Merkel Does Mahathir and Martin Luther: Tilting the Market Table

In theory, free markets provide "just" prices or a level market table and thus allocate profits such that all market participants are willing to exchange goods freely. This is the basis of the division of labor in a free economy. In practice, speculators are finding they can tip the table as well as any government or church, thus inspiring an increasing unwillingness to play their game.

In 1998, Malaysian Prime Minister, Mahathir Mohammed imposed capital controls ostensibly to protect Malaysia from speculators like George Soros. Then as now (with respect to German controls, also ostensibly to ward off speculative attacks) the financial press was full of quotes proclaiming the foolishness of such actions. The Church of Free Capital is, apparently, a dogmatic church- nation-states, according to the creed, have no right to impede the flow of holy money, or alter the terms of trade.

The Church of Free Capital's creed states that prices set by market speculators (i.e. big finance) are, in a sense, divinely inspired, leading to the best outcome. That big finance has been taking home an increasing share of decreasing profits has not shaken faith in the creed among speculators, but it has angered capital providers in Germany sufficiently to provoke a protest and policy schism.

This isn't the first time Germany has protested the policies of a major Church. Interestingly, both protests, in a sense, included the imposition of capital controls.

Roughly five hundred years ago, a monk named Martin Luther sent a list of complaints- the 95 theses- to his Catholic superiors. His main complaint was about indulgences, whereby a Catholic could buy redemption from sin. "Why does the pope," Luther argued, "whose wealth today is greater than the wealth of the richest Crassus, build the basilica of St. Peter with the money of poor believers rather than with his own money?"

Back then, the Renaissance Popes were rebuilding Rome. Men like Michelangelo, Bramante and Raphael were paid to work on St. Peter's Basilica (inter alia) with money raised, in part, from the sale of indulgences to northern Europeans. Germany, then as now, wanted to keep their money. Whether the current schism in capitalism becomes as widespread as the former schism in Christianity remains to be seen.

I, for one, think the Church of Free Capital is overcharging for its services about as much as the Vatican was then. To their credit, at least the Vatican left something for posterity. We'll have to wait and see if the Church of Free Capital leaves anything to posterity besides broken dreams.

Returning to Malaysia, by the time (15 months after the crisis hit Thailand) Mahathir imposed his controls in September 1998 (about which, more here, and here), the Ringgit had already lost about half its value vs. the US$. That is, most of the capital that could and wanted to flee the Asian crisis had already fled. Thus, I suspect, Mahathir imposed capital controls hoping to avoid "punitive" speculation, since he was about to put his second in command, Anwar Ibrahim, a favorite of Western Financiers, in jail.

One wonders, to the extent the analog holds, what surprises Germany has in store for the Free Capital faithful. Perhaps, alternatively, Germany is simply trying to ensure that profits made on any future EU bond issues remain in Europe, or at least accrue to EU bond holders.

I'm very interested in Germany's policy shift because it's the first time in decades a mature industrialized nation has protested the allocation of profits decreed by financial orthodoxy. At core, German bans of "naked" (held by those who don't own the securities) shorts, paraphrasing Ms. Merkel- perhaps unsurprisingly the daughter of a Lutheran Minister- stops people profiting from the destruction of their neighbor's house at cost of less liquidity in the restricted markets.

In a sense, the policy shift is akin to a theoretical banning of naked shorts, such as occurs in the futures markets, by grain speculators. In theory, grain speculators, by providing liquidity- more potential contract prices than would occur in a simple point of sale transaction- in grain markets, help producers (farmers) and consumers exchange goods more efficiently.

In practice, grain speculators charge producers and consumers a fee, in the form of speculative profits, to provide price liquidity. If the fee is small, producers and consumers will find that additional efforts, such as spending more time at market finding people willing to deal at their preferred price, cost more than the additional profits so produced. Additionally, speculators take on risks producers (who want high prices and thus fear a bumper crop) and consumers (who want low prices and thus fear a lean harvest) might wish to avoid. Importantly, speculation neither increases total profits nor decreases total risk, it merely distributes them differently.

For example, imagine a farmer who produces 5,000 bushels of wheat (one CBOT contract), a wheat speculator, and a bread maker willing to buy the wheat. Imagine the farmer's costs of production and transportation come to $3.50 per bushel while the bread maker can sell bread profitably so long as he can buy wheat below $5.25. Let's assume our speculator's costs come to $0.05 per bushel. Each bushel of wheat then provides a profit opportunity of $1.70.

Ideally, the farmer sells his wheat to the speculator for $4.20 and the speculator sells the wheat to the bread maker for $4.55. The farmer makes $0.70, the bread maker makes $0.70 and the speculator makes $0.30.

Sometimes, producers or consumers try to tilt the trading table their way. Farmers might get government to put a floor on prices, say at $5.00, and keep more of the available $1.70, which will eventually piss off the bakers. Bakers, alternatively, might get government to put a ceiling on prices, say at $3.75 and shift the profits their way, which will eventually piss off the farmers.

A third scenario, closer, I suspect, to the way things work now, might look something like this. Speculators, after getting government to bar farmers from speaking directly to bread makers, manipulate prices lower early in the growing season and scare farmers into selling their wheat at $3.75 and then manipulate prices higher late in the growing season forcing bread makers to pay $5.00. Under that scenario, the farmer and break maker split a $0.50 profit evenly while the speculator walks away with $1.20.

Over time, the third scenario leaves both farmers and bread makers short of capital and forces them to borrow from the speculator to make necessary capital improvements. Eventually, barring a revolution, the speculator owns both farm and bakery and has to manage disgruntled employees on both ends, which likely leads to both less wheat and inferior bread.

Hopefully, the above thought experiment explained some of the important work markets do in providing prices. When they work well, primary producers and secondary manufacturers both find it profitable to produce, and middle men are rewarded for managing the transaction risks. However, when the table is tilted too far in any participant's favor, the whole system, which requires willing cooperation from all for optimal results, risks deterioration.

The above model can be used to examine any market transaction, even government debt finance. German controls, in effect, reduce the share of profits (if any) of such borrowing going to middle men. We'll soon see if the service provided by those middle men was worth the cost.

500 years ago, the Germans defied orthodoxy and ushered in a revolution which moved the center of Europe from South to North. They are defying orthodoxy again, and I can't wait to see what happens next.

GoldiSachs and the TBTF Banks

GoldiSachs and her friend MorganStanley were tired (of worrying about insolvency) so they went upstairs in the Banks' home and found a bed labeled TBTF that was just right. In contrast to the children's story, GoldiSachs and MorganStanley were welcomed into the club.

In March of 2008, years of poor investment decisions finally caught up to Bear Stearns, forcing the firm to accept a $2 per share bid (later revised to $10) from JPMorgan (financed by loans from the NY Fed). A once mighty financial firm which had survived the Great Depression was no more. Adding insult to injury, its final 5 year stock price chart, which depicted a dive from over $150 to the single digits could easily have been mistaken for that of a dead Tech firm which never generated a dime in profits.

Coincidentally, the Federal Reserve announced the creation of the Primary Dealer Credit Facility (PDCF) which allowed any Primary Dealer not already authorized to borrow at the Fed's Discount Window, to, in effect, enjoy the privilege of discounting their securities if they were cash poor.

Despite the new access to Fed liquidity, however, stock prices of Primary Dealers, who, inter alia, sell US government debt, were under assault within 6 months. Lehman Brothers did not survive the assault, declaring bankruptcy on September 15.

Perhaps due to the thinning ranks of Primary Dealers (in the previous 2 years, 5 Banks, ABN AMRO, CIBC, Nomura Securities, Lehman Brothers and the aforementioned Bear Stearns, had left the club or died) or some other reason (more on that in my next post) the Fed and Treasury made the hitherto unsaid policy of Too Big To Fail (TBTF), explicit, and welcomed GS and MS into the club (which, according to Simon Johnson and James Kwak, numbers 13), declaring the new entrants Bank Holding Companies (BHCs), for emphasis.

A recent check of the Fed's NIC (a wonderful resource on BHC data) demonstrates that GS and MS fit into the BHC club about as well as I fit into the crowd on my first visit to Beijing many years ago. Their source and use of funds are quite different as are their arenas of profit.  They are investment firms, more closely related to Hedge Funds than banks.  I'm all in favor of investment firms, however, I don't agree that, if TBTF is wise policy (which, at this stage, I doubt) they should be included in the protected group.

I still, on the topic of sticking out from the crowd, remember being asked to join a picture of a Chinese family during a visit to the Great Wall, because, I suspect, this rural family rarely saw white people and wanted to show the folks at home their great adventure.

Banks, as I recently argued, always and everywhere earn their money lending. As the table below demonstrates, however, the meaning of the term "bank" is being diluted at roughly the same pace as the US$.  Admittedly, the banks themselves, in their desire to be more like Hedge Funds, are helping the dilution of meaning.  This makes me wonder if the next GS to join the club will be George Soros. Perhaps if he becomes a primary dealer....

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As you can see, GS and MS needed no help in provisioning against bad loans (one argument, with some merit, in favor of TBTF is that the banks provided more mortgage credit than they otherwise would have if the government wasn't promoting home ownership).  These investment houses earn money from, inter alia, Investment Banking, Brokerage and Proprietary Trading. 

Proprietary Trading is the arena one tends to find "rogue traders" like John Rusnak, Brian Hunter of Amaranth fame and this fellow from France.  A policy of TBTF might well bail out a "rogue bank"or the banks' creditors, perhaps it already has.  This isn't to suggest I'm against prop trading (it's one way I earn my keep) I just don't see the positives (if any) outweighing the negatives. 


A thoughtful reader at Seeking Alpha wanted a more explicit statement of TBTF effects which inspired the use of "scam" in my last post.

TBTF direct effects include, as he noted, creditors avoiding "haircuts" (reduction or total loss of investment), and, as I added, employees and owners equally avoiding "haircuts" (reduction in compensation and loss of investment).

I used the term "scam" in reference to the latter two effects.  Reductions in compensation and dividend outflow would go right to the bottom line, mitigating the need for equity and liquidity support.

TBTF rewards failure, which creates its own ill effects, and it will impose financial costs on families across the US as the effects of the changes in the Fed's System Open Market Account (latest data seen below) and growth in US Federal Debt manifest.  Further, supporting firms which failed to see the collapse coming, or minimally to adjust their exposure accordingly, removes from the list of positives the one social virtue of trading I needed to know to become licensed as a securities' dealer- price discovery.

While I agree with the reader that US financial authorities had trade-offs in mind (I didn't use "total" in my original title) when TBTF became explicit (some going beyond finance, as I'll discuss in my next post) some are taking advantage or "scamming" the public in the lax environment.

Take a good look at aggregated employee compensation in the first table.

The ultimate question of TBTF is not "if" it will end.  It will.  Such arrangements always end.  The Medici were known as God's Bankers, under the protection of the Vatican- the best shield going at the time- and they went under. Money, like water, eventually finds a way to flow around (or through) constraints. 

The question is, will we end TBTF or will it end us, in our current form?

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.

Who's Afraid of Naked Short-Selling?

The real significance of the naked short-selling issue isn’t so much the actual volume of the behavior, i.e. the concrete effect it has on the market and on individual companies — and that has been significant, don’t get me wrong — but the fact that the practice is absurdly widespread and takes place right under the noses of the regulators, and really nothing is ever done about it. Matt Taibbi


Naked short selling, or the sale of a security you don't already own, has been an issue of concern for corporations for many years. According to those affected, the practice allows traders to drive a stock price lower than it "should be" if the practice was restricted.

This is, no doubt, true. Beyond the equity markets, this activity has been common practice in the foreign exchange markets for decades, and has inspired similar complaints. Ex-Malaysian PM Mohammed Mahathir heaped scorn on George Soros and other speculators for attacks on Malaysia's Ringgit and other currencies during the Asia crisis. Before that Mr. Soros became infamous as the man who broke the Bank Of England, driving the GBP and ITL out of the European ERM bands.

While I see the point of those affected, and agree that naked short selling run amok could stifle corporate IPOs and young businesses- which might not be a bad thing at certain times- there is a way to avoid a good deal of the damage this type of trading can unleash. Keep your financial house in order.

On the national level, it seems worth noting that Soros didn't try to short the DEM or the CHF, he chose the GBP and ITL for a reason. Those currencies were mispriced within the ERM.

More to the point, due to the guarantee of the ERM (which aimed to keep bilateral exchange rates within a trading band) long before Mr. Soros decided to short the GBP, speculators had bought it at the bottom of its trading rage against the DEM to pocket the interest rate spread between Britain and Germany. Mr. Soros' sales may have upset the balance, but it was the weight of "free money" investors who got, justifiably, spooked and ran for the exits, which crashed the GBP.

In other words, if the price of the security is not too high- say, as a result, in the equity arena, of too much debt and too little profit- short sellers will likely not find your security a profitable sale. Yes, there is a lot of gray here and I don't doubt that currencies or securities that might eventually justify their price could fall prey to naked short-selling. However, a company with a strong balance sheet and highly profitable capital stock might enjoy a round of short selling, to buy back their own stock.

What I found most interesting about Mr. Taibbi's excellent reporting is the increased Congressional interest. As the big banks in the US increasingly realize that they, given their extremely leveraged position, are prime candidates for naked short selling they will be caught in something of a dilemma.  On the one hand, they either engage in the practice themselves (after all what is the bet in a credit default swap) or finance hedge funds who do, while on the other they will (much more slowly I imagine) see themselves as potential victims.  I'm probably only half joking when I suggest that naked short-selling will surely be outlawed when Goldman Sachs, as one of the last banks standing, finds its stock under attack.

Karma can be a b!tch.