, say 4% in the US 10yr.  An even wiser rat, having decided the meal was not to his liking (or so I understand the debt rating downgrade from a Chinese rating agency), might sell while the selling was good, say while the ship’s owner (the US) was buying.

I’m most curious to watch US debt trading in the coming months as Treasury data on foreign inflows details the movement of the rats off the ship.  Once the other rats know that many are leaving the exodus will become a stampede (lots more leveraged longs in US debt markets than in Irish debt). 

Who knows, in the not too distant future the press might speak of US Bond investors demanding ever higher yields.  

Disclosure: No positions in US Treasuries (yet)

Tuesday, November 09, 2010

Do We Need Another World War?

Ask the average guy on the street if we need another world war and he might respond with, “We need another world war like I need a hole in the head.”   Yet, there are medical conditions which can be solved by holes in the head, such as cranial swelling, i.e. when your brain gets too big for your skull.

War, according to Carl von Clausewitz, is merely the continuation of politics by other means.  In other words, when talking fails to resolve an issue in need of resolution, military force will accomplish what persuasion couldn’t.

However, winning a war, which, in Clausewitz’ view, means achieving political goals via military means, is easier said than done.  As Machiavelli warned, It ought to be remembered that there is nothing more difficult to take in hand, more perilous to conduct, or more uncertain in its success, than to take the lead in the introduction of a new order of things. Because the innovator has for enemies all those who have done well under the old conditions, and lukewarm defenders in those who may do well under the new.

The end results of WWII are consistent with Machiavelli’s warning.  Nazi Germany, Japan and Italy started the war to, inter alia, create a new world order and they succeeded, in part.  At war’s end, a new world order was created, with the US on top.

Having proved its dominance on the battlefield (leaving aside, for this essay, the stunning success of the Russians against the Germans), and carrying the big stick in the form of Atomic Weapons, the US could talk softly, solving, for a time, international financial conundrums which had proven intractable within the context of the League of Nations.  From this perspective, the “success” of the UN, IMF and World Bank, in contrast to the “failure” of the League of Nations is more a function of US power exercised through the new international institutions than some new-found commitment to cooperation. 

Of course, US dominance of world politics was due not just to military might but to its substantial Gold holdings, undamaged by war capital infrastructure, domestic commodity resources, and sheer economic size.  It seems to me the more recent failures of international financial institutions is more a function of the US resource depletion, gold reserve and capital infrastructure exports, and rapid economic growth of China and other populous nations, than some new found weakness in those institutions. 

Defendants don’t fear the Judge who imposes sentence but the power of the state behind him. 

The last world war was, in a sense, a schoolyard brawl decisively won, and broadcast globally, by the strongest kid, who happened to have the richest parents.        

I ask the opening question from the above perspective.  Do we need another world war to breathe new life and power into current or new international financial institutions- solving problems currently deemed intractable?

Barring a new enlightened faith in the virtues of international cooperation by top policy makers, and given the pressing need to apportion financial losses accruing from, inter alia, unprofitable international investments, the answer may be yes. 

Fasten your seat belts.

Sunday, November 07, 2010

Are We There Yet?

With the US$ sinking and Gold setting new highs every few days those, like me, who have been waiting for the final collapse of the current $ based international financial system have one question on our minds- “are we there yet?”

“Not yet.  But we’re getting very close.”

This past week the US electorate, in a fit of justified pique over Democratic failure to fix the broken (at least from the perspective of the majority of US citizens) economy, put Republicans back in charge of the House of Representatives.  Big Finance must have viewed election results with glee.  Gridlock, as we Americans lovingly refer to government divided and thus incapable of passing radical legislation, means the Volcker Rules (or other meaningful financial reforms) have an even slimmer chance of becoming law. 

Coincidentally, the Federal Reserve announced plans to buy, during the next 9 months, $600B of long dated US Treasuries- a policy they refer to as “quantitative easing”.  I prefer “monetizing debt” to avoid confusion.   

While Big Finance in the US celebrated the return of Gridlock and the gift from the Fed, our foreign financiers most likely took a less sanguine view of the policy changes.  US banks will soon be free to take even bigger risks while the Fed actively drives the value of the US$- the ultimate “asset” our financiers are promised- ever lower. 

The wonderfully apt, in this case,  phrase, “thick face,” no doubt crossed many Chinese minds as they pondered US Treasury Secretary Geithner’s proposed current account targets to “accelerate global rebalancing” in the context of US debt monetization and ever more impotent regulation of the big banks who have led the world to the current impasse. 

To wit-  Cui Tiankai, a deputy foreign minister and one of China’s lead negotiators at the G20, said on Friday, “We believe a discussion about a current account target misses the whole point,” he added, in the first official comment by a senior Chinese official on the subject. “If you look at the global economy, there are many issues that merit more attention – for example, the question of quantitative easing.”
It seems to me a sign of the times that Mr. Geithner didn’t respond to current concerns over the declining $ as Nixon’s Treasury Secretary, John Connally once did, i.e. the US$ “is our currency, but your problem.”  The swagger of US policy makers evident in decades past is now shrouded in sophisticated euphemism- but the effects will be similar.

“But, are we there yet?”

“Not yet.”

There is, in my view, one last road sign before we reach our destination.  When the US Bond Market begins to “fight the Fed”- a strategy normally as wise as spitting into the wind- we will begin the end stage of our journey to a new system of international finance.  When US Bond prices fall despite Fed intervention (better yet, when bond prices fall on news of increased intervention) the excrement will be about to hit the fan in international finance. 

We must, however, be getting close.  I noticed the Fed established the Office of Financial Stability and Research this past Thursday.  Talk about closing the barn door after the horses have all escaped.