Bubbles and Public Facts
May 23, 2011 2:23 PM Subscribe
The Destruction of Economic Facts - "Renowned Peruvian economist Hernando de Soto argues that the financial crisis wasn't just about finance—it was about a staggering lack of knowledge" (via)
During the second half of the 19th century... To prevent the breakdown of industrial and commercial progress, hundreds of creative reformers concluded that the world needed a shared set of facts. Knowledge had to be gathered, organized, standardized, recorded, continually updated, and easily accessible...BONUS
The result was the invention of the first massive "public memory systems" to record and classify—in rule-bound, certified, and publicly accessible registries, titles, balance sheets, and statements of account—all the relevant knowledge available... for investors to infer value, take risks, and track results... Over the past 20 years, Americans and Europeans have quietly gone about destroying these facts. The results are hardly surprising. In the U.S., trust has broken down...
- The Gaussian copula function tattoo
The financial crisis was a major event which was caused by Wall Street's shortsighted greed — a greed which is epitomized in the way that the copula function became ubiquitous even though risk managers and even Li himself knew full well that it was extremely limited in how it should be used. If we want to 'be vigilant and not forget' the destructive potential of Wall Street, then the Gaussian copula function is actually a really good thing to get as a tattoo. There's an irony here too. Elms got this tattoo, in part, because of its very incomprehensibility — the way it epitomizes the way that Wall Street is 'predicated in obfuscation'. But Wall Street embraced Li's formula for the opposite reason — that it was very tractable and easy to understand, at least if you were a quant with a degree in finance. Elms's tattoo is the version of the formula which I used in the Wired article — but it's not, actually, the version of the formula which was used day-to-day on Wall Street... Most representations of the copula look nothing like that, and are much harder to understand. All of which shows that Elms is absolutely right, at heart, about the copula function and what it represents. To Wall Street, it's simple and easy — disastrously so. To the rest of us, however, it makes a Semiotext(e) book look like a Sesame Street lyric. And that, I think, is why Levin and Elms are going to be disappointed, and Blankfein is going to remain out of jail. Back in 1933, when Ferdinand Pecora uncovered huge scandals on Wall Street, they were easy for all Americans to understand, and easy to protect against. This time around, Wall Street's activities are incomprehensible not only to the lay person but even to senior bankers: a big part of the reason why the crisis was so big and so bad is precisely that people like Stan O'Neal and Bob Rubin failed at their job of understanding the risks their banks were taking. They were knavishly foolish, but still more fools than knaves — which means that it's extremely hard to make a strong case in front of a jury that what they did was criminal.
- The new argument against financial innovation - "It is from the not yet but soon to be famous Alp Simsek, at Harvard, and smart people tell me it is important and already influential..." cf. Speculation and Risk Sharing with New Financial Assets
While the traditional view of financial innovation emphasizes the risk sharing role of new financial assets, belief disagreements about these assets naturally lead to speculation... Financial innovation always decreases the uninsurable variance because new assets increase the possibilities for risk sharing. My main result shows that financial innovation also always increases the speculative variance. This is true even if traders completely agree about the payoffs of new assets. The intuition behind this result is the hedge-more/bet-more effect: Traders use new assets to hedge their bets on existing assets, which in turn enables them to place larger bets and take on greater risks. This effect suggests that financial innovation is more likely to be destabilizing in more complete financial markets and when it concerns derivative assets... A question emerges as to how new assets should be introduced to minimize their short run impact on the speculative variance. I show that staggering (or delaying) the introduction of new assets is not effective because it reduces traders learning simultaneously with their speculation. A viable alternative is to set temporary position limits (or taxes) on new assets.
- Financial Repression - "There are only a few ways to bring down sovereign debt burdens. Growth is one, but growth may be impaired by high debt burdens. Austerity is another, but to cut debts this way requires a long period of painful policy, of the sort that's rarely tolerable to electorates. Default is another way. And rapid inflation is another way still... a fifth option—financial repression—was key to quickly and relatively painlessly addressing large sovereign debts... The tight financial controls associated with post-Depression financial regulation and the introduction of the Bretton Woods system enabled a period of financial repression that persisted from the end of the war to around 1980. This period was characterised by low real interest rates (during this time they were quite often negative) persistently, modestly high inflation rates, and rapid reduction in debt levels thanks largely to this 'financial repression tax'. It was an incredibly effective mix of policies." cf. The Liquidation of Government Debt [1,2,3]
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