One of the more pestilential elements of the atmosphere of modernity is a tendency to substitute for the actualities of things - for example, the concrete society into which one was born, say, the ancien regime - fantasies, phantasms, and illusions that faintly resemble those realities, but are, in reality, utopias - no-places. This aspect of modernity can manifest itself in virtually any corner of the human experience, though the specifically political seems to exert an especial attraction. Nevertheless, the tendency toward abstraction and fantasy can deform any discipline or practice, even those that are ostensibly tethered to quantifiable realities. And while the consequences may not be as sanguinary as those of the overtly political ideologies, they are no less real.
Exhibit A in the migration of the ideological temperment from the lush pastures of the political should be the black-box economy of collateralized debt instruments, derivatives, structured investment vehicles, and other financial arcana associated with the current liquidity crisis.
a staggeringly complex financial instrument that most Americans had never heard of, and which many financial writers still don't fully understand, became in a matter of months the most important influence on home values in America. That's not how the economy is supposed to work - or at least that's not what they teach students in Economics 101.The reason this had been happening totally out of sight is not difficult to understand. Banks of all stripes chafe against the restraints that federal and state regulators place on their ability to make money. By cleverly exploiting regulatory loopholes, investment banks created new types of high-risk investments that did not appear on their balance sheets. Safe from the prying eyes of regulators, they allowed banks to dodge the requirement that they keep a certain amount of money in reserve. These reserves are a crucial safety net, but also began to seem like a drag to financiers, money that was just sitting on the sidelines.
"A lot of financial innovation is designed to get around regulation," says Richard Sylla, professor of economics and financial history at NYU's Stern School of Business. "The goal is to make more money, and you can make more money if you don't have to keep capital to back up your investments."
The rudiments of these esoteric instruments are not exactly new; various forms of derivatives have been employed for over a century as forms of insurance.
But today, increasingly, a new generation of derivatives doesn't trade on markets at all. These so-called over-the-counter derivatives are highly customized agreements struck in private between two parties. No one else necessarily knows about such investments because they exist off the books, and don't show up in the reports or balance sheets of the parties who signed them.
In other words, the new categories of exotic financial instruments were expressly created as essentially non-market vehicles, for the purpose of sidestepping regulatory requirements, particularly reserve requirements. It also bears mentioning that the mania for deregulation which swept over the Western political cosmos over the course of the last two decades created the atmosphere within which a dimly-comprehended, highly-leveraged class of speculative vehicles could be looked upon with benign neglect.
As the derivatives business has grown more complex, it has also ballooned in scale. Broadly speaking, (Satyajit) Das - author of a leading textbook on derivatives and complex securities - estimates that investors worldwide hold more than $500 trillion worth of derivatives. This number now dwarfs the global GDP, which tops out around $60 trillion.Essentially unregulated and all but invisible, over-the-counter derivatives comprise a huge web of bets, touching every sector of the world economy, that entangles a massive amount of money. If they start to look shaky - or if investors need to start selling them to cover other losses - that value could vanish, with catastrophic results to the owner and unpredictable effects on financial markets.
A vast, incomprehensible latticework of abstruse financial abstractions, each one leveraged upon the one preceding it, may be more than seven-hundred percent larger than the real economy, to which it is only loosely tethered, being insusceptible of normal market valuation, and possesses the capacity to precipitate profound disruptions in the real economy if there occur but slight perturbations in its preconditions.
Two observations are apropos of this development, which itself threatens to wrest control of the real economy from real market actors, inclusive of the central banks. First, there has existed, beneath all of the rhetoric surrounding deregulation and the retreat of the frontiers of the state, a somewhat naive and misleading conception of the naturalness of economic activity, as opposed to the contrivances of political intervention. The former would, if left to their own devices, somehow "take care of themselves", while the latter would only muck things up by precluding the former from doing so; and, in the context of the political controversies of the Seventies, there was a measure of truth to the argument - which, however, remained misleading. Any economy more sophisticated than simple hunting and gathering, or the crudest sort of command economy, presupposes a body of custom and law by which economic practices are regulated and structured; simplistic arguments in favour of deregulation, therefore, either obfuscate by pretending that the question of which configuration of laws should be observed can be expressed in the form of whether there should exist (certain categories of) such laws, or substitute the phantasm of a natural realm, autonomous and self-sustaining, for the inevitable complexities and contingencies of actual economic practice. The former sort of rhetorical confusion engenders a confused and opaque political discourse, in which terms and concepts no longer possess stable meanings; the latter confusion is simply that of ideology proper.
In either case, the animating ideal, in the one case muddled, and in the other clearly expressed, is that of the self-regulatory capacities of market functions, a notion derived from the economic ideal of equilibrium, according to which markets rapidly correct for imbalances between supply and demand, minimizing the incidence and severity of economic downturns. It is imperative that it be recognized that equilibrium is merely an ideal, presupposing conditions which are impossible of realization, such as large numbers of small firms competing in an integrated market (ie., one with no purely regional players, locally dominant firms, etc.) bereft of 'friction', perfect information and the dissemination thereof, wholly rational (ie., "Utility-maximizing") actors, and so forth. Difficulties arise when it is imagined that the ideal can be incarnated, and when particular rule-sets, which may be radically flawed, are mistakenly perceived to be, or cynically presented as, a natural state of affairs. The related notions of a self-regulating market order and spontaneous order contain large elements of truth; it is merely the case that such orderly checking and balancing only occur within the framework of a wisely articulated and prudentially enforced and elaborated legal regime. Otherwise, the notion of ineffably wise and judicious, self-regulating, spontaneously orderly markets is mere cant. Knowledge is imperfect, men are irrational, and externalities always intrude; men are finite and fallible.
The potency of the fantasy, however, which has imparted an obscurantist colouration to our politics over the past generation, lies in its aforementioned ideological quality: the ideal of self-regulation implies the absence or superfluity of regulation correlated to concrete, contingent circumstances - something valid universally. Moreover, something valid universally obviates the necessity of prudential judgment, the ongoing balancing of ends and means in a matrix of inherited traditions and practices, and normative discourses. The distillation of ideology is the negation of prudence. There is always one answer. Reality always obtrudes upon such reveries, as it has in the current financial shakeout.
Second, seen under the aspect of ideology, the highly abstract, disincarnate nature of these exotic instruments and processes - essentially, symbolic manipulations which, by the alchemy of the age, high finance, are convertible with tangible realities - is representative of one of the general tendencies, or modes of thought, of Western modernity. Abstract symbolic functions are to some degree confused with the actual, substantial realities of the economic life of a nation, and eventually come to dominate that life, and that reality no longer possesses an independent integrity, but exists to serve the abstractions; reality gradually develops a tropism towards speculative vehicles divorced from concrete facts. These abstract symbolic functions are also the province of a coterie of mystagogues, governed by laws and relationships so arcane and abstruse as to place them behind the logic of ordinary market forces (Which is why some critics and regulators have spoken of "assigning" market valuations to them, to the end that some order might be brought out of chaos. But market valuations are not assigned at all.): a concatenation of abstractions predicated, ultimately, not on the nominal backing - bundled mortgage paper, for example - but in a fantasy of a finite infinity, the occult magic whereby ostensibly finite quantities can be multiplied almost indefinitely (yielding $500 trillion worth of paper predicated upon a small fraction of $60 trillion worth of real GDP). This is modernity's secular parody of the creatio ex nihilo.
Exhibit B in that migration of the ideological fever should be the transmogrification of evolutionary theory from a set of empirically-grounded and testable hypotheses to a sort of timeless, eternally valid set of precepts, applicable to anything whatsoever:
So it is that, in the field of evolutionary studies, we now find strange séances in high-tech laboratories where biologists, bent over their computerized abstractions, struggle to bring them alive as mutating, replicating, evolving organisms.The scientists engaged in this occult-sounding project begin with a simple array of numbers—a data structure—where each number represents a low-level computer instruction. Perhaps, to begin with, the combined instructions don’t do anything sensible other than to direct the computer to replicate the entire data structure. However, you can arrange the supporting software so that every so often a “mutation” occurs, resulting, for example, in an altered, added, or deleted instruction. This might destroy the possibility for replication, but if you start with a considerable number of these data structures, an occasional mutation might yield a non-destructive new capability. For example, a mutated element in a data array might happen to be the computer’s instruction for performing a primitive logical operation, or, in combination with other, already present instructions, it might manage a more complex logical operation. Conceivably, a large number of such mutations could eventually produce a data structure capable of directing the computer to calculate the sum of any two supplied numbers, a feat that (depending on the computer) might require thirty-five or more instructions in a given sequence.
If you are like many scientists working in computational biology, you will be inclined to regard such data structures, along with the associated bits of programming, as “digital organisms”—organisms that, under the right software conditions, can be said to “reproduce,” “evolve,” and become “fitter.” Each data structure, with its array of computer instructions, can be thought of as a “genome.” When mutations produce a new logical capability, the software “rewards” the organism with more opportunities to execute its instructions and to reproduce, whereas mutations that compromise its logical capabilities reduce those opportunities. The organism thus has a “metabolism”: it gains “energy” in the form of computer processing time whenever it is successful at logically processing numbers (“food”) received from its software environment and returning the numerical products of this activity back to the environment. This means that the more logically capable organisms tend to proliferate and are encouraged along their evolutionary path toward ever more sophisticated arithmetic prowess. (Steve Talbott, from Ghosts in the Evolutionary Machinery, in The New Atlantis.)
At which point I will note simply that Talbott's essay is not to me missed, and that his takedowns of Per Bak and Daniel Dennett occasion much hilarity. Despite the disparate natures of the phenomena, both the black box economy, and quantitative, utilitarian economics generally, and the field of computational biology are manifestations of the distemper, namely, the ideological deformation of or discourses, which leads us to prefer our fantastical constructions and speculations - the ideas of things - to the things themselves. In the one, wealth that doesn't really exist reproduces itself indefinitely, and can convert itself into tangible things, and can even throw the world of tangible things into chaos and old night, while in the other, non-organisms reproduce and evolve as though they were organisms, and are thought equally as real, or perhaps more real still, than actual organisms - all because they express more 'purely' the eternal 'logic' of evolution. Such a preference for fantasy and illusion over reality is a sacrament of endarkenment.
Comments (44)
Evolutionary theory now has the status of Mathematics--it is logically true.
There exist mathematical algorithms
based upon Evolutionary Theory called
Genetic Algorithms that optimize given configurations subject to constraints ie find optimum configurations in a landscape of potential configurations.
Posted by Bisaal | February 14, 2008 1:56 AM
Maximos:
Your article is interesting as usual---though, I confess, it sends the reader scampering to the thesaurus more often than perhaps really necessary! (You might use "prudent" in place of "prudential"; but you have not asked my advice on style, have you? Nor am I qualified to give it to you.)
Your thesis is compelling: that the imagined is valued more highly than the concrete. It brings the example of the professional economist to mind. A recovering ex-free trader like me marvels at the stubbornness with which a professional economist can cling to the pretty differential equations he uses to model the economic theory of comparative advantage. This, in spite of a rapidly deepening accumulation of mundane observations that suggest that his model does not in fact adequately describe the relevant aspects of the real economy. In his view, data are only to be permitted to validate the model, never to invalidate it. When data do not fit the model, the economist reasons, it suggests that the data---not the model!---were unsatisfactory. Our economist is persuaded only when we present him with a better model.
Why? Because, left without a model, our economist feels unhappy.
Nonetheless, it seems to me that the suspicion your article casts on exotic financial instruments needs better support. There are many, many things in the world I do not adequately understand: naval tactics; why fixed wings actually keep airplanes aloft; how the farmer delivers eggs that don't make me sick; the ways in which policemen track down murderers; etc. That I do not understand these things does not prevent me from trusting the admiral, the engineer, the farmer and the policeman to do their part to keep me safe, healthy and prosperous. Now, if our Navy kept losing ships and islands, if airplanes began falling out of the sky daily, if this were the third year in a row an egg had poisoned me, or if the separate murders of four on my street remained unsolved, I should begin to wonder. It may be that the financiers are precipitating an economic disaster through their exotic instruments, but if so, I admit that I shall need more convincing. I mean, suppose that I suggested that, through your "exotic publishing methods," you were complicit in America's declining standards of journalism.
I do not know what the $ 500 trillion figure you cite actually represents. It represents contracts to do---what? That I do not understand does not make you wrong, of course. Markets can be capricious. However, governments can be even more capricious. Before one agrees to encourage a government to meddle in anything with a $ 500 trillion price tag, one wants more persuasion than vague suggestions that the financial instruments of which you speak are unreal.
I am not arguing against you. I am only asking questions, not because I disagree with your article but because I find it interesting.
(And maybe you can find a typo in this comment to pay me back for having shaken my thesaurus so rudely at you.)
Howard
Posted by Howard J. Harrison | February 14, 2008 6:37 PM
I would argue that the place to begin in assessing the exotic financial instruments implicated in the present economic downturn is precisely the Boston Globe article I cited in the original piece. Just read between the lines a little: few people have even a tenuous understanding of these instruments, they dwarf the real economy, and result in the transfer of 'control' over vast swathes of the real economy from non-market processes to... who exactly? The point being that this is simply not how 'capitalism' is really supposed to function (setting aside the theory/reality distinction for the moment); capitalism is supposed to involve the market determination of values, and in fact, the essence of the system is found in the price mechanism as the mediator of information, upon which market actors base their decisions. This was, after all, the linchpin of the refutation of socialism/central planning: you cannot propound five-year plans in the absence of information, which is only afforded by a price mechanism, and, assuming the existence of such a mechanism, no central authority can fully comprehend it. Socialism presupposes what it effectively negates; ie., it is self-refuting.
Unfortunately, these arcane instruments occupy an analogous status within capitalism; they flout the laws of what we are informed is the logic of capitalism, though they have developed out of some of the foundational institutions and practices of capitalism, and, in a sense, they falsify some of the more extravagant claims advanced on behalf of capitalism. Objectively speaking, they instantiate the logic of pyramid schemes more closely than that of what we like to think of as capitalism proper - that's the reason for the obsession with interest rates and liquidity: the entire system is predicated upon debt and speculation, all of it underwritten by the implicit promise of more debt in the future, which will allow the present fools to cash out. But you cannot get something from nothing.
Old-school, sound-money, cranky libertarians - the sort that still take their von Mises seriously - work themselves into high dudgeon over this stuff, and, excepting the myths of the self-regulating economy, they are largely correct.
Another way of appreciating the scandal of this stuff is that it is all debt; and debt, being a claim upon someone's future earnings, is inherently redistributive. Hence, we have a category of speculative abstractions, all more or less off-market, which amount to vast claims upon someone else's future wealth - by the nature of the case (the vast sums of money involved) far in excess of what anyone has bargained for in actual market transactions. The ostensible squaring of the circle is to be effected by that liquidity that factors in all of the discussions; in other words, the circle will be squared by - wait for it! - inflationary monetary policy, concealed by all of the rigged calculations (core inflation, the CPI, etc.) that the system has developed over the past 40 years for the purpose of cloaking reality. In other words, inflation is redistributive, both in the structural sense of underwriting speculative investments leveraged in midair, and in the sense that those institutions and their principals through whom the new credit is issued benefit from the new issue before the currency depreciation filters through the market (devaluations and price shifts are never instantaneous or uniform, but uneven: information is always imperfect). Not only that, but one of the central achievements of conservative economics over the past 30 years, the taming of inflation, is either a)undone by bad monetary policy, b)disclosed as a fraud, or c)never really happened. I don't have an opinion on that question yet, but this is one of the seldom-spoken factors spurring globalization: international labour and manufacturing arbitrage holds down prices that would otherwise rise, but does so with a declining currency - a Sisyphean task.
Essentially, this process represents a concentration of economic power, albeit outside the bounds of 'the market' in any meaningful sense of that term ("the market" cannot refer to just anything that a capitalist chooses to do); it is the analogue of off-budget black ops in government. It is difficult to say much more than this, given the abstruse nature of these vehicles; but the downsides and instabilities, not to mention the political implications, are obvious enough. I would that I could say more concerning how these things could be redressed, but most economists don't understand the instruments themselves, let alone how to correct the flaws they reveal in an economy. I suppose that a return to the financial division of labour of something like Glass-Steagall, which precluded the mingling of banking functions (ordinary loans and securities, for example) intrinsic to such speculation, would help; but any attempt to reform the laws must first engineer a gentler landing before forbidding the avaricious from leveraging investments 10 times over. As for trusting professionals and experts, well, I really do believe that it is one thing to trust an aircraft engineer, and quite another to trust investment bankers whose actions have palpably negative effects. We don't need to comprehend everything the banker does to discern that some of it, as divined through its consequences, is other than fully kosher.
Posted by Maximos | February 14, 2008 9:50 PM
What do the old-school libertarians who take their von Mises seriously say should be done? (This isn't a trick question. I know pretty much nothing about this stuff and would never claim to. I'm just honestly curious.)
Posted by Lydia | February 14, 2008 10:25 PM
End "fiat-money" based financial systems, ie., abolish the Fed, returning to the gold standard, probably with a free-banking system of competing currencies. Not that I am persuaded that this would be viable; I don't understand enough of the argument for free banking to say more than that it sounds slightly hinky. But a lack of an alternative does not invalidate a critique, and a critique that may extend too far does not necessarily invalidate its own premises.
Posted by Maximos | February 14, 2008 11:08 PM
I have a few mild reactions to the Globe article. Generally speaking I'm not a 'macro' guy, so there is a lot of high-level economic theory that I can't speak to; though full disclosure requires me to say that that is in part because every time I look at it it fails the bullsh*t smell test in the first few premeses.
I want to be clear that I'm not arguing with Maximos here, I'm just letting loose with a little stream of consciousness reaction.
Hedge fund activities are described as
What immediately strikes me as odd is the very notion that there exists some group of "experts" who "understand how it works". I don't believe that there is or ever has been any such thing.Second, the reason the banks are screwed over their subprime CDO plays is not because of hedge fund managers. Pretty much the exact opposite is the case: the banks put these byzantine debt contracts that they didn't understand themselves together assuming that on the downside the hedge fund guys would be willing to buy it out on the cheap if things went south, given that there are underlying (real estate) assets collateralizing the debt. Unfortunately for the bankers, the hedge fund guys aren't biting, because nobody really knows what these contracts are worth. Heck, in a lot of cases it isn't even clear who really has title to the underlying real estate. The real issue is that hedge fund investors have to be "qualified" as a regulatory matter: that is, they have to have (e.g) a personal net worth of >$1MM and/or family income >$300K/year, while bank investors and borrowers are everyman. There is a reason why hedge fund and private equity investors have to be qualified: everyman really ought not be playing with these arcana, because he doesn't understand them and he can't afford to lose the way a qualified investor can afford to lose.
Third, I don't know where the notion comes from that CDO's are off the books and unregulated. If they were off the books then it makes no sense to observe that they are being "written down". The reason they have to be written down is precisely because they are on the books. It is true that the inherent risks weren't being discounted properly by the bankers, but that is what happens when you play with derivatives. We've had the S&L crisis and the Orange County debacle and the junk bond/LBO hubbub and all kinds of other things before. If this stuff were all off the books and in a dark hole somewhere it would take years for problems to reveal themselves. If anything the speed with which the problems with CDO's revealed themselves was significantly greater than in past macro-incidents. It is true though that there are other vulnerable areas, most particularly in unsecured consumer credit; but the biggest issue with the sub-prime crisis is that the collateral isn't really there, so the risk discount was off.
Fourth, people don't have to buy bloody McMansions for $500K with 5% down. They just don't. I realize I am unusual, but I've never bought a house without paying cash. And I've lived paycheck to paychek in a rental before too: it isn't like I haven't lived that side of the equation. When you own a large asset which is "worth" many times your annual income, that asset owns you. What is more, you are highly leveraged: any price fluctuation on the downside is going to hammer you good and hard. People feel like they are entitled to home values that never go down, so that they can always sell on a moment's notice and get back what they put in plus a profit. Too bad. Welcome to reality, have a nice day.
Fifth, one positive in all this is that quite a few people are now geographically stuck in the communities in which they have bought homes. They simply can't afford to move, even though they aren't necessarily teetering on foreclosure. Some built in barriers to the modern suburban hobo lifestyle are probably a good thing. Too bad it is only temporary.
Sixth, asset-backed money is simply not going to work, in my view. I don't think tightening the liquidity of cash can do anything but harm. Credit tightening (in the sense of qualifying borrowers better) is almost certainly necessary, or at least a better reflection of risk in interest rates charged is necessary, but reducing the liquidity of cash just strikes me as a really, really bad idea. It seems backwards in much the same way that blaming hedge fund managers for the subprime crisis that they are smart enough not to bail out even at pennies on the dollar is backwards: we want cash to be better valued relative to debt, not tightened relative to debt, and radically reducing the liquidity of cash by going to an asset-backed currency would certainly have the opposite effect.
As usual, anyone who reads my comments on finance should consider the possibility that I don't have the faintest idea what I am talking about.
Posted by Zippy | February 15, 2008 11:47 AM
Oh, and on the main theme of the modern disease of valuing abstraction over concrete reality: go Maximos!
Posted by Zippy | February 15, 2008 11:48 AM
Actually, Zippy, I find all of that very helpful. Stupid question: "Asset-backed currency" means something like "gold standard," right? (See, I'm so ignorant I'm not even sure of that. But I think so.)
I like your "welcome to reality" attitude towards home debt. I have a similar attitude to car debt. I couldn't buy a home without some debt but jolly well paid it off as fast as possible and would never in a million years have gone with anything but a boring, traditional mortgage. No balloons, thank you, except at birthday parties! But with cars, I've only one time in my life bought a car for anything but cash, and that was with a no-interest, very short-term, very small loan from a relative. I simply cannot understand people living on a shoe string who buy a $15,000 brand-new car on credit. It makes me almost angry. I suppose that's how you feel about people who buy $500K houses when their income really won't support it.
By the way, it's my impression (I'm no expert) that the biology stuff mentioned in the OP is indeed baloney on stilts. (Is there such a thing as baloney on stilts?) Thinking that little computer-generated "creatures" are really creatures, or even probably good models of real creatures, is ridiculous, and thinking that if you can't get something to happen in the real world you've proved something if you can get it to happen in a computer program is even more ridiculous.
Posted by Lydia | February 15, 2008 12:18 PM
Excellent comments, Zippy. I do concur in the judgment that one of the unintended consequences of this is positive: a temporary impediment to the suburban nomad lifestyle. And, of course, many of these hapless home-occupiers (they cannot be owners in any meaningful sense of the term) ought never have purchased McMansions with low-down-payment mortgages, or no-down-payment ARMs. On the other hand, I don't believe that there should exist such instruments as ARMs, largely because the average person simply cannot reasonably be expected either to read dozens or hundreds of pages of fine print, or, if they have, to really comprehend it. Many financial services people don't fully understand all of the legalese, and neither do the home-buyers. A valid contract ought not be esoteric to either one of the parties.
I do believe, though, that there is some substance to the objections some economists have to all of these byzantine arrangements; while it is always hyperbolic to presume that anyone can comprehend the whole, most of the professionals find these instruments opaque at best, and when such instruments proliferate, people only tangentially related to them can be harmed, big-time, as in past financial debacles. I find that the following is a decent rule of thumb: when few people understand some social, political, or economic practice that nonetheless involves enormous wealth and power, the odds are well better than even that someone is taking the shaft.
FWIW, I don't believe that I'm laying all of the responsibility for this debacle at the feet of the hedge funders - though I've known some, and don't think much of them - and have no problem taking the point that ordinary bankers may be more responsible than any other faction. However, in a broad, macro sense, this stuff is merely the current manifestation of a sort of speculative derailment that has happened many times previously, and that certain regulatory bulwarks were supposed to insure against. And in that instance, regulators, from the Fed on down, have both connived at weakening the regulations, and looked the other way when 'innovative' new vehicles were developed, vehicles that could be analogized in some respects to previous troublemakers. One of the reasons for this trend has been the naive deregulation-mania; another has been that liquidity obsession - which does have a systemic function, in a very broad macro sense: a compensatory measure for a deindustrializing economy that no longer produces, but only imports and services.
All of which leads to the question of asset-backed money, for which I'm not offering a brief, inasmuch as legions of speculative bubbles and collapses have occurred even with asset-backed money (just look at the linked chart...). The issue seems oblique to the question at hand, as far as I am concerned. Nevertheless, while a finite money supply may engender all manner of problems, I confess that I don't quite understand how our cash can be better valued, relative to debt, when the spigots are wide open, resulting in the cash actually being worth less relative to everything as time progresses. Credit tightening under conditions of constant or increasing liquidity can mean that "too few" borrowers exist for the available credit, resulting in the panic measures of lower interest rates until they are nominal, as in Japan during the 90s. So, consider this a request for clarification/elaboration.
Posted by Maximos | February 15, 2008 12:27 PM
Lydia:
"Asset-backed currency" means something like "gold standard," right?
Yes, precisely, though there is nothing particularly special about gold contrasted to other valuable assets. We could take all the land owned by the federal government and create a land-backed currency, for example; or we could take a whole basket of assets - land, oil, gold, water, cars, toenail clippers, pork bellies - and require the federal government to yield a specified quantity of those assets on demand to any holder of US legal tender. What the point to doing so would be remains somewhat mysterious. Seemingly doing so would hedge inflation to some extent, since having the government's guarantee that you can always get six tonail clippers for a buck directly from the government does tend to stabilize prices. But I expect its stabilizing effect is more putative than actual, and I'm not sure why the Federal government ought to be in the business of stockpiling toenail clippers simply to have them in inventory in case of a sudden burst of demand in the first place.
Given the strategic nature of oil perhaps we ought to have an oil-backed currency. But that runs rather at cross-purposes to the point of having strategic oil reserves in the first place, which is to shield them from arbitrary consumer demand so that they can be preserved for use when certain acute conditions arise. I don't advocate an oil-backed currency by any means, but I think thinking about commodity-backed currencies in terms of if oil were the commodity - and the US government had to produce fixed, specified quantities of it on demand in exchange for legal tender - might be clarifying.
Maximos:
A valid contract ought not be esoteric to either one of the parties.
Indeed. That is why in general investors in private equity, venture capital, and hedge funds have to be accredited, and why margin trading accounts have reserve requirements, etc. (Whether as a prudential matter these should be tightened is certainly open for discussion). Everyman is (rightly) presumed not to understand the risks involved; the opposite presumption (not always rightly) legally applies to accredited investors.
Of course it isn't criminal to take investments in (say) your little high tech startup from grandma. But if you do so, and she loses her money and [she or some party with legal claim to her assets] sues you, you will almost certainly lose. The civil law presumption is in her favor, unless her net worth is over $1MM (or something like that -- I haven't looked at the current numbers).
Indeed the whole point to "publicly traded" securities is precisely the concomitant disclosure requirements on the one hand coupled with a larger market of investors - and therefore greater liquidity - on the other.
The issue seems oblique to the question at hand, as far as I am concerned.
I agree: asset-backed currency is its own sort of little religious war, and isn't central to the issue of transparency, etc. It isn't so much that I disagree with critiques of fiat currency as that I strongly suspect that the putative solution involved in stockpiling toenail clippers or some other commodity doesn't work the way people think it works. But I am far from an expert on the subject.
Posted by Zippy | February 15, 2008 1:43 PM
Quite educational. Thanks, Zippy.
Posted by Howard J. Harrison | February 15, 2008 2:03 PM
On this point:
Amen to that. Our all-atom computer models of how proteins fold can only handle a few residues. (An average real proten has hundreds or thousands of residues, with multiple interdependent proteins coupled together into functional quaternary structures; and gene expression itself has allosteric dependencies, not merely code dependencies). All the other computational biology models at the protein level are - as far as I am aware - either grossly simplified lattice models which are being used to explore the basic mathematics of how one-dimensional strings with bead-affinities can become stable singularly-determined two- or three-dimensional structures, or are strictly qualitative. And the notion that higher-level software "organism" models map to anything "real" is pure assumption, with no basis whatsoever in reality. If you think about computer modeling of weather, and then crank up the complexity by many, many orders of magnitude, and then throw in the problem of the goal-directedness of biological structures, you can get some idea of how distant from reality these things are. We don't even know what kind of principles might apply; but a century of presenting Darwinism as a proven deal means that nobody can admit to the true level of ignorance on the subject.Oh, and it is going to rain at the intersection of 14nth and Main at exactly six o'clock this August 17th. Really. And if you believe that, I've got a structured financial instrument you might be interested in.
Posted by Zippy | February 15, 2008 2:05 PM
I hope that means Phil the Groundhog is also bad at predicting weather, because he said six more weeks of winter a couple of weeks ago, and I'm definitely ready for an earlier spring. :-)
Seriously, it's excellent to have a far more expert opinion on computer biology.
Posted by Lydia | February 15, 2008 3:24 PM
Seriously, it's excellent to have a far more expert opinion on computer biology.
Indeed. I'm just grateful to have my instincts confirmed on this point: the 'science' is cromulent (Simpsons reference), meaning that it has the superficial sheen of legitimacy, but is really bunkum.
Posted by Maximos | February 15, 2008 3:27 PM
Zippy's original remarks concerning asset-backed currencies occasioned thoughts of what is probably the principal theoretical problem with an asset-backed currency, namely, deflation. An expanding economy with a fixed currency will simply have to experience broad-scale wage and price deflation. The response of the theorists to this conundrum is to say that this would be a positive phenomenon, insofar as a given unit of currency would purchase more labour or goods. However, this dynamic would merely reverse the dynamic of an inflating fiat currency, in which the unevenness of the inflationary effects, and the localization of the entry-points for the additional currency result in a regressive, redistributive effect: the downward price fluctuations under the fixed-currency regime would be uneven, mediated by the inevitable distortions of, and frictions in, the dissemination process of information, resulting in more knowledgeable actors buying cheaply when local conditions could not sustain such reductions, leading to a collapse of demand and scrambling price signals. No rational actor produces for the promise of lower returns.
All of which is to state that the critiques of central banking and fiat currencies are devastating, and that the critiques of asset-backed currencies are also devastating. There exists no perfect system, nor does there obtain a perfect theory; all systems are desperately flawed, and, like political institutions generally, require ongoing prudential evaluation and modification. Moreover, even under hypothetical conditions of asset-backing and free banking, central authority will be necessary, if only to impose and enforce such regulations as reserve requirements, as evidenced by the actual history of banking on the frontier, where banks would often issue scrip devoid of actual backing. If the power to tax is the power to destroy, so also are the powers of creating money and lending it.
As regards all of the highly-leveraged financial instruments, well, yes, reserve requirements must be tightened, inasmuch as many of the more exotic of those instruments were developed precisely to evade the requirements, which seem already to have been loosened. The imposition of stricter requirements might amount to de facto prohibition of certain arrangements, but this is really a feature, and not a bug; extreme leveraging sooner or later yields disaster, and we do well not to court it.
Posted by Maximos | February 15, 2008 8:33 PM
I do agree that leverage can be abused, both in public markets and in (e.g.) global macro hedge funds. I just don't see debt leveraged financing as such a huge deal on the investor side at the present time. Debt spending is a huge bad deal on the consumer side, but that doesn't really carry over to hedge funds, private equity, etc, where often as not an excess of uninvested cash is the problem. I mean, I've seen one limited partner default in the last six years or so in private equity. Obviously that guy was over-committed; but I don't think he is the norm. He represented less than one tenth of one percent of the fund in question, in terms of committed capital. And corporate coffers are filled to unprecedented levels with uninvested cash -- I wish I had a link to the the article I recently read on the subject.
The sub-prime crisis is a leverage problem on the consumer side, for sure. A requirement across the board for 30% down to purchase a house, and fixed-interest loans only, would go a long way toward calming that nonsense down - both the consumer's lunacy and the lenders' exploitation of the insane. But the problem on the bank side (again AFAIK) wasn't that the banks themselves were over-leveraged, borrowing to make investments: it was that the CDO's were put together with no clarity on actual title to the actual underlying properties. IOW it wasn't an issue with sources of funds, it was an issue with what was purchased as an investment using those funds.
Posted by Zippy | February 15, 2008 9:04 PM
If I'm not just mistaken, I can remember when no one had ever heard of anything other than a fixed-interest loan. Like, perhaps, twenty years ago or less, yes? Thirty percent down was a little higher than usual even then; twenty to maybe twenty-five percent seems by my recollection to have been the norm. When we were buying nigh on thirteen years ago, non-fixed interest loans still sounded like some new-fangled thing, and I can remember vividly how adamant my husband was that we would never do any such stupid thing. It sounded to me like he was talking sense, as of course he was.
Today at the bank I saw an advertisement for home equity loans--up to 100% of your home's value minus mortgage. It was being pushed on the sign in this strange way, something bizarre like, "So you can have cash on hand." I can imagine someone making an _agonizing_ decision to take a home equity loan in some major life emergency, but to think people would do it just to have "cash on hand"! Are people nuts?
Posted by Lydia | February 15, 2008 9:24 PM
"As the derivatives business has grown more complex, it has also ballooned in scale. Broadly speaking, Das - author of a leading textbook on derivatives and complex securities - estimates that investors worldwide hold more than $500 trillion worth of derivatives. This number now dwarfs the global GDP, which tops out around $60 trillion.
Essentially unregulated and all but invisible, over-the-counter derivatives comprise a huge web of bets, touching every sector of the world economy, that entangles a massive amount of money."
1) The modern emphasis on the abstract over the incarnational seems to be finding fulfillment in our complex, unaccountable and obscurantist financial system. Smash the icons, remove the images and the blank imagination will still be filled. Just not with the Good.
2)We were told the Catholic Church's stand against usury held millions back from sharing the wealth created by credit. Perhaps that view may be tempered after this storm reaches it's climax.
3)Those who have made an Idol of the Market have some serious 'splainin to do.
Posted by Kevin | February 16, 2008 11:24 AM
...estimates that investors worldwide hold more than $500 trillion worth of derivatives. This number now dwarfs the global GDP, which tops out around $60 trillion.
It is hard to know what to make of this claim. My first reaction is that - whatever else may be said about it - it is comparing apples and oranges: derivatives are a class of assets, usually contracts guaranteeing a particular sale price or buy price for some other asset; whereas GDP at least ostensibly measures production. Also, I don't know what this measure is supposed to be a measure of: are we measuring the values of options themselves, or of underlying assets? The latter is ordinarily several orders of magnitude larger than the former, and a really big number might sound dramatic but in fact be rather ho-hum.
Example: suppose I purchase options to buy the stock of a particular company. A typical option represents the right to buy the stock at a particular price; a right which ordinarily expires at some time in the future. There are two sides to this. Person A actually owns the stock, which is presently valued at (say) $10/share. Person B buys the option from him -- not the stock itself, but the option to buy it at (say) $12/share. Person B thinks the stock is going to go up to $15/share before the option expires, and person A doesn't think so but he figures that he would sell the stock if it went over $12 anyway. So B pays A 10 cents per share for the option: in return for his money he is getting any upside in the stock over $12/share in the given period, while A is giving that up but he gets B's cash right now.
Now, if we are reporting the value of the "derivative held by the investor" in this very simple example as the ten cents per share that he paid for the contract, that is one thing. If we are reporting it based on some assumed value of the upside above $12 in the stock that he owns based on the current stock price and movement, that is another. And if we are reporting it based on the value of the underlying stock, that is something else again. And all of these numbers can differ from each other by orders of magnitude.
Another thing to notice is that the more stable the price of the underlying asset, the greater the difference will be between the value of the option and the value of the underlying asset. That is, if the price of the asset itself is stable then downside derivatives and upside derivatives aren't worth much, because the price isn't likely to move enough for them to be in the money before they expire. So for stable assets you can have huge differences here: an option on a billion dollar asset might be worth pennies, if the asset's price is extremely unlikely to move enough to trigger the conditions of the option. So depending on how the measurement is being done, that is, on how they are coming up with that $500 trillion number, I might spend a hundred dollars on options and add ten million to that $500 trillion total.
In summary, my reaction to the claim in the Globe article isn't "wow, that sounds like a really big scary number". My reaction is "what the Hell are you talking about specifically?"
Posted by Zippy | February 16, 2008 4:31 PM
Another interesting thing that occurs to me is that a commodity-backed currency turns cash into a certain kind of derivative. Legal tender becomes a contract to buy a specific amount of the specific backing commodity from the federal government at a fixed price in perpetuity. I'm not quite sure what to make of that, but it is food for thought.
Posted by Zippy | February 16, 2008 4:51 PM
V. helpful analysis, Zippy. Now I have some idea what this is all about, which is a start.
I've always had a sneaking liking for the notion of commodity-backed currency because it makes me feel like I would know what I'm talking about when I answer the question, "What is money?" or "What does money mean?" As it is, when my kids ask me that question or a related one I have nothing much intelligent to say.
Posted by Lydia | February 16, 2008 5:04 PM
"what the Hell are you talking about specifically?"
Your response echoes what more than a few brave souls said the past 8 years as "sub-prime" mortgages became the basis for a complex investment vehicle. I work with some very bright folks on Wall Street who analyzed and promoted CDO's, who are legitimately stunned at how this is playing out. Yes, there was some of the same self-deception that fueled the tech bubble, but I also believe; "ideas are in the saddle" in ways that are both unfathomable and...scary.
I'm afraid Burke's warning against sophists and calculators will take on a special saliency in the years ahead.
Posted by Kevin | February 16, 2008 8:24 PM
Shorter Maximos:
I don't understand all this high finance business, but it scares me because it is too complicated for me to understand and some people might lose some money, or their house, or something.
Shorter Zippy:
Uh, Maximos, you need to ask better questions of the articles you read about high finance and do some research before you make sweeping claims that all this high finance "possesses the capacity to precipitate profound disruptions in the real economy if there occur but slight perturbations".
Who knew Zippy was so smart! Finally a traditionalist who understands how capitalism works!
Here is the bottom line: all of these "exotic" financial instruments are simply contracts and since we are all sinners, some of us won't be honest about entering into contracts and therefore we need the law (both civil and criminal) to protect us from contract fraud and breach of contract. As Maximos correctly notes in his original post, a market economy "presupposes a body of custom and law by which economic practices are regulated and structured." Most of the smart libertarian economists over at CATO and George Mason would make the case that we should do a better job of enforcing contracts and increasing transparency (see for example this item: http://cafehayek.typepad.com/hayek/2008/01/tylers-latest-i.html) and at the same time they would continue to support less government regulation because the market really does do a better job of policing itself, assuming we can go after the cheaters, than the government can (see this wonderful post on why the current subprime problems aren't that worrisome and why less, not more banking regulation, leads to more competition, which is a very good outcome: http://cafehayek.typepad.com/hayek/2008/01/i-worry-much-le.html).
If investors didn't understand what the homes were really worth that backed their investments (or didn't understand the real ability of the borrowers to pay their mortgages) then either a) the market should have priced these assets as if they were very, very risky or b)they took risks assuming someone would bail them out and they wouldn't face the consequences of their actions. Something closer to (b) is what happened and there is a strong case that all sorts of government regulations ostensibly designed to help certain classes of consumers and investors (e.g. anti-redlining laws) have actually mucked things up worse than if we had followed the wisdom of what Maximos calls "the mania for deregulation". There is also a strong case for letting some of these banks fail so that investors will do a better job in the future of ascertaining the real "risk discount" behind mortgage backed securities and other financial derivatives.
Finally, I just don't understand this statement: "Another way of appreciating the scandal of this stuff is that it is all debt; and debt, being a claim upon someone's future earnings, is inherently redistributive." If I take out a loan to start a business and my business makes me lots of money so that I pay back the loan (with interest), I'm richer and the bank is richer. How is that "inherently redistributive"?
Posted by Jeff Singer | February 16, 2008 8:40 PM
Kevin:
Your response echoes what more than a few brave souls said the past 8 years as "sub-prime" mortgages became the basis for a complex investment vehicle.
No doubt. And directly to Maximos' point, that complexity can become a kind of barrier behind which short-term players who structure the deals can hide, while avoiding the long term consequences of the deal. This is unquestionably a potent criticism in my view, and I'll reiterate the preface of my remarks by saying again that I wasn't arguing with Maximos as much as just letting loose with stream of consciousness reactions.
Jeff Singer:
A few people do seem to think I know a thing or two about capitalism, though that may reflect upon their judgment as much as upon my knowledge. I have an MBA, I've founded and sold companies, I've been partner in a number of investment partnerships, I've sat on the board of directors of public and private companies, I've been an executive in both public and private companies, etc etc. But people would do well not to misinterpret all that to mean that I know "what is going on" in some macro sense. I know a lot about how various things work at the nuts and bolts level, I suppose, but as I mentioned before I don't believe anyone knows "what is going on" at the macro level, let alone is in a position to control the economy with the sorts of policies implicated in the Globe article. And I am completely on board with Maximos' basic premise that capitalism is not 'disentagled' from the moral law or the cultural context in which it operates: that capitalism is as subject to the moral law as any human endeavor, that consent and contract are not morally primary, etc. etc. I've discussed the subprime crisis in very narrow terms here, because those narrow terms are really the only terms upon which I claim to have any understanding. Indeed, I have little doubt that Maximos' understanding of macroeconomics is more well-informed than my own, despite my knowledge of the blocking and tackling involved in many particular business matters. (Part of that is personal disposition. Reading stuff by the Cato institute, for example, often gives me indigestion, since the appetizer with every meal is so blatantly ideological that it irritates my objectivity-sensitive constitution).
I happen to think that the present recession worries are overblown, the equity markets are oversold, and that the next president will inherit (and doubtless take credit for) a robust economy. I would never pretend to call a bottom, but barring some black swan event the present woes will be shallower than what is presently priced into the markets, in my view. My confidence in this is fair-to-middling, not unequivocally bullish, though I have in fact treated the present conditions as a buying opportunity. (Of course I can also afford to lose).
But assessing the particular facts on the ground is quite a different matter from the larger macroeconomic+moral point that Maximos is making, and which quite frankly I've not yet fully grasped - specifically when it comes to liquidity. And on improved transparency we all seem to be agreeing.
On the final point, it seems pretty obvious to me that consumer debt at least is inherently redistributive, since it permits and indeed encourages the consumer to sell out his future productivity in order to satisfy present (typically narcissistic media- and advertising-driven) desires. That he generally cooperates in this redistribution doesn't make it not-redistribution.
I don't think leveraged debt is necessarily redistributive in the same way, at least as long as one isn't being played for a sucker. If I borrowed to invest (which I've done at least on behalf of others, that is, other investors) then I am putting more at risk than the lender, since the lender gets first claim to principal and his rate of interest, while I get claim to any profits which exceed those, and he has further claims on my other collateralized assets in order to recover his portion. I expect that this is not "usury", at least the way Belloc might have understood it, whereas there is little doubt that consumer debt is usury plain and simple.
Posted by Zippy | February 16, 2008 9:34 PM
Zippy,
I would invest my life savings with you! (Actually I wouldn't, but I wanted to sing your praises anyway).
Sometimes I too think I'm "on board" with "Maximos' basic premise that capitalism is not 'disentagled' from the moral law or the cultural context in which it operates: that capitalism is as subject to the moral law as any human endeavor, that consent and contract are not morally primary, etc. etc." But then he tries to tease out what this means and I find him retreating to what I consider ill-informed screeds against either the history of capitalism or against some particular feature of capitalism for which he has a not well-thought out argument (e.g. liquid financial markets).
I know and expect a blast from him soon defending himself, but I always find his defense begging more questions than it answers.
Finally, I wanted to comment on something Lydia said:
"I couldn't buy a home without some debt but jolly well paid it off as fast as possible and would never in a million years have gone with anything but a boring, traditional mortgage."
Her attitude towards her debt and non-traditional mortgage's fascinate me because the only question I ever had when buying and/or selling my homes was whether the decision and the mortgage made sense financially for me. So here in Chicago, thanks to all the wonderful innovations in the mortgage markets I was able to: buy a condo with about 5% down; sell it roughly five years later for a $100K profit; use this profit to buy a single-family home with a large down payment; take out a new 5-year ARM as interest rates went lower so my payments would be nice and low; save up my money over the ensuing 4 years; take out another, larger loan than the one I had so I could finance home additions/improvements (my deck looks great and you should see the little one's new room!); and now get ready to re-finance again because rates are going lower. I could do all of this because I have excellent credit, other assets to cushion me during times of financial hardship, figure out how to amortize closing costs with each refi so I knew I was actually saving money before I signed on the dotted line, etc., etc. When someone like Maximos says we should eliminate all these mortgage innovations because some people are too stupid to deal with it or because they are risky -- then like Lydia's reaction to the hypothetical poor family financing a brand new $15K car, it almost makes me angry.
But since Maximos is a scholar and a gentleman, I don't really get angry...I just wonder why he is so scared of economic innovation? I know we've been down this "only the horse buggy manufacturers are afraid of the combustible engine road" before, but it still baffles me how traditionalists don't appreciate the enormous gains in material well-being brought about by capitalism and modernity.
Posted by Jeff Singer | February 16, 2008 10:09 PM
I prefer not to live in Chicago in the first place. :-) (I grew up there and never want to go back.) That way--living somewhere much cheaper--I don't have to play all those financial games (that could backfire) to end up with a nice house, all paid off, no debt, and have money in the bank to pay cash for my home improvements. But I'm not going to question, Jeff, that you did your homework and could have handled the backfiring. I just take a "don't try this at home" attitude and have never regretted it.
Posted by Lydia | February 16, 2008 10:29 PM
When someone like Maximos says we should eliminate all these mortgage innovations because some people are too stupid to deal with it or because they are risky...
I take his point though, or at least one of them - and the subprime crisis does bear this out - that when (e.g) consumers treat their homes as leveraged investments in that way and the sh*t hits the fan, many people who didn't sign up for those risks get hurt, and this is also true of other kinds of investments. He isn't wrong about that. Those creative mortgage structures (as an example everyone probably understands well enough for the sake of discussion) do enable homowners to engage in speculative investment as opposed to, well, home ownership. Perhaps in order to do so they ought to be accredited investors, etc. But then that would rather spoil the point, which is to be empowered to not only speculate with capital one doesn't have but to speculate where one is not even in a position to cover the losses. If your condo were a margin account, which is basically what a low down payment adjustable mortgage is, then you'd have to meet certain cash reserves before speculating with it -- for good reason.
I don't know about policy answers, since I'm not even entirely clear on the questions. Maximos and I aren't always in lock step on these things. But enormous material gains do not a good society make, and a good society takes political precedence over ideologically unfettered market transactions.
Posted by Zippy | February 16, 2008 10:52 PM
I love the stench of condescension in the evening, Jeff.
This is scarcely a question of me, personally, failing to understand the arcana of high finance; more than a few actual economists concede that many of the exotic forms of derivatives are obscure; hell, their very obscurity is one of the reasons it often takes a bit of time to unwind them once they have become untenable. But never you mind that; this is all nothing more than the raving of a cranky skeptic of high capitalism.
Your points a and b are not exhaustive, as far as the circumstances are concerned. There is enough unpredictability in the underlying conditions of some asset classes to make assigning value difficult, especially when wagering on, or presupposing, some future outcome. Of course, many of the principals, borrowers, lenders, and purchasers of the various derivatives, assumed that they would be bailed out; and anti-redlining regulations are a factor in the subprime end of the turbulence. But these latter regulations are neither necessary nor sufficient as causes of the turmoil. Many of the CDOs were developed as means of evading reserve requirements, among other things, so inadequate regulation, or inadequate oversight on the basis of existing regulation, cannot be excluded. The bailout of last resort, of course, would be some form of formal intervention, as occasioned by past crises and panics; however, the entire process has been unwritten by monetary policy: an abundance of available credit, offered at low rates of interest, propping up demand to ensure a steady rise in asset valuations. The recent 'bubble', to the extent that it was a bubble, was based largely on real estate, the spectacular appreciation of which presupposed as an initial condition that very monetary policy, along with the expansion of the class of mortgage-holders. Which leads me to the following:
I'm richer and the bank is richer. How is that "inherently redistributive"?
It's not. Herein lies the distinction: your business is productive in a way that real-estate appreciation/speculation is not. Production is not the same sort of thing as asset appreciation and speculation based upon the latter, particularly when the latter is influenced by loose monetary policy, and presupposes the continuation of the same, so that present obligations can be covered with future appreciation. A loose monetary policy, ie. one that is inflationary - though we have ways of disguising this - is inherently redistributive; this is an integral element of Austrian analysis. It isn't necessarily the derivatives which have the redistributive effect; it's the monetary policy itself, which effectuates this gradually and quite gently, but nonetheless genuinely, all the same. The significance of this is simply that the nominal appreciation will disguise the gradual devaluation of the currency for a while, but that this cannot be a permanent condition. At some point, as a result of innumerable factors, the appreciation halts or ceases, at which point the mortgage debt starts to function as consumer debt. In other words, some debt is fecund, and other debt is not, at least not necessarily, and in the long run. And when a speculative bubble in real-estate bursts, yes, institutions that were overexposed should be permitted to fail, though they ought to be prohibited from exposing themselves so thoroughly in the first instance, precisely because bank failures are disruptive. Which is why they aren't really permitted to occur.
That $500 trillion figure is one that quite a few economists have bandied about, on both sides of the pond; none, however, has bothered to demonstrate the method of its calculation. Which may indeed make this much ado about something moderate in severity. The objection I have to this is that innovation in financial services predicated upon asset appreciation is neither a substantial basis for an economy - and I mention this only to allude to the fact that real-estate has driven the economy for a few years now - nor the sort of innovation that generates lasting prosperity. Hence, a complaint about the increasing power of the financial sector - which is real, indeed - is really intended as an argument to the effect that America must engage in productive economic activities, which go beyond finding ways to cause asset classes to appreciate, consumer debt to expand, and services to be provided less expensively and more efficiently.
Posted by Maximos | February 16, 2008 10:53 PM
Jeff, just for the record, I wasn't trying to be testy; I merely thought your "shorter Maximos" summary snarky. Were I supplying my own abstracts, I'd say that the "shorter Maximos" is simply that asset-appreciation based speculation, fueled by monetary policy, ain't no way to manage an economy.
Posted by Maximos | February 16, 2008 11:14 PM
Interesting, Maximos. Let me see if I can restate it:
Existing home real estate appreciation (and fixed asset appreciation more generally) is really just a form of inflation, since nothing is produced -- prices just go up. To the extent this contributes to new home prices it is also 'inflationary' growth rather than 'real' growth. By accounting for this the same way as we account for fecund use of assets (love the term) which produces 'real' profits, we are just hiding the inflation ball. Doubly so, it would seem, since inflation eats the currency and yet we account for this kind of inflation-driven appreciation in assets as GDP.
I'll have to think about this before I know what I think about this.
Posted by Zippy | February 16, 2008 11:16 PM
Maximos,
I can't help it...you bring out the worst in me! A quick check on Google (I love, love, love American innovation) tells me that the financial sector is about 8% of total U.S. GDP. So apparently we are still engaged in all sorts of "productive economic activities" (which I put in scare quotes because I don't think the financial sector is unproductive...there may be more speculation in the financial sector than other sectors, but given the number of small businesses that fail every year in America, I'd say there is lots of speculation in all sorts of sectors, which is as it should be in a thriving, market economy...creative desruction baby). And what's wrong with providing services "less expensively and more efficiently"? Services just represent another form of economic activty that provides people with what they want/need. There is nothing inherently more "productive" going on in a steel plant versus a health-care consulting firm. In each case a business is providing a good or service that someone else wants/needs. End of story.
Posted by Jeff Singer | February 16, 2008 11:26 PM
There isn't necessarily anything wrong with providing services less expensively and more efficiently; it all depends upon the nature of the case, the basis of the, well, utility gains, and so forth. But that's another conversation.
Services may well be considered productive in one sense; but they presuppose productivity in another sense: you must first create/add value by transforming some part of 'nature' before you can engage in/purchase services. This is one of the few parts of Locke that I think makes sense! You've got to mix your labour with something before services become viable as the refinements of civilized existence.
Posted by Maximos | February 16, 2008 11:36 PM
"...it still baffles me how traditionalists don't appreciate the enormous gains in material well-being brought about by capitalism and modernity."
Really? Surely more than mere crankiness can lead one to conclude that the spiritual price for all this progress may not have been worth it. I think the following quote suggests Christian anthropology has a much different understanding of what constitutes man's well-being.
"When, therefore, men or women pretend to be autonomous or totally self-sufficient, they risk being closed up in a self-realization that considers the overcoming of every natural, social or religious bond as a conquest of freedom, but which in fact reduces them to an oppressive solitude."
Benedict XVI.
Posted by Kevin | February 16, 2008 11:46 PM
Don't have time to read all of this this morning (but I'm interested, so I will), but a quick point to Jeff Singer: You say you get annoyed at the way traditionalists sometimes seem to undervalue material progress and prosperity. So do I. (Perhaps you were lurking when I was tackling apparent nostalgia for the Medieval period in a thread a week or two ago, with reference to the Black Death.) But surely that's not decisive in the present case. I have no strong position on whether variable-interest mortgages should be illegal, people should have to be accredited before taking them, or what; I don't know enough. But unless it's your position that regulations may _never_ prevent people from harming themselves severely financially through handling things they aren't qualified to handle, that would seem to be something we could discuss without launching into the whole debate over whether the spiritual costs of material prosperity outweigh the benefits, etc., etc., etc. And my libertarian sympathies aren't so doctrinaire that I would just say "never, never, never" on that sort of thing. Maybe we should stop worrying about protecting people from hot coffee at McDonald's or whether children's toy capes enable the user to fly and start worrying instead about protecting them from engaging in financial speculation for which they are totally unqualified.
Posted by Lydia | February 17, 2008 9:14 AM
Lydia, that reminds me of an incident that occurred when I was a preschooler: a classmate of mine, when we are all about 3 1/2 years of age, donned his superman underwear and cape, and leaped from his second-floor bedroom window. Mercifully, he sustained only a pair of broken legs. At that tender age, my thoughts were along the lines of, "How stupid must he have been to think that underwear and a cape can make you fly?" Pursuing labeling requirements cautioning against such stupidities, or entertaining the inevitable lawsuits, wastes our time and resources, and mocks our intelligence.
Preventing the financially and yes, intellectually, unqualified from engaging in risky leverage schemes, on the other hand, would not be similarly wasteful. At a minimum, requiring some form of net-worth related qualification for certain classes of financial instruments would seem to be warranted. Obviously, some people are able to avail themselves of such instruments without imperiling themselves, their families, the lenders, and those invested in the lending institution(s). It certainly appears, however, that most of the sub-prime mortgages implicated in the present turmoil were originated precisely to extend credit to the unqualified, which is not merely predatory (though that is hardly the only factor; anti-redlining regs have played a role in this...) but stupidly, incompetently so. And many of the borrowers were consumed by avarice; many were openly engaged in thievery, knowing that they were extended beyond their means, but intending to walk away once the interest rates hit the fan.
Not everyone can engage in financial speculation; it is a 'game' for the wealthy, and, perhaps, the exceptionally clever non-wealthy on the way up. Some means should be found to ensure that lending regulations enforce this point.
Posted by Maximos | February 17, 2008 1:33 PM
Lydia: I think part of the issue is that leveraged investment in homes is seen to some extent as a 'democratic' way for everyman - even 'subprime' unqualified buyers who are not in a position to cover losses - to get access to the kind of returns usually reserved to the rich. Combined with lottery culture and the (irrational and demonstrably false) belief that real estate values never go down, plus the incentive of financial players to sell contracts (they get commissions on contracts sold and are long gone when it comes time to pay the piper), the mixture is toxic.
Understand why everyman likes leverage to begin with. Suppose he puts $20K down, borrows $80K, and invests it. (The fact that it is invested in a home is irrelevant - it could be anything). Now suppose the property appreciates in value by $10K. He has now invested $20K of his own money (plus some interest), and earned $10K in equity appreciation: a 50% return on what he invested himself. If he put only $5K down, he made a 200% return. If there was no money down, he got free money! What's not to like?
The problem, of course, is that losses are amplified in the same way -- only worse. If he put down $5K and the property lost $6K in value, he is underwater: the bank can't even recover its principal in foreclosure.
There is a pernicious thing built into the nature of the math that a lot of people don't 'get', too. Suppose the investment loses half its value: a 50% loss. It is now worth half what it was before, so in order to get back to square one, it has to return 100%! A 50% loss requires a 100% return in order to recover. You need to be twice as lucky as you were unlucky just to break even. That tends to counterbalance the notion that "real estate always goes up". Real estate always goes up, except when it doesn't; just like stocks or any other investment.
Posted by Zippy | February 17, 2008 3:28 PM
I suppose (being very tentative here) that even if real estate _usually_ goes up, and even if your real estate _does_ go up, there could still be a problem and a poor overall investment if your interest rates went up significantly after the low-interest period and you ended up being stuck in the mortgage for a much longer time than you had originally bargained for and paying so much in interest over the term of the mortgage that you really were losing out.
Am I understanding correctly, too, that one feature of these variable-interest mortgages is that you are not permitted under the contract to make a payment directly to principal? So even if Aunt Ethel leaves you a nice little nest egg, you can't simply slap that on the principle and greatly shorten your mortgage period? My initial reaction to that is that (if this is true) _that_ aspect should be illegal, if anything. It ought to be possible any time to pay off part of the principal you owe someone, even a bank, up to and including just plunking down the money to pay off the rest of the principal debt and walking free. Or at least, that's my first intuition.
Posted by Lydia | February 17, 2008 4:04 PM
I'm pretty certain that it is always legal to pay off principal -- that is, that it is illegal to issue a loan (at least to an individual) which denies this right. In some ways that contributes to the trouble though, because people simply assume that they will at some point be able to refinance on more favorable terms. Often they can, but a whole lot of often doesn't make up an always.
Borrowing money in order to invest it has two effects: it takes away a certain amount of return off the top in interest and other finance charges, and it multiplies gains - including the negative gains we call "losses". Throw in adjustable rates and balloon payments and you are already starting to look more complicated than a margin account for trading in stock options; and with a margin account you've got to meet cash reserve requirements or you can't play.
Posted by Zippy | February 17, 2008 4:38 PM
I've heard more than a few reports on subprime mortgages mention the dreaded pre/early/double/whatever payment penalties, so I have the same understanding as Lydia. I'll have to check into this.
Posted by Maximos | February 17, 2008 4:44 PM
Lydia,
I find that you and Steve Burton are probably closest to my own political/social/philosophical views with respect to the WWWTW gang, but I like reading all of you to sharpen my thinking on the subjects you cover on this blog. I was indeed lurking (why that word? it conjures up all sorts of inappropriate associations in my mind...I'd rather we just say I was reading your comments) when you were "tackling apparent nostalgia for the Medieval period" and I was cheering you on.
I agree that some regulations on certain financial investments may make sense to help protect people from their own stupidity and/or gullibility and I also agree that we should be able to discuss such matters "without launching into the whole debate over whether the spiritual costs of material prosperity outweigh the benefits". But I didn't read Maximos' OP as a sensible call to control who can invest in some of the more risky financial instruments out there. He seemed, at least to this humble reader, to be once again taking an example of a market problem and using it to bludgeon the market economy and modernity itself (e.g. "Two observations are apropos of this development, which itself threatens to wrest control of the real economy from real market actors, inclusive of the central banks...beneath all of the rhetoric surrounding deregulation and the retreat of the frontiers of the state, a somewhat naive and misleading conception of the naturalness of economic activity, as opposed to the contrivances of political intervention...the highly abstract, disincarnate nature of these exotic instruments and processes - essentially, symbolic manipulations which, by the alchemy of the age, high finance, are convertible with tangible realities - is representative of one of the general tendencies, or modes of thought, of Western modernity.") And along the way, he makes sweeping statements about the modern market economy that are either factually incorrect (e.g. "symbolic functions are also the province of a coterie of mystagogues, governed by laws and relationships so arcane and abstruse as to place them behind the logic of ordinary market forces") or that need further clarification to discern their meaning (e.g. "debt, being a claim upon someone's future earnings, is inherently redistributive"...but by "debt", I find out in the comments, he really only means "consumer debt").
So I guess it is Maximos' style of writing, more than anything, that gets under my skin. But, to give the man some "props", as the kids like to say, his analysis above of the benefits and problems associated with paper money versus asset-based money is excellent and I appreciate the fact that he understands the danger of deflation associated with a gold standard (or any asset-based currency).
I have a friend who is crazy about the gold standard and is always sending me stuff from websites like "Goldseek" [sic] and The Mises Institute; most of these writers come across as conspiracy-minded and slightly insane. They aren't just convinced that fiat currency is harmful in some way: they are convinced that the ELITES (and the neocons get thrown into the mix from time to time) are INFLATING the currency for some nefarious purpose, which always remains obscure to me, but you get the idea. Sometimes when I read Maximos, I get a whiff of some of this stuff.
Finally, it is always legal to pay off the principal, whatever type of exotic mortgage you might have. And while you are happy that you left Chicago behind, should you and the family ever find yourself in my fair city again, please drop me a line. I'd love to treat you all to lunch...I had a delightful time taking Larison out to lunch about a year ago and I always welcome the opportunity to break bread with traditional conservatives who make me think.
Posted by Jeff Singer | February 17, 2008 5:02 PM
Thanks, Jeff--sometime I may take you up on the invitation. I'm hardly ever over there, but my parents still are, which worries me just a bit sometimes.
Perhaps the deal about paying off the principle is that there's some sort of penalty that you agree to at the outset--that is, your signature on the contract means that if you pay off the principal early you will pay a special fee of some sort to make up in part to the lender for the lost interest. (?) Never having had a variable-rate mortgage, this is all rather vague in my mind, and even if this characterization is right, I have no idea how high the fee might be or to what extent it is prohibitive and makes it very hard to pay off early. If there is such a penalty, it strikes me as a _very_ unpleasant aspect of the arrangement, though of course it doesn't actually follow that it should be illegal.
Yes, bloggers do need a better term than "lurking."
Posted by Lydia | February 17, 2008 5:12 PM
Ah, Jeff, much of my colourful rhetoric is merely a translation of complaints that economists have made about various speculative instruments, to take one example. When the real-estate basis of a lot of overleveraged derivatives collapsed, plenty of economists worried that the traditional policymaking toolkit offered few options for correcting the effects of a speculative bubble, as opposed to a normal recession. As for the coterie of mystagogues, well, that's a reference to the sorts of mathematical-genius speculators who have brought us some of the more extreme varieties of leveraged investments; it's the uncertainty, the interconnectedness of different vehicles, and the difficulty of ascertaining the values implicated of which some economists have complained. I'm simply taking their word for it. Why didn't I write it all the boring way? Because it's boring! Anyway, all that goes to emphasizing my bottom-line point about asset-appreciation and speculation being an insufficient basis for economic stability/prosperity.
Regarding the arguments against central banking and fiat currencies, centuries of debate demonstrate nothing so much as that certain interests support them for any number of reasons, while certain contrary interests oppose them for, more or less, the shadows of those reasons. It's worth distinguishing between the functioning of such monetary systems and the purposes to which individual actors might like to turn them; but all I can say with confidence is that banking has been enormously influential in the political economy of modernity; just consider the Nineteenth-century American controversies over Hamilton's beloved National Bank, for one thing. Anyway, my previously-stated conviction is that the recent emphasis upon liquidity-for-asset-speculation, and the burgeoning consumer debt loads, have been systemic compensations for the uncertainties and instabilities engendered by globalization, as well as the (formal) disappearance of the Keynesian settlement of mid-century. We just prime the pumps with consumer debt now, that's all.
It is always legal to retire the principal, albeit some mortgage terms specify penalties for early payment, usually stipulating a period of a few years within which the penalties will be applicable. The lenders anticipate a certain amount of interest in return on the loan, and the penalty is a way of recouping some of that in the event of early payment. I think it's hinky, but it does make some sense; then again, I think that most of the ARMs are hinky, too.
Posted by Maximos | February 17, 2008 5:38 PM
“People don’t know what’s out there, they haven’t sorted out what’s good and what’s bad, so they are throwing all credit assets out,” said Meredith Coffey, director of analysis at the Reuters Loan Pricing Corporation."
Sounds like a plan.
http://www.nytimes.com/2008/02/19/business/19banks.html?ei=5065&en=3c5a1bcd8911fae0&ex=1204002000&partner=MYWAY&pagewanted=print
Posted by Kevin | February 19, 2008 11:50 AM
"Unlike the internet bubble, this is not a crisis based on irrational behaviour but one of sophistication and disintermediation. The new risks produced by financial innovation were left to a sector that alone was considered able to understand its instruments. The crisis demonstrates the costs to the real economy and lack of an efficient self-regulating system."
Exactly.
http://www.ft.com/cms/s/0/59266a6c-e090-11dc-b0d7-0000779fd2ac.html?nclick_check=1
Posted by Kevin | February 22, 2008 1:31 PM