Sunday, 24 October 2010

High Frequency Trading and Flash Crash – 1: The Ones Who Saw It Coming

The ignorant, pompous academics who created “Continuous-time Finance” — ignorant because they were pompous, pompous because they were ignorant — considered it the crown jewel of their intellectual achievements. Happy were those years of success in the limelight, with this one nominating that one for the Nobel Prize who then turned around and nominated this one for the same. Nobels all around, was the happy cry. Nobels to the Crowd!

To understand Continuous-time Finance (CTF), we have to understand Newtonian mechanics and its language, differential calculus.

Newtonian mechanics revolve around key terms like instantaneous speed and constant acceleration. These are not intuitive concepts. The only way of really grasping them is through mathematics, specifically, calculus. In fact, this branch of mathematics was invented by Newton (and independently, by Leibniz) for that very purpose.

Newton was working to solve the puzzle of the working of celestial bodies that begins with the old question: Why does an apple fall from a tree to the ground but the moon does not? The answer is that the moon is constantly falling but is kept in orbit by the centrifugal force of its rotation around the earth. To get to that answer, one has to know the dynamics of falling bodies: how far they fall and how fast. That is the definition of speed.

We calculate the speed of a moving object by dividing the distance it has traveled by the time it takes to travel. The distance between NY and LA is 3,000 miles. If a plane travels it in 5 hours, the speed of the plane is 600 miles/hour.

What about the speed of a golf ball dropped from the top of the Empire State Building? The building is 1,800 ft tall and it takes 10 seconds for the ball to hit the sidewalk.

In this case, we cannot directly divide the distance by time. What worked for the speed of the plane won’t work here because we assumed the speed of the plane was constant, a logical assumption for our purposes. But the speed of the falling golf ball is not. It’s zero at the top of the building, just before the fall. It is quite high — something we need to calculate — when the ball hits the sidewalk. Between these two points, the speed constantly increases. Since space and time are continuous, it is a perfectly valid question to ask: what would the speed of the ball be in, say, 3.21 seconds after the fall, or after it has fallen 329.73 feet? That is instantaneous speed, the speed at that instant. That is where differential calculus comes in. It is a tool for calculating the instantaneous change in the value of a variable (speed or distance fallen, in our example), as a result of instantaneous change in another variable (time).

CTF is the adaptation of this system to finance. It is finance in a “world” in which prices change continuously and instantaneously, just like the distance traveled by a falling golf ball, only that prices are bi-directional. They go up and down.

The first use of calculus in finance dates back to the beginning of the 20th century. In 1900, French mathematician Louis Bachelier published a differential equation describing stock price movement. It is a perceptive and intelligent model. In Vol. 3 I showed how its use decades later significantly contributed to the success of the Black Scholes option valuation formula.

Of course, the stock price changes in the Paris Bourse of the early 20th century were far from instantaneous. But Bachelier reasoned that the sum of instantaneous changes could approximate the price change over longer intervals; that, after all, is what the other half of calculus – integral calculus – is all about. At any rate, the stock prices seemed to set the irreducible minimum level of activity to which one could apply calculus without looking absurd or ridiculous. Sure, one could use calculus to “calculate” the change in the price of a pizza pie “as a result of” change in its size. But that would be a fool’s errand, a pointless and absurd exercise that only an idiot would undertake. So the matter rested there for nearly 50 years.

It must be a cosmic law of fools that if a fool’s errand exists, a fool is bound to show up, if not sooner then later. The fool came in the form of Paul Samuelson. The future “Titan” had set out to make a name for himself and had decided on mathematics as the desired means. If a Frenchman could apply differential calculus to stock prices, the American was going to outdo him and apply it to all prices – a pound of sugar, a house, an airplane engine, a dozen eggs, a cup of coffee, a diamond ring, a bulldozer. He was coming whether prices were ready or not.

A publicity picture that the New York Times used in his obituary last year shows Samuelson against a blackboard with some bogus equations. Here is the picture.


In this picture, the blackboard is used the way a Caribbean Island might be used in the photo-shoot of a swim-suit model: to accentuate the main attraction’s endowments – physical in one case, intellectual in the other. Let us look at it closely.

In the center, there is price-vs-quantity (P-Q) graph, the crudest and most superficial idea in economics, the if-price-goes-up-demand-drops stuff that only a Sarah Palin might buy. That is what Samuelson is teaching. But he has jazzed up that nonsense with the standard notation of calculus. P and Q have become P(t) and Q(t), meaning that they are “functions of time”, i.e., they change with time.

In the upper right hand corner, at about “one o’clock”, P is expressed by a partial derivative equation. The first term is L, which must stand for labor. The second term is t, which is time. The equation is saying that price — any price — changes with “labor” and time. “Labor” is presumably the “price of labor” or wages.

I need to digress here to say a few words on the role and function of math and why we use it.

Take this simple problem. A father is 48 years old; his son, 18. How many years from now will the father’s age be 3 times the son’s?

If all you know of math is arithmetic, you will struggle with this problem; you have to use a relatively complex chain of reasoning to solve it.

Thanks to Islamic mathematicians, however, we have algebra, the science of manipulating the unknowns. Let the unknown “number of years from now” be X. X years from now, father will be (48 + X) years old; his son, (18 + X). For what value of X then (48 + X) is 3 times (15 + X)? Solving (48 + X) = 3 (18 + X), we get X = -3. Negative X means that the event happened 3 years ago, when the father was 45 and the son 15.

Note how math corrected us. We stated the problem in the future tense: “how many years from now will ...”. Math ignored that phrasing and gave us the right answer by pointing to the past.

That is the function and raison d`etre of mathematics: a tool to employ when intuition, imagination or contemplation could not solve the problem, or solve it only with great difficulty. In the example of the falling golf ball, if you do not know how to differentiate a function, you could not possibly know that the speed of a golf ball 3.21 seconds after the fall would be 102.72ft/second.

Return to the blackboard now and look at P(t)and Q(t): Price and quantity are functions of time, meaning that they change with time. What purpose does this addition of “change with time” serve? Time is a condition of experience. There is absolutely nothing in the world, without exception, which is not a “function of” time. We bothered with learning algebra and writing the equation (48 + X) = 3 (18 + X) because it helped us solve a problem. But writing P(t) instead of P merely looks more complex without in any way helping us learn more about how prices change.

Every single expression on the blackboard behind Samuelson is an indictment of the writer, a prime facie evidence of chicanery. Only a complex character – 1/3 pompous ass, 1/3 ignorant fool, 1/3 perspicuous cheat – would put this tritest of facts into mathematical language – and pose in front of it.

(In calculus, the “function of” association is used not for stating the obvious but for signaling the variable with regards to which a function is to be differentiated or integrated. The distance X that a golf ball falls is X = 16t(squared). To find the speed of the ball at an instant, we must differentiate the function with respect to t. So, we say that X is a function of time, t: X = f(t). The differentiation, by the way, yields V(t) = 32t. The speed of the ball 3.21 seconds later would be V(3.21) = 32 x 3.21 = 102.72ft/second.)

Not everyone fell for Samuelson, though. Harvard refused to hire him. The newspaper of the record mentioned the incident in the obituary but used a red herring to spin it:
Harvard made no attempt to keep him, even though he had by then developed an international following. Mr. Solow said of the Harvard economics department at the time: “You could be disqualified for a job if you were either smart or Jewish or Keynesian. So what chance did this smart, Jewish, Keynesian have?”
We could see that Mr. Solow is being disingenuous. Harvard not keeping Samuelson had nothing to do with his smartness or Jewishness or Keynesianism. Only that the pre-Dershowitz, pre-Summers, pre-Kagan Harvard of yesteryears at times saw through the fools and passed on the opportunity to retain them. Those were the days that the nation’s oldest university could have gone either way.

There was of course a reason for Samuelson’s embrace of mathematics, which I pointed out in Vol. 1:
The years leading up to World War II and immediately following it, brought unprecedented advances in technical and theoretical knowledge that culminated in the building of the atomic bomb. Mathematics was instrumental in that success. A skillful mathematician, it was believed, could solve all problems that lent themselves to mathematical formulation.

Pursuing mathematical finance was advantageous in other ways too. It provided a respite from the contentious ideological disputes in economics between the Left and Right that in the era of McCarthyism were beginning to assume an ever sharper, and potentially career-ruining, tone. Research in mathematical finance had no downside risk. It was socially safe, it provided a perfectly respectable line of research and, with luck, it could lead to new discoveries and from there, to fame and fortune.
Even the purest of mathematical thoughts are not completely void of ideological content, so there was a subtext to the use of mathematics, a hidden message of sorts. If Western economics could be described by the mathematics of Newtonian mechanics, it “followed” that economic system of the West was as solid and permanent as the world itself. And it would last that long. That theoretical lagniappe played no small part in facilitating the funding and propagation of Samuelson’s economics.

Ultimately, though, what the man said was drivel. It corresponded to nothing in real life, so it was forgotten. Then came the collapse of the Bretton Woods system in the early 70s and the rise of speculative capital which gave a new lease on life to the application of mathematics in finance.

Speculative capital is capital engaged in arbitrage: simultaneously buying and selling two equivalent positions. That amounts to – and requires – the instantaneous buying and selling of the positions. From Vol. 1:
After any purchase, the speculator faces the risk that what he has just bought will fall in price. That can only happen with the passage of time. It is through time that the price of widgets drops, and it is through time that the speculator fails to find a buyer. Time is the medium through which the risk–and everything else–materializes. To the uncritical, yet practical, mind of the speculator, time appears as the source of the risk. He concludes that if the time between his purchase and sale is shortened, the risks of the transaction must proportionally diminish. In the extreme case, when the time between the two is zero, the risk would completely disappear. In that case, he could earn a risk-free profit. That is because no purchase is made unless a sale is already in hand. When the time between purchase and sale is reduced to zero, the two acts become simultaneous. A simultaneous “buy-low, sell-high” results in a risk free profit. That is arbitrage. The speculator has found the Holy Grail of finance: making money without risking money.
Speculative capital rapidly expanded to dominate the trading pattern of financial markets. The expansion required people skilled in mathematics to detect the arbitrage opportunities. These people were found in the math and physics departments. The newcomers applied themselves and their skills to their new field and soon produced a voluminous body of work in finance that seemed coherent, even revolutionary and groundbreaking. The Black-Scholes option valuation formula is perhaps the most outstanding example of their accomplishments.

That is how continuous-time finance came to be, with the practitioners of the discipline becoming known as “quants” or “rocket scientists” by virtue of their mastery of mathematics.

But they knew nothing of economics or finance. In Bernestein’s early 90s bestseller, Capital Ideas, tellingly sub-titled The Improbable Origins of Modern Wall Street, there is a telling passage about them:
The gap in understanding between insiders and outsiders in Wall Street has developed because today’s financial markets are the result of a recent but obscure revolution that took root in the groves of ivy rather than in the canyons of lower Manhattan. Its heroes were a tiny contingent of scholars, most at the very beginning of their careers, who had no direct interest in the stock market and whose analysis of the economics of finance began at high levels of abstraction.
“No direct interest in the stock market” means no background in economics and finance. And the “high levels of abstraction” that Bernstein observed likewise had to do with forcing mathematics on finance without regard to, or awareness of, its social aspects. We saw in Vol. 3, for example, how Black, Scholes and Merton priced the options and yet got the options fundamentally wrong.

The consequence of this ignorance, as always, was in prediction of the future. If you know the relation between mass, force and acceleration, you could predict with precision the behavior of a satellite millions of miles from the earth. You could surmise the existence of a planet even if you could not see it.

Economic relations are never that exact, but fundamentals still apply. If you know that profit rate tends to fall, you would not be surprised by the persistent unemployment in the West or the events taking place in Europe; you would not ask, How is it that as the people’s health improve, they have to work longer and harder for less wages and a smaller safety net?

Or, if you know that arbitrage is by definition self-destructive, you would expect a crash in financial markets – if not sooner, then later.

But the pioneers of modern finance knew nothing of these principles. They noted the increase in trading and observed that it led to lowering spreads. But they interpreted it as the march of capital markets towards “efficiency”, which to them meant low trading costs. And since the markets were only rising, it stood to reason that everyone would soon be trading.

The new world of CTF thus envisioned was a bona fide Norman Rockwell tableau in which everyone constantly and incessantly traded: businessmen in New York during their commute, Valley girls in LA on their way to parties, salt-of-the-earth farmers in the Midwest, the rednecks in the South, retirees in Florida, blacks in Watts and smartly dressed preppies in Greenwich – they all traded all the time. Jews, too. Yes, most definitely Jews, too.

The real life turn of events proved a tad more Gothic.

Tuesday, 12 October 2010

The Foreclosure Mess: 7 Reasons Why It's Much Worse Than You Think

We're in a big, big mess with home foreclosures in the U.S. (foreclosuregate, if you will). I'm not sure many people understand the awful magnitude of this train wreck. So here is my look at seven reasons why it's much worse than you think. Below I partly synthesize much of the fine analysis being done elsewhere (Mike Konczal has been absolutely superb on this issue, as has Yves Smith).

Quick background: In 1996, a private company was formed called Mortgage Electronic Registration Systems, or MERS for short. Why should you care? Chances are better than 50-50 that, if you own a home, MERS officially recorded the mortgage -- probably unknown to you. MERS is headed by R.K. Arnold, a former U.S. Army Ranger with a law degree from Oklahoma City University, ranked #104 in the nation this year by the Association of American Law Schools.

Now you may be worried that Arnold, a guy who apparently doesn't exactly have a stellar legal pedigree, is the CEO of this giant institution that registers millions of mortgages from Big Sur to Beacon Hill. Don't be. Because MERS doesn't have any real employees. It's kind of a shell. MERS Treasurer William C. Hultman revealed as much during a deposition in Bank of New York v. Ukpe:
Q I thought, sir, there’s a company that was
formed January 1, 1999 [sic], Mortgage Electronic Registration
Systems, Inc. Does it have paid employees?
A No, it does not.

Q Does it have employees?
A No.

Q Does MERS have any employees?
A Did they ever have any? I couldn’t hear you.

Q Does MERS have any employees currently?
A No.

Q In the last five years has MERS had any
employees?
A No.
Why the heck would you form a company, then not hire anyone? Well, what's the purpose of your company? If you're making widgets, you need widget inspectors, widget engineers, widget fabricators etc. But MERS was created for mortgage banks to dodge paying local recording fees (and doing the associated paperwork, one assumes) when mortgages were re-assigned. So let's say Wall Street wants to bundle a bunch of mortgages into a security, which then is cut up into teeny pieces to go into another security, which is diced once more to go into another security ... thanks to MERS, you can do all this with a minimum of hassles/expense.

Cool beans, until it all starts to come apart at the seams, and you realize that the companies making the original loans were extending credit to people who could barely fog a mirror in the midst of a huge housing bubble and you've got to foreclose and where's all that paperwork you're going to need dammit?

So, without further ado, here are seven reasons we're in the middle of a really epic mess right now:

1. MERS may be a fraudulent company at its very core.

This becomes obvious in the answer to a simple question: How does a company with no employees foreclose on millions of homes across the U.S.? Easy. Apparently it "simply farms out the MERS Inc. identity to employees of mortgage servicers, originators, debt collectors, and foreclosure law firms." MERS even sells its corporate seal for $25 on its Web page. This corporate structure "is so unorthodox as to arguably be considered fraudulent," says Christopher Peterson, a law professor at the University of Utah.

Exacerbating this problem: no state legislature or appellate court ever gave its stamp of approval to MERS in the first place, so it has no acknowledged legitimacy.

2. Widespread fraud may be taking place to cover up the lapses of MERS.

Mike at Rortybomb does a great job explaining how your mortgage consists of two parts, a promissory note (you promise to repay the lender X dollars, and under what conditions, and with what penalties for missing payments) and a mortgage, known in some states as a deed of trust. Mike reduces all this nicely: "The note is the IOU, it’s the borrower’s promise to pay. The mortgage, or the lien, is just the enforcement right to take the property if the note goes unpaid." Common sense dictates that both parts are necessary to move to foreclose. You can't apply the enforcement without knowing the terms of the note and how much remains unpaid.

But as Yves Smith alarmingly details at naked capitalism, the banks apparently got impatient with the messiness of paper notes in an electronic age. Again, without anyone's approval to do this (no courts signed off, no legislatures gave authority), it looks like they converted physical notes on a massive scale to electronic documents -- safer, cheaper, easier to store etc. ... and destroyed or misplaced a lot of those original notes.

The trouble is when the homeowner being foreclosed on demands that the note be produced. The ensuing document scramble has led to fraudulently created replacements. It's hard to say on what scale this is occurring, but Yves included a chilling quote that she says came from the CEO of a big subprime lender, who defended the practice of transfers lacking paper notes, then had a nervous moment of doubt: “Well, if you’re right [that it's a problem], we’re f**ked. We never transferred the paper. No one in the industry transferred the paper.”

3. This mess is greatly complicated by long, complex chains of securitization.

Mike at Rortybomb provides a good diagram. Start with Joe Homeowner, whose mortgage is originated by say Easy Mortgages 'R Us. Easy Mortgages 'R Us passes the note to the next link in the chain, a sponsor for the security being created (say it's Bank of America, which will scoop up a thousand mortgages, including Joe Homeowner's, and turn them into a product called a residential mortgage-backed security). Then there's a depositor that stands between Bank of America and the trust itself for the mortgage-backed security.

Phew. That's plenty complex. But Mike gave readers only the short form. The residential mortgage-backed security can itself be bundled with other similar securities into a creature called a collateralized debt obligation, or CDO (that should sound familiar from Congressional hearings). And then the CDO can be sliced up and bundled with other strips of CDOs into something known as a CDO squared. Now do it one more time and you get a CDO cubed.

Now remember that old saying: a chain is only as strong as its weakest link. Now here are the many links we've just created for Joe Homeowner's mortgage:

Joe Homeowner --> Mortage Originator --> Sponsor --> Depositor --> Trust for RMBS --> CDO --> CDO squared --> CDO cubed. Moreover, I've probably left out a few entities on the CDO level; I'm sure they use similar intermediary units as the RMBS to create their securities.

Exacerbating this problem: The chains were created too quickly, during what turned out to be unstable times (a bad real estate bubble being inflated). So they're not even relatively robust chains.

4. Ladies and gentlemen, I present: Lawsuit-palooza.

Mike delves into this. Foreclosuregate is a full employment act for lawyers. You could have lawsuits anywhere up and down that chain of document transfer. Investors in the mortgage-backed securities will sue servicers. Homeowners will sue on being foreclosed on, demanding to see the note (with the number of suits increasing exponentially as there are more victories, creating a crushing backlog of cases in our legal system). Investors in the securities will jostle for position and battle with each other, the junior debtholders aligned against the senior. The RMBS trust will go after the sponsor for dumping mortgages on it that lacked the proper paperwork.

5. This will be resistant to fixes, for one, because the mortgage-servicer system for the securities is badly set up, with all the wrong incentives.

Mike nails this one too. The smart way to fix these problems would involve lenders working with homeowners to pare down the loan principal for deeply underwater homes. This approach has been shown consistently to work out better for all parties than foreclosing. At the same time, the lender could take the opportunity to remedy the defective paperwork.

But the mortgage servicer, the one who controls what happens with the mortgages that are now embedded in a security (or maybe multiple securities -- remember those CDOs squared?), doesn't have an incentive to do this. His incentives are narrowly structured: he gets fees, on a certain schedule, for foreclosing. He doesn't get paid for the time-consuming process of working out a solution that would ultimately benefit the investor in the security and the homeowner as well.

In fact, as Mike notes, securitizations must be passive entities to win a bunch of tax breaks. As such, they can't do much hunting down of notes or anything else, it seems, without risking losing their tax-exempt status. A really miserable setup, which is going to be an obstacle to resolving this mess.

6. This will also be resistant to fixes because it's going to be hard to wave a magic wand on the federal level and make the problems disappear.

This situation is playing out locally, not federally -- county by county, state by state. And as the political heat builds on the big, bad banks -- much of America already hates them for their oversized bonuses, for their lack of repentance after driving the economy into the ditch, for the bailouts that saved their asses while leaving double-digit unemployment in its wake -- it's going to be hard for Congress, operating under the klieg lights, to ram through the kind of legislation that could straighten things out. Congress is already perceived as being snugly in the pockets of Wall Street. One thing is for certain: NOTHING will happen before the election. This is a live third rail right now.

7. MERS owns more than 60 percent of U.S. mortgages.

I haven't seen anyone sort through the implications of this, but I've seen in the comment sections of blogs, some people sniffing about, sensing the implications. Namely: I make regular mortgage payments, I have great credit, but what if I ask to see my note? What if they can't produce it? Does that then make me foreclosure proof? This will add an interesting element to valuing more than 60% of the mortgages in this country. How much will Joe Investor pay for the right to payments from a mortgage that may be "foreclosure proof"?

So there you have it. Seven reasons why we really need to be paying attention to the mortgage mess. It's hard to overstate how serious it is.

Verdicts on TARP: What I Wish I'd Said

When the authority of TARP recently expired, a predictable flurry of opinions made cases for and against the largest bank bailout Western civilization has ever known. I could weigh in too, but I found someone who expressed my sentiments so well, I'd just like to quote her for a few short paragraphs.

Alice Schroeder was writing in Businessweek about Charlie Munger, Warren Buffett's right-hand man, who rather scornfully told an audience of Michigan college students that we "shouldn't be bitching about a little bailout" of the banks. Munger also said, in a curious application of the second-person pronoun (is he secretly from another civilization? or planet?), that the bailouts were "required to save your civilization." (The phrasing carries the whiff of the moral harangue from the elder who knows best; one imagines gramps pulling his cracked leather belt from his trouser loops and announcing to the youngster about to get a good strappin', "I'm doing this for your own good.")

And this is Schroeder's very intelligent response (my bold):
... the problem is the false dichotomy it presents. The choice wasn't between the bailout or no bailout. It was between the bailout we financed, which didn't resemble capitalism in any known form, and a bailout more intelligently executed.

No one made us bail out shareholders along with the banks' bondholders. We didn't have to preserve institutions that are still too big to fail in any meaningful sense of the term. We could have propped them up temporarily, then recapitalized them as smaller, more manageable entities, with former equity holders assuming the cost of the risk they assumed.

We missed the chance to reduce systemic risk by comprehensively rewriting regulation for the financial-services industry. Instead of withdrawing government guarantees, we increased them. So there are plenty of reasons to complain about the bailouts.
Yup.

Monday, 11 October 2010

The Laborers of the World! Behold the Three Nobel Prize Winning Labor Economists: Larry, Curly and Moe

In an ideal world, I would not have bothered with this year’s three Nobel Prize winners in economics; they would not have merited a mention. But this is not an ideal world.

According to the New York Times, three men won the Nobel Prize in economics for their work on “markets where buyers and sellers have difficulty finding each other, and in particular on the difficulties of fitting people to the right jobs.”

So, in a nutshell, the contribution of prize winning scholars to economics is applying the business model of dating services to the labor market.

As for the specific applications of their research:
Some of the applications of the research include understanding why unemployment rises during recessions, why similar workers get different wages, why wages do not fall much during recessions even though that might make additional hiring more attractive to employers, and how so many people can be unemployed even when there are a large number of job openings available.
Three mature, presumably fully developed adults trained as economists want to know why unemployment rises in times of recession.

Without having the slightest familiarity with their plans, let me then predict their future research topics: why some work in factories, others in department stores and still the third group in banks? Why some workers commute long hours and some don’t? Why do workers look different? Why are some workers men, others women?

But let’s not laugh, even though the characters are clownish, as behind their seemingly idiotic research stands a serious and sinister purpose. Why else would their research be funded?

Note, for starters, “why wages do not fall much during recessions even though that might make additional hiring more attractive to employers”. You do know where this line is going, right? In case you don’t, the Times spells it out for you:
Their work has suggested, for example, that unemployment benefits can have the unintended consequence of prolonging joblessness by making it less costly to be without work.
Unemployment benefits prolong joblessness. That’s one conclusion for you.

There is more. According to Robert Shimer of the University of Chicago:
“Most of these models suggest that even in a depressed economy, more generous unemployment benefits tend to raise the unemployment rate.”
And according to Prof. Lawrence Katz of Harvard:
“If you make it harder to hire and fire, then you end up with what’s called a sclerotic labor market, with less movement between jobs and more long-term unemployment.”
So, now we “know” that: i) the unemployment benefits increase unemployment; and ii) unemployment is the result of labor market regulation.

The logical policy directive, then, if you are a politician who really cares about the unemployed? Why, cut the unemployment benefits and make sure that workers are not protected by regulation.

Let me end with a question of protocol.

Aren’t three Nobel Prize winning academics entitled to a respectful treatment of their work, without being called stooges? Can’t disagreement with them, no matter how strong, be polite?

The answer is, No. It would have been Yes, if the agenda of their research had been their own, set by them. But it is not. The purpose of their research is to ennoble the ideas of businessmen beneath the veneer of science. And not ordinary, everyday businessmen, but the most self-serving, vicious, narrow minded and ignorant of the lot.

In Opinions That Men Hold, I quoted Mortimer Zuckerman from a Wall Street Journal opinion piece. Here is a longer paragraph of what he wrote:

If there is one great policy failure of this recession, it’s that we have not used the crisis to introduce structural reforms. For example, we have a gross mismatch of available skills and demonstrable needs. Businesses struggle to find the skills and talents that are needed to compete in this new world. Millions drawing the dole to sit around should be in training for the jobs of the future that require higher educational skills.
There is a gross mismatch of available skills and demonstrable needs.

People drawing dole to sit around and do nothing.

If there is one great policy failure of this recession, it’s that we have not used the crisis to introduce structural reforms”, i.e. cut the unemployment benefits and do away with labor regulation.

Sound familiar?

Enough said.

Tuesday, 5 October 2010

Translating a Sophisticated American

Today, on its front page, the Financial Times informed its readers of a “call for new global currencies agreement.”
The Institute of International Finance, which represents more than 420 of the world’s leading banks and finance houses, warned on Monday that a lack of [a] coordinated rebalancing could lead to more protectionism. Charles Dallara, IIF managing director, said: “A core group of the world’s leading economies need to come together and hammer out an understanding.”
So, forty years after that mountebank, Milton Friedman, swore by his mother’s grave that adopting a “free” exchange rate regime between the currencies would cure all the ills of humanity, including the balance of payment problems, we have to come to this: the spokesman for 420 of the planet’s leading banks and financial institutions is calling for some kind of “understanding” in the currency market. You realize he cannot say regulation or currency management. So, he says “understanding”.

(That’s what Friedman said: if currencies float freely, there could be no balance of the payment problem because the currency of the country importing more “goods and services” would depreciate, making imports more expensive and exports cheaper and thus, restoring the balance. Everyone praised the simplicity of his logic. Everyone hailed the genius who at last made the argot of economic discourse plain to common folks. Why, even idiots could understand what he was saying. Ah, how he was made into a hero of his time.)

But as a U.S. official who worked on the 1985 Plaza Accord which made Japan “It” (which eventually took it to its “lost decade”) Charles Dallara knows that “understanding” will carry you only so far. So he wants something more concrete, a “more sophisticated version” of the Plaza Accord, according to the Times. That would include “stronger commitments to medium-term fiscal stringency in the US and structural reform in Europe”. “Exchange understandings are of little use on their own,” he said.

I concur. Understanding is over-rated and exchange understandings cannot be trusted. Ultimately it is the fundamental economic factors in a country that determine the strength of its currency. Walther Funk, president of the Reichsbank — that would be the predecessor to the Bundesbank — also agreed. In a 1940 speech in which he talked about his vision for the “New Order” that was to prevail after the war, he said:
We will use the same methods of economic policy that have given such remarkable results, both before and during the war, and we will not allow the unregulated play of economic power, which caused such grave difficulties to the German economy, to become active again ...Money is of secondary importance; the management of the economy comes first. When the economy is not healthy, the currency cannot be healthy.
Note the difference between Funk’s worldview – it’s a worldview and not a mere economic view – and Dallara’s. The Reichsminister only talks about the economy and its management. Dallara is numb on the subject. And how could he not be? He is the spokesman for finance capital which abhors industrial capital and anything there is to do with building and manufacturing. Dallara’s worldview is that of a Shylock. He wants “medium-term fiscal stringency in the US and structural reform in Europe”. The first one means cutting social security, welfare, Medicare, Medicaid, etc. The second one means prescribing the same for Europe as well, as I wrote here and here.

But, why all the fuss, and why now? Why do Charles Dallara or the IIF care about currencies?

The answer is that the pre-WWII competitive devaluation of the currencies is replaced with competitive interest rate cuts. The Fed cuts the interest rates to zero, so the Bank of Japan cuts the rates to zero, so the Bank of England cuts the rates to zero. The European Central Bank will soon have to follow. These are the “G4” that Mr. Dallar suggests should come to some understanding.

As a result, a massive arbitrage is at works. Funds and speculators are borrowing money at almost zero interest rate in “G4” countries and buying assets in emerging markets. Virtually all the money created through the quantitative easing of the Fed, for example, can be shown to have flown to Asia and Latin America.

You know what that means, or rather, bodes. So does Charles Dallara – and his constituents. Hence, their concern to do something about the crash that will come with the inevitability of night following day if something is not done – and soon.

There is more information in your local newspaper than in most top secret intelligence reports. It is a matter of knowing how to read it.

Sunday, 3 October 2010

A Commentary on the Joint CFTC-SEC “Flash Crash” Report

I have been busy lately reading and rereading Hegel; what he wrote and what is written about his philosophy. I had to. Writing a volume on Dialectics of Finance demands having a dialectical method at one’s fingertips and I noticed in certain places I wasn’t up to par. Hence, the need for going back to the original source.

Hegel purports to explain the world. That’s a tall order. To that end, one must first explain what is meant by “explanation”. At what point, when or how, will we know that the world is satisfactorily explained?

The apparent way of explaining something is pointing to its cause. If we know A is caused by B, then we say that the cause of A is known, or A is explained. The cause of boiling water, for example, is heat; it boils when it is heated to 100 degrees Celsius.

But the world cannot be explained in this manner. Assuming we could show that A is caused by B; B by C; C by D, etc., the last phenomenon – “the first principle of the world” – by definition, will have no cause because it is prior to everything else. The last cause of the world, therefore, would remain a mystery, which means that our entire explanation would revolve around a mystery. That is no explanation.

Upon closer examination, we realize that the cause and effect provides no explanation even for everyday phenomena. Water boils at 100 degrees Celsius. Why? We do not know. It is a fact that dogmatically asserts itself and which we have observed millions of times. But why it should be so, no one knows. No amount of logical thinking could lead to boiling water from the idea of heat. Heat could as well result in water freezing. Knowing the intermediate steps will not help a bit. Suppose we know that heat results in water boiling because, as a result of heat, the speed of the atoms’ electrons around the nucleus increases. The question would still remain: why should heat increase the speed of electrons – and not, for example, cold?

Take the famous example of evil. As Stace explains in his Philosophy of Hegel, suppose we know that the cause of evil in the world is a virus; never mind its implausibility. But even if we knew the cause of evil, it would still remain a mystery. We would still not know why it should exist.

From this, Hegel concluded that the meaning of explanation is providing the reason for it. That is, the “explanation” of a phenomenon is not providing a cause of which the phenomenon is an effect but a logical antecedent of which it is the consequence. Nothing further is needed because reason is a self-explanatory process. Stace writes:
It is of the essence of reason that its entire process is necessary. Nothing in it can be arbitrary of accidental. It does not begin and end anywhere. Its progress if fixed by its own rational principles and cannot be altered by our individual whims ... The essential character of reason is necessity.
I thought of all this because on Friday, the joint CFTC-SEC Findings Regarding the Market Event of May 6, 2010 was released.

I knew about the project. I knew it was being led a physicist who had promised that his investigation would “zero in on a specific sequence of events that preceded the crash.” I knew from reading Hegel that such clerical reading of the events would explain nothing.

Well, they do not.

The report is a clinical, blow-by-blow description of the events preceding the crash, without saying why the things happened. Here is an example:
At 2:32 p.m ... a large fundamental trader (a mutual fund complex) initiated a sell program to sell a total of 75,000 E-Mini contracts (valued at approximately $4.1 billion) as a hedge to an existing equity position.

Generally, a customer has a number of alternatives as to how to execute a large trade ... This large fundamental trader chose to execute this sell program via an automated execution algorithm (“Sell Algorithm”) that was programmed to feed orders into the June 2010 E-Mini market to target an execution rate set to 9% of the trading volume calculated over the previous minute, but without regard to price or time.
Does this mean that if the customer had chosen to transmit his sell order via other alternatives, there would not have been a crash? The report uses “without regard to price or time” to insinuate something sinister. But that is the description of one of the most common orders in the market. When you pick up the phone and instruct your broker to sell 1000 shares of IBM at the market, that is a sell order without regard to price or time.

The report’s failure was preordained. Now, I could count the reasons, but the list is legion and will take time. Better for me to return with my take on the subject. It should be easier to explain the problem rather than pointing out the errors of a long report.

Saturday, 2 October 2010

Geniuses at Work

Early this week, the MacArthur Foundation announced the winners of its 2010 “genius awards”. Twenty three geniuses were granted $100,000 a year each for 5 years – no strings attached – to continue doing whatever ingenious work they were doing, free from financial concerns.

One genius was economics professor Emmanuel Saez of Berkeley who, according to the New York Times, “studied the economic impact of outstanding kindergarten teachers.”

I spent a few minute to check out the work. It is a collaborative project with 5 other economists from Northwestern and Harvard which purports to fill a perceived gap:
What are the long-term impacts of early childhood education? Evidence on this important policy question remains scarce because of a lack of data linking childhood education and adult outcomes.
To that end, Saez et al follow a group of kindergarteners to adulthood and, using tax returns, match the subjects’ income to their class size and teachers’ experience in kindergarten. They conclude that:
improving the quality of schools in disadvantaged areas may reduce poverty and raise earnings and tax revenue in the long run.
I will not say anything about the methodology of the research: first, equating the reported income of grown men and women with their “success” and then using that income to judge the role of their kindergarten teacher or the size of their kindergarten class in making that income. I will not say anything because I know this type of mindless, clerical quantitative work is what passes for economic research in the nation’s universities.

Nor will I comment about the purpose and conclusion of the research. Six economists spending heaven only knows how much in grant money to conclude that: i) education is somehow important to “adult outcomes” and; ii) the poor do not get good education. Any comments along that line would be missing the point.

I only want to draw your attention to the cynicism of the researchers. Note their statement in the beginning about early childhood education being a “policy question”.

Exactly. The reason that millions – and tens of millions of students, preschoolers or otherwise – do not get a proper education is a matter of policy, i.e., conscious, decision.

Our researchers know that. And, yet, how do they confront the problem? They meekly suggest that perhaps the powers that be should consider improving the lot of down-and-outers because that would result in higher tax collection.

That’s a theoretical cold-bloodedness that would make Larry Summers cringe. As for the practicality of their advice? It is certain to be adopted the morning after Judgment Day.