The Lost Secrets of the Federal Reserve

I have a very esoteric mind....if I could just remember where I put it. A. Burns

The problem with esoteric institutions, from the Priests of Ancient Egypt to today's Federal Reserve is the difficulty in retaining the well-hidden secrets these institutions are built upon.  The more successfully esoteric the institution, the greater the risk "essential"- a claim deserving of vigorous debate, in my view- secrets will be lost.

The priests of Ancient Egypt, whose understanding of Nile flood cycles, inter alia, made them one of the first economic policy makers in the historical record, hid their knowledge of seasonality behind a dense a screen of esoteric theology.  The science, or exoteric understanding of the effects of the earth/sun relationship was left to younger cultures, uninhibited by Egyptian taboos on such studies, to "discover."

The Egyptians worshiped the Sun and made sacrifices and offerings thereto (thus enriching the priests).  The Greeks openly theorized about the sun and many other things and thus developed a more accurate world view.

In more modern times, the US Federal Reserve, the Creature from Jekyll Island, as some have called it, was formed in secret, around secrets.

I'd like the share some of those secrets (assuming I've actually divined them- an assumption the reader must determine for himself):

1) Industrial Capitalism is (and can continue to be in the future) so efficient that an ever increasing percentage of an ever increasing number of people can do nothing and yet receive the necessities of survival.

2) The social utility of money- i.e. the elastic variety of modern Central Banks- is (and has been for decades) decreasing as  an allocator of capital resources and increasing as an allocator of (ever increasing) labor resources.

In other words, the problems of economics once a nation industrializes (and more so when nations trade freely) are not on the production side (the already sufficient pie, if you will, can yet grow) but on the distribution side (how shall the pie be sliced). 

Consider, as an example, US agricultural production:

• 1900:  41 percent of workforce employed in agriculture
• 1930: 21.5 percent of workforce employed in agriculture;
• Agricultural GDP as a share of total GDP, 7.7 percent
• 1945: 16 percent of the total labor force employed in agriculture;
• Agricultural GDP as a share of total GDP, 6.8 percent
• 1970: 4 percent of employed labor force worked in agriculture;
• Agricultural GDP as a share of total GDP, 2.3 percent
• 2000/02: 1.9 percent of employed labor force worked in agriculture (2000); Agricultural GDP as a share of total GDP (2002),
• 0.7 percent

Source: Compiled by Economic Research Service, USDA. Share of workforce employed in agriculture, for 1900-1970, Historical Statistics of the United States; for 2000, calculated using data from Census of Population; agricultural GDP as part of total GDP, calculated using data from the Bureau of Economic Analysis.

We, in the US, can not only feed ourselves, we can generate an exportable surplus using less than 2% of labor resources.  Food is easy, which explains, in part, the obesity problems of the modern world.

Food, houses, clothes, transportation (most likely not of the automobile variety), education and health care, to name a few key "necessities" of life can be produced in excess of demand.  The problem, in my view, lies in how to distribute the goods. 

One solution, chosen by men steeped in the tradition of the Protestant work ethic, was the use of elastic money to keep idle hands from "the devil's work."  Rather than a massive expansion of welfare, which, I believe, would be more intellectually honest and restrict money's social utility to capital resource allocation- i.e. the hard money advocated by Ron Paul, inter alios- money would be (and still is, with decreasing efficiency) used to soak up excess labor resources and "explain" the vagaries of goods distribution within a society to modern sensibilities.

Paradoxically, Rep. Paul favors not only hard money, but also further decreases in transfer payments, i.e. welfare and "make work."  Hard money, in my view, generates increased efficiency- more goods for less labor- which, in turn, generates unneeded labor resources.  Hard money "end the Fed" advocates need to ponder the unnecessary, but existent population problem.  Swift's modest proposal of eating Irish babies, which we can expand, in the modern world, to eating unemployed people (Soylent Green!) strikes me as most unsavory.  (I couldn't resist)

State enforced population restriction, like China's "one child" policy could be used, at risk of imposing human for "natural" selection on humanity.  How would we know which humans are worth bringing to life?

The esoteric solution of the Federal Reserve, aided by the views of JM Keynes, worked, in my view, tolerably well so long as the secret of excess labor was understood by its leaders and national capital infrastructure wasn't in need of retooling.  Greenspan's statistical fumblings with productivity coupled with his anti-welfare/anti-inflation views suggest to me that the secret was not well transmitted as does the lack of import placed on previously believed key elements of the Fed's role in fomenting social stability embodied in Humphrey Hawkins legislation.  The financial sector, taking its cue from the confused Fed thinks its function is to make money rather than allocate capital resource.

The secret has been lost.

Thus, it seems to me, the current problem of long term unemployment.  The policies of the idle wealthy, or leisure class, desirous of maintaining and bequeathing to their progeny their position at the head of the pie cutting table via reductions in transfer payments implemented by the financial sector risk increased social tensions, and increasingly widespread populist uprisings, such as we are witnessing in Egypt and other nations. 

Solving this problem, in the context of the need to recapitalize our transportation system away from the automobile (and goods trucking) towards more efficient means, will be most difficult unless we are willing to slay a few sacred cows. The protestant work ethic inspired elastic monetary system insulates the real (production) sector from necessary conforming to new reality (decline in US and world oil production) pressures until a crisis is reached.  Hard money would make the necessary transportation (and other sector) changes easier, but would increase the social tensions noted above.  Increased transfer payments in the proposed hard money system should alleviate these tensions. 

Sadly, as noted, the hard money advocates are not fond of such transfer payments.  Perhaps they will be fonder of such socially calming methods when the turmoil in the Middle East rears its head closer to home.

The Big School and Convertibility Lost

As described in The Partnership: The Making of Goldman Sachs: Coyne [CEO of J. Aron] learned that the central banks of many nations kept their currency reserves in gold bars stored in the vaults of the Bank of England in London or the New York Federal Reserve Bank. Taken together, all this great wealth of nations had what Coyne saw as one fascinating characteristic: It earned zero return. It just sat in the vaults. But Coyne knew that the time value of money always figured into any futures contract...so he called on the central bankers in one country after another and made what appeared to be a generous and innovative offer: "Lend me your sterile bars of gold bullion and I'll pay you a fee of one half of one percent every year!"

Why then was this forbid? Why but to awe,
Why but to keep ye low and ignorant,
His worshippers; he knows that in the day
Ye Eate thereof, your Eyes that seem so cleere,
Yet are but dim, shall perfetly be then
Op'nd and cleerd, and ye shall be as Gods
Milton: Paradise Lost

There are, it may seem to a new student of economics, more schools of thought in the field than stars in the sky. I sometimes wonder if David Bohm, author of, inter alia, The Qualitative Infinity of Nature, might have felt more comfortable as an Economist than a Physicist. While the physical sciences, according to Thomas Kuhn, exhibit totalitarian tendencies with violent revolutions, Economics is far more democratic, tolerating, albeit not without disputes, multiple coincident schools of thought.

Of late, however, one school of economic thought has become increasingly dominant in policy making circles. The Big School holds that the larger a financial institution becomes the more protected it should be, and vice versa, the smaller a financial entity is, the less protection it should receive.

As an example of this (somewhat) facetious claim, consider the views of JPM's David Lowman: Like all loans, mortgage contracts are based on a promise to repay money borrowed. Importantly, there is no provision in the mortgage contract, express or implied, that the lender will restore equity or reduce the repayment amount if the value of the collateral – be it a home, a car or a stock market investment – depreciates. If we re-write the mortgage contract retroactively to restore equity to any mortgage borrower because the value of his or her home declined, what responsible lender will take the equity risk of financing mortgages in the future? What responsible regulator would want lenders to take such risk?

In other words, the same bank (there were, of course, others) whose inability to meet its contractual obligations a few years ago was such that it needed loans from, and preferential swapping of toxic for performing securities with, the Fed, equity support from the Treasury, and a release from the onerous task of marking securities to market, NOW thinks contracts, regulations and agreements are sacrosanct.

I wonder if the issue up for debate was deriviatives regulation or marking toxic assets to market, would any person from a bank end a paragraph with "what responsible regulator would want lenders to take such risks?"

Big School Rules.

In a Jonathon Demme film appropriately (for our purposes) titled "Stop Making Sense", the Talking Heads' David Byrne asked, "Well, how did I get here?"

The Big School took its cue from Kuhn and engaged not in democratic debate, but totalitarian revolt. They appropriated Walter Bagehot's views on the Central Bank's Lender of Last Resort facility in times of crisis but perverted them in the process. Instead of the outline presented in Lombard Street of "very large loans at very high rates" which, in modern times, became, "lend freely at a high rate", the Big School preaches the doctrine of "lending freely (to the banks) at a very low rate" thereby relieving the Central Bank of its responsibility to enforce prudence.

I may, however, be wrong in assuming the Big School appropriated their "lend freely (to the banks) at a very low rate" doctrine from Bagehot (they may simply have thought "lots of free money would sure be nice"), because this implies a reading thereof. If they had read Lombard Street they would have found these lines of concern about big banks, and management practices obscured from review:

The second misgiving, which many calm observers more and more feel as to our largest joint stock banks, fastens itself on their government. Is that government sufficient to lend well and keep safe so many millions?

All that the best board of directors can really accomplish [in the largest joint-stock banks] is to form a good decision on the points which the manager presents to them, and perhaps on a few others which one or two zealous members of their body may select for discussion

There is no more unsafe government for a bank than that of an eager and active manager, subject only to the supervision of a numerous board of directors, even though that board be excellent, for the manager may easily glide into dangerous and insecure transactions, nor can the board effectually check him.

Our great joint stock banks are imprudent in so carefully concealing the details of their government, and in secluding those details from the risk of discussion. The answer, no doubt, will be, “Let well alone; as you have admitted, there hardly ever before was so great a success as these banks of ours; what more do you or can you want?” I can only say that I want further to confirm this great success and to make it secure for the future. At present there is at least the possibility of a great reaction. Supposing that, owing to defects in its government, one even of the greater London joint stock banks failed, there would be an instant suspicion of the whole system. One terra incognita being seen to be faulty, every other terra incognita would be suspected. If the real government of these banks had for years been known, and if the subsisting banks had been known not to be ruled by the bad mode of government which had ruined the bank that had fallen, then the ruin of that bank would not be hurtful. The other banks would be seen to be exempt from the cause which had destroyed it. But at present the ruin of one of these great banks would greatly impair the credit of all. Scarcely any one knows the precise government of any one; in no case has that government been described on authority; and the fall of one by grave misgovernment would be taken to show that the others might as easily be misgoverned also. And a tardy disclosure even of an admirable constitution would not much help the surviving banks: as it was extracted by necessity, it would be received with suspicion. A sceptical world would say, “Of course they say they are all perfect now; it would not do for them to say anything else”.

A read of Lombard Street would not have led to the Big School's conclusion that the Lender of Last Resort should, in times of crisis, lend only to the banks, and even insolvent ones.

Bagehot advised differently: A panic, in a word, is a species of neuralgia, and according to the rules of science you must not starve it. The holders of the cash reserve must be ready not only to keep it for their own liabilities, but to advance it most freely for the liabilities of others. They must lend to merchants, to minor bankers, to “this man and that man,” whenever the security is good. In wild periods of alarm, one failure makes many, and the best way to prevent the derivative failures is to arrest the primary failure which causes them.

In other words, Bagehot argued the Central Bank's responsibility was to "the market", not the banks.

Further, he argued: the majority to be protected, are the “sound” people, the people who have good security to offer. He also speaks to the issue of unsound people, perhaps using a bit of wishful thinking: No advances indeed need be made by which the Bank will ultimately lose. The amount of bad business in commercial countries is an infinitesimally small fraction of the whole business. That in a panic the bank, or banks, holding the ultimate reserve should refuse bad bills or bad securities will not make the panic really worse; the “unsound” people are a feeble minority, and they are afraid even to look frightened for fear their unsoundness may be detected;

While the fraction of business which is unsound today is likely larger than in Bagehot's England, I suspect most is sound. Unfortunately, the unsound elements, while small in practical classification (derivatives, mortgage backed securities, etc.) are huge in terms of currency relative to the whole economy.

Big School means Big Problems

Why, I wonder, did the other schools of thought so meekly submit to the Big School's totalitarian revolution? Perhaps the question might better be phrased, what problem(s) deemed intractable by most other schools of thought did the Big School solve.

My best guess; one of the problems the Big School solved is Triffin's Dilemma. Alternatively, a previous (temporary) "solution" of Triffin's Dilemma, the London Gold Pool, was brought back to life, a la Frankenstein's monster which begat Big School thinking.

Triffin's Dilemma states that when a national money is used as an international medium of exchange and international reserve there will be trade-offs between the national and global effects of the reserve currency issuer's monetary policy. Moreover, the reserve currency issuer nation would soon find that it had to run increasing current account deficits to provide liquidity to the rest of the world. This, in turn, would erode confidence in reserve currency convertibility, eventually leading to international currency instability and potentially a break down in world trade.

Robert Triffin forecast the breakdown of the Bretton Woods system based on this dilemma. Of late, his work has been cited by the PBOC.

Issuing countries of reserve currencies are constantly confronted with the dilemma between achieving their domestic monetary policy goals and meeting other countries´ demand for reserve currencies. On the one hand,the monetary authorities cannot simply focus on domestic goals without carrying out their international responsibilities on the other hand,they cannot pursue different domestic and international objectives at the same time. They may either fail to adequately meet the demand of a growing global economy for liquidity as they try to ease inflation pressures at home, or create excess liquidity in the global markets by overly stimulating domestic demand. The Triffin Dilemma, i.e., the issuing countries of reserve currencies cannot maintain the value of the reserve currencies while providing liquidity to the world, still exists. Zhou Xiaochuan: hairman, Monetary Policy Committee of the People's Bank of China

Triffin, in the late 50s, called for the creation of a new global currency to act as international reserve, along the lines of Keynes' Bancor, or the IMF's SDR (deliberations for the creation of which were informed of his concerns), which, in my view, invites a whole new set of problems, but may still, barring a significantly large, in economic terms, country usurping the US$'s role, e.g. China (which invites similar problems, and leads to the US' loss of the exorbitant privilege), prove the best solution. A "free banking" system of competing moneys is another option.

As the US, not entirely without globally altruistic justification, did not want the Bancor in 1960 any more than it wanted it in 1945, the dilemma of convertibility fears was managed by illusion by way of intervention. The London Gold Pool was established in 1961 to keep the "market price" of Gold at $35 and thus reduce the incentive to demand promised convertibility from the Fed.

This worked until French demands for Gold were not satisfied. The cartel failed to maintain prices within the target and within a few years Nixon's closing of the Gold window ended US$-Gold convertibility.

I'll spare you the details of the 70s inflation and early 80s newfound stability. Suffice it to write that US$ reserves were accepted as semi-convertible- if not to Gold at a fixed price, at least to Gold and a basket of commodities with limited (until recently) fluctuations at new, higher prices.

In one (presumably easily accepted) respect, Big School banks that created and kept markets going in multiple new ($ based) investment vehicles helped sustain the sense of convertibility so long as those markets were trading.  Markets to spend one's $s, even if one never shops there, engender a sense of stability.

Also coincident with this new found stability was the beginning of a business deal between J. Aron (purchased by Goldman Sachs in 1981) and Central Banks around the world. As described in The Partnership: The Making of Goldman Sachs: Coyne [CEO of J. Aron] learned that the central banks of many nations kept their currency reserves in gold bars stored in the vaults of the Bank of England in London or the New York Federal Reserve Bank. Taken together, all this great wealth of nations had what Coyne saw as one fascinating characteristic: It earned zero return. It just sat in the vaults. But Coyne knew that the time value of money always figured into any futures contract...so he called on the central bankers in one country after another and made what appeared to be a generous and innovative offer: "Lend me your sterile bars of gold bullion and I'll pay you a fee of one half of one percent every year!" (pg. 258)

The book goes on to detail that J. Aron was actually making 8% on the deal with no money down, "it produced a nearly infinite rate of return." The book suggests they pulled a fast one on the central banks.

What Coyne may not have known was that at least some governments may well have done the deal for nothing. J. Aron offered to do what the London Gold Pool had done, and was willing to take the risk itself- a risk passed on in the merger to GS.  An added benefit, assuming the deal worked as described, no gold had to actually be sold on the market, paper gold would suffice.

GS was not alone in this game. By the mid to late 80s when I was at Chase (now JPM), our Gold desk (fortunately positioned right behind the options desk where I worked) was playing the same game. Paper gold flooded the market.

One of the reasons I began working with GATA a decade ago was my observation (shared by them) of Gold's stubborn reluctance to rise in price despite the rapidly increasing external US$ reserves. If Gold was, as Triffin asserted, undervalued in the early 60s, surely, I thought, it was a steal in 2000 at $275.

Global US$ reserves have done nothing but rise since, at an increasing pace.

In 1978, Triffin and Mundell were warning of a sudden collapse of the US$ due to the growth of those reserves. Back then they wrote in astonishment of US$ reserves in the few hundreds of billions. Now, such reserves are measured in the trillions.

Without concrete data I can only speculate as to the extent of Central Bank gold leasing, or its effect on the price. In the past few years, the price of Gold has risen above $1000. Interestingly the price broke above the early 1980s high of $800 when problems began appearing in large US banks. The mid 2008 dollar squeeze in international markets capped its advance at that time, only to bring the US banking system to the brink of disaster.

How causal the coincidence proves to be remains a mystery. What seems certain is that, if Central Bank gold leasing is a policy aimed at extending the life of the US$ as global reserve currency, the banks so engaged cannot be allowed to fail, or the game is over.

Thus, I wonder how much effect, if any, the Gold leasing practices of the big NY banks had on the decision to make them too big to fail.

Have we dodged Triffin's dilemma by trying to maintain the illusion of convertibility only to invite a banking collapse worse than Bagehot's worse nightmare?

How will the US respond if an economy as large as China's needs a boost in international liquidity?  How large might an IMF rescue package need to be to keep China from suffering a disastrous contraction?  Would the US, as is its wont, allow the current account to widen further to ensure China repaid the IMF?

What if Japan needs IMF support?

How far off might such events be?

Big Questions for the Big School

Capitalism is Dead: Keynesianism, Marxism and Communism are too!

The Obama administration is making final preparations to sell its stake in the New York bank (Citibank), according to industry and federal sources. At today's prices, the sale would net more than $8 billion, by far the largest profit returned from any firm that accepted bailout funds, and the transaction would be the second-largest stock sale in history.  WSJ

John Kenneth Galbraith was once asked what he thought Nixon meant when he said, "We're all Keynesians now." Galbraith responded, in part, "He probably didn't know himself."  This might have been a joke.

I'm no expert on his views, but here's my attempt to succinctly present Keynesianism: 1) Capital (the means of production) is not the ultimate driver of economic growth, Demand is. 2) Demand can be manipulated by changes in government taxing and spending. 3) Economic growth can (and should) be maintained, if necessary, by such manipulations.

This interpretation of Keynesianism contrasts with that of Capitalism, which, I believe, in an ideologically pure sense holds that privately owned Capital, regulated solely by adherence to hard money rules of profit, loss and bankruptcy, is the driver of economic growth. Within that perspective, "Supply Side-ism" (if you will, a "child" of Capitalism) adopts the latter two elements of Keynesianism- capital can and should be manipulated by government intervention.

Using those definitions, with which, I'm sure, many will disagree, Capitalism is a rarely seen model. Supply Side-ism seems the most prevalent model in the west historically, and, recently throughout the world. US so-called Capitalists at the turn of the last century are, due to protective tariffs, better termed, Industrialists.

Within the past 30 or so years, however, the long time model of Supply Side-ism (sometimes leavened with Keynesianism, more often not) has fallen into disfavor and a new model has become preeminent in the US-Speculationism.

I'll borrow from Friedrich Nietzsche to continue: Have you not heard of that madman who lit a lantern in the bright morning hours, ran to the market-place, and cried incessantly: "I am looking for Capitalism! I am looking for Capitalism!"


As many of those who did not believe in Capitalism were standing together there, he excited considerable laughter. Have you lost it, then? said one. Did it lose its way like a child? said another. Or is it hiding? Is it afraid of us? Has it gone on a voyage? or emigrated? Thus they shouted and laughed. The madman sprang into their midst and pierced them with his glances.


"Where has Capitalism gone?" he cried. "I shall tell you. We have killed it - you and I. We are its murderers. But how have we done this? How were we able to drink up the sea? Is there any up or down left? Are we not straying as through an infinite nothing? Do we not feel the breath of empty space? Has it not become colder? Is it not more and more night coming on all the time? Do we not smell anything yet of Capitalism's decomposition? Capitalisms too decompose. Capitalism is dead. Capitalism remains dead. And we have killed it. How shall we, murderers of all murderers, console ourselves? That which was the holiest and mightiest of all that the world has yet possessed has bled to death under our knives. Is not the greatness of this deed too great for us? There has never been a greater deed; and whosoever shall be born after us - for the sake of this deed he shall be part of a higher history than all history hitherto." (with slight modifications)

Nietzsche's madman ranted about God, but I think his form is useful in the current regard. For Nietzsche, God died because man stopped understanding the word (a pun for theologists) and believing in its intended sense. Those who followed after God's death would need some new more powerful (Nietzsche hoped to find something more fundamental, or was he just mocking the attempt, it's hard to tell sometimes) controlling idea or chaos would ensue.

While I feel Nietzsche's argument form seems quite apt for the purpose of this essay, I don't share his faith (if such was the case) that we will find any more powerful, fundamental, controlling idea....and thus chaos ensues.

Consider the opening news item. The government bought a corporation not with the idea of controlling it- i.e., contra right wing talk radio, Obama is no Marxist- but with the idea of profiting from the speculative purchase.

To paraphrase Nixon, "we're all Hedge Fund managers now."

Capitalism is dead. Long live Speculationism.

Speculationism is the belief that economic growth is a function of money flows- not the hard money of decades past but money of indeterminate value which allows its quantity to be increased almost endlessly. Like Keynesianism and Supply Side-ism, note the implicit coordination of the state's power to create money and the providers of economic growth, finance.

The above, as an aside, is but an observation, not a critique. I do, however, find it funny that in the same way US Industrialists, protected behind tariff walls, fancied themselves "capitalists" decades ago, so too do today's Speculationists, protected by the Fed's ability to create money. Who are they kidding?

To wit, the US seems increasingly comfortable allowing its capital to move where it will (and it seems to want to move away) so long as Speculators can profit, not by running the company- i.e. controlling the means of production- but by betting on changes in its "market set" value. In Speculationism the term widget can, in the new textbooks, apply equally well to the things produced and the means of producing them.  The term capital itself has morphed and is no longer a reference to the means of production but rather to the money (sometimes previously referred to as financial capital, but this became repetitious) which, presumably drives it. 

Economic growth in the US is less and less a function of what we make (and how efficiently we make it) and increasingly a function of speculative profit. Thus, argue the Speculationists, the foolishness of Volcker's idea of separating speculative activities from commercial banking: Industry is dying, commerce is a small thing. The business of America is Speculation.

And they are right. Whether this will prove wise in the future remains to be seen, but things don't look good from where I sit.  I think we will miss Capitalism, and the capital (in its old sense) which has moved away.

p.s. Yes I waxed hyperbolic and didn't do justice with my definitions. This is but an essay, a word which means, to try (in this case to throw some ideas into the internet ether)

Will the US sell Manhattan?

Those who face insolvency, Mr. Schlarmann, a senior member of Germany's Christian Democrats, said, must sell everything they have to pay their creditors. Thus, he said, Greece, given its debt problems, should consider selling some of its uninhabited islands to cut its debt.

The headline in the Bild newspaper took the argument a bit further, "Sell your islands, you bankrupt Greeks - and the Acropolis too!"

I guess we might call this the Andrew Mellon approach to sovereign debt crises- liquidate, liquidate, liquidate, on a national scale. It's a strategy which, if Niall Ferguson's argument-which contains the wonderful line, US government debt is a safe haven the way Pearl Harbor was a safe haven in 1941- that the US, and other western nations, may soon follow Greece into crisis, proves prescient, might inspire calls for the US to sell some islands, like Manhattan.

Perhaps selling the island outright might be a bit much. Yet, while the Chinese Government isn't a fan of the Dalai Lama it might appreciate the Karmic touch of leasing Manhattan from the US for, say, 99 years. Imagine the road signs, "Now Entering New Hong Kong."

In a sense, assuming Wall St. and the NY Fed were included in the lease, it would be the ultimate "pump and dump"- temporarily stabilize the financial system, in large part with money from Asia, and then dump it, and the derivatives portfolios contained therein, on China. Why wait for the next financial crisis to go hat in hand to Asia. Let's sell Citibank at $4 instead of waiting for it to fall under a buck.

The world might even benefit from such an arrangement. Yesterday, Paul Volcker told the House Financial Services Committee that regulators, like the NY Fed, are unlikely to rein in excessive Wall St. speculation. If the Chinese get the NY Fed, and thus oversight of financial markets, their no-nonsense approach to dealing with corruption, which includes the death penalty, might help finance get back on the "straight and narrow." I'd love to see Lloyd Blankfein testify to the Chinese Communist Party.

A man can dream, can't he? And who knows what the future will bring. I doubt the Ottoman, Mughal and Manchu Empires could have imagined that the West would take over administration of their territories.

Fortunately, at least for Wall Streeters wary of Chinese justice, the German proposal fell on deaf ears. Yet, the seemingly intractable problem of many western governments' unsustainable debt levels remains.

Niall Ferguson argues that the problem is the welfare state- perhaps he should take on Keynes with a new book, The Economic Consequences of the Welfare State. I suspect, however, improper- to the extent such policies are seen as wise means of avoiding social unrest- welfare state funding is but a symptom of an apparently widely held view by many in both public and private sector positions of power that, in the words of Dick Cheney, deficits don't matter. 

War finance and Wall St. bail-outs played at least as large a part as welfare spending in US Federal Debt doubling since 2001.   Those bail-outs, in turn, were made necessary by Wall St.'s take on Cheney's wisdom, which they express as, too big to fail.

Contra Mr. Cheney, deficits, which add up to debt over time, do matter.  Contra Wall St., no insitution is too big to fail.  Both views are, in my view, effects of a broader issue.  There is no agreed upon method, barring adoption of island sales, for sovereign debt resolution. In decades past when nations retained currency sovereignty devaluation was always an option, and fear of devaluation kept investors on their toes. The more recent desire for supra-national currencies turns countries like Greece into states like California with very limited options.

If current trends continue, nations like Greece and states like California might simply be absorbed into larger bodies. Greece could become a special administrative region of the EU and California could become a district of the US Federal Government. Yet this would simply buy time, making the ultimate sovereign debt problem that much harder to resolve.

If the world is ever to reform global finance it will need, first and foremost, to agree upon a method of debt resolution applicable to all large institutions, public and private.   So long as those running large institutions feel there are no consequences to deficits, debt problems will continue to mount.  If we are going to use money to drive the world, we need to take it seriously.

Reflections on Soros' Reflexivity

I can state the core idea in two relatively simple propositions. One is that in situations that have thinking participants, the participants’ view of the world is always partial and distorted. That is the principle of fallibility. The other is that these distorted views can influence the situation to which they relate because false views lead to inappropriate actions. That is the principle of reflexivity. George Soros

The FT has most kindly provided excellent coverage of George Soros' recent CEU lectures on reflexivity and its relation to economics and finance. Both transcripts and video are available.

While reading his lectures I often found myself nodding in agreement. The man draws from an extremely eventful life with a gifted mind. If you opted to stop reading this blog now and "clicked" over to The Soros Lectures (instead of finishing my two cents worth now) you would only miss a small critique on his conclusions- a critique, however, which may have substantial ramifications.

For all his financial success, Mr. Soros strikes me as a man whose true calling was teaching. He has been pushing "his" Theory of Reflexivity for decades and remains somewhat baffled that it hasn't caught on. He suspects that the Financial Crisis of 2008 might be sufficiently negative feedback to inspire a broader examination of his theories in schools and use of his views in the formulation of public policy.

If I had a chance to offer Mr. Soros one sentence that might help him stop banging his head against the wall, it would be this: The safest general characterization of the European philosophical tradition is that it consists of a series of footnotes to Plato- Alfred North Whitehead.

2400 years ago in a culture that had reached a pinnacle of success in its area of the globe, but had suffered some defeats Plato watched the Athenian Democracy put his teacher, Socrates, to death. He spent the rest of his life exploring human thought individually and collectively in light of Socrates teachings and death as well as those successes and defeats.

He too drew on an extremely eventful life with a gifted mind and left his teachings for any who wished to read (albeit subject to the availability of books, which was a large issue, up until Guttenberg). Judging from his analogy of the cave, I don't think Plato would be surprised that few now "see" the value in his work. Nor, I suspect, would he be surprised by Soros' views, although he might find the term "reflexivity" (the quantum mechanical word is "entanglement") interesting as he wrote of the effects of the observer on the observed, and vice versa.

In other words, as Whitehead noted, the observer-observed problem has been an issue for thousands of years. Soros' views on reflexivity aren't new, but rather, as William James called his Philosophy of Pragmatism, a new name for old ways of thinking. This isn't in any way to diminish their importance. Many of the most important lessons in life are timeless. I'll bet there are quite a few speculators who wished they took to heart the Biblical teaching about 7 fat years and 7 leans years- an oldie but a goody.

What does strike me as somewhat new in reflexivity is the increased number of people observing the action, and acting on their observations, thus creating that which will then be observed- economic and financial self-awareness is on the rise. One additional effect of increasing wealth, not studied by the Greenspan Fed, is an increase in economic and financial reflexivity which reminds me Keynes ruminations on the topic, recently well described by John Cassidy at the New Yorker: He [Keynes] compared investing to newspaper competitions in which “the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view.” If you want to win such a contest, you’d better try to select the outcome on which others will converge, whatever your personal opinion might be. “It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest,” Keynes explained. “We have reached the third degree, where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.

It's quite a tangle, as Soros found himself: Reflexive feedback loops have not been rigorously analyzed and when I originally encountered them and tried to analyze them, I ran into various complications. The feedback loop is supposed to be a two-way connection between the participant’s views and the actual course of events. But what about a two-way connection between the participants’ views? And what about a solitary individual asking himself who he is and what he stands for and changing his behavior as a result of his reflections? In trying to resolve these difficulties I got so lost among the categories I created that one morning I couldn’t understand what I had written the night before.

The harder you try to get concrete answers based solely on these reflexive feedback loops the more complex the issue becomes- a Mobius strip with no beginning and no end..........

In the short run, the market is a voting machine but in the long run, it is a weighing machine. - Ben Graham

This brings me to an Alexandrian moment before the Gordian Knot. Let's cut the complexity. If one is an investor, which I define as one who acts on the long view, the more Benjamin Graham's weighing machine comes into play. Reflexivity is more a function of action on the short view when Graham's voting machine is in play.

In my view, public policy should not make use of Soros' ideas, which are most suited for his Hedge Fund work, but rather should focus on the long view. That short run fluctuations threaten the system is to me more a sign that leveraged speculation has run amok. There's too much voting, which increasingly drives finance into the political TV talking heads frame of mind-which is as endless as that Mobius strip- and not enough weighing, due, in large part, to increased opportunities to leverage, as Soros noted.

One trend whose premise is false is that increased leverage has made the world's financial system more stable. Leverage tends to increase the importance of short term price fluctuations, and gets people increasingly involved in the endless feedback loop.  The amplitude of the boom-bust cycle increases when leverage is increased.  If financial market stability is a goal of public policy, reducing the amount of leverage seems a wise first step.