The New Paradigm for Financial Markets

So, George Soros has written an interesting little book that would be easy to dismiss.

I mean, after all, here is a (wildly) successful speculator turned philanthropist and all around do-gooder who admits in the introduction to the book that he really wants to be know as a philosopher. If you follow these things, you will also know that he has written essentially the same book three times in the last 20 years, each time crying wolf and predicting an end to the "super-bubble" of financial capitalism, and has lately has been ceaselessly flogging his "theory of reflexivity" in the dozens of articles and op-eds his success affords him. And to top it all off, Soros is a quite perfectly atrocious writer, though, of course this is but par for the course in finance; the world's most interesting system as analyzed by bunch of over educated but somehow only semi-literate neanderthals in suits.

In short, you would be forgiven for not taking the book completely seriously, intellectually speaking.

And yet, I think Soros actually has something quietly profound to say. Yes, you have to wade through some 50 pages of what only a very generous reader could describe as "philosophy" (Do we really need repeated explanations of how we both think about the world as well as act in it? Does this come as some sort of new philosophical problem? Does Soros do anything new to help us understand it?). But once you get through this, you realize that Soros has actually outlined, in his own ploddingly schizophrenic manner, a theory of feedback loops that makes a lot of sense, particularly in the context of financial markets.

The basic idea is the relatively simple ones that Keynes (who was admittedly stiff competition, verbally speaking) put much more eloquently -- "successful investing is anticipating the anticipation of others". Soros describes this as the "two way interaction of thinking and reality". Reality, of course, is defined as the actual economic fundamentals at any given moment. Things like how many teddy bears are being manufactured, or how much demand there is for gold. Thinking, by contrast, involves the anticipation of changes in these quantities and the calculation of how they fit together. If lots of people want golden teddy bears and there aren't many of them, their price will increase. The prices of assets in financial markets are in this sense thinking about reality.

Typically, of course, financial market prices and economic fundamentals stay rather closely aligned. Companies who say they are going to make less money next year see their stocks fall, and when guy with a towel on his head can't find reverse on a soviet tank, the price of oil goes up. No mystery here. Neither is it news that prices in financial markets influence the future course of the economic fundamentals they currently reflect. After all, neoclassical economics has touted for a long time that one of the fundamental purposes of a market is as a price signalling mechanism that helps us determine what we need to make more or less of. So Soros is utterly in error when he claims that the idea that prices can interact with fundamentals, and that changes in prices (thinking) can cause changes in fundamentals (reality), is in any way a new idea.

What Soros does contribute, however, is a more general theory about the way prices and fundamentals interact. He calls this his "theory of reflexivity". He simply means that prices and fundamentals are involved in a feedback loop, and that they reciprocally impact one another. As I say, classical economics understands this quite well, but assumes that the feedback loop is always a negative feedback loop, the type of feedback loop you find in control systems such as a thermostat that tend to maintain themselves at equilibrium. Usually this is a pretty good assumption. If I see my neighbor charging a fortune for his new housingdefaultswap.com website, I might be tempted to get in on the act and make one for myself. The high price leads to an increased supply which leads to a low price. The system tends towards equilibrium.

Soros simply points out that this negative feedback loop, where random fluctuations tend to damp themselves out, is really a special case (even if it is the more common one). Sometimes prices and fundamentals interact via a positive feedback loop where higher prices lead to even higher prices, or vice versa. Economics doesn't deal with these situations too much for a very good reason -- they lead inherently in the direction of infinity. Infinity, as usual, is a problem. Some days, I think infinity is the only problem, but that's a story for another post. Anyhow, because of the counter-intuitive idea of prices spiraling upwards (or downwards) in a feedback loop, and the mathematical intractability of any system that works like this, we have tended to ignore this possibility. Which is odd, because there is absolutely overwhelming evidence that it happens all the damn time in the real world.

As a thinking person, you can't work in the financial markets for more than five minutes and still believe that they are perfectly rational efficient equilibrium-tending mechanisms. This idea has always been a farce; what Soros does is describe a simple mechanism by which the markets might tend away from equilibrium. Consider the interaction between the price of a house and how much money you are willing to lend against it. As the value of the house increases, a bank will be willing to lend you more money against this more valuable collateral. If you go out and spend this money on remodeling your house, you will complete a feedback loop where an increase in the price of housing causes the bank to lend more, which causes the price of housing to increase further in a runaway loop.

Stop me if you see where this is going.

There are millions of examples like this, and the point Soros wants to make is that these positive feedback loops live alongside the more common negative ones. In the housing example, the rising prices --> rising debt --> rising prices loop lives alongside the more typical rising price --> increased supply --> lower prices loop. Normally, the (dare we call it ecological?) interaction of these forces leads to a more or less stalbe equilibrium, but this result is not guaranteed in advance, and in some cases, for whatever reason, the positive feedback loop runs out of control and we have what people commonly understand as crashes and bubbles.

Why Soros feels the need to bring up Karl Popper, truth, fallibility and naive enlightenment ideas about scientific progress in this context remains a bit of a mystery to me, but, hey ... everybody should have their day to pontificate in the sun. At any rate, the basic idea is quite simple and really pretty important.

Like most people who think they've said something smart, and like pretty much anyone who considers themselves a philosopher, Soros applies his idea to e-v-e-r-y-thing. Fortunately, I think it's actually a pretty profound idea that you can usefully apply to all kinds of things.

It really is a sort of new paradigm for the financial markets, in contrast to the idea that they are efficient. It gives a (somewhat vague, admittedly) framework for thinking about market mechanisms, and separates out their complexity into two basic types, positive and negative feedback loops. As far as its direct usefulness for succesfully trading ... well, I think you probably have to be George Soros to make money off this idea. After all, he's really just pointing out that momentum trading works under certain circumstances. Once a feedback loop catches on, it will keep going until it blows up, one way or another. You should be able to make money if you identify these mechanisms in the early phase, but its anybody's guess how long a fuse these things have.

I also think his application of the theory to politics is not entirely misguided. Soros is a classic liberal, and was a major critic of the Bush administration. In the book he argues that Bush manipulated the media (our thinking) so that it became completely divorced from reality in the same way that prices and fundamentals get divorced in a financial bubble. Here he shades into philosophy when he should be more careful to talk about mechanism (there are clear feedbacks loops in our political system -- campaing finance and media access and regulation, to cite the simplest ones), but seeing the Bush years as a phenomena similar to a financial bubble is interesting. He refers to this idea as his "super-bubble" theory, and it is part political observation and part analysis of the long credit boom that has occurred since Reagan took office.

Now you can start to think about the structure of a system that is really always out of equilibrium, particularly as you increase the scale at which you consider it; start pondering bubbles within bubbles and other larger-scale phenomena, and you quickly do get into really philosophical territory. After all, the industrial revolution, the evolution of talking monkeys, or the consciousness of an ant colony doesn't sound much at all like a system at equilibrium. "Reflexivity" at this level starts to look like a basic way of restating the theory of immanence (there is no vantage point outside the world) and a stab at perhaps the most fundamental classification of algorithms -- ie. some go on and on, and some stop.

Right so enough already. The last thing is that I found that the book combined well with Nassim Taleb's Black Swan ideas. Taleb would love to beleive that he's being more precise and scientific than Soros the philosopher, but in reality all he points out is that the statistics of the market pretty clearly indicate that it is not efficient because the distribution of outcomes has much fatter tails than you would expect if it were. Fine. But it's not like the guy ever proposes a mechanism for how his alternate Black Swan distribution is actually produced. Maybe you have to pay him $50,000 to eat lunch with you in order to find this out. So while Taleb highlights the off-kilter statistics of a chart like this, Soros actually gives you an idea of what mechanism might have produced those numbers:

Densha to hōmu to no aida ga hiroku aite orimasu no de, ashimoto ni go-chūi kudasai.

Tim Duy has two pieces that repeat the same basic ideas:

1. It looks like the current stimulus is way too small, way too slow, and not exactly what one would call stimulative, given how much of it goes to tax cuts. It's lovely that the NIH and NEA and everybody else get some more money, but this really isn't a solution to our economic problems because these areas have already been so gutted that even tripling their budgets is a tiny drop in the bucket. Wouldn't it be better to tout these changes to Bush era policy directly -- "look, we think education is important, let's spend more money on it" -- rather than try to wrap these changes in a larger stimulus bill and pass it under cover of nightfall?
2. The bank bailout is almost certain to be a fiasco. We're heading for Japan here. Monday the plan is announced, so we should really wait and see, but I'm completely out of confidence now; we've gone back to the concept of "ring-fencing". This means drawing a line in the sand every few meters, waiting for the water to go wash over it, which everybody knows it will, and then stepping back and doing the same damn thing again, that is nationalizing the banks piecemeal as things gradually get worse. This won't work with the tides either. So I don't quite know what these guys are thinking. I can't tell whether they are just completely bumbling academics, or whether their hands are tied by politics, or whether they think that they can pull one over on investors, convincing people to climb back into the financial sector in the hopes that this is the bottom, the bottom, no, really, the bottom, I swear. We are a year and half into this now. We need to stop fucking around. America is full of animal spirits and traders who will buy the palpable sense of relief that hangs in the air as each new line is drawn, and sell each panicked wave of mounting losses as they break on the shore. But the real investors, the guys who actually put up the money for factories and office buildings will just sit on the sidelines and watch.

Anyhow, a few choice quotes from Duy:

3. Triage? From Bloomberg:

The Treasury may increase its stake in lenders that are judged short of capital, the people said on condition of anonymity. Should extra taxpayer funds result in a majority ownership by the government, officials would then decide whether to liquidate the institutions, place them into receivership or retire the companies' assets over time, they said.

This sounds like Treasury would try to identify those institutions worth saving, and either nationalize or liquidate those with that require federal help on the order of a de facto nationalization. The Wall Street Journal suggests something different:

The rescue is shaping up to include a second round of capital injections with tougher terms. The government is looking to get money into banks by buying preferred shares that convert into common equity within seven years; that avoids diluting current shareholders' stakes while helping banks better withstand losses. The Treasury may also allow banks that already received capital injections to convert the Treasury's preferred shares to common stock over time.

The Journal version sounds like an effort will be made to protect existing shareholders and avoid nationalization.

My suspicion is that Treasury will talk tough, but continue a band-aid approach that dribbles out funds at a rate that both avoids the messy issue of nationalization while providing insufficient funds for adequate capitalization, all while trying to keep toxic assets in the banking system. Clearly, I am not optimistic.

By the way, I would appreciate it if someone would explain to me how all this preferred converting to common in seven years "avoids diluting current shareholders". Or is this just because some sucker other than the current one (aka the baby boomers just as they retire) will be left holding the bag?

We also have a description of the repeated parlor tricks that will be used to make it look like this is doing something. After all, we can't have the market cratering the very day they announce that the financial rapture has come.

I have got to say, at least from someone on the outside looking in, the US government appears to be headed down a path already proven to be a failure. Is more of a failing policy smart policy? But it gets worse:

The latest round of discussions also appear to have addressed the most controversial aspect of the big bank concept: Pricing.

Under the emerging plan, the government will buy toxic assets below the banks "carrying value," which is basically market value, but not at fire sale levels, the source said.

That approach will likely placate both taxpayer and Congressional concerns about the government over-paying for the assets. But, the source noted, it could "trigger an accounting problem for the banks," presumably because the institutions will have to report a loss on the transactions.

The Obama administration is now working on ideas to address that, which might entail a temporary suspension of certain accounting rules.

Classic. Absolutely classic. Is this really addressing the problem of pricing? Are we not in the same boat of "if we pay too little, the bank is undercapitalized, but if we pay too much, the taxpayer holds the bag and therefore we need to nationalize"? Obviously we are in the same boat, because the new plan may cause an "accounting problem." Like insolvency. That is, in fact, a problem, no argument from me. Apparently, though, the Administration's solution is a suspension of accounting rules. Translation – we are going to try to hide the problem.

...

The financial crisis has been so mismanaged that the public will not support package with a high price tag, a price tag that could climb into the trillions. And there is no way to even bring the issue to the public unless taxpayers effectively buy troubled banks, which can only be justified after first wiping out shareholders and bondholders. Then the bad assets could be rooted out once and for all. But this Administration appears no more willing than the last to consider temporary nationalization. They either do not want to own banks (I don't blame them), or they are in too deep with Wall Street interests to upend the status quo.

We used to wonder aloud at the intransigence of Japanese policymakers. How could they allow their banking system to deteriorate? Why not take decisive action? Now we know: Fettered to an adherence to the status quo and an aversion to the concept of nationalization, the political will to attack the problem head-on is overwhelmed by the enormity of the financial crisis.

I feel like it gets clearer and clearer by the day; Zakaria was right, we don't have an (insurmountable) economic problem -- we have a political problem.

Top-down corruption

My pithy observation after living in Argentina for a while was that corruption there was a bottom-up affair, by contrast to the United States, where it works top-down. Same total amount of corruption, just distributed differently and with accordingly differing consequences.

Yves said something similar about the shocking, shocking revelation that Henry Paulson may just possibly have over-paid his former employers at Goldman Sachs when he bailed them out.

Corruption in high places is so rampant that I don't see how we dig ourselves out. And that puts it on much the same footing as our debt hangover.

I wonder what Hanky-Pank Hank will do now that he's not at Treasury? Perhaps open a chain of lower Manhattan shooting ranges where they serve pork out of a barrel? Dick Cheney could serve you dinner from a wheelchair while stroking a Persian cat ... and then shoot you in the face for desert.

Ballmer may get it, but I don't.

Steve Keen generally has an interesting perspective, but I don't understand where he comes up with the justification for his Ballmer Gets It post:

Ballmer's perceptive analysis of what is going on is:

"We're certainly in the midst of a once-in-a-lifetime set of economic conditions. The perspective I would bring is not one of recession. Rather, the economy is resetting to lower level of business and consumer spending based largely on the reduced leverage in economy," said Chief Executive Steve Ballmer during a conference call. For consumers, that may mean less discretionary income to spend on a second or third home computer, he said.

Bravo. That is precisely what is happening. It is also why, though government action might slow down the decline, ultimately it can't prevent a serious decline in economic activity.

So Balmer may get it, but I don't.  Why is it exactly that we need to reset to a lower level of economic activity?  Why don't we all just keep doing what we were doing yesterday?  Keep going to work and making stuff and swapping it for the stuff other people made?  Steve Keen has some interesting points in general-- he seems to be the Aussie cousin to Mish Shedlock -- and I am sympathetic to the idea that the change we are seeing now is not like an ordinary recession, but something more fundamental.  But I fail to understand how either of the remedies he proposes in order to bring our debt back in line with our productive capacity (inflation or debt restructuring) necessarily entails that we let our productive capacity fall.  Either of these factors are essentially just mechanisms for redistributing wealth ¿no?  If we don't pay off our mortgages, the guys who owned them will get less money ... and ... so then those guys will have fewer numbers after their name on the bank statement.  Remind me what the earth-shattering impact of this is going to be? 

I understand why debt deflation conspires to form a vicious circle if the financial economy continue to be coupled to the real in the same way as always.  But that circle becomes the collective madness of a nightmare we can awake from whenever we decide to if we are simply willing, for a moment, to suspend the rules of the game and move the chips around so that we can all start playing again.

I can understand that saying, in aggregate, "fuck you", to the Chinese will result in them not wanting to work so much for us and get paid only in IOU's.  Temporarily, this will mean that we will have to forgo some consumption to replace the production that they provided.  These factories won't get built overnight, and we won't be able to watch the TV's that come out of them till they are built.  So I accept some real hangover to the big party because we have dramatically mis-allocated our resources and built things like McMansions that don't help us build more things.  But for Christ sake let's quit whining and make some factories already.

The zombie dollar

This is a bit of an obvious one, and both the Economist and Felix Salmon have gone before me, but I feel the compulsion to vent regardless.

So what exactly is it about the phrase "A strong dollar is in America's national interest" that is so damn special. Is this some sort of ancient incantation from the hermetic order of the free-masons. Why does every Treasury secretary repeat this like a chant when we all know that America has no dollar policy at all, and that if it decided to start having one, it would sure as hell included weakening the damn thing as much as possible. Shit like this scares me about the Obama administration. Somebody, at some point, with some authority, needs to actually get up there and tell the American people that they have no banking system, and that the dollar depends entirely upon the kindness of strangers, lest we end up like Reykjavik-on-Thames.

Politics Precedes Being (rich)

Martin Wolf echoes the thoughts I have been having in watching the first days of the Obama administration.  I am very concerned that we have simply elected a celebrity when we need a serious uber-mensch.  Not that the other option would have been better of course.  But to date, I feel like Obama is getting completely outmaneuvered by the opposing team, even though they suffered a serious defeat not three months ago.  He can't seem to get anybody confirmed without a fiasco.  He hasn't proposed anything sensbile for the banks.  He hasn't come up with a serious stimulus package.  And he hasn't put the fucking screws to congress. 

The world desperately needs Mr Obama to take a firmer grip at home and lead abroad. The plans he is now announcing give him a chance of doing the former. The April summit of the Group of 20 countries, in London, is his chance for achieving the latter.

Unfortunately, what is coming out of the US is desperately discouraging. Instead of an overwhelming fiscal stimulus, what is emerging is too small, too wasteful and too ill-focused. Instead of decisive action to recapitalise banks, which must mean temporary public control of insolvent banks, the US may be returning to the immoral and ineffective policy of bailing out those who now hold the "toxic assets". Instead of acting as a global leader, there is resort to protectionism and a "blame game".

I am tempted to hypothesize that things like Japan's lost decade or the Great Depression are not fundamentally economic phenomena at all; at bottom they are politics.  They are created by the structural inability of a poltical system to represent the welfare of the people, the capture of politics by a minority.  Perhaps Obama represented a move away from this stagnation, but congress is firmly mired in more of the same.  Once the political system is hostage to the career calculations of a bunhc of corrupt bureaucrats, countries can do any number or remarkably "irrational" things that we all imagine we have the collective wisdown to avoid -- like inserting protectionist clauses in a stimulus, or bailing out your buddies in the banking industry, or ...

Of course, I am hardly the only one who is seeing these patterns.  Krugman and Buiter and a slew of other are making similar comments. 

Freudian Blip

Google's Marissa Meyer updates us on a small snafu:

If you did a Google search between 6:30 a.m. PST and 7:25 a.m. PST this morning, you likely saw that the message "This site may harm your computer" accompanied each and every search result. This was clearly an error, and we are very sorry for the inconvenience caused to our users.

What happened? Very simply, human error.

Well Dave, I don't think there is any question about it, it can only be attributable to human error. This sort of thing has cropped up before, and it has always been due to human error.