30 April 2011

Public and Private Pensions

A passage from what will become chapter 14.

Let's talk about pensions. In the simple dictionary sense, a pension is a fixed amount paid by an employer to a retiree or a former employee's survivors in consideration of past services.

A pension plan is a fund established with an eye to subsequent such payments.

Pension plans are often divided into two general types, "defined benefits" and "defined contribution". The labels are self explanatory. But just to be very clear ... in a defined contribution plan, the sponsor/employer on the one hand and the employee on the other will make specified contractual contributions to the fund over the period of employment. The benefits are not defined, and so they will be determined by non-contractual factors, notably, how successfully those contributions are invested over the period before the fund has to make payments to the retiree/beneficiary.

In a defined benefit plan, on the other hand, the employer/sponsor becomes the guarantor of the contracted-for benefits, regardless of how well the fund does.

The golden age of defined-benefits plan was also the era of U.S. hegemony and self-confidence. It was the post-World War II era -- Bretton Woods tied the dollar to gold and tied every other currency in the world to the dollar, which seemed only right, given U.S. strength and centrality. Nobody ever expected that the major US corporations, those that hired the much maligned men in the gray flannel suits, would not always be around, or would not always be good for the money they were promising in decades to come.

In Detroit, the golden age of defined contributions was the time of Alfred Sloan and Walter Reuther, the heads of General Motors and the United Auto Workers respectively at the time of the "Treaty of Detroit" in 1950. GM was coming off a very profitable year (1949 was a record maker for it) and felt sufficiently flush to declare a stockholder dividend of $190 million when it decided to ensure itself against labor unrest by paying half of employees' hospital and medical insurance, and offering a pension of $125 a month. As measured by the value of the U.S. dollar at the time of the 2008 crisis, that would be the equivalent of $1,040 a month.

In his 1963 memoir Sloan would congratulate himself on introducing "an element of reason, and of predictability" into GM's labor relations.

But of course, it was an element of "predictability" only because continued prosperity for General Motors was deemed predictable. Further, the precedent once established, buying peace in this way became a habit, because at each negotiation cycle thereafter the issue would be one of embellishing the benefits offered in the existing system.

Both sides of such a negotiation could benefit by billing the future, by creating an ever more expensive defined benefits plan to be financed however-it-would-be and paid at a future date. The corporate bosses avoided strikes, keeping their shareholders happy. It was easier to promise benefits in subsequent decades than it would have been to make here-and-now salary concessions. For the same reasons, the Labor bosses were happy. They had a win with each round, and could brag to their rank-and-file about how tough they were.

Under the heading of public pensions, there is this.

29 April 2011

Part Three Begins

Part Three of my book will have the heading "Some Policy Consequences."

Some transitional material. In chapter 10 we asked ourselves: what keeps those hungry piranha alive in the liquid marketplace? After all, they can't perform their function of continuing to eat up raw meat (profitable inefficiencies) unless there is a fresh supply of raw meat. We identified some of the sources of inefficiency. One of these is bankruptcy law, and the opportunity it affords to those willing to buy up distressed debt and maneuver their way through the system.

But of course it is not the job of public policy to make life easy for such piranha. Indeed, I propose in the following four chapters to work on the presump-tion that it is the job of public policy to make their life more difficult, to narrow the ecological niche that piranha fill.

Its first chapter, 13, concerns "Bankruptcies and Rescues."

Within US laws that now govern corporate bankruptcies, there are at least two great sources of inefficiency. The first is the degree of secrecy the system allows, and the second is the skewed incentives that it creates for trustees. We'll look at those in that order, and then we'll ask a broader question: does the U.S. really need a voluntary system of corporate reorganization at all? What might happen if the only corporate bankruptcies were the involuntary sort sought by creditors?

The Federal Rules of Bankruptcy Procedure in their current form [though amendments are scheduled to take effect this December], prescribe disclosure by an "entity or committee representing more than one credit" of the identity of the creditor involved, the nature and amount of its interest, the dates on which the separate interests were acquired, and even the amounts paid for them. If rigorously enforced, that would make life rather difficult for speculators, who depend upon the opacity of the proprietary strategies. They have resisted rigorous enforcement of that rule, creating committees that aren't really committees, for example.

In the case of Northwest Airlines (2007), this technical-sounding issue received a burst of publicity. The condition of the US airlines industry made this bankruptcy of especial interest to a broad public.

28 April 2011

Evolution as Path Dependence

In a message board to which I go now and then to vent, I initiated a discussion of evolution. My own view, FWIW, is that humans almost certainly evolved from non-human primates, who in turn almost certainly evolved from non-primate mammals, and so forth. On the question of mechanism, I am skeptical about the explanatory value of natural selection. Still, I wanted the sense of my fellow posters'/venters' opinions, and not surprisingly got an earful.

I was also challenged, appropriately enough, to present a fuller statement of the reasons for my own view. I'll reproduce part of what I said in response, here:

Of course, macroevolution involving Australopithecus, Homo Habilis, and the rest of that cast of characters cannot be “observed” in 2011, any more than Julius Caesar can be. We have no choice but to rely on inferences in either case. But I’m not willing to give up on knowledge of the past of either thousands or millions of years ago.

If that is all I had to say, though, I’d be evading your sensible call for reasons. So here, with that as qualification and introduction, is a fuller statement of some of the lines of evidence that lead me to infer that the origin of our species is likely not that of a separate creation, but a matter of evolution from other less brainy primates.

To begin, there are our own bodies. In some respects, these do not seem to have been the product of any one-time intelligent design. Consider our appendix. This has been the subject of much contention. ID and creationist literature has made the point that the appendix can do various valuable things here.

Yet there is still the fact that a lot of us manage to live long lives long after the appendix has been removed – and that it had to be removed because it posed a threat to our lives. This seems, on the face of it, a counter-example both to intelligent design and to natural selection. But I'm just making a case here for path dependence, for the notion that our very distant ancestors were very different creatures from ourselves, and that this fact helps make us who we are. It does seem that the appendix continues to qualify as a dangerous vestige of earlier periods. Confusion comes about because of the misuse of the word “vestige” in this context, but let us avoid purely semantic quarrels. I'll link to a detailed discussion here.

Second, still looking inward, even aside from vulnerabilities such as the appendix, there are oddities such as the way Ostriches use their wings for balance when running. (Okay, this is a non-human example, but it relates to the broad issue of macroevolution). Surely an engineer, an intelligent designer, could have designed a more efficient way for a creature to balance itself. Lots of creatures run very quickly without falling over, and without the help of wings.

It seems to me (yes, making inferences, indulging in speculation) reasonable to suppose that the ostrich is descended from other species of bird that flew. Over time, creatures evolved from them that did not fly. Why? Because flight itself is a great expenditure of energy for those creature that rely upon it, and that energy could well be redirected into, say, finding a mate and caring for the young. Survival pressures might have started working against flight as soon as predators disappeared from a particular environment for whatever reason, so the energy use of flight became a waste. The wings, as pre-existing material, were then available for use as a balance, and that functionality was built into further evolutions, until we got to the ostrich. I suppose, if you wish to consider all birds simply as birds, that particular hypothesis could even be accepted and labeled as “micro-evolution.” But if that is micro, then the evolution of humans from other primates is micro, too. If the development of humans qualifies as macro, then I submit so does the development of the ostrich.

Thirdly, let’s talk about fossils. What are we to say of the Tiktaalik roseae?.

According to the University of Chicago, this is the fossil of a creature with a mix of fish and amphibian traits. It seems to have moved about on land without having been ready for that quite yet. The adaptations that would make sense for a more determined land dweller weren’t there, and some that make sense only for a sea creature were still there. Further, the specimens are dated to 375 million years ago, which fits nicely into the story that evolutionary biology had been putting together about life on earth before these fossils came into the ken of human observation … in 2005.

Fourth, let’s move up to something a little more recent. A mere 47 million years ago. Only one-eighth as old as Tiktaalik. What are we to say of the Darwinius Masillae? You can figure out what its discoverers thought of it (the name they gave it is a hint.).

The photograph there is a thing of beauty. The actual cladistic significance will be a subject of debate for a long time, since that is how science works. Plenty of room for inferences yet undrawn, not to mention wilder speculations here. But underneath it all, Darwinius seems “designed” to point in two different directions, toward lemurs on the one hand, and toward monkeys on the other.

Further, note the dating in each case. Yes, evolution would have suffered something of a blow if the Tiktaalik had been dated to only 47 million years ago and the Darwinius to 375. But that did not happen. Each fossil is where it ‘should’ be in the timeline.

Finally, let’s come to the paleontology of primates. The cluster of Ardipithecus, Australopithecus and Homo species and debate about them continues of course. Competing museums, universities, and paleontological egos are at stake, so we can be sure there is a big future for such debates.

Recent excitement, though, (including some of my own) centers on Michel Brunet and his discovery in Chad, the Sahelanthropus Tchadensis.

Teeth and skull seem “human,” and these fossils date to between 6 and 7 million years ago. My own best inference from such fossils is that they will in time coalesce to tell a coherent story of development through various sorts of primate of the features of modern homo sapiens. You can always prefer to believe that God simply decided to create the Sahelanthropus, and the Orririn Tugenesis, and the Ardipithecus kadabba, and so forth – the whole range of species in the Africa of millions of years ago as indicated by such fossils – that each was specially created and involved no transitions to one another. Yet that seems uneconomical, and seems more a matter of giving up at explanation than of having found one.

My own conviction is that our bodies like our minds are the consequence of the will of a Prime Mover, and many of their particulars are path dependent, the product of the various secondary causes through which that Prime Mover has deigned to work. These big cerebral hemispheres with which we ended up can be put to few better uses than to work out the connections, which will surely over time shed light on our present condition.

24 April 2011

For Your Easter Sunday

From Albert Schweitzer, The Mystery of the Kingdom of God.

All italics in the original.

"Jesus, however, reached back after the fundamental conception of the prophetic period, and it is only the form in which he conceives of the emergence of the final event which bears the stamp of later Judaism. He no longer conceives of it as an intervention of God in the history of the nations, as did the Prophets; but rather as a final cosmical catastrophe. His eschatology is the apocalyptic of the book of Daniel, since the Kingdom is to be brought about by the Son of Man when he appears upon the clouds of heaven (Mark 8:38 - 9:1).

"The secret of the Kingdom of God is therefore the synthesis effected by a sovereign spirit between the early prophetic ethics and the apocalyptic of the book of Daniel. Hence it is that Jesus' eschatology was rooted in his age and yet stands so high above it. For his contemporaries it was a question of waiting for the Kingdom, or excogitating and depicting every incident of the great catastrophe, and of preparing for the same; while for Jesus it was a question of bringing to pass the expected event threough the moral renovation."

23 April 2011

Not Scott Adams!!!

I'm a huge fan, But this news rather dismayed me.

Scott Adams is the wonderfully talented creator of "Dilbert." I am a fan not only of that strip but of some of Adams' other writings, as I've established on this blog by regularly employing his list of "tomorrow's headlines."

That has no very close connection to this ... Adams has described evolution as an established fact. But he has also said he expects the notion of "time" will be radically re-formulated in our lifetimes, and that the overthrow of any theory about biological evolution will be one consequence of that. This gives him an interestingly bifurcated view of the subject.

Who cares what a cartoonist thinks about evolution, or for that matter about the physics of time? Well ... nobody much.

Anyway, the minor brou-ha-ha about Adams' sock puppetry came to my attention because I checked Felix Salmon's blog Monday morning and saw this.

So I've been thinking about Adams, and this has led me in turn to think some more about evolution.

Insert some clever joke about the evolution of sock puppets here.

22 April 2011

A World Without A Monetary Superpower

What will become my chapter 12.

On April 18, 2011, one of the Big 2 major credit raters, Standard & Poor's revised its "outlook" on its long-term rating for U.S. Treasury debt from stable to negative.

This news was left in the provinces visited mostly by financial-news wonks, while sleeping air-traffic controllers and a continuing civil war in Libya (and the pseudo-campaign of possible Presidential hopeful Donald Trump) continued to get headlines. Syill, the S&P announcement was yet another straw in a wind that had been blowing for some time already -- the emergence of a world in which there will be no hegemonic economic/financial superpower.

Our business in this chapter is an examination of the consequences of a truly multi-polar financial world.

Note that El-Erian, in the blog entry to which I've just linked, refers to the "risk free" standard as one of the "global public goods" that US hegemony provides. What he means to ask is:
how will anyone make use of the Black-Scholes formula if the US Treasury gets an S&P downgrade? Any use of the formula requires a value for “r,” the risk-free rate of return. My understanding is that T-bills have provided a proxy for r.

I raised this issue in the comments section of one of Felix Salmon's blog posts. Another commenter responded, "Observe option prices, assume put-call parity, and back out r."

But back to S&P. Along with the words of caution, it re-affirmed AAA sovereign credit rating for the US. Why would it do both of those things? As Einstein noted, everything is relative, and the US can only really be measured against the handful of other countries that have the coveted AAA rating. Yet in that company, it has earned its downgrade: "Even in our optimistic scenario we believe the US's fiscal profile would be less robust that those of other AAA rated sovereigns by 2013."

On a related front, Robert Zoellick, president of the World Bank Group (2007-), one-time U.S. Trade Representative (2001 - 2005), one-time Goldman Sachs managing director (2006-07), spoke in November 2010 about the need to “look beyond Bretton Woods.”

Actually, we've all been "beyond" Bretton Woods for about 40 years now. What I take it Zoellick means is that the diplomats and international finance bigwigs to whom he was addressing himself should look to fix the free-float of all-against-all that replaced it, and that they shuld seek to do so by moving forward not back.

We're building on chapter 6 especially here. Will not repeat its historical lessons. Let's focus, instead, on what Zoellick meant by this.

He seems to have in mind especially a sort of G2, an accord between the US and China to share a leadership position. "The U.S. and China could agree on specific, mutually reinforcing steps to boost growth," then to create "wide bands for exchange rates" and finally to work out a new series of market-opening trade agreements. The reference to the G2 agreement on exchange rates suggests that there could be a shared numéraire role. A numéraire is the currency-of-currencies, the one (or two?) that may be said to back the others.

I have to dissent from RZ here, the idea of 2 currencies sharing that role, especially when they are the currencies of countries so different, seems to me unworkable. Explain why.

RZ also says this: "The system should also consider employing gold as an international reference point of market expectations about inflation, deflation and future currency values. Although textbooks may view gold as the old money, markets are using gold as an alternative monetary asset today."

One or more major currencies links or re-links itself to gold, and then floats freely re: the other. Competing to acquire the status of numéraire.

Or, forgetting RZ, the US could take unilateral action in another direction, without the stigma of gold but perhaps with the same benefits. Repeal the special legal tender status of the dollar domestically, allow competing currencies. The winning currency within the US market will be in a sound position for export.

21 April 2011

On Greed and Money

Chapter Eleven.

I have to integrate bonds and bond insurance into the over-all picture I've sought to create of what happened, especially in the US though we did all too good a job of then exporting it, in the period 2007-08. This requires backing up chronologically. It was in the world of quasi-public agencies that the notion of "too big to fail" got its start when Nelson Rockefeller and John Mitchell (before he was immotalized by the Watergate scandal) planned a novel way of financing affordable housing, although they didn't actually use that phrase.

1. Nelson Rockefeller and the "moral obligation" bonds of New York
2. The rise of the muni bond insurance industry
3. Who is really paying for this insurance? Third party payment as a regular matter is a common symptom of systemic trouble.
4. MBIA, accounting chicanery, and crack houses as collateral
5. Elliott Spitzer and rumblings in early 2008. (Valentines' Day)
6. Fall of Bear Stearns. Spitzer's fall served as comic relief.
7. The rest of that year from the bonds/insurer POV.

The material included under this heading in my book proposal can serve as the chapter's ending:

Where do we go from here? The credit crunch of 2007 and the stock crash of 2008 are in the history books and time travel is impossible, so we only work forward.

We should be wary of a “hair of the dog that bit us.” We should refuse to resolve this hangover by easy-money nostrums and loose-accounting remedies, or by making it easier for corporate managers to entrench themselves. That dog will only get more rabid and bite still more devastatingly if we indulge him further.

17 April 2011

From Yahoo!Answers

Somebody using the screen name "discovery" recently asked the following in Yahoo!Answers.

Philosophers argue that God is a delusion. How should I structure my essay.

This raises the question: is his essay supposed to be about the contention that "God is a delusion," or about the philosophers who argue that? The former requires that he think about God himself, the latter only that he pass along the thinking of others.

Let's imagine that he is expected to think about God himself. The statement "God is a delusion" covers a lot of ground. There are various ways of being wrong, so it is logically possible for an atheist to deny that God is a delusion -- to maintain that God is some sort of category error.

Nonetheless, let's again make the field-limiting assumption that the claim that God is a delusion simply denies that God exists. However many distinct ideas there are of God, there are that many distinct meanings to a possible denial.

Let us make a further limitation of the field in the spirit of the Passover/Easter season. One common and historically important meaning of God is as a giver of laws for human conduct, a moral legislator. With all that in mind, I proposed on Yahoo! the following structure for a possible essay:

1. Define the idea at stake. We know that government officials tell us what to do and punish us when we fail to do it. We know also that throughout history people have appealed to a higher Authority and its Higher Laws. "Let my people go!" they say to this-worldly legislators.

2. So: Is the idea of God defined in that way a delusion? Consider three influential arguments:
2a. Hobbes, The earthly state, the Leviathan, is the only proper source of guidance so there is no appeal, no excuse for disobeying Pharoah or King Charles.
2b. Kant. Although Kant adhered to religious faith in his own manner, he held explicitly that the argument to God as a moral legislator fails because our human reason by itself explains to us how we ought to act. The law to which we appeal when we defy the authorities is within us, not above us.
2c. Contemporary atheists argue that 'God' as people conceive of Him is a pretty lousy legislator, who tells them to fly airplanes into skyscrapers for example. So we're better off without such a legislator. This is presumably related to 21b, and specifically to what Kant was saying here, but Kant's broader system allowed room for further distinctions in which contemporary atheists (Hitchens, Dawkins etc.) are uninterested.
From each of these points of view, then, we could maintain that God is a delusion.

3. There are counter-arguments to each of those three arguments. Depending on how long your essay is going to be, you can either provide them in full or merely hint at them.

16 April 2011

Yes, Joan is Pregnant

Back on March 3 I posted a summary of the final three episodes of season four of Mad Men. Yet, as Cicily reminded me in the comments section at the time, I neglected to mention a rather important datum: Joan's pregnancy. Here is my penance -- the Joan story arc.

We first met Joan (then Joan Holloway), played by red-haired, buxomy Christina Henricks, in the opening moments of the first episode first season, where she was the veteran showing the ropes to the new secretary, Peggy Olson.

We soon learn that Joan has had a long term relationship with Roger Sterling. In episode six of this season, Roger buys Joan a bird. Why? Apparently to keep her company while she is alone in her apartment, so she won't be seeking other men to keep her company while he, Roger, can't be there (because of the wife and stuff.) Joan exhibits an unflustered realism about Roger, as she does about most of what happens in her life throughout the show's run. She says for example, "We both know I'll find a more permanent situation and you'll find a new model. The 61s are coming out soon."

In the second season, Joan briefly seems to have found a new career niche for herself, as Harry (who is now head of the 'TV department' -- actually, he is the department) puts her to work reviewing the scripts of TV episodes to be sure that there is nothing in them that conflicts with the products Sterling Cooper wants to sell. This doesn't last, though, and Joan is crestfallen when Harry finds somebody else to do that work.

Even more important, in this season Joan acquires a fiance, Dr. Greg, and we see that Greg has a dark side. He rapes Joan on a visit to the workplace -- in Don's office, as it happens -- and when Joan abandons her resistance to this she looks resignedly to the drinks cabinet as the camera pans off. Marital rape was generally not a crime in 1963 -- but these two weren't yet married -- yet the event has no repurcussions. Joan has apparently decided that marrying a doctor is the sort of thing she is supposed to do, and the significance of this event is to warn us, and her, what this particular marriage will entail.

In the third season, in July 1963, the Brits are taking over the agency, and Joan is supposed to have a going-away party (doctor's wives don't work). That party, though, is rather rudely overshadowed by a nasty incident with a tractor that crushes one of the Brits' feet. He'll never golf again, as someone remarks.

We see Joan a couple of episodes later working at Bonwit Teller, where snivelling Pete has to go to exchange a dress, for reasons I won't get into. She is there because of Dr. Greg's career troubles.

We catch up with her again when the Americans, dissatisfied with their Brit overlords, leave to start their own agency, and realize in the process that they can't do it without her. She is hereafter Mrs. Harris.

This gets us back to season four. As I've noted in earlier blog entries, Greg's career troubles drive him into the Army, and to Vietnam in the course of this season. On the day when Greg learns that he is headed for that battleground, Roger Sterling decides to re-ignite his old affair with Joan. She proves initially unreceptive, and he buys her a professional massage, which seems to both literally and figuratively loosen her up, as intended.

They have a meal together, and soon after they leave the restaurant, they are accosted by a stick-up man, who makes off with Roger's watch and wallet and Joan's bag. This proves stimulating, and they proceed to have sex in the street. This is the encounter whence comes Joan's pregnancy.

In the following episode, presumably some weeks later, Joan tells Roger she's late. "Very late." The subject of abortion immediately arises, although in coded language. Roger thinks she should have the baby -- after all, Greg could conveniently die in Vietnam, never knowing anything about it. Joan objects to this heatedly.

In a later scene we see Joan in the waiting room of a doctor's office, presumably with abortion in prospect. She speaks to another woman in the waiting room -- that woman is the mother of a 14-year-old pregnant girl, and assumes Joan's situation is the same. Joan goes along with this assumption. But we don't see anything further of Joan in this episode, and the fan sites buzzed thereafter with the question whether she went through with the abortion.

In the season finale there's a neat quiet moment with Joan and Peggy eating lunch together, grousing about Don's engagement to Megan. Joan says, "I learned a long time ago not to get all my satisfaction from this job."

Peggy replies, "That's bullshit," and they laugh.

In the final scene, Joan Harris is talking to her husband, who we see at his base in Vietnam. The conversation makes it clear to us that she did not have an abortion, and that she has told Greg she is pregnant with his child.

That, then, is the Joan saga to date.

15 April 2011

The Sloppier Reality

Some thoughts toward what will eventually become chapter 10 of my book, ECMH, The Much Sloppier Practice.

Though there is much to be said for the ECMH, it has its limits as an explanatory tool. There are certain respects in which certain asset price moves are not random, and in which accordingly those properly placed to take advantage of the moves can make a good deal of low-risk money.

Let us note before going further that the great paradox of the ECMH is that it only works to the extent a lot of sophisticated people disbelieve it.

A market can be what ECMH posits that it is, an efficient machine quickly processing all available information, only because there are lots of wily traders looking for inefficiencies and exploiting them. A market is a bit like a river with pirahnas. We can say, as observers, that the river is almost certainly void of large chunks of fresh meat. Why? because if fresh meat were there, it would not be there long! That is in quick form the ECMH argument, where "fresh meat" is an inefficiency and thus a non-random price move. Yet the piranhas are still there, and something is keeping them alive! If there isn't any fresh meat, how do the piranhas continue working to keep the river clean of fresh meat?

One could hypothesize a lot of "sucker piranhas," who wrongly believe that they will find fresh meat and who are in time washed out to sea in their emaciated condition. Would these unhappy piranhas, during their brief life, be sufficient to underwrite the theory: to guarantee the meatfree character of the river?

That won't work. After all, the value of the piranhas in keeping the river free of meat depends upon their being sophisticated enough to know where the profit opportunities are. It seems unsatisfactory that our theory requires that certain fish be both emaciated suckers and sophisticated feeders. If the piranhas stop believing in the presence of fresh meat, they'll stop being piranhas -- they'll find another line of work in which they won't starve -- and the theory will lose its enforcers. Inefficiencies will then prevail, according to the reasoning of the ECMH itself.

What is really going on here? I submit that the reality is sloppier than the theory, and it is the sloppiness at the edges that makes the theory (for the most part) a valuable one.

How might sophisticated traders make money and stay alive? Four examples will do:

1) Distressed debt/assets, reorganization proceedings (intra-national)
2) Distressed sovereign debt (international)
3) Regulatory arbitrage
4) Currency disparities/ the carry trade.

14 April 2011

ECMH, A Tidy Theory

Some notes toward what will eventually become chapter 9 of my book, "ECMH, A Tidy Theory."

The efficient capital markets hypothesis is the view that, given minimally liquid and transparent markets, publicly listed securities will trade at prices that fully reflect all available information.

Comes in three varieties: weak; semi-strong; strong. Discuss each. Here is a helpful link for an analytical take.

I. Some consequences:

A) even the weak version indicates that stock price movements are random. This is counter-intuitive. If markets are rational, shouldn't they be predictable, i.e. non-random? Isn't a "random walk" what a drunk does?

B) if you believe either the strong or the semi-strong version, you will conclude that an investor without material non-public information can never beat the market. It is impossible to beat the market unless you are a crook!

C) Thus, the type of advice that legions of well-paid Wall Streeters are paid to give is worthless. Active asset management in general is worthless. Hedge funds are a star system that preys on the gullible, etc.

Those are the consequences. Let's clear up a couple of misconceptions about the theory:

II. Misconceptions

A) That giving credence to ECMH requires the view that all traders are rational. Consider micro and macro cosms, brain cells, etc.

B) That you can give credence to ECMH and still beat the market by taking a contrarian position.

III. Arguments

But why should we believe the theory in any of those forms?

I won't make this presentation a historical one. This chapter needs to be analytic. Still, near the end I can introduce a historical fact, that though it has its roots in classical economics, the clear formulation of ECMH had to wait for 1965, and publications by Eugene Fama and Paul Samuelson.

10 April 2011

Lucia di Lammermoor

I saw the opera Lucia di Lammermoor Wednesday evening with Cicily.

The opera was performed at the Met, in NYC, but we watched it on a live feed to a theater in West Springfield, Mass. in HD. Part of the Metropolitan Opera's attempt to make itself a global franchise.

Of course, nothing is quite so real an immediate presence as ... immediate presence. In other words, any electronic mediation is different from Being There. Still, the good folks behind this try to make up for the mediation by backstage segments between the Acts, in which the audience in places like West Springfield gets to watch the crew putting the next Act's scenery in place or listen to live interviews with the singers/actors about how they're psyching themselves up for the big aria ahead of them etc.

Lucia was excellently done. My congrats to everyone involved.

The story comes from a Walter Scott novel The Bride of Lammermoor. Scott wrote it in 1819 and set the events in the Scotland of a little more than a century before -- in the time of Queen Anne.

The plot involves two feuding families, Ravenswood and Ashton. Edgar Ravenswood is in love with an Ashton heiress, Lucy. They pledge their troth. Soon after the pledge is made, Edgar has to travel to France for pressing political reasons.

While he is away, the rest of the Ashton family press Lucy to renounce Edgar and marry the Laird of Bucklaw, who will be a powerful political ally and defender, helping the family restore its past glories. In Scott's novel, it is Lucy's mother who sets these machinations in place. In Donizetti's opera, on the other hand, Lucy is mourning her recently deceased mother when the curtain first rises: it is her brother who plays the true-love-frustrating villain.

This lets the opera tell the tale as a woman caught between two men.

In either version, though, Lucy goes ahead with the arranged marriage, goes mad, and stabs the groom when they are alone in their bedchamber. The groom survives his injuries in Scott, though they are fatal in the opera. Lucy descends further into madness and, soon enough, into death.

In either version, Edgar too dies soon thereafter, though his death is managed somewhat differently in each.

The short description of either tale, though, is that it is a transmutation of Shakespeare's story of star-crossed lovers to the Scottish moors.

Donizetti (and his librettist, Salvadore Cammarano) are faithful to the spirit of Scott's story, taking the usual liberties as I have mentioned, and of course giving all the characters the Italian variant of the name Scott had bestowed upon them.

This particular production of Lucia took a further liberty. It moved the setting forward in time, to a period more recent than the opera's composition, although only slightly so. This is a early-Victorian-era Lucia. The chorus looks a bit like they wandered in from a Sherlock Holmes movie. At one point, an early camera is set up on a tripod in order to take a wedding-day photo.

I don't know whether those changes are entirely successful, but I suppose Mary Zimmerman is entitled to her own vision.

09 April 2011

Colonel Roosevelt and Secretary Bryan

"Colonel Roosevelt" is the title of a new book by Edmund Morris, the final installment in his series on the life of Theodore Roosevelt, focusing on TR's post-Presidential years. I admit up-front I haven't read the book. I have only read the paraphrases and quotations from it provided by some reviewers, including Henry S. Cohn, who reviewed it for the latest issue of The Federal Lawyer.

Cohn paraphrases Morris thus: "Roosevelt could abide neither Wilson nor his secretary of state, William Jennings Bryan, who viewed the war as an exclusively European affair. Roosevelt spoke out against the 'pacifist' Bryan until he was removed from the cabinet in June 1915 and, in April 1917, Wilson asked Congress to declare war." The scare quotes around the adjective "pacifist" there are appropriate.

Yes, unfortunately for clarity the term sometimes means anyone who is arguing against any particular military intervention, and Bryan was certainly doing that as a member of Wilson's cabinet. But the term is more appropriately used for a broader, principled, commitment to a laying down of arms among nations. In that sense, neither Bryan nor Wilson was ever a pacifist. Indeed, it is well to remember that Bryan seemed to be threatening the UK with war in the course of his famous "cross of gold" speech.

It was the Bank of England that, in the imagery of that speech, was threatening mankind with crucifixion to preserve the one-metal backing for money. It was imperialism, as Bryan saw it, and "the issue of 1776 over again". At least some of Bryan's 'pacifism' in the context of 1913-15 arose from his suspicion that Anglophiles like Roosevelt were on the wrong side, the side of the still regnant world-straddling Empire. His own sympathies were with the rising challengers to that empire -- in this instance, the Germans.

08 April 2011

Corporate Accountability

Some thoughts toward what will eventually become chapter 8 of my book, Corporations and Accountability.
Sometimes the iffy accounting isn't the result of inflation, honest confusion, or simple self- deception.

Sometimes it is the consequence of blatant fraud -- a corporate management that in cold blood sets out to cheat investors by lying to them about the corporation's prospects.

Enron's use of "special purpose entities" that effectively turned their own stock into a company asset is an example of the blatant lying.

The fundamental equation of accounting is this: assets - liabilities = equity. That is also, not surprisingly, the format for a balance sheet.

What a company is worth to its stockholders consists of everything the company owns, minus everything it owes.

For a company to treat its own stock as one of its assets is in effect a matter of blatant double-counting. Suppose a company owns only a lot of furniture -- $7 million of furniture. Suppose it owes $6 million to various parties. Its equity is, then, $1 million. If it has one million owners with shares of equal value then one would expect the value of each share to be ... $1. Simple enough, right?

Actually, that's far too simple for a lot of reasons, and the shares if publicly traded will be worth whatever buyers agree to pay and sellers agree to receive. But in the very simple case described above, one would expect the market prices to cycle around $1.
To get to the point, though: suppose the company starts treating that $1 million equity as an asset. Aha! so it has now discovered that has assets of $8 million (because this accounting trickery doesn't affect the vaue of the furniture). Subtract $6 million from $8 million and you get ... $2 million. The effect (and most likely the point) is to trick the shareholders into thinking their shares are more valuable than they are.

Likewise, a company cannot use an increase in the value of its own equity to spruce up its income statement, wiuthout producing the same sort of nonsensical circularity.

But Enron found a way around this simple-seeming prohibition. It created special purpose entities (SPE), and supplied these off-book entities with Enron stock. Then it dealt with those entities in ways that spruced up both the balance sheet and the income statement.

The SPE's could be kept off-book, under accounting rules, so long as 3% of theiir equity belongs to someone who was neither Enron nor an Enron "related entity." The 3 percent figure may seem modest under the circumstances. But the point of it was that someone else has to be willing to put that their own investment at risk. (Recall that a defining feature of equity is that it is the residual bearer of risk.)

The ways in which Enron satisfied that 3% requirement were risible. A homosexual relationship with an executive doesn't make one a "related party" because Texas laws don't recognize such relationships, they reasoned.

Beyond such minor points, Enron sometimes entered into explicit side agreement with the parties contributing thaty 3% assuring them it would make good on any losses. So it wasn't really equity at all, and the circle is closed. [Eichenwald pp. 596-97 gives a dramatic scenario of Enron execs redicovering the crucial document, and realizing that they are 'toast'.] Early 2001, Carl Bass, a member of Artrhur Andersen's Professional Standards Group, objected to such practices by Enron and his superiors at AA removed him from that account.

When Skilling testified before Congress, in 2002, he tried to justify such trickery by saying in effect that it is no worse than what you, the Congress, have allowed and in fact encouraged as to the non-expensing of stock options.

Implicit in this, "because you have allowed us to deceive ourselves, now we are entitled to deceive others."

07 April 2011

Accounting issues

Some thoughts toward what will eventually become chapter 7 of my book, the chapter on Accounting and Valuation.

... The problem is not simply that the wrong accounting choices fool the tax authorities. The problem is not even that they fool investors. For our purposes in this book, the gravest difficulty is that the wrong accounting choice can prove a means by which management fools itself about the value of its company, its reserves of cash and other assets, and its strategic options. ["Big Oil's Accounting Methods" etc. 2006.]

Consider to understand this an accounting issue less obviously tied to inflation than the LIFO/FIFO imbroglio. Consider the question of the expensing of stock options.

In the dotcom-a-go-go years of the 1990s, neither the law nor accepted accounting principles required employers to recognize that in issuing stock options to their employees they had in effect expended enterprise wealth, i.e. stock options were not expensed.

Stock options were a critical part of the compensation package for many of the high-tech start-ups that give those years their distinctive flavor. The practices of not expensing such options allowed start-ups to show a profit sooner than otherwise would have been the case, and this in turn helped keep the original investors happy, while allowing start-ups to bring in new investors.

That was the argument -- when arguments came to be necessary -- for continuing to use stock options without calling them an expense. Yet it was also the argument for calling them an expense. For the obvious problem with the use of stock options was that they diluted the value of the company's equity. At some point some number of the options will be exercised and this increases the amount of stock outstanding -- there is a larger supply of that stock, then, capable of satisfying whatever the market demand may be.

For internal managerial purposes, too, it is important to know what is happening and what is likely to happen to the value of equity. It has a great impact on the company's ability to raise money quickly, on its ability to purchase other firms or to maintain its independence against those who would purchase it, and so forth.

Indeed, one could make an argument that the Financial Accounting Standards Board's politically motivated retreat from an expensing mandate was a signal -- something akin to a starter's pistol -- for the dotcom boom. In 1993 the FASB recommended a rule that would have installed expensing as part of the generally accepted accounting principles (GAAP) in the United States.

[My readers will want to know a bit about what the FASB is, if I have not already provided that info.]

Joe Lieberman (D-Conn.) a Senator from the state where the FASB has its headquarters, sponsored a Senate resolution declaring that the new proposed accounting standard would have "grave consequences" for entrepreneurs.

Indeed, on March 25, 1994, roughly 3,000 gathered at the San Jose Convention Center, in San Jose, California, protesting the threat posed by those distant Connecticut accountants to their beloved stock options. Kathleen Brown, the state treasurer, daughter of the once-and-future Governor Jerry Brown, addressed the crowd.

According to an account in FORTUNE, she shouted, "Give stock a chance," and the crowd loved it.

Lieberman and like-minded folks did manage to kick up enough of a fuss so that the FASB backed down, and continued to allow Silicon Valley and its favorite accountants to pretend that they were giving out something costless.

In face of political pressure, the FASB retreated. It said that in the main body of their books, companies could continue to pretend that options were, in effect, free. The retreat was not complete, though, because the FASB still required disclosure in footnotes.

This seemed like an awkward compromise to everyone, and unsurprisingly debate continued. By 1197 two analysts, Micahel L. Goldstein and Jonathan Freedman, had estimatef that the profits that corporations were showing about 5% the artifact of this rule and increased use of oiptions it encouraged.

The debates were kicked up several notches in intensity after the dotcom collapse. Heck, the debate was on The Simpsons. In an episode that aired in April 2002, ["I Am Furious (Yellow)"], Bart and Lisa were briefly employees of a dotcom company, paid in options. The company goes broke, and the siblings discover that their options are worth $0. But they have one million of them!

Bart to Lisa, "What's one million times zero?" then in a low growl he continues, "and don't tell me zero!"

03 April 2011

Betting on Foreign Exchange

In the previous chapter (see full table of contents), we listed "metals" as one type of commodity. Yet the precious metals have a special historical significance -- for most of the history of civilization they weren't something bought with money. They were money.

That situation, their commodification: change came slowly, in many steps. In this chapter, I'd like to trace those steps, because they are critical to understanding the crisis that is our central topic. We have come back again and again to the idea of "hard money" versus "soft." How did money get so chronically soft? For simplicity's sake, this will be a US-centric account of what is in fact a multinational story.

1. Bimetallism and the Wizard(s) of oz

2. No-Metallism

3. Gold Returns: Bretton Woods system, 1944-1971.

4. US Hegemony Wanes

5. Johnson to Nixon. The end of the gold window.

6. A “Tobin tax” and other dubious notions arise.

7. Back to Chicago: Leo Melamed, and how the Merc outflanked the CBOT

8. Everything floats against everything. What could go wrong?

9. British pound in 1992, East Asian currencies later in the decade.

10. Staggering proliferation and complexity of financial derivatives.

11. Does the FX market constrain central banks? How well or poorly?

12. Another angle on the CME/CBOT merger

02 April 2011

Commodities and Their Derivatives

You'll remember that my March 12 blog entry consisted of a discussion of what is to become the fourth chapter of my proposed book as represented in the table of contents I provided in this blog on December 10, 2010. Now I move to the fifth chapter, about commodities and their derivatives.

This will make five points.

1. definition of terms

A commodity in the sense significant for this book is a physical (and usually a fungible) item of commerce. It is distinct from intangible goods such as patent rights, or a share of equity in a company. It is also usually distinct from any complicated manufactured item, such as a custom-built hot rod. Foods, metals, and natural fibers are all commodities.

2. Brief history of the derivatives exchanges

Commodity futures are the paradigmatic "derivatives." Birth of the Chicago Board of Trade. The CME and a cross-time rivalry. Imitators and developments.

3. Federal regulation up to 1974

Federal regulation of futures contracts began with the Futures Trading Act of 1921. Declared unconstitutional by SCOTUS later that year. How this decision was circumvented and the regulatory system established. Why it took another 50 years for the system to crystallize into the CFTC.

4. the OTC derivatives market and its challenge to the exchanges

One distinction between OTC and exchange trading involves the margin requirements of the latter: performance bonds that market participants must post, in amounts that vary in a way based on the risk and volatility of the product. In the OTC market there have long been no rules, so the parties negotiate their own collateral arrangements. Dodd-Frank. What happens next?

5. It is time now to deal with the spectre of speculation.

Speculation is not gambling. Why not? Because gambling creates its own risk for the sake of the game. A gambler puts money on how a pair of dice will land. Nobody would even bother rolling those dice unless somebody was putting money on them.

What about sports gambling? The game exists independent of the risk. We might suppose that basketball games will continue to take place even in a (hypothetical) world in which gambling on basketball comes to a quick and complete end. But the game itself is not a risk for the folks in Vegas putting their money on the line. It becomes a risk when they decide to accept that risk, both for the chance of profit and for the thrill.

How is that different from financial and commodity speculation? Consider orange juice futures, the subject of a memorable Eddie Murphy and Dan Ackroyd collaboration. These risks are not optional. Anyone investing in an orange grove, in the expectation of selling the fruit of his labors to the OJ market is taking enormous risks. The “dice” are meteorology on the one hand and fickle breakfasting-consumer preferences on the other. The producers can only hedge these risks to the extent that speculators are willing to take it from them.

6. Our first look at the CBOT/CME merger of 2007. We'll come back to this.

01 April 2011

Space Opera

In my post March 18 I linked you to a graphic that presents the history of science fiction. Some of you may have noticed the prominence of the expression "Space Opera" in that graphic.

What does that mean? As you might have inferred already, the expression came about on the analogy with "soap opera," and it refers to the more melodramatic sorts of sci-fi. It also refers to the large scale on which a plot works -- a space opera might portray a war between two galaxies, or a multi-generational saga spanning millennia, or both.

The following will give you a feel. This is the opening paragraph of A DEEPNESS IN THE SKY (1999).

"The manhunt extended across more than one hundred light-years and eight centuries. It had always been a secret search, unacknowledged even among some of the participants. In the early years, it had simply been encrypted queries hidden in radio braodcasts. Decades and centuries passed. There were clues, interviews with The Man's fellow-travelers, pointers in a half-dozen contradictory directions: The Man was alone now and heading still farther away; The Man had died before the search ever began; The Man had a war fleet and was coming back upon them."

One hundred light years and eight centuries -- a mere niche in space, a flicker in time, on the scale of space operas. Further, the object of this manhunt is a single man, which tells us something about longevity in the distant future when this is set. Indeed, routinely long lives are a common feature of space operas, not necessarily for any reason more complicated than this: it allows a single protagonist to experience several long-lasting flights hither and yon.

From the above paragraph, reading between the lines just a bit, we can begin to grasp some points about the world to which we've been introduced. There was a war or revolution in the past, and "The Man" was on the losing side, which is why he went into hiding. He continues to be sufficiently dangerous that his sympathizers can with some plausibility claim he has raised a new war fleet. At any rate, the established powers -- his successors -- are looking for him.

We immediately have questions. Should our sympathies be with him or with his pursuers? Is he more like Eichmann in Argentina, or Jean Valjean, condemned over a stolen loaf of bread? Related: what do they plan to do when they find him? Assume he has no warfleet -- assume he is a man living an unremarkable life in an unremarkable place when they find him. What then? Summary execution? A trip "home" (wherever that is) for trial? Something else?

I won't spoil it. If your interest is piqued, the book is here.

That is the meaning of the term "space opera."

Knowledge is warranted belief -- it is the body of belief that we build up because, while living in this world, we've developed good reasons for believing it. What we know, then, is what works -- and it is, necessarily, what has worked for us, each of us individually, as a first approximation. For my other blog, on the struggles for control in the corporate suites, see www.proxypartisans.blogspot.com.