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...

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]
posted by kliuless (35 comments total) 70 users marked this as a favorite
That's a lot more inside, but the lead article pretty much sums it up. The discussion of regulating these markets is a joke because they're completely opaque, so how would regulation even work? And if they were regulated, the banks would just bury everything into some unregulated area and carry on. Good article(s).
posted by GuyZero at 2:35 PM on May 23, 2011

didn't realize Hernando de Soto was still alive. good article too!
posted by stbalbach at 2:55 PM on May 23, 2011

That first article really rang true to me. I fear no complexity, and watching people attempt to explain a lot of these financial objects without the explanations going all Klein bottle was amusing until they managed to set fire to everything.

No facts, then no investors, only gambling and displays of power.
posted by dglynn at 2:58 PM on May 23, 2011

One of the links is to reason.com. Is that allowed on this site?
posted by ZenMasterThis at 3:27 PM on May 23, 2011 [1 favorite]

didn't realize Hernando de Soto was still alive

yeah, I was excited for this post to be about zombie conquistadors.

posted by elizardbits at 3:49 PM on May 23, 2011 [3 favorites]

One of the links is to reason.com. Is that allowed on this site?

Sure, because it's a nice break from arguing for unregulated heroin because some people clean up nice.

Seriously, there are some pretty wide gaps in tone in that magazine.
posted by StrikeTheViol at 4:04 PM on May 23, 2011

I'm getting the impression that our financial sector can only be described by game theory, and specifically the game of Calvinball.
posted by RobotVoodooPower at 4:11 PM on May 23, 2011 [12 favorites]

Knowledge is highly overrated. One would imagine.
posted by It's Raining Florence Henderson at 4:15 PM on May 23, 2011 [1 favorite]

(actually, the Reason perspective on heroin is closer to the truth than the common mythology about it: only about 85% of users get hooked, for example).
posted by Maias at 4:29 PM on May 23, 2011

I hear only 1/6th of russian roulette players blow their brains out.
posted by GuyZero at 4:35 PM on May 23, 2011 [1 favorite]

Is this called a bacon post? Because this should be called a bacon post.
posted by notion at 4:36 PM on May 23, 2011

Reason.com is consistently one of the best explicitly political publications on the Web, "gaps in tone" or no. (I've never read their print magazine, so I can't judge.) Attack them as glibertarians all you want, but if you read their stories it's hard to escape the feeling that non-coopted libertarians and leftists have a lot more in common than people on this site like to claim.
posted by nasreddin at 4:38 PM on May 23, 2011 [7 favorites]

I think there's enough meat in this post to discuss without the Reason.com derail. If that needs to continue, please take it to MeTa.
posted by hippybear at 4:40 PM on May 23, 2011 [5 favorites]

Yeah, Reason.com is an argument for ye olden days style of explicitly situated political writing and journalism. When you read it, you know where to look for bad argument. Unlike Fox, they try not to humiliate themselves with stupidity since they know they they carry the standard of "modern libertarian magazine".
posted by a robot made out of meat at 4:49 PM on May 23, 2011

Oops, I didn't actually intend to derail the post! Sorry about that. DeSoto Polar himself seems to have interesting ideas about indigenous poverty, as well.
posted by StrikeTheViol at 4:57 PM on May 23, 2011

Alp Simsek's argument sounds like a kind of risk homeostasis: one risk decreases, so traders increase another. I don't have a clear opinion on whether that's rational behaviour or not*, but why would it increase financial instability? You would have to argue that uninsurable variance isn't as destabilising as speculative variance, which is a whole new hypothesis that needs verification.

*Risk homeostasis is probably irrational in the context of drivers speeding up when they wear seatbelts, but for a trade there may be an optimum level of risk below which returns start dropping.
posted by topynate at 5:00 PM on May 23, 2011 [1 favorite]

If we can agree that the recession wasn't about bubbles but about the organization of knowledge, we can move on to restoring the systems that allowed the global economy to expand more in the last 60 years than in the previous 2,000.

Um, no, we can't agree. Hiding economic facts simply hastened the bursting of the bubble building for the last 60 years.
posted by 3.2.3 at 5:07 PM on May 23, 2011

Money money money money Money money money... money.
Money money money money Money money, money, money (money money money).
Money money money money:
1) money
2) money
3) money

Money money money money-Money- money money money? Money money money money money money money money!

Professor Rush Limbaugh's Slippers
Mobil-Halliburton-Bechtel-Pfizer University
Reagan-Thatcher Chair of Anglo-American Thought
posted by larry_darrell at 5:28 PM on May 23, 2011 [4 favorites]

It's possible for humans to create systems that too complex to understand. There's an unstated assumption that what is made by mortal hands can be harnessed, understood, and unmade if necessary— but the modern bureaucracy and the modern economy betray the falsehood and arrogance of this subconscious axiom.

The financial system crashed because of two things. The first is simple criminality. The second is that it is no longer possible for any one person to understand the financial system. This fact by itself is a strong argument against a free market.
posted by Electrius at 5:44 PM on May 23, 2011 [5 favorites]

I know a risk manager who walked away from Enron because he didn't understand their accounts. It was a brave decision to make since everybody else seemed to be making out like bandits. Of course subsequently he was proved right, but it didn't stop his company getting sued by the people they unloaded the Enron stock onto.

At bottom this is a risk management story. If you have a 95% chance of doubling your money every year, and a 5% chance of losing everything, you look FUCKING good nineteen years out of twenty. That is how hedge funds work. Anyone who tells you different is lying.
posted by unSane at 5:49 PM on May 23, 2011 [5 favorites]

I was expecting him to mention the absolutely dismal, and shockingly unethical performance of the ratings agencies in this piece - agencies that are, at least in practice, charged with giving us some knowledge. Despite Moody's and S&P's horrendous record, governments of all levels, investment funds and banks are still using AAA and the like as justification or inspiration for a range of fiscal policies. The oligarchic nature of these agencies and their clients has never been more clear; they don't exist to inform, merely to protect their clients and promote their neoliberal goals.

If any company outside the financial sector had performed in that way, they would be dust almost overnight. The agencies continue on, performing a public function in private, inscrutable ways, for private reasons.
posted by smoke at 5:50 PM on May 23, 2011

... And I'm a fucking idiot for commenting before reaching the bottom of the piece:

6) Rating Agencies. Originally created to get and communicate the facts regarding the trustworthiness of businesses through a ratings scale, ratings agencies were an innovative way to get an abbreviated picture about a given business. But their reputation suffered when highly rated companies barely survived the outbreak of the recession or had to be rescued.

There seems to be more of a consensus about how to reform the ratings system. Dodd-Frank provides for an Office of Credit Ratings, though it has yet to be staffed. Europe, too, has established a new regulating agency, European Securities and Markets Authority, responsible for creating a central data repository to track rating agencies and their performance.

Important, too, is to consider whether overreliance on ratings based on co-variance formulas is a trustworthy substitute for facts. Any reform effort must keep in mind the difference between facts, which can be tested for truth, and opinions, such as ratings, which can't. Facts are not simply about transparency; facts are about empirical truth.

posted by smoke at 5:52 PM on May 23, 2011 [1 favorite]

1) money
2) money
3) money

That sounds familiar...
posted by MattMangels at 6:18 PM on May 23, 2011 [1 favorite]

larry_darrell, you left out de Soto Polar and his friends at the Cato Institute.
posted by sneebler at 6:50 PM on May 23, 2011 [1 favorite]

Hernando De Soto deserves the Nobel. His The Mystery of Capital was a brilliant breakthrough and some of the best research/writing on Economics that I had seen (in 2003) - I was dogearing practically every other page. Not only that, I found it to be a page-turner.

I know of no other economist who has so successfully analyzed and deconstructed economics and finance as De Soto.
posted by Vibrissae at 6:51 PM on May 23, 2011 [3 favorites]

Oh, yeah, here's more about money, from Pink Floyd.
posted by Vibrissae at 6:59 PM on May 23, 2011

I've seen the future, I can't afford it.
posted by larry_darrell at 7:20 PM on May 23, 2011

If any company outside the financial sector had performed in that way, they would be dust almost overnight. The agencies continue on, performing a public function in private, inscrutable ways, for private reasons.

you can almost see them getting away with it, e.g. "In the final days of negotiations over Dodd-Frank, lawmakers stopped short of eliminating the so-called issuer pays model that causes potential conflicts of interest."

also btw, speaking of conflicts (and dust...)
The Case Against Private Prisons
Private prisons don't save money, but they create an obvious and counterproductive profit motive that leads to policies that increase the prison population. Private prisons need more prisoners. While the most effective way to reduce prison costs is to "reduce the headcount," that is, the number of incarcerated. Private prison companies have a financial interest in doing the opposite. So whatever cost-saving private prisons might offer in the short run is swamped by their interest in making sure America imprisons more people, because otherwise they'd go out of business...

I'd be much more sanguine about the prospects for an agency in either the prison or welfare system that got paid only if their "clients" stayed employed, out of jail, and drug free for a year after leaving the system. But I doubt you could find many companies willing to take on such a contract, because who wants to bet on your ability to change the behavior of legal adults who have, as a group, a higher-than-normal propensity to be out of work and take drugs? ...

The genius of the real private economy is that firms that are really poorly run go out of business. It's not that some magic private sector fairy dust makes the firms all be runs soundly. Lots of bad businesses are out there. But they tend to lose money and close. Meanwhile, well-run firms tend to earn profits and expand. The public sector doesn’t have this feature. Just because a public agency is inept is no guarantee that it will go out of business. Resources are allocating according to political clout rather than any criteria of merit. It's a problem. But it's not a problem that "privatizing" public services actually solves. There's no magic private sector fairy dust.

posted by kliuless at 8:42 PM on May 23, 2011 [4 favorites]

Oh, it's more than that, klieuless:
Five of eight private prisons serving Arizona did not accept inmates with “limited physical capacity and stamina” or severe physical illness or chronic conditions, according to the state’s analysis, issued last month. None took inmates with “high need” mental health conditions. Some inmates who became sick were “returned to state prisons due to an increase of their medical scores that exceeds contractual exclusions.”

“Unlike the private contractors,” the analysis said, the state “is required to provide medical and mental health services to inmates regardless of the severity of their condition.” Medical costs averaged up to $2.44 a day more for state inmates, a third higher than private prisons.

That gap can be wider. In Florida, officials found that two private prisons spent only about half as much on health care per inmate as comparable state prisons, a difference of $9 million over two years. Florida officials say that the new plan will better balance costs, and that private prisons comply with a 7-percent-savings law. But skeptics like State Senator Mike Fasano, a Republican, fear cherry-picking may be the only way they can do that.
posted by hippybear at 8:59 PM on May 23, 2011

I used to work for the financial regulator of an industrialized country and the general thrust of this post- that information in markets is unreliable and thard to come by- is spot on. At least, I think it is. I was personally not able to comprehend the systemic forces in markets, and sometimes had difficulty finding important data necessary for the policy-making with which we were charged. Maybe I was incompetent, but I didn't see anything in my more senior (and usually highly intelligent and dedicated) co-workers to suggest that any of them was capable of doing so either. Maybe someone was good enough- I don't think we were, or could be. And I think we were pretty good.

While I worked there, I thought that one of the factors we should consider in making policy was simplicity. Any new approach in the market should be presumed to be a bad idea if it further complicates the situation. I never did suggest it, since I was very junior and it seemed like a radical suggestion. But if you think that the regulators play an important role, then something that makes them more effective- whether comprehensibility of markets or anything else- should be considered a positive. This kind of thinking is unpopular in the present political climate, in which regulation has been successfully branded as limiting, stifling, and negative.

I would also add #7 to this list: Trades should be conducted in open markets. "Dark Pools" of capital are growing. That sounds ominous, right? I think it is. For a variety of reasons (front-running algos, internalization of order flow by large players, desire for secrecy), a smaller portion of trades are being conducted on the open markets (on NYSE, the LSE, etc), reducing price discovery and further obscuring important financial data, and creating large information asymmetries between those in the know and the rest of us.

Thanks for this excellent post. There's a lot of interesting material here.
posted by the thing about it at 10:16 PM on May 23, 2011 [4 favorites]

The idea of regulating levels of complexity is very attractive. But complexity is tricky and can be expressed in many forms, across different agencies and legal codes: it can exist on many different levels. To my knowledge, there isn't a well-accepted method for measuring complexity even of such well-defined things as computer programs. There is "algorithmic complexity", but this measures the speed of computation in problems requiring vast repetition of simple steps. It's not helpful in trying to determine the complexity or number of decisions needed to determine the ownership of a piece or property, or the legality of an action.

Is anyone aware of work being done in rigorously defining the complexity of a rule-based system, such as a regulatory or a legal system?
posted by yoz420 at 1:15 AM on May 24, 2011

If you have a 95% chance of doubling your money every year, and a 5% chance of losing everything

I think the interesting part is if you don't have a basis for risk analysis, then you cannot make any pronouncements about what the chances of anything are. You require inputs to make the risk calculations, and without them, you are not investing, you are betting.

And financial institutions who maintain positions on the basis of risk analysis that has no anchor in reality believe they are secure, when in fact they have no idea of their risk exposure. Oh boy.
posted by dglynn at 5:30 AM on May 24, 2011 [2 favorites]

His general thesis seems to be: law comes first. Then the kind of market that the law supports.

I think this is broadly correct. Certain kinds of market can only exist where there are certain networks of law. Without them, you do not get effective capitalism. Put another way: libertarianism can actually only exist in a greenhouse. Somebody else has to build the greenhouse.

Hence, the state comes first, because you need something of sufficient power to act as referee - or judge.
posted by lucien_reeve at 5:46 AM on May 24, 2011

Any sufficiently advanced incompetence is indistinguishable from malice.
posted by vicx at 8:37 PM on May 24, 2011 [2 favorites]

re: front-running algos, there was a good article in the lrb recently, that i excerpted here...

also re: risk homeostasis, i think we had a good discussion thread in this post from awhile back (complete with car and sports analogies!)

Any sufficiently advanced incompetence is indistinguishable from malice.

oh and, fwiw, altho used to set up a point about the conspicuous lack of women roaming the halls of power, i thought this paragraph ably described the (apparent) collective apathy of society that allows incompetence/malice to be tolerated...
Now, our information society has made admirable progress learning to appreciate the behaviors and pathologies of the New Global Elite over the last few years (and adjust our expectations accordingly). We have given up our naive belief that laws will be used to prosecute “fraud” and made our peace with their brazen tax avoidance schemes, and we have, for the most part, come to recognize that whatever “rage against the machine” we harbor is best targeted at unionized sanitation workers, public school teachers and the like. What we have not fully come to terms with is how the unstoppable rise of the New Global Elite has ravaged gender relations...
[random 'impressionistic' links thrown in to provide 'context' ;]
posted by kliuless at 10:02 AM on May 25, 2011 [1 favorite]

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