An Economist of Our Time

Few people stand up to a close scrutiny. Paul Samuelson, who died on Sunday at the age of 94, fell apart at first glance. The man was a mountebank, a particularly offensive mix of knave and fool whose crowning as “Titan of Economics”, as the Wall Street Journal put it, said volumes about the society which did the crowning.

He neither understood nor followed the age-old advice that Clint Eastwood’s Inspector Callahan disdainfully summarized: “A man’s got to know his limitations”. In that, he was a fool. He knowingly and methodically downplayed, dismissed and covered up the contradictions that came into his ken, especially the ones which sprang from his “theories”. For that, he was a knave.

He was a “popularizer”; he stripped the “complexities” from the ideas to make them more palatable to the masses. He explained, according to the New York Times obituary, “what Marx could have meant by a labor theory of value”. (Marx meant what he said!)

He dabbled in everything and left behind “voluminous” writings. To the Times, they are the evidence of his “astonishing array of scientific theorems and conclusions”. What they are is a circular canon of superficiality; they show how one may write million of words on a subject and not advance it one iota forward. His Economics is a case in point. It sold millions of copies. It was a veritable cash cow for the Titan over a half a century. And it reads like a Danielle Steel novel, only with more inconsistencies. It is a hillbilly tune to the grand symphonies of the classical economics.

Here is a sample of the Times’ description of Samuelson’s contribution to economics, beginning with his much touted Neoclassical Synthesis.

Mr. Samuelson wedded Keynesian thought to conventional economics. He developed what he called Neoclassical Synthesis. The neoclassical economists in the late 19th century showed how forces of supply and demand generate equilibrium in the market for apples, shoes and all other consumer goods and services. The standard analysis had held that market economies, left to their own devices, gravitated naturally towards full employment.

Economists clung to this theory even in the wake of the Depression of the 1930s. But the need to explain the market collapse, as well as unemployment rates that soared to 25 percent, gave rise to a contrary strain of thought associated with Keynes.

Mr. Samuelson’s resulting “synthesis” amounted to the notion that economist could use the neoclassical apparatus to analyze economies operating near full employment, but switch over to Keynesian analysis when the economy turned sour.

To summarize: Theory A worked under Condition A, but not Condition B. Theory B worked under Condition B and not Condition A. Paul Samuelson came along and “wedded” the two together to create Theory AB. He suggested using part A under condition A and part B under condition B. This, he called “Neoclassical synthesis” – or “Can’t We Just Get Along?” (He probably got the idea from quantum mechanics, where the light is shown to be both wave and particle at the same time).

His speeches and his voluminous writing had a lucidity and bite not usually found in academic technicians. He tried to give his economic pronouncements a “snap at the end”, he said, “like Mark Twain”. When women began complaining about career and salary inequalities, he said in their defense, “Women are men without money.”

So the “Titan of Economics” wanted his comments to have bite, just like Mark Twain! How could have one explained to him that Mark Twain’s comments had a bite because he was conscious of the larger social inequalities. On this topic, he would have probably said: Women are black men.

Mr. Samuelson also formulated the theory of public goods – that is, goods that can be provided effectively only through collective, or government, action. National defense is one such public good. It is nonexclusive; the Navy, for example, exists to protect every citizen. It also eliminates rivalry among its many consumers; that is, the amount of security that any one citizen derives from the Navy subtracts nothing from the amount of security that any other citizen derives.

The features of public goods, Mr. Samuelson taught, stand in direct contrast to those ordinary goods, like apples. An apple eaten by one consumer is not available to any other. Public goods, he concluded, cannot be sold in private markets because individuals have no incentive to pay for them voluntarily. Instead they hope to get a free ride from the decisions of others to make the public goods available.

Here, Samuelson compares the U.S. Navy with an apple and “concludes” that no one would voluntarily buy a nuclear attack submarine, no matter how bad the crime situation got in the neighborhood. From this, he draws the further conclusion that the government has to force everyone to pay for the navy. (Notice how he chooses the safely remote Navy and ignores police, a more logical and intuitive example of the “public good”. Some might have questioned the “nonexclusivity” of the police force from their experience.)

Mr. Saber, now, really. You must be exaggerating; having fun at the expense of the dearly departed. There had to be some value to Samuelson’s work. More than half a century of prizes, awards, citations, recognitions; his book being translated to more than twenty languages and now all these posthumous praises. Surely you are not suggesting that all that is due to chicanery and the man fooled most of the people all his life. You, yourself call him an economist of our time. Even with the hint of disapproval that it is there, he had to do something to deserve the designation. No?

Samuelson influenced our world in two ways. Both were destructive. Both set back the cause of science and gave a black eye to civilization.

One is his “introduction” of mathematics to economics and, later, finance. A single sentence in the Times obituary – in code, as usual – captured this sinister deed:

Mr. Samuelson was credited with transforming his discipline from one that ruminates about economic issues to one that solves problems, answering questions about cause and effect with mathematical rigor and clarity.

Here, “mathematical rigor and clarity” means calculation. It is referring to Paul Samuelson taking economics, which was a social and philosophical discipline concerned with discovering the laws of the dynamics of social change, and bringing it down to the service of the businessmen, putting it to use for the calculation of profit and loss. It was the opportunistic seizing of an opportunity by an opportunist. And it was a serious blow. If the war of ideas were fought like wars, Samuelson would be shot for treason. I wrote about this in Vol. 1:

Pursuing mathematical finance along the lines of Portfolio Selection 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.

But, taking the Times’ descriptions, how does one solve problems and answer questions about cause and effect without ruminating about the issues? This question did not concern Samuelson. He was not interested in the larger social issues that resulted from the business decisions. His work on linear programming is the Exhibit A in this regard. From Vol. 1:

Linear programming epitomized the “objective” science. It seemed to be the embodiment of Friedman’s assertion that “positive economics is in principle independent of any particular ethical position.” The solutions it offered were arrived at mathematically and were indisputable. There was only one best way of scheduling oil tankers between a given number of ports if the profits were to be maximized or costs minimized. Democrats and Republicans, capitalists and communists, oil producers and tanker owners, all had to agree on it.

But while mathematics is abstract, it is always applied in the context of given social conditions. And precisely because mathematics is abstract, upon application it assumes the characteristics of the context to which it is applied. If the context is the Battle of Britain, the mathematics of linear programming shows the best way of organizing fighter planes. If the context is the profitability of commercial airlines, it still shows the best arrangement, which is establishing “hubs” and cutting service to low traffic destinations. Both solutions are mathematically correct. In the latter case, because the purpose behind the application of the method has changed–and that purpose is determine by social conditions–the solution leads to a different kind of consequences: medium-sized and small communities become further isolated.

It mattered little that Samuelson’s knowledge of mathematics was, like his knowledge of economics and finance, shallow. In Vol. 2 of Speculative Capital, you may recall, I examined a densely mathematical passage he wrote on warrants pricing. I was taken aback by flagrant flaws in calculation and reasoning and, especially the way Samuelson handled a contradiction that his own formulation had created; he simply dismissed it as “prosaic”. I wrote: “The passage, after it ceases to be funny, remains difficult to believe”.

What mattered is that Samuelson “delivered” the goods, the goods being the nations’ best and brightest to the service of finance. “When today’s associate professor of security analysis is asked, ’Young man, if you’re so smart, why ain’t you rich?’, he replies by laughing all the way to the bank or to his appointment as a high paid consultant to Wall Street”, he wrote in the introduction to Merton’s Continuous-Time Finance. That was the new goal of economics: training highly paid consultant to Wall Street. Looking back at what took place in the business schools and economics departments in the past 30 years, we must, in fairness, acknowledge Samuelson’s service.

When economists “sit down with a piece of paper to calculate or analyze something, you would have to say that no one was more important in providing the tools they use and the ideas that they employ than Paul Samuelson,” said Robert M. Solow, a fellow Nobel laureate and colleague of Mr. Samuelson’s at M.I.T.

Exactly. That is the secret of Samuelson’s fame and success: genuflection in the direction of the businessman. What a falling off was there.

Still, this retrogression pales next to the effects of Samuelson’s other deed, whose impact went further and deeper in the society. I do not suppose the man who emptied economics of social elements noticed or appreciated the irony.

Prior to Samuelson – and Friedman – writing and speaking about economics had been in the form of discourse, which is “proceeding from one judgment to another in logical sequence”, according to its dictionary definition. All classical economists were schooled in logic and philosophy. They could disagree with each other – and they often and vehemently did – but each side could answer and refute the opposing arguments point by point. Because there was a logical relation between the points of a case, in this way one could, if he had the logic on his side, refute the core thought of his opponent.

Samuelson, and his partner in crime, Milton Friedman, changed that. The change was violent and disorienting. It had a similar effect on the intellectual terrain that the introduction of the machine gun had brought to the battlefields of WWI. Whilst previously cavalry had charged the enemy lines, now two men behind a machine gun could hold the line against a thousand charging cavalrymen.

Samuelson and Friedman had no core theory, no central point, no logical anchor, only an “astonishing array of scientific theorems and conclusions”, which meant that they could not be nailed down to any particular position; they switched the subject and sides at will. And they were “formidable debaters”, according to the New York Times, precisely because the substitution of the spoken word for the written word created the ideal environment for their style of polemics. They uttered rapid-fire sequence of nonsensical assertions, peppered with false statistics that they knew no one could check.

With the rat-a-tat of their drivel, they killed discourse. They made discussion, and even conversation, impossible. What do you do with a man who goes on and on about the contrast between the U.S. Navy and an apple and cannot be thrown into a madhouse because of his Nobel Prize and M.I.T. tenure?

In this way, the Tweedle Dee and Tweedle Dum of economic scene invented the aggressive in-yourfaceness of unreason that we see today in talk radio hosts, Rush Limbaughs and the public figures. That is the main legacy of Samuelson with which we will have to live for years to come.

The Times obituary mentioned that Samuelson had trained and mentored many “brilliant” economists who went on to occupy important positions in academia, government and the private industry. Looking around at the social and economic landscape, I must say that I could have surmised that on my own.

The Trojan War
is over now; I don’t recall who won it.
The Greeks, no doubt, for only they would leave
so many dead so far from their own homeland.

The U.S. Treasury Reaps Big Profits

The news that the U.S. Treasury had “reaped” $936 million from the sale of JPMorgan warrants was everywhere over the weekend. Google “treasury + $936 million” and see for yourself.

Credit the U.S. Treasury with the P.R. job. Its announcement said that JPMorgan’s warrants provided “an additional return to the American taxpayer from Treasury’s investment in the company”.

Additional return. Investment. American Taxpayer. Only Apple Pie and Motherhood were missing from the formal communiqué.

If the “return to U.S. taxpayer” had any meaning, or if the sum involved even matched what Maddoff “investors” are going to get back from the IRS, I would go through the trouble of showing in numbers what this “return” entailed; I know a thing or two about warrants and options.

Still, you can form an informed opinion about the matter from the concluding sentence of the FT article that reported the happy news on its front page:

The Treasury said the price was well above what JPMorgan had offered to buy back the warrants, adding that the auction had been oversubscribed.

The price was well above what JPMorgan had offered. That is called lowballing.

The auction had been oversubscribed. There was nary a word about the buyers, but you could bet your top dollar that they were all professional traders and fund managers. And they were falling over one another to buy the warrants, which is why the auction was oversubscribed.

Bravo, Secretary Geithner – playing one scene of excellent dissembling and letting it look like perfect honor.

A Brief Commentary On a Picture

According to the New York Times, this is how Prof. Sidney Plotkin of Vassar “dramatizes the pressure a president faces in a falling economy”. Click here to see how.

The paper said that Prof. Plotkin shines “a Marxist light” on the economic crisis, though Marx is an “uninvited guest,” the professor was quick to add.

What does he know about his uninvited guest?

Marx wrote: “In the analysis of economic forms … neither microscopes nor chemical reagents are of use. The force of abstraction must replace both”.

Prof. Plotkin has substituted dramatization for abstraction. He no doubt thinks that this shows his enthusiasm. And he may well be enthusiastic. But there is a deeper rationale behind his theatrics which makes them appeal to his students and administrators.

Here is an excerpt from the manuscript of Vol. 4 of Speculative Capital. We pick up where the product is produced and must now be sold, i.e. converted into money. Without this conversion, the production process will come to a halt:

Given this centrality of sales and its practically limitless sub-specialties in a Capitalist society– in the U.S., one would find hiring ads for “nuclear waste salesman” – it is natural that the subject is deeply embedded – intertwined, really – with the culture. Often, it is the driver and creator of the culture, especially in the “Anglo-Saxon” U.S. and U.K., where the businessman’s influence goes further than it would in other nations. The culture in these countries could be said to be the culture of a salesman, as it is shaped by the habits, sensibilities, tastes and priorities of a salesman. This point can best be seen by a look at Dale Carnegie’s How to Win Friends and Influence People.

The book’s title is precise. It telegraphs the content, so attention must be paid. Carnegie wants to win friends. Why? Because he wants to influence them. But the purpose of this influence is not bringing new friends to the righteous path. Carnegie is not an Islamic zealot practicing the Prevention of Vice and the Propagation of Virtues. He wants to influence people in order to sell to them. Friendship is a strategy, a mere means, towards that end. Note the word “win” – not finding friends or making friends but winning friends. The purpose is exploitation, after which “friends” become what they always were: people. It is a singularly cold-blooded and cynical title.

A straight line connects Dale Carnegie to the modern financier, Michael Milken who, responding to a minion’s comment that the rate they were charging a friend was too much answered: “Who are we going to make money off of if not our friends?”

I am not overstating the role of this depression-era salesman. Dale Carnegie did not invent the ways of salesmanship. He merely categorized them – arranged them around a central theme and in doing so, gave them cohesion and focus. His is the authentic voice of a salesman the way braying is the voice of a donkey.

Look at his chapter titles: Three Ways of Handling People; Six Ways to Make People Like You; Twelve Ways of Winning People to Your Way of Thinking; How to Change People Without Giving Offense or Arousing Resentment (in 9 steps, ending with “Making People Glad to Do What You Want”). Little wonder, then, that his book became the manifesto for a country whose “chief business” President Coolidge had declared was “business”.

What Carnegie began has grown into a multi-billion a year “self-improvement” and “interpersonal skills” business. Millions of people have taken courses on dressing, speaking, walking, even sitting – that would be “your silent presence” – to hone in their selling skills.

The graduates have then gone on to quietly instill the culture with the values that they learned and internalized in the classrooms. In this way, the modus operandi of the salesmen has turned into the cultural trait of the society. When the modus operandi changes, the culture changes.

One main change in the past 40 years has been the intensified competition due to the falling rates of profit. That has made selling a far more stressful occupation than it was in the heydays of the U.S. industrial power. The salesman is under constant pressure to be more “productive”, meaning that he has to sell more in less time.

The ensuing stress has darkened his mood. The passive Willy Loman has given way to the obscenities-spewing, conniving and downright criminal salesmen of Mamet’s Glengarry Glen Ross.

In practical terms, efficiency squeeze has necessitated harsher sales tactics. One is that the prospective buyer has to be evaluated quickly: is he/she going to buy or not? There is no time to be wasted on those “just looking”. This could only be done visually, checking the prospective buyer’s car, clothes, shoes – in short, any outward signs of material wealth. Hence, the elevation of the visual and “first impression” above all else. Rorschach test is the “psychological” test of this culture in which the salesman constantly and quickly “sizes up” his prey ...

In this way, the reliance on the visual becomes the norm. The “visual art” rises.

Prof. Plotkin’s understanding of economics is shaped by the salesmen, in the same way that Black, Scholes and Merton’s understanding of options was shaped by the traders. Those who have read Vol. 3 know the price one pays for blindly following these agents of circulating capital.

A Daisy Chain of Crises

What should you conclude upon hearing of the financial crisis in Dubai?

Perhaps the question is too vague. So let me give a hint:

• after the collapse of the financial system in the U.S.;
• after the collapse of the financial system in the U.K.;
• after the collapse of the financial system in much of the Western Europe;
• after the collapse of the financial system in the Eastern Europe;
• after the collapse of the financial system in the emerging countries;
• after the collapse of the Russian economy in 1998;
• after the collapse of the Mexican economy in 1994;
• after the collapse of the financial system in Argentina in 2001;
• after the collapse of the “Asian” economies in 1998 – that would be Hong Kong, Indonesia, Malaysia, Singapore, Thailand, The Philippines, South Korea, Taiwan;
• after the economic and financial crisis in 1998 in Latin America – that would be Brazil, Argentina, Chile, Bolivia, Ecuador, Columbia, Uruguay;
• after the collapse of the Japanese economy that has been going on for almost two decades;
• after the protracted economic and financial crisis in Turkey in 1980s and 1990s and the 2000s that saw Turkish lira lose its value 1,000,000 times;

After all these crises, what should you conclude when you hear of the crisis in Dubai?

You must conclude that theses economic and financial crises cannot, by definition, be aberrations or exceptions. They are more like a natural phase of the system, the inevitable and necessary aspect of its operation.

That is the subject of the Vols. 4 and 5 of of Speculative Capital: the crisis as the “property” of the financial system currently in place in much of the world, with all the social, economic and financial implications that follow.

Stay tuned.

A Question of Perspective

Last Friday, William Dudley, the president of the Federal Reserve Bank of New York delivered a long speech on “Lessons From the Crisis” in the Center of Economic Policy Studies Symposium at Princeton University. I don’t suppose you could get any more serious than that in terms of authority and setting, even though the speaker felt compelled to issue a disclaimer: “As always, my remarks reflect my own views and opinions and not necessarily those of the Federal Reserve System.” It is astounding how no one dares to speak freely, even when the subject is a non-political, technical one and the speaker is the president of the New York Fed.

My aim is not to offer a blow-by-blow critique of the speech. What I want to focus on, rather, is Dudley’s perspective, the way he sees things. I wrote about this seeing-things-through-the-eye-of-finance-capital in here and here. So the focus is not on Dudley. He is merely a Rumian part that adequately reflects the whole.

The technical description of markets and processes in the speech are generally accurate. But look at the circumlocution and the child-like narrative when the speaker explains the tri-party repo market.

In the case of the tri-party repo market, the stress on repo borrowers was exacerbated by the design of the underlying market infrastructure. In this market, investors provide cash each afternoon to dealers in the form of an overnight loan backed by securities collateral.

Each morning, under normal circumstances, the two clearing banks that operate tri-party repo systems permit dealers to return the cash to their investors and to retake possession of their securities portfolios by overdrawing their accounts at the clearing banks. During the day, the clearing banks finance the dealers’ securities inventories.

Usually, this arrangement works well. However, when a securities dealer becomes troubled or is perceived to be troubled, the tri-party repo market can become unstable. In particular, if there is a material risk that a dealer could default during the day, the clearing bank may not want to return the cash to the tri-party investors in the morning because the bank does not want to risk being stuck with a very large collateralized exposure that could run into the hundreds of billions of dollars. Overnight investors, in turn, don’t want to be stuck with the collateral. So to avoid such an outcome, they may decide not to invest in the first place. These self-protective reactions on the part of the clearing banks and the investors can cause the tri-party funding mechanism to rapidly unravel. This dynamic explains the speed with which Bear Stearns lost funding as tri-party repo investors pulled away quickly.

The result was a widespread loss of confidence throughout the money market and interbank funding market. Investors became unwilling to lend even to institutions that they perceived to be solvent because of worries that others might not share the same opinion. Rollover risk—the risk that an investor’s funds might not be repaid in a timely way—became extremely high.

These words are simultaneously convoluted and simplistic. When the speaker says that in the tri-party market “investors provide cash each afternoon to dealers in the form of an overnight loan backed by securities collateral”, it is as if a 5th-grader is explaining the market. And he has the order wrong. The drivers of the tri-party repo market are not investors who provide cash but the broker dealers who seek money to buy an asset that they themselves could not otherwise afford. If you miss this point, you will not understand the tri-party repo market.

Dudley’s language reflects his thought process, the ways he see things. But the language is not only a passive reflector. It has an active, pernicious side as well: It hinders thinking by creating the impression that something new was told and learned while in fact nothing of the sort happened. So the real cause remains unexplored. Look at this explanation of the crisis:

At its most fundamental level, this crisis was caused by the rapid growth of the so-called shadow banking system over the past few decades and its remarkable collapse over the past two years.

But why was there a remarkable growth of shadow banking? Why did it collapse? Mr. Dudley is giving as the explanation of the crisis the very things that he is called upon to explain.

With such muddled thinking, his “framework” to fix the problem naturally degenerates into a discussion of the “psychology” of lender and borrowers, as in this gem:

This second cause of liquidity runs—the risk of untimely repayment—is significant because it means that expectations about the behavior of others, or their “psychology”, can be important. This is a classic coordination problem. Even if a particular lender judges a firm to be solvent, it might decide not to lend to that firm for fear that others might not share the same assessment.

This is the nonsense that he must have heard from some CEO or one his minions as the cause of the crisis.

I wrote about the role of the tri-party repo market in fermenting the crisis here and here. Read them to see why I emphasize, and mean by, the perspective, the “angle of vision on reality”; it liberates the language and allows for imparting knowledge.

On the larger question of the cause of crisis, I have already pointed out that only two issues matter: the structure of the financial system which develops naturally and could be said to be imposed onto the system, and the fall in the value of the securities due to the transformation of values to prices. Most of this blog has been about the first issue. The question of transformation I will take up in Vols. 4 and 5 of Speculative Capital.

On “Industrial Policy”

What type of stories would I cover if I were a financial journalist?

A couple of weeks ago, The New York Times had an interview with William Clay Ford Jr., “perhaps the most seasoned auto executive in Detroit.” He has more than 30 years on the job at Ford Motor Company which was founded by his great grandfather. He is presently the executive chairman of the board. A Q&A and the follow-up went as follows:

Q: Is the financial support given by taxpayers to G.M. and Chrysler a positive development for the American economy?

A: The biggest concern that we had all through this was the collapse of the supply base. I believe that if G.M. and Chrysler had gone into free-fall bankruptcies, it could have devastated the entire industrial base of this country.

Q: Does the average American value the domestic auto industry?

A: They should. One cannot find a healthy economy anywhere in the world that does not have a strong industrial base, period. We seem to be the only country in the world that doesn't strongly value that. Everywhere else Ford does business in the world the government and people understand it, and do everything they can to enhance it. The notion that we can just simply become an information-age data provider as a nation is ludicrous.

The interview was published in a special section about cars and not in the business section.

If I were conducting the interview, I would note that Ford Jr. was lamenting the lack of an industrial policy, although he did not dare/care/want to mention that phrase. I would also note that he was lamenting the lack of an industrial policy the way one would lament the lack of, say, good beaches in the country.

I would gently push him on the subject, encouraging him to continue with his thoughts.

“Mr. Ford”, I would ask, “as a high ranking executive of Ford Motor Company and a powerful business executive, your views carry tremendous weight on the subject of manufacturing. You have the ear of every Fortune 500 executive and every policymaker in this country, including the president of the U.S. Since you maintain that without an industrial policy a nation is doomed, “period”, why is it that you have not pushed for the creation and adoption of just such a policy? More importantly, given the critical role of such policy, one would expect it to be the playbook of the business and the government activities. But it is not. Who and what stand in the way? Please take your time.”

I would then go to Larry Summers, the wunderkind working from the While House, and ask him the flip side of the question.

“Dr. Summers”, I’d ask. “The Wall Street Journal of February 13, 1998 carried an incredible news story on page A2 pertaining to your testimony in front of a congressional committee in the context of the Asian financial crisis that was then raging. Here is what you said:

There has been more progress in scaling back the industrial policy programs in these countries in the last several months than there has been in a decade or more of negotiations.

“In your testimony, you expressed satisfaction at the scaling back, or even the destruction of, the industrial policies in Asian countries. Is it now or has it ever been the policy of the U.S. to dismantle the industrial policies anywhere it finds them, including within the U.S.? If so, how and where is this policy set? If there is no coordinated opposition, why do you think that there has not been any such policy despite the conviction of manufacturing executives that it is absolutely needed?”

These are the questions I would ask if I were a financial journalist.

What We Learn From the Financial Journalists

This past Tuesday, The New York Times was plugging the new book by its “merger and acquisition correspondent”, Andrew Ross Sorkin, big time. The book is called, Too Big to Fail: The Inside Story of How Washington and Wall Street Fought to Save the Financial System – and Themselves. That long and yet empty title is what you get when you try to include all the “hot” issues of the day in a single phrase. But the gimmick apparently works, or it could have been the heavy promotion: the book sold out in New York’s Barnes & Nobles.

I have not read the book, but from the excerpt in the Times, I know what is inside. Here is a passage:

Increasingly desperate that morning – “I feel like I’m playing Whack-a-Mole,” he complained to his peers – Mr. Fuld decided to call his old friend John Mack, the chief executive at Morgan Stanley, the second-largest investment bank after Goldman Sachs. After dialing Morgan’s New York office, Mr. Fuld was transferred to Paris, where Mr. Mack was visiting clients in the firm’s ornate headquarters, a former hotel on the Rue de Monceau.

After some mutual disparagement of the markets, the rumors and the pressure on Fannie Mae and Freddie Mac, Mr. Fuld asked candidly: “Can’t we try to do something together?” It was a bold question and Mr. Mack had suspected it was the reason for the call. While he didn’t believe that he’d be interested in such a prospect, he was willing to hear Mr. Fuld out.

“We’ll come over to your offices,” Mr. Fuld, clearly anxious, said.

“No, no, that makes no sense. What if someone sees you coming into the building?” Mr. Mack asked. “We’re not going to do that. Come to my house, we’ll all meet at my house.”

On Saturday morning, Mr. Fuld pulled up to Mr. Mack’s mansion in Rye, N.Y. Despite the beautiful weather, he was tense. He could already imagine the headlines if it leaked.

The Morgan Stanley team had arrived and was socializing in the dining room, where Mr. Mack’s wife, Christy, had put out plates of food she had ordered from the local deli.

What we learn from the above is that:

• When Fuld called Mack, Mack was in Paris, in Morgan Stanley’s ornate headquarters, which was a former hotel on the Rue de Monceau.

• Mack and Fuld knew each other.

• Mack and Fuld did not like – or understand – what was happening in the markets.

• Mack had a sixth sense, certainly a strong intuition. When Fuld reached him in Morgan Stanley’s ornate office in Paris, he “suspected” that Fuld was calling him for something important.

• Fuld who had reached Mack in Paris to talk about his firm’s survival had not prepared a proposal or even an opening pitch. “Can’t we try to do something together?” is what he said, by way of proposing a merger involing about $2 trillion in assets.

• Fuld was a simpleton, suggesting to go to Mack’s office. A child would know not to do that. (Paulson met with the Goldman Sachs board in Russia – when he was the U.S. Treasury secretary.)

• Fuld was a quick learner. On Saturday morning, in front of Mack’s mansion, he was tense (although the weather was good) because he had learned that it was not good for him to be seen with Mack

• Mack’s wife, who goes by the name Christy, had ordered takeout food from a deli in Rye, New York which is where she and her husband, Mack, live in a mansion – Mack Mansion, presumably.

Perez Hilton, meet financial journalism.

It serves no purpose to comment on this trashy, gossipy writing masquerading as financial investigative journalism, except to point to the way it is intended to drum up the sale. The tidbits that permeate the narrative send the subliminal message that the author is close to the center of power and hence, privy to knowledge and inside information. That association is the source of his authority; he knows the cause of the crisis because he knows the players whose actions influenced it. That it is precisely the opposite, that businessmen and traders could shed absolutely no light on the cause of the crisis, that the more nonsensical tidbits you hear or read about the less you would know, is something that neither Andrew Ross Sorkin nor those who bought his book will easily believe – or understand. The milieu in which these events take place stands against such understanding.

I caught a glimpse of Ross Sorkin on Charlie Rose. The host and guest agreed that the main lesson of the crisis is “ultimately” about the human failure. You know about this the-fault-is-not-in-the-stars thing, akin to saying that an airplane crash was “ultimately” due to the gravity. The author is a young man. He talks fast and confidently, the way confidence men do. He has no qualms or doubts about what he knows; how could he, having heard the behind-the-scenes drama from the movers and shakers, knowing what a lawyer was wearing to a weekend meeting and which highway Fuld's driver took on the way to New York?

Not to be too harsh on him, but he, too, while also a victim, is at the same time a part of the fraud that is continuously perpetuated on the citizenry.

If the young lions of financial journalism are bad, the old timers are scarcely better. On Friday, Ron Chernow, the author of a confused history of J.P. Morgan, wrote an Op-Ed Page piece in the New York Times in which he compared the current financial crisis with the crash of 1929. Here are three sample statements, followed by my comments:

For many participants, a whiff of sin only enhanced the stock market's seduction. Small investors imagined that the large speculators who dominated the exchange could, if necessary, levitate the market and prevent unpleasant crack ups.

The modern markets, too, thrived on the whiff of scandal. All Madoff investors were told – and passed it to others – that the “New York people had a system.”

Margin loans equivalent to one-fifth the value of listed stock poised the market on a tall but shaky scaffolding.

In the current criss, while the margin on stocks was one-half, the firms as a whole had margins in excess of thirty to one, six times higher than what was allowed for the individual stock investors in the late 1920’s.

Unlike the 2009 crash, the 1929 debacle didn’t topple major banks or corporations. It simply wiped out a generation of speculators.

The crash of 1929 only toppled speculators and not banks because in 1929, banks were not involved in speculation. In 2007, they were.

Chernow has no central argument, he has no point. His writing is a hodgepodge of anecdotes and false parallels and analogies that ultimately leave the reader frustrated and exhausted.

What these men want to offer, but cannot, is a coherent narrative of a crisis that has devastated much of the world's economies in the past two years. I explained the crisis in some length in the Credit Woes series. Since Lehman’s case, for good reasons, is intricately linked with the crisis, let me once again use it to highlight the things we need to know. Only then we will be able to understand the crisis. This is not a “case study” approach, but an analysis of a part that contains some critical aspects of the whole.

Lehman had $1 capital, its own money. It then borrowed $32 and use all the money to buy securities worth $33. The securities were pledged as collateral for the loan, the way you would pledge your house for mortgage. Unlike your mortgage, though, Lehman’s borrowing was short term; it had to be refinanced, i.e., renegotiated, every day, or every week or every month.

In 2007, the securities prices dropped – crashed, really. (As an example of the severity of the crash, Merrill sold some of its securities for 22 cents on a dollar.) The securities that Lehman had purchased for $33 were now worth, say $20. The lenders did not accept holding $20 worth of collateral for loans totaling $32. As per terms of the loans, they demanded that Lehman pay the shortfall, the $12. Lehman had only $1. It could not pay $12.

Under these conditions, the die was cast. Short of a government bailout – the Fed or the Treasury giving Lehman the life-saving $12 – there was no way the firm could survive. Paulson and Geithner refused. The firm went under.

Three questions must now be answered, one specific to Lehman, the other two, general:

1. Why was Lehman allowed to fail?

To the extent possible, I answered this question here and here.

2. Why did Lehman follow a suicidal business model, borrowing 32 times its capital?

The answer is that it had no choice. Had it not pursued that specific business model, it would have been forced out of business or taken over many years prior to 2008. That was the case with all broker/dealers; Lehman was by no means an exception. So it is nonsensical to speak of management failure, as the decision to increase the leverage was conscious and deliberate.

Now, why is this so, i.e., why are financial institutions forced to behave in this way, is the subject of Vol. 4 and especially, Vol. 5, of Speculative Capital.

3. Why did prices drop?

The answer does not involve buyers going "on a strike" or the market being flooded with the securities or irrational exuberance. It has to do with the transformation of values to prices, something very objective. It is a fascinating subject that must be developed from the ground up and followed to its logical conclusion. That is the subject of Vols. 4 and 5 of Speculative Capital.

Stay tuned.

What We Learn From the Businessmen

If you did not recognize the style of Death of a Deal Man, you do not know John Das Passos. If you are an American, that is doubly unacceptable. His is the only name you can utter when an anti-American foreigner claims that your country has not produced a single writer or artist of international standing. Das Passos’s U.S.A. trilogy is a masterpiece of fiction in form and content. Once in this blog I asked the philosophical question: What do we need to know about something so we could say we know it? When it came to people, Das Passos knew the answer; he gave it to us with an impossible mix of brevity and completeness that approached poetry. Read the biographies in the U.S.A. and judge for yourself.

I thought of Das Passos when I was reading Wasserstein’s death notices. Even the man’s obituaries were hurried, as if rushing to complete an about-to-expire deal. Deal making alone drove the narrative, as in this gem in the Wall Street Journal (Oct 15, p. C3):

A former editor of the school newspaper at the University of Michigan, Mr. Wasserstein long has had an interest in media deals.

Do not blame the reporter for bad writing. The corollary is absurd because it captures the absurdity of a life whose focus on deals distorted all the relations. Eugene O’Neill perceptively captured this affliction in Hughie’s small-time gambler, Erie Smith. In the dinner party of a puritan hostess, with her children present, Erie recounts the story of one his wagers in a horse race, reasoning that the children would love “animal stories.”

The unintended humor is not confined to the dearly departed. In the same week, I also read the news of the retirement of James Simons, the founder of Renaissance hedge fund who made billions in trading. The Times said that “many on Wall Street” still believe that Mr. Simon has a “supernatural talent for making money.” Now that is a juxtaposition of spiritual and the material that only a Rumi could pull off. How life’s extremities give rise to poetry!

And there was John Mack, the outgoing CEO of Morgan Stanley, telling a TV interviewer on Friday that “our focus” must be on the job creation. This, from a man known as “Mack the Knife” for his relentless cutting of workers always and anywhere he went.

Now that a few market indexes are up and the immediate danger of a collapse seems to have passed, the men of finance are returning to the limelight, assuming Rodinesque poses and availing themselves to awe-struck financial reports for insights about “what went wrong”. They might even be right about the direction of the dollar or the yield of the 10-year Treasury by next year.

But that is not finance as discussed in this blog. We will learn nothing about finance from these men because what they see is always the appearance and never the substance. We will learn nothing from a mouse about the working of the cosmos, even though it could consistently find the cheese, as if by a supernatural talent.

If you are a student of real finance, you are in the right place. Stick around.

What We Learn From the Nobel Laureates

I had never heard of Oliver Williamson and Elinor Ostrom until they won the Nobel Memorial Prize in Economics this past week. So, what I know about their work is what I read in the papers. But that is sufficient; somewhere in this blog I wrote that everything you need to know is always right in front of your eyes!

Let us begin with Elinor Ostrom whose research, The New York Times tells us, led her to believe that something called the “tragedy of the commons” was inaccurate.

Ms. Ostrom concluded in her research that the “tragedy of the commons” was an inaccurate concept. Particularly in 17th- and 18th-century England and Scotland, the concept described villagers’ overgrazing of their herds on the village commons, thereby destroying it as a pasture. The solution often invoked was to convert the commons to private property, on the ground that self-interested owners would protect their pasture land.

Setting out to show that the tragedy of the commons is inaccurate is akin to setting out to show that Santa Claus does not exist. It is a curious starting point.

The idea of the “tragedy” came from a half-wit Texan by the name Garrett Hardin. His Wikipedia biography lists his “research” interests: overpopulation, immigration, race and intelligence – you get the idea. The Tragedy of the Commons is his magnum opus in which he argued that a shared social resource is doomed to exhaustion because the individual users will maximize their own interest at the expense of the long term social good. His conclusion: to avoid the ruin, the common property had to become private.

You see the angle. The Tragedy was published in 1968, just about the time when Milton Friedman was being pumped up to bamboozle the nation with his drivel.

So the good Indiana University professor wasted a good deal of time refuting something that did not merit a response. But what did she, herself, have to say on the subject?

Her most recent research has focused on relatively small forests in undeveloped countries. Groups of people share the right to harvest lumber from a particular forest, and so they have a stake in making sure the forest survives. “When local users of a forest have a long-term perspective, they are more likely to monitor each other’s use of land, developing rules for behavior,” Ms. Ostrom said in an interview.

Note the reference to “the relatively small forests in undeveloped countries” and earlier to the 17th- and 18th-century England and Scotland in the Tragedy.

The social system in a pre-Capitalist community is based on barter. In such a system, the members of the society use the common resource to satisfy their personal (including family) needs and not more. So, the common resource survives. Rules merely codify the individual uses that never exceed the capacity of the common resource.

With the rise of Capitalism, the society moves from barter to commodity trading. Now, the objective is no longer the satisfaction of the personal needs but the sale of the commodity for money – an open ended process that is limited only by the number of buyers. If the commodity happens to be fabric which is made from sheep wool, then to satisfy the demand for the expanding British fabric manufacturing, ever more sheep will have to be introduced to the pasture – far above and beyond its capacity. The result is first, overgrazing, and then the replacement of people by sheep. That is what caused the protracted Irish famines starting in 18th century. I thought this was known even to school children – but apparently not.

The Nobel laureate, who, by the way, is a social “scientist”, de-contextualizes the social system she is writing about, as if observing it in an imaginary Mister Rogers’ Neighborhood. That is why what she says comes across as simplistic, to the point of being childish. It is certainly irrelevant to our lives. Imagine we the people approaching Verizon or Chevron to ask for the management of our common resources, airwaves and oil!

For an adult’s take on the subject of the individual’s approach to a common resource within the given conditions, see Pontecorvo’s 1957 Wide Blue Road. You will learn more from this perceptive movie that all the works of all Nobel laureates in economics combined.

The work of Oliver Williamson, by contrast, is on a strictly contemporary phenomenon: the corporation. He discovered that, in the words of the same Times article, “large corporations exist because, under the right conditions, they are an efficient way to do business.” The Wall Street Journal (Oct 13, p. A19) explained his work in more detail:

Mr. Williamson showed that horizontal mergers of companies in the same industry – even those that increase market power and even those where the increase in market power leads to a higher price – can create efficiency. The reason is that if mergers reduce costs, the reduction in costs can create more gains for the economy than the losses to consumers from the higher price.

So Bruce Bid’Em Up Wasserstein was the agent of social efficiency. Also note Professor Williamson’s point of view in using the work “efficiency”. I earlier wrote about this view which is that of finance capital.

The most interesting part of the prize was the citation of the Award Committee that, perhaps innocently, but revealingly all the same, put the utterly incompatible works of Ostrom and Williamson next to each other to produce an anti-regulatory manifesto:

Rules that are imposed from the outside or unilaterally dictated by powerful insiders have less legitimacy and are more likely to be violated. Likewise, monitoring and enforcement work better when conducted by insiders than outsiders. These principles are in stark contrast to the common view that monitoring and sanctions are the responsibility of the state and should be conducted by public employees.

Bernie Maddoff could not agree more.

Wall Street and the “Real Economy”

A never-ending subject of thoughtful deliberation among economic and finance professors is the relation between the “Wall Street” and the “real economy” – whether the woes in the realm of finance spill over to the “real economy”.

You can see why the simple question remains an impossible puzzle. The very first step in answering it would be to define finance and explain what is meant by the real economy – without quotation marks. That, the university economics cannot do. Hence, the endless discussions and points and counterpoints.

In Vol. 4, I take up this question in detail. Before then, here is a news item from the New York Times to highlight the relation between finance and the real economy. The article is about the massing of lobbyist to influence the new law overhauling the financial industry.

But since virtually every imaginable company could be touched by the comprehensive legislation proposed by the Obama administration, the surprisingly broad array of lobbyist trooping to Capitol Hill also includes advocates for airlines, pawnbrokers, real estate developers, farmers, car dealers, retailers and energy and telephone companies. They want to make sure any new oversight of the financial system does not lead to tighter regulations of their businesses or make it more expensive for them to finance their operations or hedge their risks.

By far, the most direct link between finance and industry is through money markets, where hundreds of billions of dollars of the corporate working capital are parked to earn a few basis points. Any loss of this capital directly impacts the production and could even disrupt it, as we saw in the aftermath of the Lehman bankruptcy.

The Death of A Deal Man

Bruce ‘Bid’em-Up’ Wasserstein was born a deal maker. He was born in Brooklyn, went to the University of Michigan, studied business and law at Harvard, did a stint at Cambridge, became a Knox Fellow and authored a book, but his true love was deal making. He was called smart, driven, a chess player, a strategist, a tactician, but all he wanted to do was make deals. “In the deal world, there was Bruce, and then there was everyone else,” people said. He thrived in the deal making frenzy and he made deals always and everywhere so everywhere he went turned into the Deal World – the Hamptons, his Midtown office, home, planes, trains, automobiles. “Let’s make a deal,” he would say. And he made deals fast and furious, so fast and furious that once he overloaded First Boston’s phone system. His deals were many and varied: Philip Morri’s purchase of Kraft and General Foods; Ichan’s assault on AOL Time Warner; Kraft’s potential takeover of Cadbury; KKR’s takeover of RJR Nabisco; Texaco’s acquisition of Getty Oil; ABC’s sale to Capital Cities. Sometimes things did not work out. KKR’s takeover of Nabisco was a fiasco. Texaco’s acquisition of Getty led to a $10 billion court judgment. But through the thick and thin Bruce remained undeterred. He made deal making an art, made it a street fighter’s game, made it lucrative for himself and corporate raiders and greenmailers. He created the “Pac-Man defense” and “front-end loaded two-step tender”, built his own firm, sold his own firm, tried merchant banking, returned to deal making and accumulated immense wealth, but his true love remained deal making. On Wednesday, Bruce died. He left a wife, 3 ex-wives, 8 children, a tangled estate and an untold number of undone and as yet to be conceived deals behind.

Financial Regulation, Theoretical Poverty (2 of 2)

In a perceptive line in The Critique of Dialectical Reasoning, Jean Paul Sartre writes that “the future comes to man through things in so far as it previously came to things through man.”

The idea is not new, but Sartre expresses it more eloquently than others. What he is saying is that, in the course of his material activities, man creates tools and organizations whose very presence compels him to act in a certain way, thus shaping the course of the history. Sartre’s example is a machine. “Thus, the machine demands to be kept in working order and the practical relation of man to materiality becomes his response to the exigencies of the machine,” he writes. Man is the product of his product.

As with machines, so with the financial systems. They, too, demand to be kept in working order. But unlike machines which are built on well-understood principles and can be relied upon to work in a precise manner, the working of financial markets remains hidden from the view because they are created in response to the exigencies of finance capital. Finance capital cannot itself create markets. It employs the regulator, the trader, the professor and the banker as its proxies to the do job. These men are endowed with a free will, but, unbeknownst to themselves, they do the bidding of speculative capital, building the markets to its needs and specifications.

Speculative capital is capital engaged in arbitrage. In Part 1, we saw how it logically and seamlessly develops from trading and hedging. Vol. 1 in its entirety deals with this particular question.

Arbitrageable differences are never large enough to allow for a comparable return with other forms of capital; it would be a gross inefficiency in capital markets if they were. So, speculative capital boosts its return through leverage, i.e., borrowing. Wall Street Journal, Oct. 16, 1995:

Before [February 1994], speculators had been borrowing at a short-term rate of like 3% and buying five-year Treasury notes yielding around 5%, a gaping spread of two percentage points that enabled some to double their money in a year. The math was tantalizing. Using leverage, an investor with $1 million could borrow enough to acquire $50 million in five-year Treasury notes. And the spread of two percentage points could generate about $1 million in profits on the $1 million investment.

There is, however, little money to be made in Treasuries; the article makes it clear that the golden opportunity was arbitraged away some time ago. To make money through arbitrage in the bond market, one has to go down the credit ladder. But the lower-rated securities could not be pledged as collateral for borrowing. Could the Fed, perhaps, help? The WSJ, April 1996, describing what the Fed called “one of the most significant reductions in regulatory burdens on broker-dealers since 1934”:

The final rules … will eliminate restrictions on a broker-dealer’s ability to arrange for an extension of credit by another lender; let dealers lend on any convertible bond if the underlying stock is suitable for margin; increase the loan value of money-market mutual funds from a 50% margin requirement to a ‘good faith’ standard … and allow dealers to lend on any investment-grade debt security … the Fed will allow the lending of foreign securities to foreign persons for any purposes against any legal collateral … It will also expand the criteria for determining which securities qualify for securities credit, a change that will sharply increase the number of foreign stocks that are margin-eligible.

This is saying that many securities that were not eligible as collateral could now be pledged as collateral – for more borrowing. What follows is not merely predictable; it is inevitable. WSJ, Sept 22, 1997:

Everyone who has even thumbed casually through the books of securities firms recently agrees they are more highly leveraged than ever.

You see the loop-feedback mechanism at work. Every phase of the process, from the rise of speculative capital, to broker-dealers borrowing more than 30 times their equity, takes place rationally. Even the collapse is rational, as it is the necessary outcome of the operation of a self-destructive force.

What would you do if you were the Fed chairman or the Treasury secretary under these conditions? The “practical” answer is that, Lehman aside, pretty much what they have done in the past two years. There was, realistically speaking, no other option.

Speculative capital, you see, not only eliminates the arbitrage opportunities but the policy options as well. Men can boast of their free will. But what defines freedom is the availability of choices. As the choices narrow, the freedom is curtailed. A man without choice is a condemned man. Speculative capital limits the choices by creating conditions in which any action not in accordance with its interest looks naive, irrational or radical.

Such an environment is ripe for the rise of men most concerned about looking naive, irrational or radical. They are the functionaries and palan-doozan whose policy decisions at all times remain preordained. When they deviate from the prescribed course, not so much due to courage but incomprehension, the ensuing storm publicly chides and corrects them. Lehman bankruptcy was the Exhibit A in that regard.

Nothing illustrates this subjugation of man to the dynamics of speculative capital better than the option valuation theory. As I showed in Vol. 3, the entire option valuation literature is fundamentally incorrect and based on a misunderstanding. An option is not a right to buy or sell. It is right to default. This is the very “scientific-mathematical outlook” which Paul Krugman pompously called “the true glory of our civilization”.

Under these conditions, when the actions of the players are influenced by a hidden force, the regulation of the financial industry can proceed on only two paths. It must either be in conformity with the needs of speculative capital, such as creating a living will for the institutions to go out of business without complications, or skirt the issue altogether, which is just about everything else, including executive bonus and consumer protection. If any provision of the law currently being written contradicts this general outline, the matter will be worth a second look. But do not bet on it.

But is it possible to “do something”, Mr. Saber, anything at all, about the situation? After all, you criticized Godard for being nihilistic. Between not succumbing to speculative capital and destroying the system altogether, do you have any bright ideas?

To that hypothetical question, I had a modest answer a while back. I humbly suggested that shorting Treasuries be disallowed. This would be tantamount to turning a floodlight on a vampire. It will not kill the beast but temporarily paralyze it.

Given the reality around us – the amount of trading that is centered around Treasuries, for example, and the liquidity that such trading provides to the financial markets – the proposal is too radical and thus, naive.

Financial Regulation, Theoretical Poverty (1 of 2)

One of the issues being debated these days is the regulation of over-the-counter derivatives, the privately negotiated, customized contracts that exist in a legal world parallel to their standardized, exchange-traded cousins. The Financial Times was surprised that even the European industrial companies had come out against the regulation:

Some of Europe’s industrial companies have warned they could shift their financial hedging away from Europe if proposed reforms of the vase over-the-counter (OTC) derivatives markets go ahead as proposed by the European Commission ... The comments show that opposition to a key part of US and European proposals for reform of the financial system is gathering from an unexpected quarter: industrial companies.

The paper gave the reason for the opposition without, naturally, understanding the centrality of the issue to the current crisis:

Many companies use OTC derivatives, such as interest rate and currency swaps, to hedge routine business risks like fuel purchase and future pension liabilities.

This need of industrial companies for hedging is the genesis of the speculative capital, the latest and most versatile form of finance capital, that is born from the marvelously dialectical transformation of defensive hedging to predatory arbitrage. I was first to explain this metamorphosis in Vol. 1:

The most important point in the rise of arbitrage trading is that the practice develops logically from hedging and, on paper, is indistinguishable from it.

The purpose of hedging is preserving the owners’ equity. The hedger begins with an existing asset (liability) and seeks to find a liability (asset) which will offset its adverse price changes. The purpose of arbitrage, by contrast, is profit. The arbitrageur has neither an asset nor a liability. To that end, he looks for any two positions which will enable him to “lock in” a spread. The two acts are mathematically indistinguishable. What logically separates them is the purpose of each act which translates itself to the sequence of execution of trades. When done sequentially, the act is defensive hedging. When done simultaneously, it is aggressive arbitrage. Otherwise, the transformation of one to the other is seamless.

The sole subject of finance is studying the laws of movement of finance capital and its various forms such as speculative capital. The role of individuals, to the extent that it exists, is incidental.

The centrality of finance capital in studying finance is acknowledged – if only unconsciously and unknowingly – by the mouthpieces of the orthodox economics. They, who never tired of sounding off on the primacy of the individual and his supposed “free will” as an “economic agent”, these days talk of “jobless recovery”. Google the phrase and see how through sheer usage it has become an accepted term of discourse.

Writing in his column about the expanding army of the unemployed, Bob Herbert of The New York Times condemned this point of view without understanding its roots.

The Beltway crowd and the Einsteins of high finance who never saw this economic collapse coming are now telling us with their usual breezy arrogance that the Great Recession is probably over. Their focus, of course, is on data.

In the phrase “jobless recovery”, the news pertaining to the people is grim; there are no jobs to be had. Yet it contains “recovery”. So, what is it that is being recovered? The answer is: the agreeable rate of return of capital. The “data” measures the pulse and performance of capital, which the university professors study and comment about without ever understanding the larger issue surrounding it.

The outward appearance of the phenomena in economic life is deceiving. In fact, the appearances tend to show the opposite of what is actually taking place. Hence, the authority of the great thinkers of the classical economics who showed us the way.

The story-telling school of economics and finance that is in currency now concerns itself with the most immediately visible. Naturally, it gets everything wrong. Here is a full time professor of economics and finance at Yale explaining a crisis that has paralyzed much of the world for the past two years:

“The fundamental problem, as Franklin Delano Roosevelt said in 1933, is fear”, [Robert] Shiller, a Yale University Professor said. The great depression was deepened by a “sense of lost confidence and animal spirits that was a self-fulfilling prophesy. The worry is that we will have the same kind of issue rising again,” he said.

Even academics are beginning to see the superficiality of their theories; the long-present elephant in the room can no longer be ignored. The policymakers always knew it, which is why they practiced “pragmatism”. But in markets dominated by finance capital, pragmatism – doing the “proper” thing given the circumstances – is nothing but yielding to the diktat of finance capital. That is the part that neither the policymaker nor their critics who accuse them of “taking the side of their banker friends” understand. Like the focus on the data that Herbert criticizes, the problem goes much deeper.

I will return shortly with the second and final part of this piece.

A Glimpse of the Monetary Policy (in Action)

So, what rules did Bernanke break when he tossed out the rule book?

Here is a story about the reduction in the Treasury’s Supplemental Financing Program that no one probably read because the few who understood it did not have to read it and the rest would not get it. According to Bloomberg:

The U.S. Treasury Department plans to cut back its borrowing on behalf of the Federal Reserve as it seeks to keep government debt under a legal limit ... The Treasury will reduce the outstanding borrowing in its Supplementary Financing program to $15 billion “in the coming weeks,” the department said in a statement in Washington. The Treasury has been keeping the account, set up last year to give the central bank more flexibility as it undertook unprecedented lending, at about $200 billion.

Note the critical phrase “on behalf” in the opening sentence – the Treasury is planning to cut back its borrowing on behalf of the Federal Reserve. That is an accurate characterization of the program, although the phrase does not appear in the Treasury communiqué that announced the inauguration of SFP. The dreary language of the announcement precludes the use of simple phrases such as “on behalf” and that is a good thing, because the phrase invites inquiry.

What does on behalf mean?

It means that the Treasury is borrowing money not for its own needs but at the instruction, and for the benefit of, the Federal Reserve.

As any loan officer would tell you, that cannot be done; you cannot borrow money on behalf of anyone. In this particular case, there are added complexities.

The Department of the Treasury represents – stands for – the U.S. government in financial markets. Only it, and no other entity, can borrow as, and on behalf of, the U.S. government. That is another way of saying that any borrowing by the U.S. Treasury is, per se, borrowing by the U.S. government, regardless of the intent and the use of funds. You can see this in the Bloomberg story. The Treasury is curtailing the program in order to reduce the U.S. government debt [which was reaching it legal limit of $12.1 trillion]. So the Treasuries issued “on behalf of the Fed” were clearly counted as part of the U.S. government's debt.

But why the need for this arrangement? Can't the Fed borrow money itself?

The answer is, No, it cannot. It is prohibited by law from doing so. Earlier this year it tried to change that law , but ran into opposition and a wall of technical complexities. Some insiders also did not like the idea of the Fed issuing its own debt, but I was enthusiastically for it. I wanted to see how this debt would be priced against the Treasuries.

The Fed, you see, cannot borrow as the U.S. government because it is not the U.S. government – or any part of it. It is not a part of the executive branch. It is not a part of legislative branch. And it most certainly is not a part of the judiciary.

The Fed was incorporated as an entity in 1913. It is comprised of private banks and follows an “independent" monetary policy – independent in the sense that it operates without regards to the economic policies of the government. That is another way of saying that it runs its business as it sees fit no matter who or what party is in charge.

The Fed’s business, among other things, is issuing Federal Reserve Notes, commonly known as money. If you take a bill from your pocket you will see that at top of the side which has the picture of a dead president, it says: Federal Reserve Note. The authority of issuing money and conducting “monetary policy” is vested in the Federal Reserve. The Treasury – that would be the U.S. government – has no say in it.

Why is an “incorporated entity” in charge of the nation’s money supply and monetary policy is a topic for another occasion. We were considering whether the Treasury could borrow money “on behalf” of a non-governmental entity and we saw that the answer was no. The U.S. government could guarantee a borrower – whether explicitly like Ex-Im bank credit lines or implicitly, like old Fannie Mae and Freddie Mac – but it cannot borrow under its name and turn over the funds for the use of others. Yet, as the Treasury secretary, Paulson agreed to this arrangement and Geithner continued with it. Bernanke was not the only one tossing out the rule book.

Why does the Fed which controls money and money supply need the Treasury Dept to arrange borrowing on its behalf?

The answer is that the purpose of the SFP is not so much getting money into the Fed as it is siphoning it out of the system.

Historically, the Fed had strict requirements for the so-called “Fed eligible” securities that the banks could pledge in return for cash. After Lehman, those rules were tossed out and the Fed began taking in junk synthetic securities as collateral that were trading as low as 22 cents on a dollar. However, it accepted them at much higher values than the market, at times close to par, because that is where the banks had financed the securities. If you had $5 and borrowed $95 to buy a $100 security whose price subsequently dropped to $40, you still owed $95. The market did not pay more than $40 for it, but you needed $95. The Fed came in and took your junk for $95. After all that talk, for more than 30 years, about the critical role of the markets in price discovery and fair pricing, the fair market value was likewise tossed out. That was the mother of all rule violations, a replay of the worst excesses of the most unscrupulous mortgage-brokers: valuing the underlying collateral higher than its market price.

In this way, between the summer of ‘07 and January ‘09, the balance sheet of the Fed increased from just above $700 billion to over $2 trillion. The quality of its assets moved in the opposite direction.

The flooding of markets with so much money, above and beyond the value of securities “in play”, risked inflation. To counter that, the SFP was created to take the money out of the system. The Treasury Dept sold Treasuries to take in the money that the Fed had provided to the market in return for junk collateral. Presumably, the monetary policy gurus at the Fed thought that that would be the end of the cycle. But capital is a thing in motion. There is no end point in its circulation. The financial institutions which bought the Treasuries pledged them again with their counterparts for the cash. And the Fed, in order to keep interest rates low and the money flow going, began “quantitative easing”, a code for buying the Treasuries! So, here is the full cycle: giving money away, siphoning it out of the system through the sale of the Treasuries and then introducing it to the system by buying the Treasuries! That is the monetary policy for you.

According to the official statement, the termination of the SFP would have no adverse effects on the Fed actions. The Fed officials stated that that they have other policy levers at their disposal.

I bet they do.

Looking Back in Incomprehension

It is the anniversary of Lehman’s demise and everyone is looking back for “lessons learned”. The passage of time has not helped. The usual nonsense about greed, bad management, etc. is being regurgitated, with a new spin making the rounds: that Lehman’s demise prevented even bigger collapses. Goldman’s Blankfein was first to float this nonsense.

“A bailout of Lehman Brothers might have provoked a public backlash, causing the government “to let the next institution fail” instead, Blankfein said ... “It might have been a much bigger one with much more dire consequences.”

Joe Nocera of the New York Times picked up the same theme in a front page article claiming that if Lehman had been saved, a much bigger firm such as Merrill might have collapsed.

The claim can be neither proved nor refuted. It is an idle conjecture. Nocera’s Merrill example shows how little he knows about the markets. Merrill was bigger in terms of assets. But Lehman was a far more “connected” – systemically important, if you will – firm. It was one of the largest issuers of commercial paper. It was the freezing of the CP market, after Lehman had filed for bankruptcy, that triggered the crisis.

The spin tries to make the boys who let Lehman down look less bad. Nice try, gentlemen.

The how of Lehman’s collapse is a technical matter involving the business model of a highly leveraged broker-dealer. I described it in detail in the Credit Woes series, especially parts 9 and 10.

The why of Lehman collapse – why Geithner, Paulson and Bernanke allowed it to happen – cannot be known without a full confession from the said individuals. But I doubt that malice, in the sense of involving calculations and plot, played any role. That would be giving these men credit for what had to be a complicated chess move.

The truth is more banal. I think I came close to it when I described why Lehman was allowed to fail. Read it here and judge for yourself.

Looking back, I also think that I grasped the significance of the event better than others. Read it and judge for yourself.

Functionaries (passed off) as Revolutionaries

I was at the start of my vacation when Bernanke was reappointed. In terms of newsworthiness, then, the story is a tad dated. But this is not a news site, and there are important points about the reappointment that I would like to write about.

Ben Shalom Bernanke secured a second term as the chairman of the Board of the Federal Reserve because he played ball in his first term. He played ball obediently and unquestioningly.

In the ceremony announcing the reappointment, President Obama said that Bernanke’s “bold action and out-of-the-box thinking” helped save the economy from free fall. That was the agreed-upon line on Bernanke that the media had been promoting for over a year: a bold and unconventional thinker and doer – a veritable revolutionary, in other words, of the kind that these crisis times demanded. Google “Bernanke + rule book” and see how many sources, from the New York Times to the National Public Radio, approvingly talk of Bernanke “throwing out” or “tossing out” the rule book – the rule book being the policies of the Federal Reserve.

Rule books spell out the details and boundaries of actions in organizations. They are written to be followed. Anyone who has ever worked in an organization knows that ignoring the rules, to say nothing of tossing them out altogether, would be committing career suicide. In many cases, it would be a criminal offense. Imagine a pilot violating the rules of aviation. Or an accountant ignoring generally accepted accounting principles. Or a bank compliance officer not reporting suspicious transactions. Such conduct is so predictably ruinous that if willful and intentional, must to be pathological.

For Bernanke, this pathology was presented as heroic and as the evidence of his courage. The trick worked thanks to the perversion of the social frames of reference, of the kind that Shakespeare said make foul fair, black white, wrong right, base noble and coward valiant.

Let us begin with the “tossing out” part, that not-playing-by-the-rules shtick that is invoked to conjure up the go-it-alone ways of the heroes the Western movies. Hollywood was instrumental in creating the link between such “mavericks” and the frontiersmen who built the U.S. In the American psyche, patriotism and individualism – the latter connoting non-conformity – are thus linked.

The American individualism, however, always had a commercial base, even when it took the form of exploring the nature. The “enterprising” men and women could go off the well traveled paths and take whatever risks they chose, as long as their goal remained pursuit of money, which the Founding Fathers somewhat defensively called “the pursuit of Happiness”. That kind of individualism was encouraged, promoted and admired because it was in line with the guiding principles of the country.

Individualism, if it involved questioning the guiding principles which were codified in law, was strictly discouraged because the “common good” was supposed to trump individual interest. Those who went against these principles, whether for personal gains or out of concern for others, were branded outlaws and dealt with accordingly.

With the rise of speculative capital, the balance between the individual and the common good – between the narrow and general interests – was shaken in favor of the narrow interest. Speculative capital is an expansionary force. Expansion is the condition for its preservation. Constant expansion naturally brings it into conflict with the myriad of laws and regulations which inhibit its growth. So it strives to eliminate them. In Vol. 1, I wrote at length on the dialectical relation of speculative capital to law and regulation, which produced, starting with the Carter presidency up to current times, the longest running orgy of deregulation in the history.

Speculative capital abhors regulation. Regulations interfere with the cross-market arbitrage that is its lifeline. If speculative capital cannot freely operate, it cannot generate profits and must cease to exist. The opposition of speculative capital to regulation is thus not a matter of some technical or tactical disagreement but a question of life and death.

The attack of speculative capital on regulation is not indiscriminate. Though generally suspicious of regulation, speculative capital singles out only those regulations which directly or indirectly hinder its free flow across the markets. The same speculative capital, meanwhile, supports and pushes for the passage of sweeping laws. In so opposing the regulation and supporting the law, speculative capital distinguishes between the two in ways few philosophers of law could.

But how could the idea of dismantling laws that protected the common interests be sold to the public? The trick was in framing the issue “properly”, which is to say, emotionally, by personalizing it. Whilst originally the “common good” trumped individual interests, now the concern for the individuals was used as the pretext for discarding the rules for the common good.

Focusing on the individual is the secret and foundation of storytelling in which Hollywood excelled. So beginning in the early ‘70s, parallel to the rise of speculative capital, we see the appearance of Clint Eastwood as “Dirty Harry”, a sadistic and criminal cop who shot and tortured suspects but the audience was made to cheer for him because his actions were in defending the “rights” of the victims. A torrent of vigilante movies and “tough but fair” cops followed, all with a similar theme but progressively more violent and more lawless characters. The culmination of that trend is the current TV show “24” where torture is sold as advisable and even normal.

To what extent this indoctrination – now supported and reinforced by the radio talk shows, newspaper columns and the TV commentaries – has succeeded in making foul fair can be seen from the comments of Antonin Scalia, the justice of the Supreme Court of the United States about the fictional character of “24”.

Senior judges from North America and Europe were in the midst of a panel discussion about torture and terrorism law, when a Canadian judge’s passing remark—“Thankfully, security agencies in all our countries do not subscribe to the mantra ‘What would Jack Bauer do?’ ”—got the legal bulldog in Judge Scalia barking.

The conservative jurist stuck up for Agent Bauer, arguing that fictional or not, federal agents require latitude in times of great crisis. “Jack Bauer saved Los Angeles. … He saved hundreds of thousands of lives”...

The real genius, the judge said, is that this is primarily done with mental leverage. “There’s a great scene where he told a guy that he was going to have his family killed,” Judge Scalia said. “They had it on closed circuit television—and it was all staged. … They really didn’t kill the family.”

Jack Bauer saved Los Angeles. He saved hundreds of thousands of lives!

These words about a fictional TV character from someone charged with interpreting the U.S. Constitution.

(Read the last paragraph again and pay attention to the tone, narrative, the use of “great scene” and the way Scalia articulates what he has seen on TV: “There’s a great scene where he told a guy that he was going to have his family killed. They had it on closed circuit television—and it was all staged. … They really didn’t kill the family.” If this quote is accurate, the man’s mental capacity can be no more than that of a 7-year old.)

It is within this environment that Bernanke’s throwing out the rule book “to save the financial system” was sold to the public as a heroic, albeit slightly unconventional, act – in the manner of Jack Bauer saving Los Angeles from a nuclear attack. The president had little choice. They had him on the run with the same rhetoric and a not-so-subtle threat, in case he did not get the hints:

A top White House official said Mr. Obama had decided to keep Mr. Bernanke at the helm of the Fed because he had been bold and brilliant in his attempts to combat the financial crisis and the deep recession ... Some analysts caution that the economy is still so fragile that financial markets would react badly if President Obama decided to install new leadership at the Fed anytime soon.

“He’s the best person for the job,” John Makin, a senior fellow at the American Enterprise Institute, said of Mr. Bernanke. “Why would anyone want to change the Fed chairman now?”

Why, indeed. That would be like changing Superman just when General Zod had broken into Daily Planet.

Three questions remain. One concerns Bernanke’s boldness. One of the main criticisms directed at Ibsen’s feminist manifesto, A Doll’s House , is Nora’s quantum psychological leap that takes her from being a “silly bird” of a housewife to a woman able to leave her husband – all within the span of 48 hours. The criticism is a valid one. In real life, people who have been meek all their lives would not disturb a comfortable status quo to face uncertainty and danger. How, then, did a meek academic, whom the New York Times described as “a quiet and often unprepossessing person” – and was installed at his position because of those qualities – become so bold so as to throw out the Federal Reserve rule book?

The second question is, how did he know what he was doing, after he had tossed out the rule book, was the right thing to do?

Finally, who was behind Bernanke? Who promoted and passed him off as a bold and revolutionary thinker and doer?

The answer to all three questions is: speculative capital.

Among the official press, the New York Times alone sensed the need to explain the source of Bernanke's uncharacteristic courage; it implied it came from the firm conviction of knowing the right way, itself the result of first-rate scholarship.

Mr. Bernanke was a leading scholar of the Depression who had broken important ground on the links between financial crises and the real economy. In his work on what he called the “financial accelerator,” Mr. Bernanke argued that a run on banks or other disruptions in financial markets could turn a relatively mild downturn into a severe one.

In truth, the quality of Bernanke's academic work is on par with his academic peers: overdone on technical details, dreadfully shallow, almost childish in depth. Here is a single, albeit telling, line from one of his main speeches just before the onset of the financial collapse that shows his grasp of finance.

As emphasized by the information-theoretic approach to finance, a central function of banks is to screen and monitor borrowers, thereby overcoming information and incentive problems.

The central function of banks is to screen and monitor borrowers – this according the “information-theoretic approach to finance”, which he approvingly quotes.

The same year that he spoke of this central function, the U.S. banks sent 5 billions credit card offerings to about 112 million U.S. households – roughly about one credit card per week per household. That is screening borrowers for you.

Bernanke knows finance no more than Scalia knows law – or the reality.

So, no, it was not Bernanke’s knowledge that showed him the way and the strength to act. It was the demand of speculative capital.

Speculative capital is constantly in motion. Whether in expansion during “economic growth” or in retraction during crisis, it naturally finds the most profitable path for itself. Because the public at large has been made to see the events from the viewpoint of speculative capital, the path that speculative capital chooses appears as the only viable, logical option. Alternative options, if they are noticed at all, seem non-workable, irrelevant or radical.

In this way, the course of action becomes preordained and if the rules stand in the way, so much the worse for the rules.

In this environment, functionaries rise to fame. By virtue of unquestioningly executing the diktat of speculative capital, they are thrust upon the center stage as bold thinkers and doers – bold because they discard the existing rules. In doing so, they become the instrument of the destruction of the old system and the creation of a new one in which speculative capital holds sway even more extensively.

But speculative capital is self destructive. It destroys itself and the environment in which it operates, only that each phase of destruction is more intense and violent.

That is where we stand now. The “financial markers” seem to be gradually stabilizing but the Federal Reserve, in circumvention of all the laws and regulation that created it and defined its operations, is saddled with over $2 trillion of junk securities.

When a pilot deviates from the aviation rules or an accountant violates the accounting principles, the consequences are immediately clear. The consequences of the Federal Reserve issuing U.S. treasuries for junk is not immediately transparent. I will return to this topic in later entries and in Vol. 4.

In the mean time, Bernanke’s children and grandchildren will tell tall tales about how Grandpa Ben singlehandedly saved the world from the brink.

(Vainly) In Search of an American Godard

Had I not mentioned Godard a few weeks back in this blog, I would have ignored the comments of A. O. Scott, the chief film critic of the New York Times, about John Hughes being “our Godard”. But I had, and there he was, writing a posthumous review about a director that he said was the “auteur of teenage angst”.

Especially for those of us born between the Gulf of Tonkin Resolution and the Bicentennial, the phrase “a John Hughes movie” will instantly conjure a range of images, including the smooth, pale faces of a bevy of young actors.

But I don’t think I’m alone among my cohort in the belief that John Hughes was our Godard, the filmmaker who crystallized our attitudes and anxieties with just the right blend of teasing and sympathy. Mr. Godard described “Masculin Féminin,” his 1966 vehicle for Jean-Pierre Leaud and Ms. Karina, as a portrait of “the children of Marx and Coca-Cola.” Mr. McCarthy and Ms. Ringwald, in “Pretty in Pink,” were corresponding icons for the children of Ronald Reagan and New Coke.

Note the pretentious reference to the Gulf of Tonkin Resolution. It is meant to give the discussion a political bent. Scott could have easily said “Kennedy assassination” or the mid 1960s; a few years would have made no difference in a time line that was intended to establish a generational reference point. But he says “Gulf of Tonkin Resolution” that, for those who know, stands for government duplicity – an outright lie in order to escalate a war.

Why is he saying that?

Because Godard is political. But not one in 10,000 adults in the U.S. who came of age during the Gulf of Tonkin Resolution have heard of it or know what it signified. The proof is Scott’s own writing. Look, for example, at his analogy, meeting Godard’s witty, immediately-accessible contrast of Marx and Coca-Cola with a meaningless and nonsensical contrast between Ronal Reagan and New Coke. The man knows nothing about Godard or his work.

John Hughes was the director of this generation. Breakfast Club, his magnum opus, is a sophomoric and pretentious movie about mall rats – all white, of course – whining about their “angst”.

So, why mention Godard at all? Why not just compare Hughes to say, Spielberg – John Hughes was the auteur of teenage angst the way Spielberg is the auteur of extraterrestrial angst.

The answer is that the lack of a U.S. Godard is embarrassing. Scott invokes Godard’s name in the same spirit that the New York Times writes about “New York intellectuals” and finance professors speak of Modern Finance Theory. These are things that one wishes existed because their absence is embarrassing.

But they do not exist. American Godard, New York intellectuals, Modern Finance Theory – where they ought to be, there is a big hole.

I cannot do too much about the other holes. But I intend to plug the one about finance theory.

Meanwhile, let me know if you are looking for a good movie. I fancy that I know a thing or two about movies.