Tag: economics

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economics

Blue swan with pink spots

Could perhaps be created using genetic engineering in the future 🙂 I’ve been reading Nassim Taleb’s The Black Swan. It’s an engaging book once you get beyond the pages and pages of insults directed against professional statisticians.
They key point could be summarised as follows. Professional statisticians have become obsessed with applying gaussian distribution models to real world phenomenon which don’t match the model for a range of reasons. Primarily the gaussian model attaches a lower probability to rarer events than is actually the case in many real world phenomenon such as degrees of wealth. When these models are used for prediction and risk management the results may be acceptable when making predictions about data close to the median but are hugely error prone about rarer conditions. The seeming success of the model in limited predictions promotes over-confidence and encourages further bad predictions.
Mr. Taleb goes on to point out that Mandelbrotian randomness more accurately depicts many phenomenon as it allows for greater deviations within a sample and more probable outliers. The point is made enthusiastically and in an idiosyncratic style. It’s accessible in a way that encourages most people to understand the contents and query current models for market analysis. It’s not an in-depth mathematical treatise and this is ultimately a weakness given some of the grand claims. However, Taleb’s rage at the amount of bullshit spouted by should-know-better financial and quantitative engineers is understandable. You only have to watch market analysts in programmes on CNN, MSNBC to figure out that, with a lot of jargon, there’s often not a lot of actual knowledge or understanding. Differences of opinion and rude/crude arguments abound but few of the experts called the current crisis. What’s the point of accepted financial models if they’re not just unsuccessful at predicting (a very hard task) but cause risk to be discounted (a very bad thing)? The Black Swan is essential reading for anyone who’s blithely applying statistical models to whatever economic, marketing or social science application they’re working on. It should give them pause for thought.
So, back to my headline. Mankind are great at producing huge inequalities and surprising outliers. History is littered with them! The more power we achieve over our environment and, indeed, our genetics the more probable the improbable becomes. I’d content that the number of potential black swans increasing (if that isn’t too wild any idea). Not in a linear way of course. More of a giant leap, black swan, kind of increments 🙂 We’ve found black swans on the moon, black swans in space, black swans in the earth, on the earth and with genetic engineering we can create human black swans. Scary.
So the current market models are deeply flawed. Indeed they don’t seem so much models as talking points for TV debates. Who predicted the crisis? Currently in the “Deep Financial Shit is Nigh” hall of fame are international players like Peter Schiff, Nassim Taleb and local players like David McWilliams, Alan Ahearne and Morgan Kelly. Very few economists correctly predicted the current crisis nationally or internationally.
I believe one reason for this is that it became fashionable for these most miserable of analysts to predict boom followed by a soft landing. Economists by their nature are supposed to be pessimistic and risk aware. They should be over-predicting recessions, which is the butt of the famous economist joke.

“An economist is a person who predicts 10 of the last 3 economic recessions”

In this case, there seems to have been an international fear of being caught out in predicting an end to this boom, fueled by financial innovations in the bond market. Many economists simply suspended disbelief even when scandals like Enron encouraged skepticism. Conversely this old joke gives the lie to the belief that economists create recessions. They make predictions and pass comments. Some may add to recessions and further despair but if they could really create economic turmoil then their predictions would never be wrong!

Categories
economics

Nash, McWilliams and an economy of words

I picked up this link in my travels. The article contains an interview with John Nash where he discusses the current economic crisis.

“I get the impression that the government is not ready to do anything that is really beyond a short-term basis,” said Nash, a senior research mathematician at Princeton. “[But] we need a natural stability of value.”

Nash advocates an international monetary system with suitable accords like a new Bretton Woods. He fundamentally believes that such a system should be democratically introduced. He believes that short-termist keynesianism has wrecked the stability of the financial system. A big problem he has cited now and in the past is the variable rate mortgage. Should home-owners really be speculating on their repayments? Do many really understand the implications?
In many cases the illusion of liquidity was craved more than any tangible value. The sprocket-loan derivative market (fictional I HOPE) could be a great source of earnings as long as people kept buying sprockets. If they slow down, the mechanics of the market falls apart as, like a Ponzi scheme, it’s reliant on getting more derivative buyers in so previous buyers can bail out at a profit.
Something like the gold standard has always been deemed inflexible in times of extravagance, mostly due to the cost of warfare. Does anything good come out of a fiat currency, unbacked by commodities? Does it really create sustainable wealth that wouldn’t arise otherwise?
Is the opportunity it creates simply too hazardous to our wealth (and health)?
Despite his well-documented problems Nash is, perhaps the world’s most famous and most brilliant economist with a formidable reputation as a pure mathematician. His comments ring true and this crisis is an opportunity to bring about a more conservative economic system again with less exotic derivative products acting as “get rick quick” mechanisms for greedy hedge funders. Still you have to be brave and a bit different to affect real change.
Right now, we really need change. Lateral thinking backed by some pragmatic experience. One way to do this is to put someone in charge of the banks in this country who thinks differently Which brings me around to the obvious conclusion that Lenihan should appoint David McWilliams as the CEO of one of the banks. Yes, the floppy ginger haired bloke who used to present Agenda and wrote those books about our economic rise and fall. If anything, he’s got timing and great TV hair. Very important in a bank CEO.
I’m deadly serious here. McWilliams has the credentials and the experience of the banking sector. He has worked in the central bank, as an analyst for UBS and as a director of BNP. His predictions have been prescient yet he appears to listen and respond to criticism well, certainly on the evidence of his blog. When an idea is berated he’ll discuss it rationally, responding reasonably to even savage criticism. We don’t get much of that in the FF-led government these days. BIFFOT, Minister for Cork & Battman don’t seem able to take criticism with anything less than a snarl. Then there’s my namesake.. 🙁
On the positive side the Walking Handshake from Drumcondra is gone!
Even more importantly, McWIlliams would scare the over-leveraged but still living shit out of the incumbents. He’s been attacking them for years so imagine their discomfort to be faced with him as their boss or competitor. We might aswell make Michael O’ Leary Taoiseach. Now there’s an idea.
Seriously though, whatever cash he wants, whatever it takes to entice him back into the financial sector, we should pay him. It would be worth it for the entertainment value alone and we’ll need a lot of entertainment over the coming months to distract us from the economic misery in store.

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Uncategorized

The debt black-hole

I read a report recently that suggested the US credit derivatives market is worth at least 50 trillion with CDS’s making up the majority. These are estimates obviously but the bottom line is a figure so large that it could collapse a country never mind a bank. Admittedly that figure is believed to be the total amount of credit derivatives swaps outstanding in the US.
Because of the good old US belief in minimally regulated market freedom a reasonable sounding mechanism to transfer risk became the spring board for a range of financially engineered derivatives which multiplied both the number of parties involved and the net effect of any individual default. CDS’s require low capital backing so they’re risk that appears “cheap” to play with and potentially very lucrative. On the way up, this creates liquidity. However, the multiplying affect is probably 10 or more as the commercial loan market in the US is supposed to be worth around 5 trillion dollars.
So one bank fails and, simplistically, brings down another 10 financial services companies with it. As banks of differing sizes tend to buy credit from banks up the food-chain, Credit is almost like a commodity that can be manufactured and productised into other packages suitable for smaller financial services companies with different capitalisation, risk profile, timeframes etc. Therefore, it’s possible that a large failure, causes a catastrophe for a few smaller banks. If their problems are resolved, the effects are felt by even smaller banks etc. It’s a ripple effect that we can’t insulate ourselves from, even with an unlimited governmental guarantee.
This won’t “balance out” as they say due to the multiplying affect and the scale. There’s simply more risk-based derivatives out there than assets to protect. Even more so when you consider those assets are inflated. We already know European banks have participated in this market so even if no Irish bank has partaken in the CDS market directly, it is reducing and will further reduce the ability of Irish banks to get credit. It could also devalue their other foreign investments. No bank is an island 🙂
I think the size of this black hole of risk is what’s terrifying world governments into producing these massive bail out packages. As it’s cheaper to nationalise or recapitalise one bank than it is 10. Better to protect defaults at source than wait for the meltdown.
Essentially, this is the goal of the 700 Billion dollar bailout package that was passed recently in US Congress. Purchase the debt that’s in default or most likely to become “toxic” ASAP before the “ripple effect”. Now consider, the multiplier effect and you have 7 trillion of associated CDS’s sitting out there. Some has possibly been triggered already due to the events at Lehman Brothers. Although there are differences of opinion regarding exposure, the multiplier factor and the Net effect. Also, it’s worth remembering that you actually have to be able to get the money from the CDS counter-party. They could simply refuse to pay.
How to mitigate the risk of this happening again? Bubble-expert Yale professor Robert Shiller makes a few suggestions which are discussed over the at the freakonomis website. These focus on improving the information available between institutions and public so risk profile is less opaque. He also proposes the solution of creating derivatives on city-level real estate prices. I don’t like this solution as by his own admission markets are subject to mass delusion regarding prices going onwards and upwards. The ability to short these markets may limit control, but with leverage it IMO provides another mechanism for ordinary joe (popular guy recently) to see one of his life’s major investments exploited by profit-hungry hedgers. Reducing leverage capacities of both banks and individuals is an excellent idea. It’s tough love and many commentators suggest it damages liquidity but that’s arguably adopting a catastrophist attitude towards tighter regulation. What good is all that liquidity if it’s going to be channelled into trading timebomb credit derivatives? What’s wrong with telling someone who can’t afford to buy a house that they can’t have it? The only reason they wanted to buy was because of the mass delusion of the ever-ascending property ladder. If sub-prime buyers had been encouraged to wait it out the prices wouldn’t have overheated.
Or to use another(‘s) metaphor we could do worse than remember the world of John Maynard Keynes:

“A general bonfire is so great a necessity that unless we can make of it an orderly and good-tempered affair in which no serious injustice is done to anyone, it will, when it comes at last, grow into a conflagration that may destroy much else as well.”