The Committee of Public Safety

To paraphrase Voltaire on the unfortunate Admiral Byng, in this country it is wise to throw a central banker under the bus from time to time to encourage the others. I nominate Helicopter Ben for chief encourager.

• Isegoria links to this post on how many nuclear bombs it would take to destroy the world. An illustration:

How many nukes does it take to destroy the world?

• Classic crank Nassim Nicholas Taleb writes to Tory leader David Cameron on how to make a black swan safe world. You can hear Taleb gesticulating wildly as he writes:
  

  The solution is obvious: build an economy that increases the role of well-tested traditions. Ban financial derivatives that require advanced mathematics rather than trial and error. Look at mother nature. There is a complex system built around sound principles that has insured both evolution and survival. It does not let anything get too big to fail. It breaks things early. I don’t understand why people who stand against tampering with nature accept tampering with the economy that would have organically grown too. Work on building a “robust” society, capable of withstanding errors, in which the role of finance (hence debt) would be minimal. We want a society in which people can make mistakes without risk of total collapse. Silicon Valley offers a good example, where people have the chance to fail fast (and repeatedly).

  The best blueprint is the very opposite of the Obama administration’s economic policies (its foreign policy is commendable). It has been administering pain-killers without addressing the cause of disease. Obama is strengthening those who do the wrong thing. Take the “cash for clunkers” programme. It is a handout to those who bought the wrong – uneconomic – car. He is penalising people who did not make a mistake. The same applies to other “rescues”. By raising taxes after the crisis, the administration is hampering evolution. Those who do well in difficult times end up paying more tax and those who lost money in the crisis pay less. The rich who got us here are being rescued by regular Joes and being subsidised by the tax system.

From Nassim Nicholas Taleb:

People discuss “value” in stocks as if it were something tangible –beyond a mere opinion, and a public opinion at that. Listed stocks are not “self-liquidating” –at least not in any realistic investment horizon; an investment in the market is largely a bet on what some other idiot will think of the investment in a few years, assign “value” to it, or invent a convincing and contagious narrative. It is simply psychology of the other idiot. This makes anyone investing for “hard” value extremely vulnerable. Most people who act conservative in their regular business become suckers from listening to the news.

This passage from William Buiter’s post The unfortunate uselessness of most ’state of the art’ academic monetary economics (props Naked Capitalism) is electrifying:

The efficient markets hypothesis assumes that there is a friendly auctioneer at the end of time – a God-like father figure – who makes sure that nothing untoward happens with long-term price expectations or (in a complete markets model) with the present discounted value of terminal asset stocks or financial wealth.

What this shows, not for the first time, is that models of the economy that incorporate the EMH – and this includes the complete markets core of the New Classical and New Keynesian macroeconomics – are not models of decentralised market economies, but models of a centrally planned economy.

The friendly auctioneer at the end of time, who ensures that the right terminal boundary conditions are imposed to preclude, for instance, rational speculative bubbles, is none other than the omniscient, omnipotent and benevolent central planner.  No wonder modern macroeconomics is in such bad shape. The EMH is surely the most notable empirical fatality of the financial crisis.

More useful excerpts from the Financial Modeler’s Manifesto, a useful warning about believing that reality can always be exactly modeled by the application of math and numbers:

Physics, because of its astonishing success at predicting the future behavior of material objects from their present state, has inspired most financial modeling. Physicists study the world by repeating the same experiments over and over again to discover forces and their almost magical mathematical laws. Galileo dropped balls off the leaning tower, giant teams in Geneva collide protons on protons, over and over again. If a law is proposed and its predictions contradict experiments, it’s back to the drawing board. The method works. The laws of atomic physics are accurate to more than ten decimal places.

It’s a different story with finance and economics, which are concerned with the mental world of monetary value. Financial theory has tried hard to emulate the style and elegance of physics in order to discover its own laws. But markets are made of people, who are influenced by events, by their ephemeral feelings about events and by their expectations of other people’s feelings. The truth is that there are no fundamental laws in finance. And even if there were, there is no way to run repeatable experiments to verify them.

You can hardly find a better example of confusedly elegant modeling than models of CDOs. The CDO research papers apply abstract probability theory to the price co-movements of thousands of mortgages. The relationships between so many mortgages can be vastly complex. The modelers, having built up their fantastical theory, need to make it useable; they resort to sweeping under the model’s rug all unknown dynamics; with the dirt ignored, all that’s left is a single number, called the default correlation. From the sublime to the elegantly ridiculous: all uncertainty is reduced to a single parameter that, when entered into the model by a trader, produces a CDO value. This over-reliance on probability and statistics is a severe limitation. Statistics is shallow description, quite unlike the deeper cause and effect of physics, and can’t easily capture the complex dynamics of default.

Models are at bottom tools for approximate thinking; they serve to transform your intuition about the future into a price for a security today.

Our experience in the financial arena has taught us to be very humble in applying mathematics to markets, and to be extremely wary of ambitious theories, which are in the end trying to model human behavior. We like simplicity, but we like to remember that it is our models that are simple, not the world.

Unfortunately, the teachers of finance haven’t learned these lessons. You have only to glance at business school textbooks on finance to discover stilts of mathematical axioms supporting a house of numbered theorems, lemmas and results. Who would think that the textbook is at bottom dealing with people and money? It should be obvious to anyone with common sense that every financial axiom is wrong, and that finance can never in its wildest dreams be Euclid. Different endeavors, as Aristotle wrote, require different degrees of precision. Finance is not one of the natural sciences, and its invisible worm is its dark secret love of mathematical elegance and too much exactitude.

We do need models and mathematics – you cannot think about finance and economics without them – but one must never forget that models are not the world. Whenever we make a model of something involving human beings, we are trying to force the ugly stepsister’s foot into Cinderella’s pretty glass slipper. It doesn’t fit without cutting off some essential parts. And in cutting off parts for the sake of beauty and precision, models inevitably mask the true risk rather than exposing it. The most important question about any financial model is how wrong it is likely to be, and how useful it is despite its assumptions. You must start with models and then overlay them with common sense and experience.

Many academics imagine that one beautiful day we will find the ‘right’ model. But there is no right model, because the world changes in response to the ones we use. Progress in financial modeling is fleeting and temporary. Markets change and newer models become necessary. Simple clear models with explicit assumptions about small numbers of variables are therefore the best way to leverage your intuition without deluding yourself.

All models sweep dirt under the rug. A good model makes the absence of the dirt visible…

Building financial models is challenging and worthwhile: you need to combine the qualitative and the quantitative, imagination and observation, art and science, all in the service of finding approximate patterns in the behavior of markets and securities. The greatest danger is the age-old sin of idolatry. Financial markets are alive but a model, however beautiful, is an artifice. No matter how hard you try, you will not be able to breathe life into it. To confuse the model with the world is to embrace a future disaster driven by the belief that humans obey mathematical rules.

Paul Volker on financial innovation:

[Volker= scoffed at the notion that those entities must be free to innovate -- stating that financial "innovations" like asset backed securities and credit default swaps have brought few benefits. The most important "innovation" in banking for most people in the last 20 or 30 years, he maintained, is the automatic teller machine.

Yves Smith over at Naked Capitalism links to a Financial Times article (login required) on Richard Koo’s critique of Japan’s Lost Decade. The Committee covered this earlier in Koo d’etat. It’s worth repeating here:

A healthy economy has a healthy mix of supply and demand. However, in a recession following an expansion of credit-fueled excess, demand falls due to economic contraction. If you give money to a bank or a consumer in an attempt to recreate demand, instead of spending it on consumption, thereby creating new demand, they will pay down the excessive debt they incurred during the expansion. This is logical and beneficial for an individual or firm. It will place them on a sounder financial footing. However, when a large number of people do this, it’s economic suicide. Someone, somewhere has to spend money or an economy will grind to a halt.

Koo argues that the solution is massive government spending. This directly injects capital into the economy, artificially keeping it alive until normal business activity resumes. It bypasses intermediaries like banks who, in a fit of logical individual self-interest, would pay down their debt instead of spending it. Koo points out that the Japanese economy picked up when the Japanese government consistently spent money but it went back into severe recession when the Japanese government tried to do something fiscally responsible like cut their deficit. He also points out that during the Great Depression, when the Roosevelt Administration tried to balance the budget in 1937, it pushed the economy back into severe recession, a downturn that didn’t end until the massive arms buildup for World War II.

Koo suggests that the American government push down the gas pedal on spending and keep it down for the foreseeable future. The target of spending is irrelevant. Infrastructure, whatever. Koo mentions that, curiously enough, military spending is a good target. Military spending in the late thirties moved Nazi Germany, Imperial Britain, Republican France, and Isolationist America out of the depression. It has the advantage of being spent on useful weaponry and employing large numbers of people. The US needs to replace all of the equipment it’s worn out in the last 10 years. Who knows? It might work.

Any such process, of course, is helped along if you nationalize the banks.

Manifesto

James Grant has this passage in his recent book Mr. Market Miscalculates: The Bubble Years and Beyond:

Now I want to quote to you from one of my favorite books on finance–indeed, one of my favorite books. My Life as a Quant: Reflections on Physics and Finance, by Emanuel Derman, is…a kind of confessional. Before he took up with derivatives, Derman was a physicist, and here is what he says about the difference between the laboratory and the marketplace: “The techniques of physics hardly ever produce more than the most approximate truth in finance, because ‘true’ financial value is itself a suspect notion,” writes Derman. “In physics, a model is right when it correctly predicts the future trajectories of planets or the existence and properties of new particles…In finance, you cannot easily prove a model right by such observations. Data are scarce and, more importantly, markets are areas of action and reaction, dialectics of thesis, antithesis, and synthesis. People learn from past mistakes and go on to make new ones. What’s right in one regime is wrong in the next.

“As a result,” Derman goes on, “physicists turned quants don’t expect too much from their theories. though many economists naively do. Perhaps this is because physicists, raised on theories capable of superb divination, know the difference between a fundamental theory and a phenomenological toy, useful though the latter may be. Trained economists have never seen a really first-class model. It’s not that physics is ‘better’ but rather that finance is harder. In physics you’re playing against God, and He doesn’t change his laws very often. When you’ve checkmated Him, he’ll concede. In finance, you’re playing against God’s creatures, agents who value assets based on their ephemeral opinions. They don’t know when they’ve lost, so they keep trying.”

Derman contributed to the Financial Modelers’ Manifesto with this Modelers’ Hippocratic Oath:

• I will remember that I didn’t make the world, and it doesn’t satisfy my equations.
• Though I will use models boldly to estimate value, I will not be overly impressed by mathematics.
• I will never sacrifice reality for elegance without explaining why I have done so.
• Nor will I give the people who use my model false comfort about its accuracy. Instead, I will make explicit its assumptions and oversights.
• I understand that my work may have enormous effects on society and the economy, many of them beyond my comprehension.

An interesting coda to these passages is this EconTalk podcast in which host Russ Roberts, an Austrian School economist, wrestles with the limits of data, empiricism, and scientism.

This post from Governance Matters over at the World Bank highlights an interesting issue: much as the developed world prides itself on the absence of the sort of squalid and parasitic corruption endemic in the Third World, in truth we haven’t become less corrupt but more ambitiously corrupt. Finance, instrumentally, is the allocation of capital to develop productive resources. Finance has, however, often been more an enterprise of high stakes gambling than productive investment. Something about the scale of the crime makes the man of capital more respectable than the operator of a casino. However, while this may be fine if losses as well as profits were privatized, increasingly public goods are being seized to repair private losses. Government and private actors (or, perhaps more accurately, the open state and concealed state) collude to loot the public rather than the more difficult and risk-prone path of investing in productive resources. Buying a congressman may be cheaper than investing in productive resources.

This theme is expanded upon within the post:

Enter now the problematic field of study of corruption, which has many challenges nowadays.  One of them is having underplayed for too long the study of misgovernance in the financial sector.  But briefly about the basics first: the way corruption is traditionally defined in this area of research is flawed, and its approach to measurement also requires further scrutiny.  The interpretation of the traditional definition of  “abuse of public office for private gain” is often ‘legally’ biased towards unearthing evidence that an egregious illegal act has been committed, and, further, biased towards pointing a finger at a public official as the main culprit.

I thought this definition was inadequate years ago, when we were quietly writing about it (e.g. research papers such as ‘Legal Corruption’).  The incipient evidence from the current mammoth financial provide more dramatic evidence than any paper we may have written.

As we wrote some time ago, the focus on corruption needs to move away from exclusive focus on the ‘abuse of public office’ and squarely acknowledge that corruption often involves collusion between the public and private (and at times outright capture by the private potentates).  Further, corruption ought to also encompass some acts that may be legal in a strict narrow sense, but where the rules of the game and the state laws, policies, regulations and institutions have often been shaped in part by undue influence of certain vested interests for their own private benefit (and not for the benefit of the public at large).  It may not be strictly illegal, but unethical and extra-legal.  This undue influence by private vested interests on the state sector may, or may not, involve the exchange of a bribe or, depending on the country’s laws, another illegal act.

Therefore, it makes sense to have a neutral and broader definition of corruption, akin to “the privatization of public policy”.  In addition of being a legally neutral definition, it moves beyond coarse manifestations of bureaucratic bribery, and it would encompass undue influence or capture of regulations and policies by narrow interests.

Would this view of corruption change the measurement of how countries rate on corruption?

Absolutely.

Let us take the case of the United States.  Over the past few years, traditional measures of corruption, such as Transparency International CPI, have placed the US at about the 10th percentile, currently in fact the # 18 among 180 rated countries.  By stark contrast, when we calculated an index that only focused on ‘legally corrupt’ manifestations (undue influence through political finance, powerful firms influencing politicians and policy-making), the US rated in the bottom half among over 100 countries where businesses were surveyed!

In our estimates, countries like the Netherlands, Norway, Denmark and Finland scored highly on the extent of corporate legal corruption and undue influence (1st to 4th, respectively, among the 104 countries rated).  By contrast, the US rated in 53rd place, Russia 74th, and Italy 47th.  Chile was rated 18th, well above the US on this particular legal corruption dimension, and so were Botswana, Colombia and South Africa which rated above the US.  By contrast, Argentina and Venezuela rated much worse than the US.  This data is from four years ago (the same variables are not been available more recently), but typically such ratings do not improve dramatically unless there is a major political change and decisive reforms.
While the low rating of the US on the extent of capture and undue influence by vested interests does stand out among industrialized countries, the US is not alone in its governance mediocrity on this (legal) corruption dimension.  In fact, the G-7 as a block does not fare well (and performs even worse as a G-8 block…), sharply contrasting the good performance of the Nordic countries.  In fact, as a group, even the Asian Tigers rate above the G-7.

These are no longer mere abstract ratings of different states.  Now we know that particular failures in some dimensions of governance, capture and corruption in the most powerful countries in the world, evident in the data a few years back already, matter enormously for the whole world.  Quasi-legal manifestations of corruption in the realm of high finance, however ‘gray’ such corruption may be, can be more vastly and far more costly to the world citizenry than an outright illegal bribe paid by an entrepreneur to get around a regulation to start an enterprise.

It may be that corruption, like the poor, will always be with us. However, it’s important to make it as productive as possible, what Walter McDougall calls “creative corruption”. The example McDougall uses to illustrate creative corruption is the Transcontinental Railroad accross the United States. Congressmen were bought, millions of dollars worth of land were handed to the Union Pacific and Central Pacific Railroads, shareholders and workers were defrauded on a massive scale, and shady operations like Credit Mobilier flourished in an incestuous marriage of business and state. However, at the end of the day, the nation still had a railroad that crossed the continent, paying for itself many times over.

The current crisis has no such creative corruption. Even recent outbreaks of mass corruption like the Internet and telecom bubbles left behind a surplus of stronger network infrastructure and long distance fiber optic cables. All that the current crisis has left is lots of empty houses in the desert and a trail of ruin.

Good call by Nouriel Roubini to nationalize the banks. Useful action hero catchphrase:

Basically, we’re all Swedes now. We have used all our bullets, and the boogeyman is still coming. Let’s pull out the bazooka and be done with it.

(props Naked Capitalism)