Reshaping Narrow Law and Art

CDO Meltdown (3): Summary of Results

2010-04-03T15:44:00.000-07:00

(Part 1, 2)

My previous post summarized a few major aspects of that were well-known about CDOs--mostly notes from the first 27 pages of Anna Katherine Barnett-Hart's thesis, "The Story of the CDO Market Meltdown." However, this is just the first quarter of a 115 pp. paper. What follows is attempt to summarize more of the actual findings peculiar to the paper.

EXAMINATION OF THE CREDIT RATING AGENCIES

The credit rating agencies (CRAs) consist of Moody's, Standard & Poor's, and Fitch. Fitch was a relatively minor player in the CDO sector for reasons that will be investigated in the "Findings" part of this post. Letter ratings by the CRAs have had statutory significance for decades, since pension funds were required by law to invest only in AAA securities.¹ In theory, institutional investors or banks were obligated to practice due diligence; complete abdication of responsibility to CRAs for such an important function seems rather extraordinary.

The ratings supplied by CRAs are supposed to measure the likelihood of fulfillment of the obligations of the underlying security. The securities we are talking about are securitized debt and bonds, or derivatives thereof, and the question that a rating is supposed to answer is, How likely is it that the investor will receive principal and interest on time? In some cases, interest payments and principal are rated separately; in other cases, the only thing being rated is the likelihood of the of the investor getting the initial investment back.²

After 2002, when the CDO became a major investment vehicle, CRA business soared.³ A curious aspect of this boom in ratings demand was that CRAs were now the most important customers for their own product. CRAs rated residential mortgage backed securities (RMBS) or other constituents of CDOs, and then used these same ratings (plus formulae for pooling and diversifying risk) . For purposes of pooling, it was useful to have multiple CRAs rate the same security, and then use it in multiple CDOs. If a CRA was assessing securities already rated by another agency, it would typically "notch" the rating (downgrade it one grade).⁴ So "duplication of effort" was a major source of business.

Of course, "duplication of effort" did not occur as far as due diligence was concerned. Instead, a few data inputs were used to assess the base assets. Ratings did not correlate well with rates of default or with subsequent downgrades, even by the limited metrics imposed by the agencies themselves. But CDOs were supposed to incorporate the broader, systemic risk of loss; this, the CRAs were unable to do.⁵

In the event, the CRAs' own staffs were never able to agree on a single coherent notion of what risk was.

EXAMINATION OF THE UNDERWRITERS

The underwriters were investment banks that created CDOs . By far the largest ABS CDO underwriter was Merrill Lynch, followed at a distance by Citigroup.⁶ Soon the underwriters ran out of asset-backed securities and began to incorporate assets consisting of tranches from earlier CDOs. Merrill Lynch, for example, bought 32% of its own RMBS and CDO issues for CDO repackaging.⁷

Underwriters made the situation worse by carrying the super-senior tranches in off-book special purpose vehicles (SPVs) , justified to regulators by hedging--i.e., purchases of credit default swaps (CDS). Merrill Lynch was thus obligated to write down USD 51.2 billion in the wake of the crisis.⁸

However, there was immense difference in performance of CDOs depending on the originator. Goldman Sachs performed comparatively well, with "only" 10% default compared to 40% for JP Morgan.

Hypotheses

Barnett-Hart lists several hypotheses she tests using a combination of regression analysis and probit analysis (p.36).

Hypothesis 1A ("The Housing Effect"): Increasing exposure to residential mortgages, specifically subprime and Alt-A RMBS, is associated with worse CDO performance as measured by defaults.
Hypothesis 1B ("The Vintage Effect"): Increasing exposure to 2006 and 2007 vintage collateral, particularly assets with floating interest rates, is associated with worse CDO performance as measured by defaults.
Hypothesis 1C ("The Complexity Effect"): Increasing the amount of synthetic collateral, the amount of pre-securitized CDO collateral, and the overall number of collateral assets is associated with worse CDO performance as measured by defaults.
Hypothesis 2A ("The Underwriter Effect"): Holding constant general CDO characteristics, CDO performance varies based on the underwriting bank.
Hypothesis 2B ("The Size [of the underwriter's CDO business] Effect"): The performance of an underwriter’s CDOs varies according to the size of their CDO business, with overly-aggressive or very inexperienced banks issuing worse CDOs, as measured by their ex-post defaults and rating downgrades.
Hypothesis 2C ("The Originator [of the underlying collateral] Effect"): Controlling for the type of mortgages issued, as measured by average FICO, CLTV, and DTI scores, the performance of a CDO depends on the specific entities that originated its collateral assets; in other words, was CDO performance affected by the emergence of banks that acted as both CDO underwriters and collateral originators?
Hypothesis 2D ("The Asymmetric Information Effect"): CDO performance will be affected if it contains collateral originated by its underwriter, although the performance might improve or decline, depending on the importance of reputation vs. adverse selection and moral hazard.
Hypothesis 3A ("Recycled Ratings Effect"): The most important factor in explaining initial levels of AAA given to a CDO are the credit ratings of their collateral pool.
Hypothesis 3B ("The Peer Pressure Effect"): The % of AAA given to a CDO will depend on the number of rating agencies rating the deal.
Hypothesis 3C ("The Seniority Effect"): Controlling for the default rate of the CDO collateral, senior tranches have experienced more severe downgrades.
Hypothesis 3D ("The Asset-Class Effect"): The realized defaults associated with a given credit grade varies based on the asset type. Similar to Hypothesis 1A, except that here we're interested in the effect on default likelihood for a given CRA rating applied to CMBS versus RMBS or HEL.
Hypothesis 3E ("The Super-Senior Effect" : Rating agencies were overly optimistic in giving AAA ratings. CDOs given more initial AAA ratings, in terms of number of AAA tranches and percent of the transaction rated AAA, are now exposed to larger losses. The name for this hypothesis was apparently inspired by Janet Tavakoli (2005), in which she cites the impact on the actual risk of a waterfalled security of a super-tranche. CRAs did not specifically account for the additional risk posed to the smaller AAA tranche by having a larger share of the CDO's liabilities be senior to it.
Hypothesis 3F ("Conflict of Interest"): Conflicts of interest caused by the fee system of credit ratings would result in more aggressive initial ratings, subsequently more downgrades, and worse accuracy in prediction for the CDOs of large underwriters. Barnett-Hart tested this hypothesis by comparing the amount of business the CRAs did with each underwriter with the number of tranche-rating downgrades. A very large downgrade meant a larger favorable bias toward the underwriter, which was (in turn) tested against the volume of business the CRA did for that particular underwriter.

In total, thirteen hypotheses about the factors that most severely stimulated the crisis. These hypotheses seem well-chosen because they test market failure under conditions that most closely match perfect competition.

RESULTS OF THE STUDY

About half of the variation in ABS CDO performance was the result of CDO asset and liability properties (Hypotheses 1A-1C). In particular, regressions of asset and liability properties explained almost 60% of the downgrades in ratings for individual tranches of CDOs. The results are summarized on p.91.

Most hypotheses were validated, although it takes a close reading of the result tables to say how validated each one was. CDOs had a strong likelihood of failing if they were created in 2006-2007, were issued backed mostly by residential mortgage securities (as opposed to commercial mortgages , etc.),⁹ and were complex.¹⁰ This is to be expected; narratives of financial crises should rely on failed business models or regulatory systems. Narratives that "expose" a single person or institution as wickedly inflicting the disaster on a hapless financial system are unsatisfying.

Hypotheses 2A-2D dealt with the underwriter contributions to CDO performance, and explained less of the variance in CDO performance. Nonetheless, they were still interesting to economists. Hypothesis 2A involved a simple ranking of underwriters by CDO performance; effect of [collateral] origination and assymetric information (i.e., hypotheses 2C & 2D) was ambiguous. Some collateral originators performed worse than the rest, but mostly the asset composition was a stronger explanation (2C). Likewise, in some cases it helped that the originator of CDOs was a large player, but aggressiveness in growing structured finance departments was not a good sign (2B); and there was considerable variation from underwriter to underwriter as to the effect on using one's own collateral in a CDO tranche (2D).¹¹ These results arguably suggest that underwriters were eclipsed in importance by the fundamental business model applied to CDOs and the strategic position of the particular underwriters. For example, Goldman Sachs was in a peculiarly advantageous position with respect to the underwriters and was not obligated to pursue CDO business aggressively.

(It needs to be added that table 7 summarizing the ranking of CDO underwriters based on (a) CDO default and (b) CDO tranche rating downgrade yielded entirely different results. Goldman's CDOs had the lowest frequency of default, followed by Lehman; but Goldman was ranked 11th for ratings downgrades.)

The hypotheses 3A through 3F pertained to corruption of CRA ratings per se. Here, the hypotheses behaved very differently indeed from what was expected. While attempting to confirm Hypothesis 3F ("Conflict of Interest"), for example, Barnett-Hart ran up against the problem that the ranking of underwriters by ratings demand was the same for all three CRAs. Moreover, the largest underwriters often were the worst. To make matters more ambiguous, the real problem was that there was too little variation in ratings, not to much. Using jargon from behavioral economics, the problem was signals compression: the difference in real quality of securities, from T-bills to Countrywide CES RMBS was huge, and the ratings ought to have reflected this. Instead, the ratings reflected very small differences across the range of underlying reality.

One regression, for example, ranks underwriters by the accuracy of their ratings (table 14, panel B, p.89). The twist, here, is that the ranking reflect the success of the CRAs to make accurate judgments of the underwriters being ranked. It happens to closely match the ranking of underwriters by performance of CDO (where higher ranking means fewer defaults). In effect, the CRAs were "righter" about the best underwriters, and "wronger" about the worst.

Barnett-Hart concludes:

The errors of the rating agencies stemmed from neither conflicts of interest nor preferential treatment given to certain banks. The true culprit behind the rating agencies’ failure was the outsourcing of credit analysis to computer models and the low level of human input used to rate CDOs (p.94).

In a later post I want to address broader conclusions regarding the CDO market meltdown.

(Part4)

Notes

The term "AAA" is used by Standard & Poor's and Fitch; Moody's uses "Aaa." Here et alibi, "AAA" = "Aaa."

Tavakoli (2005), p.9; via Barnett-Hart (2009). Barnett-Hart uses the page numbers from the PDF file; here, page numbers are from the issue of the original periodical.

From exhibit , Senate Permanent Subcommittee on Investigations, April 2010, p.18.
Moody’s gross revenues from RMBS and CDOs increased from just over $61 million in 2002 to over $208 million in 2006. S&P's net annual revenues from ratings nearly doubled from $517 million in 2002, to $1.16 billion in 2007. During that same period, the structured finance group's revenues tripled from $184 million in 2002, to $561 million in 2007. In 2002, structured finance contributed 36 percent to S&P’s bottom line; in 2007, it contributed 48 percent – nearly half of all S&P revenues. In addition, from 2000 to 2007, operating margins at the CRAs averaged 53 percent, far outpacing companies like Exxon and Microsoft, which had margins of 17 and 36 percent respectively in 2007.
This information added in an update to the original post.

Barnett-Hart (2009), p.20

Tavakoli (2005), p.10.
One would think that rating agencies would at least be inter- nally consistent. But that isn’t necessarily true. Even within the same rating agency, portfolio tests and restrictions may vary by deal, and some deals are better protected than others. Different structurers within a rating agency may choose different stress scenarios when evaluating cash flows for an ultimate rating.

[....]

In 2004, Fitch’s model showed such unreliable results for structurers using Fitch’s fre- quently changing correlation matrix that industry observers dubbed it the "Fitch Random Ratings Model."
With respect to the broader measure of systemic risk: " Conventional general market risk to a portfolio is not captured by ratings." (p.9)

Barnett-Hart (2009), p.26. Here is the complete list.

This table presents the number of ABS CDO deals underwritten by the top 10 underwriters between 2002-2007. The data were obtained from S&P’s CDO Interface.
Underwriter	2002	2003	2004	2005	2006	2007	TOTAL
Merrill Lynch	0	3	20	22	33	18	107
Citigroup	3	7	13	14	27	14	80
Credit Suisse	10	7	8	9	14	6	64
Goldman Sachs	3	2	6	17	24	7	62
Bear Stearns	5	2	5	13	11	15	60
Wachovia	5	6	9	16	11	5	52
Deutsche Bank	6	3	7	10	16	5	50
UBS	5	2	5	10	16	6	46
Lehman Brothers	3	4	3	6	5	6	35
Bank of America	2	2	4	9	10	2	32
TOTAL DEALS	47	44	101	153	217	135	697

Ibid., p.27. Repackaging of CDO securities into a new CDO resulted in a "CDO-squared." The Royal Bank of Scotland did this an average of 5.32 x for its CDO securities. Merrill Lynch did it 4.79x. These were extremes, but Merrill Lynch was the biggest underwriter.

Ibid., p.32. CDS is supposed to be a form of insurance for default (rather than a proper swap), but almost immediately became very popular as a way for non-holders of CDO securities, like John Paulson, to bet against the housing market overall. The counterparties in the CDS transactions received a premium when defaults did not occur, but when they did, suffered enormous losses that required government bailouts to prevent a general run of CDO securities. This was problematic since so much of the money used to bail out the financial system went to pay off speculators like Paulson.

This hypothesis is somewhat problematic because such a large share of ABS CDOs were based on housing collateral. Remember, this category excludes the larger pool of synthetic CDOs as well as a smaller group of CDOs based on corporate bonds. RBMS accounted for about 14% of all ABS deals in 2006-2007 (Barnett-Hart, p.9, table 2) , but home equity loans (HEL) were more radioactive still and accounted for another 34% of deals during that period. Of the remaining 52%, another 11% were pre-existing CDOs (which incorporated a slightly different share of HEL & RMBS; see next footnote below). Only about 40% of the total were commercial mortgages or "other": credit card debt, car loans, and so on.

Complexity is measured by the coefficients on Number of Assets, % Synthetic, and % CDO. Please note that CDOs were a non-housing asset and "% synthetic" impinges on the 40% of ABS CDOs that were neither housing nor CDO. As it happens, synthetic CDOs performed relatively better than ABS CDOs--they failed at about a fifth the rate of ABS CDOs (See Part 2, Ftnt 4 & 5).
For a description of the findings:
1. Hypothesis 2A, p. 56 & table 7 (p.63, panel A);
2. 2B p.57 & table 7 (p.64, panels B.1 & B.2)
3. 2C: p.58 & table 8 (p.63)
4. 2D: p.59 & table 8 (p.65)

Sources & Additional Reading

Efraim Benmelech & Jennifer Dlugosz, "The Credit Rating Crisis" National Bureau of Economic Research (2009)

Anna Katherine Barnett-Hart, "The Story of the CDO Market Meltdown: an Empirical Analysis" Thesis, Harvard University (2009)

Janet Tavakoli, "Structured Finance: Rating the Rating Agencies " , Global Association of Risk Professionals, Issue 22 (Jan/Feb 2005), p.9; via Barnett-Hart (2009), p.20. Barnett-Hart uses the page numbers from the PDF file; here, page numbers are from the issue of the original periodical.

Dr. Michael Wang, Shwn Meei Lee, & Dr. John Ku, "Risks and Risk Management of Collateralized Debt Obligations" (February 2009)

Yves Smith, "The Role of CDOs in Merrill’s Losses (Updated and Expanded Version)," Naked Capitalism (24 October 2007)

Global CDO Issuance, SIFMA (Excel spreadsheet). Outstanding source on CDO statistics.

Labels: economics, finance, regulation, structured finance

CDO Meltdown (2)

2010-03-31T01:52:00.000-07:00

(Part 1)

The single most valuable resource on theCDO meltdown is Barnett-Hart (2009); this was a thesis paper submitted for a BA at Harvard University, which received a lot of attention thanks to a favorable cite by Michael Lewis.¹ Fittingly, the thesis has won many honors, and it's pretty impressive to read.

A few points introductory to this essay; first, I'm not an expert and this post is my collection of notes on what I regard as helpful or trustworthy sources. The reason why I am writing about this topic is that it's very important to understanding the financial crisis and its concomitant economic catastrophe. Readers are almost certainly not going to share my political views of the matter, but I think some grasp of the mechanics of the crisis will help out in forming their own.

Second, readers interested in an explanation of CDOs are advised to read my first installment or, better still, the first 27 pages of Barnett-Hart's paper.

Additional Background from Barnett-Hart

Most of the CDO market growth took place between 2002 and 2007; a major driving force was the fact that real interest rates were abnormally low, and institutional investors like pension fund managers were required to invest only in AAA-bond assets. CDOs used the waterfall structure to create putatively AAA tranches from pools of assets of far lower rating. In fact, this would have worked except for the fact that the asset pools were (a) not successfully or adequately diversified (i.e.,the assets in the pool were prone to defaulting all at once), and (b) composed of loans of unprecedentedly poor grade (i.e., the loans were made to borrowers who were almost certain to default).

Another reason was that bank holding companies in the USA were now underwriting securities as well as re-lending deposits as loans. Banks could increase their leverage-to-equity ratio by unloading assets to a special purpose entity (SPE; also known as a structured investment vehicle, or SIV), then harvest the returns from the SPE. In a few years, an enormous share of assets and liabilities of the US banking system (including US subsidiaries of foreign banks) were parked in this shadow banking system.

The cash "freed up" by "selling" loans to off-balance sheet zombies (Barnett-Hart called them "brain dead," p.5) was then lent out again. This ruse allowed a large increase in the supply of loanable funds available to the banking system, and spurred a huge boom in housing prices.

About 13% of CDOs issued were created to vacate the balance sheet of a bank.²

The CDOs were exceptionally complex, large entities; they tended to be just under a billion dollars in size, were divided into 7-8 tranches, which usually included one unrated tranche.³ As they became more popular, structured finance came to be the preferred form of collateral (synthetic CDOs).⁴

CDO performance in the Crisis was highly varied. Quarter of issue, asset type, and underwriter (e.g., Goldman Sachs versus J.P. Morgan) each had an effect that was statistically significant. Bonds incorporated in CDOs generally performed much worse than those that were not (Barnett-Hart, p.12, figure 3). After 2005, synthetic CDOs became the main part of the story, but as of this writing, they remain a comparatively small part of the CDO crisis.⁵

A Digression on Subordination

A very important part of the CDO boom was the role of ratings and the enhanced return relative to ratings that CDOs offered to investors. CDOs were popular with investors precisely because they were rated much higher than the underlying securities taken separately would have been, had they been rated accurately. Credit rating agencies (CRAs) such as Fitch, Moody's, and Standard & Poor's assumed that the underlying securities were pooled and subordinated in a way that prevented serious losses to investors even if the CRA ratings were excessively optimistic.

One of the indices of "safety" (or unlikelihood of failure) was loan subordination. A typical bank borrows money short-term from depositors and lends it long-term to borrowers. In order to make a return on its capital, it must lend the money at a higher rate than it pays out to depositors. If this spread is large, then the bank can increase its reserves and its capital. In either case, the bank's excess of loan revenues over expenditures (i.e., interest paid in on loans less interest paid out on accounts) protects the depositors from default by borrowers. "Credit enhancement" includes this and other ways of reducing the likely cost of default: [putatively] excessive collateral, and credit default swaps (CDS), or "wrapped securities" (securities insured against loss by a third party) are other ways.

Ratings agencies use a complex formula to pool their estimate of the value of these guarantees; the subordination is supposed to reflect the excess of cash flow over obligations as a percentage, with each tranche in the CDO possessing a different subordination value.

The Effect of Ratings

Earlier, I mentioned that super-senior tranches were supposedly better than AAA, meaning that the waterfall agreement used in CDOs ensured that even market anomalies capable of hitting a AAA security were unlikely to impact a super-senior tranche. This was reflected in the subordination levels for super-seniors: as late as 2007, they were estimated at 22%, compared to <15% for AAA, <10% for AA, and <5% for BBB (Barnett-Hart, p.15, fig.6).⁶

The ratings agencies did not know how to cope with the huge demand for data that investors (and regulators were now putting on them). The financial system was trained to measure performance by returns relative to risk. High risk investments were supposed to have high rates of return; it wasn't especially impressive if they did. With CDOs, investment houses could churn out high rates of return on low risk investments, with AAA rating. This was the essence of "alpha," or performance of a portfolio adjusted for risk.⁷

The great majority of CDOs were issued in order to arbitrage the favorable interest and risk imparted by the CDO structure itself. Hence, the CRAs were major instigators of the CDO mania. Barnett-Hart goes so far as refer to the CRAs as "manufacturing AAA CDO securities from collateral with much lower ratings" (p.23), which certainly fits my understanding of the situation.

Sources & Additional Reading

Peter Lattman "Michael Lewis’s The Big Short? Read the Harvard Thesis Instead!" Deal Journal [blog], The Wall Street Journal (15 March 2010)

SIFMA spreadsheet (accessed for this post), in worksheet "CDO Purpose." Refers to period 2005-2010, during which 13% of the USD 1.3 trillion in CDO par value issued was for shadow banking. The remaining USSD 1.1 trillion was used for arbitraging the interest premium offered by putatively AAA/AA securities.

Barnett-Hart's paper examines 735 CDO transactions with an average value of $829 million each (pp.7-8). This accounts for about half the USD-denominated CDO transactions issued between 1999 and 2007. During this period, USD-denominated transactions accounted for about three-quarters of the total (SIFMA spreadsheet, "Denomination" tab). Unfortunately, the SIFMA data does not cover CDOs before 2000, but this was a minor year in terms of the total volume. After 2008, total CDO issuance plummeted to a tiny fraction of its 2005-2007 rate, especially in the USA.

According to the SIFMA spreadsheet ("Collateral" tab), structured finance was the collateral in 1% of CDO issuance for 2001; it shot up to 63% in 2005, accounting for 91% of the growth of issuance during this period. The reason, naturally, was a shortage of the other types of collateral. Still, the CDOs included as collateral about a half-trillion USD in "high-yield loans."

Barnett-Hart's paper focuses on asset-backed security (ABS) CDOs, rather than structured finance. By February 2009, about half of these deals had been written off ("Half of all CDOs of ABS failed," Financial Times, 11 February 2009, via Naked Capitalism). This accounted for about USD 105 billion in defaults, out of a total of USD 815 billion (as of 9 Feb 2009; see "Banks’Subprime Market-Related Losses Top $815 Billion," Bloomberg). So basically about a third of ABS CDO failed, and these accounted for 13% of losses in the 2007-2008 Financial Crisis.

An additional USD 24 billion in losses was attributed to synthetic CDOs ("Warning over CDO losses if CIT defaults," Financial Times-14 July 2009). Since our estimate for synthetics comes five months later than the one for total losses and ABS-based CDOs, it's reasonable to assume the figures for the latter two were higher and synthetics performed much better. If not, ABS-based CDOs ($105 B) and synthetics ($24 B) lost $129 B of the total $815 B lost by the top 100 financial institutions worldwide in the Crisis, or about a sixth of the total. Moreover, ABS CDOs losses accounted for 81% of CDO losses overall.

In view of the fact that over half of CDOs issued during the problem period (2005-2007) were synthetic CDOs, this suggests that part of the design principle of the CDO actually worked.

For a prescient critique of the methods used by the CRAs to compute debt subordination, see Xudong An, Yongheng Deng, & Tony Sanders, "Subordination Level as a Predictor of Credit Risk" Real Estate & Urban Analysis, University of Cambridge (April 2006).

"Alpha" refers to the rate of return on an investment (or the performance of its manager) relative to the rest of the market. If the manager invests in high risk securities, the return on the portfolio will be likely be higher than otherwise, and such investors will be compensated for greater risk; but higher risk also includes a higher risk of unpleasant surprise. For this reason, people who rate portfolio managers measure "alpha" to compensate for things like the manager's risk preference and the overall behavior of the securities market.

The effect of high ratings on CDO tranches was to permit managers to achieve the illusion of high alphas because they were getting rates of return that exceeded what could have been expected, given the low risk of their portfolios.

CDO Meltdown (1)

2010-03-29T01:45:00.001-07:00

By now, the collateralized debt obligation is surely a household word. The technical nuances of CDOs remain obscure, but the essential problem here was that financial engineers believed that, by using past data they could quantify risk of default, and then pool that risk. Pooling risk, under certain circumstances--explained below--reduces risk to manageable levels.

Those circumstances include two crucial conditions: the risk being pooled must absolutely have zero correlation. Very small correlation is all right--it's not the "zeroness" that's important, it's the certitude that it is low under all circumstances. The other condition, which is really just a reiteration of the first, is that the actions of the financial engineer must assuredly have no impact whatever on the risk itself.

The first condition, in other words, means that an event that affects all the things at risk (e.g., an earthquake hitting a large ratio of properties insured by a particular firm) must never happen. The second condition means that the act of creating an insurance pool, or financial instrument, can never actually influence the risk of the parties themselves (taken as individuals). If the invention of insurance sharply alters the behavior of the insured, then actuarial data is inherently inaccurate.¹

As is now well established, the CDO made credit extremely cheap. This was done by producing an estimate of risk that could be prepackaged into a tradeable security, bundled using a structured investment vehicle (SIV), and sold with a mathematically-inferred projection of return. While credit extended to high-risk borrowers has a high probability of default, this probability was supposedly offset by pooling (with other, lower-risk borrowers) to achieve a suitable investment-grade bond.

THE CDO: A SHORT DESCRIPTION

A collateralized debt obligation (CDO) is a type of structured finance product, in which the originator creates an entity like a special purpose vehicle (SIV) to own loans and distribute payments on certificates. The CDO represents a claim many different potential kinds of assets:

investment grade and high-yield corporate bonds;
emerging market bonds;
residential mortgage-backed securities (RMBS);
commercial mortgage-backed securities (CMBS);
real-estate investment trusts (REIT) debt;
bank loans;
special-situation loans and distressed debt.

The first CDOs were used for repackaging high-risk corporate bonds and convertible bonds, but later developed into an entire parallel banking system.^2,3

CDOs are generally classified as "cash" or "synthetic." A cash CDO consists of a pool of bonds or loans. Their asset value is tied to the cash flow of the underlying assets, which consists of payments on the principle and interest.

Synthetic CDOs sell credit protection via credit default swaps (CDS) rather than debt-based assets. The CDO's asset value is pegged to specific tradeable assets, but it emulates the capital gains of the assets with derivatives (rather than ownership); hence, it is more highly leveraged. The collateral comes from a cash deposit by the depositor/investor.

The CDO pays out returns at maturity to investors at different levels of priority. In the event that there is widespread default, some of the tranches are guaranteed first, second, or third priority of repayment. The highest-risk [equity] tranches, with a high nominal rate of return, take any hits in the event of default. This is called a "waterfall structure."

CDO asset pools were quite large; typically, they involved nominal values of about USD 500 million to >USD 5 billion.⁴

RATINGS

Click for larger image

A crucial aspect of the CDO boom was the role of the ratings agencies, Moody's, Fitch, and Standard & Poor's. These agencies are quite old, but their business model has evolved over the last 40 years. Originally they were paid to rate securities by investors, who paid for their ratings. This business model dried up and was superseded by a new one in which the issuers of securities paid for the ratings.

There was an obvious conflict of interest in this arrangement, but structured finance and tranching made it worse. That's because the ratings for CDO issues were extremely important to the creation of a shadow banking system, in which liabilities could be parked off bank balance sheets, without the usual reserves or capital adequacy; and because ratings were so important to the design of CDOs.

Because of what a CDO is, it requires the ratings agencies to collude in the design and ultimate strategy of CDO-style structured finance. The tranches are rated separately; in theory, the superior senior tranch of 2006-vintage synthetic CDOs were actually better than AAA, since they had AAA-assets as collateral.⁵

COLLATERALIZATION

A critical part of the narrative was collateralization. A debenture is a debt instrument (like a bond) that is not backed by any collateral. Most bonds are debentures; CDOs supposedly would be safer than debentures because the creditors could, in the event of default, auction off the collateral. As we now understand, this collateralization was to allow the crisis to spill over more readily into the real economy.⁶ This was because CDOs created a bubble in housing prices (millions of people could borrow more than before, and bid up the price of housing--see Warren & Tyagi, 2004)

The effect of collateralization was most obviously to create not only a huge gap between the bubble price and the bust price of houses; it also flooded the rest of the credit markets with loanable funds for consumption. Arguably, this is a strategy that is not readily available for economies whose currency is not the universal reserve currency. That's because rapid expansion of the money supply is liable to lead to capital flight (interest rates fall below a competitive level). But it has a disproportionate effect on consumption, since entrepreneurs are guided by other considerations besides cheap loanable funds. This may explain why the US has such a large and persistent trade surplus. In any event, the CDO meltdown has led policymakers to wonder how the financial system could remain both innovative and stable.

(Part 2)

Notes

There is evidence it has a modest impact on the insured, but over time this impact has been statistically neutralized. See my post on "The Curmudgeon's Fallacy." Actuarial data, whether for insurance companies or financial instruments, seeks a stable estimate of risk so that the potential for loss is accurately priced. If the methods of assessing loss potential produce results that change frequently over time, then those methods are not useful for managing the probable costs of loss.

List of assets from Fabozzi, Davis, & Choudhry (2006), p.119

For a summary of the "parallel banking system," see Tobias Adrian & Hyun Song Shin, "The Shadow Banking System: Implications for Financial Regulation" , Federal Reserve Bank of New York Staff Reports, no. 382 (July 2009)

The largest CDO I was able to locate was MAX 2008-1 A1, with a notional value of USD 5.4 billion; it was underwritten by Deutsche Bank, which retained 94% equity in it. See Yves Smith, "Debunking Some AIG/Fed/CDO Theories," Naked Capitalism (4 Feb 2010). Smith cites disclosures of Maiden Lane III LLC transactions by Federal Reserve.

"A 'Rational' Explanation of the Financial Crisis" Macroeconomic Resilience (November 2009)

The real economy is distinguished from the financial sector. Usually there is some insulation between the real economy of goods and services, and the "not-so-real" economy of stocks and derivatives.

Additional Reading

Anna Katherine Barnett-Hart, "The Story of the CDO Market Meltdown: an Empirical Analysis" Thesis, Harvard Kennedy School of Government (March 2009)

Frank J. Fabozzi, Henry A. Davis, & Moorad Choudhry, Introduction to Structured Finance, John Wiley and Sons (2006)

Michael S. Gibson, "Understanding the Risk of Synthetic CDOs" Trading Risk Analysis Section, Division of Research and Statistics, Federal Reserve Board (July 2004)

Elizabeth Warren & Amelia Warren Tyagi, The Two-Income Trap: Why Middle Class Parents are Going Broke, Basic Books (2004). This book provides an invaluable explanation of how financial institutions and the two-income family combined to create a bidding war for houses in attractive neighborhoods. Warren & Tyagi wrote before the 2008 Financial Crisis but described a growing emergency in household finance that had burgeoned during the 1990's.

Credit Write-downs: Creditflux's list of credit write-downs announced since the start of the subprime crisis. Creditflux write-downs (Microsoft Excel Spreadsheet, 78 kb)

"Global Cash Flow and Synthetic CDO Criteria" Standard & Poor's Structured Finance

Slums & Favelas

2010-03-26T00:40:00.000-07:00

According to UN-Habitat statistics, the slum population of the earth is expected to exceed 1.1 billion in 2010; the total urban population for this year will probably be about 3.5 billion.¹ A common problem in all countries is equity formation in the poorest areas, which often conflicts with supplying public services to those who live there. This is because one of the most important public services is assisting job creation and capital formation, closely followed by utilities, medical services, transportation, and public health.

Selected Slums, Worldwide
Name	Metro	Est. Pop.
Soweto	Johannesburg	1,695,047
Orangi Township	Karachi	1,200,000
Nezahualcoyotl	Mexico City	1,140,528
Ezbet El Haggana	Cairo	1,000,000
Dharavi	Mumbai	1,000,000
Mathare	Nairobi	1,000,000
Tondo	Manila	630,604
Kibera	Nairobi	550,000
Bumbu	Kinshassa	525,770
Kimbanseke	Kinshassa	523,180
Korail	Dhaka	500,000
Tondo	Manila	407,330
Manshiyet Nasser	Cairo	350,000
Valle de Chalco	Mexico City	323,461
Ixtapaluca	Mexico City	290,076
Cité Soleil	Port au Prince	250,000
Rocinha	Rio de Janiero	180,000
Govindpuri	Delhi	150,000
Heliópolis	Sao Paulo	120,000
Yerawada	Poona	109,308
Belen	Iquitos [Peru]	65,000
Timbauba	Recife	60,000
San'ya	Tokyo	35,000
Cingapura	Sao Paulo	N/A

In less developed countries (LDC's), cities typically grow at the expense of the countryside, and migration is usually "push-driven." The "push" takes the form of reduced income potential from small farms (in cases where land reform has taken place) and rural unemployment (in areas where it has not).² When rural immigrants arrive in the slums, they are likely to find grossly inadequate provisions for themselves. The authorities will not know what to do with them; the local residents won't want to pay the taxes for them, or have them occupy greenfields; the local workers won't want to compete with them for jobs.

This typically leads to informal settlements, known as favelas (Brazilian Portuguese), barriadas (Peruvian Spanish), "shantytowns", "slums," and so on. These are in the city because that is where jobs are to be found.

In cities of the LDC's, informality does the following:

criminalize residency: urban residents may lack a right to live in a particular place³; they almost certainly will live in a settlement that is not authorized (say, for example, on squatted land or structures; in land set aside for farming or watershed);
deny tax revenues: in most countries that are still developing, a chronic headache is a lack of financial resources to urban governments. This is a severe problem in the USA; in countries like India or Brazil, it's catastrophic. Government revenues are allocated on the basis of official population data, which is likely to undercount by a wide margin; and most urban expenditures must come out of locally-collected taxes.
criminalize employment: informal occupations include activities that are illegal per se, such as drug trafficking or prostitution, but they are not limited to those things. All human services are supplied by the informal sector of LDC slums, from medical to transport, garbage collection, banking, local security, and prepared food. But there is no licensing system, and entrepreneurs may face violent resistance to entering markets. As a result, gangs usually act as both state (regulator and civil court) and firm.
reduce productivity: Informal businesses are almost always tiny and confined to the smallest tools available; this prevents industrial efficiency. Informal banking is expensive, unreliable, and underused; home equity is precarious and often ignored by the authorities in "slum clearing" programs.

Typically slum dwellers learn that accumulating productive capital is a doomed endeavor; the authorities will think nothing of destroying it just to get the slum dweller to go somewhere else.⁴ Yet this violates a fundamental expectation that people have of their leaders, viz., that their leaders will defend them and theirs. In slum settlements, the official authorities are little different from an army of occupation, and in many cases are an army of occupation.⁵ Activists on behalf of the slum are usually seeking formal recognition of their property rights (at least, to the physical structures); often, when this is won, the state is still inclined to ignore what it claimed to have granted. It can do this because the slum dwellers are regarded as nuisances, not citizens.

Job creation, for most slum dwellers, comes from capital formation. Labor is superabundant in the slum; it makes the slum an economic benefit for the rest of the city, but a huge share of the income of slum residents comes directly from other slum residents, not outsiders. When enterprises employ workers in the slum, they are limited by capital. This is why charitable enterprises have glommed onto the microcredit bandwagon en bloc. After decades of paying top dollar to aid recipients to get them to integrate the "backward classes" into economies that are already struggling to industrialize, aid agencies are now acknowledging the existence of a separate third world inside the third world.

The microcredit approach to capital formation (and job creation) is the main method now in place for economic development in the Third World. As mentioned, it replicates on a national level the model of development used by the World Bank/IMF towards the LDC's at a global level. Prior to the 1970's, the preferred method of economic development and monetary stabilization was prophylactic: countries like Pakistan, Indonesia, and Brazil were encouraged to develop domestic industries to reduce the hazard posed by capital flight or sovereign debt default. If essential foodstuffs were produced domestically, the argument went, then famine was unlikely to occur as a result of currency crises. After the mid-1980's, most developing countries changed to export-oriented development policies. In some cases, such as southern Africa, this can generally be said to have been unsuccessful. In areas where it has been successful, some argument exists over whether it was the EOI policy or the centralized control of capital investment and imports that did the trick (e.g., China, Republic of Korea, Taiwan R.o.C., Viet Nam).⁶

One big advantage to donor countries of the microcredit-microdevelopment approach is that it can directly bypass the local government, and deal directly with local NGO's or with the residents of slum areas themselves. A downside is that slum enterprise is itself entirely unsupervised, and can use the aid money to defraud or extort from other slum residents. It's not clear how serious a problem this last item is. One problem is that the idea assumes that slum residents are capable of sound construction work; even in jhuggi jhopri settlements (or temporary shanty towns in India, typically settled by construction workers) it's unlikely that very many workers have the spare time, energy, or range of skill to build a seismic residence (Davis, 2006, p.72).

Another advantage is that development aid is directed for the most part to things that residents are likely to want. In the past, a common approach was to clear informal structures and build housing projects. In the table above, the link for Cingapura goes to an article about a fairly recent Brazilian program of development that began with a project and turned to renovation assistance. In the areas of Cingapura where the old structures remain (but in renovated state), one appears to have Jane Jacob's ideal city: a dense, but small-structure neighborhood navigated mainly by foot, in which residents often use the street as a sort of living room.

An obvious downside to this, however, is that the slum is actually gentrified; while the residents may seem poor by the standards of North American or EU managers, the new occupants are likely to be outsiders who snap up professionally-improved lots. The former residents migrate to a new slum. At the same time, as legal structures recede to accommodate informality, the very function of the laws (such as the preservation of public spaces, safe waterways, adequate drainage and sanitation, etc.) is defeated. The local government is defeated and sidelined; it may have deserved this, but microfinance typically enshrines the defeat as permanent irrelevance for the state.

Notes

UN-HABITAT defines a slum as "housing with one or more of the following conditions: inadequate drinking water; inadequate sanitation; poor structural quality/durability of housing; overcrowding; and insecurity of tenure." See Planning Sustainable Cities — Global Report on Human Settlements 2009, Part VI Statistical Annex , p.6. However, relevant to this post is the definition of slum used by the government of Maharashtra State: "a congested, unhygienic area or buildings that are public hazards."

Population of the world and divisions thereof, see Ibid., p.9; population of slums (by country), see Ibid., p.24. Curiously, despite detailed statistics on slums in Latin America, Africa, and so on, none appear for the developed nations. However, global projections for the developed world as a whole appear in the site for the Global Urban Observatory (GUO)

That migration to cities is typically push-driven is my own personal inference based on studies of others. Take, for example, Michael Herrmann & David Svarin, “Environmental pressures and rural-urban migration: The case of Bangladesh” , UNCTAD (January 2009), p.5:
The rapid expansion of the labor force in the non-agricultural sectors, which leads the way to an accelerated expansion of the population in the urban centers, is attributable to relatively strong push and pull factors. On the one hand, a relatively weak agricultural development, which has been attributable to the recurrence of natural disasters, enforces people to search for employment opportunities outside agriculture; on the other hand, a relatively strong development of the non-agricultural sectors, which has been due to the expansion of the textile industries, has enabled many people to find employment in the non-agricultural sector.
Notice the "pull" comes from the creation of textile jobs, which are presumably more attractive than rural jobs. But rural jobs are simply unavailable; rather than leaving the countryside to seek an improvement, workers leave under duress: textile jobs are notoriously awful, especially for people accustomed to quiet and fresh air. Bangladesh slums are certainly not more attractive places to live than the adjacent countryside. And indeed, the next section of the paper cited above outlines the push-like character of pull-driven urban migration:
Although agricultural labor productivity has increased in Bangladesh, it is not so much due to an increase of agricultural value added, as it is due to a decrease of the agricultural labor force, associated with accelerating rural-urban migration in the country. The development of the agricultural sector in Bangladesh is therefore more appropriately measured by yields in agricultural produce. Our data shows that despite considerable investment in agriculture, yields in important agricultural produce have fallen during the past decades. Since the early 1980s yields of groundnuts, rice and wheat fell by 1 mt/ha on average. The main reasons for the weak agricultural development are exogenous factors, notably climate-change induced natural hazards. Natural hazards destroy harvests and threaten food security, especially of poor households.
In other words, policies taken by the (urban) authorities, or rich countries, have made it impossible for even a declining labor force to make a living off the land. Juxtaposed against the putative "pull" of urban jobs, it is clear that the "pull" takes the form of a Hobson's choice: move to a slum or starve.

Many, if not most, pre-industrial or incipient industrial countries have restrictions on labor mobility. For example, in the People's Republic of China, citizens could be compelled to live where the authorities chose, and denied permission to move. After the 1990's, there was still a requirement that citizens secure permission live permanently in any particular shi, or municipality. See Kenneth G. Lieberthal & David M. Lampton, Bureaucracy, Politics, and Decision Making in Post-Mao China, University of California Press (1992), Chapter 12, "Urbanizing Rural China: Bureaucratic Authority and Local Autonomy" p.354ff. In England, between 1662 and 1832, the Settlement Act effectively tied each certifiable pauper to one of the 15,000 parishes in the country.

Restrictions on labor mobility are typically motivated by the need to certify the poor for eligibility for relief. In pre-industrial England, for example, one was allowed to move away from one's parish, but could not receive relief outside of it. Since most laborers seem to have been vulnerable to recurring episodes of unemployment and destitution, this was an important constraint from emigrating from depressed areas. In the collectives of the Communist regimes, rural workers were typically treated as serfs of the regime and confined to kolkholzy or sovkholzy their entire lives. This was a more extreme form of mobility restriction. More recently, China and Vietnam retain the Hukou/Ho khau system of household registration (Congressional-Executive Committee on China, "China's Household Registration System"-2006)(Refugee Review Tribunal: Vietnam [Australia-10 May 2005] ).

Probably the most devastating example of this was the 2004 destruction of Yamuna Pushta, an immense slum complex in Delhi. The demolition displaced perhaps 150,000 people. It was precipitated by Delhi hosting the 2010 Commonwealth Games. This tragic event was depicted in the documentary "Yamuna Gently Weeps" (trailer here). See also "Over 300,000 people to be forcefully evicted from Yamuna Pushta," Habitat International Coalition (2004). Another documentary of slum demolition is "Phnom Penh for Sale - Cambodia" (Journeyman Pictures 2009), where a settlement on Boeung Kok Lake, Phnom Penh, was demolished to make way for commercial development ("A further 160 families in Cambodia face forced eviction," Human Rights Blog, 2009). The settlements around Boeung Kok Lake that are under attack house some 4,200 families--a tiny fraction of the number liquidated overnight in Delhi. In 2008 alone, Amnesty International received reports about 27 forced evictions, affecting an estimated 23,000 people.

In Lagos, Nigeria, there is the example of Maroko. Maroko was a former fishing village that became a refuge for urban poor driven from gentrified parts of booming Lagos. By 1990, its population was around 300,000. It was bulldozed in July of that year without any meaningful resettlement scheme. In this particular case, the perpetrator was a military regime internationally renown for kleptocracy. See Chinazor Megbolu, "Maroko Evictees Take Case to African Commission," This Day (14 January 2009). See also Davis, p.101. See also Davis's list of major slum evictions (102).

This refers not merely to obvious examples such as the Occupied Territories of Palestine, or to urban centers in Iraq, or formerly Tamil-controlled regions of Sri Lanka. In a great many LDC's, civil wars or coups have led to parts of a country being under military rule. In such cases, there was little, if any, difference in conduct between the nation's army toward its own population, and that of a foreign invader towards the civilians in combat zones.

See, for a brief summary of the history of development policy, see Rajneesh Narula, "Switching from import substitution to the ‘New Economic Model’ in Latin America: A case of not learning from Asia" , Latin America/Caribbean and Asia/Pacific Economics and Business Association (December 2002). Note that the merits of the respective policies are not at issue here; the point is merely that a change in policy regime took place, and the Bretton Woods Institutions were instrumental in this change.

Sources & Additional Reading

Tripti Lahiri, "Ayn Rand move over: In Pune, India, shantytown residents design by consensus" Christian Science Monitor, (25 March 2010)

Filipe Balestra website;"Sambarchitecture"; Sara Göransson has no dedicated website

David Basulto, "Incremental Housing Strategy in India," Archicentral (18 May 2009)

Filipe Balestra and Sara Göransson, "Incremental Housing Strategy in Pune, India," A Weekly Dose of Architecture (25 May 2009)

Bromwyn Curran, "The Cruel Utility of Slums" , Development Asia (January-March 2010), p.16

Mike Davis, Planet of Slums, Verso Press (2006)

Srinanda Sen and Jane Hobson, "The Pune Slum Census: Creating a Socio-Economic and Spatial Information base on a GIS for integrated and inclusive city development" GIS Development Conference Proceedings, Enschede, The Netherlands (May 2002)

The Society for the Promotion of Area Resource Centers (SPARC; the NGO that sponsored Filipe Balestra & Sara Göransson visit to Pune); publications page; see especially Sundar Burra, "Co-operative Housing in Pune" (November 1999)

Alex Perry, "Life in Dharavi: Inside Asia's Biggest Slum," Time (12 June 2006)

UN-HABITAT Global Report on Human Settlements,

Flickr Map of Netaji Nagar, Poona (Pune), Maharashtra State, India

1893, India, and the USA

2010-02-28T21:59:00.000-08:00

In 1892 India was a colony of the United Kingdom.¹ It was governed from Calcutta by civil servants appointed in London, but susceptible to pressure from local plantation owners (who were mostly British), importers, and financiers. Prior to European colonization, India had had rulers who circulated silver coins known as rupees; until 1892, the rupee was defined as a unit of silver. In 1816, the UK moved to a gold coin standard, and after 1870, most of the nations of Europe and America did also. The USA went on the gold standard 1 January 1879 after 13 years laborious struggle retiring Civil War greenbacks.² India, Japan (to 1897), Korea, and the Qing Empire (China + Mongolia) continued to use mostly silver money. So did Latin America.³

India was at this time the largest market for silver in the world; the USA was the second largest. Russia, like the USA, had a large internal system of silver currency despite officially being on the gold standard. During the period 1873-1902, silver prices would decline relative to gold, pushing more countries to adopt the gold standard and demonetize silver. This further suppressed silver prices, until nearly the entire global consumption of silver was for commercial purposes (jewelry, chemicals, and photography).

Click on image to enlarge

Chart adapted from Milton Friedman, Money Mischief: episodes in monetary history, Houghton Mifflin Harcourt, (1994), p.72

Note: the ratio of 16-to-0ne was a legal ratio that applied at the beginning of this period. At earlier times in the 19th century, lower ratios obtained in bimetallic countries.

India's situation was especially problematic because it was economically and administratively integrated with the British gold zone. The US situation was problematic because it had a large residue of silver currency and a major silver mining economy; and because it was such a magnet for overseas investment. It was also unusual for a large country of the day in having representative democracy. Hence, it was politically difficult for the executive branch to impose austerity conditions required for a pure gold monetary system.

India operated under extraordinarily open markets in 1892; its duties on imported goods were virtually nil, and it had a policy of free coinage (no seigniorage; the rupee therefore floated against the pound sterling).⁴ The system was not self-correcting; India's government had to pay for the costs of occupying and exploiting its subjugated peoples, and these costs had been incurred in sterling. This was being paid off in a rupee whose value was falling. In the 19th century literature, moreover, one reads of constant "crises" in Victorian finances, in which national governments were constantly struggling to maintain either adequate reserves of gold, or else resisting an inflationary spike at home. In India, the part of the system that was particularly vulnerable were "council bills," or bills of exchange drawn against the national debt of India held in London. These were adjusted automatically in accordance with the daily exchange rate of silver, which was just fine for commercial transactions; but for government business, it was a chronic strain. Officers, for example, had to be paid in rupees and their pay schedule was set by legislation in Westminster.

The USA operated under extraordinarily closed markets; the McKinley Tariff (1890) was the highest tariff schedule in the nation's history. Countervailing the successful Republican push for ever-higher tariffs was populist pressure for cheap money (as desired by farmers and business projectors) based on silver (as desired by the Western silver interests). This took the form of the Sherman Silver Purchase Act, which required the Treasury to buy 4.5 million ounces of silver per month, to be paid for in legal tender treasury notes.⁵ The effect was, unfortunately, to create a de facto bimetallic standard with silver overvalued relative to gold. Hence, arbitrageurs pumped gold out of the US banking system, since they could buy undervalued gold with overvalued silver.

(See "Precious Metals Arbitrage")

At the same time gold was being pumped out of the USA, silver was flowing into India as a result of that country's long-running trade surplus with the rest of the world (see chart below).

Click on image to enlarge Values are in UK pounds sterling
India: Influx of Precious Metals Prior to 1893 Crisis
Five Years ended 31st March		Average Gold Value of the Rupee	Average Net Imports of Gold per Annum		Average Net Imports of Silver per Annum
beginning	ending	£	(Rupees)	(£)	(Rupees)	(£)
1860	1864	0.0994	5,889,538	585,273	10,181,781	1,011,814
1865	1869	0.0976	5,835,117	569,653	9,981,112	974,406
1870	1874	0.0950	3,073,776	292,009	3,598,271	341,836
1875	1879	0.0874	639,595	55,898	6,408,692	560,093
1880	1884	0.0824	4,128,613	340,181	6,205,349	511,295
1885	1889	0.0762	3,083,670	234,963	6,896,685	525,499
1890		0.0690	4,615,304	318,571	10,937,876	754,987
1891		0.0754	5,636,172	424,803	14,175,136	1,068,392
1892		0.0697	2,413,792	168,292	9,022,184	629,034
1893		0.0624	-2,812,683	-175,582	12,863,569	803,008
Report of the West India Royal Commission Great Britain, Eyre & Spottiswoode (1897) Appendix. C, p.209 table III

The conversion to what was, in effect, a gold exchange standard, reversed the balance of trade and the flow of gold. This, of course, made the next several years a crisis because India, while possessing decades of accumulated reserves of silver, had demonetized it and now required gold--which was leaving the country, not entering it.

India's demonetization of silver was widely seen as the the immediate trigger of the Crisis in the USA. The US Treasury, ultimately liable for the total supply of paper currency, was faced with a sharp increase in the flow of gold out of the country for purposes of arbitrage; it was providing a handsome subsidy for doing so.⁶ Strangely, the rate at which this arbitration occurred was quite low. One would have expected the Treasury to be wiped out within a few weeks, given the arbitrage opportunities; instead, there was a dangerous stream out of the Treasury for many months, but nothing like the capital flights from Asian countries during the 1997-1998 crisis, or from Argentina in 2002. It seems reasonable to surmise this was because metals arbitrage was logistically very difficult.

Click on image to enlarge

Values are in current US dollars

While the USA usually ran a trade surplus with the rest of the world, India ran large surpluses with the USA (and most other nations) every year. Data from the 1889 and 1897 Statistical Abstracts of the USA

A limiting factor, however, was always the very large trade surpluses the USA had with the rest of the world; this meant that Usonian institutions (and ultimately, the US Treasury as the supreme reserve) held a massive surplus of liabilities against non-Usonian individuals and institutions. This would not have prevented massive metals arbitrage over time, since large claims on US assets did exist in the hands of foreigners; but these (a) were tied up as foreign direct investment (FDI) or portfolio investment in the USA, or (b) tended to be small enough that they restricted arbitrage to lots of small, marginally profitable steps.

However, note that India was a rare exception: trade between the USA and India was small, but consisted of huge surpluses (relative to the volume of US exports to India. This was in large measure an artifact of the underdevelopment of India; but that is outside the scope of this port.

Notes:

At this time, "India" included Pakistan, Bangladesh, and Burma (Myanmar). For a map online, see the Schwartzberg Atlas. About one third of Indians lived in the >500 princely states that enjoyed financial and internal autonomy from the capital in Calcutta. India and Burma[h] shared a currency, the rupee. Princely states also issued rupees, although the value was supposed to be the same for all varieties of the rupee.--The imperial guide to India, including Kashmir, Burma and Ceylon, John Murray (London, 1904) p.195; also, Lawson (1894), p.443

Milton Friedman, Anna Jacobson Schwartz (1963), "The Greenback Period"

Matias Romero, The silver standard in Mexico, The Knickerbocker Press (1898); for Japan and Korea, see n.587; for China, see n.606; for several Latin American states (other than Mexico), see p.576. Silver standard nations often had enormous local supplies of silver, such as Mexico; or else, were more likely to use metal coins to the exclusion of paper money or bills of exchange. The Qing Empire had floating trimetallism at the time of the 1893 crisis, meaning that copper, silver, and gold monetary systems existed concurrently with no fixed relationship to each other.

Lawson (1894), p.453; floating of rupee pre-1892, see Palgrave (1894-III), p.396. For a modern summary, see Tapan Raychaudhuri, Dharma Kumar, Meghnad Desai, Irfan Habib, The Cambridge economic history of India, Volume 2, Cambridge University Press (1983), p.587. As a general rule, countries with the power to do so implemented tariffs; countries under foreign occupation, such as India, or else under foreign hegemony, such as Japan (1856-1897), had free trade imposed at gun point.

For the McKinley Tariff, see Joanne R. Reitano, The tariff question in the Gilded Age: the great debate of 1888, Penn State University Press (1994), p.129. The previous tariff had been 38%, so prices of imported goods were effectively increased 8.33%. For the Sherman Silver Purchase Act, see Wesley Clair Mitchell, Business cycles, Burt Franklin (1913/1970), p.52.

For the perception of India's demonetization as trigger, see Conant (1909, pp.677-67). Regarding gold flows, see Friedman & Schwartz (1963) p.108 and table A-4 (Appendix A, p.769). Friedman & Schwartz do not mention the role of gold arbitrage, but include a lengthy footnote on the distinction between external and internal drains in the Treasury's gold supply. According to some commentators, such as Charles Conant (1909, p.671) and A.D. Noyes (Forty Years of American Finance, Putnam, 1909, pp.159-173), the problem was that the silver policy caused a loss of confidence in the integrity of the money supply. Friedman & Schwartz emphasize that silver probably only accounted only for the external (foreign) drain of gold.

In my view, this neglects the well-established role of metals arbitrage (which provided the motivation, for one thing, to physically relocate the gold abroad); and it imposes a distinction of the sort that doesn't really obtain in finance. Foreign actors are indistinguishable from domestic ones.

Sources & Additional Reading:

Charles Conant, A History of Modern Banks of Issue, G.P. Putnam & Sons (1909), esp. "The Crisis of 1907," p.698. Vital resource, although chapters on crises require close reading. Very useful to cross-reference with Friedman & Schwartz (1963).

Milton Friedman, Anna Jacobson Schwartz, A monetary history of the United States, 1867-1960, Princeton University Press (1971)

W.R. Lawson, "The Indian Currency Muddle," Blackwood's Edinburgh (March 1894), p.440-454. Describes the circumstances leading up to and following the momentous Indian suspension of silver coinage in 1892, which played a significant role in the 1893 Crisis.

R.H.I. Palgrave, Dictionary of Political Economy, Vol. 1, Macmillan (1894); "Exchange between Great Britain and British India," p.776; Vol. 3, "Silver, as Standard," p.395

A brief list of Depressions

2010-02-17T22:49:00.000-08:00

This is an edited version of an entry posted on the Urban Dictionary under the name, Abu Yahya.

A depression is a prolonged economic crisis characterized by drastic (i.e., >20%) decline in output, reduction in employment, and deflation. Other technical conditions include a liquidity trap and "permanent" (i.e., persisting in many sectors for several quarters) failure to reach equilibrium.

Difference between a Recession and a Depression

The technical distinction between a recession and depression can vary depending on the school of economics, although economists usually agree on which event is a recession, and which is a depression. In Keynesian economics, a depression is defined by the existence of a flat liquidity-money (LM) curve (which means that interest rates have no influence on people's determination to hold their wealth as cash); and/or a nearly vertical investment-savings (IS) curve (which means interest rates have no influence on the willingness of entrepreneurs to expand/continue operations).

In contrast, a recession is a much less drastic event. Interest rates still have influence on investment and liquidity, and there is no deflation. Conventional fiscal policy and monetary policy, combined and in moderate doses, can restore full employment.

(Please see the CEPA Economics Site for Keynesian theories of the business cycle)

Neoclassical economics/New Classical economics defines a recession as a shift in people's income/leisure preferences as the result of a technology shock. The technology shock sharply reduces the returns to labor, so workers are paid less and many withdraw their labor from the market. In a depression, the technology shocks are compounded and cause a permanent change in the production function; large numbers of enterprises are no longer viable.

More generally, a recession involves the downward phase of a routine business cycle; these typically occur every three to seven years. A depression represents a partial collapse of the industrial system, usually brought about by failed financial intermediaries.

Partial List of Depressions

Here follows a short list of economic crises that were regarded as possible depressions at the time. Items and resources will be added as they become available.

1815-21	Post-Napoleonic War Depression
1829-33	1832 Panic (per Conant, p.623) 1830-'33 Depression (per Handcock, p.228) Numerous banking failures in UK
1837-44	Commercial Crises of 1836-39 (Handcock, p.240) (Conant, p.623) Crash, Wall Street (Sobel, p.32)
1854-57	Depression of 1854 (UK)
1867-69	Failure of Overend Gurney and Co (Conant, p.643)
1876-79	Crisis of 1876 (Conant, p.648)
1893-96	Crisis of 1893 (Conant, p.668)
1920-22	Post-WW1 Depression
1929-1939	Great Depression

Major Panics & Localized Crises

1825	Crisis of 1825 (UK) (Conant, p.619)
1847	Commercial Crisis of 1847 (UK & France) (Handcock, p.259) (Conant, p.631)
1857	Commercial Crisis of 1857 (UK) (Handcock, p.292) Crash, New York ("Western Blizzard") (Sobel, p.77)
1861-1863	Cotton Famine (UK) US Civil War
1907	Knickerbocker Trust Panic (USA) (Sobel, p.297) (Conant, p.698)

Sources & Additional Reading

W. D. Handcock, English Historical Documents 1833-1874, Routledge (1996), p.228; this table cites the official Poor Law Report of 1909.

Robert Sobel, Panic on Wall Street: a Classic History of America's Financial Disasters, E. P Dutton (1988)

Charles Conant, A History of Modern Banks of Issue, G.P. Putnam & Sons (1915),

Structured Finance

2009-07-24T01:15:00.000-07:00

Disclaimer: the author is not an expert on this topic and is merely taking notes.

"Structured Finance" refers to a class of financial products that involve structured investment vehicles (SIVs).

A SHORT DESCRIPTION OF STRUCTURED INVESTMENT VEHICLES

Usually a structured investment vehicle (SIV) is a type of legal entity called an "express trust."¹ Trusts are famously used by wealthy people to manage assets that they want to pass on to their children, but they were also used in the latter 19th century to pool the interests of shareholders in multiple corporations--allowing many competing firms to become more profitable by acting as a monopoly. Hence, the efforts of Pres. Theodore Roosevelt to restore competitive markets were known as "antitrust actions" or "trust-busting."

Express trusts are also used to "own" securities and apportion payouts according to a legal formula. In the example in the footnote, the trust was created to own loans. It would then use the proceeds to make payments on the loan certificates (which it gave to ACE Securities Corp in exchange for loans it already had).

Not all SIVs are trusts; some are more complex business entities, such as corporations or limited partnerships.²

SIVs are used to own financial assets with different risk levels, pooling the returns as a hedge against the risk of any single asset class. They are also used to make the trustees' actions very difficult to track, such as when the top investment banks in the USA unloaded toxic assets on their own customers, or when the trustees want to avoid taxes/regulations.

The SIVs exist to own long-term commercial paper, including residential mortgage-backed securities (RMBS), and finance the long-term lending with short-term borrowing (such as repurchase agreements). Short-term borrowing is cheaper than long-term borrowing, except for the stress associated with rolling over debt every few days.

Typically SIVs are organized in tax havens such as the Cayman Islands, Liechtenstein, or Channel Islands. They can issue debt or equity (shares of ownership); they are effectively regulated by the ratings agencies (Fitch, Moody's, Standard & Poor), since they are otherwise beyond the reach of any direct regulation.

STRUCTURED FINANCE

The follow attributes are common to structured finance:

a complex financial transaction that may involve actual or synthetic transfer of assets or risk exposure, aimed at achieving certain accounting, regulatory, and/or tax objectives;
a transaction ring-fenced in its own SIV;
a bond issue that is asset-backed and/or external reference index-linked;
a combination of interest rate and credit derivatives;
a transaction employed by banks, other financial institutions, and corporations as a source of funding and/or favorable capital, tax, and accounting treatment;
disintermediation between banks and other corporate entities.

Financial transactions employing several of these features are generally characterized as structured finance.³

A typical form of complex security that does not involve structured finance would be an indexed fund. In this case, the fund is actually an account in a financial center that takes the money of investors and uses it to buy shares of companies listed in an index (say, the S&P 500) at a fixed ratio. Movement of individual shares in the companies listed are "passed through" to the investors in the proportion that the shares have in the index.

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Tranching refers to the creation of different tiers, or ranks of priority of repayment in the event of default. When a borrower can no longer meet mortgage payments, the pool to which that mortgage belongs loses value by some amount. Holders of super-senior tranches are first in line to get reimbursed in the event of default, followed by senior, mezzanine, and equity. In exchange for accepting a lower priority of repayment, the lower tranches receive a higher rate of return in the event of non-default.

The benefits of tranching were that they permitted originators to generate securities with risk-return values that met what the market demanded. Even if the average mortgage in a pool had an effective rate of return of 6%, an equity tranche could offer a far higher rate in exchange for the normally-low likelihood of default. In an historic period of exceptionally low real interest rates (see figure) and reduced fears of debt default (because of rising housing prices), tranching made housing finance cheap and attractive.

BIS (2005, p.5) explains the significance of tranching to the whole deal:

Tranching, in turn, contributes to both the complexity and risk properties of structured finance products. Beyond the challenges posed by estimation of the asset pool’s loss distribution, tranching requires detailed, deal-specific documentation to ensure that the desired characteristics, such as the seniority ordering of the various tranches, will be delivered under all plausible scenarios. In addition, complexity may be further increased by the need to account for the involvement of asset managers and other third parties, whose own incentives to act in the interests of some investor classes at the expense of others may need to be balanced.

Unfortunately for the rest of the planet, there was a poor grasp of what "all plausible scenarios" meant. The BIS article goes on to compare tranches with conventional bond portfolios, where the risk of loss in the event of massive nonperformance was comparatively small. In other words, for investors in a bond portfolio, default would lead to loss of some capital, but not a wiping out of "junior" investors. This may have marginally impacted the way the crisis unfolded, as investors had an extremely strong incentive to bail out at any cost.

Structured finance products are generally rated by the major agencies. To the best of my knowledge, ratings agencies are typically based in the USA and subject to the US government's regulatory regime (or lack thereof). According to BIS (2005, p.6), structured finance accounted for 40% of rating agency revenues.⁴

Another feature of structured finance, finally--from which the term "structured" comes--is the use of a carefully chosen pool of assets to achieve the desired rating. Usually, the notion that a security has any value whatever arises from the issuer's ability to pay its obligations. A share of stock's value is determined, ultimately, from the future income stream of the issuing firm: if investors believe the future business prospects of the firm are poor, then investors will not want to own a share of stock, and the price of the share will be lower. Likewise, bond ratings reflect the ability of the borrow to earn enough money to pay off the interest and principle. Structured finance, in contrast, usually features an SIV which doesn't earn income because its sole function is to own assets and distribute capital gains. The allure of ownership arises from the quality of the assets included in the SIV. So parties creating SIVs select assets with a carefully-chosen blend of high-risk, high-yield assets that are in some way hedged against failure.

In one sense, the phenomenon of collateralization was extremely old for lenders. From the very beginning of the business of lending wealth, lenders asked for collateral: if the borrower had some other asset, such as a house, then the lender could seize the collateral if the borrower failed to pay. But the SIVs made collateralization a perpetual motion machine: borrowers possessed as collateral the asset they were buying with the loan, which in turn created the market for the asset.

Moreover, the role of collateral was dramatically different. Whereas before, a lien on the borrower's collateral was a deterrent against default; borrowers reliably hoped that their collateral would always be irrelevant to the actual borrowing and repayment process. Here, the income stream of the originating firm was legally and economically detached from the SIV, so that the ability of the SIV to meet its financial duties was dependent entirely on the asset pool. If those assets stopped performing or lost value (as, for example in the event of a price bubble popping), then the lending involved not only became unsecured, it became non-performing.

GENERAL OBSERVATIONS

While structured finance was an innovation of the 1990s that led rather obviously to the Financial Crisis of 2008, it seems hard to take seriously the idea that it can be legislated out of existence. One reason is that the Financial Crisis did not destroy the power of its principals, the way the Banking Crisis of 1931-1933 did.⁵

However, structured finance remains an insidious force. If the industrialized nations of the world were not going through a political implosion, and if the business managers who had instigated this crisis were subject to some accountability, then I think it is fair to say that they would not be allowed in the future to flout banking regulations though the shadow banking system. Instead, financial intermediaries would be obligated to deal with all of their liabilities on their regular books.

Notes

For example, see this pooling and servicing agreement (1 Sept 2007) involving ACE Securities Corp, as depositor, Wells Fargo Bank, N.A., as master servicer/securities administrator, Clayton Fixed Income Services Inc., as credit risk manager, and HSBC Bank USA, National Association, as trustee. I use the full legal term "express trust" to distinguish it from far more common uses of the word "trust."

Peter Levine (2009) describes SIVs as trusts, and the sample SIV linked in note 1 is an express trust. However, Moorad Choudhry (2007, p.1147) describes SIVs as emerging in 1988 as fully-formed corporations, with a perpetual existence. Indeed, this perpetuity distinguishes CDOs from SIVs, according to Choudhry.

Fabozzi, Davis, & Choudhry (2006), p.2. Another definition, from Stefano Gatti, Structured Finance: Techniques, Products and Market, Springer (2005), insists on the importance of the SIV and its near-synonym, the special purpose vehicle (SPV). According to Gatti, the SPV is paramount for fulfilling the aims of the originator ("sponsor").

An alternative definition is from the Bank of International Settlements (BIS):
Structured finance instruments can be defined through three key characteristics: (1) pooling of assets (either cash-based or synthetically created); (2) tranching of liabilities that are backed by the asset pool (this property differentiates structured finance from traditional "pass-through" securitizations); (3) de-linking of the credit risk of the originator, usually through the use of a finite-lived, standalone special purpose vehicle (SPV).
BIS (2005), p.5

The above is cited in Fabozzi, Davis, & Choudhry (2006), p.2. Note that the BIS definition emphasizes the permanence of the SPV/SIV.

A well-nigh universal observation is that the ratings agencies had a perverse incentive structure; they were paid by the entities seeking a rating. Evidence suggests that there was massive conflict of interest in which Moody's, Fitch, and S&P sought to accommodate companies marketing financial products with favorable ratings. See, for example, Daniel M. Covitz & Paul Harrison, "Testing Conflicts of Interest at Bond Ratings Agencies with Market Anticipation: Evidence that Reputation Incentives Dominate" Federal Reserve Board (2003). As is now well established, the Fed was wrong and the naysayers were right.

For a summary of the events of the 1931-33 Banking Crisis, see Charles Poor Kindleberger, The world in Depression, 1929-1939University of California Press (1986). It was actually quite unusual that the Great Depression, unlike the many other financial and economic crises in US history, resulted in a severe blow to the status of financiers and industrialists. One reason was that the crisis of the '30s pitted rival capitalists against each other.

Additional Reading

Moorad Choudhry, Bank Asset and Liability Management: Strategy, Trading, Analysis, John Wiley and Sons (2007)

Frank J. Fabozzi, Henry A. Davis, & Moorad Choudhry, Introduction to Structured Finance, John Wiley and Sons (2006)

Peter Levine, "Abstract finance: Structured Investment Vehicles and other Tricks," Rethinking Markets Economic Sociology from the Ground Up (blog) (8 Jan 2009)

The Role of Ratings in Structured Finance: Issues and Implications" Committee on the Global Financial System, BIS (2005), p.5

Interview w/Professor Blackburn

2009-04-08T14:54:00.001-07:00

"Interview with Elizabeth Blackburn: Aging & Disease" & "Dealing with Cancer" Frontline (India)

Prof. Elizabeth H. Blackburn (physiology, biology, UC Berkeley) researches the ends of eukaryotic chromosomes^{W T}, or telomeres^W. I became aware of her entirely as a result of reading the interview in Frontline of India.

Blackburn's research became interesting to the broader public as a result of discoveries that there was a very strong link between telomeres and health conditions associated with aging.

Yes. We are looking at that. There are these successfully treated AIDS patients who have been on high activity antiretroviral therapy [HAART] for some years. Their lives have been saved, and they have been kept going for years on these drugs. The virus is kept [at a] very low [level] although it is never completely contained. And do you know what’s happening? It’s sort of an epidemic. These [successfully treated HAART] individuals are now developing diseases that look like the diseases of the aged. For their age group, these people are getting more cardiovascular diseases, more dementia, more osteoarthritis, more renal disease and a whole spectrum of diseases that are [making them] look as if they are really old.

Telomeres are regulated and restored through an unusual combination protein-enzyme known (naturally) as "telomerase." As cells divide, the telomeres at the end of each chromosome are subdivided until they are either restored or depleted. If the telomere is depleted, the cell cannot subdivide and therefore dies. In some cases, the body supplies cells with telomerase to enable continuing subdivision and growth. In other cases, cells "develop" the ability to supply their own telomerase; their growth ceases to be regulated by the body, and they can become cancerous.

Prof. Blackburn and her assistant, Carol Greider, discovered telomerase in the 1970's. The implications of telomerase in the lives of cells was extremely far-reaching: it affected research into cancer, AIDS, aging, and organ regeneration.

The interview is pretty basic, and mostly geared to readers like myself who have never heard of telomerase. However, it veers towards speculation towards the end:

FLO: Though we know that diseases are caused by a whole lot of factors, do you see a kind of paradigm developing that would ultimately, perhaps in the distant future, lead to a unidirectional telomerase-based approach for attacking disease?

EHB: You know part of me wants to say yes. That would be terrific, but you risk hubris when you say something like that because you are then immediately proved wrong. But, as I said, because so much evidence has come in a consistent fashion, this seems like a pretty good attack on the problem. We see [that] these environmental factors like chronic stress are obviously acting on telomerase and telomere lengths through the immune system. We also see [that] when people are dealing with their stress well, it is correlating with having higher [levels of] telomerase and better telomere lengths. We put two and two together and say what if people could be helped to deal with their stresses.

Now you can’t change life. You can’t change the fact that somebody had a chronically ill childhood or the father has dementia. But, maybe, you can give people these tools, or things they can do that will help them cope. Would that modulate their telomerase up? I love it because it is very, very cheap.

I can imagine this would lead to a massive boom in the biochip industry as therapy becomes dominated by direct polymerase sampling and chain reactions. A web search turned up this recent patent for a biochip that directly captures and analyzes circulating tumor cells (CTC).

Sources & Additional Reading:
Superscript^W links to relevant Wikipedia article; superscript^C to Cells Alive article; superscript^T to Library/Thinkquest article. Errors in the summary below are my fault, and not the fault of the linked authors.

The reference to HAART involves some explanation: HIV, the virus that causes AIDS, is known as a retrovirus^W ^C it attacks the actual DNA of the patient via the enzyme for DNA replication (i.e., RNA), and thereby integrates itself into the patient's DNA. As a consequence, antiretroviral therapy (ART) mainly consists of chemical inhibitors. Usually ART is administered with several inhibitors (sometimes referred to as a "cocktail"), in which case it is known as "high activity" ART, or HAART. See "Recommended HIV Treatment Regimens" and "Approved Medications to Treat HIV Infection" , US Department of Health and Human Services (Dec 2008).

Put another way, therapies for AIDS target the process of cell reproduction at the polymerase level—at the point in which DNA strands are replicated through interaction with the enzyme RNA^W. This naturally has deleterious side-effects, since some desirable polymerase activity is also suppressed. The overall effect is similar to regular aging: as organisms get older, their body fails to reproduce moribund cells.

Future Combat Systems

2009-04-04T21:49:00.001-07:00

Costliest weapons program ever?

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M1203 NLOS-C 155mm howitzer

One major source of technological innovation is, naturally, warfare and international competition. It seems self-evident that much of modern weapon systems development is guided not so much by current conflicts (with insurgents in Iraq and Afghanistan, who mainly focus on "soft targets") but a tacit competition with other major industrialized powers. Hence, the ongoing race to develop more "competitive" jet fighters, naval weapons systems, and so on.

Weapons systems also constitute an obvious form of technology that is not morally neutral. For example, while the use of the nuclear bomb against Japan may have helped the Allies hasten the defeat of a dangerous regime, the ramifications of use were a disaster for democracy. The FCS represents a weapons program (now in transition) with the seemingly uncontroversial objective of modernizing existing weapons systems in a comprehensive way. Land-based weapons systems are intended to mesh with enhancements of air-based and sea-based systems, and all are to exploit the latest developments in space-based telemetry.

The core of the FCS program has been the non-line-of-sight (NLOS) cannon, mortar, and launch system. Three other systems are robotic: sensors, unmanned vehicles, and unmanned aircraft. The NLOS systems are to be installed on some of the eight manned ground vehicles (MGV) in the program. The launch system (NLOS-LS) can be described as a "snap-on Katyusha": a box of 15 small missiles and a control system, capable of being bolted onto truck beds or sea vessels.

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NLOS-LM Netfires PAM

Interestingly, the FCS clinically categorizes Army weapons systems by the range, caliber, and precision of their firepower. The platforms for the combat MGV's is standardized, suggesting that the old days of tank warfare are understand to have passed: in the past, main battle tanks (MBT's) were designed as massive rolling bunkers with as large a gun as could be accommodated with the weight of the armor. The Mounted Combat System (MCS-XM1202) is intended to succeed today's MBT's, but the basic "vehicle" is identical to that used by the XM1203 NLOS-C (which is simply a self-propelled artillery piece) and the XM1204 mortar.

The most decisive component seems to be the NLOS-LS "Netfires" Precision Attack Munitions (PAM). What makes this so important is that it is supposedly capable of destroying nearly any form of mechanized tank. A box could be parked scores of kilometers away from the theater, and a remotely-piloted or "unmanned aerial vehicle" (UAV) could loiter over the battlefield. The UAV could target an endless number of enemy objects and remotely guide missiles to them. Currently, the unpiloted drones used in Afghanistan/NWFP of Pakistan have carried their missiles, limiting their lethality and range. The NLOS-LM is regarded as so effective, that FCS was designed with the assumption that any adversary would be unable to use tank busting weapons against its MGV's.

But of course the MGV's represent a revenant of the mechanized Army, much the way the Strategic Air Command (SAC) fought successfully to maintain a fleet of airplanes as nuclear weapon delivery systems, long after they'd been rendered obsolete by ICBM's and SLBM's. There's little compelling reason to spend scores of billions on totally new mortars, self-propelled artillery, and "neo-tanks" (XM1202's) when incremental improvements will suffice, and unsurprisingly the MGV's are the part of the program that the White House wants to delay.

All this time, Predator drones have fired many missiles in Afghanistan; the drone attacks have been notoriously ineffective as a strategy, since the killings seem to have stimulated support for the Taliban faster than they've eliminated significant Taliban officials. Since 2006 there have reportedly been 60 drone attacks with a death toll of >500.¹ In early 2009 a large number of drone attacks were launched against targets in Pakistan, understandably provoking outrage; the attacks violated Pakistani sovereignty, yet provided nothing whatever to the Pakistanis in exchange (unlike, say, US support to regimes facing armed insurgencies).

Another component of the FCS is the armed robotic vehicles (ARV's), which seem to remain a small component. Very little recent literature on the ARV program is available online, but the system seems to be pursuing unpiloted, "intelligent" robots. These would be self-guided combatants, like the fire-and-forget missiles. Even if the fulfillment of this goal by the ARV program remains incomplete, it's very disturbing.

Of the programs I've described, one seems to be progressing successfully: the NLOS-LM Netfires PAM. The contractor for this program is Netfires LLC, a joint venture of Raytheon and Lockheed Martin. The entire rest of the program is under EADS, a massive British contractor descended from British Aerospace (and former Airbus partner).

Notes

Non-line-of-sight (NLOS) refers to one of many important features of the NLOS-C, NLOS-M, and NLOS-LS. Both permit the user to target objects that are over the horizon, behind a mountain, or otherwise invisible. In the case of the launch system, NLOS includes the ability of a missile to "loiter" in the sky while it seeks a target, and then aim itself at the newly acquired target. This is also called "fire-and-forget."

NLOS is also used to refer to wireless technology (IEEE 802.16, or WiMax) that permits connections to a base station that is likewise over the horizon.

For the argument that drone attacks mainly stimulate support for Taliban, see Prof. Juan Cole, "Urdu Editorials Condemn US Predator Strikes on Pakistan," Informed Comment (28 March 2009); or "Anger in Pakistan at US plans to expan drone attacks," The Guardian (19 March 2009). For estimates of the number and toll of drone attacks in Afghanistan, see "Drone Attacks will continue," The Nation [of Pakistan] (27 March 2009). Author Ayaz Ahmed Khan argues here, as well, that the drone attacks only worsen the Taliban problem for Islamabad and Kabul.

Sources and Additional Reading

"Future Combat Systems," GlobalSecurity.org (warning: lots of pop-ups)

"Robo-Cannons Manpower Problem" (27 Oct 2008) and "Future Howitzer Mystery" (27 March 2008; about the M1203 NLOS-C), War is Boring

Lewis Page, "Networked multipack cruise missiles in successful test," The Register (4 Dec 2008)

ADDED:

"Administration moves to scrap FCS in existing form," Washington Technology (20 May 2009)

"Looting The Dead" Murphy's Law (21 May 2009)

Some Notes on Arbitrage

2009-03-10T16:34:00.000-07:00

Arbitrage is a concept that comes up in finance and economics a lot. As I understand the concept, it requires that a market exist for at least three items (say, tomatoes, lettuce, and cucumbers). Suppose a head of lettuce costs two tomatoes, and one cucumber. In that case, we can assume that the cucumber is also worth two tomatoes. But what if it's actually 1.5 tomatoes? In that case, you want to exchange cucumbers for lettuce, then exchange the lettuce for tomatoes, and then "buy" cucumbers for all those tomatoes. If you start out with 1 cucumber, then you'll wind up with 1.333 cucumbers, then 1.777, then 2.370, then 3.161....without doing anything other than cart around a burgeoning pile of vegetables.

That's pretty much the whole concept. What makes it tricky is finding comparable items. Arbitrage opportunities involving things that belong to identical categories (like foreign exchange) will be rare.

Precious Metals Arbitrage

In the 19th-20th century, while currencies were officially pegged to gold, they often oscillated within a range of ±0.4-0.9% of the actual mint parity ratio (ratio of the two currencies respective gold content). These were known as the gold points: if the spot rate for a foreign currency exceeded the gold points, it was financially worthwhile to redeem the local currency in gold, and physically transport the currency abroad (or, conversely, import it from abroad). The problem was that the gold points had to be calculated by experts, and varied over time.

If the spot price of a currency remained within its gold point spread, then it made more sense to remit payments abroad using bills of exchange. But there were different types of bills of exchange, and their creditworthiness varied. Therefore, one could locate spreads between different bills and form an independent estimate of what they ought to be. For example, the most reliable bill of exchange for 19th century remittances was the council bill (for exchanges between India and the UK). This was basically government paper issued by the government of India for financing its debt with the Bank of England (Palgrave, 1894, p.442). Another form was commercial paper, which was very frequently discounted abroad (Houston, 1917, p.1235). A seasoned arbitrageur could take advantage of different discount rates for different bills of exchange, whether domestically or internationally.

In cases where different gold/silver standards are in effect, or where a country has multiple metals in use, arbitrage can have serious consequences. An obvious example is when a currency's currency moves well outside the gold points. For example, a country might suffer a minor regional panic, which triggers other banks to restrict loans so as to restore their reserves. In the Usonian banking system of the 19th century, this could mean country banks withdrawing interest-earning reserves deposited in city banks. Fears of a more general collapse of the banking system could lead to a scramble to convert US dollars to UK pounds, driving the pound upward against the dollar. Instead of the mint parity ratio of $4.8667 per pound, this surged to $5.11 per pound. In such a case, the exchange rate has shifted by only 5% in favor of the UK pound, but this would be massively more than the gold point. Gold in the form of a sovereign (a gold £1 coin) would be worth more than gold in the form of an eagle (a gold $10 coin), so of course gold would physically flow out of the USA to London, where it would be minted into sovereigns. Notice this would usually occur at precisely the worst possible time, whether for England or for the USA.

Note also that the problem would not be insufficient gold content in the eagle relative to the sovereign; it would be panic about the "specie liquidity" of Usonian banks, and hence the currency they issued (i.e., 19th century nationally chartered banks in the USA could issue currency but it had to be backed by some quantity of specie). In order to cover the cost of operations, gold in a "country bank" (an outlying bank) not located in a designated reserve city was partly relocated to a reserve or central reserve city, where it was usually used as the reserves of that bank's currency issue as well as earning interest. Both banks might well be solvent, and capable of meeting lawful obligations, but they would require some time in order to do so. Runs rendered them illiquid, but not insolvent.

A problem peculiar to the USA was the political demand for "free coinage" of silver, in which people with silver in non-coined form (including silver ore) could bring it to a mint, have it assayed, and receive coins equal to the value of the silver. This was never actually implemented, but the US Treasury was obligated after 1890 to buy 4 million ounces per month (124.4 metric tonnes) of silver and issue coins from it. During the period that the USA was on the gold coin standard, this was a serious problem.

The official ratio of gold to silver was 16:1; one ounce of gold was supposed to be worth 16 ounces of silver. In fact, it was 20:1 in '90 and had been 22:1. It reached 26:1 during the 1893-95 Depression, and would rise much further. But silver coins were legal tender at the 16:1 ratio, which meant they were overvalued relative to gold. If the Treasury did not buy silver, this was moot; but during the period of the Sherman Silver Purchase Act, this led to a massive outflow of gold.² The reason was that silver could be sold to the US mint for legal tender US dollars, and the US dollars could be redeemed for gold worth about 37% more than the silver used initially. This led to an enormous outflow of gold that nearly caused the collapse of the Usonian financial system.

Interest Arbitrage

After 1897, exchange rates for different national currencies were very rare; in that year, Japan, Chile, and Korea went on the gold standard, and gold point spreads were in decline. This state of affairs continued until the outbreak of World War I (1914), when the international gold standard was suspended. The restoration of gold convertibility in some countries only increased volatility with respect to those that did not; and the Interwar gold standard was short-lived. During the postwar period, most countries were on a gold exchange standard with the US dollar as the anchor.

Under a gold exchange standard, gold points no longer existed because currencies were not convertible to gold, but only to the dollar; and the cost of transporting US dollars internationally was nil. Speculation in currencies occurred within a narrow band when there was evidence that a revaluation or devaluation would occur (i.e., a change in the fixed exchange rate under the Bretton Woods regime). Under the gold exchange standard, national governments were compelled to use monetary policy to ensure they had adequate reserves against foreign liabilities, rather than respond to recessions.

With exchange rates that move within wider bands, or rates that float, currency zones have their own rates of interest. A speculator from A can sell bonds domestically and use the proceeds to buy bonds in B.¹ If the interest rate on b (the currency of B) is higher than the rate on a, then the speculator makes a profit on the spread.

Supposing a rises against b. If this happens, then payments on the b loan will probably be worth less than payments on the a loan, even though the speculator knew the nominal value of both at the time of the transaction. The speculator could potentially make huge losses for a small mistake. If a declines against b, the payoffs could be large; but assuming constant relative risk aversion, the speculator is probably going to think twice about taking such a risk without some form of hedging (like buying futures contracts for a to cover the risks of a change in the exchange rate).

Covered Interest Arbitrage

This is an especially important form of arbitrage, for reasons explained below. In covered interest arbitrage, one tries to capitalize on the differences between exchange rates and between interest rates at the same time; and one uses derivatives to eliminate the risks.

For a borrower in country A, country B may well represent better venues for raising money since its local rates are lower. But add to that the risk that the exchange rate may fall, and those rates may not look so good. Our borrower could

sell a bond in B and buy call options for b to match repayments in the future
sell a bond in A and buy put options for a in units of b to match repayments in the future.

In the first case, the borrower guarantees the payments for the loan will not cost more in the future, since she can buy b for a price guaranteed not to exceed the strike price on the option. In the second case, she raises the possibility of paying off a domestic loan with a foreign currency that is rising against a. If b does not rise against a, she doesn't have to exercise the put, and can pay it off in a.

Needless to say, covering one's risk is expensive: options aren't free. And in this case, the borrower has essentially bid up the price of derivatives to eliminate the arbitrage opportunity. Economists tend to assume that markets will find such opportunities and eliminate them, although accurately establishing risk premia is still open to interpretation.

Importance

In the case of interest rate arbitrage, we used the example of a speculator selling bonds domestically in order to buy them abroad. The proceeds from the foreign bond pay for the domestic one. Assuming the speculator does nothing to cover the risks, then the great danger of huge losses would strongly discourage such arbitrage. The real profit-making opportunity could exist, but it would not be utilized, and therefore the benefits of arbitrage would be greatly reduced.³ Instead of eliminating persistent windfalls to one winner, arbitrage can only contain them.

Hedging reduces the risk but also reduces the potential profits; indeed, the exact return is known the day the investment is made. Options are more expensive, but leave a (remote) possibility of a surprising upside windfall for the arbitrageur. Also, covering risk allows the possibility for the arbitrageur to sell his positions as a new derivative.

Notes:

Supposing A uses a currency called "a," and so on for B and C. For the borrower in A, a rise in the exchange rate means that b and c now cost more units of a. For an outsider, it would look as though the a is falling. If exchange rates rise, then the actual interest rate for the borrower is higher than if the borrower lived in the country from which she was borrowing money. A good introduction to the subject is "Assessing Exchange Rate Risk," BNET (date unknown).
For the Sherman Silver Purchase Act, see Wesley Clair Mitchell, Business cycles, Burt Franklin (1913/1970), Table 72, p.285; or see Graph 45, p.284. Notice the sharp spike in gold exports after '91,

The benefits of arbitrage are that economic rents are eliminated.

Sources & Additional Reading:

Frank K. Houston, "Commercial Paper: Its Uses Part I," The Financier Magazine, Vol.CIX (12 May 1917)

Jeff Madura, International financial management, Abridged 9th edition, Cengage Learning (2009)

R.H.I. Palgrave, Dictionary of Political Economy, Vol. 1, Macmillan (1894); "Exchange between Great Britain and British India," p.776; Vol. 3, "Silver, as Standard," p.395

What is VaR?

2009-01-04T10:34:00.000-08:00

Disclaimer: the following article is not by an expert in the subject; corrections and criticisms are welcome. These are my notes as I study the subject.

VaR stands for "Value at Risk," and represents a popular mathematical expression of financial risk. From the point of view of banking regulators, VaR refers to the range of assets that the institution bears a measurable risk of losing ("taking a haircut"). The value of VaR as a metric is that it allows any pool of assets to be evaluated for aggregate risk.

Whether or not that evaluation is of any value is now a hotly debated matter.

The Basic Idea

The day-to-day movement of asset values is assumed to be stochastic.¹ When we say "stochastic" we are assuming (at least at first) a "normal distribution" of outcomes, which means if you graph the daily changes in asset prices over many years, then the statistical frequency of price changes of each particular size and direction will follow a well-known pattern. In order to estimate the risk of a portfolio of assets, we therefore need to know the mean and the standard deviation of asset value changes.

When different types of assets are in the portfolio, however, there is a further question of whether or not the assets covary or not. In other words, a portfolio contains a mixture of assets that are supposed to reduce the risk of the entire portfolio losing its value at the same time. Ideally, covariance of the different assets in the portfolio is very low, so that if A drops in value suddenly, asset B or C will not. (If covariance is negative, as with a hedge, then asset B will increase in value if A declines, and vice versa).

In 1995's, JPMorganChase began selling a service called RiskMetrics, which was accumulated means, standard deviations, and covariances of different assets.² This made it quite easy to estimate the precise risk of an asset portfolio based on past history, even if the "portfolio" was an entire financial institution. RiskMetrics coined the phrase "Value at Risk" to refer to the maximum probable value that a portfolio could lose in a week, provided it did not exceed a 5% probability worst-case scenario. For example, suppose we have a portfolio worth $1 billion. After factoring in covariance and standard deviations of asset price changes, we establish that there's a 90% chance that the value of the portfolio will remain within a range of 0.98 billion and 1.02 billion. The downside risk is $20 million could be lost. It's possible that losses could exceed $20 million, but not very probable: less than one in twenty.

While the VaR statistic for a portfolio is a single number, it has three parameters: the downside loss, the time period (1 week) and the confidence interval (95% single-tail). One way of saying this is that the VaR represents the 5th percentile scenario net outcome: 95% of outcomes will be better, and 5% will be worse; and we're measuring the net change in portfolio value.

Suppose that the log of the portfolio value is normally distributed with annual mean μ and annual standard deviation σ. The portfolio value at concluding time T is v_T and σ is the standard deviation of portfolio value.³

(The symbol "~" means "is equivalent to").

Most VaR calculations are not concerned with annual value at risk. The main regulatory and management concern is with loss of portfolio value over a much shorter
time period (typically several days or perhaps weeks).

The main computational challenge of VaR calculations is matrix covariance of different asset pools. Risk is increased when the different assets of a portfolio have a high rate of covariance with each other; when there is a large number of different assets held in very different quantities, then determining the covariance of all of the assets concurrently requires matrix algebra and massive amounts of historical data about prior asset movements.

Problems with VaR:

The most obvious problem with VaR is probability distribution. The distribution function used with VaR is a [log] normal distribution (the logarithm of probable asset values are supposed to be distributed normally).

The problem of computing historical asset covariance with non-normal distributions (basically, recomputing covariance from the historical data) doesn't sound like such a severe challenge, but the problem is, calculations of VaR are extremely sensitive to slight adjustments of distribution and covariance.⁴ While it's commonly agreed that a normal distribution is not accurate, establishing another is quite difficult.⁵

Another problem with VaR is that it is conceptually flawed:

I also find a real problem with the idea that one can forecast a correlation matrix.
If you try and forecast the correlation matrix, you’ve got a point estimate in the
future. The errors that we’ve seen, resulting from correlation effects, dominate the
errors in market movements at the time. So the correlation methodology for VaR
is inherently flawed.
Ron Dembo, quoted in Holton (2002), p.24

Nicholas Nassim Taleb argues:

The condensation of complex factors naturally does not just affect the accuracy of the measure. Critics of VaR (including the author) argue that simplification could result in such distortions as to nullify the value of the measurement. [...] Operators are dealing with unstable parameters, unlike those of the physical sciences, and risk measurement should not just be understood to be a vague and imprecise estimate.
Taleb, quoted in Holton (2002), p.24

Holton defends VaR against this criticism by claiming that all probability estimates (including covariance) are subjective.

A third criticism is that VaR permits dangerous market behavior; financial managers could package risky assets like collateralized debt securities (CDS's) as assets, and summarize pools of CDS portfolios as if they were diversified, rather than the applying covariance matrices across the entire pool of assets. In other words, slicing and repackaging mortgage obligations into securities, and reselling those securities as shares in a giant CDS portfolio, concealed the fact that covariance was basically 1 and the risk of asset devaluation was highly unstable. If housing prices were like atoms of strontium, and there was a random rate of price/isotope decay, then we could easily quantify the risk-weighted value and create a new asset with a stable value of its own. But markets for such things are not subject to ergodic probability; the risk of a generalized implosion is entirely unquantifiable.

Notes:

1 When a thing being observed, like the daily closing price of a particular stock, varies randomly, it is referred to as a "stochastic process." For a more precise description, see Thayer Watkins, "Stochastic Process" (San Jose State University, CA). There are four basic kinds of stochastic process described in the article, but we're interested in the "additive random walk." If none of these concepts are familiar, please see the link for a description.

One important distinction between random walk and stationary stochastic processes: for the latter all the shocks are transitory, whereas for random walk all shocks are permanent.

2 Aswath Damodaran, "Value at Risk" Stern University (date unknown), p.2

3 Simon Benninga & Zvi Wiener, "Value-at-Risk (VaR)" Mathematica in Education and Research, Vol. 7 (4 Nov 1998), p.2

4 Tanya Styblo Beder. "VAR: Seductive but Dangerous," Financial Analysts Journal. (September / October 1995). Summary: "Applied 8 VaR calculations to 3 hypothetical portfolios. Used historical simulation with two different data bases and two holding periods (1 day and two weeks), and Monte Carlo simulation with two sets of correlation estimates and the same two holding periods. Also applied two confidence levels (95% and 99%). At the extreme, the resulting estimates of VaRs differed by up to 14 times. However, where the parameters were constrained, the differences were much less significant." Please note the probability distribution functions were not one of the parameters, but obviously if they were, then the resulting estimate of VaR would be even more different.

Glyn A. Holton, in a working paper ("History of Value-at-Risk: 1922-1998" Contingency Analysis [2002], p.23) mentions that the Beder study and others since were excessively harsh; they varied too many parameters and used short histories (with volatile σ). Holton argues that skillful use of VaR could overcome the variance in result among different data sets.

5 For a determined effort to do so, see Svetlana I Boyarchenko & Sergei Z Levendorskii, Non-Gaussian Merton-Black-Scholes Theory, World Scientific Publishing (2002), esp. Chapter 1.2: Regular Lévy Processes of Exponential type.

Additional Sources and Reading:

Simon Benninga & Zvi Wiener, "Value-at-Risk (VaR)" Mathematica in Education and Research, Vol. 7 (4 Nov 1998)

Glyn A. Holton, "History of Value-at-Risk: 1922-1998" Contingency Analysis (2002)

Thomas Linsmeier & Neil Pearson, "Risk Measurement: an Introduction to Value at Risk" University of Illinois, Urbana (July 1996)

Joe Nocera, "Risk Mismanagement" NY Times Magazine (4 Jan 2004; via Kevin Drum)

Yves Smith, "Woefully Misleading Piece on Value at Risk in New York Times," Naked Capitalism (4 Jan 2004; via comment at Kevin Drum)

Solving a Three-Good Utility Function

2008-12-30T23:28:00.000-08:00

According to the principles of Neoclassical economics, we would turn to a utility function of three variables to investigate.¹ Usually, the concept is explained with two goods so it can be illustrated (x and y being goods, and z—the vertical axis—standing for utility). But we can't illustrate this one fully because we are interested in cases where there are actually more than two goods determining utility.

Let U be utility as a function of x, y, and z, where x refers to everything one buys other than software, y is cheap software, and z is costly software (α, β, and γ are arbitrary constants; x₀, y₀, and z₀ are threshold levels of consumption) .

U(x, y, z) = αln(x-x₀) + βln(y-y₀)+ γln(z-z₀)

subject to

I = p_xx + p_yy + p_zz .

where I is income and p refers to the price of the respective good.

The Lagrangian will be

L = αln(x-x₀) + βln(y-y₀)+ γln(z-z₀) + λ(I - p_xx - p_yy - p_zz)

and first order conditions will be

First we solve for x, y, and z in terms of the constants (and λ)

and then we solve for the Lagrangian multiplier λ:

And we substitute the values for x, y, and z into the equation for the Lagrangian multiplier.

Now, so far this has just been a generic solution of a symmetric 3-good constrained optimization problem, and it can be made even more general for a very large number of goods:

where g_j is any good, c_j is the corresponding constant I've been representing with Greek letters, I is income, and i is the counter for summation within the equation (So, for example, p_j refers to the price for the good g_j whose optimal amount g* you're trying to determine, while p_ig_i refers to the amount expended on any individual good listed in the summation from 1 to n goods).

(Discussion of Findings)

Notes:

1 Regarding the utility function: I prefer to use the linear expenditure model instead of the Cobb-Douglas model everyone else uses, because the CD utility function leads to rigid expenditures between x, y, and z. If a researcher wanted to perform regression analysis of "observed preferences" to establish what the coefficients were, the existence of threshold levels of consumption would correspond to y-intercepts for each good.

Pay-per-use your own computer?

2008-12-29T16:17:00.000-08:00

Gregg Keizer, Microsoft specs out 'pay as you go' PC scheme, Computerworld

The idea is something that might have been a story problem in a class on welfare economics: assuming the cost of metering computer usage is negligible, discuss the merits of such a proposal. MS filed a patent for a proposal to sell computers (presumably well below the cost of production), then bill customers for both the use of installed programs and the use of computer power.

Microsoft's plan would instead monitor the machine to track things such as disk storage space, processor cores and memory used, then bill the user for what was consumed during a set period.

So you would be billed x per MIPS-hour, even though this would require you to have the highest-performing processor installed all the time. Also, it would allow you to briefly use premium softwares for hourly (?) rates.

At first blush, this does sound a lot like MS is at it again, trying to squeeze more revenue out of customers for software that is costlier and buggier. A major benefit for MS would be stimulating computer revenue by offering pay-per-use options; note there's an extremely severe recession approaching. With respect to hardware, there would be an obvious relative increase in the incentive to get the most powerful devices, since there would not be a price premium... except on the occasion that you used their full capability. Semiconductor fabricators like AMD might grumble about the price squeeze value-added retailers like Dell were imposing, but really, they'd really only need to ship a larger number of top-of-the-line chips, rather than a mix of different premium chips.

Where the idea gets interesting is software, since the object would be to create a market for much higher-end programs (most likely games, but also business applications). MS could allow users to download "riskfree" programs that had been recently developed, collect revenues, and perhaps stimulate demand. Which opens the question, what exactly would this scheme do for software demand?

Solving a Three-Good Utility Function
Section excised and put in another post

Findings

Usually discussion of utility functions present them as indifference curves between two similar goods. I prefer to think of utility functions as part of firm's production function, in the sense that there's more money to be made with an optimal expenditure on different items. But in the case of an actual business strategy, it makes sense to begin with the understanding that customers can spend money on

high-end software (z)
low-end software (y)
everything else (x).

Usually I use the x-axis to represent "everything else" (example). Textbook writers, sometimes in an effort at humor, will select two very similar items (pizza versus hamburgers) , but assume consumers' expenditures on the two items together will remain the same regardless. I remain curious, though, as to what would happen if you're looking at a market for two similar items, in which most income will be spent on neither. If the price for one goes down, demand for the other may not necessarily go down (as it would if there were only two items).

Another deviation from usual practice is to use the linear expenditure function instead of a Cobb-Douglas function. The Cobb-Douglass utility function is unappealing to me because, while it's easy to use mathematically, it results in a fixed share of income being spent on each good. Logically, if the price of a thing is sharply reduced, you would expect people to spend a larger share of their income on that thing; spending the same amount of money as before now yields more satisfaction, so people will find more occasions to use spend more money on it, not merely buy more units. For some products, the opposite may be true (health care), in which case the threshold level of consumption can be made negative.

The threshold level of consumption is a phrase I made up to refer to what x₀, y_o, and z_o represent: a minimum level of consumption of these respective goods. Consumption of x < x₀ means that x ties up income but contributes nothing to utility. As is often the case, extreme conditions are seldom relevant: we aren't usually interested in situations where x < x₀. Instead, we're interested in situations where x >> x₀, and we're making a modest shift in position. Technically, a negative threshold level of consumption implies that even negative consumption of a thing contributes to utility, to say nothing of no consumption at all. That's absurd. On the other hand, the curve created by a negative threshold may realistically describe conditions in which an increase in prices leads to an increase in total expenditures.

I set up the equation so that threshold levels of consumption were positive for all goods; the price of "everything else" was fixed; high-end software yielded a higher utility per unit, and software generally had a higher utility per unit than "everything else." I found that increasing prices for y actually reduced spending (demand) for z, albeit much more slowly than reducing the price for z.

A lot of this has to do with the coefficients of the utility function: α, β, γ, x₀, y_o, z_o, and I. The values of α, β, and γ determine the gradient of the utility function at I. When creating the graph above, I chose values for β and γ that were much higher than α; that reflects an assumption that ongoing expenditures on low-end software (not to mention high-end software) provide more bang for the buck than money spent on "everything else." That's an intensely controversial proposition, but I doubt it would face controversy at Microsoft.

The values for threshold spending (x₀, y_o, and z_o) are naturally a mystery; high values for x₀ and y_o (i.e., both "everything else" and low-end software) lower z*, while high values for z_o increase z*. All this means is that, if thresholds are high, a price reduction causes expenditures on the good to increase. If threshold = 0, then a price reduction causes expenditures to stay the same. For computers generally, there is strong historic evidence that falling prices have sharply increased expenditures, leading to the conclusion that the threshold value is large but is offset by a high coefficient of utility.

The effect of the original business scheme of Microsoft would lead to a shift in software expenditure from low-end software to high-end, and stimulate spending on software generally. The logic of this is intuitive: access to high-end functionality would be on tap, but users would not have to actually commit to owning the whole package. This would increase the overall utility of software per se.

Parenthetic Note on the Use of the Atomic Bomb

2008-12-21T17:39:00.000-08:00

I recently wrote a post on the Manhattan Project in which I wrote:

I've been disappointed by the way the issue has been generally exploited by partisans to support opinions on other subjects—a football, so to speak, in an ongoing propaganda war. As an amateur student of history, I personally have learned that it's vain and self-deceiving to make judgments on these matters because one cannot (or will not) ever make a valid reconstruction of the understanding historical actors had of the events in which they acted...

The Manhattan Project emerged from under this avalanche of history as the prototypical project to use a massive drive to develop a "magic bullet," a technology that would end the War. Somehow, that technology has been divorced from any context. I guess people want to conjure up the amazing technical feat of not only achieving a nuclear bomb in only three years, but achieving the first nuclear bomb in only three years; and applying this to some unknown new technology, similar to the A-bomb in its revolutionary character, but reversing the moral polarity.

My post neglected to explain why I was disappointed; it was not by the fact that people try to make judgments on "these matters." It was how they go about it.

In American Hiroshima (Trafford Publishing, 2006; p.108ff), David J. Dionisi makes a fairly compelling argument that the US government was well aware of the inevitability of Japanese capitulation well before the use of the bomb. The customary evidence for this (it's been made many times before) is the 1946 US Strategic Bombing Survey, "Japan's struggle to end the war.":

The time lapse between military impotence and political acceptance of the inevitable might have been shorter had the political structure of Japan permitted a more rapid and decisive determination of national policies. Nevertheless, it seems clear that, even without the atomic bombing attacks, air supremacy over Japan could have exerted sufficient pressure to bring about unconditional surrender and obviate the need for invasion.
Based on a detailed investigation of all the facts, and supported by the testimony of the surviving Japanese leaders involved, it is the Survey's opinion that certainly prior to 31 December 1945, and in all probability prior to 1 November 1945, Japan would have surrendered even if the atomic bombs had not been dropped, even if Russia had not entered the war, and even if no invasion had been planned or contemplated.
(Emphasis added—JRM)

While this seems like the most plausible conclusion for historians, there are a few caveats I want to make here:

In hindsight, historical events always seem inevitable. More precisely put, when undertaking a speculative counterfactual (e.g., what if the US had failed to develop an atomic bomb by 1 January 1946?), an analyst can invariably alter nearly all incidentals and still expect the same outcome. Certainly leaders of the defeated government would naturally want to ingratiate themselves with the SCAP authorities by affirming that there was little support for the regime among ordinary Japanese, or even intense opposition among professional commanders and managers. This would contribute to a sense by the committee that Japanese capitulation was "inevitable."
The main reason cited for certainty of Japan's imminent surrender is "air power." But aside from massive conventional bombing (which failed to induce Vietnamese capitulation in the 1970's), what form would that air power take? Aerial campaigns against the major cities of Japan had led to gigantic death tolls (100,000 deaths in Tokyo alone), and even after the bombing of Nagasaki, stalwarts in the army planned a coup to seize the Imperial Palace rather than allow the Emperor to accept capitulation.

The point is that, revisionist historians have tried to make the case that not using the atomic bombs would have been virtually cost-free. This is not a plausible claim; the bombing survey, which claimed that neither atomic bomb use nor an attempted invasion would have been necessary to defeat Japan, does assume continued air power (meaning, continued use of conventional bombs against the civilian population). Precision bombing most emphatically did not exist, and the Japanese military machine did not rely on large, easily-identifiable plants such as those supplying the Third Reich armies.

Another point that needs to be made is that it would have taken preternatural political courage to refuse to use a weapon, now available, to hasten the end of such a war. I don't think this theme needs further development.

Now, I believe I have stripped away the various efforts to game the argument. Had the USA not used indiscriminate terror bombing—incendiaries and atomic bombs against civilians—then the war would have lasted longer and killed more Usonians. Use of incendiaries is not dramatically different from the use of atomic bombs; both were used in the Pacific War to kill many thousands of noncombatants.It would seem that neither was illegal in 1945, although I could be mistaken.¹

The United States government made the decision in 1942 to launch a major, secretive program to create a nuclear bomb. It is here that the moral judgment was, in my view, made. After 1944, a suspension of the program was probably impossible; after 16 July 1945, non-use of the atomic bomb would have required unheard-of heroic moral courage. It was in 1942, in other words, that the temptation was embraced. During the following year, moreover, the Allies began greatly intensified bombing of Axis countries; Japan, in particular, was the target of massively lethal incendiary campaigns that targeted the entire population, not explicit military capabilities.

The problem was that the Allies, at the core of their strategic planning, adopted a scheme to win the War by enormous random massacres. Among the non-ruling populations of Axis countries—particularly Japan—this was to undermine the moral legitimacy of the Allies and their postwar order. While the Japanese Militarist regime had committed crimes against humanity, peace, and the laws of war, the Allies committed crimes against the peace on three continents, crimes against humanity, and crimes against the laws of war.² The Nuremberg Trial Proceedings defined war crimes to include "wanton destruction of cities, towns or villages, or devastation not justified by military necessity," which probably led directly to Protocol I of the 1949 Geneva Conventions. But the question of "military necessity" was an extremely dangerous loophole. The Allies, in particular, had designed their entire strategy—their calculus of "military necessity"—around the concept of remote bombing. Wanton destruction was intrinsically a military necessity. Its logical culmination was the nuclear bombing of Nagasaki and Hiroshima.

The purpose itself of destroying entire cities to win wars is categorically immoral; the Allied powers agreed to this when they undertook the first wave of trials for crimes against the laws of war. They adopted the premise that this immorality ought to have been obvious to Axis military personnel, even though international law had not yet been promulgated to say so. There was never any risk of Japanese destruction of Usonian cities, so the Usonians could not plead that they were avenging, or protecting their own cities; and even if they were, the terms of the Convention were not to be waived even if the enemy broke them. Even if the bombing were needed to induce total Japanese surrender, it was a war crime.

The effect of the bombing was a disaster of human liberty and the moral standing of democracy. Its worst spiritual impact was on the Usonians themselves, who now accepted leaders who blithely proposed to use the atomic bomb in most conflicts to which it was a party. The atomic bomb appears to have strongly influenced the ideology of the Cold War belligerents not only toward the possibilities and dangers posed by warfare, but towards the very ideologies themselves. For example, Usonian ideology morphed from an authentically conservative doctrine of caution, continuity, and particularism, to something new and strange. Before, there was at least some serious regard for Mills-style liberalism, which was already understood to impose absolute limits on the portability of any new progressive social development. According to Tocqueville, the Usonian outlook was particularist in so far as Usonians regarded their historical legacy (short though it was) as rare, extraordinary, and endowing themselves with unique virtues, virtues that enabled democracy.

Now "democracy" was used as a symbol for something else; it referred not to any system of political rights-cum-electoral rule, but to the Usonian-led team. Hereafter, few would find it odd that Finland or India, with their authentically democratic institutions, were not in the "democratic" camp, but military juntas in Pakistan, Thailand, Greece, and Venezuela were. "Democracy" was now understood as instrumental to the survival and expansion of capitalism, because it was taken for granted that capitalism was uniquely suited to democracy, not because actual democracies favored capitalism. Added to this was the doctrine that unlimited force could be brought to bear to preserve capitalist political orders in any country of the world, regardless of their local unpopularity and their illegitimacy.

The role of the atomic/nuclear bomb in this ideological shift was its extraordinary harnessing of natural forces. Now, political triumph had nothing to do with legitimacy and free will; it was entirely an industrial problem, solved by superior application of Taylorism and enlightened management techniques. Even though the atomic bomb would not be used again in warfare, Usonian leaders openly and soberly contemplated its use in every military action they took. The failure of bombing to actually influence social outcomes was always assumed to be the result of failure to bomb adequately. So, for example, Laos was bombed more profusely than Japan and Germany (put together) during WW2, and of course has a far smaller population, area, and economy than those two countries. Yet the legend persists and amounts to conventional wisdom, that Laos fell to Communism because the United States military held back. Always at the back of the demagogues' minds was the failure to use nuclear bombs in each theater; this was always taken as evidence that the US had "fought with one hand tied behind its back."

By assuming that it could mold the political order of each nation on earth with sufficient resolve, the "democratic" ideals of the Usonian political establishment dispensed with any appeal whatever to free will or freedom. The only freedom that mattered, clearly, was free enterprise. The Manhattan Project was launched with a view to molding human will like a recalcitrant mountain top. What is astonishing is how its close cousin, the modern "conventional" bomb, failed utterly in its purpose. Instead of molding the Vietnamese, Lao, or Afghans, the atomic bomb molded Usonians. Our view of other communities became solipsistic; they could be made to actually be what our leaders wanted, if only we had sufficient resolve—where "resolve" was defined as indifference to suffering.

It would be nice to be able to speak of the atomic shadow on Usonian thought as something receding: a past historical anomaly, now reverting to a more sane view of other humans. Surely, it would seem, exposure to flesh-and-blood Arabs or Southeast Asians would arouse our natural empathy and affection for them. I don't really see signs of this, however; I think we're still in the process of collectively forgetting how we once viewed the world as only partly susceptible to technological control. In our efforts to come to grips with the calamities wrought by excessive fossil fuel consumption, urban sprawl, and digital waste, we still see the problem as one requiring more ecological redemption to fix.

Notes

Area bombing ("pattern bombing") where a number of clearly separated military objectives are treated as a single military objective, and where there is a similar concentration of civilians or civilian objects, is a violation of Protocol I, Art. 51, Sec. 5a. However, this specific protocol did not exist until August 1949. Obviously, the "counterinsurgency" tactics used in the Second Indochina War (1955-1975) were profusely contrary to PI.51.

Most rules governing conduct of combat operations (e.g., prohibition of chemical weapons) are to be found in the Hague Conventions of 1899 & 1907. The use of incendiaries was banned in the Incendiary Weapons Convention of 1980.

It is problematic to me that the use of area bombing became illegal shortly after World War II. It certainly ought to be illegal, and the government of the United States has violated Protocol I copiously since it was passed (under the pretext that it was assisting in the suppression of an "insurgency," rather than conducting an actual war). One could grumble that the Allies (a) passed the 1949 Geneva Convention after they themselves had committed the most egregious violations of it and (b) nonetheless prepared to commit still greater violations of it. The Japanese and the Third Reich waged war savagely, but they lacked the means to wage air campaigns comparable to those of the Allies, and did not make significant preparations to do so. Obviously, the NATO and Warsaw Pact accumulated stockpiles of nuclear weapons that would have made a complete mockery of Protocol I.

The Allies could not have failed to know that they were encoding principles, not safeguards: had the Nazis made adequate preparations for air warfare, no protocol would have spared the Allies from marauding fleets of German superbombers; and the Allies knew they were mostly safe from Axis bombing after 1943 (after which Allied bombing of Japan and Germany was stepped up immensely). The Usonians and the British, in other words, were not really retaliating for Shanghai and Coventry; the Usonians were retaliating for an attack on a military target, while the British had actually initiated use of bombing campaigns against Germany, rather than vice versa.

Moreover, the fact remains that morals change gradually. Clearly, if area bobming was outlawed in 1949, then the Allied powers must have known that it was wrong before that time. Unlike conventions passed prior to the War, the 1949 Geneva Convention were binding on signatories regardless of compliance by the enemy. This implies that the Allies believed that terror bombings were so immoral that, even if they were effective, any civilized belligerent could not possibly engage in them. In six years, the Allies and neutral powers had gone from massive use of area bombing, to outlawing something that had been both their primary weapon in the previous conflict, and their intended primary weapon in the next.

See Nuremberg Trial Proceedings Vol. 1, "Charter of the International Military Tribunal" (Avalon Project, Yale Law School); the distinct categories "Crimes against Peace," "War Crimes," and "Crimes against Humanity" are defined in Article 6. The Axis Powers committed crimes against peace by invading countries in Europe and East Asia; the Allies had earlier waged aggressive wars against nations of South Asia, Africa, and Latin America (creation of French, British, and Belgian empires; US interventions in Latin America). The Axis Powers had committed crimes against the laws of war by murdering 12 million civilians in scores of countries, sacking all of Europe, and seizing hostages. The Allies had treated prisoners quite badly, such as forcing many thousands to clear mines, or being lackadaisical about providing for them. See Wikipedia, "Disarmed Enemy Forces"; see also modern literature on French, British, Usonian, and Netherlander treatment of combatants in wars of national liberation prior to WW2 (e.g, Sven Lindqvist and Joan Tate, Exterminate All the Brutes, New Press, 1997). Finally, while the Nazi Holocaust and enslavement of foreigners practically defined the crime against humanity, Allied powers such as the United States had a system of apartheid for African Usonians, sequestered Native Usonians on reservations, and allowed employers to maintain armed gangs to terrorize employees; the British Empire inflicted devastatingly awful conditions on African and South Asian subject peoples; and the Soviet Union, I presume, needs no introduction as an egregious violator of human rights.

Sources & Additional Reading

Avalon Project Listing of International Conventions on the Laws of War

Marilyn B. Young, excerpt, Bombing civilians from the Twentieth to the Twenty-First centuries , New Press (2009)

Counting the Cost: the Financial Crisis

2008-12-03T22:10:00.000-08:00

Disclaimer: I am not an expert in this field; these are my notes as I research these topics using the usual internet/public library resources. In many cases, links have been added to subsequent posts in this blog. Apologies in advance for any mistakes of interpretation.

How much will the financial crisis cost the US taxpayer? Most of the attention has focused on the Troubled Asset Relief Program (TARP), a $700 billion package initially designed to restore financial markets by buying up troubled assets. That's understandable, but it mainly reflects Congressional debate over a smallish share of the overall government response. According to Barry Ritholtz, et al., that government response was predominantly administered by the Federal Reserve System, and is measured by capital stakes.

An additional component of the bailout, also far surpassing the TARP agreement, is outlays by the Federal Deposit Insurance Corporation (FDIC). The FDIC approved the Temporary Liquidity Guarantee Program (TLGP) in October; it provides a guarantee of non-interest bearing deposits up to $250,000 instead of the usual $100,000.

TARP and the FHA "Hope for Homeowners" programs were designed mainly to inject a stream of payments into the huge pool of obligations taken on by federally guaranteed agencies.

Here follows a review of the items on Ritholtz's list.

Federal Reserve System

The Federal Reserve System took on potentially $5.8 trillion in liabilities in response to the initial wave of banking failures. Here are the programs it has created for coping with the catastrophe.

Commercial Paper Funding Facility: created 7 October 2008, shortly after a disastrous meltdown of the commercial paper markets (Bloomberg; see chart). Accepts newly issued 3-month unsecured and asset-backed CP from eligible issuers as collateral in exchange for funds (3 months).
Term Auction Facility: created 12 December 2007. Up to 90 loans to depository institutions (thrifts, savings banks, credit unions) for emergency reserves, supplementing the usual interbank reserve lending. Not a permanent institution, but a series of auctions of funds held every two weeks. The banks successfully bidding must provide suitable securities as collateral.
Money Market Investor Funding Facility: created 21 October 2008 to provide liquidity to money market funds; object to prevent sales of assets in falling market (debt deflation).
MBS Purchase Program: created November 2008 to buy mortgage-backed securities from FNMA, and FHLMA (Fannie Mae, and Freddie Mac; known collectively as the GSEs). This was intended take the place of the suddenly-defunct market for MBS collateralized debt obligations (CDOs). This is not the same thing as the project of re-absorbing the GSEs themselves. In terms of financial risk, this is probably qualitatively riskier than the other programs.
Term Securities Lending Facility (TSLF): created 11 March 2008 & renewed 3 December; lends Federal Reserve holdings of US Treasury securities to NY Fed primary dealers.
Term ABS Lending Facility (TALF): created 25 November 2008; loans to entities buying asset-backed securities (ABS); borrowers required to not be originators of the ABS.
Credit Extensions (mostly AIG): large number of different interventions to salvage network of CDS counterparty liabilities; includes at least $122 billion (apparently, not the same money as the $150 billion of TARP funds authorized as of 9 November specifically for AIG). Most money ever directed by the USG to any single enterprise (NY Times).

Federal Deposit Insurance Corporation

The Temporary Liquidity Guarantee Program (TLGP) was rated at costing potentially $1.4 trillion, although so far it has not cost anything yet--it is an extremely new program, and we don't know how many banks are likely to default on their largest deposits.

The FDIC also provided Citigroup with $306 billion in loan guarantees (Bloomberg), with Citigroup required to absorb the first $29 billion in losses, and 10% of losses after that--for a potential maximum liability to the FDIC of $249.3 billion. The FDIC provided a similar loan guarantee of $139 billion to General Electric (Bloomberg). Ritholtz lists the current amount for this line item as 100% of the maximum, which presumes an implausibly disastrous collapse of Citigroup and General Electric asset value.

US Treasury

It may come as a surprise to learn that the Treasury Department's role in the federal government response to the financial crisis was small potatoes. There are two main programs, the Troubled Asset Recovery Program (TARP) and the GSE bailout (separate and distinct from the MBS purchase program).

SOME REMARKS

This is where I was supposed to carefully review all of the programs and their interplay, and make some assessments. One meta-assessment is that James Hamilton of Econbrowser (7 October) was unable to say, and he really is an expert (I'm just trying to learn about this). The reason is that the financial system has certain metaphysical obstacles to consequential analysis: there's no agreement on what this relationship of debt to economic output really means.

Having examined several of the programs set up by the Federal Reserve and the Treasury, I think I can understand why the approach taken was so complex: each industry had to be treated differently. For example, while money market funds usually rely on commercial paper markets for investor return, they have constraints and problems that are distinct enough to need different approaches. But the complicated arrangement of credit triage supplied by the Fed to its [still more] complicated patient means unpredictable results and unpredictable market response.

When I was studying theories of monetary policy, like the debate over "commitment versus discretion" (see Dotsey 2008), the papers and textbooks described a world of macroeconomic stability. A bad monetary policy might lead to a monotonic increase in bond yields, but it was a well-behaved catastrophe. I understood that this was an introduction to the idea, and meant to help students understand the basic terms of the debate, but it did not occur to me that the real controversy would erupt during a multi-dimensional crisis in which many different financial markets were flying apart. Here, there were no rules to commit to: the contribution of economic theory to debate in this crisis has been to grumble about moral hazard.

What we are really discussing here is something that economic theories do not describe in any meaningful sense of the word "describe," and something more akin to a turbofan engine. Except that a turbofan engine was designed and produced by a single firm, and its operating principles are well known to the designers or mechanics. The financial system was designed by no single entity, and its relationship with the real economy is mired in doubt.

Having said that, it seems to me that a big part of the rescue program sketched above is multiple layers of liability. A homeowner borrows money from a mortgage originator, who sells the mortgage to an investment bank. The investment bank creates an SIV and sells the mortgage to it, in exchange for a stream of payments to depositors. The mortgage may be insured against default with a credit default swap, whose counterparty is a hedge fund. The hedge fund may hedge its CDS liabilities with put options on the same CDO, and the counterparty to the puts may be another investment bank that finances with commercial paper. That commercial paper, finally, finances the original homeowner's money market fund. The same liability is repackaged, leveraged, and perhaps even multiplied through options and credit default swaps.

The Fed's program, in effect, rescues each layer. Party A uses some federal funds to repay B, who uses that plus more federal funds to repay C, and so on. This increases the Fed's exposure but reduces the unit risk of that exposure.

However, it seems clear that this post can never be more than a bookmark, which I will need to revisit as the situation unfolds.

Sources & Additional Reading

Barry Ritholtz, "Calculating the Total Bailout Costs" and "$7.8 Trillion Total Bailout Commitment," The Big Picture (November 2008)

Bloomberg:

"Funds' Flight From Commercial Paper Forced Fed Move"(October 2008)
"GE Wins FDIC Insurance for Up to $139 Billion in Debt" (12 November 2008)
"Citigroup Gets Guarantees on $306 Billion of Assets" (24 November 2008)

Econbrowser (James Hamilton's blog)

"Term Securities Lending Facility" (15 March 2008)
"Balance sheet of the Federal Reserve" (7 October 2008)

Federal Reserve System sites:

Olivier Armantier, Sandra Krieger, & James McAndrews, "The Federal Reserve’s Term Auction Facility," FRB of NY (July 2008)
Michael Dotsey, "Commitment versus Discretion in Monetary Policy" FRB of Philadelphia (accessed December 2008)
"Forms of Federal Reserve Lending" FRB of NY (accessed December 2008)
"Commercial Paper" Federal Reserve Board (accessed December 2008)
"Term Securities Loan Facility" FRB of NY (accessed December 2008)
"Term Asset-Backed Securities Loan Facility" FRB of NY (accessed December 2008)

Marco Arnone & George Iden, "Primary Dealers in Government Securities: Policy Issues and Selected Government's Experience" Working Paper, International Monetary Fund (March 2003)

"Financial Crisis – News and Resources" page at Morrison & Foerster, LLP website (outstanding!)

Andrew Ross Sorkin & Mary Williams Walsh, "AIG May Get More in Bailout," New York Times (9 Nov 2008)

Joe Weisenthal, "Explaining The AIG Black Hole," Business Insider (30 October 2008)

Neil Irwin, "Fed Prepared to Prop Up Money-Market Funds," Washington Post (22 October 2008)

Cyberwarfare

2008-11-25T22:28:00.000-08:00

During the disastrous crisis in South Ossetia¹, we received a glimpse on the state of cyberwarfare. I've occasionally heard breathless references to this, but so far the "main weapon" seems to consist of distributed denial of service attacks:

NY Times Blog: Besides the bloody shooting war going on between Georgia and Russia, there’s another, quieter battle going on in cyberspace. The Georgian government is accusing Russia of disabling Georgian Web sites, including the site for the Ministry of Foreign Affairs.

[...]

The attacks are structured as massive requests for data from Georgian computers and appear to be controlled from a server based at a telecommunications firm, he said. This kind of attack, known as a distributed denial of service attack, is aimed at making a Web site unreachable. It was first used on a large scale in 2001 to attack Microsoft and has been refined in terms of power and sophistication since then. The attacks are usually performed by hundreds or thousands of commandeered personal computers, making a positive determination of who is behind a particular attack either difficult or impossible.

It's been noted (in comments to the above post) that "mere" DDoS attacks probably were the work of enthusiastic supporters of the Russian war effort, and not the Russian military itself. Such attacks were not significant to the Georgian war effort, partly because internet penetration in that country is very limited.

According to the PBS documentary on cyberwarfare (see below), a much more alarming prospect is something like the Slammer (or "Sapphire") worm.

SearchSecurity.com: While Slammer choked many Internet service providers and networks over the weekend, it didn't have a destructive payload, said David Litchfield, a well-known vulnerability-finder and co-founder of Next Generation Security Software, which is based in Sutton, England. "It could have been so much more nasty," he said. "It appears they wrote it to prove a point."

Slammer exploits the six-month-old SQL Server Resolution Service buffer overflow flaw that Litchfield discovered. While the worm isn't destructive and only attacks Windows 2000 systems, it can gum up networks by generating massive amounts of traffic. It then scans random IP addresses looking for other vulnerable servers.

One of the more vulnerable targets of cyberwarfare is a class of machines known as systems control and data acquisition (SCADA). These are computer systems used for monitoring real-time industrial or communications processes, such as oil refineries or telecom switching. Because of the complexity and integration of such systems, they are usually connected to the internet, and often through cellular communications. Hence, there is a risk that a future terrorist attack could avoid bombs entirely and attack a SCADA that was critical to, say, the functioning of a subway system.

This is discussed in a few interviews at the PBS page on SCADA vulnerabilities. The general tenor of the interviews is that there seems to be little evidence that a technology exists for penetrating SCADA systems en masse.

Notes
1 [UPDATED] Impartial information on the South Ossetian War of August 2008 is quite difficult to come by, but one trustworthy source is "All Parties in August/South Ossetia Conflict Violated Laws of War," Human Rights Watch (23 Jan 2009)

Additional Sources
(From How Stuff Works)

Cybertelecom, "CyberWar." (Sept. 30, 2008)
Jack M. Germain, "The Winds of Cyber War." TechNewsWorld. Sept. 16, 2008. (Oct. 1, 2008)
Michael Kirk, "CyberWar!" Frontline, PBS. April 24, 2003. (Oct. 1, 2008)
Gregory M. Lamb, "Anatomy of a cyberwar in Georgia" Christian Science Monitor (13 Aug 2008)
John Markoff, "Georgia Takes a Beating in the Cyberwar With Russia" New York Times. (11 Aug 2008) & "Before the Gunfire, Cyberattacks" New York Times (12 Aug 2008) &

The Manhattan Project

2008-11-17T14:53:00.000-08:00

Please stop using the term "Manhattan Project" to refer to a government-funded project to develop a desired technology.

Click for larger image

Please.

The original Manhattan Project was initiated by the US government in July 1941 in response to the MAUD report, a study commissioned by the National Defense Research Committee liaison office (UK) to establish the feasibility of a nuclear bomb. The MAUD report established that, not only was such a bomb immanently possible, it was probable that the Third Reich was working on one of their own.¹ Prior to this, the (US) National Academy of Sciences had taken a skeptical view of nuclear ordnance.

Vannevar Bush was able to persuade the Roosevelt Administration to launch a new, specialized agency for R&D into the nuclear bomb (November 1941). With the attack on Pearl Harbor a month later, everything was greatly accelerated. The original program to actually develop a working uranium bomb was set up in Syracuse, New York and later in New York City. Hence, it was called the "Manhattan Engineering District" (MED

Click for larger images

) instead of anything referring to its function. The MED was administered by the Army Corps of Engineers and included researchers from the UK and Canada as well as US nationals.

By 17 September '42 the MED was under the management of Brig. Gen. Leslie Groves, and in Oak Ridge, TN. Groves was responsible for logistics, while J.R. Oppenheimer was responsible for scientific research. A major time constraint for the production was the production of an adequate stock of fissile U235, which required three different facilities using different methods to produce.² The Manhattan Project quickly focused on two main design strategies: a uranium design, which would blast a cork-shaped mass of uranium into another mass of uranium in order to trigger a nuclear explosion; and a plutonium design, in which a spherical mas of P239 was enclosed in a larger sphere of explosives. The later design was more technically demanding because of the need for extremely precise coordination of the explosive "tiles" encasing the plutonium.

The explosion created by the two bombs virtually eradicated the urban centers of their respective targets, Hiroshima and Nagasaki. The "little boy" bomb used on Hiroshima (7 August) had an explosive force of 15,000 tons of TNT, and probably killed about 70,000 people in the initial blast. In the years that followed, the combination of burns and radiation poisoning may brought the death toll up to 200,000.³ The other bomb, "fat man," had a yield of 22,000 tons TNT and was used against the city of Nagasaki. This city was smaller and the death toll was somewhat lower.

There remains a firestorm of controversy over the necessity or morality of the use of the atom bombs on Japan. I've been disappointed by the way the issue has been generally exploited by partisans to support opinions on other subjects—a football, so to speak, in an ongoing propaganda war. As an amateur student of history, I personally have learned that it's vain and self-deceiving to make judgments on these matters because one cannot (or will not) ever make a valid reconstruction of the understanding historical actors had of the events in which they acted. (I am well aware of the fact that many people will think this is somehow immoral, as if I'm somehow evading a great moral test.) But this is a bit far afield from my original subject.

UPDATE: My views on the ethics of the A-bomb use.

The Manhattan Project emerged from under this avalanche of history as the prototypical project to use a massive drive to develop a "magic bullet," a technology that would end the War. Somehow, that technology has been divorced from any context. I guess people want to conjure up the amazing technical feat of not only achieving a nuclear bomb in only three years, but achieving the first nuclear bomb in only three years; and applying this to some unknown new technology, similar to the A-bomb in its revolutionary character, but reversing the moral polarity. People have been calling for a Manhattan Project to develop competitive products, or resolve our dependence on fossil fuels, or even resolve our financial crisis.

But any such program would have to incorporate the Japanese anyway; their control of trillions of Eurodollars plus their mammoth technical skills make them indispensable. Moreover, there is something basically insidious about the whole idea of a technology, divorced from economic or political context, actually solving anything. I would argue that the A-bomb was an inherently bad technology, like torture: even if it might potentially have "worked" one time, its existence tended to corrode democratic values and basic principles of just war. It was developed in the absence of any serious consideration of what its use would do to the concept of democracy or "legitimate use of force," and as such it inevitably undid any short-run advantage gotten by its first use.

NOTES:

1 "The Manhattan Project: an Interactive History," Department of Energy website. Vannevar Bush was the founder and director of the Office of Scientific Research and Development (OSRD), a wartime agency.

2 "The Manhattan Project: an Interactive History,"Ibid. Uranium atoms have 92 protons and 92 electrons, but anywhere from 125 to 150 neutrons (an isotope of an atom is a "version" of that atom distinguished by a particular number of protons + neutrons). The vast majority of uranium isotopes have a tendency to "decay" into something else within a microsecond or less. We call an isotope "stable" when it has a half-life measured in years, and there are six of these for uranium. The most common one that can sustain a chain reaction is U235 (92 protons + 143 neutrons); this accounts for about 0.7% of all uranium found in nature. However, about 99.3% is U238, which has an additional three neutrons. U238 cannot sustain a chain reaction, and must be refined away from an available crucible in order to produce "weapons grade" uranium (>80% U235). This is an extremely costly and difficult process, and it is astonishing that the US government was able to organize a successful extraction regime in less than three years.

Plutonium is an artificial substance that does not exist in nature. There are twenty isotopes, but the one primarily used for nuclear weapons is Pu239. Plutonium is synthesized from uranium in a specially-designed reactor and refined from the residue that forms in a nuclear reactor fuel rod.

3 "The Atomic Bombing of Hiroshima," Ibid. Many readers will object that I'm citing Department of Energy information, since the DOE is an arm of the same government that carried out the bombing. Some other sources include: Dan Ford, "How many died at Hiroshima?" (Dan Ford is an aviation and military history enthusiast); "Hiroshima and Nagasaki: The Physical, Medical, and Social Effects of the Atomic Bombings" (Committee on Damage by Atomic Bombs in Hiroshima and Nagasaki, 1981, London), cited in "A Photo-Essay on the Bombing of Hiroshima and Nagasaki" University of Illinois.

Additional Sources and Reading:

"The Atomic Bombings of Hiroshima and Nagasaki," Special Manhattan Engineer District Investigating Group, The United States Strategic Bombing Survey, The British Mission to Japan, and the Joint Atomic Bomb Investigating Group (Medical)

Some Banking Industry Sources

2008-09-23T16:52:00.000-07:00

Here's a listing of some sources of information on finance and banking:

Targeted search engine (allows one to search Federal Reserve, Treasury Department, and 19 other specialized sites)
Federal Reserve Bank publications (search all Federal Reserve sites)
Office of Domestic Finance, US Department of the Treasury
Office of the Controller of the Currency (OCC), US Department of the Treasury
Securities Exchange Commission (SEC)
New York State Banking Department
BusinessWeek
Bloomberg
Schema-Root: Financial Services

Internationally, excellent research resources include the International Finance Corporation (World Bank Group) website and the Bank for International Settlements (BIS).

For historical research, try the Economics History (EH) website.

Commercial Banking

2008-09-21T14:17:00.000-07:00

Commercial banking is what we usually think of when we speak of banks: an institution that accepts deposits from customers, and loans those deposits to others at a somewhat higher interest rate. There are many varieties of commercial bank, even within the United States, but the core function is to accept deposits and re-lend the money. Banks may also be involved in the expansion of credit.

Loan Banks

An early form of bank in Britain and North America, loan banks issued paper script backed by surety of real estate, merchandise, or personal security.¹ During the period 1690-1740, businessmen in France and the English-speaking world made many attempts to introduce paper money, and they kept trying despite some disastrous failures (e.g., John Law's scheme). One particular loan bank scheme set up in Massachusetts (the Land Bank, 1740) had people "subscribe" by identifying land they wished to use as collateral, plus 40 shillings for each £1000 subscribed (that's about £1 per £500 lent). The principal was to be paid in 20 annual installments of 5% each, and 3% interest per annum. The loans were to be repaid in "manufactory notes" or hemp, flax, lumber, bar-iron, cast-iron, etc. Evidently these manufactory notes were supposed to be surrogates for actual English money in Massachusetts.²

While the Massachusetts Land Bank and its local rival, the Silver Bank, were liquidated the next year by the application of the 1719 "Bubble Act", another loan bank in Pennsylvania (1722) successfully introduced paper money through small loans. The land used as security for the loans was to be twice the value of the money lent. It has been noted that these early "banks" were not banks as we understand them, but batches of money.³ However, the loan banks served an essential function of creating the financial instruments that would first be used by the banking industry.

Bank of the United States

This was the first and (until 1863) only federally chartered bank in the US; the first one was chartered between 1791 and 1811, and the second was chartered from 1816 to 1841.⁴ It was primarily intended to create a system of accounts in a standardized currency (this would be the US dollar, adopted 1793) and make national credit available. In many respects, the BUS served as a central bank, issuing national currency and serving as the national government's banker. However, in other respects it was merely the largest of five commercial banks, distinguished by its unique federal charter, 20% government ownership, and guaranteed federal acceptance of its notes.⁵ State-chartered banks regarded the BUS as pernicious competition; opposition to it and its successor, the 2nd BUS, became an early sectional issue.

The BUS did play a pioneering, at least in the Usonian experience, in monetary policy. The market for debt was not yet highly developed, and it was not really possible to influence the prevailing rate of interest, but the BUS could "inject" liquidity into the securities market by occasionally becoming involved. Politically, this was explosive, as the bank's opponents argued it was a dangerous plaything of economically useless speculators (and therefore was accused of either causing bubbles and panics, or else--by palliating them--coddling speculation).⁶

Commercial Banking to 1913

Banking has always been heavily regulated; it's just that the regulations are difficult to compare across epochs. The notion that the 19th century was a golden age of laissez-faire is not really accurate. To begin with, while regulations of business were a lot less complicated in the 19th century, they were usually in more sweeping terms: prohibition of branching, or extremely large reserve requirements. Requirements to redeem obligations in specie (gold or silver coin) were such that perfectly legitimate institutions, guilty only of smallness, were vulnerable to being put out of business through peremptory demands on reserves.⁷ While banks did issue their own banknotes until 1913, the federal government began to impose capital adequacy requirements in 1863; these were made progressively more complex to prevent evasion, and to regulate more sophisticated securities markets.⁸ Issuance of notes, before this, was regulated by state laws and banks were regarded by state legislatures as quasi-public entities, especially in the Mid-Atlantic: state legislatures [sometimes] authorized purchases of bank stock for newly-chartered banks, gave special recognition to banks they had chartered, and expected the banks to serve the interests of their respective states. Needless to say, each state had a different regulatory regime, and the regulations changed very often. After 1864, national banking laws effectively eliminated state-chartered banknotes, and regulated federally-chartered banknotes.

Data from EH.net

Click for larger image; units in basis points

During the period between '64 and 1900, national banks became predominant, but did not eliminate state banks; typically, state banks had much lower capital adequacy standards, and were rather more likely to fail. In 1878, 6.68% of state banks (measured by assets) did fail; this is easily the worst year ever for bank failures, and in '77 only 22% of bank assets were in state banks (the corresponding losses for nationally chartered banks that year was 0.38%, the fourth worst for nationally-chartered banks during the period before the Federal Reserve Act. The worst ever for nationally-chartered banks was 0.85% in 1893. In four years, 1867, 1892, 1903, and1905, national bank failures were higher than state bank failures). During the period '63 to 1913, failure rates were very high; this was frequently said to be the result of reserve/capital adequacy requirements that tended to force monetary contractions when economic conditions worsened.

The creation of the Federal Reserve System (1913) meant an authentic central bank governed by policy discretion and countercyclical monetary policy.⁹ Unfortunately, there would be at least two major depressions before the Fed became effective.

Commercial Banking, 1913-present

The enterprise of investment banking and securities dealing expanded rapidly in importance in the early 20th century. Partly this reflected the growth of publicly traded corporations; prior to the Gilded Age, securities trading involved a fairly small number of stable firms. While securities and underwriting are enterprises dating back to the 16th century in Europe, they remained extremely small in scope in the US until the early 20th century.¹⁰ Underwriting was mainly the purview of merchant banks until the capital markets became fairly large and mature, in the early 20th century. Commercial banks tended to dabble in a range of financial operations as they became prominently lucrative, and by 1929, were heavily involved in both marketing stocks from the secondary market (speculating and hedging) and new issues of stock (underwriting). Banks developed notoriety for opaque blendings of these enterprises: use of assets to buy huge tranches of stocks, thereby stimulating the market briefly in order to expedite an initial public offering (IPO), then withdrawing from the market once the offering was sold, or else using the bank assets to "play" the stock market, buy outstanding shares in the inflated markets, and use the profits to manage a leveraged buyout of the bank on behalf of management.¹¹

In the years sandwiching the abolition of the Glass-Steagall Act, a lot of papers were published at the Federal Reserve or the Department of the Treasury that sounded as if they'd been written by commercial bank spokesmen.¹² Mostly these are methodologically flawed; for example, the whole point of conflict of interest between dealing securities (on the one hand) and underwriting them (on the other), or underwriting securities and lending money to the same firms, is not that the company involved is liable to do more poorly than the market, but rather, that it has such an unfair advantage that there is a generalized misallocation of resources. When a company is not allowed to fail because it would be too expensive for its sponsoring bank to let it; and if the sponsoring bank has the ability to pump gigantic sums of money into the enterprise until it's viable (perhaps because it has market dominance), then that's a deadweight loss for the economy. This is, after all, the main rationale for why command economies are unsuccessful.

In the event, financial institutions of the 1920's were Petri dishes of conflicted interest.¹³ While the Glass-Steagall Act was also accompanied by deposit insurance, which has played an important role in the stability of commercial banks, the G-S period of banking was a period of unusual banking stability. It may be said to have ended with the Garn-St. Germain Bill of 1982, which created a dangerous loophole for thrifts.

The Glass-Steagall Act of 1933 was an early New Deal measure. As with any public policy, it suffered from several flaws; much of the early New Deal itself was unguided by any compelling sense of direction. However, it transformed banks back into quasi-public institutions. Commercial banks were staid, cautious, and transparent. They seldom failed, and they were not big innovators.

Thrifts

Thrifts (Savings and Loan Associations) are a separate category of retail bank. Initially they were non-profit societies that took deposits and made loans. They require a separate entry.

NOTES:

1 Davis Rich Dewey, The Financial History of the United States, 8th ed., Longmans, Green & Co. (1922), "Loan banks," p.24. Link goes to complete text online. The book, by the way, is one of the most poorly written I've ever seen.

2 England and Scotland were merged politically in 1707 after being
under identical monarchs for 106 years. The Royal Bank of Scotland and the Bank of Scotland issued pound notes identical in value to the English pound for centuries. The North American colonies had been created as private ventures under patent to the Crown, and officially subordinate to it (rather than Parliament); the colonies during this period had their own respective currencies, and sometimes more than one (e.g., Connecticut had its own pound and dollar). The provinces of Canada mostly used banknotes from the southern colonies (chiefly Massachusetts, which first issued them in 1690) , and after 1812, from their own respective provincial banks. Montreal's banks furnished most of the early dollars used in British North America, but the Maritime provinces also issued their currency, denominated in pounds. See James Powell, A History of the Canadian Dollar, Bank of Canada (2006?), "British Colonies in North America: The Early Years (pre-1841)." Link is to complete text online.

3 For example, Theodore Julius Grayson, Leaders and Periods of American Finance, Ayer Publishing (1969), p.14.

4 David Cowen, "The First Bank of the United States," EH.Net Encyclopedia, ed. by Robert Whaples (16 March 2008)

5 Robert Wright, "Origins of Commercial Banking in the United States, 1781-1830". EH.Net Encyclopedia, (26 March 2008). By 1799, the number of commercial banks in the US had risen to 33; at the time of its charter, however, the BUS was much larger than the four other banks combined (measured by capital). In 1796, the US government divested much of its stock to raise money for debts outstanding to the BUS.

6 Robert Sobel, Panic on Wall Street: A History of America's Financial Disasters, Beard Books (1988; link goes to '99 edition), "William Duer and the Panic of 1792"

7 For example, most banks issued their own banknotes prior to the 1863-1864 National Banking Acts. In New England, banks were extremely small and had no branches; banknotes from "country banks" were difficult to redeem. In 1818, the Suffolk Bank was chartered in Boston and devised an arrangement with other banks whereby it would handle redemption of most notes. In this way, the Suffolk Bank could send agents to banks in rural areas with huge amounts of banknotes from that bank, and demand specie redemption at once. Since the banks could not meet the demand, they were compelled to join the Suffolk redemption scheme, which of course imposed its own regulatory regime. See Howard Bodenhorn, "Antebellum Banking in the United States," under the entry for the "Suffolk System." Here, of course, the Suffolk System was a monopoly arrangement with kickbacks to big banks upon whom the Suffolk Bank relied.

There is a famous period of "free banking" in the USA (1837-1863), when only state-chartered banks existed. In some states, for a time, it was possible to form savings associations under very minimal regulations. See Gerald P. Dwyer Jr., "Wildcat Banking, Banking Panics, and Free Banking in the United States" (PDF), Economic Review, Federal Reserve Bank of Atlanta (Dec 1996). However, what free banks could actually do was very highly restricted.

8 Richard Grossman "US Banking History, Civil War to World War II"; mostly addresses regulation.

9 "Countercyclical" means that the policy taken by the authorities (either in the money supply or aggregate demand) is in opposition to, and therefore counteracts, the [business] cycle. For an explanation of the general concept, see Satyajit Chatterjee, "Why Does Countercyclical Monetary Policy Matter?" (PDF), Business Review Federal Reserve Bank of Philidephia (1Q 2001). On the effectiveness of the Fed in preventing or causing depressions, see Milton Friedman & Anna J. Schwartz, A Monetary History of the United States, 1867-1990, Princeton (1971), Chapter 7. While there is ample criticism of F&S's thesis, this part of it is not very controversial.

The caption to the chart includes a link to the EH.net article with the source data, but I used an Excel spreadsheet to determine the rates of banking failure.

The Federal Reserve Act of 1913 was drafted by Rep. Carter Glass (R-VA), who later developed the Glass-Steagall Act (1933). See James McAfee, "'These Gambling Activities': Carter Glass and the battle to rein in the banking industry" The Region Federal Reserve Bank of Minneapolis (March 2000).

10 Getting a grip on the comparative size of securities dealing is extremely difficult. Most histories like to cite some amazingly early date, such as the founding of the Amsterdam Stock Exchange in 1531, or the Buttonwood Agreement that created the New York Stock Exchange (sort of) in 1792. Sobel (1988; see note 6) mentions several manias that gripped New York City or the nation, but these either (a) involved very small numbers of people, or (b) were a transcient fad, like the "scriptomania" of 1792. When an enterprise like securities dealership to the general public becomes economically significant, it tends to come under regulation. This first took place in Kansas ("A Brief History of Securities Regulation," State of Wisconsin Department of Financial Institutions). The SEC was created in 1933, and established minimum national standards for the first time in US history.

11 Merchant banks are actually the oldest types of banks; underwriting was first carried out in an orderly fashion by them. See, for example, Ron Chernow, The House of Morgan: An American Banking Dynasty and the Rise of Modern Finance, Grove Press (2001), pp.23-28; Chernow mentions (p.225) that national banks were prohibited from underwriting or securities dealership, but could own subsidiaries that did either. See also L M Bhole, Financial Institutions and Markets: Structure, Growth and Innovations, Tata McGraw-Hill (2004), p.13.28ff

12 An especially cheeky example is Assistant Secretary for Financial Institutions Richard S. Carnell's remarks at the Women in Housing and Finance Symposium (9 Feb '96); here is an example of someone supposed to be in charge of regulating financial institutions, fulminating at the sheer stupidity of regulations entirely. Anti-regulation articles at the Federal Reserve include David P. Ely & Kenneth J. Robinson, "How Might Financial Institutions React to Glass–Steagall Repeal? Evidence from the Stock Market" (PDF), Financial Industry Studies, Dallas Fed (Sep 1998), p.1 (PDF-page4); Luca Benzoni and Carola Schenone, "Conflict of Interest and Certification in the U.S. IPO Market" (PDF), Federal Reserve Bank of Chicago (Sep 2007). Note that Benzoni & Schenone's review of the literature includes no papers critical of the repeal of Glass-Steagall. Finally, there is this bio of Carter Glass at the Federal Reserve Bank of Minneapolis--a singular case of remorseless character assassination by an institution that normally is highly indulgent of reactionary tendencies. (Like most Southern politicians of the early 20th century, Carter Glass was in favor of segregation; while this has no relevance to the Glass-Steagall Act, the Minneapolis Fed resorted to trumpeting it violently in order to demonize the act itself).

13 On evidence of such conflicts, one scarcely knows where to begin. Ron Chernow's The House of Morgan, p.174ff; Sobel's Panic on Wall Street, Chapters 8-11; Burton Malkiel, A Random Walk Down Wall Street, W. W. Norton & Company (2004), p.183ff; for non-Usonian examples, see Stefano Battilossi, "Corporate Governance, Moral Hazard and Conflict of Interest in Italian Universal Banking, 1914-1933" (PDF) University of Madrid (Feb 2003).

SOURCES & ADDITIONAL READING:

EH.Net Encyclopedia

Howard Bodenhorn, "Antebellum Banking in the United States" (26 March 2008)
Richard Grossman "US Banking History, Civil War to World War II" (16 March 2008)
Elmus Wicker "Banking Panics in the US: 1873-1933" (5 Sep 2001)
Robert Wright, "Origins of Commercial Banking in the United States, 1781-1830" (28 March 2008)

Milton Friedman & Anna J. Schwartz, A Monetary History of the United States, 1867-1990, Princeton (1971), esp. chapters 2-4. F&S find the Greenback period (1863-1879) extremely interesting, and it receives almost as much scrutiny as the onset of the Great Depresssion (1929-1933); writing in 1971, they were totally amazed by the idea of freely floating, non-redeemable currency, with inflation rates of almost 4.5% annually. This is, of course, the way things have been for the last 35 years.

Epitaph for an Industry: Investment Banking

2008-09-20T21:29:00.000-07:00

Investment banks have long been separated from commercial and savings banks by federal law. When we speak of a "bank," we usually think of a business that takes money from depositors (savings accounts, savings accounts, money market accounts) and lends to other entities. The bank's income comes from the spread between the interest rate it pays on deposits, and the [higher] rate it charges on loans. This is not what investment banks do.

Deserted interior,
Lehman Europe HQ, Sep 2008

Click for larger image

An investment bank's customers are corporations issuing stock, bonds, or paper.¹ When a company wants to issue stock, it approaches an investment bank to raise the money. The investment reviews the prospectus for the issuing firm, carries out its own research, and determines how much money can be raised on the capital (stock) or money (bonds, paper) markets. It draws up the actual securities and buys them from the client, then sells the securities on the capital markets. The difference between the face value of the stocks and their sale price is the IB's main source of revenue.

If the share issue is quite large, then the IB usually spreads the risk through syndication. The primary IB in contact with the issuing firm contacts other IB's and invites them to buy a share of the security issue; in the case of paper, the issue is routinely absorbed by a money market fund.² Members of the syndicate usually make a firm commitment to distribute a certain percentage of the entire offering and are held financially responsible for any unsold portions. Selling groups of chosen brokerages assist the syndicate members meet their obligations to distribute the new securities. Members of the selling group usually act on a "best efforts" basis and are not financially responsible for any unsold portions.

IB's are not a very large sector of the Usonian economy: about $200 billion in total revenues for 2006,³ or probably 31% the size of the commercial banking sector.⁴ Fannie Mae and Freddie Mac belong to neither sector. However, the smallish revenues belie the great importance of this business to the world economy. The US IB sector is immensely important to the coordination of capital markets; it mediates the best available data on sector growth in other industries, soundness of management at individual firms, etc., into capital allocation (bond and stock issues). Commercial banks traditionally address more routine needs for loans; they are usually more interested in the firm's balance sheet, rather than its long-run outlook for expansion or diversification. In a way, IB represents a disembodied and convicted guide to world industry, a not-so-invisible hand with its own peculiar ideological proclivities.

One of the most important New Deal measures was the Glass-Steagall Act (1933), which created firewalls between the different functions of banks. The most important of this was between investment banking and commercial/savings banking; another isolated financial firms generally from non-banking activities. After 1960, the Glass-Steagall Act was eroded by loopholes, until the last barriers were dissolved (1999); the financial services industry was opened up to homologization. There was an immense spike in the number of mergers, and in the value of the deals.⁵ Nearly all recent literature reviewed (i.e., published pre-2008) is emphatically in favor of even more consolidation, with the claim that further homologization in the financial services industry has created intense competition. Judging by the Japanese experience of the late '90's, it seems plausible that the banking regulators will see consolidation as a low-cost way of resolving bad balance sheets.

As of this writing, the IB industry has been almost completely annexed to other financial services, and we can safely assume the age of the universal bank/financial supermarket has arrived. On Wall Street, only two independent investment banks remain: Morgan-Stanley and Goldman-Sachs; the latter is extremely well-connected politically.⁶

NOTES:

1 "Paper" (commercial or government) is short term debt; it is usually acquired by money market funds, because it affords extremely low risk.

2 Money markets deposit accounts were an early breach in the wall between investment and commercial banking; they were accounts offered by banks whose value was tied by an index to the money market funds (1982; "Money Market Deposit Account," Financial & Investment Dictionary). They are required by law to invest in federally listed low-risk securities, of which paper is a major part. See "Money Market Funds," US Securities Exchange Commission, specifically the "Investment Company Act of 1940" (PDF). Commercial paper is not a very important market; it only accounts for $150-200 billion dollars of debt at any time (Federal Reserve). Money market fund balances are around $3.2 trillion (retail + institutional); see "Economic Indicators," GPO (July '08); they've become a rather important component of M3.

3 US Bureau of the Census, Economic Survey 2006, NAICS 52 (PDF).

4 US Bureau of the Census, Economic Survey 2002, NAICS 522110; unfortunately, the latest available commercial banking revenue data is for 2002. IBISWorld estimates 2005 revenues at 635.9 billion for '05.

5 Data on M&A activity specific to banking is proprietary; however, one source is Steven J. Pilloff, "Bank Merger Activity in the United States, 1994–2003" (PDF), Board of Governors of the Federal Reserve System (May 2004). The largest spike was in 1998, the year before the much-anticipated dissolution of Glass-Steagall. However, this was mainly due to the merger of CitiCorp with Travellers.

6 Well connected politically: e.g.,

Treasury Secretary Henry Paulson is a former CEO;
White House Chief of Staff Josh Bolton is a former executive director;
Asst Secretary of Treasury Neel Kashkari (Financial Stability) is a former VP at Goldman Sachs. He was appointed to this job by his once-and-present boss, Henry Paulson, 8 October (yes, this is an update);
PFIAB Chair Stephen Friedman, previously Chair of the National Economic Council (NEC), has worked most of his live in executive positions at Goldman Sachs. The PFIAB stands for "President's foreign intelligence advisory board"
World Bank President and US Trade Representative Robert Zoellick is a former managing director;
New Jersey Gov. Jon Corzine is a former senior partner.
Former partner Robert Rubin was President Clinton's Treasury Secretary.

Conversely, E. Gerald Corrigan, once President of the Federal Reserve Bank of NY, is now a Goldman-Sachs Partner.

ADDITIONAL READING:

Steven Druckera & Manju Purib, "The Tying of Lending and Equity Underwriting" (PDF), Federal Reserve Bank of Chicago (2004)

Peter Thal Larsen & Francesco Guerrera , "Investment banks’ future questioned," Financial Times (18 Sept 2008)

Notes on a Meltdown

2008-09-17T21:07:00.000-07:00

First things first: how to describe the current crisis in global finance? Here are some of the events under consideration:

Washington Mutual, IndyMac, Wachovia: over-leveraged banks; WaMu has lost 96% of its market value (BW), while IndyMac (BW) was seized by the Feds and Wachovia implodes (NYT).
American International Group (AIG): extremely large insurance company; received $85 billion loan from US Treasury (17 Sept; BusinessWeek-1, -2, -3); >$1 trillion in assets; expected to be broken up;
Lehman Brothers Holdings: bankrupt (15 Sept); investment banking and trading divisions acquired by Barclays (BusinessWeek/AP);
FNMA "Fannie Mae" and FHLMC "Freddie Mac": see separate article
Merrill Lynch: avoided bankruptcy by merger with Bank of America (MW, 14 Sept) after losing almost $20 billion between July '07 and July '08 (BW).
Bear Sterns: bankrupt (Mar 14); JPMorganChase has acquired the firm (BusinessWeek).

This is not [entirely] confined to the USA: "Germany Dreads Financial Meltdown" (Der Spiegel); "Russia's financial crisis" (al-Jazeera video) "Russian Stock Market Plummets" (Russia Today video); "China's Stock Market 'World's Worst' In '08" (NTDTV video); and so on. The overseas effect appears to be mostly hidden from view, since bailouts in most developed countries are carried out secretly.

However, it appears so far that financial contagion originated in the USA and spread to other countries via their immense holdings of dollar-denominated assets. A logical corollary to this, in my view, is that for decades assets based in the USA and denominated in dollars were so popular that, despite our immense and growing trade deficit, non-Usonians would buy financial assets with the huge pools of dollars they acquired from ordinary business. Now, it seems as though dollars will be seen as having the same systemic risk as Korean won or Thai baht.

SOURCES & ADDITIONAL READING:

"FACTBOX: Government bailout tally tops $900 billion" (Reuters)

Fannie Mae and Freddie Mac

2008-09-10T21:07:00.000-07:00

The Federal National Mortgage Association (FNMA) was created in 1938 by Act of Congress. The purpose was to purchase loans from conventional lending institutions, such as thrifts, thereby reducing the risk to the firm originating the loan. In order to ensure the loan was worth something, the new Federal Housing Authority (FHA) investigated the terms and the property before permitting the FNMA to buy the loan. In a very short time, the FNMA became a de facto monopoly for home loans, even though it did not originate any; all of the nation's lending institutions simply deferred to its FHA guidelines on making loans, and then passed them on to "Fannie Mae." In 1944, VA loans were added to the FNMA portfolio.

This is credited with stimulating a postwar boom in new housing; loans were now virtually risk-free to the originator, and easy to obtain.

In 1968, Fannie Mae was privatized; at the same time, a large segment was spun off as the Government National Mortgage Association (GNMA), which remains a division of Housing and Urban Development (HUD). GNMA specialized in special government development programs and higher risk loans; by 1997, it (rather than Fannie Mae or Freddie Mac) handled 95% of FHA loans, and 13% of residential loans.¹ Ginnie Mae does not buy or sell loans or issue mortgage-backed securities (MBS); instead, it guarantees loans for fourth party issuers such as Countrywide or Wells Fargo.²

Two years after the split/privatization of Fannie Mae, the Federal Home Loan Mortgage Company (FHLMC, or "Freddie Mac") was created by Congress explicitly for the savings association system (thrifts).³ Freddie Mac usually buys loans with higher credit ratings than Fannie Mae does, and it favors special savings association loans; according to Wikipedia entries, the 2007 assets of Fannie Mae were $882 billion, and those for Freddie Mac were $794 billion.

Freddie Mac and Fannie Mae are both known as government-sponsored entities (GSE's); in addition to the $1.68 trillion in assets that they hold in their portfolios, they sell an immense number of MBS's. Ginnie Mae, as mentioned above, contracts out the mortgages to fourth parties; assets held by it are not available.

A Brief Description of Mortgage-Backed Securities

When a mortgage is purchased by the GSE's, it becomes part of an immense pool of assets. This pool is divided into numerous subdivisions based on comparative risk; tiny pieces of the total are sold off as securities. The risk of default on any loan is distributed therefore evenly across all of the loans in the pool. MBS are commonly referred to as "pass-through" certificates because the principal and interest of the underlying loans is "passed through" to investors. The interest rate of the security is lower than the interest rate of the underlying loan to allow for payment of servicing and guaranty fees. Ginnie Mae MBS's are guaranteed by the full faith and credit of the federal government. Whether or not the mortgage payment is made, an investor in a Ginnie Mae MBS will receive payment of interest as well as principal. In the case of Fannie Mae/Freddie Mac, there is considerable variation in available instruments.

In 1983, Freddie Mac introduced a variation on the MBS called a "collateralized mortgage obligation" (CMO). The CMO segments the cash flows from the underlying block of mortgage loans into four basic classes of bonds with differing maturities. Prior to the CMO, FNMA and FHLMC issued plain vanilla MBS's like the ones described above. The CMO prioritized payments received; high priority meant low risk (and therefore, low—but reliable—ROI), while low priority meant high risk (and therefore, potentially high ROI).

The GSE's: Public or Private?

Ginnie Mae is a division of the Department of HUD; it's obviously a public sector entity. It carries no MBS's on its balance sheet. Fannie Mae and Freddie Mac became private sector entities when they issued public offerings of stock (1968 and 1970, respectively). Incidentally, I've noticed some confusion between "private sector" (which means, "non-governmental, for profit") and "privately held" (which means, there is no publicly issued stock in the firm). A publicly-held corporation usually is run for a profit, but has traded shares; a privately-held corporation is also run for a profit, but it's not possible to buy shares in that company. The GSE's were publicly traded until the recent melt-down wiped out 99.4% of their value.

However, as private-sector entities, there were some peculiarities about the GSE's:

Five members of the board of directors (a minority) were appointed by the White Houst e;
The Secretary of the Treasury could invest up to $2.25 billion in GSE securities;
They were exempt from corporate income taxes;
Their debt securities were eligible as collateral for federal government deposits of tax revenues in private banks;
Risk-weighting of their securities was only 20% for banking capital, as opposed to 100% for private-sector companies (under the terms of the Basel 2 Accords—PDF)

The last point is somewhat arcane, but the Basel Accords (1 & 2) were agreements to regulate the capital requirements of banking institutions worldwide; the purpose was to ensure that banks based in countries with lax standards would not have a competitive advantage vis-à-vis banks based in countries with sound standards. Banks based in the USA were allowed to use GSE shares to meet capital adequacy standards, with the understanding that GSE shares were effectively gold-plated.

Not surprisingly, the GSE's were regarded with hostility by the rest of the financial sector since they competed on a very uneven playing field. While lobbyists for the GSE's argue that the above features ensured that their funds cost the government nothing (and Fannie Mae/Freddy Mac were required to warn investors that their issues were not backed by the federal government), the Congressional Budget Office estimated that the opportunity cost to the federal government amounted to $6.5 billion annually (1996), of which $4.4 billion was passed through to customers. A 2001 survey revised the estimate slightly downward, to $5.4 billion in '95 and $10.6 billion in '00. Projections in the same report suggested this would reach $13-16 billion by '08.

There's some controversy over the cost of this. The CBO's estimates include a few hundred million in lost tax revenues, combined with several billions in opportunity costs. In other words, either the GSE's ought to have done something more with the off-book assets they enjoyed (e.g., used their fiduciary role to require better urban design, and subsidized the marginal cost) or else given the federal government the money. The money was "captured" from the financial services industry and its customers by the peculiar financial advantages the GSE's enjoyed.

NOTES:

Fourth party issuers: the first party is the home buyer; the second is the firm that originates the loan. GNMA (third party) guarantees the loan, and the approved issuer (say, Countrywide or Wells Fargo Home Mortgage) issues the actual GNMA MBS. Countrywide was the largest approved issuer in '07, writing $20.6 billion in MBS. The fifth party is anyone who buys the MBS.

ROI: return on investment; the payoff of an investment.

1 John W. Reilly, The Language of Real Estate, Dearborn Real Estate Education (2000), p.181

2 GNMA home page

3 "Savings and Loan Associations," US History Encyclopedia; captured from Answers.com

SOURCES & ADDITIONAL READING:

NYT: Fannie Mae, & Freddie Mac; see also Eric Dash, "Federal Mortgage Success Stories" (9 Sep 2008) on "Ginnie Mae" & "Farmer Mac"

Reuters: "FACTBOX: Government bailout tally tops $900 billion" (16 Sept 2008)

John W. Reilly, The Language of Real Estate, Dearborn Real Estate Education (2000)

Congressional Budget Office, "Assessing the Public Costs and Benefits of Fannie Mae and Freddie Mac" (May 1996)

Freddie Mac, "Information Statement" (PDF), includes general reference on firm (26 March 2001)

Epilogue to Oil Speculation

2008-08-22T00:44:00.000-07:00

During recent months the world has experienced something of a roller coaster on oil prices.

Click for larger image—Note baseline is 50

I've been very skeptical of allegations that speculators are to blame for this, although in previous entries I've examined ways in which they might have (1, 2, 3).

I believe I've exhausted that subject. Since mid-June, when I last wrote about the subject, oil prices have completed a mini-spike (from a base of $122/bbl on 5 June to a peak of $147 on 11 July), and subsequently fell to levels first seen in March. At the same time, the euro has also retreated to March levels.

(The euro-denominated price of oil rose 84% as much as the price in US dollars, using 2005 as a baseline.)

However, it is probably worth noting recent disclosures about a firm called Vitol (Switzerland). Vitol's oil trades were investigated by the Commodity Futures Trading Commission (CFTC):

WP (via War & Piece): The CFTC, which learned about the nature of Vitol's activities only after making an unusual request for data from the firm, now reports that financial firms speculating for their clients or for themselves account for about 81 percent of the oil contracts on NYMEX, a far bigger share than had previously been stated by the agency. That figure may rise in coming weeks as the CFTC checks the status of other big traders.

Some lawmakers have blamed these firms for the volatility of oil prices, including the tremendous run-up that peaked earlier in the summer.

"It is now evident that speculators in the energy futures markets play a much larger role than previously thought, and it is now even harder to accept the agency's laughable assertion that excessive speculation has not contributed to rising energy prices," said Rep. John D. Dingell (D-Mich.). He added that it was "difficult to comprehend how the CFTC would allow a trader" to acquire such a large oil inventory "and not scrutinize this position any sooner."

BTW, please observe the special focus from Michigan congresspersons: oil prices have been especially devastating to Usonian car manufacturers, who have lost market share to better-engineered Japanese models.

Vitol was implicated in the UN "oil-for-food" scandal associated with the sanctions regime imposed on Iraq between June 1990 and March 2003.

IHT (20 Nov '07): Prosecutors alleged that Vitol, through an associated entity or third parties, paid $13 million in kickbacks to Iraqi officials in connection with oil purchases under the program from June 2001 through September 2002, but allowed false representations to be made to the U.N. that no kickbacks were paid.

Vitol's case is one of several that are the result of a wide-ranging criminal probe into the oil-for-food program.

Last week, Chevron Corp. agreed to pay $30 million (€20.2 million) to settle civil and criminal charges related to secret surcharges paid by third-party merchants in exchange for oil under the program.

While it's not obvious to me how the oil-for-food corruption is linked to illegal trades, it's hard to imagine how I can avoid mentioning it.
_______________________________________

All the same, while Vitol SA was able to briefly take a position on >11 million barrels of oil, the CFTC maintains that the real reason for the recent spike in petrol prices was supply and demand. So, while I'm aware of the Vitol story, I'm sticking to my original position.
_______________________________________
ADDITIONAL READING
David Cho, "A Few Speculators Dominate Vast Market for Oil Trading" Washington Post (21 Aug 2008)

Ann Davis , "'Speculator' in Oil Market Is Key Player in Real Sector" Wall Street Journal (20 Aug 2008)

Pochade Boxes

2008-08-18T15:48:00.000-07:00

Click for article + larger image

Click for larger image

From Lines and Colors, a lovely article about pochade boxes. They're compact kits used for painting outdoors or in museums, and according to the referenced article, there's recently been a flourishing of both the use of such kits, and improvements in them.

Pochade boxes are generally supposed to be actual boxes, with more-or-less detachable bases; they are not to be confused with the much larger "French easels" (see second figure), which include adjustable clasps for larger canvases.

Canvases have long been available either as a stretched sheet over a wooden rectangle (which is what you usually encounter in the museum), or stretched over firm cardboard, masonite, or whatever. The later are thin and stiff; the former are typically about 20 mm thick and require a special grip. Traditionally, pochade boxes used the latter, thinner panels.

I'm not going to duplicate Mr. Parker's work; it's a long article, and explains a little bit about the specialized types of boxes and their advantages. There was one he plugs towards the end, the Alla Prima, which does indeed impress mightily for cleverness and beauty. He also includes some discussion at the very end on kits for do-it-yourself boxes.

This reminds me that it has been much too long since I've done any serious artwork of my own.

Searchme, etc.

2008-07-29T01:49:00.000-07:00

Via PC Mag.com, word of a handy visual search engine SearchMe. Enter the search term, and you can scroll horizontally through captures of web pages with the search term. The page uses Apple's Cover Flow interface to display results.

There's another site, Viewzi, which is a metasearch engine (meaning, it recovers results from multiple engines) and displays them in any of several different formats. Here are a few examples (click for larger screen captures):

*Web Screenshot*	*Basic Photo*
*Four Sources*	*Timeline*

There are actually many more viewing options besides these; some are suited for searches of iTunes, etc.

Another recommended site was Howcast.com, which includes detailed video instructions of how to do various things. Howcast includes some absurd topics, like "How to write truly tasteless wedding vows," so caveat emptor.

Robert Blinn on sustainable design

2008-07-03T21:54:00.000-07:00

The truth of the matter is that environmentalism and ecological sustainability is a huge subject—indeed, it's the largest possible subject. First of all, there's the problem of competing goals: should environmentalism seek to challenge the basic structure of society, on the grounds that it's in an inescapable conflict with sustainability? Or is the object rather to make other social decisions (such as they are) sustainable through [technical] engineering? Then there's the point of view of scientists evaluating costs and benefits of mitigation plans: do we focus on greenhouse gas abatement or toxin abatement? habitat preservation or emissions regulation?

In my "Cataclysm" series (link is to part 1) I wrote about ways of thinking about technology. In "Jevon's Paradox" I discussed at least one very important obstacle to engineering our way out of environmental catastrophe. Robert Blinn, writing at Core77, also introduces the economic conflicts with environmental protection.

When mankind took up only a small portion of the planet, our growth could subsist on the losses of the far larger animal population. Now, instead of displacing the habitats of others, we're beginning to disturb our own. The "commons" were so large relative to us that our abuses were barely noticeable, but now that we're over six billion strong, our damage is starting to show. We're contributing to what's being termed the anthropocene era, where human pollution is influencing the geological fate of our planet. The commons can no longer afford to be discounted; they're all we have.

The tragedy of the commons is a type of collective action problem, a social trap where all parties agree that action should be taken, but gains will not be realized unless they all act as one. While each player knows what would be best for the communal good, self-maximizing choices fail to realize the optimal outcome for all parties.

In practical experience, there really is no resolution to the Tragedy of the Commons besides some enlightened state or meta-state; and even this approach has severe shortcomings.

Looking at the world through such a lens makes one thing clear: Despite our mansions and our roadways, our designer jeans and our iPhones, human beings have made very little. Instead we've transmuted stored energy into temporary value in exchange for long-term waste...It burns stored solar energy to provide the illusion of growth. The amount of stored energy, real value, in the world is actually shrinking. Our process of "growth" is entropic, creating local pockets of order at a greater net cost in energy.

In the comments section that follows, there seems to be some confusion about the idea of zero-sum phenomena in economics. Blinn refers to the consumption of fossil fuels, which represent solar energy in a very concentrated form.

A basic concept in economics is the idea of future discounting. You can't have your cake and eat it too; and usually economists assume you'd prefer to eat it (now), since future consumption is always valued less than present consumption. Likewise, consider the oceans: they're an example of the commons. The oceans allow for massive movements of their own resources, such as fish, over vast distances. Hence, there's no way of staking a claim over a segment of the ocean's resources and protecting it as private property. Individuals have a personal incentive to extract as much value as possible from the commons for their own use. While oil fields are controlled by nation-state "owners" of the surface, the zero-sum issue arises with present-versus-future consumption of such a valuable resource.

I had some semantic issues with Blinn's use of the term "zero-sum." His definition of the term (and re-definition for commentor John) didn't make clear that zero-sum transactions do include situations where both parties capture some utility; an example is terms of trade between two mineral-exporting countries. Since they cannot really increase production over the short run, their wealth depends on the comparative value of their own respective mineral. If one country exports gold and the other oil, an increase in the demand for gold will necessarily reduce the real wealth of the oil-exporting nation (since it has to pay for gold with exports of oil). The other problem is fairly basic: the increasing-sum component of the modern world economy arises from the ability to add some value to a product that is greater than the cost of the raw materials. It's not inconceivable that a future USA could consume less of every type of raw material, and still have a higher GDP: improvements in economic or technical efficiency could lead to lighter products of superior usefulness.

How to Use LinkedIn

2008-06-21T18:34:00.000-07:00

LinkedIn is a website used for access to people who can help with job searches. The object is to furnish a professional introduction online that will help you to put your best foot forward. LinkedIn is specifically designed for job searches and business connecting. It allows one to manage recommendations, an interactive résumé, and third-party connections.

It's actually fairly well-conceived. After being invited to join, one can accept and create a profile for oneself. The profile includes an online resume (you can select what is visible to whom); and a listing of your contacts. You can search for people you remember the names of, or you can look up the listings of members by employer, city, and industry. If they aren't already registered, you can invite them to join; actually editing their own page may occur much later.

LinkedIn follows a pattern that is becoming very standardized with sites such as YouTube, Flickr, and Facebook. Members have the option of carefully formatting their page and uploading content, but are under no obligation to do so. Registering allows one to access the content of invites or organize links to favorites (e.g., photos on Flickr, videos on YouTube). Amazon is moving towards full-fledged social networking, with the profile pages that link to friends or "interesting people" (meaning, you can link to them unilaterally). For years I've been posting reviews; now I can really go nuts with lists of books, and so on. I can also link to different social networking sites, including, naturally, this weblog.

Another fairly important feature of social web sites is that many can be linked together through iGoogle. The obvious example is the link between Digg and Facebook; when you Digg an article, a link to it appears in your Facebook minifeed (explained here).

Unfortunately, this doesn't really eliminate the business of contacting employers with customized cover letters that must arouse interest without aggravating. I find that sort of thing utterly dispiriting.
__________________________________________
ADDITIONAL READING & SOURCES:

Guy Kawasaki, "Ten Ways to Use LinkedIn" How to Change the World (Jan 2007). Kawasaki makes several unsupported claims, and I'm not interested in trying to defend them. He mentions that one can use LinkedIn to increase one's Google page rank. This is especially effective, he argues, because the page ranking of LinkedIn is itself quite high.

Another point he makes is that "People with more than twenty connections are thirty-four times more likely to be approached with a job opportunity than people with less than five." This seems implausible to me; and there's no source for this claim. "Approached with a job opportunity" can include unwelcome spam to join an MLM, anyway.

The Social Laffer Curve

2008-06-20T21:52:00.000-07:00

Click for larger image

This was borrowed and adapted from
Monissen (1999)

Click for image source

Wikipedia: Revised version of Martin Gardner's
Neo-Laffer curve.

The Laffer Curve was intended to illustrate a correlation between tax rates as a share of GDP and tax revenue. The x-axis is supposed to represent taxes as a share of GDP, and the y-axis is supposed to represent tax revenue. The problem with the Laffer curve is pretty severe: even as a thought experiment, it's impossible to map out an observable y-axis. Suppose we take a unitary government with a total overall tax rate of 0.75 of GDP (see upper figure). We surmise that the peak of the curve is at .55, and at 0.33, it's back down to whatever it was at x = .75. If that's true, then the effect of cutting taxes 26.3% is an increase in revenue to the state, and the effect of a halving taxes is to make revenue the same. This cannot be what Arthur Laffer meant, of course; surely some time is required before the tax cuts work their supply-side magic.

Ah, then in that case we have to say that the tax base is increasing now because the tax cut stimulated investment and labor. So what are we saying the y-axis measures? It must be tax revenue at some as-yet-unspecified future date.

I could be very generous and surmise that the Laffer Curve is based on the Ramsey-Cass-Koopmans model (which is pretty fundamental to modern economics), and that the values of y corresponding to each value of x are determined by the usual utility-maximizing objective function; at some point in the future the labor market reaches a new equilibrium of output at which point revenues reach their new equilibrium as well. But, in such a case, the derivative of the curve at each point is dependent on conditions under which taxes are cut or raised, and on expectations of future tax increases.¹ This means that the derivative is entirely indeterminant, and hence the function that the Laffer Curve is supposed to represent has no fixed value. In other words, there's no sense in which the y-axis means anything at all.²

Even intuitively it is not much help because there's no consideration of what the government actually does with the money, which may be more important than the precise amount levied or raised. That's even assuming all the economic assumptions that orthodox economists make.

Aside from the trivial observation that tax rates of 0 or 100% of GDP will fetch zero revenues, while for rates between % and 100%, it'll be >$0, the Laffer Curve says nothing.

A Possible Analogy to the Laffer Curve
A modest proposal

Now, let's look at the Laffer Curve as a measure of social policy. We could say that the x-axis represents the rate of government spending on social welfare per person. We make some minor assumptions:

social welfare spending mostly targets illiteracy, preventable diseases, and other obstacles to earning a living;
social welfare spending has some marginal utility; it might not be perfect, and we assume there is some waste, but more spending in any given time period t_i leads to greater income in period t_{i + 1.}

In that case, it is reasonable to expect that if social welfare spending G_i is 0% of GDP, then total income will be low since poverty rates will be high and have dire consequences for civil order. If social welfare spending G_i is 100% of GDP, then the customary incentive effect is going to be bad, as everyone would expect: everyone is guaranteed everything that they could possibly have to consume, so productivity wastes away (albeit, probably not to nothing). For that matter, bureaucrats would probably be the worst offenders, so we'd never reach that point, but if we did, it's not controversial to claim that the economy would grind to a halt.

But in between there is going to be an optimal level of social welfare spending which might possibly be measured in terms of the total factor productivity (TFP), or perhaps an index that incorporates TFP and the human development index (HDI). Growth rate, in my opinion, is not really useful because so many things affect growth rates, such as saving (which can be distorted upward by the absence of a social welfare system, as it is in China, or distorted upward by the presence of one, as in Scandinavia or Japan).

So what about TFP? Why is this important?

It's not as important as the actual well-being or sense of connectedness that people in a [morally] good society feel towards their neighbors, but TFP may well be a good numerical surrogate. That's because TFP measures the effectiveness of utilization of economic inputs. In a society where crime rates are high, the GDP will be padded by spending on law enforcement, courts, and corrections. Since it is necessary, the money will be spent, but it will not contribute to productivity. Likewise, if the polity refuses to spend money on education for the ignorant masses, then productivity increases may occur, but they'll be mainly caused by the accumulation of capital (which is subtracted from productivity growth to get TFP). Also, extreme misery among the permanently poor and hopeless will require an immense wall around the squalid quarters where they live, wastage of money on armored Hummers for the affluent (to avoid getting carjacked and held for ransom), a less efficient transit system, a less efficient sewage and drainage system (with every house needing its own septic tank, whether the water table can sustain one or not), and so on.

When a social problem is not very intense, fighting it is comparatively cheap per victim.

Drug addiction is a good example. In the USA, there are reportedly six million users of cocaine, or 3% of the population aged 15-65. There are 3.6 million ATS users, some of whom also use cocaine. Possibly ten million Usonians use a class A drugs on a regular basis.³ Prevalence for class A drugs in the USA is usually several times what it is in Western European countries, especially for cocaine. The enormous number of users, particularly of ATS, has created a market for more pernicious drugs than were used in the past. While there are doubtless many explanations for the extraordinarily high US rates of class A drug use, one has to be the weak social model. During the period 1990-2000, drug use declined in the US (as did most types of crime) but it did so at a terrible cost: record-busting incarceration rates, a compromised judicial system, paramilitary policy forces, and ultimately, the loss of basic Usonian freedoms.⁴ In effect, the people of the United States paid very heavily for a reduction of crime to average OECD levels. Measuring this with TFP indices is unreliable, but clearly turning huge regions of modern cities into armed camps, and adopting the highest rates of incarceration in the world (mostlly for nonviolent drug offenders) had a dire impact on the productive deployment of labor, capital, and energy.

I am aware that the last sentence is obscene. Please accept my apologies; if you've read this far, you probably sense that I think the real cost is not in terms of output or measurable welfare, but in terms of human freedom and moral decency. But when one attempts to analyze the impact of a large number of heterogeneous policies on the large set of heterogeneous human activities known as an "economy," one has to use the language and methods of economics.)

Another compelling example is poverty itself. Poverty is closely tied to location; the poor are less mobile and usually can leave a depressed community only with difficulty. In many cases, a policy change of reducing welfare/food stamps causes a loss of jobs in retailing in the community; firms that were viable at the prior level of custom go out of business, and unemployment rises. The community will experience a multiplier effect, and finally settle at a much greater level of unemployment.While the initial policy might have supplied $1000/person per month on average, the new policy might supply $500/person per month; but there's twice as many aid recipients, and since poverty is more intense, the community where they live can no longer sustain schools or internet access. Poverty there has become virtually hopeless, and the surrounding community has to be defended from a desperate, sick, ignorant, and antagonistic enclave. Public libraries contrive ways of excluding the poor, denying them access to job opportunities. Private property, such as cars used for business or construction tools, are stolen or impounded (because the owner can't keep up the registration).

Even outside of blighted ghettos, the effect of reduced public spending below a certain point can sharply worsen the ability of people to be productive, and thereby make the usual business of government costlier.

For example, the US government is organized so that most social services are provided by state and local governments, while the federal government takes care of the military, foreign relations, some law enforcement, and some supplemental R&D for big corporations (Department of Energy, Department of Transportation, the BLS, etc.). During business cycles, the federal government not only continues to spend the same amount on soldiers, narcs, and gizmos, it actually increases spending during recessions. The states, cities, counties, and school districts are compelled to cut back. In fact, their budget typically decreases by much more than the local gross state product does, because tax revenues are volatile. When a recession hits, the proportion of governmental expenditures directed at things people actually need, like health care services, schools, local infrastructure, public transit, and law enforcement, declines; government spending actually shifts to things that are largely destructive and pointless, such as preparing for another optional war or rescuing the coal industry.

As a result, the Usonian educational system is subject to violent budgetary swings and enormous local variance in quality. Mathematically, education spending per student per year averages out to something quite high, but with programs like education, extra spending in boom years is mostly wasted; the bad years ruin the progress in building up a strong, committed cohort of educators. Police forces react to reduced funding by shifting energies to traffic tickets and impoundings. This, of course, negatively impacts safety and makes the worsened social problems costlier to deal with.

Conclusion

The Laffer Curve has towered over policy debate in the USA for almost 30 years now. While it is not helpful for describing the behavior of revenues in response to tax policy (except at the extreme points of 0 and 100%), it actually has some practical relevance for social spending. To wit, assuming that

social spending moves within reasonable limits (say, the levels encountered in OECD countries during the last forty years),
social spending is managed in good faith and does not vary greatly in efficiency over the relevant domain,
social spending is mostly directed at assisting the ability of people to become or remain productive,

then TFP is a curve that is concave downwards with respect to the horizontal axis. The peak value of TFP will correspond to "pre-emptive redress" of social problems like poverty, public health risks, education, infrastructure, and safety (G*). "Pre-emptive redress" implies that problems are redressed at a level of thoroughness such that they remain at a relatively low, manageable level; do not impinge on the general quality of life; and do not jeopardize the resource-base of the economy.

Levels of social spending in excess of G* will of course pose the expected problems posed by exorbitant taxes and hyperactive states. But at levels significantly below G*, social problems will grow in size so that maintaining them at a higher degree of severity (e.g., higher crime rates, worse poverty, more cases of tuberculosis) becomes more expensive, and government expenditures will have to rise at a later date just to contain them. The surprising inference is that attempting to reduce the cost of government by slashing social spending will likely lead to increased government spending in subsequent budget cycles, as routine governance gives way to putting out fires.
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Notes:

1 There is a Keynesian method of predicting the stimulus caused by a particular tax cut under particular circumstances, and there's a rational expectations (REH) method. The latter method requires that one know what the future fiscal balances will be after the cuts. The REH method incorporates (to some degree) the Ricardian Equivalence Hypothesis, in which taxpayers adjust their savings and investment strategies in expectation of future deficits (and a probable tax increase).

The short version of this is that, if the government slashes taxes without reducing spending, then taxpayers will anticipate the approximate size of the deficit and include a future tax increase in their personal financial planning. The effect, according to Robert Barro, was that the intended stimulus of deficit spending will be entirely thwarted. Instead of actually increasing aggregate demand, consumers will hoard wealth because they know they'll need it when the government has to balance the budget again.

How do households know when or how big the tax increase will be? They don't, but a very rough guess of both is surprisingly effective. The reason is that the longer the government waits to restore a balanced budget, the larger the tax hike will have to be. Economists assume that households value future income/spending less; so if the government waits a short time and raises taxes a little bit, then that little bit will have about as much effect as a long wait and big tax increase far in the future. Based on past experience and cultural expectations, households will tend to guess correctly what the most likely course of action will be.

For an introduction to this idea, see Douglas W. Elmendorf & N. Gregory Mankiw, "Government Debt" , originally an excerpt from Handbook of Macroeconomics Federal Reserve Board (1998), p.28.

2 A Mr. Hans G. Monissen wrote "Explorations of the Laffer Curve" (1999) in which in included a large number of assumptions to allow the Laffer Curve to "mean something." Specifically, a cut in taxes reduces the demand for leisure and consumption, and increases the willingness to work and to save. Investment increases the productivity of labor, and workers will accept longer hours (bidding down the price of labor). According to the Swan-Solow Classical Growth Theory, this stabilizes at a new GDP, which is definitely higher than the old one. Under certain assumptions one can calculate what that new GDP level will be; but it corresponds to a future date which has to be specified. In order for the Laffer Curve to work, however, workers will need to "know" that it will work, because if they assume that deficit spending will be followed by a comparably-sized surplus, they will not make the virtuous adjustments that a Keynesian would automatically expect them to, and that would lead to increased revenue. If they guess wrong, no stimulus will occur and deficits will in fact follow (as they expected), which means that they weren't wrong at all. Monissen's attempt to salvage some meaning for the Laffer Curve leads to a paradox in which there are actually infinitely many rational expectations with self-fulfilling prophesies.

3 United Nations Office on Drugs and Crime, World Drug Report 2008 , table 7, p.84; see also The Threat of Narco-Trafficking in the Americas, p.21. Please note that cocaine is not the only serious drug problem. See also the Global ATS Assessment, which mentions that amphetamine-type stimulants (ATS; includes methamphetamine, crystalline methamphetamine, and ecstasy) are much more prevalent than either heroin or cocaine. See p.11. Exact comparisons of different "habits" are difficult, but the prevalence of ATS in the USA is massively greater than in any other region. This, despite a near-halving of ATS usage since 2001. See p.14. Heroin usage is much larger outside of the Western Hemisphere than in it, but heroin is used by far fewer people in Europe than cocaine is by North Americans.

Class A drugs are ecstasy, LSD, heroin, cocaine, crack, magic mushrooms, amphetamines (if prepared for injection). The term is British but fits standard penal classification in other countries as well.

4 It is difficult to make a fair comparison between crime rates internationally, but see the International Crime Victimization Survey (ICVS), 1989-2000, ICVS International Working Group (United Nations 2006). The ICVS is the most thorough international study of crime; it is probably unique insofar as it consists of survey of many different national populations, directly, by a single organization. The Codebook is part of the data package that one downloads at the link above; it has a section called "Key Findings from the 2000 ICVS" which is an outstanding summary of the data. Most types of crime monitored by the ICVS declined in the USA (1990-2000; see the Codebook in the data download, "Findings"), but increased sharply through 1996 everywhere else. As a result, except for murder, the crime rates in the USA are no longer particularly high.

Incarceration rates: see Christopher Hartney, "US Rates of Incarceration: A Global Perspective" , National Council on Crime and Delinquency (Nov 2006); see chart, p.2. The rates of incarceration in the USA are about 5x that of the UK and Spain, which are (in turn) the highest rates in the rest of the industrialized democracies. France has one eighth the incarceration rate. In contrast, the Stalinist GULAG held only a slightly larger share of the Soviet population at its peak in 1950.

Compromised legal system: I am to blame for such a vaguely-worded rebuke, but one exceptionally good source (on DVD) is Frontline: the Plea, PBS (2004). Bearing in mind that the vast majority of criminal cases are resolved through plea bargaining, "plea bargaining" is almost synonymous with "criminal justice system." Hence, another excellent source is George Fisher, Plea Bargaining's Triumph: A History of Plea Bargaining in America, Stanford University Press (2004), especially III: "On-file Plea Bargaining and the Rise of Probation." Fisher is very restrained in making any sweeping editorial claims. Another, more plaintive work is Jonathan Simon, Governing Through Crime: How the War on Crime Transformed American Democracy and Created a Culture of Fear, Oxford University Press (2007).

Paramilitary policing: a widely-cited reference is "Botched Paramilitary Police Raids" and Radley Balko, "Overkill: the Rise of Paramilitary Police Raids in America" , both hosted by the Cato Institute (2006); see also Christian Parenti Lockdown America, Verso Press (2000), Chapter VI.

Loss of basic Usonian freedoms: technically, the Military Commissions Act of 2006 rendered the Bill of Rights null and void. Text of Act ; ACLU fact sheet; Amnesty International report. The Act does not include language that precludes US citizens or legal residents from being designated "illegal combatants" and held without charge. Since military commissions do not include a grand jury and are not subject to writs of habeas corpus, it is potentially irrelevant to them whether any US citizen/legal resident is plausibly engaged in any "combat," illegal or otherwise.

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Additional Sources and Reading:

Barbara Sard & Jeff Lubell, "The Value of Housing Subsidies to Welfare Reform Efforts," Center for Budget & Policy Priorities (2000)

Hans G. Monissen, "Explorations of the Laffer Curve" University of Wuerzburg, Germany (1999)

The Optional Catastrophe

2008-06-13T22:07:00.000-07:00

This is a question that's been tormenting me for a very long time: how can derivatives influence the spot price of the underlying item?

In order to answer this question, I've considered futures and call options. It just dawned on me that there was a scenario in which the options market could conceivably affect the price of an underlying commodity, which I have dubbed "the optional catastrophe" (OC). I'm going to use an example of West Texas Intermediate (WTI) crude, but it's important to understand that the OC would probably strike the other crude markets as well. For simplicity, I'll start by assuming everything is done in US dollars.

While the supply curve of the good has shifted to the left,
many buyers have options that allow them to pay P* for
Q*; this pushes the price for everyone else up to P***,
rather than the equilibrium price P**.

It's February 2008 and the price of WTI has just punctured $100/bbl. An investment banker known as Writer makes a huge gamble that the price of WTI will now back away from its "psychological barrier"; she takes the biggest risk of her career and writes a naked call option for 1 million bbls. of WTI at $101/bbl. The option sells at a small premium of $0.30/bbl, so that Writer gets $300,000 for something with no intrinsic value. We will call the buyer of this option "Secondary." At first it looks like Secondary has been played for a sucker, as the spot price of WTI falls to $98.57 the next day. But on Leap Day, WTI rises again to 101.79 and Writer's nerve gets a test drive. She is now $490K in the hole. It gets worse. On 13 March, WTI is 110.21, and Writer is on the hook for $8.91 million. The price sinks back to $100.92 by April Fools' Day, and Writer is feeling triumphant. But the ascent resumes, and by 11 April, Secondary decides to exercise when the spot is at $110.14. Writer must come up with 5 million barrels that she doesn't happen to have. Fortunately, her firm has deep pockets and can afford a 8.91 million loss; unfortunately, the sudden spike in demand (by Writer) drives the price to $119.17. The options mean that the demand-suppressing effect of soaring prices does not come into play (see figure).

Now, I should mention that there are many grades of crude, and if we had a huge number of cocky Writers cranking out naked options (that routinely stayed out of the money, racking up free premia), then a few interlocking blunders like this could push the price up quite a bit.

(UPDATE (26 July 201o): the technical term for what I have described above is a "short cover." For any method in which one can take a short position on a stock/commodity, there is a scenario in which the shorts can be caught flat-footed, and compelled to buy more of the underlying stock/commodity. This can make a surprise rally somewhat more pronounced than it would have been otherwise.)

Moreever, there are some flaws in my exposition. Given the vast range of different call options strike prices, each buyer would have a jagged (and unique) supply curve: jagged, because each one would have been accumulating options over time and exercising them to buy different "batches" of WTI crude at different prices. Conditions where different buyers pay different prices is known as discriminatory pricing, and when sellers can match prices to individual consumers, it's a powerful tool for maximizing monopoly rents. In this case, the discrimination would have been partly random and partly self-selecting; prices could be higher for those who could pay more, and lower for others. For those who did not dabble in options at all, the price would be immensely higher. There might not be much incentive to produce, however, since a select number of major buyers (Secondaries) would have enjoyed such huge discounts.

Futures
The influence of futures is somewhat hazier, and I'm obligated to rely on the testimony of George Soros (3 June 2008). My understanding is that, in the past, futures traded at a discount relative to cash; in other words, a bank could buy futures from a producer, and be (on average) guaranteed a profit. The cost to the bank, aside from the actual future itself, was the time that passed before the bank could cash out; and since banks can borrow money more cheaply than anyone else, banks were uniquely empowered to profit from doing so. For this reason, after the 1999 financial liberalizations, which allowed homologization of the financial sector, indexed commodity funds became popular.

An indexed fund is a portfolio of assets which corresponds to some prominent index, such as the S&P 500 index of US-based industrial firms. The object is to reduce systemic risk using a current indicator. Commodity indices became popular because they were known to offer low-risk interest arbitrage to banks (which were, in fact, lending money to the commodity producer). But, per Soros (p.3), as large numbers of fund customers bought into the commodity indices, this drove up the price of the futures. What would occur when the futures matured and prices were so high that there was a glut? The supplier of the commodity (again, say, petroleum) could agree to simply exchange the old future for a new one.

Endlessly distributing new contracts with maturation dates ever-further off into the future: and producers large enough to play this game would remain liquid by continuing to produce a dwindling volume of the underlying good. In this case, the object would be to treat the future price as a leading indicator of the appropriate price and cut output so that the futures themselves seldom ever had a price reduction. In that case, the real impact would be producer use of the derivatives market, rather than the real goods market, as the source of price signals.

Speculation and Prices

2008-06-10T17:45:00.000-07:00

With oil prices continuing to hover around $135/barrel (or €85/barrel), the speculation hypothesis has widespread support. That's the theory that high prices of commodities generally reflects illegitimate financial market activity. I'm trying to keep an open mind but none of the arguments I've seen are convincing.

To me, the big headache is establishing a mechanism by which either (a) high futures prices drive up oil spot prices, and (b) how high flows of money into the forward markets (futures & options) influence the strike price of the commodity.

(For an introduction to this topic, see my post "Commodity Prices and Speculators.")

To some readers, these may seem like very dumb questions. If a lot of people are trying to abandon US dollars as a store of value, then they will want to buy up large tranches of oil future contracts, or perhaps options. That naturally drives up the strike price. When producers see that the strike price is rising, they naturally want to withhold stocks from the market in anticipation of still higher prices. Refiners likewise respond to the high forward prices by hoarding it. This drives prices even higher.

There are two steps to this explanation: one explains how a lot of currency flowing into commodity forward markets can drive up the strike price, and the other explains how a rising strike price can push up the spot price. Both steps are problematic. First, options can be traded at any of a wide range of strike prices.¹ At the time of this writing, Brent crude was trading at about €87 per barrel. Options must exist for €85- and €89-barrel Brent, and probable for a wide range of prices above and below that. Also, new options are written each day for spot ± €0.50/barrel, so that options are tradable from €57-89/bbl (reflecting, in other words, the range of prices over the previous six months). So it's possible for a lot of speculative money to flow into the options market at lower strike prices. Buying an option for 100 barrels of Brent that expires in 3 months with a strike price of €68/bbl means an outlay of about €1,900; should the price fall to €80/bbl, then your loss will be €700, or 36% of your initial investment. If the strike price is €89, then the option is "out of the money," and costs very little; but then you're betting that the price will rise above €90 and stay there long enough for you to cash out.

When the market for options is extremely brisk, naturally the money goes to the people writing them: in theory, suppliers of the underlying good, but also some daredevils who may write "naked options" on [say] shipments of crude they don't own. Options can absorb immense amounts of speculative money, since anyone can write them and most will expire as worthless scraps of paper. They provide no benefit to the person writing them other than the fee and favorable price movements. Basically, they are a hedge: if you are a supplier and you write a lot of call options at the current price, you are locking in the strike price as the most amount of money you will make, but if you understand the market well, then you can reap a handsome profit when your product's price falls well below the strike price. Conversely, you might be a refiner who buys a lot of crude at the current high price; you anticipate that the price will rise even more, so you write put options and sell them to suppliers in which you promise to buy crude at €90/barrel. If the price does indeed go to €100, it sucks to be you but at least you got the money from selling the options to cautious suppliers.

Nevertheless, it's hard to see how this can influence the actual price of the underlying commodity. Writing options does allow buyers and sellers to recoup a modest amount of money from unfavorable movements of the market; when money flows from the non-financial sector into options trading, the effect is to shield options "customers" from some of the consequences of unfavorable movements (giving them time to prepare for new business conditions), while partly compensating "writers" for losses incurred by unfavorable movements.

(See here for an exceptional scenario.)

Futures are a different matter. Taking crude oil (again) as our example, there's a global demand of about 83 million bbls. per day; supposing about 10 million bbls. are sold as future contracts well in advance. Normal derivatives traffic ensures minimal price risk to suppliers and refiners. Then, so to speak, Satan enters the garden in the form of hedge fund managers desperate to park $10 million per day of new money. The hedge fund buys a large number of futures, but it has no intention of taking delivery of all that oil; instead, when the futures near maturity, it sells them to a major (i.e., one of the large multinational, vertically-integrated oil companies). The problem is that the oil company can choose between buying the inflated future or a lower spot price.

David Kruse, President, CommStock Investments, wrote an editorial describing precisely this scenario:

Cash commodity markets however, run the risk of becoming the tail swung by price discovery of futures exchanges that are not based on commodity market fundamentals but on the capital investment flows in and out of the commodity sector. The connection between cash markets and respective futures markets differs between commodity markets....

When funds dominate the futures trade, a fundamental distortion can occur. We believe it has occurred in soybean prices this winter. U.S. soybean carryover was projected to reach 565 million bushels this year which eclipses the previous historical carryover record of 346 million bushels in 1998-99. Global soybean carryover is record. We could have a flat out soybean crop disaster in 2006 and not run out of soybeans next year. Why did the market call for so many more acres of soybeans when carryover was already at an all-time record? The market didn't, funds did. November new crop soybeans traded $1 above fundamental market values all winter, producing incentives for farmers to plant more soybeans which the USDA says they strongly responded to.

In this case, the mismatch produced a soybean glut (in 2006).

Over the years different Usonian commodity futures markets have adopted cash settlements. Prior to 1982, when a future expired, you either took delivery or else arranged a cash sale of the commodity to someone who wanted it. Then the Commodity Futures Trading Commission (CFTC) allowed indexed commodities and cash settlement.² While CFTC regulations are designed to prevent destructive speculation, it is worth noting that massive futures trading could easily lead to suppliers learning to anticipate the market's preferences for cash settlements rather than tangible delivery; and lead to sales of contracts for several times the actual volume of goods being sold. Note that CFTC regulations are supposed to prevent this; however, the much-discussed InterContinental Exchange (ICE) based in Atlanta, Georgia, allows one to trade virtual commodities over the web in London and Dubai.

This was extremely important because futures are very highly leveraged instruments. Typically one pays about 5% of the value of the underlying commodity (so, for 100 bbl. of WTI, $675 plus premium)³; in theory, this allows one to claim very large pools of oil for very little money. A squeeze is a situation in which a trade goes long by an amount that exceeds the actual physical capacity that can be loaded during the month. Then the trader claims delivery, knowing that the supplying parties will not have sufficient supplies to meet their obligations. This drives up the price, but the effect is of very short duration (usually a couple of weeks, at most).
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NOTES:
1 An option is similar to a future except that options are binding on only one party, while futures are binding on both buyer and seller. A [call/put] option is a tradable right to [buy/sell] a commodity at a fixed price on or before a given date in the future. For an explanation of options and how they work, see "Factors affecting Options...." For our purposes, "options" are understood to be American style, i.e., they can be exercised at any time prior to expiration.

2 Leo Chan, "Cash settlement and price discovery in futures markets," Quarterly Journal of Business and Economics (Summer 2001). The mechanism for cash settlement works like this: supposing the commodity price rose $10/unit over the period the investor held it. Rather than take delivery, the investor merely accepts a payment of $10 (minus some fee), and the supplier sells the product to another buyer for cash. Assuming the price falls by $10, the investor pays the supplier; in both cases, the transfer of money effectively cancels out the price change (as far as the supplier is concerned).

3 The premia on futures and options varies with the number of futures/options bought. Very large trades involve very small premia per contract/option. Different brokerages have very different schedules of forward premia.

Long: in finance, a "long position" in a security or commodity is a position where one benefits if the price goes up. This includes writing a naked put option, buying the underlying commodity, buying futures for delivery of that commodity, or buying call options for same commodity, are all examples of "going long" or "taking a long position."
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SOURCES & ADDITIONAL READING:

Senate Committee on Comerce, Science, & Transportation: Hearings, 3 June 2008

"The Role of Market Speculation in Rising Oil And Gas Prices" (PDF), Permanent Subcommittee on Investigations, United States Senate (27 June 2006)

Bundles and Bundling

2008-05-31T00:40:00.000-07:00

In economics, a "bundle" is a group of goods that are associated in some way. The most common context is in welfare economics, in the sense of an indifference curve. Each point on the indifference curve represents a different bundle of goods A and B; each point, that is, represents different quantities of each. Naturally, if one doesn't need to draw a diagram, one could use the same equations to solve problems involving bundles of many commodities; although technically, 10 different goods in a bundle means a 10-dimensional "indifference surface."

Commodity bundles are an important topic of interest for determining the true rate of inflation, the true purchasing power parity of currencies, or the actual rate of poverty in different times and places. Since inflation affects different commodities to different degrees, the difficulty lies in deciding how much weight to assign to each good.

A more interesting context for the idea of bundles is in analyzing the economics of goods that are really a group, or bundle, of simpler goods. An example of this is the financial services sector, which spent several centuries developing the concept of a merchant banking account, and then suddenly decided that what customers really wanted was all of these services sold separately:

The reason that growth has continued despite adversity, or perhaps because of it, is that these new financial instruments are an increasingly important vehicle for unbundling risks. These instruments enhance the ability to differentiate risk and allocate it to those investors most able and willing to take it. This unbundling improves the ability of the market to engender a set of product and asset prices far more calibrated to the value preferences of consumers than was possible before derivative markets were developed. The product and asset price signals enable entrepreneurs to finely allocate real capital facilities to produce those goods and services most valued by consumers,...
Alan Greenspan, remarks, 19 March 1999 (PDF)

Customers are expected to buy all of the separate features of a bank account separately, possibly from different vendors, and most likely as computer-generated securities. It bears noting that consumers may neither want to, nor be able to, supplant the expertise of an actual bank manager. Nevertheless, the fact that banking services have indeed been unbundled—i.e., detached from each other and sold separately—has allowed banks to establish what customers are actually prepared to pay for.

Tradable Streams

2008-05-29T11:53:00.000-07:00

Every time the topic of high commodity prices comes up, there's a lot of talk about Enron. Can speculation drive up the prices of traded commodities? Of course, Enron proves it. That's the commonsense answer, and I think it would be a good idea to address this in a dedicated post on the subject.

The Story of Enron

Enron was a very large energy company created by a flurry of mergers and acquisitions in the early 1980's. The core firm was InterNorth, a holding company created in 1979 to provide an additional layer of protection from the risks of a rapidly expanding subsidiary, Northern Natural Gas Company. The purpose of Northern Natural Gas was to build and operate 103,000 Km of PNG pipeline connecting Texas and the Great Lakes region. InterNorth acquired a natural gas supplier, Houston Natural Gas, and changed its name to Enron (1985). The following year Ken Lay, took over at the company, and relocated it to Houston.¹

Enron remained almost exclusively a PNG supplier and pipeline operator until 1998. That year it attempted to diversify into water; they acquired Wessex Water, turned it into Azurix, and lost about $2 billion trying to turn water into a lucrative business.² Enron then turned to broadband, partnering with Sun Microsystems to dive into the internet bubble. That, too, was a hugely costly failure that was not wrapped up until November 2001. But Enron's real business was trading in streams.

Streams Explained

A stream (in this sense) is a supply of a benefit that has to be continuous through time. An example of this is electricity. Electricity, for the end user, is something that has to be available at all times. Hence, when streams are commoditized and traded, they are fundamentally different from other commodities. First, there is no possibility of an inventory; electricity cannot be stored. It has to be continuously available to be useful. This means that, as a tradable thing, streams must necessarily incorporate a period during which they are supplied.

Someone might point out that the things I refer to as "flows," viz., crude oil, iron ore, gold, pork bellies, rolled steel, and the like, have active futures markets. Futures contracts specify not only the amount and quality of the commodity to be delivered, but also the date of delivery. But those are derivatives, not the underlying good. Second, a future contract to deliver a load of a particular commodity on a particular day is not comparable to a contract to deliver a stream of service over a period of time. The exact time period of the service is an inherent and permanent feature of the thing being sold.

Examples of Streams

The most obvious examples of tradable streams are

pressurized natural gas (PNG);
electricity;

other very common examples include

water/wastewater;
broadband internet connectivity;
long distance telephone service;
insurance.

The last one is actually the earliest stream to be traded: Lloyds of London introduced the concept of securitizing risk and trading it. Natural gas can only be stored or reshipped with difficulty; usually it is consumed fairly close to the source, although Enron's precursor, Houston Natural Gas, created a complex network of PNG lines spanning thousands of kilometers.

Problems with Trading Streams

As we shall see, this makes trade in streams inherently much more complicated than trade in flows.

The first reason is that packaging a stream (as opposed to an item like an ingot of steel) is likely to sharply impinge on the value or character of that stream. For example, for industrial applications, a kilowatt-hour is not a generic thing at all; often major commercial consumers of electric power require a premium vendor who can ensure no spikes, extra support, and so on. While it's possible to specify different grades of stream, or even unbundle those services and trade them as separate steams, this defeats the point of premium service since the consumer has to essentially replicate the administrative abilities of the premium supplier.

Second, markets don't clear in the same way when the commodity is time-specific. Let me explain again: other commodities can be traded as future contracts, for delivery of a specific amount, quantity, and quality by a specific point in time; a stream is for something that exists only during a period of time, namely, the period during which it is actually used.

The market price of a thing represents the opportunity cost to the supplier of actually supplying that good to the person paying the price. In other words, commodities have prices because they are scarce, which is to say that there are alternative uses for them. Our market economy uses prices to ration commodities to those who can pay the most for them. However, as the time approaches when the stream bid upon is to be delivered, the price can become highly volatile.³ The total number of buyers and sellers shrinks very fast, which tends to make any "equilibrium price" very unstable. Essentially, basic economic theory gives way to the arcana of game theory and multiple equilibria. The result, at best, is a much more demanding regulatory environment; at worst, unacceptable disruptions in the system of energy supply; and in between, a permanently higher cost (if not price!) of the stream itself.

Part of the problem, naturally, is that both buyer and seller have a gun to the other's head. Trading in streams, in practice, typically involves transactions that take place literally minutes before delivery of the stream for the relevant time period. Since it's not really practical for smaller players to engage in games of "chicken," this restricts stream trading to very large customers.

This doesn't mean the concept is a failure. It does mean that the system only works when it's tightly controlled, as in Western Europe.

_________________________________________
1 Enron does have an extremely interesting history, especially since it consisted of a merger of several older firms. Bryce (2002, see below) emphasizes Houston Natural Gas (HNG) Co. as the core firm, as well as the peculiarities of Houston's business culture. However, Enron appears to have always been something of a bungling conspiracy of its components, rather than an organically unified entity.

2 When Bryce wrote Pipe Dreams, Enron had tried and failed to displace Vivendi (Compagnie Générale des Eaux) and Suez, the two French companies that dominate the market worldwide. As Bryce's book came out, it depicted Vivendi as the seasoned victor of its clash with Enron, which it was in 2000, when Azurix imploded. Nevertheless, Vivendi suffered a financial meltdown at the time of publication, as a result of Jean-Marie Messier's spectacular joyride at the helm (Time). Vivendi's water business is now Veolia Environment.

Suez is still in business; it dates back to the 1850's, although it had taken its current name in 1999 after a merger; its water operations are named "Ondeo," which makes for a much easier Google search. Suez is about to be acquired by Gaz de France (Forbes).

3 An exception to this is Nord Pool, where the balance from the spot market is maintained until the actual, physical delivery takes place under the regulating power market in Norway. Denmark, Sweden, Finland, and Germany are also members of Nord Pool. Another energy trading regime exists in the UK.
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SOURCES & ADDITIONAL READING

PBS: The Rise and Fall of Enron
"Dueling Lawsuits in Enron – The Complaints in the Northern Natural Gas Dispute" (PDF) Orrick, Herrington & Sutcliffe LLP
"Blind Faith: How Deregulation and Enron’s Influence Over Government Looted Billions from Americans" (PDF), Public Citizen (Dec 2001)
Robert Bryce, Pipe Dreams: Greed, Ego, & the Death of Enron, PublicAffairs/Perseus Books (2002)

Commodity Prices and Speculators

2008-05-22T13:33:00.000-07:00

Figure 1

Source: International Monetary Fund WEO, Chapter 5

Figure 2

Since the summer of 2007, the world has experienced an extremely rapid increase in the price of many commodities (figure 1); the most obvious is oil, which has recently reached $135 per barrel. The recent climb in oil prices can be said to have begun in January '07 when the 12-month price change reached a cyclical trough and began to rise, becoming positive in March and began to rise (figure 2). Not only have oil prices been rising; the first derivative of oil prices (i.e., the rate at which oil prices have been increasing) has also increased, with the most recent quotes suggesting a 94% increase over the price 12 months ago.

This post will deal with the question of whether or not speculative activity has played a role in the recent run-up of the price of oil. The null hypothesis* is that recent conditions are nothing more nefarious than the adjustment of prices to increasing demand. Rejecting the null hypothesis means we need to acknowledge that speculative activity on commodities markets has led to the recent increases (or contributed somewhat to the size).

SOME THEORY

I'm going to need to introduce some technical terms for explanation.

pools: an asset for which the total tradable supply is either permanently limited (e.g., paintings by dead artists, real estate) or represents a share of the total (e.g., equities).
flows: an asset that is produced and consumed at fairly high rates, such as oil, copper, wheat, or steel.
tradable streams: an exotic type of tradable that includes electricity and pressurized natural gas (PNG). Markets in tradable streams are, at best, not mature and I won't be discussing them here.
null hypothesis: In statistics, the negation of the idea one wants to test. When statistics is used to establish a particular finding of fact, there must be an explicit statement of fact that one is seeking to prove (the test hypothesis) and an explicit contradictory hypothesis (the null hypothesis) that one seeks to prove false.
inventories: US inventories of crude oil are counted in two ways: commercial and commercial plus strategic petroleum reserves (SPR). The Department of Energy usually supplies statistics on both, but it's commercial inventories that get reported. The SPR is under Congressional control; usually Congress has an incentive to add to the SPR, rather than release reserves, so it should come as no surprise that the SPR is huge: almost 650 million bbls, or twice the commercial inventory. Recently, as prices hit staggering highs, Congress took the momentous decision to desist from further expansion of the SPR.

The Coleman-Levin report features a chart on p.19 that reveals the oscillation of private inventories (commercial US less SPR); inventories are shown mainly oscillating between 290 and 330 million bbl (i.e, over a range equal to 4 days worth of imports to the USA).
strike price; guaranteed price of a commodity at date that futures contract matures. Hence, a future contract for 100 bbl of WTI oil at $150/bbl for 6 months in the future (23 Nov '08), which is currently $18 above the price this exact minute.
spot price is the actual quoted price of the commodity

"Pools" and tradable "streams" can be subject to price manipulations; the one through corners, and the other through shorts and derivatives. In fact, the 2000-2001 energy crisis in California was largely the result of intentional manipulation of TS markets by Enron and Reliant Energy Systems.

Figure 3

Figure 4

But "flows" are very difficult to manipulate. Basically, you have to hoard the supply in some way; long-run price controls are really hard to do unless you're the government of a major country and can permanently interfere in the supply. At least, this is orthodox economic theory as I learned it in college. In figure 3, when the demand curve slides to the right, the equilibrium price (p* to p**) will rise, as will the equilibrium flow rate (Q* to Q**). All that that has happened is that the increase in alternate uses for each unit of each commodity (or "an increase in demand") has resulted in a new equilibrium price.

But let's now introduce financial speculators. Suppose they know the demand curve is actually concave with respect to the origin (Figure 4). If one really big investor could carry it off, he could buy a huge amount of the stuff, hoard it somewhere, and then sell it. The price would go up a lot, which would make profit α, while the loss incurred selling the inventory on the world market would be the smaller amount β.

More realistically, speculators don't buy current flows, but future ones: say, oil in six months time. Now, there's no huge tank farms with sequestered inventory, but rather, a bubble in the price of oil to be delivered in December '08. The problem, of course, is that this is always possible; and as the price gets more and more out of line, demand shrivels. But producers of either refined gasoline products, or products that require energy to produce, aren't in a position to know that. So they plan based on the forwards market rather than the spot (or current) price. When Dec '08 arrives, other commodities have gone up in price because production of them really has gone down, in response to the soaring costs of inputs. Of course, the oil producers (Kuwait, Venezuela, etc.) have to adjust production of oil downward in response to the pancaking demand.

LIMITATIONS OF THE THEORY

In theory, speculators who buy commodities future or options (the forward markets) are betting against producers on the price at the time of delivery. Gordon Gecko thinks West Texas Intermediate Crude will be $200/barrel in December; Ellis Wyatt thinks it will be $150. By agreeing to pay Wyatt $175/barrel for oil delivered then, Gecko allows Wyatt to ramp up production to where marginal cost of recovery and shipping is $175/bbl. And if Gecko is right, he walks away with an enormous profit. If he's wrong, and oil is less than $175, then he's already paid for Wyatt's capital expansion; the losses would come out of previous successful bets he's made. The speculator, in theory, absorbs the risk of major short-run fluctuations in price.

But what the speculator can't do, at least in theory, is influence the outcome. Gecko can buy all the options in the world, bidding up the forward price to something astronomical: on the actual commodities markets, the flow of commodities into port facilities all over the world has to match the flow out of them, and the flow out will stop if processors and refiners can't afford them. Several news outlets have suggested that speculators contribute to the high price of petroleum, although without offering details as to how this is possible.

(Examples include Financial Times "Commodity prices part speculative - IMF"; Los Angeles Times, "Are commodity traders bidding up food, fuel prices?")

However, I had heard references to a US Senate Report entitled "The Role of Market Speculation in Rising Oil And Gas Prices" (link below), which alleged that the most plausible price for oil was well below $60/bbl.

Since late 2004, the amount of stored oil in the United States has been increasing. Oil inventories recently reached 347 million barrels – an eight-year high and the largest U.S. inventory since 1998, when oil was $15 per barrel. Similarly, oil inventories in Organisation for Economic Co-operation and Development (OECD) countries recently reached a 20-year high. As the report explains, the traditional factors of "supply and demand" do not tell the whole story on oil and gas prices.

What is new, according to the Levin-Coleman report, is that over the past few years market speculators have poured tens of billions of dollars into the energy commodity markets. For example, the International Monetary Fund reports that over the past three years approximately $100-$120 billion has been invested in energy markets worldwide. Over this same period about $60 billion has been invested in oil futures on the NYMEX.

Bear in mind that that report was published in late 2006, when $60 billion was comparable to about one quarter's worth of US crude oil consumption. Since that report was published, crude oil inventories in the USA have declined somewhat to 320 million bbls. Inventories did indeed reach a high at the end of '06, but Department of Energy statistics show both US and OECD inventories have hovered around 2400-2700 million bbls since 1994 (EIA). And they've fallen off considerably since the late-'06 spike.

One major issue for Congressional investigators was the popularity of commodity indexed funds, which allowed small investors to buy stakes in the movements of commodities. As speculators bought futures in (say) WTI oil for delivery in December, the strike price would presumably soar (this ignores the fact that a booming futures market can include contracts with any strike price, and indeed does: complete listings include the prices for futures at many different prices, including above and below the spot price. Another consideration, though, is the impact of derivatives markets on inventories of the traded commodity: basically, if an index fund is pegged to the price of WTI oil, then the firm offering the fund is presumably obligated to own tangible inventories of the commodity equal to the amount notionally owned by investors buying into the fund.

(I am not aware that this is essential; a fund could instead invest in instruments intended to beat the judgment of amateur investors in no-load funds; in most quarters, the short-run liabilities for the fund would be smaller than quarterly net increases in asset values, and there would be no need to literally match what the investors actually did. So if I offer a fund whose value is indexed to WTI oil, then all I need to do is own financial instruments that match or exceed the growth in value of WTI oil. If there are many other funds offered by my firm, then the risk that I'll fail to do this is greatly mitigated by the fact that in quarters like this one, the losses from the WTI fund will be offset by net gains from the other funds.)

While the Senate report includes a lot of hyperventilating claims about speculation, there's surprisingly little (for a 60-page report) on actual mechanisms for "disconnecting" market equilibria and the price of petroleum. Essentially, everything is riding on a brief spike in oil inventories, and a rather smallish one at that.

There does exist a nontrivial question of volatility, in which refiners are left trying to make decisions about stocks and blends in the face of wildly oscillating futures prices. More precisely, some of the price of retail gasoline at the pump may constitute a premium for uncertainty. But even my Senate report was uncertain if commodity speculation was to blame for volatility.
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SOURCES & ADDITIONAL READING:

"The Role of Market Speculation in Rising Oil And Gas Prices" (PDF), Permanent Subcommittee on Investigations, United States Senate (27 June 2006)

Developmental State

2008-04-21T13:34:00.000-07:00

A developmental state is one in which the authorities (included foreign aid agencies) favor the development of alternative business sectors. Reasons may include:

the businesses in which the country is strong do not employ remotely enough people (because of the production function existing for those businesses);
the businesses in which the country is strong include a small number of markets for which output and prices are too vulnerable for stable monetary management;
the businesses in existence are extractive, and therefore discourage the development of national loyalties, a professional class, or a viable state.

Developmental states are extremely commonplace, and typically refer to a function of the national government, rather than a specific country. For example, the early federal government of the USA had a cluster of policies known as the "American system,"¹ whose purpose was to liberate the nation from economic dependence on Great Britain, stimulate a balanced economy, and prevent the recurrence of depression. It differed from French dirigisme in the sense that the Federalist/Whig policies focused on altering market conditions within the USA, as opposed to supplanting the market itself.

Chalmers Johnson defines the [capitalist] developmental state thus:

The communist-type command economy characteristically retains all ownership and control in the hands of the state, whereas the capitalist developmental state (CDs) rests on genuine private ownership of property but indirect state control of economic decisions. The CDS is infinitely more efficient than its communist rival, but not as efficient as the ideal market economy with perfect competition.
(pp.45-46)

Johnson, whose writing really opened up the controversy over"economic revisionism," argued that countries such as Japan, Germany, Korea, and Taiwan flourished economically as developmental states, i.e., by rejecting the orthodox model of economic growth and adopting various schemes of growth management. Japan's economic growth was managed mainly through the Ministry of International Trade and Industry (MITI), but also through the Ministry of Finance (MoF), which managed the city banks and long term capital banks. Germany relied on different instruments during different phases of its recent history, but the most enduring and pervasive approach was through the cartel, which authorized price cooperation and higher profits, in exchange for fulfilling state objectives. Another Northern European form of developmentalism was the commissioning of entire industries, such as railroads and heavy shipping.²

Developmentalism was embraced wholeheartedly by the northern German states, particularly after the formation of the Zollverein (customs union; 1834). In Austria/Austria-Hungary, the main element was protectionism; in Prussia and the German Empire (1870-1918), protectionism played a relatively minor role, and was supplemented by the creation of the Navy and a dynamic chemicals industry.³ However, one of the most spectacular cases of developmentalism in a modern European state was Finland.⁴

The opposite of developmentalism is not laissez-faire, but colonial underdevelopment. At least in theory, a country with an idealized market economy will accumulate capital based on the optimal trade-offs between present and future consumption. This is likely to slow down as certain industries that have already developed enjoy a permanent premium in ROI, which is, nonetheless, subject to diminishing marginal returns (Swan-Solow Classical Growth Theory). On the other hand, underdevelopment is a process in which development is actually reversed.

[Andre Gunder Frank] wrote of underdevelopment as an historical process which was causally related to the 'pattern of evolution' of developed, industrial societies. In one part of the world, the North, the process whereby producers were separated from their means of production was matched by one in which they were reabsorbed and reintegrated in the production process as proletarian wage-workers.⁵

In other words, underdevelopment is a process in which capital accumulation in the colonial metropole leads to the loss of domestic ownership over the means of production. When this happens, increased productivity in the colony does not lead to increased income for the people who live there, since the business enterprise is foreign-owned and its profits flow abroad. Since the residual gains to the colony consist only of wages paid to workers in the exporting industry, and since those wages must pay for imports from the metropole (with its monopoly on exports to the colony), it logically follows that the terms of trade for the colony must get progressively worse. Locally-owned resources, such as land and water, can be bought with derisory amounts of the foreign currency (because the local currency will be worth almost nothing).

Under colonial rule, this is exactly what happened to the nations of Africa and South Asia (and, to a lesser degree, Latin America). An obscure process to people living in the Developed North, it was very easily understood and observed by the peoples of the South. Idealistic leaders who had guided their countries to independence in the mid-20th century perceived the need for a developmental policy.⁶ In a few cases, such as the Republic of Korea, Singapore, and Malaysia, such policy has been an unqualified success. In other cases, such as Chile (since 1990), Costa Rica, and Uruguay, developmentalism has mainly targeted general social indicators, such as infant mortality, literacy, and so on. In such countries, disappointing long-run economic growth may jeopardize political support for developmentalism.

Abuses of the Developmental State

Furthermore, the developmental state may had undergone a political upheaval that repudiates the old order; in that case, it may require a developmental policy for the revolutionary government to be strategically tenable. In some cases, the objects of nationalism, national defense, and ideological ascendancy may be so strong they lead to disastrous developmental policies, such those of the Democratic People's Republic of Korea (DPRK); more commonly, the effects merely depress economic growth. An example is the policy of many governments to develop flagship industries such as auto production. For developing nations like Indonesia, the production of autos is really an inappropriate use of scarce resources, and in fact the Astra conglomerate took up the enterprise as part of an elaborate scam on behalf of Gen. Suharto's family.⁷

Supporters of a laissez-faire minimalist state approach have argued that Suharto is the norm; even notable success stories, such as Singapore, Taiwan, and Korea have paid high prices in political freedom (or simply enjoyed peculiar advantages, such as Cold War alliances with Washington). Part of the problem, however, is that the propensity for corruption and extortion is a deeper problem than one related to economic policy choices. Haiti is not a mess because since administrators succumbed to the false promise of developmentalism; it's a mess because it suffers from retarded civil society and a predatory comprador class, which foreign powers have been all too eager to utilize.
___________________________________
NOTES:

Here, "American System" refers to a series of proposals made by Alexander Hamilton and endorsed by, inter alia, Henry Clay and H. Charles Carey. It included federal (hence, "American," in the sense of "all-American" or "all-Union") improvements on interstate roads, canals, and seaways; protectionism, as a deliberate policy of import substitution; and direct federal involvement in the creation of the financial infrastructure. For a summary of the views of H.Charles Carey, see "Henry Charles Carey, 1793-1879," CEPA History of Economic Thought. The Wikipedia entry for this is especially good.

See also Alexander Johnston & James Albert Woodburn, American Political History, 1763-1876 (complete text online) G.P. Putnam's Sons (1913); XVII: "The American System: Internal Improvements and the Tariff," p.341.

The phrase "American System" is a bit overused, and was subsequently used to refer to the concept of line manufacturing, in which items are fabricated from inventories of identical parts assembled by specialized workers.

The literature on developmentalism in Europe is amazingly chaotic. Few, if any works exist on the general phenomena of developmentalism in non-Communist states, unless we count Ha-Joon Chang's Bad Samaritans (Bloomsbury Press, 2008; mainly an indictment of World Bank/IMF policies towards underdeveloped countries). Instead, one is stuck with monographs on the history of specific industries in specific countries. For example, buried in Jürgen Kocka's Industrial Culture and Bourgeois Society: Business, Labor, and Bureaucracy in Modern Germany, Berghahn Books (1999), there is the following reference to developmentalism in Bismarckian Prussia:
Consequently, strong and efficient public administration played an important role in the process of economic, social, and political modernization in Prussia and in other German states during the early nineteenth century. This role was in part helpful and in part harmful to economic growth. Industrialization was started and continued partly under governmental supervision, partly with limited administrative help, mostly under strong bureaucratic influences...

There were many channels through which bureaucratic patterns spread to the factory system and its management. Various amalgamations and interdependencies between governmental agencies and civil servants, on the one hand, and early enterprise, on the other, continued after the mercantilist period. Prussian civil servants acted as entrepreneurs, and the government continued to run some enterprises, especially in mining (until the 1860's), and later in the railroad sector. Civil servants played a leading role in the system of technical and industrial education begun in the 1820s and also in early scientific and industrial associations. Engineering expertise was concentrated in the Prussian technical administrative branches and military men where hired by private entrepreneurs who paid higher salaries than the government...
[p.28-29]
In regards to the commissioning of a national railroad network and mining, see Hajo Holborn, A History of Modern Germany, Princeton University Press (1982): p.11-12; additional discussion of the ideas and influence of Friedrich List appears later in the same chapter.

For a brief discussion of the role of the German developmental state in the creation of a chemicals industry, see Ernst Homburg, A. S. Travis, & Harm G. Schröter, The Chemical Industry in Europe, 1850-1914, Springer (1998) p.99ff. Mostly the Federal Republic of Germany (1949-present) has been regarded as averse to state developmentalism, but
The Weakest tradition of State interventionism is clearly to be found in West Germany—although the picture is much more complex than is sometimes supposed, In the first place, there is a surprisingly big public industrial sector in the Federal Republic. The State has a 25 percent or more stake in some 130 companies with over 800 subsidiaries and these include industrial giants such as Salzgitter, Viag, and Saarbergwerke (with majority stakes), Veba and Volkswagen. Secondly, Bonn has never hesitated to use tariffs and quotas to protect industries such as ship-building, coal mining, textiles, food-processing, aircraft, and metal production. Third, the State has poured subsidies into industry in the shape of cheap loans, guarantees, special depreciation allowances, tax privileges, anti-pollution grants, research and development aid.
See Yves Meny, Vincent Wright, Martin Rhodes, The Politics of Steel, Walter de Gruyter (1987), p.41

Markku Kuisma & Kari-Erik Micheisen, "Nationalism and Industrial Development in Finland" Business and Economic History Second Series, Volume Twenty-one (1992).
A committee set up by private business associations in 1913... recommended, first, that Finnish companies that exported goods should form cartels to minimize domestic competition, and second, that the government should take strict measures to protect domestic industries (iron and steel, textiles, food stuffs) from foreign competition. In the midst of the political chaos, the Finnish government quickly introduced a new economic policy based on these two recommendations...

In addition, Parliament passed laws prohibiting foreign enterprises from purchasing or owning land, forests, hydro power resources or mineral ore deposits. New tariff regulations and tax reductions were introduced which gave domestic industries almost total protection against foreign competition... Cartels also promoted the increase of exports by establishing broad networks of sales branches in major European, North and South American, and Asian cities. In addition, Finnish export cartels collaborated with other Scandinavian paper and timber cartels, for instance with Scannews and Scankraft.

The new economic policies were highly successful. The volume of
Finnish industrial production increased at almost 8% annually during the
interwar period.
Similar policies, albeit less extreme, were adopted by other Scandinavian countries.

Michael Cowen & Robert W. Shenton, Doctrines of Development, Routledge (1996), p.57-58.

In some cases, such as the Arab Middle East, this was conveniently impossible thanks to the political arrangements prevailing at independence. Much of the conflict that raged in the period 1954-1990 was directly linked to this problem. As developmentalism took hold, conservative/obscurantist opposition took the form of Deobandi or Salafist movements (see Import Substitution, nt.1). In other cases, such as the Philippines, the terms under which independence was granted made developmentalism difficult and unpopular (e.g., the Bell Trade Act of 1946). In still other cases, such as Congo-Kinshasa, independence was essentially thwarted by Western intelligence agencies, and rule persisted through surrogates like Mobutu Sesse-Seko (r.1963-1994). Other interesting cases include Haiti and Madagascar.

Suharto seized power in a coup in September 1965, and launched a massacre of political opponents that may have killed about one million. It is generally understood that he was assisted by the CIA, and not only targeted ethnic Chinese and Communists, but also rival factions in the Indonesian military. One of the sleaziest despots of the 20th century, he developed a vast commercial empire through family seats on the boards of companies like Astra International. See "Dad, Can I Have the Keys to Indonesia's Auto Industry?" BusinessWeek (18 Nov 1996). For a general overview of the Suharto family, see "All in the Family," Time (CNN 1999).

SOURCES & ADDITIONAL READING:

Bruce G. Carruthers & Sarah L. Babb, Economy/society: Markets, Meanings, and Social Structure, Pine Forge Press (1999)

Louis Ferleger & William Lazonick, "The Managerial Revolution and the Developmental State: The Case of U.S. Agriculture" Business and Economic History Volume Twenty-two, no. 1 (Fall 1993)

Alexander Hamilton , "Excerpts of the Report on Manufactures"; "Report on Public Credit"; "Argument in Favor of the National Bank" (Via Wikipedia )

Chalmers A. Johnson, Japan, who Governs? The Rise of the Developmental State, W. W. Norton & Company (1994); also, "Odyssey of a Concept" (p.33) in Meredith Woo-Cumings (editor) The Developmental State, Cornell University Press (1999).

Markku Kuisma & Kari-Erik Micheisen, "Nationalism and Industrial Development in Finland" Business and Economic History Second Series, Volume Twenty-one (1992)

William Mass & Hideaki Miyajima, "The Organization of the Developmental State: Fostering Private Capabilities and the Roots of the Japanese 'Miracle'" Business and Economic History Volume Twenty-two, no. 1 (Fall 1993)

C. H. Tzeng, "Understanding Economic Development in Modern China: The Interplay among the State, the Market, and the Social Sector" Business and Economic History Volume 3, (2005)

Maki Umemura, "The Interplay between Entrepreneurial Initiative and Government Policy: The Shaping of the Japanese Pharmaceutical Industry since 1945" Business and Economic History Volume 5, (2007)

The Gold Standard-3

2008-04-13T15:42:00.000-07:00

(The Gold Standard 1 | 2 )

Some technical details

In Part 1, I proposed some definitions of gold exchange standard (GXS) versus gold standard. A more nuanced breakdown follows (Officer, 2008):

In principle, a country can choose among four kinds of international gold standards -- the pure coin and mixed standards, already mentioned, a gold-bullion standard, and a gold- exchange standard. Under a gold-bullion standard, gold coin neither circulates as money nor is it used as commercial-bank reserves, and the government does not coin gold. The monetary authority (Treasury or central bank) stands ready to transact with private parties, buying or selling gold bars (usable only for import or export, not as domestic currency) for its notes, and generally a minimum size of transaction is specified. For example, in 1925 1931 the Bank of England was on the bullion standard and would sell gold bars only in the minimum amount of 400 fine (pure) ounces, approximately £1699 or $8269. Finally, the monetary authority of a country on a gold-exchange standard buys and sells not gold in any form but rather gold- convertible foreign exchange, that is, the currency of a country that itself is on the gold coin or bullion standard.

During the two previous posts on the gold standard, I did not use this distinction, and feel some regret about it. Instead, I used "gold standard" to mean any financial system in which gold or gold substitutes are the sole form of legal tender; and I used GSX to mean any system in which gold is used as a benchmark of value (i.e., what Officer refers to as a "bullion standard" as well as a true "gold exchange standard").

As I mentioned regarding the Canadian bullion standard (1926-1931), regulations of bullion export were often invoked in times of crisis in order to prevent liquidity crises for vulnerable national treasuries. But even countries on the "gold coin" standard, such as the USA (1879-1917), France (1878-1914), and UK (1821-1914) had other ways of managing gold supplies.

There are costs of importing or exporting gold. These costs include freight, insurance, handling (packing and cartage), interest on money committed to the transaction, risk premium (compensation for risk), normal profit, any deviation of purchase or sale price from the mint price, possibly mint charges, and possibly abrasion (wearing out or removal of gold content of coin -- should the coin be sold abroad by weight or as bullion).

"Mint parity" is the ratio of one currency to another in terms of gold weight; so, for example, the UK pound sterling was worth $4.8665635, when expressed as comparative gold weight content. At the time, gold points were defined as the rates produced by buying gold in one country and selling it in another; more precisely, as the point...

... at which it would be as cheap for a person in one country who has to discharge an indebtedness to a creditor in another country, to do so by sending gold as by buying and remitting bills, As regards any particular country, there will be a point at which gold will be likely to leave it, and a point at which gold will be likely to come to it. Given the mint par between the currency units of two countries and the cost of sending gold, the gold points will be found by deducting the latter from the former for the outward gold point, and adding it thereto for the inward gold point.
The Banker's Magazine, vol.80, no.741 (Dec 1905), p.715

The above periodical helpfully takes the example of France and Britain: the pound sterling was then at a mint parity of 25.2213 francs; it cost about 7-10 centimes per sovereign (i.e., gold £1 coin), so the outward gold point is 25.15-25.12 and the inward gold point is 25.32. For purposes of international comparison, the cost of importing gold from the UK to France is .2776%. According to Officer's latter-day studies, this gold point was closer to 10.2 centimes, or .4063%.

Supposing it were zero? Or, say, something very close to zero? Well, if the US dollar were to sink to (say) 1 basis point below its mint parity with the sovereign, then one could make a fortune buying gold with dollars, exporting the gold to London and selling it to the Royal Mint, then taking the pounds and selling them for dollars. One would immediately buy gold and repeat the process. The amount of money made with each cycle would be tiny, but assuming it could be done in a day or so, one could actually contrive to leverage the operation to massively increase the profitability. Unsurprisingly, the gold point spread with the passage of time, so that such arbitrage became much more difficult. With a gold point of 45 basis points, and a spread of about twice that, there was some modest room for interest rate arbitrage among the major money markets (Vienna, Berlin, London, New York, and Paris).

I skimmed the abstracts of some other papers by Officer on gold point arbitrage. Most of these were unavailable for further study, but a general summary is available via the footnote.¹ Another feature of the global gold standard that Officer examined was the effect of interest rates; when interest rates were markedly different for similar classes of borrowers in different money markets, this also had a major impact on flows of money internationally. If interest rates in London were 3% and in New York were 3.75%, then this stimulated exports of gold to the USA (since holders of pounds would have them physically converted into US dollars, and the US dollar would rise in value). This would increase bank reserves of gold, naturally, allowing an expansion of the money supply (albeit at a higher interest rate than London's), and probable shift of the balance of trade in favor of the UK. The trade balance would reverse the flow, unless some spoke got in the wheel.

In practice, there was a bias toward inflation in boom years; different banking regimes in different countries led to different forms of price instability, so that gold and currency traders sought to arbitrage real interest rates rather than nominal ones. In this way, 19th century securities markets tended to be about as complicated as modern ones; it was just that, instead of the complex derivatives of today, traders had to factor in tangible barriers to the mathematically smooth adjustments of market equilibria.

Notes

These include "Gold-Point Arbitrage and Uncovered Interest Arbitrage under the 1925-1931 Dollar-Sterling Gold Standard," Explorations in Economic History, Volume 30, Issue 1 (January 1993) Pages 98-127; and Monetary standards and exchange rates, Routledge (1997), written with Maria Cristina Marcuzzo and Annalisa Rosselli. For a general summary of Officer's work, see Alan M. Taylor, "Review of Lawrence H. Officer, Between the Dollar-Sterling Gold Points: Exchange Rates, Parity, and Market Behavior." EH.Net Economic History Services (20 Mar 1998). The last article IS online and outlines the general thrust of Officer's research on the period of the global gold standard: that the cost of international gold shipments was relatively higher than formerly believed, and formed measurable boundaries of the rational exchange rates; that observed exchange rates moved within these boundaries, and were further restricted by covered interest rate arbitrage; and that weakly efficient markets prevailed under the global gold standard. Critics of the gold standard per se are not likely to be moved by such arguments because they relate to the technical administration of the standard, rather than the monetary policy it imposed.

Additional Sources & Reading

Lawrence H. Officer,"Gold Standard". EH.Net Encyclopedia, edited by Robert Whaples (26 March 2008)