noah smith

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Will Gold Be a Medium of Exchange Again?

While gold is widely held as a store of purchasing power, and while it is possible to use gold as a unit of account (by converting its floating value to denominate anything in gold terms), gold is no longer widely used as a medium of exchange.

Noah Smith says that gold will never be a widespread medium of exchange again:

In the days when people carried around gold doubloons and whatnot as money, you had a global political system characterized by pockets of stability (the Spanish Empire, or the Chinese Empire, or whatever) scattered among large areas of anarchy. Those stable centers minted and gave out the gold coins. But in the event of a massive modern global catastrophe that brought widespread anarchy, the gold bars buried in your backyard would not be swappable for eggs or butter at the corner store. You’d need some big organization to turn the gold bars into coins of standard weights and purity. And that big organization is not going to do that for you as a free service. More likely, that big organization will simply kill you and take your gold bars, Dungeons and Dragons style.

In other words, I think gold is never coming back as a medium of exchange, under any circumstances. It is no more likely than a return of the Holy Roman Empire. Say goodbye forever to gold money.

Well, forever is a very long time. Human history stretches back just six million years. Recorded history suggests that gold has only been used as a medium of exchange for five or six thousand years. But for that tiny sliver of human history, gold became for many cultures entirely synonymous with money, and largely synonymous with wealth. So I think Noah is over egging his case by using the word forever. Societies have drastically changed in the last six thousand years, let alone the last one hundred. We don’t know how human culture and technology and societies will progress in the future. As humans colonise space, we may see a great deal of cultural and social fragmentation; deeper into the future, believers in gold as money may set up their own planetary colonies or space stations.

But what about the near future? Well, central banks are still using gold as a reserve. In the medium term, it is a hedge against the counter-party risks of a global fiat reserve system in flux. But central banks buying and acquiring gold is not the same thing as gold being used as a medium of exchange. Gold as a reserve never went away, and even in the most Keynesian of futures may not fully die for a long time yet.

And what about this great hypothetical scenario that many are obsessed with where the fragile interconnective structure of modern society — including electronics — briefly or not-so-briefly collapses? Such an event could result from a natural disaster like a megatsunami, or extreme climate change, or a solar flare, or from a global war. Well, again, we can’t really say what will or won’t be useful as a medium of exchange under such circumstances. My intuition is that we would experience massive decentralisation, and trade would be conducted predominantly either in terms of barter and theft. If you have gold coins or bars, and want to engage in trade using them — and have a means to protect yourself from theft, like guns and ammunition — then it is foreseeable that these could be bartered. But so too could whiskey, cigarettes, beer, canned food, fuel, water, IOUs and indeed state fiat currencies. If any dominant media of exchange emerges, it is likely to be localised and ad hoc. In the longer run, if modern civilisation does not return swiftly but instead has to be rebuilt from the ground up over generations then it is foreseeable that physical gold (and other precious metals, including silver) could emerge as the de facto medium of exchange, simply because such things are nonperishable, fungible, and relatively difficult to fake. On the other hand, if modern civilisation is swiftly rebuilt, then it is much more foreseeable that precious metal-based media of exchange will not have the time to get off the ground on anything more than the most localised and ad hoc of bases.

Noah concludes:

So when does gold actually pay off? Well, remember that stories do not have to be true for people to believe them. Lots and lots of people believe that gold or gold-backed money in the event of a global social disruption. And so when this story becomes more popular (possibly with the launching of websites like Zero Hedge?), or when large-scale social disruption seems more likely while holding the popularity of the story constant, gold pays off. Gold is like a credit default swap backed by an insolvent counterparty – it has no hope of actually being redeemed, but you can keep it around forever, and it goes up in price whenever people get scared.

In other words, gold pays off when there is an outbreak of goldbug-ism. Gold is a bet that there will be more goldbugs in the future than there are now. And since the “gold will be money again” story is very deep and powerful, based as it is on thousands of years of (no longer applicable) historical experience, it is highly likely that goldbug-ism will break out again someday. So if you’re the gambling type, or if you plan to start the next Zero Hedge, or if your income for some reason goes down when goldbug-ism breaks out, well, go ahead and place a one-way bet on gold.

Noah, of course, is right that gold is valuable when other people are willing to pay for it. The reason why gold became money in the first place was because people chose to use it as a medium of exchange. They liked it, and they used it, and that created demand for it. If that happens again, then gold will be an in-demand medium of exchange again. But for many reasons — including that governments want monetary flexibility — most of the world today has rejected gold as a medium of exchange.

But there is another pathway for gold to pay off. Noah is overlooking the small possibility that gold may at some point become more than a speculative investment based on the future possibility that gold may at some point return as a monetary media. In 2010, scientists from the Brookhaven National Laboratory on Long Island, using their Relativistic Heavy Ion Collider (RHIC) collided some gold nuclei, traveling at 99.999% of the speed of light. The plasma that resulted was so energetic that a tiny cube of it with sides measuring about a quarter of the width of a human hair would contain enough energy to power the entire United States for a year. So there exists a possibility that gold could be used at some date in the future as an energy source — completely obliterating any possibility of gold becoming a medium of exchange again. Of course, capturing and storing that energy is another matter entirely, and may prove impossible. In that case — if gold does not become a valuable energy source — it is almost inevitable that some society somewhere at some stage will experiment again with gold as a medium of exchange.

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Do Wages Benefit From A Shrinking Labour Force?

Dean Baker says yes:

The retirement of the baby boom cohorts means that the country’s labor force is likely to be growing far more slowly in the decades ahead than it did in prior decades. The United States is not alone in facing this situation. The rate of growth of the workforce has slowed or even turned negative in almost every wealthy country. Japan leads the way, with a workforce that has been shrinking in size for more than a decade.

Baker concludes:

With a stagnant or declining labor force, workers will have their choice of jobs. It is unlikely that they will want to work as custodians or dishwashers for $7.25 an hour. They will either take jobs that offer higher pay or these jobs will have to substantially increase their pay in order to compete.

This means that the people who hire low-paid workers to clean their houses, serve their meals, or tend their lawns and gardens will likely have to pay higher wages. That prospect may sound like a disaster scenario for this small group of affluent people, but it sounds like great news for the tens of millions of people who hold these sorts of jobs. It should mean rapidly rising living standards for those who have been left behind over the last three decades.

Of course, Baker could just look at the data from Japan. Real wages there have been depressed in recent years, even while the labour force has shrunk:

Japanwages

Even more damningly, labour’s share of income in Japan has declined even more considerably than the United States, and other nations with a growing working-age population:

ShareofLabourincome

Matthew C. Klein asks an important question:

Perhaps Mr Baker was thinking of an older example: the Black Death, which killed about half the people in Europe. Many (including me until I looked it up) believe that the resulting shortage in agricultural labour led to soaring real wages for peasants and a redistribution of economic power away from landowners. Recent evidence, however, casts doubt on this hypothesis. While nominal peasant wages did indeed increase in the aftermath of the Black Death, real wages may have actually fallen for decades. That may have helped heavily indebted peasants, but everyone else had to endure punishing declines in their standard of living, not to mention the psychological trauma of surviving such a devastating plague.

And the evidence on the Black Death seems conclusive:

In southern England, real wages of building craftsmen (rural and urban), having plummeted with the natural disaster of the Great Famine (1315-21), thereafter rose to a new peak in 1336-40. But then their real wages fell during the 1340s, and continued their decline after the onslaught of the Black Death, indeed into the 1360s. Not until the later 1370s – almost thirty years after the Black Death – did real wages finally recover and then rapidly surpass the peak achieved in the late 1330s.

And if we look at China — a country which has seen stunning real wage growth in recent years — it is clear that that growth has come in the context of a growth in the working-age population. China’s working-age population hit one billion for the first time in 2011.

To me at least, this seems to suggest that while all else being equal, a shrinking working age population might lead to a more competitive labour market, all else is not equal. Employers invest in more capital-intensive processes like automation and robots to compensate for a lack of workers, or in our globalised world they shift operations to somewhere with a stronger labour force (like China today, or perhaps like Africa further into the future). Even more simply, a falling population as a result of a natural disaster like the Black Death, or even just as a result of demographic trends like Japan, may lead to an economic depression due to falling demand.

This suggests that Baker’s conclusions are extremely optimistic for labour, and that shrinking populations may be bad news for wages.

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Do Creditors Exploit Debtors, or Vice Versa?

I’m asking this question because I think a proper understanding of the answer is a giant leap toward grasping the geopolitical realities of the relationship between America and China.

This discussion was triggered by Noah Smith’s discussion of David Graeber’s ideas on debt, and particularly his idea that debt is a means to “extract wealth” out of others.

Noah Smith on David Graeber:

“Debt,” says Graeber, “is how the rich extract wealth from the rest of us.” But sometimes he seems to claim that creditors are extracting wealth from debtors, and sometimes he seems to claim that debtors extract wealth from creditors.

For example, in the Nation article, Graeber tells that The 1% are creditors. We, the people, have had our wealth extracted from us by the lenders. But in his book, Graeber writes that empires extract tribute from less powerful nations by forcing them to lend the empires money. In the last chapter of Debt, Graeber gives the example of the U.S. and China, and claims that the vast sums owed to China by America are, in fact, China’s wealth being extracted as tribute. And in this Businessweek article, Graeber explains that “throughout history, debt has served as a way for states to control their subjects and extract resources from them (usually to finance wars).”

But in both of these latter cases, the “extractor” is the debtor, not the creditor. Governments do not lend to finance wars; they borrow. And the U.S. does not lend to China; we borrow.

So is debt a means by which creditors extract wealth from debtors? Or a means by which debtors extract wealth from creditors? (Can it be both? Does it depend? If so, what does it depend on? How do we look at a debtor-creditor-relationship and decide who extracted wealth from whom?) Graeber seems to view the debtor/creditor relationship as clearly, obviously skewed toward the lender in some sentences, and then clearly, obviously skewed toward the borrower in other sentences.

But these can’t both be clear and obvious.

What Graeber means by “extracting wealth” in the context of a relationship between, say a mortgager and a mortgagee seems to mean the net transfer of interest. It is certainly true on the surface that there is a transfer of wealth from the debtor to the creditor (or from the creditor to the debtor if the debtor defaults).

However, between nations Graeber sees the relationship reversed — that China is being heavily and forcefully encouraged to reinvest its newly-amassed wealth in American debt (something that some Chinese government sources have suggested to be true). But if the flow of interest payments — i.e. from America to China — is the same debtor-to-creditor direction as between any creditor and debtor, then is the relationship really reversed? If China is being forced to amass American debt by the American government, is America effectively forcing China into “extracting its wealth”?

The thing Graeber seems to miss is that the transfer of interest is the payment for a service. That is, the money upfront, with the risk of non-repayment, the risk that the borrower will run off with the money. That risk has existed for eternity. In this context, the debtor-creditor relationship is a double-edged sword. Potentially, a debtor-creditor relationship could be a vehicle for both parties to get something that benefits them — in the case of the debtor, access to capital, and in the case of the creditor, a return on capital.

In the case of China and America, America may choose to pay off the debt in massively devalued currency, or repudiate the debt outright. That’s the risk China takes for the interest payments. (And the counter-risk of course being that if America chooses to repudiate its debt, it risks a war, which could be called the interstate equivalent of debtors’ prison).

Of course, the early signs are that China’s lending will be worth it. Why? Because sustained American demand provided by Chinese liquidity has allowed China to grow into the world’s greatest industrial base, and the world’s biggest trading nation. And it can’t be said that these benefits are not trickling down to the Chinese working class — China’s industrial strength has fuelled serious wage growth in the last few years. Yes — the Chinese central bank is worried about their American dollar holdings being devalued. But I think an inevitable devaluation of their dollar-denominated assets is a small price for the Chinese to pay for becoming a global trading hub, and the world’s greatest industrial base. Similarly, if American firms and governments use cheap Chinese liquidity to strengthen America, for example funding a transition to energy independence, then the cost of interest payments to China are probably worth it. And that is a principle that extends to other debtors — if the credit funds something productive that otherwise could not have been funded, then that is hardly “wealth extraction”. There is the potential for both parties to benefit from the relationship, and the opportunity costs of a world without debt-based funding would seem to be massive.

But what if tensions over debt lead to conflict? It would be foolish to rule out those kinds of possibilities, given the superficial similarities in the relationship between China-America and that of Britain-Germany prior to World War I. It is more than possible for an international creditor-debtor relationship to lead to conflict, perhaps beginning with a trade war, and escalating —  in fact, it has happened multiple times in history.

It is certainly true that devious creditors and debtors can extract wealth from each other, but so can any devious economic agent — used car salesmen, stockbrokers, etc. The actual danger of creditor-debtor relationships, is not so much wealth extraction as it is conflict arising from the competition inherent to a creditor-debtor relationship. Creditors want their pound of flesh plus interest. Debtors often prefer to be able to shirk their debts, and monetary sovereign debtors have the ability to subtly shirk their debts via the printing press. That is potentially a recipe for instability and conflict.

There is also the problem of counter-party risk. The more interconnected different parties become financially, the greater the systemic risks from a default. As we saw in 2008 following the breakdown of Lehman Brothers, systemic interconnectivity can potentially lead to default cascades. In that case, debt can be seen as a mutual incendiary device. 

So the debtor-creditor relationship is very much a double-edged sword. On the one hand, if all parties act honestly and responsibly debt can be beneficial, allowing debtors access to capital, and allowing creditors a return on capital — a mutual benefit. In the real world things are often a lot messier than that.

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Of Wages and Robots

There is a popular meme going around, popularised by the likes of Tyler Cowen, Paul Krugman and Noah Smith that suggests that recent falls in worker compensation as a percentage of GDP is mostly due to the so-called “rise of the robots”:

For most of modern history, two-thirds of the income of most rich nations has gone to pay salaries and wages for people who work, while one-third has gone to pay dividends, capital gains, interest, rent, etc. to the people who own capital. This two-thirds/one-third division was so stable that people began to believe it would last forever. But in the past ten years, something has changed. Labor’s share of income has steadily declined, falling by several percentage points since 2000. It now sits at around 60% or lower. The fall of labor income, and the rise of capital income, has contributed to America’s growing inequality.

…

In past times, technological change always augmented the abilities of human beings. A worker with a machine saw was much more productive than a worker with a hand saw. The fears of “Luddites,” who tried to prevent the spread of technology out of fear of losing their jobs, proved unfounded. But that was then, and this is now. Recent technological advances in the area of computers and automation have begun to do some higher cognitive tasks – think of robots building cars, stocking groceries, doing your taxes.

Once human cognition is replaced, what else have we got? For the ultimate extreme example, imagine a robot that costs $5 to manufacture and can do everything you do, only better. You would be as obsolete as a horse.

Now, humans will never be completely replaced, like horses were. Horses have no property rights or reproductive rights, nor the intelligence to enter into contracts. There will always be something for humans to do for money. But it is quite possible that workers’ share of what society produces will continue to go down and down, as our economy becomes more and more capital-intensive.

So, does the rise of the robots really explain the stagnation of wages?

This is the picture for American workers, representing wages and salaries as a percentage of GDP:

WASCURGDP

It is certainly true that wages have fallen as a percentage of economic activity (and that corporate profits as a percentage of economic activity have risen — a favourite topic of mine).

But there are two variables to wages as a percentage of GDP. Nominal wages have actually risen, and continued to rise on a moderately steep trajectory:

WASCUR_Max_630_378

And average wages continue to climb nominally, too. What has actually happened to the wages-to-GDP ratio, is not that America’s wage bill has really fallen, but that wages have just not risen as fast as other sectors of GDP (rents, interest payments, capital gains, dividends, etc). It is not as if wages are collapsing as robots and automation (as well as other factors like job migration to the Far East) ravage the American workforce.

It is more accurate to say that there has been an outgrowth in economic activity that is not yielding wages beginning around the turn of the millennium, and coinciding with the new post-Gramm-Leach-Bliley landscape of mass financialisation and the derivatives and shadow banking megabubbles, as well the multi-trillion dollar military-industrial complex spending spree that coincided with the advent of the War on Terror. Perhaps, if we want to look at why the overwhelming majority of the new economic activity is not trickling down into wages, we should look less at robots, and more at the financial and regulatory landscape where Wall Street megabanks pay million-dollar fines for billion-dollar crimes? Perhaps we should look at a monetary policy that dumps new money solely into the financial sector and which has been shown empirically to enrich the richest few far faster than everyone else?

But let’s focus specifically on jobs. The problem with the view that this is mostly a technology shock is summed up beautifully in this tweet I received from Saifedean Ammous:

The Luddite notion that technology might render humans obsolete is as old as the wheel. And again and again, humans have found new ways to employ themselves in spite of the new technology making old professions obsolete. Agriculture was once the overwhelming mainstay of US employment. It is no more:

farmjobs

This did not lead to a permanent depression and permanent and massive unemployment. True, it led to a difficult transition period, the Great Depression in the 1930s (similar in many ways, as Joe Stiglitz has pointed out, to the present day). But eventually (after a long and difficult depression) humans retrained and re-employed themselves in new avenues.

It is certainly possible that we are in a similar transition period today — manufacturing has largely been shipped overseas, and service jobs are being eliminated by improvements in efficiency and greater automation. Indeed, it may prove to be an even more difficult transition than that of the 1930s. Employment remains far below its pre-crisis peak:

EMRATIO_Max_630_378

But that doesn’t mean that human beings (and their labour) are being rendered obsolete — they just need to find new employment niches in the economic landscape. As an early example, millions of people have begun to make a living online — creating content, writing code, building platforms, endorsing and advertising products, etc. As the information universe continues to grow and develop, such employment and business opportunities will probably continue to flower — just as new work opportunities (thankfully) replaced mass agriculture. Humans still have a vast array of useful attributes that cannot be automated — creativity, lateral thinking & innovation, interpersonal communication, opinions, emotions, and so on. Noah Smith’s example of a robot that “can do everything you can do” won’t exist in the foreseeable future (let alone at a cost of $5) — and any society that could master the level of technology necessary to produce such a thing would probably not need to work (at least in the sense we use the word today) at all. Until then, luckily, finding new niches is something that humans have proven very, very good at.

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The Burden of Government Debt

There has been an awful lot of discussion in recent months about whether government debt is a burden for future generations. The discussion has gone something like this: those who believe government debt is a burden claim that it is a burden because future generations have to repay taxes for present spending, those who believe that it is not claim that every debt is also credit, and so because the next generation will inherit not only the debt but also the credit, that government debt is not in itself a burden to future generations, unless it is largely owed to foreign creditors.

It is relatively easy to calculate what the monetary burden of government debt is. Credit inheritance and debt inheritance are not distributed uniformly. The credit inheritance is assumed strictly by bondholders, and the debt inheritance is assumed strictly by taxpayers. Each individual has a different burden, equalling their tax outlays, minus their income from government spending (the net tax position).

For an entire nation, everyone’s individual position is summed together. In a closed economy where the only lenders are domestic, the intergenerational monetary burden is zero. But that is by no means the entire story.

First, debts to foreign lenders are a real monetary burden, because the interest payments constitute a real transfer of money out of the nation. Second, while there may be little or no debt burden for the nation as a whole, interest constitutes a transfer of wealth between citizens of the nation, specifically as a transfer payment from future taxpayers to creditors. This adds up, at current levels, to nearly half a trillion of transfer payments per year from taxpayers to creditors. So while the intergenerational burden may technically add up to zero for the nation, it will not for individuals. The real burden is huge transfers from those who pay the tax to those who receive the spending, and those who receive the interest. So who loses out?

Here are the figures for 2009 showing net tax position for each income quintile:

Bottom quintile: -301 percent
Second quintile: -42 percent
Middle quintile: -5 percent
Fourth quintile: 10 percent
Highest quintile: 22 percent

Top one percent: 28 percent

The negative 301 percent means that a typical family in the bottom quintile receives about $3 in transfer payments for every dollar earned.

What this data does not show are the reverse transfers via interest payments. There is no data (that I can find) on treasury interest payments received by income quintile, but assuming that the top quintile dominates income from interest (as they dominate ownership of financial assets, owning over 95% of all financial assets) this leaves the lower income quintiles benefiting from transfer payments, the top quintile benefiting from interest (as well as policies like bank bailouts, corporate subsidies, and quantitative easing, whose benefits overwhelmingly benefit the top quintile), and squeezing the taxpaying middle quintiles who receive neither the benefits of interest payments, nor significant welfare transfers.

To misquote George Orwell, when it comes to the national debt and who takes its burden, some pigs are definitely more equal than others.

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The Real Testosterone Junkies

I especially enjoy reading things that I disagree with, and that challenge my own beliefs. Strong ideas are made stronger, and weak ideas dissolve in the spotlight of scrutiny. People who are unhappy to read criticisms of their own ideas are opening the floodgates to ignorance and dogmatism. Yet sometimes my own open-minded contrarianism leads me to something unbelievably shitty.

According to Noah Smith:

Zero Hedge is a financial news website. The writers all write under the pseudonym of “Tyler Durden”, Brad Pitt’s character from Fight Club. Each post comes with a little black and white icon of Brad Pitt’s head. On Zero Hedge you can read news, rumors, facts, figures, off-the-cuff analysis, and political screeds (usually anti-Obama, anti-government, and pro-hard money). On the sidebars, you can click on ads for online brokerages, gold collectibles, and The Economist.

The site is a big fat hoax. And if you read it for anything other than amusement, you’re almost certainly a big fat sucker.

That’s a bold claim! Why do I make this claim? Well, in one sense, all financial news is a hoax. Financial news, by definition, is public information — if you’ve read it, you can bet that thousands of other people have too. That means that if the market is anywhere close to being efficient, any information in any article you read will already have been incorporated into the price of financial assets. Reading or watching public information should not, in theory, give you any “alpha”.

If the writers of Zero Hedge really knew some information that could allow them to beat the market,why in God’s name would they tell it to you? If they had half a brain, they’d just keep the info to themselves, trade on it, and make a profit! Maybe then, after they had made their profit, they’d release the news to the public (and collect ad revenue), but by then the news would be worthless. Financial news sites, you should realize, are not in the business of giving you insider tips out of the goodness of their hearts.

As you might expect, it’s not hard to look back at Zero Hedge’s predictions and see that a large number of them are junk. For example, here’s a bunch of posts from 2009 predicting imminent hyperinflation. Hope you didn’t make any trades based on that bit of wisdom!

So how does Zero Hedge get away with this hoax? Barber & Odean (2001) give a big hint. Tyler Durden, whose name and image grace every Zero Hedge Post, is a symbol of masculinity. More specifically, he is a nerd’s imagined vision of what a really masculine nerd would be like. In Fight Club, Durden says: “All the ways you wish you could be, that’s me. I look like you wanna look, I fuck like you wanna fuck, I am smart, capable, and most importantly, I am free in all the ways that you are not.”

In other words, you are a young smart (i.e. nerdy) guy sitting at your computer with rivers of testosterone coursing through your veins. And now here comes Tyler Durden, your generation’s Platonic ideal of pure masculinity, telling you that Real Men Take Risks. At the top of the site, there is a Tyler Durden quote: “On a long enough timeline the survival rate for everyone drops to zero.” In other words, gamble. Bet that you’re the smart guy and not the sucker. Because hey, you’re going to die anyway, so there’s no use hedging your bets. Zero hedge, right?

I wouldn’t be surprised if “Tyler Durden” were actually a bunch of behavioral finance grad students, snickering behind their hands at everyone who takes their site seriously.

This is what passes for financial analysis today? Let’s ignore the obvious fact that Zero Hedge has never pretended to offer investment advice. We should take all financial news with a large grain of salt (anyone who has read the latest uber-bailout rumours out of Europe should know that). Anyone who bases their trading activity on blindly following the pronouncements of one site, or one trader deserves to lose their coat. Blindly following a messiah-figure or (even worse) the herd is a surefire recipe for disaster.

But Smith has got his facts wrong. While there has been no hyperinflation, those who traded their hunch and bought gold — pretty much the archetypal Zero Hedge trade — have not done badly. Here’s the price of gold — contrasted against the S&P500 — since Zero Hedge was born in January 2009:

Drawing a meaty profit and significantly outperforming the S&P500 is hardly what you’d expect from a “big fat hoax”. Certainly, you’d have made a loss, not a meaty profit, from betting with Bernanke’s pronouncement that subprime was “contained”.

Smith is spinning loose psychoanalysis spiced with conspiracy theories and schoolboy misunderstandings in order to generate pageviews. He obviously hasn’t read Zero Hedge enough to realise that “on a long enough timeline the survival rate for everyone drops to zero” reflects the reality that calamities and resets happen, and that — given the level of mess, corruption and perversity in finance today — a systemic reset could be just around the corner. And the last thing i would want to do in the face of a systemic reset — or any kind of large-scale financial calamity (a la 2008) — is gamble. The smart thing is to hunker down and robustify, by minimising exposures to all forms of connective risk and financial fragility . Zero Hedge is not about having no hedges and gambling as recklessly as possible; it is about having hedges against the system going to zero. 

Ironically, Smith is accusing entirely the wrong segment of the financial world of wild recklessness. While there are surely many day traders who lose their coats on the pronouncements of analysts (especially the Crameresque stock-picker — something which Zero Hedge has never done), the real danger is surely the testosterone-Red Bull-and-cocaine-fuelled TBTF trader or 21-year old PhD-wielding quant working for a bailed-out bank with an implicit taxpayer backstop on zero-interest government money. The level of moral and financial hazard is simply staggering, and of course this has bred much reckless behaviour; from the evident criminality of manipulating LIBOR, to Corzine’s destruction of MF Global (and theft of customer funds),  to the absurd market-cornering London Whale’s speculation using customer deposits, to the off-balance-sheet activities of Kweku Adoboli, to Goldman’s quote stuffing. And — I am sure, much much more — these are just some of the scams and scandals that are known; there is much more darkness beneath. Zero Hedge has been a powerful journalistic force and clearinghouse in bringing the light-of-day onto these corruptions and criminalities, something that Smith seems entirely ignorant of.

No day trader or goldbug stacking gold eagles has ever blown up the nation’s pension fund, but the protected TBTF banks funded by earth-shattering leverage and taxpayer guarantees have again and again endangered retirement funds, and lost their clients’ fortunes.

It is not unusual on Wall Street to see massively leveraged double or nothing Martingale trading strategies where traders take a position and push leverage and counter-leverage to create a favourable outcome. In theory — with unlimited funds — such an approach always wins, but in reality this approach usually ends in traders running out of counter-parties or running out of leverage, and ending up with a massive loss. It’s picking up nickels in front of a steamroller, and is of course made much easier thanks to the new and manipulable world of high-frequency trading.

It’s ironic (and jaw-dropping) that Smith castigates Zero Hedge as the home of testosterone junkie traders when in fact the vast majority of Zero Hedge writers and readers are angling for better regulation of high-frequency trading to prevent market manipulation, an end to nickels-in-front-of-steamrollers strategies (the best way is to end the taxpayer guarantees so that traders who blow up the system will reap the consequences), and the return of Glass Steagall (or similar) to keep depositors’ funds out of hyper-fragile shadow intermediation chains and the derivative casino.

The financial system is being regulated by clueless schmucks — many of whom would also castigate Zero Hedge as a “big fat hoax”, while ignoring grift and degeneracy within the financial establishment and the TBTF banks. In the face of such grotesque incompetence who can blame market participants for wanting a hedge against zero?

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The Meaning of Libertarian

I’ve been giving libertarianism some thought over the past few days. My natural instinct when people attack (most) libertarians and libertarianism in general is to become quite defensive. To me, libertarianism implicitly tends to mean constraining the state to various forms of one function: protecting liberty. Implicit in that is the view that states should never resort to force or violent coercion (“the non-aggression principle”). In my cosmos this manifests itself as non-interventionism (i.e. negative liberty) — unwillingness to intervene in the affairs of foreign nations, in markets, in citizens’ private lives.

We have had years of big, visible interventionist screwups — an Iraq war that left over a million Iraqis dead, economic policies like bank bailouts and quantitative easing associated with growing inequality, etc. So I tend to lean toward the idea that irrespective of the libertarian alternatives to the status quo, libertarian criticism is at the very least a noble pursuit.

One problem with libertarianism (and with all schools of thought based around “liberty”) is that no two people will necessarily agree on what liberty is. Libertarians’ cousins, the liberals tend to constellate their ideas around the goal “protecting liberty”, too. But their version of “liberty” is highly interventionist (i.e. positive liberty): they want to use the machinations of the state regulate banks, to regulate the climate, to regulate markets, to dole out money to the less-fortunate, and sometimes even to intervene in the affairs of foreign lands.

And the really complicated thing is that in the real world most people tend to want some of both; protection by the state, as well as freedom from the state. And different people want different aspects of each — some “libertarians” may want freedom from financial regulations, but may believe strongly in drug testing welfare applicants. Other “libertarians” may want gay marriage rights, but also want Glass-Steagall-style financial regulations. Some “libertarians” may want an end up to corporate campaign financing, and others may say that is an essential aspect of free speech. Some “libertarians” may believe strongly in corporate personhood, while others may say that limited liability is effectively market-rigging.

And even when libertarians agree on what they want to achieve, they often cannot agree on how to get there. Some libertarians want to abolish everything tomorrow, others want a more gradual change. Some want to end the foreign wars and nation building first, others first want to kick people off welfare.

Here’s a Twitter conversation I had yesterday:

For readers unfamiliar with so-called “libertarian” Tyler Cowen’s positions, here’s a primer:

Cowen has been described as a “libertarian bargainer” — someone of moderate libertarian ideals who can influence practical policy making. In a 2007 article entitled “The Paradox of Libertarianism,” Cowen argued that libertarians “should embrace a world with growing wealth, growing positive liberty, and yes, growing government. We don’t have to favor the growth in government per se, but we do need to recognize that sometimes it is a package deal.” Cowen endorsed bailouts in a March 2, 2009 column in the New York Times. He was a supporter of the Iraq War.

Cowen could be fairly described as a raging neocon wrapped up in the language and mannerisms of libertarianism.

I think what most people are missing is that ideology is very often a mask for interests. Wealthy business interests are happy to wear the clothes of libertarianism and appeal to libertarian principles (including even the principles of non-violence and voluntarism) when they want to ask for tax cuts. But they are less willing to do so when it comes to slashing subsidies, or outlawing corporate or government snooping, or preventing wars from which they might profit. They might be happy to preach the doctrine of free markets when their companies are successful, but happy to embrace bailouts when their companies fail.

And that is the problem with ideology. Too easily it can become a tool. Or worse, it becomes a weapon to enforce a party line. And that’s why I cannot in good conscience call myself a libertarian, or a classical liberal, or member of any kind of ideological mass movement. The terms are all quickly hijacked and rendered meaningless. And this isn’t solely a political point: think of musical movements like “punk” and “grunge” and “hip hop”.

So I reject ideology, and instead embrace principles. The key difference is that while ideologies are generalised blanket positions that encompass an entire range of issues, principles apply locally. I accept some “libertarian” views, and I reject others. It seems completely pointless to muddy the conversation by defining myself as a libertarian (or a liberal, or a conservative), thus associating myself with a whole blanket of ideas, some of which I agree with and others that I don’t. It is better to just talk specifically about policies and positions that I agree with, or disagree with.

I disagree passionately with handouts to big finance, with aggressive or imperialist foreign policies, with prohibitionism, with corporate personhood and with large-scale central economic planning. On the other hand, I think that a small social welfare net funded by taxation is a good idea. Does that make me a libertarian? A liberal? I don’t care.

The main problem with this anti-ideological view is that ideological labels are — for most people — a useful shorthand. Nothing will stop the cascade of labels that are thrown around. It’s quick, dirty and easy. But we should be aware that they smudge reality into digestible compartments, at the expense of detail. We should be aware that they are intellectual shortcuts.

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Bubble Economy

Noah Smith asks:

What is a “bubble”?

Well, it’s something that looks like this:

Prices go way up, then they crash back down. Look at any long-term plot of any asset price index (stocks, housing, etc.) and you’re likely to see some big peaks like this. That’s what I call a “bubble.” It’s also the definition used by Charles Kindleberger in his book Manias, Panics, and Crashes.

That sounds about right. We see these patterns everywhere — from Bitcoins, NFLX, and copper today, to the DJIA, NASDAQ and many commodities and stocks during the last century. Smith continues:

But the real question is why we care about bubbles. Some people believe that bubbles are merely responses to changes in expected fundamental value of an asset (the “fundamental value” is the expected present value of  the income you get from owning an asset). According to this view, the NASDAQ bubble happened because people thought that internet companies were going to make lots and lots of profit, and when those expectations didn’t materialize, prices went down again. This view is held by many eminent financial economists, including Eugene Fama, the most cited financial economist in the world.

If bubbles represent the best available estimate of fundamental values, then they aren’t something we should try to stop. But many other people think that bubbles are something more sinister – large-scale departures of prices from the best available estimate of fundamentals. If bubbles really represent market inefficiencies on a vast scale, then there’s a chance we could prevent or halt them, either through better design of financial markets, or by direct government intervention.

Smith goes on to quite elegantly show that a lot of evidence suggests that bubbles are probably an entirely natural phenomenon.

As an Englishman, there is an example much closer to home:


Gordon Brown claimed that his government had abolished boom and bust; there would be no more foundering capitalist bluster, no slump after the boom, just slow, steady centrally-planned growth.

Then 2008 happened, his claims were made to look infantile, and he was shunted from office by a man who at the very least has some backbone.

Bubbles are expressions of human exuberance. That is because value is subjective (and as such, the notion of incorrect “fundamentals” is extremely fuzzy — how can any subjective value be “fundamental”?) Humans are herd animals — we move where the money is. If an asset value is rising, speculators will want a piece of the action. And why not? Money made speculating is money made with little or no effort. Sometimes there is some underlying reason as to why an asset value is rising: expectations of rising earnings, or a prospective takeover. Sometimes it is just hot air and animal spirits.

A simple heuristic: bubbles happen. Even when central planners have explicitly gone out of their way to prevent bubbles, they still seem to happen.

On the other hand, it is possible to make societies more robust to bubbles. For a start, if a bubble is built on debt-acquisition (e.g. 1929) its collapse will be more painful than otherwise due to counter-party risk, because of the resultant default cascade. So, basing the banking system around debt is by default quite fragile. So too is allowing a humungous scheme of credit creation via securitisation and rehypothecation. And so is allowing the unregulated trading of huge quantities  of exotic derivatives and swaps.

Andrew Haldane, writing in Nature, describes the bubble that emerged:

In the run-up to the recent financial crisis, an increasingly elaborate set of financial instruments emerged, intended to optimize returns to individual institutions with seemingly minimal risk. Essentially no attention was given to their possible effects on the stability of the system as a whole. Drawing analogies with the dynamics of ecological food webs and with networks within which infectious diseases spread, we explore the interplay between complexity and stability in deliberately simplified models of financial networks. We suggest some policy lessons that can be drawn from such models, with the explicit aim of minimizing systemic risk.

Regulators overlooked huge systemic fragility because they had no concept of its existence. That is the very definition of a black swan. And the nature of reality suggests that no matter how good we get at modelling reality and behaviour, those black swans will keep clusterflocking.

Bubbles happen: what matters is how resilient we are to them. And  — with gross derivatives exposure as high as ever before, with government and private debt as high as ever before, and with unemployment still perilously high — it would be quite hard to say we look very resilient.