Central Banker to the World

If there’s one guy in the entire financial world who is not only useless, but also extremely dangerous, it’s Nobel Prize-winning schmuck Myron Scholes. Scholes won the Nobel for his contribution to the Black-Scholes-Merton derivatives pricing model. In theory, that equation allowed financial actors to more easily calculate their risk and reward positions, and hedge accordingly. This led to the development of a variety of complex hedging and arbitrage strategies that have spawned the complex web of interconnected debt and derivatives that we see today, where huge parts of the global economy have become too interconnected to fail. And as we are slowly learning, being too interconnected to fail doesn’t prevent failure — it just makes its effects more poisonous.

Myron Scholes’ own ventures were very unsuccessful. He was the “brains” behind Long Term Capital Management, the ill-fated hedge fund that blew up in 1998:

Nassim Taleb put it better than I ever could:

This guy should be in a retirement home doing Sudoku. His funds have blown up twice. He shouldn’t be allowed in Washington to lecture anyone on risk.

Yet lecturing the world on risk, as well as financial stability and the international financial system is exactly what Scholes is doing.

From Ambrose Evans-Pritchard:

So the question arises, should the rest of the world take over management of Europe to prevent or mitigate disaster? Specifically, should the US Federal Reserve assume leadership as a monetary superpower and impose policy on a paralyzed ECB, acting as a global lender of last resort?

In essence, the US would do for EMU what it did in military and strategic terms for the Europe in the 1990s when Washington said enough is enough after squabbling EU leaders had allowed 200,000 people to be slaughtered in the Balkans. The Pentagon settled matters swiftly with “Operation Deliberate Force”, raining Tomahawk missiles on the Serb positions. Power met greater power.

Personally, I have not made up my mind about the wisdom of a Fed rescue. It is fraught with dangers, and one might argue that resources are better deployed breaking EMU into workable halves with minimal possible damage.

However, debate is already joined – and wheels are turning in Washington policy basements – so let me throw this out for readers to chew over.

Nobel economist Myron Scholes first floated the idea over lunch at a Riksbank forum in August. “I wonder whether Bernanke might not say that we believe in a harmonised world, that the Europeans are our friends, and we know that the ECB can’t print money to buy bonds because the Germans won’t let them. And since the ECB will soon run out of money, we will step in and start buying European government bonds for them’. It is something to think about,” he said.

Now, I don’t believe that an idea is necessarily discredited because its author is stupid. But this is another very bad idea from the author of many very bad ideas.

Bernanke’s copying of the failed Japanese response to a burst bubble — print money and avoid liquidation — has already doomed the United States to over two years of zombification, lowered employment, weak lending, biflation, and a lack of new growth or creative destruction. Does Europe — and the globe — deserve to be subjected to the same horrendous zombified state? I don’t think so.

Bernanke’s approach is deeply reactionary — it puts systemic stability above everything else — and will take any measure necessary to ensure it. But is systemic stability really worth anything if the system that is stabilised — encumbered by excessive debt, malinvestment and fragility — stinks? In my view, the bad debt, bad investments, and bad companies need to liquidate. The recapitalisation comes afterwards.

The best way to “save” a bad system is to let it fail, and help rebuild it. Clearly, neither Europe, nor America, nor the globe are working. Policymakers need bolder policy — they need to start looking at allowing what is failing to fail — and then facilitating rebuilding. If stern teutonic monetarism allows for the kind of global failure that can allow the junk to liquidate, then I am all for it. Yes — it undermines the Federal Reserve’s reactionary money printing policies. But that’s the cost of a system as fragile as the one Myron Scholes has helped build, where American stability is threatened by crisis in Europe, etc.

It is my theory that the real disaster in economics in the last half century was its takeover by mathematicians like Myron Scholes. These people never seemed to care much about reality, or empiricism. They have been lost in their imagined abstractions, drunk on maths, drunk on the beautiful, idealised, linear models that they create — but which merely resemble reality. Models are not real. That was the problem at Long Term Capital Management — their statistical arbitrage models worked perfectly at a theoretical level, but crashed and burned in complex, messy reality — at cost to the taxpayer, the investor, and the financial world at large. I can’t help but think that this is the problem here too — the ideal of a highly liquid, hugely interconnected and truly global financial system is seductive to idealist mathematicians, and therefore its preservation has become central to the Fed’s policies (the FOMC is dominated, of course, by mathematical economists and econometricians). In messy, non-abstract reality, the fragility of such a system makes it absolutely unsustainable. The mathematicians will keep pumping liquidity and trying to save their paradigm. But it won’t work.

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