Divine Neutrality, Blog. Science, Philosophy

Bubbles

December 15th, 2015

Irrational Exuberance


In a lovely talk to the Concept Exchange Society, economist Daniel Friedman told us about financial markets. He said that a financial market is a “marketplace where promises are bought and sold by strangers”. I like that image. A bond is such a promise; a promise to pay interest at fixed intervals and to repay its principal, the loan amount. A mortgage, or a package of them, is also such a promise.

Dan discussed the history of recurrent fluctuations in market prices. They undergo inflation then deflation and back again. He mentioned such a balloon event that culminated in 1720 England; the escapade of the South-Sea Company and its scheme to buy the National Debt. Here is my understanding of the scheme. It may be flawed.

In economics parlance when you ‘buy debt‘ you don’t acquire the debt itself – the owing of money – but rather you acquire the right to collect the debt. You buy the creditor’s promissory note. If the note stipulates periodic interest payments, you are buying yourself an income stream.

The debt involved in the South-Sea Company scheme was the British Government’s promissory notes. They paid regular interest and were held by a large number of the public. Held, say, by people who had put their life’s savings into something that would pay them a modest income on which to live. An income stream from Government secured notes.

The notes had been issued by various Departments of the British Government. At that time each Deparment of Government made its own financial arrangements. Each had its own accounting section which issued and managed these debt accounts. With such a system in place it was easy to argue for consolidation of the debt; all loans into one grand account. And to be issued by one single agency of Government; the treasury.

The promoters of the scheme had members of Parliament make speeches exactly to this effect. And these promoters offered a solution. They would acquire every note-holder’s note. The Government could make the entirety of its regular interest payments to a single recipient, the South-Sea Company. The South-Sea Company would acquire the notes by ‘buying‘ them; exchanging shares in the Company for the notes at the rate of £115/share. If your note was worth £1,150 you got 10 shares of South-Sea Company stock in exchange for it. In the parlance of the cogniscenti, “debt was exchanged for equity”.

Why would a note-holder want to do this? Because the value of South-Sea Company stock had been steadily rising and continued to rise on rumors of impending good fortune. You could double your money! Or better! The share value topped £800 at one point. There arose a mass hysteria to acquire South-Sea Company shares. The buying hysteria spread to shares in any company at all. So all financial market share prices rose stimulating even more of a stock buying frenzy. To capitalize on the moment new companies formed and offered stock.

In his book, “Extraordinary Popular Delusions and the Madness of Crowds” (1841), Charles Mackay writes “Every body came to purchase stock. Every fool aspired to be a knave.” “But the most … preposterous of all (stock companies) and which shewed … the utter madness of the people, was … entitled ‘A company for carrying on an undertaking of great advantage, but nobody to know what it is’.”

In fact the South-Sea Company was a sham. It had no prospects. It paid some dividends to stock holders at the beginning using the pool of interest payment money coming to it from the Government. These dividends helped the Company’s image and increased its share value. But the Company never had a significant source of income other than from the Government. So it collapsed bringing the market down with it.

Now consider the U.S. mortgage bubble of 2008. Here is my overview of events – revised from the original flawed post:

Insurance companies, banks, pension funds, investment fund managers, investment banks and hedge funds hold capital that they must invest. They can’t just store it in a vault. Money is expected to earn money. The very safest investment is in Treasuries; bonds issued by the U.S. Treasury. But the returns from these are low. Safe investments with higher returns are always in demand. And, for an investor, safety is quantifiable; a matter of, say, an AAA rating by the ratings agency, Standard & Poors; an organization specifically devoted to assessing risk.

Intelligent and very imaginative people at a major financial institution introduced the idea of packaging home mortgages into securities salable in financial markets. They are called Mortgage Backed Securities (MBS). The purpose was to invent something attractive to buy for the people holding capital. The digital age, in which we live, allows the complex accounting tasks involved to be assigned to a computer.

The governing rationale to the scheme was this: that mortgages, when pooled together by thousands in a package, hold less risk than their average individual risk. The assessment of risk is not an exact art. Mathematically astute people persuaded the financial community that financial engineering – smart packaging – produced securities of good return but low risk. The ratings agencies must have been cowed by the arguments (or otherwise influenced) because they certified these securities as, indeed, low risk. That the theory was wrong became apparent with the financial collapse that ensued; events belied the theory’s predictions.

The demand for mortgages to package into securities incentivized mortgage-lending banks to produce more mortgages; to court new home buyers in order to replenish and sell their mortgage holdings again. Thus loan eligibility requirements become lax and the mortgages being absorbed into pools were ever more risky. When this became apparent the value of the Mortgage Backed Securities dropped precipitously. The scheme collapsed bringing the market down with it.

See Can Growth be Sustainable?

An essential element of our economic structure – the financial market – depends intimately on gambling! And, among the gamblers, are marvelously clever fellows. Their originality shows itself in the creation of novel financial instruments. Those who game the system see the activity as an art form. They feel a calling to do it. They are probing its limits. Just such probing is respected in many fields of activity – in sport, in art, in science, in dance, in mathematics, in music … Only the most gifted among us probe the limits of a human construct.

After every market collapse there arises a howl of indignation. People are indignant about the perfidy of the perpetrators. How could such chicanery be allowed to happen? Why can’t laws be passed that will stabilize the market and prevent these fluctuations; prevent rogues from manipulating the market?

I suspect that nature will not allow us to rid ourselves of rogues. They are as necessary to us as gambling is. No law can guarantee a clean demarcation between productive and unproductive speculation. The reform of banking, say, by resurrection of the Glass-Steagall Act of 1933, repealed in 1999, will be a deterrent to some schemes. But nature evolves, as will financial institutions evolve, and new mischief will be created to upset them – perhaps, next time, by an emancipated woman instead of a man. Society must perpetually re-adjust its legal stance, each time proscribing the last blow it received. Future originality, by the meaning of the concept, is not predictable. So human institutions will always be under attack. The price of well-being is eternal vigilance.

Of course, a life devoted only to vigilance is a meagre one. Playful irreverence is needed for fullness. And that is what motivates the attackers.

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Right Wrongs

August 1st, 2015

Drowning in the ocean of injustice.

Context: An atomic bomb was dropped by the U.S. on Hiroshima, Japan in August of 1945. This event was the critical one which ended the Second World War. Some claim that it was an act of savagery needlessly killing many because the war could have been ended without that event.

Dear Ted:

Thank you for the passages from Zinn. (H. Zinn, 2010, “The Bomb”) Your outrage against the injustice portrayed by Zinn is understandable. My world outlook forbids me from accepting Zinn’s thesis without scrutiny but let us accept it for the sake of conversation. The thesis is this:

    Influential advisors, mainly Jim Byrnes, led President Truman, in 1945, to sacrifice the lives of over 200,000 people unecessarily, by dropping an atomic bomb on them, for the sake of a political power gambit: to pre-empt any Russian influence in the defeat of Japan. To “let us dictate the terms of ending the war.”

Let’s grant this interesting thesis. What are we to make of it?

I know, Ted, what you make of it. A reason for moral outrage. A call to wake fellow citizens to this atrocity committed by our government.       (more…)

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Money Mechanics

July 27th, 2011

Money: Nutshell Mechanics and the Significance of the Debt Ceiling

Premise: Government functions. It does things. It must pay for its buildings, for roads, for its military, for its functionaries, for farmers’ subsides, for welfare projects …

1. Primitive government finance.

Government (its treasury) pays its bills with printed certificates (called currency) These certificates are promissory notes. The promise is to redeem them – to accept them in payment of any obligation to the government. For example, it promises to accept these same notes in payment of tax obligations.

A balanced budget is when the Government collects in taxes as much as it spends. Naturally the Government is loathe to collect taxes because tax collection makes the Government unpopular. So it tends simply to print whatever currency it needs to pay its bills. Doing this causes the currency to lose value. When the supply of circulating currency rises, each unit is worth less in goods or services. The steady loss of currency value is called inflation.

2. Modern government finance.

In modern times the printing of money is not something that the government does directly. Until a Central Bank was created in the U.S. most any bank at all issued currency. They had ‘bank notes’ printed. Each bank issued its own notes. To ‘issue’ means to ‘pay with’. They ‘paid’ (made their loans, bought supplies, paid employees) with their bank notes. These were promissory notes; promises to pay on demand. To pay what? Answer: specie or gold, but more importantly, the promise was to redeem the note. To redeem the note means to accept it in payment of any debt to the bank. For example the interest payment to the bank on a mortgage it holds.

These bank notes functioned as money in the community. They were generally accepted in payment for goods or services since the holder could, in turn, use the bank notes to pay his or her own bills. The notes of different banks were exchangable via exhange rates between them. Like exchange rates between different national currencies today.

Currently the U.S. Central Bank – the Federal Reserve – is the only bank in the U.S. allowed to issue bank notes. And these are used for currency. The Government’s Treasury pays all the Government’s bills. It pays the salaries of officials. It pays the debt service. It pays for the military etc. All with the bank notes issued by the Federal Reserve.

It acquires these bank notes in two ways. It collects taxes which are paid with these bank notes. And, when need arises, it solicits loans. It issues (sells) long term promissory notes called bonds. Bonds are promissory notes that need be repaid only many years after their sale. They are purchased by investors and the money paid for them – in bank notes – goes into the Treasury. The Treasury must pay the interest that is due each bondholder and it must eventually ‘redeem’ the bond. i.e. repay the loan that the bond represents. The bondholder buys the bond for its income (the interest payments) and because a U.S. Government Bond is considered to be an essentially risk free investment.

The Federal Reserve Bank buys these bonds on the open market with ‘bank notes’ i.e. with printed paper certificates called Federal Reserve notes. The idea: Every bank note issued is ‘backed’ by a valuable asset: a bond of the U.S. Government (assumed to be as good as gold!).

Click on the go/reset button in the Money Creation motion graphic above to see the process visually. In that graphic each column pair represents a balance sheet. Liquid assets are green. Illiquid assets are brown. Liabilities are red. And net worth is blue. See  http://chesters.org/marvin/economations/ for further elucidation.

The modern method of ‘printing money’ to pay its bills is this: The Government Treasury issues (i.e. sells) bonds which the Central Bank (the Fed) then buys with ‘bank notes’ that it prints. The law says that the government may not exceed the debt allowed by Congress. So the debt ceiling must be raised periodically to permit the Treasury to sell bonds in order to have money printed by the Federal Reserve to pay its debts.

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