November 29, 2009

Speculation vs. Actual Investments - The Carrot and the Stick

Paul Krugman takes a stand in support of taxing financial transactions. He mentions activities in the financial sector that Adair Turner referred to as "socially useless", meaning especially speculation. I'm all any means of reducing excessive speculation, if a workable solution can be found.

On the other hand, there could be more talk about encouraging more socially useful activities. Investment must be directed away from speculative secondary markets and into primary markets that create new real assets.

There was a failed attempt at getting tax relief for "angel investors" in Finland. The idea was quite sensibly dropped, because an "angel investor" is not a concept that anybody is able to define in a watertight manner in a legal sense.

So I thought: Why not give a tax relief to all capital gains income from first resales of stock that was bought in an issue. Thus, the original holder of any newly issued equity would have a favorable treatment. This would both create an incentive for participating in stock issues and a disincentive for giving up the original ownership.

This would encourage people to invest in newly started or growing businesses. It would also encourage companies to acquire new capital, thus acting as a disincentive for excessive leverage.

As a bonus, there would be no need to define any ambiguous terms like "angel investor".

October 14, 2009

John Hussman - Zen and the Art of Market Analysis

Fund manager John Hussman makes some interesting, if a bit gimmicky, connections between the zen Buddhist teachings of Thich Nhat Hanh and financial decision making in his latest newsletter:
The best way of preparing for the future is to take good care of the present, because we know that if the present is made up of the past, then the future will be made up of the present. All we need to be responsible for is the present moment. Only the present is within our reach. To care for the present is to care for the future.

Thich Nhat Hanh

This week's comment is dedicated to my dear friend Thich Nhat Hanh, a Vietnamese Buddhist monk who was born on October 11, 1926, having been born previously in January of that same year, and twice again about 25 years earlier, not to mention countless other times through his ancestors, teachers, and other non-Thich Nhat Hanh elements. Thay (the Vietnamese word for “teacher”) would simplify this by saying that today is his eighty-third “continuation day,” because to say it is his birthday is not very accurate.


So here's another koan – “If a share of stock is sold in a forest, and nobody is around to buy it, does it still generate a fill?”

The immediate implication of interbeing is that we are forced to think about “general equilibrium” rather than imagining that one side of a trade can exist without the other. This immediately clarifies all sorts of misconceptions that we could fall victim to if we aren't careful.

For example, it immediately tells us that “cash on the sidelines” is not a useful concept, except as a measure of issuance. See, whatever “cash” is there on the sidelines exists because government has created paper money, or the Treasury has issued bills, or because companies have issued commercial paper. Until those securities are actually physically retired, they will and must remain “on the sidelines” because somebody will have to hold them.

If Mickey wants to sell his money market fund to buy stocks, the money market fund has to sell commercial paper to Nicky, whose cash goes to Mickey, who uses it to buy stocks from Ricky. In the end, the commercial paper Mickey used to have is now held by Nicky. The cash that Nicky used to have is now held by Ricky, and the stock that Ricky used to have is now held by Mickey. There is exactly the same amount of “cash on the sidelines” after this transaction as there was before it.


Here's another koan:

A novice monk approaches his teacher and asks “What is the price movement of one share being bought?”

The teacher holds out a cypress leaf in his palm and asks, “Did I catch the leaf as it fell from the tree, or did I raise it from the ground?”

We are used to thinking that the act of buying necessarily implies rising prices. But think about this for a second. In either case, the teacher gets the cypress leaf. What makes the difference so far as direction is concerned is where the pressure is coming from. If the cypress leaf is being offered down by gravity, it is caught on a decline. If the leaf is being lifted by the teacher, it is caught on an advance. Remember that. It is easy to get trapped in wrong thinking by people who talk about “cash on the sidelines” or talk about “investors” buying or selling in aggregate.

There was no excess of stock that was “sold” in March that has to be “bought” back now. Investors didn't “get out” of the market last year, and we shouldn't think that they have to “come into” the market now. Every share that was sold was bought. That has been true for every minute of every trading day since the beginning of the financial markets.
These insights, though perfectly understandable without esoteric zen Buddhist thinking, are spot on. There is no such thing as "cash on the sidelines".

Instead, one could try to evaluate the amount of potentially untapped credit. Reductions in credit lines all around have been taking this measure down lately. Both businesses and households have been shrinking their debt loads in the US somewhat. Unfortunately unemployment, lack of demand and shrinking collateral are eating the other side of the equation.

Thich Nhat Hanh writes well about zen in terms that are easily understandable by the average layperson. I liked his book "Peace is Every Step". He has lots of interesting advice for practicing zen in everyday situations, like driving a car or washing dishes. Unfortunately I have great problems in adhering to the principle of mindfulness. Absent-mindedness is my second nature. (Or is it the first?)

Financial Analyst Bias and Client Pressure

Bloomberg has published an interesting article by Edward Robinson about the influence that sales representatives of investment banks have had on the financial analysts working at the companies (hat tip to C K Michaelson of Some Assembly Required):
When Credit Suisse Group analyst Ivy Zelman refused to turn bullish on homebuilding stocks during a rally in the fourth quarter of 2006, the blowback was intense.

She says investors told her that some housing industry executives were ridiculing her analysis as a “jihad,” and several of the bank’s sales representatives pressed her to upgrade “hold” ratings to “buys” on companies to appease bullish institutional-investor clients. One sales manager even sent her an e-mail warning that analysts who stayed bearish too long often lost their jobs.
The article goes on to explain how very biased analysts in general are against handing out "sell" recommendations for stocks.

The pressure that is applied on analysts that make "sell" recommendations has been documented before. Start analyst Meredith Whitney even got death threats for giving out a pessimistic but accurate analysis of Citigroup in late 2007.

The reference to "appeasing insitutional-investor clients" is a dead giveaway of the cause of this pressure. These clients are not after sound advice. They have already made their minds. What they are after is a blanket of security in the form of advice that just happens to agree with their prior decisions.

If things go wrong, these institutional investors (read retirement fund managers) can just explain that they relied on the investment bank analyst's analysis. This partly relieves them from the responsibility for the bad investments.

Maybe it would not be a bad idea to prevent companies that handle client money or have proprietary trading desks from publishing any analysis or advice at all. At least fund managers shouldn't be able to hide behind advice from parties that are completely dependent on them as clients.

October 5, 2009

Bubbles, Unemployment and Fiscal Stimulus

Paul Krugman, is trying to fight for the usefulness of fiscal stimulus in mitigating unemployment.
Ryan Avent has some fairly harsh words for Arnold Kling’s recalculation theory of business cycles. Tyler Cowen, predictably, thinks Ryan is too snide.

But what none of the participants in the debate seem to realize is that Arnold is basically reinventing 1934 macroeconomics.


It’s all there: mass unemployment is necessary, because you have to shift resources away from sectors that got too big, stimulus is a bad thing because it slows the necessary adjustment. And now as then, the whole notion falls apart when you ask why, say, a housing boom — which requires shifting resources into housing — doesn’t produce the same kind of unemployment as a housing bust that shifts resources out of housing.
Both booms and busts involve shifting of resources between sectors. This much is self evident. It would be stupid to try to deny that. This doesn't mean that the unemployment should not be alleviated at all.

Krugman unfortunately makes a complete fool of himself in the last paragraph. Of course booms don't involve unemployment. In a boom, the driving force of inter-sectoral adjustment is a surge in demand. In a bust, the cause is a collapse of demand.

In a boom, the workforce moves behind the pull of opportunity. This was clearly visible in the flow of newly minted real estate brokers who were encouraged to leave their prior jobs in search of bubble-induced income. In a bust, the realignment is caused by a push-type phenomenon. (Or is it a kick?)

This is such an elementary thing that I can only wonder what Mr. Krugman has been smoking while writing that last paragraph.

To clarify, my own view is that increasing unemployment can hardly be completely avoided in a major bust of a bubble, but that government projects can (and should) be brought forward to mitigate it, if only to make use of the suddenly cheap labor and raw materials. Busts clearly have effects on people who were not directly involved in the bubble and an uncontrolled collapse is bad for everybody.

Equally, I believe that fiscal measures might even be appropriate in controlling the growth of a bubble. Additional small taxes on house-flippers (say for houses bought and sold within 12 months) could have helped slow down the development of the housing bubble. Additionally, it could have provided a larger cushion for the inevitable fiscal collapse.

In both ends of the boom-bust cycle, monetary policy should be the primary means ahead of fiscal measures. In this sense, the QE policies should go even further, as there is a lot of credit that is (and should be) paid down.

This collapsing credit can be replaced with base money even if the money multiplier has collapsed to unity. Instead of "mopping up the liquiduidity", central banks should bring back meaningful cash reserve requirements (to all bank-like entities) after the economy has recovered from the excess of credit. This would naturally will be fought against tooth and nail by the financial sector.

September 28, 2009

Must There Be a Safe Haven for Savings?

Tyler Durden wrote a post at Zero hedge on Friday that points out the massive move from long term bonds to shorter term bills in foreign purchases of US government securities. The surge in the short-term market, even at the face of extremely low interest rates, is a clear sign of a run to safety.

An overall stampede to safety is somewhat detrimental to overall wellbeing, because of excessive liquidation of productive assets. It should be resisted by governments. Savers should be encouraged to either put their savings into proper investment or cease saving in the first place.

I wonder what would happen, if the US government would simply refuse to sell additional short term securities. As the interest rates for the existing securities have nowhere to fall to, the possible set of outcomes is:
  1. Buyers would move into longer term government securities. This would be good for the government, as it would get a better control of the long term cost of the debt. It would also lower the overall price level of longer term debt.
  2. Buyers would move into the private sector market for short term securities or bank deposits. This would be a positive thing, as there is a real shortage of short term funding for the private sector.
  3. Buyers would stop buying any securities at all. Instead they would make real investments. This would be good for overall employment and economic development.
  4. Buyers would reduce savings and start to consume more. As previous, this would be helpful to employment. It would not be a bad outcome for the Chinese, for example.
  5. Buyers would move their savings into commodities and other speculative plays. This scenario would probably have some adverse effects.
  6. Buyers would keep their money in cash. This would be a bad outcome, but highly improbable, as the savings would be threatened by inflation.
All but the first outcome could result in an overall increase in the interest rates that would be paid by the US Treasury.

The question is, would a denial of such an absolute safe haven for savers be an overall improvement, or would it cause even more disruption? What adverse effects would such a move present?

September 25, 2009

Pricing and Utilization of Pharmaceuticals - Nonsense from Greg Mankiw

Greg Mankiw shared his wisdom with us in an editorial in the New York Times last week:
Imagine that someone invented a pill even better than the one I take. Let’s call it the Dorian Gray pill, after the Oscar Wilde character. Every day that you take the Dorian Gray, you will not die, get sick, or even age. Absolutely guaranteed. The catch? A year’s supply costs $150,000.

Anyone who is able to afford this new treatment can live forever. Certainly, Bill Gates can afford it. Most likely, thousands of upper-income Americans would gladly shell out $150,000 a year for immortality.
The true costs of pharmaceuticals are mostly incurred at the development phase. The actual cost of production is insignificant. No medication costs anything like $150,000 per year to produce.

So, if thousands of people are willing to pay $150,000 per year, then quite possibly tens of millions of people are willing to pay $150 per year, which would most probably bring many times the income to the drug company. Modern pharmaceuticals are simply not the hand-crafted luxury items that Mankiw is trying to portray them as. (Some of the more egregious items used in older traditions are a bit different.)

When it comes to the cost of the actual medication, any expansion of health care coverage only needs to increase the aggregate cost of medication by the price of the additional production, which really isn't very much at all. Wider utilization of a drug actually decreases the burden on individual users, as the cost of development is borne by more people.

September 22, 2009

Rational Expectations in a Recession

Paul Krugman wrote a (bit self-serving) post about the differences of viewpoints between the "saltwater" and "freshwater" economists in the US.

In this article there is one bit of economic orthodoxy that I don't quite get:

Think about the story of unemployment I’ve just described. It’s a story in which a contraction in the money supply can produce a recession – but only as long as people don’t know that there’s a recession! You see, if people do know that there’s a recession, they know that the low prices they’re being offered reflect low overall demand, not specifically low demand for their products.

I'd say that en expectation of a smooth change in the overall price level in a recession is certainly not what anybody would expect in a recession.

When the general population hears the word "recession" they think of an economic disturbance. This disturbance manifests itself as a shock-wave. In this wave, most of the people quite rationally anticipate a possible loss of income, which can be passed on to expenses only with a considerable delay.

This anticipation causes people to cut down on spending, which just reinforces the initial drop in demand. It's the prisoner's dilemma with millions of participants. Betting against the shock-wave would not be too rational.

This phenomenon is not that different from a "traffic wave" that can bring a whole highway to a complete standstill even if there is no apparent reason whatsoever. However, it is quite rational to expect congestion in dense traffic, because it happens.

These kinds of issues make the economic models that assume perfection for human beings quite dangerous. As can be seen in the video of traffic waves below, even small human errors accumulate to drastic disturbances in a tightly coupled system.

To mitigate these problems, "shock-absorbers" should be built into the economy. These absorbers would eat some of the efficiency of the system. On the other hand, so do shock absorbers in vehicle suspension, if the focus is on the short term. (Shock absorbers actually do increase the initial impact of a pothole.) We really have to reach a better trade-off between efficiency and reliability in the financial system.

These economic shock absorbers could take the form of increased transaction costs, or possibly taxation of capital gains that would discourage short-term gains.

The Estonian Laboratory of "Free" Market Economics

Ambrose Evans-Pritchard of writes an opinion piece about the "debt deflation laboratory" of the Baltics. His writing is thoroughly one-sided, as usual, but he has some valid points.
Professor Ülo Ennuste from Tallinn University says the private net wealth of Estonia's people has fallen below zero. I know of no other country in the world where this has occurred, though Latvia may be deeper in hock. Estonia's foreign debt is 116pc of GDP, second highest in Eastern Europe.

It is not a good moment for the poster-child of the flat-tax revolution, but those crowing the end of "Margaret Thatcher's Baltic Model" neglect half the story. Estonia's euro peg is anything but free-market. It makes Tallinn dance, awkwardly, to Frankfurt's distant tune. It stoked the boom by enticing people to borrow cheap at eurozone rates: it is now prolonging the bust.


The government could spend more. The national debt is just 5pc of GDP. It chooses not to do so. Such ultra-orthodoxy shows admirable discipline. Estonians will be a shining example to us all if they pull it off – and hold their society together.
Prof. Ennuste has some dubious figures. It's hard to believe that Estonian private assets would be worth less than 116% of GDP. There are other inaccuracies in the article as well.

However, the criticism against the Baltic currency peg policies is perfectly reasonable. Deflation (or "internal devaluation", as the euphemism goes) brings undeserved short term gains to those who are in cash assets. It will also encourage liquidation of real capital in a scramble to cash.

Keeping the currency pegged while maintaining completely disparate interest rates made absolutely no sense from the start. It was a source of "free money" to anyone who borrowed in Euros and invested in local currencies. Unfortunately, there's no such thing as a free lunch and never will. This "free money" virtually guaranteed a foreign currency denominated credit bubble.

The Euro is the wrong point of fixation. After all, the Euro has no inherent value of its own at all. The only meaningful measure of the value of a currency is against real goods and assets.

It might be absolutely impossible to avoid a degree of deflation after a humongous credit-fueled asset bubble, but at least one shouldn't be aggravating it, unless the objective is a massive overshoot in the downside.

A commenter "John" strongly disagrees with the opinions of Evans-Pritchard:
Estonia won't benefit from a devaluation, it will merely create instantaneous inflation, because the country is so small and so intertwined with neighboring economies.
Inflationary policy is exactly what Estonia needs right now, as it is headed for a deflationary spiral that will not stop before a serious overshoot. If currency reserves are not exhausted, the deflation will eventually come to a stop when foreign money comes in for hunting bargains. At that point the Estonian people might truly have lost their net wealth. They will be forced to sell their crown jewels just to survive.

"John" continues:
Instead a devaluation would destroy the last beacon of stability, the protection of value that the currency offers.
Currency is of no inherent value whatsoever, only real investments are. In the short term, the currency may look like a means to preserving wealth. However, this doesn't mean that people in aggregate are maintaining their wealth.

Even though the "value" of the currency is steady, or even grows in comparison to real goods, the quantity of currency shrinks through deleveraging. The grand total is actually shrinking. This reflects the real value that is destroyed through liquidation.

To all those who like comparisons to Zimbabwe: The Baltic policy is the mirror image of the Zimbabwean policy. In both cases the central bank and government is aggravating an already adverse trend. Hyper-deflation is not much nicer than hyper-inflation.

The Baltic states truly are a laboratory for the Chicago school of economics, with flat taxes, efficient market theories and all. I feel sorry for the human guinea pigs of the Baltic states.

July 13, 2009

Financial Engineering, Gambling and Deflation has a nice summary of the gambling associated with structured finance, written by Barbara Garson. She has been searching for unemployed people that were handling those structured financial products, especially credit default swaps, that seemingly brought the whole world down. She was absolutely unable to find such people, even from Lehman Brothers or AIG. (Note to Garson: These people like to call themselves financial engineers.)

At the last paragraph Ms. Garson reviews the situation from the point of view of the real economy, where productive people are kicked out of jobs, while financial engineers keep on pushing their wares.
In other words, people are speculating on derivatives and derivatives of derivatives because there's no action in the real world. You can't invest in new real businesses or lend money to old real businesses for expansion unless people can afford to buy the products they'll produce. That brings me back to where I started: our real world. You know, the one where just about everyone's unemployed except those swap guys.
In a deflationary environment, real assets, like factories, start to look like huge risks. To keep investors from withdrawing from the real economy, financial assests need to be equally scary to investors. Governmental bailouts of financial assets simply encourage people to withdraw their capital from the real economy to plunk it into government-guaranteed gambling.

Safe financial assets, like cash and government securities, that have no backing in the real world, need to be scary as well. To achieve this, some inflation expectations are required. The Federal Reserve has been quite aggressive on this front, and clearly quite successful. Unfortunately, the European Central Bank does not seem to take this thankless task quite seriously.

Even if holding cash could be turned into a scary proposition, there are ways to store value that, even though physical, are equally as useless to the real economy. With this I naturally mean precious metals. Naturally some of the "real" economic activity has not much value either. Activity with negative value is quite possible. (Let's call it the salad shooter economy, in honor of James Howard Kunstler.)

All this trouble was brought to us by a financial market that grew to be bigger than the real economy. The solution to our problems should not necessarily proceed by making the real economy even smaller. That route will only result in a self-reinforcing deflationary spiral. Instead, the real economy should be functioning, while the financial economy should deleverage and shrink. A complete government bailout of the speculative financial system will achieve the exact opposite.

Let gamblers take their losses. That alone will give a boost to the attractiveness of the real economy. There's a problem with that proposition: all of us with savings at financial institutions are part of the gamblers through our funding of it. But as we have all gambled, we must all bear the losses.

Even though deflation is the immediate issue, as credit is collapsing, ultimately existing savings that are invested in credit will lose some value, because of the eroding base of credit worthy debtors on which its value was based. This loss of value can happen through a process of default, through being diluted by new savings, or through a devastation of the real economy.

The third option initially involves massive deflation, which might make it attractive to those that hold cash assets. However, it will ultimately result in people with cash assets facing empty store-shelves, at which point the deflation will suddenly turn into massive inflation, quite similar to the receding shoreline before a tsunami.

We have to remember that inflation has both a numerator and a denominator. In this situation, increasing the numerator (in the dilution scenario) is much preferable to a collapse of the denominator. Unfortunately, this might already be somewhat too late. If the collapse advances from industrial production to food production, there will be real trouble.

July 8, 2009

Paradox of Thrift, Savings and Investment

There was such a great comment by reader "es" on a post about the paradox of thrift at Paul Krugman's blog that I just have to copy it here verbatim.


The story behind the paradox of thrift goes like this. Suppose a large group of people decides to save more. You might think that this would necessarily mean a rise in national savings. But if falling consumption causes the economy to fall into a recession, incomes will fall, and so will savings, other things equal. This induced fall in savings can largely or completely offset the initial rise.

Which way it goes depends on what happens to investment, since savings are always equal to investment. If the central bank can cut interest rates, investment and hence savings may rise. But if the central bank can’t cut rates — say, because they’re already zero — investment is likely to fall, not rise, because of lower capacity utilization. And this means that GDP and hence incomes have to fall so much that when people try to save more, the nation actually ends up saving less.

Okay, I admit I don’t really understand this. I always seem to get hung up on S = I (Savings equals Investment). What would happen if you worked from the hypothesis that S = I + W, with W standing for Waste? Sure it muddies things, because it’s hard to weight whatever you are measuring as to its true productivity. But this is reality. When the old paradigm doesn’t work, or leads to paradox, you have to question your basic assumptions. Not all savings lead to purposeful investment. Witness the proverbial gold under the mattress. Witness wheat put by for a bad harvest and then mouldering in a badly maintained storage facility. Check out the over-elaborate plastic toys that over-stimulate and maybe poison our already hyper-active children. Especially pertinent, witness a population underfed and under educated and inadequately protected from disease to guard against the future possibility of debt.

Already in your columns I see you speaking of saving and investment as different entities, and then when you get “wonkish” (I guess you mean mathematical) you fall back to S = I.

I recommend that you assign a graduate student to work on the need to incorporate more variables into the S=I axiom. It might get him a Nobel prize, or save the world, or something.
I just love the snark in that last paragraph.

Of course, the identity of savings and investment doesn't make any common sense, but since when such a thing has been expected of economic theory?

I'm not sure either if it makes any sense to think of this identity in terms of any units of currency, but in addition to the waste term on the right, there should at least be a term for credit expansion on the left. I would also amend the equation to

S + C = I + W,

where C is the net amount of credit creation. Of course this equation is not a real equation. There are severe time lags in all the processes that are part of it. It can only be discussed in a statistical sense:

E[S + C] = E[I + W],

where E denotes the expected value. In addition to a temporal sense for this statistical dependence, one must also think about the ensemble statistics to account for people with different concepts for value, etc.

Credit has the ability to create investment without any net savings. Somebody gets into debt, which is equivalent to negative saving. Somebody else gets the loaned sum of money, and decides to save it. The net savings are zero.

However, there would have possibly been an investment that was made with the borrowed money. All is well, as long as the debtor pays the money back. Credit is a form of delayed savings. Investment is made first, then come the savings, little by little.

Problems occur when too much credit is extended. What if there is no income from which to save? People default on their loans. Oops... Now (nominal) investment has been much higher that the "savings" from which it was supposedly made. Savings are actually smaller than investment.

This is where the identity asserts itself with a lag. The value of savings increases while the value of investment decreases. Result: deflation.

June 23, 2009

More on the TED AR Embarrasment

Chris Anderson of in Twitter about the Chris Hughes augmented reality talk scandal:

@UnitZeroOne Chris Hughes agrees we shd take down the current version of his talk. See my comment: & thanks.
about 1 hour ago from web in reply to UnitZeroOne

At 1:59, this might be the shortest ever #TED talk. Augmented reality in a browser. It's a wow.
about 6 hours ago from web

From "wow" to take-down in 5 hours. Amazing.

Ugly AR Ripoff at

I am completely dumbfounded. Hacker Chris Hughes made a very short presentation of Flash-based augmented reality in TED2009 without mentioning the open source projects (FLARToolkit and Papervision3D) that his very basic demo is almost completely based upon. In addition, he made remarks that let the audience understand that he had a major role in the development. Read more of the issue at UNITZEROONE.

Could it really have been true that the moderators of TED were so completely unaware of the state of the art in augmented reality? This presentation was a big failure on the part of the TED2009 organizers.

I don't think Chris's response quite cuts it. He should really apologize instead of making lame excuses about the "fear and frenzy" of speaking at a TED conference. On the other hand, I kind of feel sorry for the guy. Having made his appearance at TED practically an obsession, it surely does not feel good for him to come out of it looking so awfully bad.

June 19, 2009

Anti-Keynesian Insanity in Latvia

Has the Latvian government gone mad? Sacrificing the whole economy of the country to maintain a currency peg is insane. It will most probably result in a devaluation later anyway, with much less results than an earlier devaluation.

It is a question of fairness. The only party that gains an advantage from the currency peg are those with Lat-denominated paper assets. It doesn't make much sense either, because the kind of deflation that is required for keeping up the peg will result in the paper assets being defaulted upon anyway, except for the government paper.

Devaluation will not prevent the problems that were created by excess credit, but it is an important tool in preventing a deflationary spiral.

Robert Anderson and Stefan Wagstyl wrote in the Financial Times about Latvia's conundrum:

With the backing of the International Monetary Fund and the European Union, Riga is hoping that if it can impose enough pain on the domestic economy, it will be able to maintain its exchange rate peg to the euro. That would allow it entry into the single currency zone within the next four years.

After months of dithering, the government last week put together a package of measures that will mean Ms Blumberga – who earns just 280 lats ($552, £337, €398) a month – along with hundreds of thousands of other public sector workers will suffer a 20 per cent pay cut. Even pensioners will see reductions of 10 per cent.

This is just insane. A crash in domestic demand is the only thing that is sure to follow from such moves. There is a very high risk of starting a deflationary spiral.
Landmark property developments such as the twin Panorama Plaza towers on the road between Riga and the airport stand all but empty and shopping malls look forlorn. House prices fell by one-third last year, insolvencies are up and banks are repossessing more mortgaged properties and leased cars. “Business is in hibernation,” says Gunnar Ljungdahl, who chairs the Swedish chamber of commerce in Riga.
How exactly is intentional deflation going to help in this situation? When wages are drastically cut, we can safely wait for even more insolvencies and repossessions. Shopping malls are a dead investment when the purchasing power of the population rapidly shrinks.
In these circumstances, many governments devalue to spread some of the costs to foreign creditors and to boost the economy by making exports – which include wood products – more competitive. IMF officials have indicated that the organisation was divided over the wisdom of defending the lat’s peg but was finally persuaded by pressure from Riga’s EU partners as well as the Latvian government’s own refusal to contemplate devaluation.

So it's actually other EU countries that Latvians can thank for this disastrous policy. I thought the EU was supposed to be a project of peace. Killing a member country to "protect" irresponsible creditors at other member countries is a recipe for serious conflict.
Latvia sees the currency peg as the linchpin of its economic policies. It helped drive down inflation and is the route to euro entry. Latvia’s governments have often been weak but have always defended the peg and supported the powerful central bank, where both the prime minister and finance minister used to serve. “For Latvia the peg is the last pillar of trust,” says Henrik Hololei, an Estonian cabinet head at the European Commission.
All hail The Peg!
Also, Latvian officials argue that in a small economy, where 60 per cent of export value is in imported content, devaluation will not do much except encourage inflation. With some 90 per cent of all loans in euros, they add, it could bankrupt tens of thousands of companies and individuals. But the price of avoiding devaluation will be huge economic, social and political strains. Valdis Dombrovskis, prime minister, admits his main challenge now is “to preserve the social peace”.
"Encouraging inflation" (or discouraging deflation) is exactly what is needed at the threat of a deflationary spiral. Instead, Latvian officials are ready to give the economy a good kick to the backside. The foreign loans that turn out to be unaffordable will be defaulted upon one way or the other. If the income of debtors shrinks the effect is exactly the same. And a defaulted loan in euros is no bigger loss to the creditors, whatever the exchange rate.

So, as there is a wave of defaults anyway, why should there be a wave of deflation as an insult added to the injury. Deflation is an unjust reward of those who hold paper assets, and a punishment for those who hold actual assets.

Cantarell Depletion Rate Reaches 35 Percent per Year

Robert Campbell reports at Reuters about the amazing rate of decline at the giant Cantarell oil field in Mexico.

Cantarell produced more than 2 million barrels per day as recently as 2004, but yield has plunged as the aging field enters its natural decline phase, sending Mexican oil production tumbling to its lowest level since the mid-1990s.

The giant offshore Akal field and several nearby deposits that Pemex groups as Cantarell produced only 713,000 bpd in April, below Pemex's forecast of 756,000 bpd for 2009. Yields from the area have fallen at annualized rates of more than 35 percent in recent months.

Amazing. 35 percent per year. That is some serious cliff diving. If the end of Ghawar will be equally drastic, the world is going to be in a heap of trouble.

June 15, 2009

Max Boot Shows Sympathy for Fellow Militant Conservatives in Iran

Andrew Sullivan is attentive to neoconservative attitudes to the Iranian election fraud issue:
Max Boot seems pleased. The neocon hope that Ahmadinejad keeps himself in power - barely disguised any more - seems to me premature. The US would be wise to wait and see how this develops before making any policy decisions. We have learned two things we knew already but now know with fierce urgency - that the Iranian people want more freedom and better relations with the outside world, and that the regime itself has a desperate, dangerous core that cannot be trusted. But how we engage these two facts remains a prudential decision best left until this revolution takes its course. What I find a little gob-smacking is that this outbreak of democracy in Iran seems to have left the neocons saddened. Interesting, no?
Max Boot has now made it official: the radical conservatives in US and Iran have a mutually cherished love/hate relationship. Max Boot on June 14 at Commentary:

On the principle of “the worse the better” for our enemies–and, make no mistake, Iran is our enemy–it is possible to take some small degree of satisfaction from the outcome of Iran’s elections.

If the mullahs were really canny, they would have let Mousavi win. He would have presented a more reasonable face to the world without changing the grim underlying realities of Iran’s regime–the oppression, the support for terrorism, the nuclear weapons and ballistic missile programs. He is the kind of “moderate” with whom the Obama administration could happily engage in endless negotiations which probably would not accomplish anything except to buy time for Iran to weaponize its fissile material.

If would be so sad if more reasonable people would come to power in Iran, wouldn't it? Without the Iranian threat there would be no distraction from the pressure for resolution of other issues in the region. This attitude is completely understandable. Peace is such an awful state of affairs.

May 23, 2009

Insights in to the Financial Crisis

There was a good collection of (US-centric) insights to the credit crisis in a symposium arranged by the New York Review of Books and PEN World Voices on April 30. The symposium was attended by a good number of people who gave copious warnings prior to the onset of the actual crisis.

Yet all these insights seem to be somehow a bit disconnected. A bigger picture is clearly being formed as all these great minds get to put their thoughts together. Too bad that it has to be in hindsight.

Paul Krugman makes a pointed statement about social safety nets:
The other thing not to miss is the importance of a strong social safety net. By most accounts, most projections say that the European Union is going to have a somewhat deeper recession this year than the United States. So in terms of macromanagement, they're actually doing a poor job, and there are various reasons for that: the European Central Bank is too conservative, Europeans have been too slow to do fiscal stimulus. But the human suffering is going to be much greater on this side of the Atlantic because Europeans don't lose their health care when they lose their jobs. They don't find themselves with essentially no support once their trivial unemployment check has fallen off. We have nothing underneath. When Americans lose their jobs, they fall into the abyss. That does not happen in other advanced countries, it does not happen, I want to say, in civilized countries.
Niall Ferguson tries to make a case for the incompatibility of monetary and fiscal remedies to economic downturns.
There is a clear contradiction between these two policies, and we're trying to have it both ways. You can't be a monetarist and a Keynesian simultaneously—at least I can't see how you can, because if the aim of the monetarist policy is to keep interest rates down, to keep liquidity high, the effect of the Keynesian policy must be to drive interest rates up.
This view is completely bogus, as explained by the other participants. The point of monetary stimulus is not primarily to drive interest rates down. Its point is to drive up the money supply. When the interest rates are solidly against the zero lower bound, fiscal stimulus is actually helpful in increasing the total amount of credit. Additionally, a downturn is a great time to bring forward public investments that would have to be made later anyway. They can now be financed cheaper that ever.

Ferguson is right in worrying about the solvency of the US government. The other panelists claim to be worried as well, but their overall attitude to the deficits tend to have a somewhat worrying level of cavalier indifference.

There is one quite difficult point in this whole dislocation. Because indebted nations have been living beyond their means, there is no escape from the fact that despite any "solution" to these problems, there will be some attrition in overall standards of living.

These changes will not affect all strata of society equally. It is a very bad thing to bail out the most guilty and undeserving parties at the expense of the whole society. Some losses that, as said, are unavoidable, should be shared equally between all holders of imaginary financial "wealth".

Because huge amounts of eventual losses are unavoidable, the governments of debtor nations should not attempt a return to the "old normal". That would be a self-defeating exercise. The focus should instead be on controlled assignment of losses where they belong. And no, the losses do not all belong to the end-user speculators. Those who lend to speculators are making an equally speculative bet on the creditworthiness of the debtors, as well as any collateral that was willingly accepted.

The issue is completely different in creditor nations with low domestic levels of consumption, like China. These governments should apply fiscal measures with abandon.

Then there is the case of Japan, which has already spent its ammunition in trying in vain to uphold its previous bubble economy. This just goes to show the dangers of trying to sustain the unsustainable. In hindsight, Japan should have let financial assets go down. This would have improved the relative value of real assets and given the government more ammunition against unemployment. Unfortunately it would have hurt pension savings, which are highly dependent on financial assets.

Existing financial assets, level of employment and future debt load form a trifecta, of which any one can be improved only at the expense of the other two.

There is a danger in the US that the financial assets (partially earned through an unsustainable debt-powered boost to GDP) of aging baby-boomers will be overzealously protected at the expense of either real economic activity or future debt loads.

If losses are to be metered to financial assets as they deserve, there should be a combination of monetary expansion (effective sovereign default) and limits to bailing out creditors (of either banks or industry). Inflation actually lifts the prices of real assets, including commodities and equity in solid corporations. It hurts non-speculative creditors of solid corporations and households, so it should only be used with extreme caution. Some losses are, however, in order for all creditors, who should take their share of the overall responsibility for the creation of excess credit.

Paul Krugman tries to pin the roots of this crisis on the tired old explanation of a "savings glut".
One way to think about the global crisis is a vast excess of desired savings over willing investment. We have a global savings glut. Another way to say it is we have a global shortage of demand. Those are equivalent ways of saying the same thing. So we have this global savings glut, which is why there is, in fact, no upward pressure on interest rates. There are more savings than we know what to do with. If we ask the question "Where will the savings come from to finance the large US government deficits?," the answer is "From ourselves." The Chinese are not contributing at all.
Krugman is right in a limited sense. Bad investments have been made because there has been too much money chasing too few investment opportunities. He doesn't shed much light on the root sources of this "savings glut". The glut exists, all right, but it is not individual savers who have created it with their saving decisions.

As surprising as it is, savings are not created by savers. Savings are created by issuance of money and credit. All the money that is in existence is always held by someone. If one person decides not to hold it, it is passed on to the next one, but it is nevertheless always there, until the original debt is paid back, or the money withdrawn by a monetary authority. Society as a whole can not choose not to save if financial institutions just keep on churning out new money.

On the other hand, the "savings glut" is imaginary in a certain sense. Because net savings can not exceed the rate of creation of new base money, every unit of money "saved" beyond that is actually balanced by equal creation of new debt, which is a form of dissaving. Problems are caused when credit and debt are socially or geographically highly separated. This is the cause of the so called "global imbalances". We have seen the world divided between western debt and eastern savings. The problem is also manifested internally in almost all economies in the form of middle and lower class debt "canceling" out saving by the affluent.

George Soros has a good point on the lack of regulation:

About regulation, we have to start by recognizing that the prevailing view is false, that markets actually are bubble-prone. They create bubbles. Therefore, they have to be regulated. The authorities have to accept responsibility for preventing asset bubbles from growing too big. They've expressly rejected that, saying that if the markets don't know, how can the regulators know? And, of course, they can't. They're bound to be wrong, but they get feedback from the market, and then they can make adjustments. Now, it is not enough to regulate the money supply. You have to regulate credit. And that means using tools that have largely fallen into disuse. Of course you have margin requirements, minimum capital requirements; but you actually have to vary them to counteract the prevailing mood of the market, because markets do have moods. It should be recognized that exuberance actually is quite rational. When I see a bubble beginning, forming, I jump on it because that's how I make money. So it's perfectly rational.

It's the job of the regulators to regulate. However, we should try not to go overboard. While markets are imperfect, regulators are even more imperfect: not only are they human, they're also bureaucratic and subject to political influences. So we want to keep regulation to a minimum, but we have to recognize that markets are inherently unstable.

Regulators are human. This is true. And this is the reason that we should strive toward regulations based on fairly stable rules that are equally applied to everyone. We should minimize the role of regulators in making decisions and see them instead as enforcers of regulations. The regulations should thus be clear, transparent and fairly rigid, maybe even a lot more rigid than is optimal in the sense of efficiency. The separation of powers to legislative, executive and judiciary branches has to be enhanced in financial regulation to avoid cognitive capture and arbitrary decisions.

For some reason Soros doesn't mention the one regulatory issue that I somehow feel is the most important of all: reserve requirements. With reasonable reserve requirements there would be a hard limit on the creation of credit, and thus a hard limit on the level of associated imbalances.

One challenge is posed by the shadow banking system (money market accounts, etc.) that has not been operating under the same rules that apply to normal banks. Regulations should be based on the roles that are performed by entities, instead of their legal status.

Paul Krugman puts the issue of regulation in his usually pointed and prosaic style:

As I've written, we need a boring banking sector again. All of this high finance has turned out to be just destructive, and that's partly a matter of regulation. But in the political economy there was also a vicious circle. Because as the financial sector got increasingly bloated its political clout also grew. So, in fact, deregulation bred bloated finance, which bred more deregulation, which bred this monster that ate the world economy.

One thing that was conspicuously missing from the discussion was the unsustainable demand of permanent exponential growth that is required for steady operation of the financial markets. There was no discussion of the limits to growth that are presented by resource exhaustion and climate constraints. In order to have a sustainable financial system, we have to take these limits into account.

The whole structure of the economy has to change away from using credit as a permanent store of value. In a few decades, we will probably have to think about a financial system that can cope with an economy that is actually shrinking steadily. A system where credit is used as a store of value will not be able to cope with such circumstances without significant inflation.

A general move away from the use of money itself as a store of value would be a good idea. Money should be primarily used as a means of exchange, while real assets should take the role of accumulating long term savings. This would be of help in remedying the paradox of thrift that Krugman has repeatedly written about.

Of course, these ideas are not new.

The whole discussion was also centered around the ordinary economic phenomena of savings and investment. I would have expected more discussion of the "paradox of risk" (as so dubbed by Charles Hugh Smith) that is so aggressively manifesting itself at the derivatives market.

May 17, 2009

Central Bank Profligacy and Massive Malinvestment

I stumbled upon a newly interesting paragraph in an article about IMF fiscal advice from 1990 by Alan Tait:
Central banks are not expected to make losses. In industrialized economies, central bank profligacy is rare. In the last few years, however, significant central bank deficits have become not uncommon in developing countries (central bank losses in Costa Rica were 5.6 percent of GDP in 1982; in the Philippines, 5.2 percent in 1984; in Uruguay, 7.6 percent in 1983; and, in Argentina, 2.5 percent in 1984). This largely occurs when a central bank undertakes quasi-fiscal activities (e.g., net lending or guaranteeing foreign exchange losses) that show up, initially, as a change in the composition of central bank's assets.
The US Federal Reserve has been working overtime to achieve an exception to the first sentence. Sure puts them in an interesting new group of peers.

A later paragraph states:
Frequently, the public sector has undertaken massive investment programs, often with an eye on the symbolic need to "think big." But some of this investment may prove unproductive if the initial capital commitment is not followed up by maintenance. Donors will give capital but are reluctant to fund maintenance costs. Fund and Bank advice may well be to forego some large new projects for the sake of maintaining and operating efficiently the existing capital stock.
Massive investment programs? Yes, sir! Unproductive? You bet.

IMF's Anti-Stimulus Rules

Mark Weisbrot writes in the Guardian of how the IMF is hurting poor countries by imposing tough rules on government deficits and interest rates at the face of a severe economic downturn. He refers to the anti-stimulative and deflationary conditions that are associated with IMF loans as "punishment". This seems to be quite justified at the face of the fact that even a 40 % budget cut in Latvia is not enough for the IMF.

Mr. Weisbrot points to the severe additional tension that IMF's diktats might potentially cause in already volatile Pakistan: "Slowing Pakistan's economy at a time when the global economic crisis is already doing that may not be the best policy from the point of view of political stability."

Getting away from government deficits is without doubt necessary in the long run, but the severity of the measures are and should be up for debate. Application of such measures should be postponed until the end of the economic downturn. They should also be associated with at least some concessions from creditors.

It also seems that American and European economists are not quite so ready to apply their "scientific" doctrines at home. This creates the inevitable appearance of high hypocrisy. Forcing some nations to tighter their belts 'till they pass out, while others freely splurge on trillion-dollar government deficits is very ugly to look at.

Western economists are quite easily throwing about the notion that these measures are for the good of the target nations, and that they must "swallow the bitter pill". What is easily forgotten is that some people's lives will be permanently ruined by such measures. When your children are about to die for the lack of medical services, the "long run" can be surprisingly short.

How the IMF works can only be described with the term "predatory lending". The whole point seems to be the creation of a permanent debt relationship, with all of the resources of a nation directed at paying the interest on the debt.

IMF strongly opposes progressive taxation as a way of escaping government debt. The regressive cuts to the most productive parts of the target governments' budgets, like education and health care, keep the debtor nations at the status of quasi-colonized sources of free labour and raw materials.

May 3, 2009

Individual Advantages as a Cause of Systemic Weakness, a Parallel in Biodiversity

BBC News reports of a study that comes to a conclusion that increased nutrients decrease biodiversity by letting the fastest growing plants grab all the sunlight, while slower growing species suffocate. In a more nutrient-constrained environment, plants that use nutrients efficiently succeed alongside plants that make effective use of light. (Hat tip to Yves Smith)

I think this is a more general game-theoretic phenomenon: the higher the number of binding constraints there are in a system, the higher the number of successful strategies. The individual constraints can be seen as objectives for a multi-objective optimization problem, thus controlling the degrees of freedom in the world of Pareto-optimal solutions.

I have been thinking of the role that this phenomenon has had on the financial world. Before 1980's, the financial world was comfortably resting on limits of liquidity, in the form of binding reserve requirements, and leverage, in the form of binding limits of bank capital.

After removing the important constraint of reserve requirements, especially after 1994, when retail sweep programs were allowed, leverage has been the only major remaining limit, and was thus taken to the maximum.

After the weakening of even that limit, by changes in rules and active avoidance of regulations, actual solvency is now the only remaining factor to limit the growth of financial institutions. This is not a good limiting factor for a system built mostly of institutions that are “too big to fail”.

May 1, 2009

Naomi Klein on Wall Street Cronyism and “Free Market” Fundamentalism

There is a really great, long interview of Naomi Klein at by Joan Juliet Buck:
JOAN: And can Obama provide the real deal?

NAOMI: What gave me hope was that when the economic crisis hit, Obama got serious and his analysis became more concrete. It’s really worth remembering that he started winning the election when Lehman collapsed and he started putting the ideology of Reaganism on trial. He started saying, “This economic crisis is the result of the policies of deregulation and trickle-down economics that have dominated this country.” But he said, “for the last eight years.” That was wrong. And that was part of the problem.

JOAN: Because it’s the last 30.

NAOMI: It’s the last 30 and, you know, that was a piece of intellectual dishonesty that I think has cost us dearly. That was a good electoral line because we all wanted to be able to blame it all on Republicans, because that was a much more sellable election slogan. “Everything was fine in the ‘90s when you had Clinton and we just need to get back to that.” And what that did was gloss over the absolutely central role that Robert Rubin and Larry Summers played in creating this crisis. And lo and behold, they’re back with their protégés in tow. There’s really a shared responsibility, and it’s an argument for more intellectual honesty, more principled stands and fewer strategic calculations. What worries me so much is that it’s fine for politicians to be strategic. But social movements should be principled. They shouldn’t always be thinking about what’s the right strategy, what’s the sellable message, what’s the talking point, because then you end up in a situation like this. Larry Summers is back. Larry Summers was given a pass during the entire election.
Ms. Klein makes some very deep observations on the dynamics of politicized mass movements:
JOAN: Just start with the Icelandic protests. Why are there no protests in the streets in America?

NAOMI: This comes back to the problems of hero worship. It’s hard to protest your hero. But it’s more than that. It’s also that the virulence of the Right in the United States is so frightening and the problem is that it is the merger of the extreme far right and large corporations, in the form of media conglomerates. So Glenn Beck on Fox or Lou Dobbs on CNN have these unbelievable megaphones to attack Obama, and to spread fear, which makes reasonable people feel that their main political role is to defend the Obama administration against this very frightening right-wing onslaught. It’s understandable but it’s also hard to do that while being in the streets protesting that administration’s bailout – which is what’s happening in Britain, which is what’s happening in France, what’s happening in Italy. I think the problem in the U.S. is that many people who were part of the campaign to get Obama into power now see their role as being kind of an unofficial arm of the administration, with some groups even taking talking points from the White House. It’s a recipe for political failure, because what actually makes space for Obama to do more of what we want him to do is to make him look less radical, by being more radical ourselves.
This is a very acute problem in two-party systems like the one in the US. It’s very hard to critique one party without the fear of playing into the hands of the other one.

I am totally dumbfounded at the lack of campaigning for a true multi-party political system in the US. What makes the idea such a non-starter? Are Americans just so used to the system that they have that they don’t even consider any alternatives?

It is natural that neither of the two power parties are going to embrace a multi-party system. Maybe this crisis could act as a lightning rod for a new multi-party revolution, as it becomes ever more clear that both parties are in the pockets of moneyed interests: employers for Republicans and Wall Street for Democrats.

Naomi presents some of the issues as a gender bias.
NAOMI: Brooksley Born [chairwoman of the Commodity Futures Trading Commission], who, during the Clinton administration, blew the whistle on the unregulated derivative industry and wanted to regulate it like any other banking sector. For her prescience she was bullied by Rubin and Greenspan and Summers, who’s actually the enforcer of the three. He was the one who called her. They argued that just by talking about the need to regulate derivatives, she was going to create market panic. So not only wouldn’t they consider it, they wouldn’t even let her talk about it. She saw this whole crisis coming. You often hear this: “Well, no one saw this coming.” And that is such a reflection on who these men believe is someone. But there are so many people who saw this coming, and they’re considered nobodies. The only way you get to be a somebody is if you agree with them. Brooksley Born saw it coming. Elizabeth Warren has been an incredible watchdog. Sheila Bair, chair of the FDIC, also had a much more principled and ethical vision of what the bailout should be, in arguing that they should be offering direct aid to homeowners, as opposed to this top-down bailout. I feel like this gender split is not coincidental. There’s a need for more of a feminist analysis in understanding how we got here.
I think Ms. Klein exaggerates the issue a bit. There were a lot of men who saw this coming. But in some cases the men were not tossed aside as easily as the women.

I do think that it is a lot easier for men to leverage their positions. It is not as easy for women to get the benefit of the doubt. It is usually men who are treated with “for his position, he has to know what he’s talking about”. Just look at the deification of Alan Greenspan. If he had been a woman, his speeches would have received a whole lot more criticism.

Somehow, I also think that women are more readily accepted as having rigidly ideological views, even when they make great and reasonable analysis based on facts and research. It is also a lot more easy to brush aside pessimistic analysis from a woman as just instinctive worrying, which is seen as a feminine trait and a weakness of mind in the irrational macho culture that is still dominant, especially in the financial world.

The dominance of macho culture and euphoric over-optimism is quite understandable in modern finance. People with normal attitudes to risk simply can not function in an industry so clearly based on an unsustainable bubble. It’s pretty much a case of self-enhancing adverse selection. At the start of an irrational boom, people who see it as such are pushed aside or drop out voluntarily, which just makes the boom stronger.

Ms. Klein presents some unfounded opposition to market-based solutions to climate change:
And at this point, I think there’s a lot of rightful cynicism about the Kyoto protocol because the whole question of "How are we going to respond to climate change?" was entirely infected by market fundamentalism. Bringing it back full circle to where we started, the ideas that have dominated for the past 30 years have utterly shaped the environmental debate during the Kyoto era. So the idea was to always find “market-based solutions” to climate change, which meant that we couldn’t really legislate, and everything had to be creating market incentives for the private sector to solve the problem for us. And I think that’s a much harder sell today in the context of people rightfully losing faith in the ability of the market to solve our most pressing problems. So I think you’re going to see a lot of very different, non-market-based solutions being proposed ahead of the Copenhagen Summit, which is in December 2009.
There is nothing wrong in principle in market-based solutions, but markets have to have clear, fair and binding rules to work properly. Solutions that would be based on unregulated markets obviously don’t work, but a well-thought-out, competitive, non-oligopolistic market solution would not be against the goals of social development.

It is truly unfortunate that people are losing their faith in the market. What they really should be losing their faith in, is the concept of “free market” as practised on Wall Street. Really free markets have strong and fair rules in effect that everybody is bound to. The modern “free market” is a mix of the law of the jungle, with a firm and unfair control from above by a semi-private block of financial interests, represented by central banks.

Principled opposition to markets is like opposition to the rule of law, because of bad laws. Anarchy is not a solution. The progressive movement is badly hurt by people who propose price controls as a way to social goals. There is really no alternative to the market in some aspects of human behaviour. We should instead be focused on the rules that govern the market.

The “free market” fundamentalism as teached by the Chicago school of economics is a perversion of the ideas of Adam Smith. David Korten wrote in his book When Corporations Rule the World:
These practices were strongly condemned by Adam Smith in The Weath of Nations. Smith saw corporations, much as he saw governments, as instruments for suppressing the beneficial competitive forces of the market. His condemnation of corporations was uncompromising. He specifically mentioned them twelve times in his classic thesis, and not once did he attribute any favorable quality to them. Typical is his observation that: “It is to prevent this reduction of price, and consequently of wages and profit, by restraingin that free competition which would most certainly occcasion it, that all corporations, and the greater part of corporation law, have been established.”
It is easy to forget, that the world of Adam Smith was very much different from ours. Back then, it was the government that had actively granted very profitable monopolies to favored corporations. Now, corporations mostly gain monopoly positions by utilizing the lack of willingness to enforce regulations that would limit their growth in size.

Smith was against monopolization, not all government action. He was not an anarchist. He was all for sensible regulation of finance, for example. In the current business atmosphere, Adam Smith would have strongly supported anti-trust legislation, which has not been properly enforced in a long time.

Economist Dean Baker recently made a good point about incorporation being a privilege:
Finally, the article asserts that: "certain very large companies must organize as separate entities that are taxed twice -- on profits and shareholder dividends." Actually, it is not true that any business "must" organize as a separate entity. Certain very large businesses choose to incorporate because they find that the benefits that the government gives them by granting corporate status are so great as to make it worthwhile to pay the corporate income tax.
Market regulation is not inherently antithetical to freedom, as long as the same rules apply equally to everybody, and no special favous are provided. The rules of the markets should be arranged so that there is a price to be paid for all actions that have adverse effects on others. Incorporation is itself an act by the government, extracting a cost from other market participants in the form of reduced competition.

But markets are ultimately made of people. Markets do not have a soul of their own, even if it sometimes seems like that. And people can not be truly free without a fair set of rules to protect their freedom. The modern “free market” fundamentalists are actually nothing but market anarchists.

April 27, 2009

The Bubbles Are Piling Up

It seems that a Kazakh bank might be the first one to collapse from losses that originated in the commodity bubble.
New York Times: The largest bank in the Central Asian nation of Kazakhstan, whose economy soared when oil prices were high, announced on Friday that it could no longer repay $11 billion in foreign debt.

The bank, BTA, said it would pay only interest to foreign creditors, who lavished the country with loans during the commodity boom. The move underscored the growing financial instability in countries all across the former Soviet Union.


BTA had been wobbly for some time. The Kazakh government partly nationalized the bank in February. That was taken as a sign that the bank’s debt might be covered by a sovereign guarantee, though even at the time government-appointed executives said they were studying ways to restructure foreign debt.
I have long been suspecting that the dangers of letting large banks fail have been much exaggerated, especially compared to the burden that is caused by governments picking up the tab. Hopefully the economy of Kazakhstan will not completely collapse.

The losses from the housing market and structured credit bubbles haven't been cleared. Yet we are already witnessing huge losses from the commodity bubble.

Since the 60's the US has seen an ever more rapid sequence of bubbles: conglomerates, junk bonds, real estate, tech stocks, housing, structured credit, commodities, and finally, government bonds. When the accumulation of foreign dollar reserves reverses itself, the government bond bubble will come to an end. That might actually be pretty close now.

It seems that the era of serial bubbles is ending in bubbles that are ever more short in duration, until they can no longer be “fixed” by creating a new one.

When looking at the whole trend, I can't help but to think that the biggest bubble of all has been of the standards of living in the developed world. Western standards of living were raised to unsustainable levels by relying on undercompensated use of colonial resources, until the 1960's. After the colonial period, a massive accumulation of debt has been used to delay the inevitable balancing of global consumption patterns. All the other bubbles are just minor manifestations of this all-enclosing bubble of debt.

Pain in the Fertilizer Supply Chain

Bad news on global agricultural output:
The Globe and Mail (Canada): Farmers across Canada, the United States and elsewhere are ... holding off on fertilizer purchases in the hope prices will fall. Their collective action has sent fertilizer sales into an unprecedented nosedive and pummelled the bottom lines of agriculture giants like Potash Corp. of Saskatchewan Inc., [POT-T]Viterra Inc., Bunge Ltd. and Terra Industries Inc.


Fertilizer dealers have been hit even harder and a few small stores in Canada have gone out of business.

"It's not good," said Bob McNaughton, who runs Sylvite Agri-Services Inc. in Putnam, Ont., which has six locations. He knows several stores that are facing financial trouble. "They're gone, or will be."

Many stores bought potash last year at close to $1,000 a tonne, he said. The price has fallen to around $800, which many still believe is too high. Even if a retailer can make a sale, Mr. McNaughton said the owners have to eat the loss.

"Everybody was expecting a mind-blowing, record fall season and it was a bust," said David MacKay, executive director of the Winnipeg-based Canadian Association of Agri-Retailers, which represents about 1,000 fertilizer dealers.
It seems that retailers will rather let their stockpiles lay still than sell at a heavy loss. I have a radical suggestion: If the producers want to see potash move in the market, they should accept that the super high prices of last fall were a mistake. They should make temporary offers of retrospective rebates to retailers, payable against retail sales, to encourage reductions in stockpiles.
Potash chief executive officer Bill Doyle said farmers are playing a "dangerous game" that will have consequences.

"This level of reduction has never been seen before," he told analysts on a conference call. "No one can state precisely what the impact will be on the world's food supply, immediately or over the longer term. But we know with scientific certainty that nutrient underapplication damages both crop yields and quality."

Mr. Doyle said farmers in Brazil and Argentina are already witnessing the fallout. They used far less fertilizer on their crops and are now seeing production yields fall by as much as 20 per cent.

He said fertilizer sales to North American farmers have dropped as much as 86 per cent but farmers still plan to plant the same amount of corn, canola and other crops as last year. If farmers around the world follow the same path, global food supplies will be affected. "After two record world crops in 2007 and 2008, the year 2009 could be a completely different story," he said.

No, it’s the potash producers who are playing a dangerous game by trying to leverage their oligopolistic market status to extract excessive profits at the expense of the whole population of the earth. Farmers don't have the money.

These kinds of “pile-ups” in the supply chain are an unfortunate side effect of unregulated speculation on essential commodities.

Tom Toles on Waterboarding Iraq–al Qaida “Links”

Tom Toles just got it:

False confessions flow naturally from torture. I think Tom just summed it up perfectly. It's a feature.

April 25, 2009

The Seducing Simplicity of Gaussian Models

This is a great illustration from Paul De Grauwe, Leonardo Iania and Pablo Rovira Kaltwasser of the dangers of using the wrong probability distributions in a statistical model. In (ht Yves Smith, emphasis is mine):

October 2008 was certainly a spectacular month in the stock markets. Large daily changes occurred that surprised most investors. Yet, although many investors had not seen such wild gyrations of stock prices for a long time, there was a general sense that this had happened before.

Those of us who studied modern finance theory, however, were truly astonished by the sheer improbability of the events occurring in the stock markets during that fateful month. One of the basic assumptions used in almost all our finance models is that returns are normally distributed. These models are widely used to price derivatives and other complex financial products. What do these models tell us about the probabilities of the events that occurred in October?

The following table gives an answer. We selected the six largest daily percentage changes in the Dow Jones Industrial Average during October, and asked the question of how frequent these changes occur assuming that, as is commonly done in finance models, these events are normally distributed. The results are truly astonishing. There were two daily changes of more than 10% during the month. With a standard deviation of daily changes of 1.032% (computed over the period 1971-2008) movements of such a magnitude can occur only once every 73 to 603 trillion billion years. Since our universe, according to most physicists, exists a mere 20 billion years we, finance theorists, would have had to wait for another trillion universes before one such change could be observed. Yet it happened twice during the same month. A truly miraculous event. The other four changes during the same month of October have a somewhat higher frequency, but surely we did not expect these to happen in our lifetimes.
Trying to explain these deviations as just a few outliers in an otherwise well-behaving Gaussian process just doesn't cut it. A simple visual comparison of these time series is enough:

Figure 1: Dow Jones Industrial Average 1928-2008

Figure 2: Random Normal Process

April 24, 2009

The “Tortuous” Search for Iraq-al Qaida Links

Jonathan S. Landay of McClatchy Newspapers drops a bomb:
The Bush administration applied relentless pressure on interrogators to use harsh methods on detainees in part to find evidence of cooperation between al Qaida and the late Iraqi dictator Saddam Hussein's regime, according to a former senior U.S. intelligence official and a former Army psychiatrist.

Such information would've provided a foundation for one of former President George W. Bush's main arguments for invading Iraq in 2003. In fact, no evidence has ever been found of operational ties between Osama bin Laden's terrorist network and Saddam's regime.

So detainees were tortured while trying to make them speak of a non-existing issue. So much for the ticking time bomb scenario. This gives whole new meaning to the original source for the title phrase of this blog. “Go massive” indeed.

April 23, 2009

Collateral Damage and Force Protection

Tom Engelhardt writes thoroughly in about the deaths of civilians in US operations in Afghanistan and the various approaches for handling the cases by the military brass.
Admittedly, there's been a change in the assertion/repeated denial/investigation pattern instituted by American forces. Now, assertion and denial are sometimes followed relatively quickly by acknowledgement, apology, and payment. Now, when the irrefutable meets the unchallengeable, American spokespeople tend to own up to it. Yep, we killed them. Yep, they were women and kids. Nope, they had, as far as we know, nothing to do with terrorism. Yep, it was our fault and we'll pony up for our mistake.

This new tactic is a response to rising Afghan outrage over the repeated killing of civilians in U.S. raids and air strikes. But like the denials and the investigations, this, too, is intended to make everything go away, while our war itself -- those missiles loosed, those doors kicked down in the middle of the night -- just goes on.


But let's consider here just one recent incident that went almost uncovered in the U.S. media. According to an Agence France Presse account, in a raid in the eastern Afghan province of Khost, the U.S. military first reported a small success: four "armed militants" killed.

It took next to no time, however, for those four militants to morph into the family of an Afghan National Army artillery commander named Awal Khan. As it happened, Khan himself was on duty in another province at the time. According to the report, the tally of the slain, some of whom may have gone to the roof of their house to defend themselves against armed men they evidently believed to be robbers or bandits, included: Awal Khan's "schoolteacher wife, a 17-year-old daughter named Nadia, a 15-year-old son, Aimal, and his brother, who worked for a government department. Another daughter was wounded. After the shooting, the pregnant wife of Khan's cousin, who lived next door, went outside her home and was shot five times in the abdomen..."


All of this was little more than a shadow play against which the ongoing war continues to be relentlessly prosecuted. In Afghanistan (and increasingly in Pakistan), civilian deaths are inseparable from this war. Though they may be referred to as "collateral damage," increasingly in all wars, and certainly in counterinsurgency campaigns involving air power, the killing of civilians lies at the heart of the matter, while the killing of soldiers might be thought of as the collateral activity.

Pretending that these "mistakes" will cease or be ameliorated as long as the war is being prosecuted is little short of folly. After all, "mistake" after "mistake" continues to be made. That first Afghan wedding party was obliterated in late December 2001 when an American air strike killed up to 110 Afghan revelers with only two survivors. The fifth one on record was blown away last year. And count on it, there will be a sixth.


Let's for a moment assume, however, that our safety really was, and remains, at stake in a war halfway across the planet. If so, let me ask you a question: What's your "safety" really worth? Are you truly willing to trade the lives of Awal Khan's family for a blanket guarantee of your safety -- and not just his family, but all those Afghan one-year olds, all those wedding parties that are -- yes, they really are -- going to be blown away in the years to come for you?

Tom correctly identifies the huge costs of trying to obtain maximum safety. Unfortunately he misses one important aspect of safety in war that plays a very important role in actually promoting the deaths of innocent civilians: force protection.

Force protection has been put into a prime position in the list of priorities for the US military, ever since the mistaken perception that the Vietnam War was lost for the loss of morale at home. Troops are trained to shoot first and ask questions later to avoid potentially hazardous situations that could be triggered by the extra few seconds or minutes that would be needed to adequately asses the threat. This is well highlighted by the case of the cousin of Awal Khan mentioned in the quote above. She most probably received five bullets in the abdomen “just in case”, simply to protect the US troops involved from even theoretical risks.

Overreliance on air power is the most awful measure of force protection. Air raids are safe for the military, but disastrous for the civilian population in anti-insurgency warfare.

This is simply wrong. Soldiers should be bearing the risks to protect the civilian population, not engaging in reckless endangerment and voluntary manslaughter on a massive scale. In this case, it is not even a case of enemy civilians, but the very civilians that the soldiers are supposed to be protecting.

Giving the safety of soldiers priority above that of the civilian population is not only wrong, but stupid as well. It unnecessarily enrages the population and enhances the popularity of the insurgency. If US soldiers are not ready to risk their lives in protecting foreign nationals, they should not engage in wars of “liberation” in the first place.

See also my post from October 2007: “Human Terrain Teams and Dehumanization of Civilians”.

March 23, 2009

About US Unemployment Non-Security

Robert Eshelman writes in, under headline “The Other War on Workers”:
Under unemployment eligibility requirements, an employer must certify whether an employee committed a "fault" on the job and was therefore terminated. If an employer indicates that no fault was committed and the employee meets several other requirements, including being physically able to work, states grant an unemployment claim. In other words, Chris's former employer granted him a small concession, while otherwise turning his life upside down amid the worst job market since 1983.
Is this really the situation in the US? No wonder people are scared of their employers. Record crime rates, here we come! Americans really have to rethink about their social safety nets.

In a later paragraph:

Someone I interviewed prior to my job center visit described her reaction when she heard that her company had recently closed a plant in the Midwest: "The first thing I thought, and I felt bad for thinking it," she recalled, somewhat sheepishly, "was that means more work for us -- at least for the time being."

Her comment speaks volumes, as does her request not to be identified. Who needs union busters, patrolling shop-stewards, or legions of high-paid lawyers fighting wage and hours claims when a worker is so anxious about job security that she responds positively to the laying off of those she imagines as potential competitors? When employees police their own behavior for fear of the axe -- monitoring their time checking email or using the bathroom -- bad times distinctly have an upside for management.


A look at corporate opposition to the Employee Free Choice Act (EFCA), whose passage in Congress is a central demand of organized labor, offers a glimpse of how persistently companies seek to disadvantage their workers. EFCA would allow workers to form a union when a majority of them sign union cards in a given workplace. "Card check," as it is frequently called, enables them to organize unions without the need for an election. In a November column surveying the business elite's response to the Act, Wall Street Journal op-ed columnist Thomas Frank wrote: "Card check is about power. Management has it, workers don't, and business doesn't want that to change."

Trying to prevent workers from setting up a trade union should be declared illegal as a violation of the workers' freedom of assembly.

March 22, 2009

Thomas Friedman: "We Must Have Growth"

Thomas Friedman states the obvious:
Let’s today step out of the normal boundaries of analysis of our economic crisis and ask a radical question: What if the crisis of 2008 represents something much more fundamental than a deep recession? What if it’s telling us that the whole growth model we created over the last 50 years is simply unsustainable economically and ecologically and that 2008 was when we hit the wall — when Mother Nature and the market both said: “No more.”
What on earth is so radical about this view? It is a perfectly acceptable possibility. It is truly sad that he feels the need to explicitly step out of the “normal boundaries” to even contemplate such an idea.

Later on he gets to his policy descriptions:
We must have growth, but we must grow in a different way. For starters, economies need to transition to the concept of net-zero, whereby buildings, cars, factories and homes are designed not only to generate as much energy as they use but to be infinitely recyclable in as many parts as possible.
Yes. Let's abolish the second law of thermodynamics. That will solve all our energy needs.

While greater efficiency is a good goal, what is it with the “we must have growth” meme? It is absolutely not true. We could very well go on with a lot less than we have, after all, our grandparents certainly did. We could produce less, we could consume less, we could travel less.

The only thing that necessitates growth (beyond population growth) is the current state of the banking system, which is built to withstand total collapse only in the presence of continuous growth. If the economy was not based on such huge amounts of debt, there would be no need for continuous growth.

US FDIC Covering Bond Holders?

Something doesn't quite sound right here: The Federal Deposit Insurance Corp. said late Thursday that it has completed the sale of IndyMac Federal Bank FSB, the firm it took over last year, and that it took a $10.7 billion loss on the deal, far more than originally expected.

The FDIC said OneWest Bank, FSB, a newly formed Pasadena, California-based federal savings bank organized by IMB HoldCo LLC, would assume IndyMac's deposits.

"As of January 31, 2009, IndyMac Federal had total assets of $23.5 billion and total deposits of $6.4 billion. OneWest has agreed to purchase all deposits and approximately $20.7 billion in assets at a discount of $4.7 billion. The FDIC will retain the remaining assets for later disposition," the FDIC said in a press release.
How can the FDIC accumulate $10.7 billion in losses while covering $6.4 billion of deposits? Sounds like the FDIC is taking a fall for other creditors of IndyMac as well. Is this really the purpose of FDIC? I thought it was only supposed to be for deposit insurance.

March 16, 2009

Lawrence Summers is a Grand Hypocrite

Lawrence Summers, former World Bank chief economics, Clinton Treasury secretary and Harvard president, has completely turn his convictions around. This would be good, if he didn't maintain that this apparent conversion is somehow 'temporary': reports (ht to Emmanuel):
Widely seen as being among the most pro-market voices in the White House, having been Bill Clinton’s last Treasury secretary in the 1990s, Mr Summers said the view that the market was inherently self-stabilising had been “dealt a fatal blow”. At a time when the Republican critique of Washington’s aggressive response to the crisis is growing more trenchant, Mr Summers made an unapologetic case for government intervention.

“This notion that the economy is self-stabilising is usually right but it is wrong a few times a century. And this is one of those times . . . there’s a need for extraordinary public action at those times...”
What a load of crap. Summers has it almost exactly backwards. The 30 years or so that this credit bubble has been constantly growing have been the time that the market has not been self-correcting. This crisis is the much awaited self-correction.

Funny that he didn't feel this way when the Asian financial bubble burst in 1997. Then he was all for harsh austerity measures. The current global phenomenon is only different in its scope and size. There is no fundamental difference.

Not that I'm at all for letting this crisis run its course without any remedial measures. But if we are going to let the unquestionably unstable credit machine churn out bubble after freaking bubble, we should device a comprehensive safety net that covers all and every part of the world economy, not just a select set of G-7 nations.

Naturally, it would have been much more fruitful to keep the lid on the credit machine that was unleashed by the Reagan and Thatcher governments in the early 1980's. Unregulated issuance of credit has always and everywhere been the source of financial bubbles.

March 3, 2009

India's Growing Supercomputing Market

Signs of the rise of India as a growing player in the world of research and development: Cray Inc. has established a presence in New Delhi. (ht Global supercomputer leader Cray Inc. (NASDAQ: CRAY) has formed a new wholly-owned subsidiary in India aimed at strengthening its presence in that country's growing High Performance Computing (HPC) marketplace.

"The senior management at Cray has felt for some time that the company needed to expand its footprint in India to provide a strong, local presence for our customers," said Andrew Wyatt, vice president, Cray Asia Pacific. "The country's HPC market is of rising importance, and establishing a new subsidiary allows us to seamlessly deliver our supercomputing expertise to both new and existing Cray customers in India."

HPC utilization is an important bellwether of high-tech, high-value added research and development.

Elsewhere, SGI has announced further layoffs of 9% of its workforce, even at the face of a big order of the US DoD:

The Register: Supercomputer maker Silicon Graphics has let go 120 more employees, nine per cent of its workforce, in an effort to cut costs as its revenues decline.

These cuts come hot on the heels of a 15 per cent layoff announced in mid-December, when SGI slashed 15 per cent of its 1,500-strong workforce, eliminating 225 positions. After the latest rounds of cuts, SGI has approximately 1,155 employees. That latest round cost the company about $3m in severance and related charges, according to the 8K filing, and SGI expects the layoffs to be completed by March 27.