Sunday, December 19, 2010

High Frequency Trading and Flash Crash – 3: How the Die Was Cast

Nathan Rothschild, head of the family’s London branch, had an agent in the Battle of Waterloo. Upon seeing that the tide of the war was turning against Napoleon, the agent rode to nearby Brussels and hired a sailor for the unheard sum of 2000 francs to take him across a stormy Channel to England and his boss. With valuable intelligence at hand, Nathan rushed to the London Stock Exchange and feigned selling. The crowd followed, on the belief that Wellington had lost. After the share prices had collapsed during the selling frenzy, Nathan Rothschild began buying, making millions.

Whether this is a true story or a legend is not the point here. The point is ethics.

No, I am not talking about Nathan Rothschild. Good for him, I say. If the goyims were slaughtering one another over money, why shouldn’t a Jew make few a pounds from the mayhem?

The question of ethics pertains to the Rothschild agent. What would you say if he had used a mule instead of a horse, or had waited for a “scheduled” ferry and calmer seas?

Why, such willful delaying tactics would amount to sabotaging his mission. That would be treason, a crime punishable by death at wartime.

Imagine now, if you will, that the Rothschilds had an equally sharp rival family. We call them Rosenzweig.

The Rosenzweigs, too, considered war a man-send opportunity for making handsome profits, but they could not place an agent in Waterloo. What they did, instead, was place a jockey with a fast Arabian horse at the ferry stop on the English side. They instructed their jockey to take a peek at the open message that the Rothschild agent was carrying and rush to the Rosenzweigs with that information ahead of Rothschild’s man.

The scenario is a bit contrived (for a really contrived scenario you have to read Friedman’s “government helicopter” dropping money on the rabble), but you see where I am going with it. Would the ethical dimension of the story change if the Rothschild agent had used a steamboat instead of a sailboat, or if the Rosenzweig man had used a car instead of horse, or one of them had used a cell phone to pass the message along or traveled with the speed of electrons?

These progressively faster means of “getting there” take us in principle from Waterloo to high-frequency trading (HFT).

In principle, but not exactly. That is because in HFT, the dialectical law that the accumulation of quantitative changes results in a qualitative change kicks in and creates a situation with its own peculiarities; there is a long way from the one off stunt of an ear-to-the-ground businessman to the way HFT works in modern, decentralized exchanges. But I started from a technical angle to show that “getting there first” – because there is money to be made from speed – is the driver of both scenarios and the sole purpose of the game. The “fairness” issue – as in the HFT not being “fair” to “others” – is a fig leaf to cover the self interest of those critics of the HFT whose interests the practice threatens. Long before the rise of HFT, brokerage firms touted their fast execution capabilities – like how news organizations tout their speed in covering “breaking news” – as a competitive advantage and selling point. It was only a matter of time before competition and technology would push the speed to its physical limit. That time having arrived, we could now focus on the financial aspects of HFT.

The practical man of finance who started the stock exchanges on both sides of the Atlantic knew that bringing buyers and sellers together, the way it is done in a flea market or a bazaar, would not in itself be sufficient for creating a viable exchange. That was only the first step, a necessary but not sufficient condition.

Why and how a stock exchange is different from a flea market or a bazaar is a relatively advanced topic in economics and finance theory. The space limitations of a blog preclude me from delving into it in detail. But I cannot give the subject a short shrift because its understanding is a condition for understanding HFT. Consider what follows a compromise.

A stock (share in the UK) is a security. A security is the evidence of ownership of notional capital.

Imagine an aspiring entrepreneur who approaches 10 people and raises $100,000 from each for a venture to produce widgets. He gives a receipt to each contributor.

After the completion of the fund raising, the entrepreneur has $1,000,000 in cash. The balance sheet of his corporation (which he has set up to produce widgets) would show $1,000,000 cash under Assets and 1,000,000 under Owners Equity. Separately, each one of the 10 people have a receipt indicating that they have given the entrepreneur $100,000.

Afterwards, the entrepreneur goes to work. He rents a space ($100,000), installs tools and machinery ($500,000), buys the raw materials ($200,000) and hires workers ($100,000). He keeps $100,000 cash for operations.

After these activities, the value of his company’s assets remains unchained at $1,000,000. But the composition of assets is different. Cash is used to buy the components of the production apparatus that will create the widgets. We could say that it is converted into those components. The conversion turns:
  • The original $1,000,000 from money into capital.
  • The people who gave money into investors.
  • The receipts in investors’ hand into securities.
From here the definition of a security as the evidence of ownership of notional capital follows. Capital is notional or imaginary because it is already spent. If one of the investors has a change of heart at this point and wants his money back, he would be out of luck. The entrepreneur would remind him that his $100,000 is already spent – converted into the elements of production. What is more, it is impossible to determine which 10% of the total enterprise belongs to a particular investor. All $100,000s were combined to create a synthetic, organic whole.($100,000 cash is as much a necessary part of operations as wages and the raw material). That, of course, was the plan all along: to spend the money in a precise, purposeful manner which would make it capable of producing profit. It is to this profit that the holder of the security is entitled on a pro rata basis.

System-wide, though, the situation of the investor who wants his cash back is not hopeless. The economic system that creates stocks also creates stock exchanges precisely for that reason: for investors to sell their securities to other investors. The mechanism merely replaces the title of the ownership of the capital but otherwise leaves it undisturbed in the production process.

That is how the stock exchanges are different from a flea market or bazaar. In the latter places, the participants are consumers and producers and what is exchanged is a commodity – worked matter, generally.

In a stock exchange, the participants are capitalists. They are not buying and selling commodities but converting one form of capital into another.

The change of forms of capital signifies movement, which is the defining characteristic of capital – in the same way that breathing is the defining characteristic of live creatures. Yet, it remains unknown to professors and bankers. That is one reason for their profound and often embarrassing ignorance of events taking place around them.

Note, for example, what happens after the widgets are produced. The composition of the company’s balance sheet changes again, reflecting another change of form of the capital. Under Assets, raw material is reduced and the tools are depreciated. But there is now a new item: widget inventory. The widgets are produced and ready to be shipped.

To keep his factory working, our entrepreneur must begin a new cycle of production. He has to buy raw material, pay the rent, pay the workers and also pay the investors. But no one wants to be paid in widgets. They all want money, which means that he must sell the widgets. That is, he must convert his capital from commodity form into money form.

It is no exaggeration to say that, unless you are reading this in a remote village, everything you see around yourself is shaped by that process. A full chapter in Vol. 4 deals specifically with that topic. As a pitch for the book, but also as further background, let me quote a few paragraphs:
During production, the entrepreneur was in full command because he had paid for, and therefore, owned, everything within in the production process. Now, the sale must be affected by buyers – outsiders over whom he has no control.

It would be saying too much to say that like the Blanche DuBois character, our entrepreneur depends on the kindness of strangers to sell his widgets. No hawker of goods ever sat completely passive. Throughout the millennia, the craftsmen in the East and West have used various venues, with varying degrees of subtlety and aggressiveness, to attract buyers. The techniques in all forms revolved around a two prong strategy that is intuitively obvious to a seller: being noticed by the potential buyers and then actually “closing the sale” against the energetic pitch of competitors. The idea of bazaar that exists in one form or other in all early communities, is the practical realization of the strategy to bring all the buyers into one place, to affect what in the modern retail business is called “foot traffic.”

An entrepreneur of the 21st Century, where Capitalism reigns supreme in much of the world, must go beyond these passive measures. He has to actively seek buyers and then entice them to buy his product as opposed to the products of his competitors who claim to offer superior or cheaper alternatives.

Every entrepreneur begins the venture by asking probing questions about the sales prospects of the product he is planning to produce: Will it sell? Who would be the buyers? How long will they continue to buy? What price would they be willing to pay? Who are the competitors?

These are the intuitive and obvious questions. But the complexity of the modern markets demands more than an intuitive approach. It demands a systematic and methodical analysis of the markets, with the goal of turning the subjective, intuitive lesson of selling into a “science” with principles. Hence, the advent of marketing which, alongside finance, is the core subject of all the business schools.


Advertising is the ‘art’ of ‘effecting sales’. Note that there is no reference here to the product. Advertising is the means affecting the sales of any product. In the eyes of a salesman, houses, nuclear waste, electronic gadgets and plots of cemeteries are all products to be sold. Only the sales pitch varies, depending on the product and circumstances. In this way, in advertising, the fundamental, which is the product, becomes an incidental, to be addressed through the manipulation of the form, which is the way the product is promoted. The fundamental is the conversion into money of whatever that is being sold.


On the surface, “affecting sale” pertains to the product, but its target is in fact the buyer. It is the buyer who must be persuaded to part with his money in exchange for the product. What we have in “affecting sales”, therefore, is influencing the behavior of potential buyers – making them buy a product which they would not have otherwise bought. When the focus thus shifts to the buyer and the ways of influencing his behavior, it matters little whether the product serves a real need. If the advertising can create the need and persuade the customer to act on it, the goal of the exchanging product for money is accomplished.
Returning to our entrepreneur, if he cannot sell the widgets, the cycle of capital’s circulation, involving re-ordering raw material, extending the lease, keeping the workers, and distributing profits to investors, would be interrupted. That would translate to a crisis, a phenomenon whose analysis is beyond our subject. I merely note that while commodity-to-money form of capital’s transformation is the most intuitive and immediately accessible, the other forms and the ease of their transformation into one another are no less important in preserving capital’s cycle.

The practical businessmen who started the exchanges did not know these theoretical fine points but they did not have to, in the same way that a six year-old who rides bicycle need not know about the preservation of angular momentum that keeps the bicycle on two wheels.

The businessmen realized that a stock is a title and claim to future steam of incomes. Future profits being inherently uncertain, an element of speculation is always present in stock prices. At times, that aspect of stock trading could get out of hand and disrupt the “equilibrium” of the supply-demand. Under such conditions, the relation of the stock prices and the underlying physical reality of capital could be severed, as it happened in 1907’s Bankers’ Panic.

Then, J.P. Morgan prevented a collapse by ordering wholesale buying of stocks. But the crisis showed the need for a formal mechanism to stabilize the market. Markets were outgrowing the capacity of one individual or firm to control them. That experience led to the establishment of the Federal Reserve in 1913, an institution whose central mission was to act as the “lender of the last resort”.

The Fed was about lending and borrowing money. The stock exchanges needed a buyer and seller of last resort. So it came that the “specialist system” was established in the New York Stock Exchange. Each specialist was assigned a group of stocks in which he had to “make market”: bid for the shares of those who wanted to sell, and offer the shares to those who wanted to buy. Buyers and sellers could not trade with one another the way they did in a flea market. They had to go through the specialists.

Later when the Nasdaq market started, the same function was duplicated there, only in Nasdaq, the title was “market maker” and they were typically the arms of the Wall St. firms such as Goldman, Lehman and Merrill Lynch.

You can see the centrality of the specialist position and how lucrative and privileged it was. Profits were virtually guaranteed. An IBM specialist, for example, would buy the stock from A for $40.125 and sell it to B at anywhere from $40.25 to $40.625. A change in the stock had generally no impact on specialists’ profits. He could maintain the same “spread” between bid and offered prices if that stock rose to $43 or fell to $38. Assuming a daily volume of 200,000 shares, that translated to about $100,000 a day.

Sure, occasionally stocks went south and sell pressure forced the specialists and market makers to dip into their own capital and buy stocks where no other buyer was present. But these instances were few and far in between.

Far more important, the specialists could see the overall buy and sell orders for a particular stock and position themselves accordingly; they could buy for their own account if they saw a strong buy order or sell if there was a sell bias in the market. That is “front running” which has always been illegal. Occasionally a few small time brokers were charged with the practice, but it was virtually impossible to prove or enforce it in the case of specialists and market makers.

Then came the Crash of ‘87. On that fateful October day, as the unprecedented sell pressure mounted and the buyers disappeared, specialist and market makers refused to accept orders. In fact, they refused to answer the phones. And then, they walked out. They had little choice. Their capital was close to exhaustion, with no end to selling in sight. At 3pm on October 19, 1987, no one dared to buy because there was no telling how much further the stock prices could drop. The normal functioning of the market had broken down.

There is a large number of books, reports and studies on the cause of the crash of ‘87. Not a single one of them got the story right. You could not get the story right without knowing speculative capital. Quite a few mentioned “program trading” as the cause of the crash without realizing that “program trading” and its cousin, “portfolio insurance” are the particular manifestations of speculative capital. The rest offered drivel. Here is what Michael Steinhardt, a hedge fund manager who had become the all-purpose commentator on the markets, said: “The stock market is supposed to be an indicator of things to come, a discounting mechanism that is telling you of what the world is to be. All that context was shattered. In 1987, the stock-market crash was telling you nothing.”

Was he wrong! Oh, boy, was he wrong! Never was the stock market so prophetic. But how could a moneyman realize that the stock market was signaling the collapse of the stock exchange system – its destruction under the onslaught of speculative capital? That is what specialists and market makers leaving their posts signified.

Sunday, December 12, 2010

High Frequency Trading and Flash Crash – 2: A Philosophical Prelude to Part 3

I sat down this morning to write the second and final part of HFT. I knew how the piece was going to end. It would end on a note of uncertainty and low-grade despair, that “nothing to be done” condition familiar to Beckett readers.

But the dialectics of finance is precisely about going beyond the passive acceptance of events just because they are, to influence and shape them. The inconsistency between the seemingly resigned ending and the active world view that drives the dialectics of finance called for an elaboration.

To purposefully shape events, we must know their dynamics and understand why and how they occur. A financial crisis, for example, has its roots in finance. Saying that the lenders’ stupidity or the borrowers’ greed caused it is saying nothing. After such “explanations”, the erudite explainers shake their head at human folly and go their way, leaving the subject exactly where they had found it. To understand the events, we must take them as they develop “on the ground”. Hegel’s assertion that what is real is rational shows us the way to proceed.

To Hegel, the real is what has happened; historical if it involves humans, natural, otherwise.

Rational involves reason and reason involves necessity.

Hegel is saying that what has happened: i)had to happen; and ii)[for that very reason] it can be logically explained.

The critical point in all this is that the “had to” part refers to the internal dynamics of the phenomenon and is defined within its confines and boundaries. There is “nothing to be done” only with the available (including permissible) means within the situation, because those means are either the results or the conditions of the situation in the first place. A cancer-ridden body cannot in itself fight cancer because it is the source of the cancer. The help must come from the outside in the form of dietary change, surgery or chemical intervention.

Far from being a passive justification of the status quo, “what is real is rational” is a call for knowledgeable action – “praxis” in Sartre’s terminology – when the “rational” proves undesirable.

Let me elaborate on this abstract point through an example from the ongoing mortgage/foreclosure mess.

Take a bank – Bank of America (BoA) would be a good example – with a large mortgage portfolio. As part of a CDO securitization, the bank sells 1000 of those mortgages to a Wall St. firm, say, Morgan Stanley. I described the process in the Goldman Case.

Borrowing money to buy a home is a process that must satisfy a variety of legal requirements, which is why the buyers must sign a thick batch of documents on the closing day. One of those documents is the “mortgage” which authorizes the bank to auction off the property and take its money in case of the borrower's default. Another document is the promissory note, which is the evidence and proof that the home buyer has borrowed money from the bank. Yet another document is the title insurance that guarantees that the home is the property of the seller and is now being transferred to the buyer and there is no dispute in that regard. With the rest, we are not concerned here.

Now, attention! Did the bank – the BoA in our example – transfer the notes to Morgan Stanley as part of the securitization process?

This is not a trick question. It does not involve gray areas, competing narratives, conflicting viewpoints and personal interpretations. Like the question of pregnancy, it is the quintessence of a binary question with a only ‘yes’ or ‘no’ answer.

If yes, if the bank did transfer the notes to the trustee and the CDO originator, then it does not have the notes, which means that it cannot foreclose on home buyers who are in default. The first step in seeking judicial relief from a court in relation with a claim is proving the claim. No proof of indebtedness, no case. Period.

If the bank did not transfer the notes to the CDO originator, then the originator – Morgan Stanley, in our example – never owned the mortgages. In that case, the securitization would not have been legal, with almost mind-numbing implications. For example, the originator would have the right to put the mortgages back to BoA. With the mortgages anywhere from 30 to 70 percent underwater, that would wipe out BoA many times over.

It is tempting to ask, Which one is it, then? But that is a sophomoric question concerned with winning a point. Hegel teaches us to look at the facts on the ground for understanding . From the National Mortgage News under the title B of A Disowns Its Own Lawyer's Argument in Fumbled Mortgage Case:
To quell doubts about its mortgage unit's handling of documents, Bank of America Corp. is distancing itself from … itself.

B of A now says that a senior litigation manager .. was out of her depth when she testified in a New Jersey courtroom about the unit's document practices ... In a series of unforced admissions, the B of A manager ... and ... the company's outside attorney described how Countrywide had failed to adhere to the most rudimentary of securitization procedures, such as transferring the original promissory note to the trusts that had purchased the loans, as required under the pooling and servicing agreement.

Both ... said it was standard practice for Countrywide to hold onto the original mortgage notes ... despite securitization contracts that require the notes be physically transferred to sponsors, trustees or custodians.
There! So the original mortgage notes were not transferred to the CDO trustee. But the CDO trustee had sold those notes to public and private funds. Who owns the promissory notes and, more to the point, how the title insurance company handles the title insurance?

From the Financial Times of November 29, under the heading US courts battle with backlog as foreclosures rise:
Florida’s legislature assigned $9.6m earlier this year to set up special foreclosure courts, labeled “rocket dockets”, with the aim of paying retired judges to clear 62 per cent of the backlog by next July.
The article reported that in a 3-month period between July 1, when the money was allocated and September 30, 65,000 cases were “cleared”. It added:
It is a truism that justice delayed is justice denied, but some say that high-speed courts are themselves risky and have an inherent bias towards the banks. “The system is designed to tilt towards the plaintiffs; the easiest, fastest, cleanest way to do this is to just grant summary final judgment and award the properties to them,” says Chip Parker, a lawyer who defended homeowners in Jacksonville.

Lawyers such as Mr Parker allege that these courts show leniency towards the sloppy bookkeeping of the banks, but crack down on homeowners who are ill-prepared.
What “sloppy bookkeeping” are the lawyers talking about? We just saw that the promissory notes were not transferred to the CDO trustees, so the banks could technically foreclose because they were holding the notes.

But often banks cannot locate the notes despite their claims to the contrary. That is the robo signing that you have been reading about.

Mr. Parker the lawyer told FT: “Countrywide was not the exception. Countrywide was the rule. Everyone did it that way, showing that securitization was never done properly.”

He then added: “After this, the judges in foreclosure cases are going to have to start ignoring massive systemic violations of law in order to grant foreclosures … Do we save the financial markets and sacrifice the rule of law? You can’t save both, you’ve got the sacrifice one for the other.”

The rule of law or the financial markets: only one can be saved. One has to choose.

Now you see the source of my interest in the breakdown of law. Starting from the very first post, O Judgment!, I have frequently written on the subject. See here, here, and here, for example.

The breakdown we are witnessing is pervasive and systematic. The Florida bankruptcy courts are merely following a trend set by the Supreme Court and the Federal Reserve.

Law is a mechanism set up to prevent social conflicts and antagonisms from being settled by force – or turning violent. As every thug knows, violence might be a necessary tool in the early stages of establishing a business, but it later becomes unnecessary and even detrimental to the business.

When the established legal system in a society is violated from the top, it is a sign that the dominant institutions of the society cannot continue business as usual under the relations that they themselves had drafted. These institutions force for even more favorable conditions which, through one off court decisions, ad hoc rulings and laws tilted towards the defendants translates in practice to lawlessness.

All these developments are rational. They all develop logically from the inner workings of the system. And they all gradually move the system towards instability and collapse.

HFT is one such development.

Monday, November 29, 2010

The Ultimate Retail Business Model in the U.S.

Today’s American Banker had an article titled What YouTube Teaches Banks About Customer Experience.

I do not know what YouTube teaches banks about customer experience. But I know what the iPhone and iPad have taught swindlers – hence the connection between the business and crime.

Apple’s business model is to provide cheap apps to a large number of users; about 250,000 apps to over 10 million users. You pay a few dollars for an app that often performs magnificently. Everyone is happy. You, because you got a good application at a next to nothing price, the vendor, who sold tens and maybe hundreds of thousands of apps, and Apple, which gets a cut from all this. The trick is the low price and large volume – the ultimate retail model.

Imagine now that you are a big company with a large number of customers and you go rouge: you begin to charge them a few dollars each month for no reason. Would anyone complain or notice? And if they did, would anyone have time to spend 45 minutes on the phone with “Mary” in Bangladesh to clear a $2 charge?

Exactly. (And if someone complains, refund their goddam few dollars.) So you get to make tens of millions of dollars a month swindling customers and hoping not to get caught.

How does this model work in practice? Click on the following links for the answer. You don’t have to read the articles. Just glance at the heading or the lead paragraph.

Click 1

Click 2

Click 3

Click 4

These are mere samples. Spend a few minutes goolging “class action lawsuit and telecom” and you will be surprised at the pervasiveness of the fraud.

Now comes the punchline: click here to see why your government has 3 branches and why the Supreme Court exists.

Friday, November 19, 2010

An Essay On the Emergence of India

During his recent trip to India, President Obama said that India “it not simply emerging. Indian has emerged”.

I concur in principle. But I am not the president of the United States and my assertions will not be accepted as proof. So, I am writing a short essay to explain my concurrence.

In the simple sentence India has emerged, we have no problem with India. The reference is clear and universally understood. But the “has emerged” part is vague because it is obviously metaphorical; as a large country, India was never hidden or submerged. I must then explain: i) what does emerge mean in the context or, to put it differently, in what sense can a large country “emerge”; and ii) what is the evidence that India in practice has accomplished the task, or fulfilled the requirements, of emerging.

Recall that capital takes social relations as it finds them and then, over time, turns them into capitalistic, i.e., transaction based, relations. The transformation is alternatively heralded as “improvement”, “reform”, “modernization”, “progress” and “development” – all words with positive connotations because the yardsticks of judgment are shaped by, and thus favor, capital-based relations.

Take modern. The word is nothing but a reflection and measure of the extent of the intrusion of capital into social relations, a point that Chaplin noticed and relayed in Modern Times. The more the intrusion, the more modern a society is said to be.

To make this point clearer, look at Cavallini’s 1290 painting, The Last Judgment.

Now compare it with Holbein’s 1533 painting, The Ambassadors.

The span between the two works is a mere 240 years. Cavallini’s work, furthermore, belongs to the Renaissance period which immediately preceded modernity. Yet, a sea change has taken place between the two. The Last Judgment looks “old” to us, with an unmistakable undertone of otherworldliness.

The Ambassadors, by contrast, is contemporary and modern. The two men confidently gazing at us could be models posing for a fashion journal in New York City.

The difference, as I previously remarked, is in the transformation of European society from the feudal to capitalist system. The Ambassadors are surrounded by a collection of valuable, traded commodities with the means of navigation symbolizing overseas trade. To capture all that, Holbein is forced to use the oil medium in the same way that modern advertisers use color picture: to accentuate the colors and fineness of the men’s wealth, including their wardrobe. Their pose and gaze is the pose and gaze of successful men of affairs, something that we see everyday in the business section of newspapers. That is why The Ambassadors looks modern to us.

Emergence has the same genealogy. The more capital-based relations intrude into the social fabric of a country, the more “emerged” it becomes. When even the far away villages are conquered in this way, the country can be said to have fully emerged.

Before taking up the case India, though, let us read this short passage from Vol. 3:
This confusing of moral, legal and financial is a common error among those looking at the appearances only. Here is the economic columnist of the New York Times [Paul Krugman] injecting morality into the subject of default: “Advanced countries – the status to which Argentina aspires – regard default on debt as a moral sin.”

In truth, “advanced countries” hold no such view. In the U.S., corporations use bankruptcy for a variety of strategic and tactical reasons – most commonly when they plan to renege on their pension liabilities. More fundamentally, in the Anglo Saxon jurisprudence, there is no inherently immoral or forbidden concept, of the kind one finds in religion. The foundation of this jurisprudence is the commercial consideration of the early stages of capitalism in England.

The “moral aspects” of default about which columnists and scholars of law are in the habit of sounding off are the indignation of the owners of capital at the prospect of losing their money. Because their views and interests set the social and cultural agenda, this view is gradually codified through casuistry and given a moral and ethical cover – and sold to the public as such.

Default is an incident in finance. Starting from the primitive societies in which “recalcitrant debtors … could be put to death and even hewn in pieces by their creditors or sold as slave beyond the Tiber” we arrive at Shylock at the dawn of capitalism who demands a pound of flesh in lieu of his money. His demand, nota bene, is legal, written into an enforceable contract. More humanitarian imprisoning of delinquent borrowers then follows, a “remedy” still in practice in many societies. As commerce develops, usury is recognized as impediment to business and outlawed. But the usurer continues to exist in the margins of the society, supplying the “weak credit” with funds and using various loopholes of the law to enforce payment.

As financial markets grow in size and sophistication, they take on the subject of default – itself a subset of credit risk – peel its social shell and turn it into a tradable commodity. The process begins with the most receptive and “logical” markets such as corporate bonds, where the relative value of credit and the possibility of default are an integral part of pricing; “cost of default” has long been a staple of this market: “Mr. Goldman [a fixed income strategist] says that a corporate bond’s interest rate spread over the government bond curve is the cost of issuer’s option to default.” Shaming, like jailing and maiming, is still used as a way of reducing defaults.

When I was writing these lines in 2005, microfinancing – lending a few hundred dollars to poor peasants to turn them into successful entrepreneurs – had captured the imagination of social reformers as the practical side of Mother Teresa’s dispensing of love to the poor. Its promoter, Muhammad Yunus, received the Nobel Peace Prize in 2006.

I was struck by the shamelessness and the absurdity of the idea. In the Inferno, the sinners’ physical deformities correspond to the kind of sin they have committed. I imagined that had there been a paradise with the same logic of reward, Mother Teresa and Muhammad Yunus would be present there, one with a large bleeding heart, the other with an oversized penis, both overlooking the wretchedness of the earth.

Five years later, the verdict is in, as reported in today’s New York Times:
Initially the work of nonprofit groups, the tiny loans to the poor known as microcredit once seemed a promising path out of poverty for millions. In recent years, foundations, venture capitalists and the World Bank have used India as a petri dish for similar for-profit “social enterprises” that seek to make money while filling a social need. Like-minded industries have sprung up in Africa, Latin America and other parts of Asia.

But microfinance in pursuit of profits has led some microcredit companies around the world to extend loans to poor villagers at exorbitant interest rates and without enough regard for their ability to repay. Some companies have more than doubled their revenues annually.

Now some Indian officials fear that microfinance could become India’s version of the United States’ subprime mortgage debacle, in which the seemingly noble idea of extending home ownership to low-income households threatened to collapse the global banking system because of a reckless, grow-at-any-cost strategy. Responding to public anger over abuses in the microcredit industry — and growing reports of suicides among people unable to pay mounting debts — legislators in the state of Andhra Pradesh last month passed a stringent new law restricting how the companies can lend and collect money.

Government officials in the state say they had little choice but to act, and point to women like Durgamma Dappu, a widowed laborer from this impoverished village who took a loan from a private microfinance company because she wanted to build a house.

She had never had a bank account or earned a regular salary but was given a $200 loan anyway, which she struggled to repay. So she took another from a different company, then another, until she was nearly $2,000 in debt. In September she fled her village, leaving her family little choice but to forfeit her tiny plot of land, and her dreams.

“These institutions are using quite coercive methods to collect,” said V. Vasant Kumar, the state’s minister for rural development. “They aren’t looking at sustainability or ensuring the money is going to income-generating activities. They are just making money.”

Reddy Subrahmanyam, a senior official who helped write the Andhra Pradesh legislation, accuses microfinance companies of making “hyperprofits off the poor,” and said the industry had become no better than the widely despised village loan sharks it was intended to replace.

“The money lender lives in the community,” he said. “At least you can burn down his house. With these companies, it is loot and scoot.”
The last point is crucial. There was always a village usurer. But however hateful he was, he lived in the community and was a part of it. It was inconceivable for him to force a widower to flee the village. He would gain nothing from it.

With the bankers and venture capitalists as usurers – they charge 30% per annum – the indebted widower must flee. There are grand designs for her village.

Has India emerged, then? I must say that it has, in principle. But we have not heard the last of this story yet.

Tuesday, November 9, 2010

A Footnote to the Post Below

Using footnotes in blogs is awkward. It forces the reader to switch back and forth between the main text and footnote, an extra step that disrupts reading. Hypertext suffers from the same drawback.

In a printed page, the matter is easier, but only if the footnote is at the bottom of the page. With a quick movement of the eyes then, the reader can read the footnote and continue with the main text.

In my books I use footnotes in two ways: to provide the source for a material I quote and to buttress the argument I make in the main body of the text. In the post below, I pointed out that when capital cannot generate profits, it will have no reason to borrow money, even if the money is offered at no cost. Under that condition the focus shifts to cutbacks, including dismantling the plant and equipment.

If I were writing that in a book, I would have footnoted it with the following Financial Times story. Under the heading US banks see demand for business loans drop, the paper reported today:
Bank loan officers say that demand for loans from small US companies fell in the past three months, casting doubt on how much the Federal Reserve can stimulate the economy ...every bank reporting a decline in small business loan demand said that its customers had caught back on their investment in plant or equipment.

There was a decline in loan demand from larger companies as well, with 25 per cent of loan officers saying it had fallen compared with 18 per cent who said that it rose.
Does Bernanke know this? That is the subject of the concluding part of the Time Preference/QE series.

Sunday, November 7, 2010

Time Preference, Kim Kardashian, Quantitative Easing, Good Black Swan – 1 of 2

The depth, sophistication and musicality of Persian poetry is unmatched in any other language. Many of the great Iranian poets were believed in their time to have divine inspirations, so perfect is the fusion of form and content in their poems. And then there was the legendary spontaneity. A popular form of entertainment in the court or bazaar alike was throwing 4 impossibly unrelated words at a poet — toe, cow, ocean and Christ, for example — which he then used fil-bedaheh in a 4-line stanza to express an overlooked truth about life. Fil-bedaheh means on the spot, without thinking and contemplation. Such power I think had its roots in the poets’ philosophical and religious world view. If you believed that all things came from God, then all had commonalities, i.e., all were related. It was only the matter of perception of seeing the common link and the skill of putting them into a coherent whole.

The title of this post comes from that tradition, except that there is nothing fil-bedaheh about it. In fact, I made up the title after I had finished the piece, which is not quite the same thing! I, too, am a man of our time, writing in New York of 2010 where, like Ace Greenberg, everyone is looking for a little unfair advantage.


There is, in the standard economics theory taught to all freshmen, the notion of “time preference”. According to this conjecture, “people” — that would be all people: men, women and children everywhere — prefer “now” to “then”; they’d rather have $100 now than one year later. So if they wait one year to get the money, they would demand more, say $105, for their sacrifice. That is why interest rate exists! The difference between $100 now and $105 in one year is the 5% annual interest rate.


On Wednesay, the Federal Reserve announced phase II of its quantitative easing program (QE2), in which it will buy $600 billion of long-term U.S. government bonds over the next eight months. The idea behind QE2 is to “drive down interest rates and encourage more borrowing and growth”.


Gotcha, Ben Shalom Bernanke! Remember your Washington Post article, published just after the announcement of QE2 to soften the critics?
Easier financial conditions [by you pushing the rates lower via QE2] will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment.
Never mind that housing shows no sign of life. What is the story about lower corporate bond rate encouraging investment? You are saying that QE2 will spur growth because it will make money available to businesses now.

But if the rates are lowered, the time preference will be destroyed. That’s what you taught in your Princeton economics course. With zero or very low interest rates, there is no incentive to act now, because the difference between then and now is zero or very little. In that case, why would corporations choose to invest now instead of say, one year from now, huh? What do you have to say to that?


I believe in the narrowest interpretation of time preference: that in our mid to late 50s we tend to be more mature than third-graders. I know that it is not a general or inexorable law.


Between being hanged today and next year, people would choose next year. That is also true of having a colonoscopy, getting an eviction notice, losing one’s job and life's other unpleasantries. Why, the word procrastination would not exist if people always preferred “now” to “then”. But it does, thus pointing to the hidden hedonistic supposition behind time preference: it exists only in relation with acquiring and consuming pleasurable things. The mindset that conjures up time preference, in other words, is that of a Kim Kardashian or a Paris Hilton. The economists representing that mindset take the idea and dress it up in high language and mathematical notations for respectability. Paul Samuelson, whose name pops up whenever a vacuous idea comes up, was one of the most vulgar, and therefore the most outstanding, representatives of that lot. Look at the title of his paper and then read the drivel in the abstract to see what I mean.

Beyond empty-headed women and mountebanks, what gives rise to the illusion of time preference and helps sustain and institutionalize it is the commodity fetishism of a consumer society. That is why this moon-is-made-of-green-cheese nonsense that a first-grader could refute survives. No less than the “anti-establishment” author of the Black Swan divides black swans to good and bad groups. He calls Viagra a good black swan!

Here is a link to Wikipedia on time preference. Do not limit yourself to that site. Google “time preference” and take a look at some of the results — this one, for example, written by 3 inquiring minds from the nation’s premier institutions of higher learning — to get an idea about the level of scholarship and critical thinking in 21st century America.


There is no such thing as time preference in economics. Interest rates do not arise because humans prefer now to then. If that were the case, we would have billions of interest rates, corresponding to the subjective perception of every person on the planet. Quite the opposite: it is precisely because interest rate exists that time has “value”.

Interest is a deduction from profit. It is the share that finance capital claims from the profit of industrial capital. From Vol. 3:
When the rate of return of industrial and commercial capital falls, credit capital must likewise lower its rate. Otherwise, it would have to sit idle, having found no takers. Interest rates could indeed fall to zero and remain there for a long time if commercial or industrial capital cannot generate a profit. Under such conditions, they would have no reason to borrow, as borrowing would only aggravate the loss. In that regard, the Federal Reserve in the U.S. that raises and lowers interest rates to “cool down” or “stimulate” the “economy” merely reacts to market condition rather than shapes it.
These lines were written more than 5 years ago. What are the conditions now?


The industrial capital in the West has migrated to the East and South in search of lower labor costs and higher profits. (Capital has migrated, not its owners.)

Alas, the investment opportunities in the East and South cannot accommodate all the mass of ready-to-be-employed capital. So, a portion of capital in the West is left behind, sitting idle with no place to go.

That cannot go on. It cannot be allowed.


One way of generating employment opportunities for the idle capital is lowering labor costs in the West. If you are reading this in the Western hemisphere, everything you read in your local newspaper about economics and “politics” revolves around this issue. Cameron, Sarkozy, Papandreou, Zapatero, Cowen, Dombrovskis, even Merkel have no higher priorities. I have written about this issue. See, for example, here and here.

This idleness has a physical manifestation as well, but its most telling sign is the large pile of cash that corporations have amassed on their balance sheet.

Economics-professor-turned-the-Fed-chairman does not understand this process; at best he understands it superficially. He is trying to revive the activities of industrial capital by lowering the rates, fancying that with rates at zero or close to zero, the prospect of even low profit rate like 2% will induce corporations to borrow and invest. But the process is not reversible. Corporations cannot be induced to making investment – no matter how low the interest rates – if their investments would not generate income. That is why they have large spare, i.e., unused, capacity. Bernanke absent-mindedly admits that much when he writes that “low and falling inflation indicate that the economy has considerable spare capacity”. When corporations do not use the money they already have – because they cannot – what would they do with more money?


Corporations sitting on a large pile of cash which they cannot invest buy other corporations to benefit from “synergy”. That is the polite word for layoffs – hardly the stuff of economic recovery.


If QE2 will not influence investment decisions and economic recovery, what will it do?

Sunday, October 24, 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.

Monday, October 11, 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, October 5, 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, October 3, 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, October 2, 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.

Tuesday, September 28, 2010

Confused on Wall Street

According to the Wall Street Journal, “macro forces” in the market are confounding stock pickers. “Big-picture market movers like the economy, politics and regulation” frustrate the efforts of the best and brightest of the stock picture, the Journal informed its readers this past Friday. It said:
More and more investors aren’t bothering to pore through corporate reports searching for gems and duds, but trading big buckets of stocks, bonds and commodities based mainly on macro concerns. As a result, all kinds of stocks — good as well as bad — are moving more in lock step.
As proof, the paper interviewed several traders and fund managers, who said more or less the same thing.

David Pedowitz of Neuberger Beeman said that his efforts at stock picking felt “like an exercise in futility.”

James Bianco of Bianco Research said: “stock picking is a dead art [and] macro themes dominate the market now more than ever.”

Cindy Sweeting of Templeton said: “All stocks are moving in the same direction. I’ve spend three decades in this market, and it’s the most macro-obsessed I’ve seen in a long time.”

Hedge fund manager David Einhorn said: “The lesson that I have learned is that it isn’t reasonable to be agnostic about the big picture.”

Lou Gerken, a “veteran fund manager” who became so downbeat about stock picking that he decided to shut down his two stock funds, concurred, said that he “now is focusing on a global bond fund and spends his days reading macro-oriented publications.”

David, Jim, Cindy, Lou, the Other David, listen up now! What you have noticed is real: stocks do move in tandem. But there is more to the story. And it has nothing to do with the people’s “obsession”. It involves the dynamics of speculative capital. You’d need to read Vol. 1 of Speculative Capital. It is an easy book to read but it is not an airport novel; you have to pay attention to what you read.

Here are a few excerpts, to convince you that it has your answers:
Speculative capital is not bound to any one market or place. Rather, it is constantly on the lookout for profitable opportunities wherever it can find them. Upon finding such opportunities, it enters into these markets and, through arbitrage, “links” them together.

Arbitrage is buying relatively undervalued A and selling relatively overvalued B. This buying and selling will tend to increase the price of A and decrease the price of B. If A and B happen to be in two different markets, and if the arbitrage is systematic, sustained and occurs on a large scale, the linkage goes beyond the individual products and encompasses the markets themselves. Movements in one market are then transferred to other markets.

The linkage knows no limits in terms of markets. It can target two similar or approximately similar markets in the same country, two separate markets within the same country, two similar markets in two different countries or different markets in different countries.
The book then goes to examine the “linkage of the various segments of the national markets” such as bonds and stocks, and the linkage of international markets, with real-life examples.

As for “poring through corporate reports searching for gems and duds” being passé? It, too, was made passé by speculative capital a long time ago. Speculative Capital quotes the Wall Street Journal of December 16, 1997:
At BNP/Cooper Neff, stocks aren’t companies in the industry sector. They are “mathematical objects.” … [The company’s president] thinks studying news and financial reports … is a waste of time … And the only way to beat the market … is to trade thousands of stocks, by the millions of shares, in search of tiny inefficiencies … he sees the world as 7,000 stocks to trade against one another in one gigantic hedge fund.
Sound familiar?

But all this was the good news! David, Jim, Cindy, Lou and the Other David, wait for high frequency trading to become the only way of trading. You will look back at these years fondly, as perhaps the best years of your life.

Self destructiveness of speculative capital is not a potentiality, something that might or might not be realized. It is the logical, i.e., necessary, consequence of its form of its existence. Now I know that sounds confusing. But that is how speculative capital is, which is why attention must be paid whenever it is the subject of discussion.

Sunday, September 26, 2010

One or Two Things You Should Know About Larry Summers

That The Brilliant Larry Summers Will Leave the Obama Administration to Return to His Tenured Teaching Job at Harvard was the main economic/political news of the week.

The first thing you should know about Larry Summers is that he is brilliant. The New York Times uses the adjective brilliant before his name the way it uses president before Obama’s name: as a factual designation. Larry Summers is brilliant as Barack Obama is president. Through constant repetition, the brilliance of Larry Summers then becomes a matter of record; there is a double entendre in the New York Times being the “newspaper of the record”. The record thus having been established, it is passed to others to spread, reinforce and better it. Hence, Edward Luce of the Financial Times:
There is barely an economist in the world who would deny that Mr Summers has a bigger brain than they do.
Even Larry Summers’ critics must start by allowing for his brilliance: Although he is a brilliant economist ...

The second thing you should know about Larry Summers is that he is a tad abrupt, a bit difficult, and may, on occasion, even come across rude. To the New York Times, these are understandable reactions of a brilliant man who surely finds working with dummies frustrating, a genius with little patience with anyone bearing an IQ under 250.

Yet, what and where is the evidence of his brilliance? If you research Larry Summers’ contribution to economics, you'd come up empty handed. There is nothing the man has said, done or written that a dull mind could not produce. He looks more like a fool.

When he was the chief economist of the World Bank in 1991, he wrote an internal memo in which he argued for transferring the air-polluting industries to poor countries because life there was cheap and the pollution related death, therefore, would be more “economical”. He wrote:
The measurements of the costs of health impairing pollution depends on the foregone earnings from increased morbidity and mortality. From this point of view a given amount of health impairing pollution should be done in the country with the lowest cost, which will be the country with the lowest wages. I think the economic logic behind dumping a load of toxic waste in the lowest wage country is impeccable and we should face up to that.
At the end, he summarized his thoughts as only the writer of the memo could:
I’ve always thought that under-populated countries in Africa are vastly UNDER-polluted [CAPS in original], their air quality is probably vastly inefficiently low compared to Los Angeles or Mexico City.
In 1998, as the assistant secretary of Treasury to Bob Rubin, he testified – triumphantly and with satisfaction – on the destruction of the industrial policy programs in Japan and other Asian countries as a result of the financial crisis.
“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.”
The quote is from the Wall Street Journal of February 13, 1998, p. A2, under the heading “U.S. Presses Japan to Stimulate Economy”.

These two episodes tell you everything you need to know about Larry Summers. He is an intellectual thug, “intellectual” in the sense that he pulls words instead of knife. In his line of work, a reputation for brilliance helps; it is the intellectual equivalent of being known for carrying a sharper and longer knife. But all is a sham, and there is no there there.

Perhaps the aggressive, in-your-face way of belittling others and pushing his opinions – however wrong-headed and idiotic – runs in the family. Perhaps it is psychosis, this willingness to say and do anything to advance the narrow interest one is serving without any consideration for the “collateral damage” or the larger interest of the society. Whatever it is, Larry Summers is off to Harvard, where he will be educating the nation’s best and brightest for years to come.

Tuesday, September 21, 2010

The Fed, Idle Ships and Interest Rates

Today, the yield on the 2-year Treasury note hit the all time low of 46 basis points, or less than .5%

Traders talk about the bond bubble (it has a nice ring to it), quantitative easing (QE) or QE2 (the second round of QE. Got it?) They opine how bonds have become attractive in the absence of other investment alternatives, which is why their price is higher and their yield lower. (Never mind the contradiction in bonds becoming attractive while their yields are pushed lower.)

All that talk comes from the illusion that interest rate is a “thing” that the Federal Reserve sets – and everyone follows.

Nothing could be further from the truth.

Interest is the claim of finance capital on the industrial capital. It is a deduction from the profit, set through negotiation and supply and demand.

When profit opportunities are destroyed and capital cannot be profitably employed, it must sit idle, either in the form of unusable cash on corporate balance sheets or, more symbolically, in the form of idle ships.

Idle industrial capital cannot pay interest. In fact, it would have no reason to borrow. Hence the fall in the demand for loan capital and the subsequent fall in interest rates.

The Fed does not “set” interest rates. Rather, it takes note of, and acknowledges the prevailing market winds and adjusts the sails of the state ship accordingly.

Sunday, September 19, 2010

The Opinions That Men Hold

Two years ago Lehman imploded. I was in Alaska on that fateful week of September 15. It took a trip to Alaska for me to see What’s the Matter with Kansas.

That, as you may know, is the title of Tom Frank's 2005 book, in which he argues that through “push button” issues such as gay marriage and abortion, blue collar Kansans are systematically fooled into voting for rich Republicans and against their own interests.

That sort of manipulation is not new. European writers and historians have traced its wholesale adaptation to the outbreak of WWI which saw young men forced to march to the slaughter fields of Europe. John Berger argues that the abrupt end of Cubism had to do with the end of the optimism that the new century had generated but which WWI crushed.

Frank’s general thesis is not incorrect. Propaganda does play a role in shaping men's opinions even against their interests. But what happened to the observation that people in general vote with their pocketbooks? I doubt that the poor cannot see their own interests, no matter how incessant the brainwashing. I think something else, something more material, is at work there that I noticed during my Alaska trip.

Alaska is a desolate place. Living conditions are hard. Except for a few transplanted New Yorkers with “liberal” views, the native Alaskan generally believes that if “it” cannot be hunted, drilled or mined, it is not worth having around. Concern for the environment, wild life protection and the like take a back seat to the daily challenges of survival. Self preservation trumps such concerns, as it perhaps should.

The immediate concern for survival is the instinct of primitive species and savages. As man learns to exploit nature and his material conditions improve, day-to-day survival ceases to be of immediate concern. He then has the luxury of turning his attention to broader issues and longer horizons. That luxury is a defining characteristic of civilization, what separates the civilized man from the savage.

In the U.S., tens of millions of people live under such “primitive” conditions. In places like Alaska, the extreme weather exacerbates the situation. But the commonality of distress in all 50 states that transcends the natural conditions alerts us that the root cause is economic. The daily struggle for survival is not less intense in Kansas and Virginia than in Alaska.

The existence of these “pockets” of poverty in rich, industrial countries is the evidence of the failure of the social system, plain and simple. It is the failure to raise the living standards and therefore, the concerns, of citizenry beyond those of the savages.

In Anchorage, Alaska, Wichita, Kansas or Olympia, Washington, everybody is strongly pro business — unbridled, no strings attached, any kind of business – because it offers the promise of a meal ticket. Hence, the poor’s support for the pro-business, millionaires’ agenda. The “push button” issues are generally a side show, never more than of secondary importance. The relatively affluent bi-coastal states, meanwhile, can afford to be environmentally and socially conscious. That’s the story behind “Two America” and “red” and “blue” America.

But the poor are not the only victims of their own self-defeating actions. The rich are in that trap too, only in their case, the estimated time to destruction is longer; it takes relatively longer time for them to be hit with the consequences of their own actions. Let me explain this through three recent news stories.

The first one pertains to one Sydney Morris, an up and coming young teacher as covered by The Wall Street Journal, Monday, September 13, page 1 of the Greater New York Section. The story’s heading is Teachers Break Union Rank:
As a teacher, Sydney Morris wants to be rewarded if she can show she helps students make progress in her classroom. She also wants to make job protections such as tenure more difficult to get, and in the event that layoffs have to happen she wants the worst teacher to be let go first, no matter how long they've been teaching.

Those are radically different positions than those espoused by the union that represents her.
A self-centered, selfish brat, you say, caring only about herself?

Then, listen to a business captain in the person of Paul Otellini, the CEO of Intel. He was being interviewed the other day on CNN:
The way Otellini sees it, Washington must decide what the industries of the future are. “We still subsidize trains and agriculture – industries of the 19th century. We should decide what’s important to us going forward and make sure we’ve got the education system in place and the capital incentive system in place to do the investment here.”
The man who runs the crown jewel of the world’s technological infrastructure has this view on the U.S. infra-structure: he thinks trains are passé and the government is spending too much money on the embarrassment that is Amtrak.

Has he not traveled at all, one wonders? Is he not aware of modern trains and their role in the economies of Europe, Japan and increasingly, China? It is difficult to say. Throw in his bizarre comment about agriculture being a “19th century industry” and one begins to wonder if he is insane.

He is not, strictly speaking. The “madness” that comes across is made of the same stuff that makes a poor Kansan voting Republican seem mad. It is the pressure of the immediate for which the future is being sacrificed against common sense. Our protagonists, however, are not aware of that, having been forced into a particular “angle of vision to reality” which dictates a certain way of thinking and, from there, a certain conduct.

Look at this excerpt from Mortimer Zuckerman to see what I mean. The man had written an opinion piece in the Wall Street Journal to explain the country’s current problems and offer a solution:
The most obvious source of distress right now is lack of payroll growth, and it’s likely to get worse.
Look at his description of unemployment. He calls it a “lack of payroll growth”. He is not trying to tone down a negative word with a bland and neutered expression, like collateral damage for killing bystanders or energetic disassembly for explosion. He is in earnest. For him, unemployment is lack of payroll growth. That is the only way he sees the problem.

I have written about this phenomenon of humans assuming the point of view of speculative capital. See, for example here and here

To prove that the point of view of this cutting edge low life is the point of view of speculative capital, let me quote his “solution” to the “lack of payroll growth” problem from the same article:
To improve our performance will involve massive increase in scholarship support for higher education, and an increase in H-1B visas for foreign students who get M.B.As and Ph.D.s in the hard sciences.
To fight unemployment, he wants more foreign programmers in the country so they could push down the wages of skilled, technical workers even further.

If you do not know Mortimer Zuckerman, you will be happy to know that his views play a critical role in shaping U.S. economic and foreign policy, especially in the Middle East.

Speculative capital is self-destructive. As it expands to permeate the different aspects of social life, it imparts its traits onto its human agents. They, too, become self-destructive. A few mountaineers showed this phenomenon better than I could ever explain.