economics - Tom on Diigo

17 Jul 08

He puts his finger on something that bothers me about all this "too big to fail" business, and it's namely this: that if investors come to believe that the government won't let something fail, then there's no reason for that something to take risks responsibly. The whole thing ends up being a confidence game. The other morning I was listening to an interview on the (excellent) public radio program Marketplace with Jim Rogers, a Singapore-based US investor, who was ripping the federal quasi-bailout of Fannie and Freddie. Here's an excerpt from the Rogers interview:

28 Jun 08

High Oil price - Good for everybody « Twenty-Minute Lifestyle

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It is easy to be short term focused and say high oil price is not good. Let us look at why high oil price is good for everybody.
Real Estate & Infrastructure - Real estate development will accelerate all over the world as people will try to move close to hub of public transport. New community development will be more organized with walk to different facilitiies. There will be significant investment in public infrastructure.
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- Transportation - Rail industry is particularly likely to benefit. Shipping, truck, and airplane users will invest significantly to use alternative source of energy.

16 May 08

LRB · Donald MacKenzie: End-of-the-World Trade

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endoftheworld economics credit finance banking markets risk

I became intrigued by an oddity that I came to think of as the end-of-the-world trade. The trade is the purchase of insurance against what would in effect be the failure of the modern capitalist system. It would take a cataclysm – around a third of the leading investment-grade corporations in Europe or half those in North America going bankrupt and defaulting on their debt – for the insurance to be paid out.
I asked one investment banker what might cause half of North America’s top corporations to default. No ordinary economic recession or natural disaster short of an asteroid strike could do it: no hurricane, for example, and not even ‘the big one’, a catastrophic earthquake devastating California. All he could think of was ‘a revolutionary Marxist government in Washington’. That’s not a likely scenario, yet the cost of insuring against it had shot up ten-fold. Normally one can buy $10 million of end-of-the-world insurance for between two and three thousand dollars a year. By early last November, the prices quoted were between twenty and thirty thousand, and even then it was difficult to buy in quantity – at least, said the banker, ‘not from anyone you trusted’.
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- The crisis isn’t just about the bursting of the US housing bubble and dodgy sub-prime lending. Nor is it merely a reflection of the perennial cycle in which greed trumps fear to create a euphoric disregard of risk, only for fear to reassert itself as the risk becomes too great. What is revealed by the end-of-the-world trade is that the current crisis concerns the collapse of public fact.
- As the American sociologists Bruce Carruthers and Arthur Stinchcombe pointed out in the journal Theory and Society in 1999, market liquidity – plentiful borrowing and lending, or buying and selling – ‘is, among other things, an issue in the sociology of knowledge’. Believable market prices, valuations, credit ratings and balance sheets encourage lending, active trading, competition and keen pricing. If credibility is lost, then everyone becomes wary of lending, deals aren’t done, and an increased proportion of sellers are the desperate, who have to accept fire-sale prices.
- CDOs come in many varieties, but one way for a bank or hedge fund to set one up is to create a separate legal entity known as a special purpose vehicle (typically registered in the Cayman Islands). The vehicle then buys assets such as corporate bonds, loans and bonds backed by mortgages, either from the parent bank – if, for example, the motive for the CDO is to reduce the risk of its loan portfolio – or on the open market.
- To raise the money that’s needed for these purchases and to create the opportunity for profit, the vehicle sells a hierarchically structured set of investments backed (‘collateralised’) by the pool of assets the CDO has bought. At the bottom of the hierarchy is the ‘equity’ tranche. Losses caused by default of the assets in the pool are absorbed in the first place by investors in this tranche, who in compensation receive the highest rates of return, often as high as 15-20 per cent. Next in the hierarchy is the mezzanine tranche or tranches, the investors in which incur a loss only if defaults are sufficiently bad to wipe out the equity tranche completely. Above the mezzanine is the senior tranche, and above that the super-senior. Because the buffer of the equity and mezzanine tranches stand between it and any losses, the senior tranche is usually regarded as very safe (equivalent to a corporate bond with the highest rating, AAA), and super-senior as even safer than that. Correspondingly, investors in these tranches have to accept rates of return substantially lower than those in the equity and mezzanine tranches.
- Over the past ten years, a model known as the ‘single-factor Gaussian copula’ has become standard. ‘Single-factor’ means that the degree of correlation is assumed to reflect the varying extent to which fortunes of each debt-issuer depend on a single underlying variable, which one can interpret as the health of the economy. ‘Copula’ indicates that the mathematical issue being addressed is the connectedness of default risks, and ‘Gaussian’ refers to the use of a multi-dimensional variant of the statistician’s standard bell-shaped curve to model this connectedness.
- The single-factor Gaussian copula is far from perfect: even before the crisis hit, I wasn’t able to get a single insider to express complete confidence in it. Nevertheless, it became a market Esperanto, allowing people in different institutions to discuss CDO valuation in a mutually intelligible way.
- Ratings aside, however, the world of CDOs remained primarily one of private facts. Each CDO is normally different from every other, and the prices at which tranches are sold to investors are not usually publicly known. So credible market prices did not exist.
- From 2003 to 2004, however, the leading dealers in the credit-derivatives market set up fact-generating mechanisms that alleviated these difficulties: credit indices. These resemble CDOs, but do not involve the purchase of assets and, crucially, are standard in their construction. For example, the European and the North American investment-grade indices (the iTraxx and CDX IG) cover set lists of 125 investment-grade corporations. In the terminology of the market, you can ‘buy protection’ or ‘sell protection’ on either an index as a whole or on standard tranches of it. A protection seller receives fees from the buyer, but has to pay out if one or more defaults hit the index or tranche in question.
- All this activity explains the attractiveness of the end-of-the-world trade. The trade is the buying and selling of protection on the safest, super-senior tranches of the investment-grade indices. No one buys protection on these tranches because they are looking for a big pay-out if capitalism crumbles: if nothing else, they have no reason to expect that the institution that sold them protection would survive the carnage and be able to make the pay-out. Instead, they are looking to hedge their exposure to movements in the credit market, especially in correlation. Traders need to demonstrate they’ve done this before they’re allowed to book the profits on their deals, so from their viewpoint it’s worth buying protection, for example from ‘monolines’ (bond insurers), even if the latter would almost certainly be insolvent well before any pay-out on the protection was due.
- It is perhaps the most sophisticated sector of the global financial markets, and a fertile source of employment for mathematicians, whose skills are needed to develop models better than the single-factor Gaussian copula.
- Why aren’t such mispricings being corrected by savvy investors, eager to seize the opportunities for profit they create? Why, for example, have people not been selling end-of-the-world insurance when the returns from doing so have jumped ten-fold while the risk of having to pay out remains small? A crucial part of the answer is that, paradoxically, a fact-generating mechanism is blocking the restoration of fact. The mechanism is ‘marking-to-market’, the compulsory revaluation of portfolios as market prices fluctuate. Its motivation is entirely sensible: for example, when regulators insist that banks mark-to-market, it should force them to disclose losses to their investors and creditors.
- Unfortunately, however, marking-to-market makes market participants extremely sensitive to short-term price fluctuations. To sell end-of-the-world insurance, for example, is almost certainly an excellent long-term bet, but traders don’t do it because of the fear that in the short run its price may increase even further, causing a mark-to-market loss. Although it would be a paper loss, it would have real consequences, damaging your bank’s balance sheet and profits, threatening your bonus, and typically forcing you to transfer valuable collateral to the custody of the buyer of the insurance.
- Josef Ackermann, the head of Deutsche Bank, has caused a stir by admitting ‘I no longer believe in the market’s self-healing power.’ The state has had to stand between the market and the abyss. Had the British government not rescued Northern Rock, bank runs would have brought down other institutions and destroyed confidence in the UK’s financial system. Had the Federal Reserve not bailed out Bear Stearns, at least one other major Wall Street bank would most likely have failed, and chaos might have ensued. With private lending having dried up, government-sponsored lenders now provide 90 per cent of the funding of new mortgages in the US.
- Donald MacKenzie’s Material Markets: How Economic Agents Are Constructed will be published by Oxford. He teaches sociology at Edinburgh University.

11 May 08

The Sources and Influence of the Kant-Friesian School

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The chart shows the cascade of Friesian influence after the Neo-Friesian revival by Leonard Nelson, together with Kantian and Scottish formative influences for Jakob Fries and for the more peripheral figures. The "Scottish Philosophy" of Hume and Smith is indicated, both for the inspiration provided for Kant, who was awakened from his "dogmatic slumber" by Hume, but also for the enduring foundation of sound economics provided by Smith.
Down the line, F.A. Hayek, C.G. Jung, and Mircea Eliade were probably unaware of the specifically Friesian influence on them.

Nelson inadvisedly repudiated Rudolf Otto's philosophy of religion. Nelson's students and their associates, Grete Henry-Hermann, Paul Bernays, Gustav Heckmann, Stephan Körner, etc., although heroically perpetuating his memory, editing and publishing the great Gesammelte Schriften [Felix Meiner Verlag, 1949-74], maintaining his Philosophisch- Politische Akademie, and pursuing Nelson's practice of Socratic Method, sometimes, seeking to accommodate themselves to trends in more recent, sceptical philosophy, abandoned fundamental Friesian principles, especially in repudiating the unique Friesian doctrine of non-intuitive immediate knowledge. Nelson himself foretold this:

04 May 08

Crunchy Con - Rod Dreher, Conservative blog, Beliefnet conservative politics and religion blog

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economics politics conservative

Yesterday at the newspaper, several of us met with a group of religious-left activists who came in to discuss some of the organizing they'd been doing, or intended to do, around the subject of income inequality. They were filled with ardor over the shrinking middle class, and mad about the fact that people are working longer and not getting ahead. It's hard not to share their concern, and in fact I do share it. But their idea for fixing it, as far as I could tell, came down to soaking the rich with taxes, and redistributing the wealth via the government. While I wouldn't mind seeing the ultrawealthy shoulder a higher share of the tax burden, that hardly begins to account for our condition.

Crunchy Con - Rod Dreher, Conservative blog, Beliefnet conservative politics and religion blog

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black swans economics future energy

It's kind of a running joke on this blog that my sensibility tends to be apocalyptic, always waiting for what Nassim Nicholas Taleb calls "the Black Swan" -- that enormously consequential big event that arrives out of nowhere and drastically alters the way we live. But what if the end of cheap energy is not a sudden Black Swan, but an entirely predictable, slow-motion Black Swan (which would not make it a Black Swan, strictly speaking, but indulge me here...). Nobody can see a Black Swan coming, though as Taleb points out, after it arrives, we look back at all the signs and say, "Of course, it was obvious!"
Peak Oil might be a Black Swan, but if so, it's not a Black Swan like 9/11 was. It's one we can see flying in over the horizon. If you don't necessarily believe in orthodox Peak Oil theory, it is at least undeniable that the rise of China and India is going to put -- is now putting -- global oil supplies under unprecedented stress. If you read nothing else today, read this from the NYT on Sunday. Excerpt:
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- Producers are struggling to pump as much as they can to quench the thirst not only of the developed world, but fast-growing developing nations like China and India, the two most populous countries. To many experts, the steadily rising price underscored longer-term fears about the future of a system that has supplied cheap oil for more than a century.
- “This is the market signaling there is a problem,” said Jan Stuart, global oil economist at UBS, “that there is a growing difficulty to meet demand with new supplies.”
- we all suffer from what Taleb identifies as the "confirmation bias" and the "narrative bias." In short, we seem geared toward believing that things will only get better, and that we will overcome any limitation on our desires, because that's been the narrative of our culture in modernity. And we are conditioned to have that belief confirmed, because that has been our recent experience (Taleb writes of the turkey who believes on the day before Thanksgiving that life is going to keep going well for him, because the previous thousand days have all been pretty great).
- I think the far more dangerous illusion we face today is believing that This Too Shall Pass without our having to make major changes in the way we live, individually and collectively. Here is Taleb's general advice:
- We cannot truly plan, because we do not understand the future -- but this is not necessarily bad news. We could plan while bearing in mind such limitatinos. It just takes guts. ...
- Invest in preparedness, not in prediction.
- This idea that in order to make a decision you need to focus on the consequences (which you can know) rather than the probability (which you can't know) is the central idea of uncertainty.
- "A crucial turning point in that earlier history occurred when men and women of good will turned aside from the task of shoring up the Roman imperium and ceased to identify the continuation of civility and moral community with the maintenance of that imperium. What they set themselves to achieve instead . . . was the construction of new forms of community within which the moral life could be sustained so that both morality and civility might survive the coming ages of barbarism and darkness. If my account of our moral condition is correct, we ought also to conclude that for some time now we too have reached that turning point. . . . This time, however, the barbarians are not waiting beyond the frontiers; they have already been governing us for quite some time. And it is our lack of consciousness of this that constitutes part of our predicament. We are waiting not for a Godot, but for another — doubtless quite different — St. Benedict." -- Alisdair MacIntyre, "After Virtue"

04 Apr 07

The Business of Global Poverty — HBS Working Knowledge

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economics harvard hbs politics poverty social-entrepreneurship

Absent a Visible Hand, Capitalism Can Make Matters Worse

by HBS Professor Bruce Scott

Unfettered capitalism exacerbates income inequality and can undermine capitalism or democracy, or both, asserts HBS professor Bruce Scott. "To put an egalitarian face on capitalism, it's often noted that more than 50 percent of Americans are shareholders," Scott observes. "But it's also true that 10 percent of Americans own about 80 percent of the stock. In Latin America, 2 or 3 percent could easily hold 90 percent. So when we talk about 'maximizing for the value of the shareholder,' we are talking about enriching the rich. In much of the world, and in Latin America in particular, thoughtful business leaders worry that capitalism, especially U.S.-style capitalism, threatens to destabilize their democracies."
As members of the School's Global Poverty Project (GPP), Kash Rangan, John Quelch, and other faculty members have studied and researched the issue of business and global poverty for some time. They believe that in pursuing its own self-interest in opening and expanding the BOP market, business can make a profit while serving the poorest of consumers and contributing to development.
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- Today, market forces, private-sector know-how, and grassroots initiatives such as microfinance are all being looked to as tools to alleviate poverty. Business, once viewed by many critics as part of the problem, is increasingly being called on to be part of the solution. How business can do this most effectively is the focus of the GPP's research and scholarly activity.
- While GPP faculty note that it is too early to declare any models runaway successes, they point to some unique ways that multinational corporations (MNCs) and local businesses are serving the previously invisible BOP market: Nestlé, with its "milk-district model" that encourages supporting businesses to spring up around its dairies in rural India; CEMEX's program of affordable payments and materials that enables impoverished Mexican families to build their own housing; or in Brazil, with Kodak's no-frills camera/film packages, or the department store Magazine Luiza's … merchandise, payment plans, and customer service, all designed to make consumers out of those outside the formal economy. "The GPP's intent is not to discover the next big idea," Rangan says, "but to find models that business can use to engage with the base of the pyramid."
- To be a positive, effective force for development, Scott concludes, a capitalist system must be understood to be more than the "invisible hand" that is implicit in the pricing mechanism. "Capitalism also has a visible hand that is the expression of public policy through legislation and regulations administered by a bureaucracy," he says. "That visible hand creates, enforces, and modernizes all market frameworks. To ignore this reality is like ignoring segregation in the Old South."
- "Poverty can only be truly addressed if you meet four conditions," Chu explains. "You must have huge scale to reach the billions who are in poverty; solutions must be enduring and last over generations; solutions must be truly effective and make a difference; and all this must happen efficiently. Only through a commercial approach can you achieve all those things, and the great power of microfinance comes through its ability to generate profit. There is no contradiction between social impact and good profitability; in fact, profitability is central to that social impact."

08 Mar 07

'Atlas Shrugged' – 50 years later | csmonitor.com

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atlas-shrugged ayn-rand csmonitor economics libertarianism objectivism politics

10 Jul 06

Rough Type: Nicholas Carr's Blog: The amorality of Web 2.0

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economics society unitended-consequences web2.0

Might, on balance, the practical effect of Web 2.0 on society and culture be bad, not good? To see Web 2.0 as a moral force is to turn a deaf ear to such questions. - thomasneal on 2006-07-10

08 May 06