Steve Hsu (hap tip Efrain)

... is another physics type who is interested in markets, though it seems that he is actually a physicist still, so I don't know how much solidarity he'd muster for us dropouts. At any rate, he also has a blog that mashes up all sorts of intellectual endeavour. Today's missive is about Keynes' brand of economics:

As someone with a mathematical bent I was not initially drawn to Keynes' brand of economics -- my interests were in areas of modern finance like option pricing theory, volatility, stochastic models. But like Keynes I have seen a bubble up close -- first in Silicon Valley, and now, from a greater distance, the current credit crisis. What seemed to be reasonable rough approximations: efficient markets, no arbitrage conditions, stochastic processes, etc., are now revealed as terribly naive and dangerous. And so over time my views have come to resemble those described below. (See my talk on the financial crisis, and this Venn diagram.)

The views described below are a piece that is floating around the intertubes this morning from the NYT magazine -- Keynes biographer basically says that Keynes came up with the idea of the black swan and not that self-aggrandizing Taleb bozo.

Keynes created an economics whose starting point was that not all future events could be reduced to measurable risk. There was a residue of genuine uncertainty, and this made disaster an ever-present possibility, not a once-in-a-lifetime “shock.” Investment was more an act of faith than a scientific calculation of probabilities. And in this fact lay the possibility of huge systemic mistakes.

The basic question Keynes asked was: How do rational people behave under conditions of uncertainty? The answer he gave was profound and extends far beyond economics. People fall back on “conventions,” which give them the assurance that they are doing the right thing. The chief of these are the assumptions that the future will be like the past (witness all the financial models that assumed housing prices wouldn’t fall) and that current prices correctly sum up “future prospects.” Above all, we run with the crowd. A master of aphorism, Keynes wrote that a “sound banker” is one who, “when he is ruined, is ruined in a conventional and orthodox way.”

This is all great and I am in complete agreement. Markets are traded by monkeys. The future is hard to predict. In the absence of information (and even sometimes in its presence) we look to our neighbor to figure out what to do. The possibility of feedback under such circumstance is obvious.

But what is new in all this? Anybody who has worked in markets for any length of time already knew that the emperor had no clothes. Disrobing Alan Greenspan and his flawed ideology is not an intellectual challenge. These guys were like the flat earth club -- fine if your in the mood to argue a bit and get into the philosophical details of what the word "proof" might mean, but a boring distraction when it comes to shipping cheap plastic shit from Long Doc to Long Beach.

What is challenging is figuring out if there are patterns to the "irrationality" of markets, and if these patterns are stable enough to be studied and related to other systems we can study in the same way that classical economics is related to physical systems that tend toward equilibrium. The sad things is that I'm sure there are economists out there studying this stuff. Only physicists (not Hsu of course) think that physics is the only science just because it happens to be the simplest one (excepting perhaps mathematics). Why don't these guys get a voice? Why is orthodoxy such a stunningly powerful force in academia?

I guess I think that the really disturbing thing is not that the emperor has no clothes, but the fact that so many people are surprised by this.

The Amero

Ecuador defaulted on its debt today. Or maybe yesterday, I don't know. For those existentialists out there this is another example that makes you question the very raison d'être of fiat money. From the FT:

Alberto Bernal, Head of emerging market macroeconomic Strategy at Bulltick Capital Markets, said the move was a prelude to a decision to exit dollarisation.

”Dollarisation is popular in Ecuador. Yet president Correa does not believe in dollarisation, and he needs further tools to pump the economy, because he will never receive the support of the private sector to generate employment,” Mr Bernal said. ”We think that a 60 per cent to 70 per cent devaluation is likely to take place at some point in the near future, unless oil prices recover fast.”

Ecuador abandoned the sucre for the dollar in 2000 after the collapse of its banking sector, which effectively leaves Mr Correa with no monetary policy of his own.

This passage makes one realize what the fundamental error is -- the government shouldn't have any monetary policy of its own. In fact, if there's one thing that the government should never ever be allowed to have, it's a monetary policy. If there's one thing you should never let the government do, it's control the supply of money. It always has and always will end in tears. Allowing the government to print money gives it an extraordinary control over society that is never apparent until it's too late.

Our Founding Fathers

I always find it interesting to see how, over the course of time, ideas get distorted into rigid ideological parodies of themselves. It is probably an inevitable consequence of mass adoption (witness religious doctrine in general). One of the cases that particularly fascinates me is how remarkably prescient Adam Smith the man was, given how remarkably awful many of the self-labeled "free market" types are who almost certainly never read a word he wrote.

Today's quote is a propos of this reflection, and the Fed's new plan to make us all rich again by forcing us to buy overpriced houses.

I can only think of Adam Smith’s warning:

The proposal of any new law or regulation which comes from [businessmen], ought always to be listened to with great precaution, and ought never to be adopted till after having been long and carefully examined, not only with the most scrupulous, but with the most suspicious attention. It comes from an order of men, whose interest is never exactly the same with that of the public, who have generally an interest to deceive and even to oppress the public, and who accordingly have, upon many occasions, both deceived and oppressed it.

One of the stranger revelations of the last few years for me has been that Adam Smith and Karl Marx could almost be thought of as being on the same team. Naturally, Marx spawned an equally absurd school of misinterpretation, though in his case, you might throw a chunk of the blame at his own doorstep.

Turning Chinese

PREFACE: Scattered thoughts on money from more than a year ago, with a small contemporary addendum at the end.


The more you read, the more you realize that despite enormous amounts of noise and hand-wringing about what we should do, the bigger question is what China is going to do. Exactly like the US in 1929, China is really the linch-pin of the global economy right now. If they fall into protectionism and purposefully try to devalue their currency, we are all likely to go down together -- trade will grind to a halt, and the dollar will skyrocket and then implode, a chart we are all very familiar with right now.

Brad Sester has the best explanation of this stuff, though the Martin Wolf editorial he cites is a close second and a good summary.

China can try to support its own growth by taking a larger share of a shrinking pie, but that hardly helps the world. The G-20 isn’t just meant to bring countries together to discuss the global economy. It also needs to encourage countries to take into account the global implications of their economic policy choices. If China – which has by far the best balance of payments position of any major economy – feels like it has to direct its government policy toward maintaining export market share, efforts to rebalance the world economy will be set back.

Let me try to explain more clearly why China is so important to the current global system.

Recently, I've been thinking a lot about the charts you can find here from Steve Keen (warning: those with heart conditions are advised not to read his blog). In particular there is one that I feel like you simply have to explain, which is the one at the top of this post. So, they send us this chart, and we're supposed to shit ourselves with fear? What's the matter with a little debt? If the system is closed, one man's debt overhang is another's surplus, so where's the problem?

As far as I can make out, the argument about the unsustainability of debt in real terms is quite subtle. First, let's simplify the question and assume that we are on the gold standard or some other system where the amount of money is fixed. Further assume that the system is rolling along more or less close to equilibrium -- that is, that everyone is working and making stuff, and is swapping it for other stuff that everyone else is working and making. It helps to think of capitalism (and science and everythig else for that matter) as an animal behavior pattern. Money is just the index of all the swapping going on, just a way of counting it.

Here you can see the first way that money could get you into trouble. Because, you need different amounts of it to facilitate different structures of swapping. For example, if the economy consisted of two large centralized and vertically integrated agents (China and the US let's say) then all the specialization necessary for production could be swapped internally, without the need for money except at the last step of the interchange between the two agents. So the US could make all kinds of sophiticated goods like blue jeans and rock'n'roll, and at the last minute, we could swap these goods for cheap plastic shit that the Chinese had made. Here you only need enough money to count the value of the final swap, not the value of all the swapping necessary for the specialized production, because you are assuming that this production is organized along the lines of barter or command-and-control or something. In other words, you only need enough money for the swapping of the net value added by the US and by China, which at equilibirum would be equal.

If, however, instead of two vertically integrated agents, your economy consists of millions of tiny producers that need to swap with one another to make one sophiticated good, you are going to need more money to facilitate all of those transactions. You are going to need gross money, rather than net money, so to speak. I think this is basically the essence of the velocity of money. Now you can see how reducing the supply of money suddenly could get you into trouble all by itself, even if nothing changes (or in fact precisely because nothing changes) in the real economy. If I'm used to converting my production into money and swapping that money for the things I need, and there is a sudden scarcity of money, then we will have a calamity. The lubrication has all gone out of the system, and to continue to produce the same amount as before, it needs to be reorganized so that more of the swapping occurs internally to the production. This sort of reorganization is possible, but it can't happen overnight; in the meantime you have a crisis that appears economic but in reality is more an information crisis than anything else. Perhaps if we let Google run our economy we would need less money.

Anyhow, getting back to the debt question. Let's throw this whole system into motion. After all, in a static equilibrium, why would you ever have anything more than the very short-term debt necessary to finance trade receivables? If at all times, everyone were only consuming the amount they were producing, debt wouldn't exist. So, to state the obvious, debt is an inherently time-indexed structure.

UPDATE 090620:

The thing that throws the whole works out of equilibrium is the fact that not everyone is consuming just as much as they are producing. In fact, part of the specialization of modern economies is that some people are busy investing now (and investment is a form of consumption) in order to produce stuff later. And each year, the scale of this investment tends to increase. We live in a capitalist economy, which is not the same thing as a free market economy, in part because it requires large concentrations of capital that are otherwise alien to a perfect market. Once you introduce the idea of large capital projects that need to be financed, you inherently need someone saving and someone investing. While a system like this certainly can reach an equilibrium, isn't it obvious that it must be a dynamic one? And isn't it obvious that this is unlikely to be as stable an equilibrium as one in which each producer and consumer is essentially self sufficient?

I continue to chug through Minsky, and my update here is coming mostly from that line of thinking. He makes the very interesting observation that capitalism is inherently unstable precisely because it is not capable of incorporating large capital projects in a stable way. I'm sure I'll write some more about this later, but his basic idea is straightforward -- stability breeds instability as the initiators of large projects and their lenders over-extend themselves. His ideas put the actual functioning of money and finance back into economic theory (don't even ask why they left it out to begin with, it's a long story). The dismissal, until just recently, of all his ideas is part of what made it so difficult and heretical feeling to think about all of this stuff last year.

Double entendre

There are two ways to look at a chart like this. You can either wonder what the Japanese market would look like if they invested more like Americans, or what the American market would look like if they invested more like the Japanese. God help us if the second came to pass.

Mixed company

Normally I don't have much use for our collectively clueless superego -- the UN. But occasionally they agree with me, and a recent update to their economic report warns that the current strength in the dollar may be temporary. They also point out that the world is a closed system, and that we can't all stimulate at the same time. What would make more sense is if the US cut back on consumer spending and Japan and China took up the slack by buying things from us. Is the solution really to yet again encourage Americans to go out and do their patriotic duty and shop? From the report:

Continuing, he said the current tendency in macroeconomic policy was not all in the right direction, particularly in the surplus countries where there had been a tightening of monetary and fiscal policies, particularly in Germany and Japan, making it more difficult for the United States to lower its external deficits by export growth. The United States would also need to adopt some contractionary policies to slow down its deficit. Another way to compensate without a major recession in the world economy was for the surplus countries to make more expansionary adjustments in their economies. The more expansionary fiscal policies of some Asian countries seemed to be insufficient to compensate for the possible deflationary effects of an adjustment in the United States.

The report called, therefore, for a coordinated strategy that would think about how to adjust global imbalances while avoiding recessionary tendencies in the global economy, he said. International policy coordination could take place outside of the mediation of the International Monetary Fund, provided that the Fund pushed ahead with its reforms and enhanced representation of the votes and voices of its members.

Obviously the second stanza here is why nobody listens to the UN. I too think that thinking about the problem is a good idea, but they don't publish a news release about that.

Dabbling in Anarchism

Normally I consider myself an anarco-theist was capitalist tendencies, but what's in a name?

At any rate, this Rothbard sounds like an interesting dude (expect for maybe the part about supporting Pat Buchanan). I'm going to read his book on the Great Depression. Just don't ask me when.