Ben Bernanke Is Right About Interconnective Innovation

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I’d just like to double down on Ben Bernanke’s comments on why he is optimistic about the future of human economic progress in the long run:

Pessimists may be paying too little attention to the strength of the underlying economic and social forces that generate innovation in the modern world. Invention was once the province of the isolated scientist or tinkerer. The transmission of new ideas and the adaptation of the best new insights to commercial uses were slow and erratic. But all of that is changing radically. We live on a planet that is becoming richer and more populous, and in which not only the most advanced economies but also large emerging market nations like China and India increasingly see their economic futures as tied to technological innovation. In that context, the number of trained scientists and engineers is increasing rapidly, as are the resources for research being provided by universities, governments, and the private sector. Moreover, because of the Internet and other advances in communications, collaboration and the exchange of ideas take place at high speed and with little regard for geographic distance. For example, research papers are now disseminated and critiqued almost instantaneously rather than after publication in a journal several years after they are written. And, importantly, as trade and globalization increase the size of the potential market for new products, the possible economic rewards for being first with an innovative product or process are growing rapidly. In short, both humanity’s capacity to innovate and the incentives to innovate are greater today than at any other time in history.

My reasons for optimism for the long run are predominantly technological rather than social. I tend to see the potential for a huge organic growth in the long run resulting from falling energy and manufacturing costs from superabundant alternative energy sources like solar, synthetic petroleum, wind, and nuclear, as well as decentralised manufacturing through 3-D printing and ultimately molecular manufacturing.

But Bernanke’s reasons are pretty good too. I see it every day. Using Twitter, the blogosphere and various other online interfaces, I discuss and refine my views in the company a huge selection of people of various backgrounds. And we all have access to masses of data to backup or challenge our ideas. Intellectual discussions and disputes that might have taken years now take days or weeks — look at the collapse of Reinhart & Rogoff. Ideas, hypotheses, inventions and concepts can spread freely. One innovation shared can feed into ten or twenty new innovations. The internet has built a decentralised open-source platform for collaborative innovation and intellectual development like nothing the world has ever seen.

Of course, as the 2008 financial collapse as well as the more general Too Big To Fail problem shows greater interconnectivity isn’t always good news. Sometimes, greater interconnectivity allows for the transmission of the negative as well as the positive; in the case of 2008 the interconnective global financial system transmitted illiquidity in a default cascade.

But in this case, sharing ideas and information seems entirely beneficial both to the systemic state of human knowledge and innovation, and to individuals like myself who wish to hook into the human network.

So this is another great reason to be optimistic about the long run.

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Why the Gold Crash? The Failure of Inflation to Take Off

One of the key features of the post-2008 gold boom was the notion that inflation was soon about to take off due to Bernanke’s money printing.

But so far — by the most-complete inflation measure, MIT’s Billion Prices Project — it hasn’t:

AnnualInflation

To me, this signifies that the deflationary forces in the economy have so far far outweighed the inflationary ones (specifically, tripling the monetary base), to such an extent that the Fed is struggling to even meet its 2% inflation target, much less trigger the kind of Weimar or Zimbabwe-style hyperinflation that some gold enthusiasts have projected.

The failure of inflation to take off (and thus lower real interest rates) is probably the greatest reason why gold’s price stagnated from 2011 and why gold has gone into liquidation the last week. With inflation low, investors became more cautious about holding gold. With the price stagnant, the huge gains that characterised gold’s rise from 1999 dried up, leaving more and more long-term investors and particularly institutional investors leaving the gold game to hunt elsewhere for yield.

I myself am an inflation agnostic, with deflationista tendencies. While I tend to lean toward the notion of deeply-depressed Japan-style price levels during a deleveraging trap, price levels are also a nonlinear phenomenon and could both accelerate or decelerate based on irrational psychological factors as much as the level of the money supply, or the total debt level, or the level of deleveraging. And high inflation could certainly take off as a result of an exogenous shock like a war, or series of natural disasters. But certainly, betting the farm on a trade tied to very high inflation expectations when the underlying trend is largely deflationary was a very bad idea, and those who did like John Paulson are being punished pretty brutally.

The extent to which this may continue is uncertain. Gold today fell beneath its 200-week moving average for the first time since 2001. How investors, and particularly institutional investors react to this is uncertain, but I tend to expect the pendulum to swing very far toward liquidation. After all, in 2011 most Americans named gold the safest investment, and now that psychological bubble is bursting. That means that for every goldbug buying the dip, many more may panic and sell their gold. This could easily turn to a rout, and gold may fall as low as the cost of production ($900), or even lower (especially considering gold’s high stock-to-flow ratio). Gold is a speculation in that it produces no return other than price rises. The last time gold got stuck in a rut, it was stuck there for almost 20 years.

However, my case for physical gold as a small part of a diverse portfolio to act as a hedge against systemic and counterparty risks (default cascades, Corzine-style vaporisation, etc) still stands, and lower prices are only good news in that regard. The financial system retains very many of its pre-2008 fragilities as the deregulated megabanks acting on margin continue to speculate in ways that systematise risk through balance sheet interconnectivity. Another financial crisis may initially lower the price of gold on margin calls, but in the long run may result in renewed inflows into gold and a price trend reversal. Gold is very much a barometer of distrust in the financial, governmental and corporate establishment, and as middle class incomes continue to stagnate and income inequality continues to soar there remain grave questions over these establishments’ abilities to foster systemic prosperity.

Save Our Bonuses!

With the British economy in a worse depression than the 1930s , bank lending to businesses severely depressed, and unemployment still high, a sane finance minister’s main concern might be resuscitating growth.

Prime Minister David Cameron And Chancellor George Osborne Ahead Of A Critical Week At The Leveson Inquiry

George Osborne’s main concern, however, are the poor suffering bankers:

Chancellor George Osborne flies to Brussels later determined to water down the European Parliament’s proposals to curb bankers’ bonuses.

But EU finance minsters in the Economic and Financial Affairs Council (Ecofin) are expected to approve last week’s proposals.

They include limiting bonuses to 100% of a banker’s annual salary, or to 200% if shareholders approve.

The City of London fears the rules will drive away talent and restrict growth.

Mayor of London Boris Johnson has dismissed the idea as “self-defeating”. London is the EU’s largest financial centre.

On Monday, a spokesman for Prime Minister David Cameron said: “We continue to have real concerns on the proposals. We are in discussions with other member states.”

But Mr Osborne’s bargaining power may be weakened further by Switzerland’s recent decision to cap bonuses paid to bankers and give shareholders binding powers over executive pay.

Now, I couldn’t care less about bonuses or pay in a free industry where success and failure are determined meritocratically. It is none of my business. If a successful business wants to pay its employees bonuses, then that is that business’s prerogative. If it wants to pay such huge bonuses that it puts itself out of business, then that is that business’s prerogative.

But the British financial sector is the diametrical opposite of a successful industry. It is a forlorn bowlegged blithering misshapen mess. The banks were bailed out by the taxpayer. They do not exist on the merits of their own behaviour. Two of the biggest are still owned by the taxpayer.  So I — as a taxpayer and as a British citizen — have an inherent personal interest in the behaviour of these banks and their employees.

In an ideal world, I would have let the banks go to the wall. The fact that the financial system is still on life support almost five years after the crisis began tells a great story. It’s not just that I don’t believe in bailing out failed and fragile corporations (although I do believe that this is immoral cronyism). The excessive interconnectivity built up over years prior to the crisis means that the pre-existing financial structure is extremely fragile. Sooner or later, without dismantling the fragilities (something that patently has not happened, as the global financial system today is as big and corrupt and interconnective as ever), the system will break again. (Obviously in a no-bank-bailout world, other action would have been required. Once the financial system had been allowed to fail, depositors would have to be bailed out, and a new financial system would have to be seeded and capitalised.)

But we do not live in an ideal world. We have inherited a broken system where the bankers (and not solely the ones whose banks are owned by the taxpayer — all banks benefit from the implicit liquidity guarantees of central banks) are living on taxpayer largesse. That gives the taxpayer the right to dictate terms to the banking sector.

Unfortunately, this measure (like many such measures dreamed up arbitrarily by bureaucrats) is rather pointless as it can be so very easily gamed by inflating salaries. And it will do nothing to address financial sustainability, as it does not address the problem that led to the 2008 liquidity panic — excessive balance sheet interconnectivity (much less the broader problems of moral hazard, ponzification, and the current weakened lending conditions).

But, if it is a step toward a Glass-Steagall-style separation of retail and investment banking — a solution which would actually address a real problem, and one advocated in the Vickers report — then perhaps that is a good thing. Certainly, it is not worth picking a fight over. The only priority Osborne should have right now is creating conditions in which the private sector can grow sustainably. Unlimiting the bonuses of the High Priests of High Finance has nothing whatever to do with that.

The Unsustainable US Financial Sector

According to Bloomberg, the vast majority of the Big Five banks’ profits consisted of a taxpayer subsidy — the Too Big To Fail guarantee. If the Too Big To Fail banks had to lend at the rates offered to their non-Too Big to Fail competitors, their profits would be severely shrunk (in some cases, to a net loss):

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What does that mean?

That means that the American financial sector is a zombie, existing on the teat of the taxpayer.

It means the huge swathes of liquidity spent on saving the financial sector are ultimately good money chasing after bad.

As Bloomberg notes:

The U.S. financial industry — with almost $9 trillion in assets, more than half the size of the U.S. economy — would just about break even in the absence of corporate welfare. In large part, the profits they report are essentially transfers from taxpayers to their shareholders.

Neither bank executives nor shareholders have much incentive to change the situation. On the contrary, the financial industry spends hundreds of millions of dollars every election cycle on campaign donations and lobbying, much of which is aimed at maintaining the subsidy. The result is a bloated financial sector and recurring credit gluts.

This is extremely prescient stuff. The Fed since 2008 has reinflated the old bubbles, while allowing the same loot-and-pillage disaster-corporatist financial model to continue.

It is insane to repeat the same methods and expect different results. This credit glut, this new boom that has seen stocks rise closer and closer to their pre-crisis high (which may soon be exceeded) will just lead to another big 2008-style slump, just as the Fed’s reinflation of the burst tech bubble led to 2008 itself. This time the spark won’t be housing, it will be something else like an energy shock, or a war. Something that the Federal Reserve cannot directly control or fix by throwing money at it.

America (and the Western world in general) post-2008 needed real organic domestic growth built on real economic activity, not a reinflated bubble that let the TBTF financial sector continue to gorge itself into oblivion. 

Securitisation and Risk

João Santos of the New York Fed notes what forward-thinking financial writers have been thinking for a long, long time:

There’s ample evidence that securitization led mortgage lenders to take more risk, thereby contributing to a large increase in mortgage delinquencies during the financial crisis. In this post, I discuss evidence from a recent research study I undertook with Vitaly Bord suggesting that securitization also led to riskier corporate lending. We show that during the boom years of securitization, corporate loans that banks securitized at loan origination underperformed similar, unsecuritized loans originated by the same banks. Additionally, we report evidence suggesting that the performance gap reflects looser underwriting standards applied by banks to loans they securitize.

Historically, banks kept on their books the loans they originated. However, over time they increasingly replaced this originate-to-hold model with the originate-to-distribute model, by syndicating the loans they originated or by selling them in the secondary loan market. The growth of securitization provided banks with yet another opportunity to expand the originate-to-distribute model of lending. The securitization of corporate loans grew spectacularly in the years leading up to the financial crisis. Prior to 2003, the annual volume of new collateralized loan obligations (CLOs) issued in the United States rarely surpassed $20 billion. Since then, this activity grew rapidly, eclipsing $180 billion in 2007. 

Corporate loan securitization appealed to banks because it gave them an opportunity to sell loans off their balance sheets—particularly riskier loans, which have been traditionally more difficult to syndicate. By securitizing loans, banks could lower the risk on their balance sheets and free up capital for other business while continuing to earn origination fees. As with the securitization of other securities, the securitization of corporate loans, however, may lead to looser underwriting standards. For example, if banks anticipate that they won’t retain in their balance sheets the loans they originate, their incentives to screen loan applicants at origination will be reduced. Further, once a bank securitizes a loan, its incentives to monitor the borrower during the life of the loan will also be reduced.

Santos’ study found that the dual phenomena of lax lending standards and securitisation existed as much for corporate debt as it did for housing debt:

To investigate whether securitization affected the riskiness of banks’ corporate lending, my paper with Bord compared the performance of corporate loans originated between 2004 and 2008 and securitized at the time of loan origination with other loans that banks originated but didn’t securitize. We found that the loans banks securitize are more than twice as likely to default or become nonaccrual in the three years after origination. While only 6 percent of the syndicated loans that banks don’t securitize default or become nonaccrual in those three years, 13 percent of the loans they do securitize wind up in default or nonaccrual. This difference in performance persists, even when we compared loans originated by the same bank and even when we compared loans that are “similar” and we controlled for loan- and borrower-specific variables that proxy for loan risk.

This is an important study, because it emphasises that this is a universal financial phenomenon, and not one merely confined to mortgage lenders that were encouraged by the Federal government into lending to risky mortgagees. The ability to securitise lending and so move the risk off your balance sheet leads to riskier lending, period.

This exemplifies the problem with shadow finance. Without the incentive of failure for lenders who lend to those who cannot repay, standards become laxer, and the system begins to accrue junk loans that are shipped off the lenders’ balance sheets and onto someone else’s. This seems like no problem to the originating lender, who can amass profits quickly by throwing liquidity at dubious debtors who may not be able to repay without having to worry about whether the loan will be repaid. The trouble is that as the junk debt amasses, the entire system becomes endangered, as more and more counterparties’ balance sheets become clogged up with toxic junk lent by lenders with lax standards and rubber-stamped as Triple-A by corrupt or incompetent ratings agencies. As more laxly-vetted debtors default on their obligations, financial firms — and the wider financial system, including those issuers who first issued the junk debt and sold it to other counterparties  — come under pressure. If enough debtors default, financial firms may become bankrupt, defaulting on their own obligations, and throwing the entire system into mass bankruptcy and meltdown. This “risk management” — that lowers lending standards, and spreads toxic debt throughout the system — actually concentrates and systematises risk. Daron Acemoglu produced a mathematical model consistent with this phenomenon.

In a bailout-free environment, these kinds of practices would become severely discouraged by the fact that firms that practiced them and firms that engaged with those firms as counterparties would be bankrupted. The practice of making lax loans, and shipping the risk onto someone else’s balance sheet would be ended, either by severely tightened lending standards, or by the fact that the market for securitisation would be killed off. However, the Federal Reserve has stepped into the shadow securities market, acting as a buyer-of-last-resort. While this has certainly stabilised a financial system that post-2008 was undergoing the severest liquidity panic the world has probably ever seen, it has also created a huge moral hazard, backstopping a fundamentally perverse and unsustainable practice.

Shadow finance is still deleveraging (although not as fast as it once was):

But so long as the Federal Reserve continues to act as a buyer-of-last-resort for toxic junk securities produced by lax lending, the fundamentally risk-magnifying practices of lax lending and securitisation won’t go away. Having the Federal Reserve absorb the losses created by moral hazard is no cure for moral hazard, because it creates more moral hazard. This issue soon enough will rise to the surface again with predictably awful consequences, whether in another jurisdiction (China?), or another market (securitised corporate debt? securitised student loan debt?).

Too Big To Understand

One thing that has undergone hyperinflation in recent years is the length of financial regulations:

Too Big To Understand

The Dodd-Frank regulatory hyperinflation crowds out those who cannot afford teams of legal counsel, compliance officers, and expansive litigation. Dodd-Frank creates new overheads which are no challenge for large hedge funds and megabanks armed with Fed liquidity, but a massive challenge for startups and smaller players with more limited resources.

As BusinessWeek noted in October:

The law requires Hedge Funds to register with the Securities and Exchange Commission, supply reams of sensitive data on trading positions, carefully screen potential investors, and hire compliance officer after compliance officer.

So, is this expansion in volume likely to improve financial stability? No — the big banks are bigger and more interconnected than ever, which was precisely the problem before 2008, and they are still speculating and arbitraging with very fragile strategies that can incur massive losses as MF Global’s breakdown and more recently the London Whale episode proves.

Andy Haldane laid out the problem perfectly in his recent paper The Dog and the Frisbee:

Catching a frisbee is difficult. Doing so successfully requires the catcher to weigh a complex array of physical and atmospheric factors, among them wind speed and frisbee rotation. Were a physicist to write down frisbee-catching as an optimal control problem, they would need to understand and apply Newton’s Law of Gravity.

Yet despite this complexity, catching a frisbee is remarkably common. Casual empiricism reveals that it is not an activity only undertaken by those with a Doctorate in physics. It is a task that an average dog can master. Indeed some, such as border collies, are better at frisbee-catching than humans.

So what is the secret of the dog’s success? The answer, as in many other areas of complex decision-making, is simple. Or rather, it is to keep it simple. For studies have shown that the
frisbee-catching dog follows the simplest of rules of thumb: run at a speed so that the angle of gaze to the frisbee remains roughly constant. Humans follow an identical rule of thumb.

Catching a crisis, like catching a frisbee, is difficult. Doing so requires the regulator to weigh a complex array of financial and psychological factors, among them innovation and risk appetite. Were an economist to write down crisis-catching as an optimal control problem, they would probably have to ask a physicist for help.

Yet despite this complexity, efforts to catch the crisis frisbee have continued to escalate. Casual empiricism reveals an ever-growing number of regulators, some with a Doctorate in physics. Ever-larger litters have not, however, obviously improved watchdogs’ frisbee-catching abilities. No regulator had the foresight to predict the financial crisis, although some have since exhibited supernatural powers of hindsight.

So what is the secret of the watchdogs’ failure? The answer is simple. Or rather, it is complexity.

Big, messy legislation leaves legal loopholes that clever and highly-paid lawyers and (non-) compliance officers can cut through. Bigger and more extensive regulation can make a system less well-regulated. I propose that this is what the big banks will use Dodd-Frank to accomplish.

I predict that the regulatory hyperinflation will make the financial industry and the wider economy much more fragile.

Is Marxism Coming Back?

It is true that as the financial and economic crises roll on, as more and more disasters accumulate, as more people are thrown into unemployment and suffering that more and more of us will question the fundamentals of our economic system. It is inevitable that many will be drawn to some of the criticisms of capitalism, including Marxism.

The Guardian today published a salutary overview of this revival:

In his introduction to a new edition of The Communist Manifesto, Professor Eric Hobsbawm suggests that Marx was right to argue that the “contradictions of a market system based on no other nexus between man and man than naked self-interest, than callous ‘cash payment’, a system of exploitation and of ‘endless accumulation’ can never be overcome: that at some point in a series of transformations and restructurings the development of this essentially destabilising system will lead to a state of affairs that can no longer be described as capitalism”.

That is post-capitalist society as dreamed of by Marxists. But what would it be like?It is extremely unlikely that such a ‘post-capitalist society’ would respond to the traditional models of socialism and still less to the ‘really existing’ socialisms of the Soviet era,” argues Hobsbawm, adding that it will, however, necessarily involve a shift from private appropriation to social management on a global scale. “What forms it might take and how far it would embody the humanist values of Marx’s and Engels’s communism, would depend on the political action through which this change came about.”

Marxism is a strange thing; it provides a clean and straightforward narrative of history, one that irons out detail and complication. It provides a simplistic “us versus them” narrative of the present. And it provides a relatively utopian narrative of the future; that the working classes united will overthrow capitalism and establish a state run by and for the working classes.

Trouble is, history is vastly more complicated than the teleological narrative provided by dialectical materialism. The economic and social reality of the present is vastly more complicated than Marx’s linear and binary classifications. And the future that Marx predicted never came to fruit; his 19th Century ideas turned into a 20th Century reality of mass starvation, failed central planning experiments, and millions of deaths.

Certainly, the system we have today is unsustainable. The state-supported financial institutions, and the corporations that have grown up around them do not live because of their own genius, their own productivity or innovation. They exist on state largesse — money printing, subsidies, limited liability, favourable regulation, barriers to entry. Every blowup and scandal — from the LIBOR-rigging, to the London Whale, to the bungled trades that destroyed MF Global — illustrates the incompetence and failure that that dependency has allowed to flourish.

The chief problem that Marxists face is their misidentification of the present economic system as free market capitalism. How can we meaningfully call a system where the price of money is controlled by the state a free market? How can we meaningfully call a system where financial institutions are routinely bailed out a free market? How can we meaningfully call a system where upwards of 40% of GDP is spent by the state a free market? How can we call a system where the market trades the possibility of state intervention rather than underlying fundamentals a free market?

Today we do not have a market economy; we have a corporate economy.

As Saifedean Ammous and Edmund Phelps note:

The term “capitalism” used to mean an economic system in which capital was privately owned and traded; owners of capital got to judge how best to use it, and could draw on the foresight and creative ideas of entrepreneurs and innovative thinkers. This system of individual freedom and individual responsibility gave little scope for government to influence economic decision-making: success meant profits; failure meant losses. Corporations could exist only as long as free individuals willingly purchased their goods – and would go out of business quickly otherwise.

Capitalism became a world-beater in the 1800’s, when it developed capabilities for endemic innovation. Societies that adopted the capitalist system gained unrivaled prosperity, enjoyed widespread job satisfaction, obtained productivity growth that was the marvel of the world and ended mass privation.

Now the capitalist system has been corrupted. The managerial state has assumed responsibility for looking after everything from the incomes of the middle class to the profitability of large corporations to industrial advancement. This system, however, is not capitalism, but rather an economic order that harks back to Bismarck in the late nineteenth century and Mussolini in the twentieth: corporatism.

The system of corporatism we have today has far more akin with Marxism and “social management” than Marxists might like to admit. Both corporatism and Marxism are forms of central economic control; the only difference is that under Marxism, the allocation of capital is controlled by the state bureaucracy-technocracy, while under corporatism the allocation of capital is undertaken by the state apparatus in concert with large financial and corporate interests. The corporations accumulate power from the legal protections afforded to them by the state (limited liability, corporate subsidies, bailouts), and politicians can win re-election showered by corporate money.

The fundamental choice that we face today is between economic freedom and central economic planning. The first offers individuals, nations and the world a complex, multi-dimensional allocation of resources, labour and capital undertaken as the sum of human preferences expressed voluntarily through the market mechanism. The second offers allocation of resources, labour and capital by the elite — bureaucrats, technocrats and special interests. The first is not without corruption and fallout, but its various imperfect incarnations have created boundless prosperity, productivity and growth. Incarnations of the second have led to the deaths by starvation of millions first in Soviet Russia, then in Maoist China.

Marxists like to pretend that the bureaucratic-technocratic allocation of capital, labour and resources is somehow more democratic, and somehow more attuned to the interests of society than the market. But what can be more democratic and expressive than a market system that allows each and every individual to allocate his or her capital, labour, resources and productivity based on his or her own internal preferences? And what can be less democratic than the organisation of society and the allocation of capital undertaken through the mechanisms of distant bureaucracy and forced planning? What is less democratic than telling the broad population that rather than living their lives according to their own will, their own traditions and their own economic interests that they should instead follow the inclinations and orders of a distant bureaucratic-technocratic elite?

I’m not sure that Marxists have ever understood capitalism; Das Kapital is a mammoth work concentrating on many facets of 19th Century industrial and economic development, but it tends to focus in on obscure minutiae without ever really considering the coherent whole. If Marxists had ever come close to grasping the broader mechanisms of capitalism — and if they truly cared about democracy — they would have been far less likely to promulgate a system based on dictatorial central planning.

Nonetheless, as the financial system and the financial oligarchy continue to blunder from crisis to crisis, more and more people will surely become entangled in the seductive narratives of Marxism. More and more people may come to blame markets and freedom for the problems of corporatism and statism. This is deeply ironic — the Marxist tendency toward central planning and control exerts a far greater influence on the policymakers of today than the Hayekian or Smithian tendency toward decentralisation and economic freedom.