Showing posts from July, 2008

Mission Accomplished: The Destruction of Fannie Mae and Freddie Mac (Part 1 of 2)

Speculative capital is inherently self destructive; it eliminates the opportunities that give rise to it. What is the real life manifestation of this characteristic? In other words, how does the self-destructive tendency manifest itself in practice?

On example I used in Speculative Capital and the Credit Woes series was the shrinkage of spreads. Speculative capital is capital engaged in arbitrage. Arbitrage, by definition, tends to bring the price of two arbitraged positions together, eventually making them equal. In such a state of equality, the arbitrage possibility vanishes, and with it, the condition for the existence of speculative capital.

Shrinkage of spreads is a technical example. As the influence of speculative capital permeates beyond the markets to the various segments of social life, does this self-destructive tendency manifest itself in a larger context with more far-reaching social ramifications? The answer is yes. One outstanding example in that regard is the premeditat…

Why Are We "Digging Deeper Into Debt"?

This past Sunday (July 20, '08) The New York Times had another front page story about the ravages of indebtedness. The heading, “Given the Shovel, Digging Deeper Into Debt” signaled the usual way the story was to be framed: irresponsible borrowers, greedy and unscrupulous lenders. The story’s “human face” was a perfect setup: a slightly overweight divorcee who likes “handbags and knickknacks” and was a “dream customer for lenders” until everything went bad. Serves her right, was the message. But even she was recruited to chastise the fellow borrowers. Her observation made the paper’s “quote of the day”:
I think a lot of people in this country have a lot more debt than they let the outside world know. I worked in retail for five years. And men, women would open up their wallets to pay and the credit cards that were in some of the wallets just amazed me.Left unmentioned in the article was the cause of the indebtedness, the reason that the US population has suddenly turned irresponsib…

Snapshots From Traders' Family Album

In more than one occasion in this blog I have written about the consequences of the genuflection of theorists to businessmen. The root of the problem is an improbably philosophical one, pertaining to the validation of theory. As a theory is a conceptual explanation of the working of the real world, it must coherently and consistently explain and foretell the real world event that it aims to explain. There is no other way to judge the accuracy of a theory.

For reasons well outside the scope of this blog, this self-evident truth was gradually turned on its head by a group of philosophers and economists in the West. Milton Friedman was the most outspoken proponent of this school (hence his fame). He elaborated his ideas in a small pamphlet called The Methodology of Positive Economics. In Vol. 1 of Speculative Capital, I spent some time on this subject:
The Methodology is a manifesto of superficiality which has cast aside its self-conscious defensiveness and assumed an aggressive posture. I…

Revisiting Continuous-time Finance (Part 2 of 2)

I don’t know what finance textbooks say about arbitrage these days; I haven’t read one in years. But in the 1980s and well into the 1990s, they had only one example of arbitrage: buying IBM at New York Stock Exchange for, say, $120 and simultaneously selling it in the Pacific Stock Exchange for $120.5 and thus pocketing 50 cents profit. Just like that!

To say that the example flew in the face of the reality and insulted the reader would be an understatement. But I understand why the nonsense stayed around for so long. To really analyze arbitrage, to even define it, one has to know the Theory of Speculative Capital.

Arbitrage is a category in finance. It means buying low and selling high simultaneously. Obviously, that cannot be done with the same commodity or security; that would entail an infinite supply of rich fools. An arbitrageur, rather, must buy (or go long) one position and simultaneously sell (short) an equivalent position.

Equivalent means the equality of certain aspects of two…

Revisiting Continuous-time Finance (Part 1 of 2)

If classic is the description of a work that stands the test of time, Robert Merton’s 700-page Continuous-time Finance is an apt example of unclassic. A mere 18 years after its publication, the book has fallen by the wayside, a colossal Ozymandias statue of ideas that lies in the ruins.

At the time of its publication in 1990, the book was meant as a celebration of the rise of “modern finance”. In a laudatory spirit, Merton elaborates, reworks and chronicles the ideas whose sum total defined the new discipline. The book’s size and heavily mathematical content is intended to show, if only unconsciously, that the foundation of modern finance was built on solid, scientific grounds.

All that is evident in Paul Samuelson’s Foreword to the book:

A great economist of an earlier generation said that, useful though economic theory is for understanding the world, no one would go to an economic theorist for advice on how to run a brewery or produce a mousetrap. Today, that sage would have to change …