Unintended Consequences

A working paper produced by an economist within the IMF recently warned about possible unintended consequences of regulations "aimed at financial stability" that focus on "building equity and reducing leverage at large banks/dealers."

Here is an abstract to the work, by Manmohan Singh.

As you'll see if you visit that page, those of us who allude to the existence of this paper are sternly warned that it "should not be reported as representing the views of the IMF." It represents the views of Mr Singh alone.

Coincidentally, Mr Singh has the same name, first and last, as the current prime minister of India. This has fueled conspiracy theories about the prime minister as a "world bank/IMF agent".

The name, though, is the only connection. The IMF economist didn't leave that employment to become PM of India!  He is still there, and this paper bears a quite recent release date as if to illustrate the point.

At any rate, the paper appears to me to be sound work and I hope it draws a wide audience.

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.

From Florence to Houston

Below is an outline for the second chapter as represented in the table of contents for my projected book.

I've already done the same for the first chapter. We will focus here on the institution of lending money for a fixed rate of interest: this is "usury" or "riba" to its foes.

I. Renaissance Florence
A. Theology, Damnation, and Evasion
B. The Rise of the Medici

II. The North of Europe
A. Luther on usury
B. Calvin
C. Calvinism in the Lowlands
D. London and the Classical Economists

III. Colonies and States
A. Debt in the Colonies
B. Debt and the Founders
C. The Post-Classical Economics of Henry George

Here I will make in essence the points I sought to make in this blog on November 19, 2010.

D. Leverage, the Business Cycle, and Enron

The difficulties that arise when finance becomes too disconnected from the physical world, when an excess of liquidity gives rise to dreams of infinite leverage, are well illustrated in the rise and fall of the now infamous energy-trading firm, and it is a cautionary tale we should heed even this early in our study.

We have addressed thus far the fundamental ideas of speculation and leverage (i.e. debt). We need to introduce the final key idea from our subtitle, regulation: and we will do that in the next chapter.

My Book Proposal

Listen up publishers. Here's a book proposal.

I'd like you to bid on rights to my not-yet-complete manuscript, Gambling With Borrowed Chips: The Role of Leverage, Speculation, and Regulation in a Modern Economy.

I am willing to accept millions, though hundreds of millions would be nice.

When complete, this will be a scholarly ms of approximately 76,000 words, with approx. 30 figures in the text, and extensive endnotes for each chapter, an index, and a bibliography.

As I complete outlines of each chapter in subsequent posts, I'll use the chapter titles here as links, for convenient navigation.

Synopsis

Speculation performs at least three indirect but valuable roles that assist a broader society in the wise allocation of resources: it allows commercial parties to hedge their positions; it uncovers the real value of assets; and it creates accountability for corporate managers, who in the absence of active speculators are better positioned to entrench themselves.

Speculative activity can become excessive and abusive -- the best check upon this, though, is not through regulation, much less criminalization -- the best check is the systemic one of a hard money policy.

The events of recent years -- as they have been popularly misunderstod -- have delegitimized this valuable activity, and that has given rise to a lot of real and threatened policy consequences that have done or would do more harm than good. Or, to be more precise, a very old stigma of the speculator as an anti-social parasite has re-emerged.

Outline

Introduction

Part One: The Value of Speculation
Chapters
1. The old stigma: speculators as parasites
2. From Florence to Houston
3. Equity and Prop Desks
4. The Crisis of 2008
5. Commodities and Their Derivatives
6. Betting on Foreign Exchange
7. Accounting and Valuation
8. Corporations and Accountability.

Part Two: Important Abstractions
Chapters
9. Efficient Capital Markets, A Tidy Theory.
10. ECMH, The Much Sloppier Practice.
11. On Greed and Money.
12. A World Without a Monetary Superpower

Part Three: Some Policy Consequences
Chapters
13. Bankruptcies and Rescues.
14. Public and Private Pensions.
15. Home Ownership.
16. Energy.
17. Conclusion.