Category Archives: essay

Film Club: “Repo Man” Turns 25

The cult classic film “Repo Man” turns 25 this year, and I’d like to mark the occasion by quoting this exchange between two of the lead characters. The context here is the moral justification for taking away people’s cars by stealth and subterfuge–an activity that looks very much like simple auto theft–when those people fail to make their contractual payments. According to Bud, the wizened Yoda to Otto’s Luke, repo work not only isn’t “stealing,” it’s a blow for justice and the American Way:

Bud: Credit is a sacred trust, it’s what our free society is founded on. Do you think they give a damn about their bills in Russia? I said, do you think they give a damn about their bills in Russia?

Otto: They don’t pay bills in Russia, it’s all free.

There’s something poignant now, even charmingly retro in the post-apocalyptic financescape of 2009, about the phrase “Credit is a sacred trust.” It seems to belong to another world.

Former Federal Reserve Chairman Alan Greenspan might have been thinking of Bud when he said in a 1990 commencement address at Harvard College,

Trust is at the root of any economic system based on mutually beneficial exchange. In virtually all transactions, we rely on the word of those with whom we do business…If a significant number of business people violated the trust upon which our interac­tions are based, our court system and our economy would be swamped into immo­bility.

Prophecy, or just a gloss of the Gospel According to “Repo Man?” You decide.

As for Otto’s utopian vision of the Russian socio-economic complex, credit cards and cowboy capitalism put an end to all that. For an excellent account (no pun intended), see Prof. Alya Guseva’s recent book, Into the Red (Stanford University Press, 2008).

Meanwhile, Happy Birthday “Repo Man!”

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Castastrophe Haiku Champs

The Catastrophe Haiku Challenge of December 11th brought many delights, not least of which was the realization that this blog has at least five readers (still counting myself) instead of the three I estimated. Huzzah!

Not only did the Challenge produce some fine entries (see the Comments section below the December 11th entry) but it introduced me to some kindred spirits, including one Tony Alfidi–a finance professional based in San Francisco–who has been blogging his own financial haiku (and limericks!) for some time. Check out his witty prose (and verse) stylings at alfidicapitalblog.blogspot.com.

Here are two of my favorites from his oeuvre, reproduced here with his gracious permission:

The Haiku of Finance for 12/18/08

Closing out short calls
Cash went to money heaven
Be careful next time

The Haiku of Finance for 12/18/08 (inspired by Bernard Madoff)

Smiling, lying guy
Trusted by rich investors
“Made off” with their cash

I find it strangely comforting to think of my life savings at peace in “money heaven.” I hope it’s next to “pet heaven,” so that the dollar bills can frolic with the souls of my late lamented hamster, Sunshine, and a passel of goldfish that have passed through my life.

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The Plague

Watching the financial mayhem unfold over the past weeks has been uncannily reminiscent of the early 1980s, when the AIDS virus was first discovered on American shores. The impact of the crisis has been startlingly similar to that of the deadly disease whose contagion changed the world forever juskeletons-from-dantin-manuscriptst a generation ago. As in the early days of AIDS, the sources of the current crisis are poorly understood but its fatal effects are all too evident–a toxic combination that has spread fear around the world. We’re witnessing a kind of global infection among our social and economic institutions, and may need to start thinking like epidemiologists—the scientists who fight the spread of AIDS and other diseasesin order to stem our losses.

Epidemiology, a word with Greek roots, literally means “the study of what is upon the people.” Typically, it means the processes by which infections spread through populations. But there are a number of reasons to think that an epidemiological model is appropriate to our current socio-economic crisis, and can help us make sense of “what is upon the people” now.

What can we learn by taking an epidemiological approach to the market meltdown? Three things, all of which were applicable to the AIDS crisis, too. The point is not to drum up sympathy for financial firms, which would seem to deserve little of our compassion, and certainly far less than victims of disease. Rather, these observations highlight the social processes through which we respond to spreading crises, and how those processes can make a bad situation worse.

1) Failing to act on signs of danger allows a problem to become an epidemic.

The panic spread by the AIDS virus was driven in large part by its terrifying unknowns: though its fatal effects quickly became apparent, it took almost 25 years to track down its origins to chimpanzees in southern Cameroon. Turns out that AIDS has been present in humans–who hunted and ate the chimps—since at least 1930, but it took 50 years to mature into a global epidemic.

Just as AIDS appeared in the 1980s, as if out of the blue, the collapse of the global economy has seemed similarly unexpected to many investors. After all, only a little over one year ago—in October 2007—the Dow Jones Industrial Average ended several trading days above the 14,000 mark. Who could have predicted that the index would plummet by almost 50% in 12 months, and that we’d be contemplating the bankruptcy of such institutions as General Motors?

In fact, some of the most distressing news about the current crisis is that people in the financial industry did see this crisis coming years ago, but nothing was done to stop it. Instead, that knowledge became the basis for unimaginable profits. Last spring, John Paulson (no relation to Treasury Secretary Hank) topped the list of world’s highest-paid hedge fund managers, earning $3.7 billion for 2007 after directing his firm to short-sell America’s sub-prime mortgage markets. And Paulson was no lonely prophet, crying out in the wilderness; he had lots of company. In 2006, at the same time Paulson was warning his fund’s investors about the imminent collapse of the mortgage market, brokers on the NYSE were predicting that GM would go bankrupt by 2009. Other hedge funds, like the UK’s GLG were busy making piles of cash on the basis of such predictions: so much so that the top three executives in the fund split a $1 billion paycheck for 2007.

Over the next year or two, we can expect to learn that the “sudden” collapse of the world economic system was in fact an open secret in the financial industry, and probably elsewhere. Given the close connections between Wall Street and Washington (it should help that our Treasury Secretary used to run Goldman Sachs, right?), this begs the same question that haunted America during the AIDS epidemic: what were our elected representatives and regulators doing when there was still time to prevent, or at least mitigate, the damage?

2) Putting ideology above pragmatism only makes the crisis worse.

If you were alive during the early days of the AIDS epidemic, you may recall that once the disease was identified, it was thought to be limited to gay men and IV drug users. Unfortunately, the ideology of the time turned that into a rationale for complacency: in the eyes of some who had the power to make a difference, the plague was a just consequence of high-risk behavior by a sub-set of the population who didn’t deserve help.

We all know how well that worked: just ask anyone who had a blood transfusion during that period. While then-President Ronald Reagan dithered, refusing to allow public service announcements to even mention safer sex practices that might have limited the spread of the disease, HIV infection rates exploded, reaching millions of people worldwide who had never had gay sex nor used drugs. Oops.

Reagan’s heirs have now had the opportunity to show how that “ideology first” strategy plays out when the economy gets sick. So, in the name of a theory—free market capitalism—Republicans let Lehman Brothers, mired as it was in toxic sub-prime mortgage debt, go bankrupt instead of arranging the kind of bailout or buyout that AIG enjoyed. For about five minutes, this looked like a win for the non-wealthy majority whose taxes pay for the bailouts, and a rare show of congruence between talk and action on the part of the political right. Two cheers for the Lehman liquidation!

Lining up for a "bailout," medieval Catholic style.

Lining up for a "bailout," medieval Catholic style.

The third cheer was silenced by the realization that as Lehman went down, it would take the rest of the market with it—including parts that had no direct exposure to the sub-prime crisis and were thought to be safe as houses (pun bleakly intended). The Reserve Primary fund, which had made the kind of ordinary short-term business loans known as “commercial paper” to the venerable Lehman Brothers, became the first public money market fund in history to “break the buck:” that is, since it would never get repayment on its loans to Lehman, the Reserve fund’s share price dipped below $1. Because money market mutual funds are supposed to be as secure as savings accounts, this one event caused the entire credit system to hit the breaks, hard. Since it appeared the anything could happen, and nothing was safe, banks wouldn’t even make short-term loans to each other, to say nothing of businesses and individuals. And that’s how the DJIA lost another couple thousand points. Oops.

3) As the contagion spreads, it destroys the trust needed to fight it.

Our current economic crisis could be explained with haiku-like simplicity, as follows:

· no trust means no credit—nobody can get a loan

· no credit means no capital to make payroll or build things

· no capital means no capitalism

Congress may have approved a $700 billion bailout package, but since the banks who got the money are hoarding it instead of lending it out as intended, we accomplished nothing besides adding a zero to the national debt.

How could this happen? Part of the problem was undoubtedly that the bailout came with no strings attached and no oversight—a political move which will live in infamy. Perhaps more importantly, the bailout didn’t directly address the trust problem: there was nothing in the deal to either assure banks that the risks of making loans had returned to an acceptable level, or to force them to lend despite heightened chances of default.

Moreover, banks realized, as did many others, that by allowing Lehman to go bankrupt, the US government had given the remaining firms in the financial industry a really good reason to lie about the true extent of their exposure to the sub-prime crisis. Following the Lehman liquidation, there was an undignified scramble to make firms look financially healthier than they really were, distancing themselves as much as possible from bailouts and forced mergers. They may have fooled Congress, but not the banks.


the plague doctor.

Tim Geithner's 17th century counterpart: the plague doctor.

And thus we find ourselves re-learning one of history’s most important lessons about plagues: trust is among the first casualties. Fear of each other erodes the very cooperation we most need to contain the crisis. Thus, when banks stopped lending to each other, as well as to the mortgage and commercial paper markets, they deepened the crisis in much the same way as institutions and individuals did when faced with the spread of AIDS in the early 1980s. As the virus spread, and became associated with gay men and IV drug users, those groups became literally untouchable—including by the doctors and nurses whose care they desperately needed. And when it became clear that the disease was not limited to “high-risk” groups, even hospitals turned away the infected until the practice was halted by a series of court decisions and new legislation.

Now that we find ourselves facing the economic equivalent of AIDS, we are making the same mistakes our forebears made in the face of those earlier contagions. Even those who aren’t directly harmed by the sub-prime crisis are infected with fear. What can we do differently this time? Unfortunately, the time for early action has passed. That leaves us with pragmatism and cooperation, two of the great virtues traditionally attributed to Americans. Let’s live up to our reputation and reject the ideologies and isolation that have only made things worse.

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Left Behind

One of the best bumper stickers I ever saw was on a red Chevy truck in Northern California about 15 years ago: it read, “In case of Rapture, this vehicle will be unoccupied.” That slogan came to mind following the uncanny confluence of God and Mammon in America in recent weeks. First we got a Vice-Presidential candidate, Sarah Palin, whose Pentacostal faith includes belief in the Rapture, in which God takes all the “elect” (those “saved” by belief in Jesus Christ) into heaven, leaving behind the “unrighteous” to suffer the throes of the world’s end. Next we got hit with the Economic Apocalypse, in which some of the “elect” (like A.I.G.) got raptured into the heavens of solvency, while the rest of us have been left behind to gnash our teeth and rend our garments, tormented by a plague of foreclosures and bankruptcies. Coincidence? You decide.

Living as an expat in Germany, I get a lot of questions about Americans’ behavior. Most recently, I’m being asked why we accept the selective bailout of some failing businesses—many of which have appear to have brought about or hastened their own demise with irresponsible debt—while the vast majority of us will receive no assistance at all. It seems particularly galling to these European observers that our political leaders scold us for our bad financial habits, then turn around and use our tax dollars to bail out firms whose risky borrowing and lending practices are incomparably more destructive than our own. Those are usually the same politicians who voted to stiffen the penalties for individuals declaring bankruptcy, and who wouldn’t dream of supporting “socialist” programs like a national healthcare system, but who are all too ready to socialize the debts of private firms.

The Europeans I know ask: why aren’t Americans taking to the streets to protest this outrageous inequity? In answer, I can only refer them to one of their own best thinkers, the late German social scientist Max Weber. Almost a century ago, Weber had a revelation of sorts about the connection between the near-simultaneous rise of Protestantism and capitalism in 16th century Europe. His theory, sketched out in “The Protestant Ethic and the Spirit of Capitalism,” suggested that among the unintended consequences of writings by Martin Luther and John Calvin were the spiritual legitimation of profit and the release of individuals from the moral obligation to share their wealth. In fact, believers in predestination came to see material prosperity as a signal from God that they were among the saved: after all, they reasoned, God would hardly allow the elect to suffer privation during their time on earth if they were destined to spend eternity in the many mansions of the Father.

Thus, economic inequality was interpreted as a sign of divine judgment: both riches and poverty were deserved. This laid a semblance of fairness over conditions that otherwise might seem patently and intolerably unjust. And it dampened Americans’ impulse to revolt against the unequal distribution of wealth: the majority-Protestant American colonies might take up arms over taxation without representation, but it took a majority-Catholic country like France to rebel in the name of an impoverished, starving peasantry, giving “Equality” and “Brotherhood” as much weight as “Liberty.”

While these beliefs may seem anachronistic, they are deeply embedded in American life, particularly in the way we think about fairness and the distribution of wealth. The Puritan colonists were fervent Calvinists, and the institutions they and their descendants established became the basis for our nation’s financial and legal systems. They also created the templates for today’s “culture wars,” which aren’t just about abortion or gay marriage, but about who deserves to be “saved” economically.

The conflict we’re seeing now is just the most recent engagement in a long national struggle. During the Gilded Age of the late 19th century, notions of Social Darwinism became popular by updating the Puritan perspective with a pseudo-scientific twist: arguing that Nature, rather than God, created the rich and the poor through a process of “natural selection.” That is, wealth was a reward for superior genetic fitness, while the biologically “unfit” were condemned to poverty. But while this theory shifted the source of socio-economic division from God to Nature, and redefined the defect as biological rather than spiritual, the result was the same: the poor were still “undeserving” of any help. It’s interesting to note that the “War on Poverty” 60 years later was led by the nation’s first Catholic President, John F. Kennedy.

This history, in turn, suggests a legitimate policy reason for Americans who support the separation of church and state to care about the religious beliefs of candidates for the nation’s highest offices: their faith will shape how they perceive the distribution of wealth, including the provision of government aid to businesses and individuals in financial distress. With the economic End Times upon us, and the election just six week away, we’re awaiting a new answer to an old question: Who among us will be saved this time, and who left behind?

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Monsters of the Complex Market

Update: a shortened version of this post was published as an op-ed piece in the Philadelphia Inquirer on November 18th. See it here!

Remember the story of Dr. Frankenstein and his monster? In Mary Shelley’s original book, the doctor isn’t evil—just a brilliant scientist out to prove his talent through innovation. Quite unintentionally, by building something more complex that he can manage, Frankenstein creates the means of his own destruction, and destroys many other lives in the process. This may turn out to be the same narrative structure upon which our current financial crisis turns.

While there may indeed have been “greedy CEOs” and “reckless speculators” running amok on Wall Street, it is more plausible that those who created and benefited from recent financial innovations were just rational capitalists rather than evil geniuses bent on defrauding the public. That is, the people who brought us the Byzantine structures of the subprime market (credit default swaps, anyone?) were too busy pursuing their own self-interest and maximizing profits to realize that they were building a system that exceeded their understanding or control.

If, instead of imaginary monsters, you want to be scared of something real, try this: the biggest problem Americans face right now is that no one really understands what’s happening in the markets. The system is so complex, it overwhelms even the financial professionals and policy experts who are paid to understand it. And this suggests a very different strategy for addressing the global market crisis than those we’ve been offered: instead of using the same tools that created the mess in order to fix it, or declaring open season on CEOs and hedge fund managers, we should be applying complex systems analysis to the problem.

The science of complex systems has been around for decades, but has only recently been applied to questions about financial markets. Research centers like the Santa Fe Institute in New Mexico have pioneered the use of complex systems models to explain biological phenomena like aging and gene expression. These are instances of what the late mathematician and computing visionary Warren Weaver called “organized complexity:” they involve seemingly random events, but only because they are governed by rules and interconnections that elude current models and measurement tools. These phenomena are often misclassified as cases of “disorganized complexity” and analyzed—incorrectly and with misleading results—using tools designed for understanding random activity. Foremost among these tools are the statistical methods favored by physics and its imitators in the social sciences: economics and finance.

There is good reason to suspect that our financial experts and policy makers are not the right people to fix the current market mess. It might seem as though those who created the problems would have the most insight on what went wrong; but instead, it’s likely that the system crashed in part because of their inadequate grasp of the social forces underpinning markets. Finance is dominated by a misplaced faith in the “efficient markets hypothesis:” the theory that people don’t make prices, markets do; as a result, prices move randomly, much like particles move under the Second Law of Thermodynamics. Uncritical belief in randomness has created an impasse, such that academic research either consigns great swathes of financial behavior to the dustbin of “irrationality,” or concedes the inadequacy of their models by adopting the behavioral assumptions of sociology and psychology. In practice, the randomness-based theories embraced by finance scholars and professionals have produced debacles like Long Term Capital Management, brought to us in part by two Nobel Prize winners in economics. If that caliber of expert could do so much damage working with inappropriate models and analytical tools, why should we expect any better from their less-illustrious colleagues?

If we really want to get our financial system up and running again, we’re going to have to wade into issues that have nothing to do with random movements of particles or prices, and everything to do with the kind of “messy” social behavior excluded from analysis in economics and finance. Issues such as trust, which we need to understand in order to solve the problem of banks who won’t lend to one another. Or the challenge of pricing—something that, as we saw in last week’s sell-off and this week’s record-setting recovery, is neither random nor in any sense governed by an invisible hand. These are very practical, brass-tacks issues for which economists, finance professionals and policy-makers have dubious models, at best.

You probably know the saying, “if all you have is a hammer, everything looks like a nail.” To solve a complex problem like the market crisis, we need people with a wide array of tools at their disposal. If the US government thinks it worthwhile to employ a Chief Economist, why not someone who understands the human factors that move markets—a Chief Sociologist, or a Chief Psychologist? Historically, the argument has been that economics is a “practical,” applied social science with outstanding predictive powers, while sociology and psychology are too focused on exploration and explanation. But this view is long out of date: economics has changed dramatically since the computing revolution of the mid-20th century, becoming so theory-oriented that data from the real world is largely irrelevant.

Sociologists and psychologists, however, are almost entirely data-driven. We tackle messy practical problems head-on, without excluding the factors which make social systems complex: emotions like fear, greed or confidence that drive so much of economic behavior; trust in institutions like banks and courts of law; and the fragile, unspoken agreements we make allowing us to exchange pieces of paper for essentials like food and housing. This is the kind of expert needed to address the breakdown of a system grown too complex for its own creators.

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