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.

Advertisements

Motherfucking Global

How times have changed for Jon Corzine.

Just a couple of months ago he looked like the prime candidate to take over Tim “No Chance of a Downgrade” Geithner’s poisoned chalice at the US Treasury.

Now he looks like he’s heading to jail for stealing money from clients.

Probably the most sage coverage of this saga comes from Roger Lowenstein writing for Bloomberg:

Thirteen years ago, when the hedge fund Long-Term Capital Management was desperately negotiating with Wall Street banks for a bailout, Jon Corzine, the chief executive officer of Goldman Sachs Group Inc. (GS), called John Meriwether, LTCM’s founder, and read him the riot act. Wall Street would invest, Corzine said, but “JM” would have to accept more controls, including strict supervision over his firm’s trading limits.

Corzine, I wrote soon after, “understood the flaws” at LTCM better than anyone. The firm had no controls over risk limits, no accountability to anyone who wasn’t a trader.

Essentially, Corzine forgot the lessons of LTCM‘s failed arbitrageurs, and went the hyper-leveraged Martingale path. The trouble is that unless you predict accurately, this kind of activity is a quick and easy road to bankruptcy. Leveraged 50:1, a 2% drop in asset prices can be a wipeout, and end in insolvency.

There are two key points, and one key question to take away from this:

  1. The American banking system is susceptible to a Euro-collapse — MF Global went down betting on a Euro-stabilisation. The web of derivatives extends across the global financial system, creating ever-growing fragility.
  2. None of the lessons of AIG and Lehman have been learned — the bailouts and stimuli saved a broken system, and allowed it to continue to be broken.

And the question:

  1. What effects will MF Global’s removal from the web of debt have on the financial system as a whole?

The first point is obvious (although Morgan Stanley will keep denying it, and focus instead on how Groupon is worth at least $100 a share). The second point has been obvious for a long time.

The question is much murkier. Is MF Global too big to fail without sending financial systems into freefall (a la Lehman)?

The answer seems to be “probably not”.

From TIME:

So far, the problems at MF Global appear to not be spreading to other banks. While MF Global has $40 billion in assets, it only owed about $2 billion outright to other banks. What’s more, more than half of that debt is owed to J.P. Morgan, which is one of the strongest banks around. There are other banks that are owed $6.3 billion from loans MF Global took out to make its Euro debt bets. But those debts are backed by the bonds that MF bought, and if they end up being good as Corzine claimed, then those banks should get their money back, as well as the profits Corzine hoped to pocket for his firm. MF Global does not appear to have the same type of derivatives exposure to other banks that led to the demise of Bear Stearns and Lehman Brothers.

Nonetheless, we will see what we will see when we see it.

Is it Always a Good Time to Own Gold?

Is it always a good time to own gold?

Absolutely not. A portfolio in the S&P 500 or Treasuries in 1973 has returned a much higher rate than gold bought that year — even if gold raced ahead up ’til 1980, and is racing ahead again now. We know that throughout history gold has sustained its purchasing power, and fiat currency has lost its purchasing power. But we also know that stocks have grown their purchasing power.

But gold continues to rise — so what makes gold different right now? Well, from a technical perspective, America and the West are in a secular bear market:

But a technical perspective doesn’t really give enough political and economic background to explain why we are where we are.

Continue reading