Back in August of 2007, Moldbug explained that the business cycle is really a central banking cycle.

-----------------------------------------

There is no conceivable way for “the system to collapse.” Much as the Fed would like us to think, the Ring has not been cast into Mount Doom. The lender of first and last resort has a printing press and shows no signs of smashing it.

For this reason, leverage is certainly not “a thing of the past.” Some of the hedgies who have been picking up nickels may need to be peeled off the steamroller wheel. Others will take their place.

The acute crisis of the financial system is a complexity breakdown in the regulatory system. The proximate cause is the existence of a large set of securities whose current market price appears to be much lower than their current regulatory-accounting value.

Investors did not buy subprimes and CDOs because they were stupid. They bought these instruments for a variety of quasiregulatory reasons which seemed politically sound at the time, but since have become invalid.

This is what happens when you speculate on political decisions, a task which by now consumes most of the combined brain and computer power of the financial world - certainly more than it spends on analyzing the productive economy.

For example, pension funds were required to buy AAA-rated bonds, and the ratings were obligingly issued by ratings agencies which had in effect become parts of the federal government, meaning they could face no market consequences for a failure of common sense, such as that implied by models which assumed the future would mirror the past. For example, banks could buy credit protection from hedge funds that were sure to vanish in a stiff breeze, without alarming the creditors of those banks, because the Fed would not let J.P. Morgan fail.

And, most of all, the global central banking system, considered as a unit, was dependent on the incredibly pathological practice of printing money to buy bonds. The “savings glut!” Of course, to the bond market, it makes no difference that the cycle of dilution crossed borders. The Fed printed a dollar, then the PBOC printed eight yuan to buy it, then bought an US mortgage security with the dollar. So? As far as it affected financial markets, Prof. Bernanke could simply have been buying American securities with fresh green Benjamins. The whole Voldemort game is smoke and mirrors.

The result of these abuses was to completely obliterate any semblance of a natural price signal in the money market. All interest rates at all maturities in all currencies were the consequence of official decisions. Price signals were only visible in risk spreads. And even there - as many found to their discomfiture - official action, such as the ratings mess, induced many to buy instruments whose risk was assigned administratively, not inferred by markets.

I state all of these propositions in the past tense. But if they were really past, leverage would indeed be a “thing of the past.” They are not and it is not.

The chronic problem is that “the economy” - in other words, the set of statistics that influence political events - is dependent on these abuses. If they were to be genuinely terminated or even scaled back, a massive “recession” would be inevitable. Some kind of “slowdown” is probably inevitable even now.

If central banks were genuinely independent, they would love a “recession,” because a genuinely independent currency issuer always wants to maximize the price of its currency relative to other goods. This can be done easily - stop creating money. I’ll bet the Fed could drive the dollar up to fifty pounds if it really wanted, assuming of course the Brits didn’t fight back.

Obviously this is ridiculous. So the “Greenspan put” or the “Bernanke airforce” have nothing to do with personalities. Central banks do not have the political power to orchestrate sustained “recessions.” At most they can do what they are doing now - creating shocks that destabilize overextended speculators, and may result in “accidental recessions” that are in fact quite predictable.

The problem is that long-term markets are learning to look past these shocks and see the big picture. And the big picture is that avoiding a “recession” in the present monetary configuration requires long-term interest rates at 5%, and (it seems) short-term rates even lower - combined with asset-price appreciation and money-supply growth above 10% per year.

The difference between these numbers is a hemorrhage of money. It is a river of cash flowing from Printing Press to Bond Market. And indirectly, thus, to voters - who have no knowledge of what it means to be cut off from this river, and no intention of finding out.

The long-term financial effect of this distortion is that any durable goodwhose price is reasonably sure to ascend linearly with the amount of money available to buy it will beat a T-bill. Over 10 years, the difference between 5% and 10% is pretty big. Especially if you add a little leverage.

And the effect, of course, is even larger if all the speculators pile into the same asset. Such as mold. Essentially, the market is responding rationally to a leaky monetary system by trying to create a new one.

This is Mises’ “flight to real value.” Since the CBs have shown great discipline in obeying their CPI indicator, which obviously has no direct influence on any financial market, the hyperinflationary spiral Mises’ phrase implies has not occurred and can’t. A hyperinflationary spiral (in which everyone flees to assets whose price will increase proportionally to monetary dilution) cannot avoid a CPI effect, so this brake is effective.

However, the CBs have yet to face a difficult choice: the stagflationary problem of whether to relax CPI targets, or visibly impose austerity. If the CPI targets are relaxed, the hard-asset speculators will become incredibly jazzed, and it will be very difficult to regain the credibility needed to stop the slide. But it is not clear to me that the CBs have much tolerance for austerity to begin with.

But the guys at the Fed are incredibly smart, and no doubt they will solve the problem as they have in the past. This is the art of central banking - creating temporary crises in which the price of your currency increases relative to other assets, to break the speculators who would otherwise drive it to zero in five seconds with the use of infinite leverage. It’s a stupid and pointless game, but it won’t stop any time soon.

Ultimately, the entire practice of printing money to purchase or guarantee financial instruments - public or private, foreign or domestic, short-term or long-term, is an appalling abuse of power. It is a leftover from the century of socialist mercantilism. And if the citizens of the world ever figure out that the authorities who pretend to be curing the business cycle are in fact in the business of causing it, I wouldn’t want to be anywhere near Washington DC.

Back in February 2007, Mencius Moldbug predicted that dollar hegenomy will end, not when the Chinese government calls in U.S. treasury debt, but when Chinese savers lose faith in the Yuan and head for gold.  Are we closer to that happening today?

--------------------

A tremendous post. Perhaps the best elegy for BWII I have read yet.

One point that this otherwise magisterial discussion does not cover, though, is that Chinese savers are not sheep. Their actions - as yesterday showed - are a variable in the equation.

When anyone, Chinese or otherwise, exchanges other goods for RMB or claims to RMB, he or she is buying an instrument whose value can only be defined by the PBOC’s balance sheet. Which consists largely of long-term liabilities of entities with a notable propensity to pay off old debts by issuing new ones. (At some point, we may have to start thinking of the US government as just another SOC.)

The RMB is certainly undervalued with respect to the dollar. But this relationship tells us nothing about the RMB’s relationship to other assets.

As China modernizes and as frictional effects decrease, the fact that yuan and yuan savings instruments are not an effective store of wealth - at least not compared to any asset whose price can keep pace with the growth of the Chinese money supply - creates demand for alternative stores of wealth.

In other words, assets like Shanghai A shares and real estate are, in a very literal sense, competing with the Chinese monetary system.

No human economy has ever existed which did not include at least one asset whose valuation relative to other goods cannot be explained by direct supply and demand. I always laugh, for example, when goldbugs claim that gold is the only workable currency because of its “intrinsic value.” Dollars have intrinsic value too - you can snort coke with them. If anyone ever manages to float a fiat currency whose supply is fixed, gold will trade for $20 an ounce and people will be using it for doorstops.

(The fact that no one will sell you gold for $20 an ounce today is not caused by the fact that today’s currencies have negligible intrinsic value. It is caused by the fact that they are financially unstable, their supply is expanding rapidly, and traders do not, at present, believe that any sustained contraction is a politically credible possibility. See, for instance, this story from Malaysia.)

In any case, if there is any force that seems most likely to rein in the PBOC, it is the humble Chinese saver. (Is there a Chinese equivalent of “Mrs Watanabe”?)

History records many attempts to turn stock markets, and real estate, into monetary systems - to overvalue them in the same way that paper currency is overvalued now, or that gold was overvalued under the classical gold standard (and is still, to a lesser degree, overvalued now). All of these efforts failed, for a very simple reason - an asset which is not intrinsically scarce cannot absorb monetary valuation.

When stock markets are overvalued relative to the cost of borrowing money, for example, the result is textbook Austrian malinvestment. Factories cannot sustain a price higher than the cost of building a new factory. Nor can skyscrapers, although there are some real estate markets (like the one I’m lucky enough to live in) which exhibit real scarcity.

No - the Chinese state needs to offer its citizens a genuinely scarce monetary asset, whose price actually increases and whose supply does not, when more of them buy more of it. The RMB at present does not fit this description. Nor do Shanghai shares.

I know very little about China and its government, and I have no way to predict when this issue will become acute, or how the PRC will respond to it. But it strikes me as a very good candidate for the eventual proximate cause of the end of BWII.

Back in early 2007, Moldbug wrote about the actions and motives of central banks.  Most of what he said came true.

-------------------------------------------

The same tools that economists use to describe flows between nations can be used to describe flows between any two sets of actors - regardless of their internal organization or management structure.

As I’ve said before, it strikes me as far more useful to draw the line not between the US and China, but between the central banks and everyone else. Hank and Ben cannot tell the PBoC what to do, but their broad general goal - preserving global prosperity - is identical.

So we have two pseudo-nations: “CB Nation,” whose incentives are fundamentally political, and “Debt Nation,” whose citizens behave as normal economic actors.

CB Nation can produce currency at near-zero cost. Predicting its behavior as if it was a private, profit-seeking entity is absurd, and leads to absurd results. There is no way to model CB Nation as though it was a nation of private investors. CB Nation’s actors are somewhat heterogeneous, but all of them exist in order to distort price signals for political purposes.

When we look at the flows between CB Nation and Debt Nation, we see that CB Nation is buying a vast quantity of securities issued by Debt Nation. Dipping into its infinite paper mine, it is purchasing across the maturity and risk spectrum. All prices of all financial instruments are affected by this so-called “savings glut.”

Since CB Nation is a monopoly producer of currency, it’s interesting to see what would happen to Debt Nation if CB Nation suddenly started behaving as an economic actor.

CB Nation, as an economic actor, has no interest in buying securities below their market price. Let’s assume that our newly economics-savvy CB Nation has no special entrepreneurial expertise, and thus no reason to think that its predictions of the future are better than those made by the markets in Debt Nation.

Therefore, CB Nation immediately stops buying the securities of Debt Nation. If you have no information about a market it is irrational to speculate in it. The “savings glut” disappears, and no more currency flows from CB Nation to Debt Nation.

The effective disappearance of CB Nation leaves Debt Nation with a fixed supply of currency. (In fact it is slightly less than fixed, because the debts to CB Nation still need to be paid off.) Prices of Debt Nation securities (and other assets) return to free-market levels, revealing a natural yield curve that is probably extremely high and upward-sloping, but which cannot be measured while CB Nation is still intervening.

The result, of course, is that almost anyone in Debt Nation with any kind of debt is insolvent. If Debt Nation has reasonable bankruptcy laws, they work out the defaults in a year or two, and normal economic activity resumes. Otherwise, Debt Nation becomes a sort of giant open-air debtors’ prison.

Obviously, since CB Nation is in fact a political actor, this is not about to happen. However, the Fed’s little experiment in raising short-term rates is a kind of small-scale hint at the above process.

In the game between CB Nation and Debt Nation, CB Nation has all the cards. The only question is how much pain CB Nation wants to inflict on Debt Nation. To answer this question, one needs to understand the political dynamics within CB Nation. Events in Debt Nation are only relevant to this question inasmuch as they have a political effect on CB Nation.

Thus the role of indicators such as “inflation,” “unemployment,” etc. In economic terms these indicators are worthless - they are great vats of aggregate fudge. However, as a means of predicting the actions of CB Nation, they are excellent.

The behavior of a rational investor in Debt Nation depends considerably on his assessment of the politics of CB Nation. The main unanswered question is how CB Nation will behave in case of an increase in both “inflation” and “unemployment.”

Obviously, anyone who has the correct answer to this question can profit almost infinitely. Which is why CB Nation cannot and will not answer the question, at least not honestly. This essential uncertainty in CB behavior is a natural cause of the business cycle.

And, incidentally, a great way to cream people whose quantitative models depend on the assumption that the past will mirror the future. By definition, you can’t model an irrational actor - irrational is not the same thing as stochastic. What the quants forgot is that the enemy gets a vote.

 In comment thread on Naked Capitalism ( of all places ), Mencius Moldbug lays his revisionist history of Vietnam.  I have never had the time to study the Vietnam war fully, so I neither endorse nor denounce Mencius' writings.  But I did want compile Mencius's comments here, so that anyone could get a quick introduction to a very different take on the Vietnam War.

--------------------------------------------------------------------------------

Yves Smith begins the discussion by writing:

Oddly, this conundrum reminds me of the situation that led DanielEllsberg to release the Pentagon Papers. Ellsberg was perhaps the bestinformed person in the US about Vietnam; he had been there for both theDepartment of Defense and the State Department, and unlike most USoperatives, had spent considerable time on the ground, including underfire.

Like many people in the intelligence community (heworked for Rand), he believed if he could only get the ear of thePresident and get them to understand what a hopeless exercise Vietmanwas, they would withdraw. But reading the Pentagon Papers, which gavethe history of the US involvement from the inside, showed Ellsberg thatevery Administration involved in Vietnam knew full well that the USwould not succeed. The Presidents had not gotten optimistic briefings;quite the reverse. Yet even though they knew this was a costly anddoomed enterprise, they refused to withdraw, deeming the prestige ofthe US to be at stake.

------------------------------------------------

Mencius Moldbug then responds:

Um, the US military actually won the Vietnam War. At least, if by "won" you mean "defeated the NLF and the NVA."

It'san astounding feat of revisionist history to call Ellsberg "the bestinformed person in the US" about the Vietnam War. He wasn't even asoldier, for cripes sake! It's like saying that Gil Amelio was the bestinformed person in Cupertino about the System 7 scheduler.

Ellsbergwas a civilian staffer at OSD. He wrote and compiled a set of documentsthat said the US military could not defeat the FLN and NVA. No onelistened. So he leaked his own work illegally to the Post, opening our present era of government by journalist. And look at the wonderful results!

Later,the US military defeated the FLN and NVA. Hardly anyone knows. Hardlyanyone cares. Welcome to Ingsoc. If at first you don't succeed, justlie and say you did.

-------------------------------------

Mencius continues:

I was wrong about one thing, actually, which you don't mention: thePPs were leaked to the Times, not the Post. Not that it matters.

Ellsberg had been a soldier, He was a Marine. a company commander for two years.

"Hadbeen." Listen to the spin. This is coming out of your own mouth. Youare so brilliantly skeptical on financial matters, and so utterlycredulous on everything else.

Ellsberg was a veteran, but not a soldier(or a sailor). He was a civilian in OSD, in McNamara's policy shop. Hewas one of the DoD "whiz kids,' with people like Alain Enthoven, etc.These were the people who thought they could beat North Vietnam withgame theory and body counts. If anyone was responsible for thescrewups, they were.

----------------------------------------------

Yves writes:

 When Kissinger became head of the NSC, he interviewed Ellsberg.Ellsberg was recommended to Kissinger precisely because Ellsberg WASconsidered to be the most knowledgeable person re Vietnam.

Whenwith the he was with Department of State and the DOD in Vietnam, unlikethe vast majority of operatives, he spent a substantial amount of timein the field, often at considerable physical risk. He not only joinedsome platoons as a supposed observer, actually wound up having to giveguidance to the commander as he was about to take actions that wouldhave exposed his troops to fire. Ellsberg also wound up taking up armsand acting as a member of the troop.

-----------------------------------

Mencius writes:

Yeah. He visited the troops. So did Bob Hope.

Noneof these Harvard types was in any way part of the organizational chainresponsible for the war. They were not, in other words, militarycommanders. What they had was guanxi with people like Neil Sheehan.

AmI saying Westmoreland was perfect? Heck, no. (Though Abrams was a lotcloser.) But to suggest that this glorified management consultant -who, considering his "hard left" connections, was probably not too manydegrees of separation from the actual people who were actually fightingagainst American troops - knew more about the war than its actual commanders, reflects a level of antimilitarism that defies belief.

Similarly,what he leaked was not his own work, it was a compilation. I forget thecircumstances under which Ellsberg came to have access to it, but hisrole in producing it was minor.

Here is a good summary of the creation of the PPs. Ellsberg was special assistant to McNaughton, whose project it was.

(Disclaimer:my stepfather, who certainly does not endorse these or any of myopinions, was a student and protege of McGeorge Bundy, one ofMcNaughton's cronies.)

Finally, I don't know how you can sayUS defeated the FLN and NVA. Yes, we won the Tet offensive, but it wasso ferocious compared to what the US military had led the public tobelieve re the weakness of the enemy that it wound up serving theirends.

You didn't even click on the linkI posted, did you? You probably looked at the source and thought"Commentary bad, New York Review of Books good," like a good servant ofthe powerful. An attitude which, I hasten to reiterate, does not maryour financial reporting at all.

From Herman:

As wehave seen, however, the withdrawal had actually been under way since1969; by August 1972, there were no more U.S. combat forces left inVietnam and a year later there were no U.S. military personnel at all.The reason, in Sorley’s words, was that by then “the South Vietnamesecountryside had been widely pacified, so much so that the term‘pacification’ was no longer even used.” Once again, this was not thepicture presented by the media, to Congress, or to the American public.

Areyou saying that there were US combat forces in Vietnam between 1972 and1975? Or that the Viet Cong (NLF) were not defeated? If so, these aresome of the best kept secrets in history.

You write:

Randinterviews of NVA prisoners were like none others they had conducted,including those during WWII, North Korea, and various Cold Warskirmishes. They concluded that the Vietnamese, unlike other opponents,could not be coerced. The only way to defeat then would be toexterminate them, and given their integration into the Vietnamesepopulation, that meant exterminating the Vietnamese, which was not aviable course of action. It took the Vietnamese 100 years to expel theChinese, but they succeeded. Few populations have that sort of tenacity.

Yup. This is exactly the sort of material that appeared in the Pentagon Papers.

Did it turn out to be true? See the above.

Didit make any sense whatsoever? Weren't the Germans and Japanese a littlefanatical, too? Did the US Army have to exterminate them? Listen to thewords that are coming out of your mouth. They are cant, drivel,propaganda. They are not worthy of your keen and skeptical mind.

Whenyou do financial reporting, do you ascribe infinite credibility to theWSJ, the FT, the NYT? Heck, no. You mock them on a regular basis, andthis is as it should be. But somehow, you accept their first drafts ofhistory, published 40 years ago and never revised, as if they camestraight from the Vatican. I just don't get it.

Reading over the above, I'm not sure I've made my interpretation of the Ellsberg scandal clear enough.

Whathappened is that there were two factions within DoD - the actualmilitary (who wanted to fight a normal war against North Vietnam, aweak and easily defeatable adversary), who were Republicans, Birchers,etc; and McNamara's people, the wonks, who wanted to try out thepreposterous and unrealistic ideas of graduated conflict they haddeveloped at places like RAND. (You've heard of "mark-to-model." Thiswas "war-by-model.")

When the wonks' limited war failed toachieve the results their theories were predicting, they shifted toplan B: the war was militarily unwinnable. Because the North Vietnamesewere fanatical supermen, or whatever. Thus, they were not at fault forpreventing the military from winning it.

In order to shop thisline, they constructed a study to fit the result. When the military,quite rightly as it later turned out, ignored them, they fought back byleaking their study to the press.

This is something that happens every fifteen minutes in DC.
Atleast, it is standard operating procedure now. Perhaps less so in theday. But it was especially unusual at the time, because the study wasmarked "Top Secret." Under, say, FDR, Ellsberg would have spent therest of his life in Leavenworth.

When the Supreme Court failedto enjoin publication of the PPs, they came to no legal conclusionabout whether the offence could be prosecuted. But it never was. Why?

Becausethe Court, in reality, was deciding who was stronger: the Times or theUS military. I certainly am no under illusions that the latter isperfect. But neither is the former. DC is a world of power, not hugsand kisses and puppy dogs and "change."

The result of this powerplay was the current precedent that no secrets are off-limits to theTimes and the Post. Which allows them to more or less run thegovernment. But perhaps you won't believe it from me - in that case,try it from Tony Blair.

 As for Herman's article, I note he claims that Ho Chi Minh was an ally of the Chinese.

Um, where do you think they got their arms from? Bolivia? Sure, many were shipped directly from the Soviet Union.

WhenMcNamara managed to arrange to meet his old enemies (I believe over adinner in Hanoi), it was very awkward and the worst moment was when hementioned the role of the Chinese in supporting the Vietnamese. Hishosts nearly jumped across the table, furious. They said that thatshowed how little the US knew about Vietnam. The Vietnamese hated theChinese, who had been occupiers, and were not going to put themselvesin a position to be under their thumb again.

I love that "had been occupiers." Yeah, what - 500 years ago?

As La Wik puts it:

"Fromat least 1965 onwards, both China and the Soviet Union provided aid toNorth Vietnam in support of its military activities."

Of course, Wikipedia is a hotbed of Birchers. You can't trust it at all.

Here'sa simpler explanation: the Hoists and the Maoists were both a bunch ofOrwellian gangsters. They worked together for a while. Then they fellout. They were mad at McNamara because he was saying that Eastasia hadnot always been at war with Oceania.

He was also assigned fortwo weeks to a platoon that was sent into a VC controlled area (RachKen) to demonstrate that the US could take and pacify such an areas. Hewas with them at all times, took and (despite his civilian standing)returned fire.

He returned fire! Yeah, so did Michael Yon.

Ellsberg is to Bob Hope as the people who were actually running the war were to Ellsberg.

Anyreports of VC presence or absence came from the same South Vietnamesegovernment that had consistently demonstrated a pattern of lying inorder to maintain our sponsorship, so I take the claim that SouthVietnam was pacified as of 1972 with a pound of salt.

Really?You don't think there were any Americans in Vietnam between 1972 and1975? All those Times reporters, all those State people, whom you trustthe way a Catholic trusts the Pope, they just went home? Talk about thedog that didn't bark.

Think about what you know about the Vietnam War. Think about how much of it predates 1969. Ask yourself why.

As for your belief that the government is controlled by the press, that is delusional.

Really?Because you go on for several miles about the press's misdeeds, Iassume you at least agree that the press is very influential.Otherwise, why would you care? I'll also give you the credit ofassuming you read that Tony Blair speech.

The question is then:who has the most influence over what appears in the press? Gee, let meguess: (a) journalists? (b) Punch Sulzberger? (c) the White House? (d)the Freemasons, Skull & Bones, etc?

Occam's razor, people.

I live in San Francisco and am a regular reader of the SF Bay Guardian, which is about as Maoist as it gets these days.

As for "vote scrubbing," I heard about it constantly. But maybe this was just SF osmosis.

Whichdo you consider worse: "vote scrubbing" (removing felons from the voterrolls) or the addition of illegal voters to the rolls? Is it worse todrop a legal voter, or add an illegal one? Why? How much of the latterdo you think is going on, which party do you think is responsible, andwhen was the last time your beloved press mentioned it to you?

As for Communism, I will have to agree - I get a very Pravda feeling off our official press. But not in the same way.

Thereare two kinds of Orwellian state: in one, the government controls thepress, and in the other it's the other way around. In both cases, thetwo are permanently and irrevocably on the same page. Whether or notyou agree that our system is actually a case of the second type, I hopeyou'll agree that they are both creepy as hell.

The following is a comment from Mencius Moldbug:

---------------------------------------------------------

If it’s not too late to add my own sad end-of-thread mot du escalier, I have to agree with Cassandra, if from a very different ideological perspective.

The word “neoliberal,” like “neoconservative,” has become a sick joke. Of course it does not mean “liberal” in the Adlai Stevenson sense. It should be “neolibertarian.” And neolibertarians have pretty much done for libertarianism what neoconservatives did for conservatism - that is, discredited it for about the next 5,000 years. No, really, thanks, guys.

The central fallacy of neolibertarianism is that, since history offers so much evidence that minimalist states (based on simple or negative law) provide better customer service than maximalist states (based on complex or positive law, aka central planning, aka regulation), reducing the scope of law (aka deregulating) can generally be expected to improve the quality of government.

This assertion is so ridiculous that to call it a theology is an insult to theologians. It cannot withstand even a moment’s consideration. If it were true, statism would have disappeared long ago, rather than being anywhere triumphant.

In numerical optimization terms, forgetting of course that we could never describe quality of government as a number, neoliberalism assumes that the optimization surface is one big mountain with the minimal, night-watchman state at the top. A simple hill-climbing strategy will allow us to ascend this lovely monotonic slope.

I have no doubt that such a mountain exists. I just don’t think we’re on it.

I think the maximalist states are enormous Rube Goldberg machines that barely work on a good day. Removing parts from these machines is not liable to fix them. It is liable to make them break down entirely. And the most likely result of this is a whole new Goldberg module which is designed and assembled with absurd haste and attached with 20,000 rolls of duct tape. Sarbox, anyone?

Neoliberalism is not an effective strategy for decreasing the size of government. It is an effective strategy for damaging government, for discrediting libertarian ideas, and ultimately for making government larger and less effective.

So when I look at our present financial imbalances, I see a broken regulatory system. There are many interesting ideas for repairing this system. I believe it would be better to replace it. But I have yet to detect any particles of productive information emanating from those who think that it’s great that this system is broken, or that by pulling out more parts we could break it even better.

Deep in a comment thread on Unqualified Reservations, Michael S. provides the best apoligia of traditional religion that I have ever read.  Years ago I stopped believing in the Christian God and left the church.  Had there been anyone of Michael's intellectual caliber still left in the Catholic church, perhaps things would have gone differently.  Below I have reproduced Michael's key comments from thread, so that others may read them easily:

-------------------------------------------------

There are at least two components to any religion, namely myth and cult. Under the heading of myth are comprised all of the just-so stories of ancient or primitive peoples. An example is the Greek myth which explained the daily rising and setting of the sun as the passage of Apollo riding his fiery chariot across the sky.The Greeks became good astronomers and by the classical period had developed better ideas about the nature of the heavenly bodies than that myth implied. Nonetheless, they did not give up the cult of Apollo, which persisted right up until the suppression of paganism. Literal belief in the myth was not necessary to the cult. The myth could be understood as symbolism and poetry.

A case in point of the distinction between myth and cult is seen in the life of Cicero, a hard-headed politician and lawyer whose surviving writings indicate that he was a follower of the New Academy of Carneades, which held that certain knowledge was impossible, and that practical assumptions based on probability were as much as could be achieved. Yet this practical and sceptical man also prized his initiation into the mysteries of Eleusis, which he claimed was the best and most divine gift of Athens to the world. One cannot imagine that Cicero took the myth as literal truth, but he was an enthusiastic participant in the cult.

Because the Abrahamic religions are scriptural, and a substantial number of their believers insist on the literal truth of scripture, it is more difficult to distinguish myth and cult in them than it is in ancient religions. Nonetheless the distinction can still be made.

Consider the example of the prophet Daniel, who, as told in the apocryphal book Bel and the Dragon, acted as a sort of spiritual detective. Scattering ashes on the floor of the temple of Bel, he revealed that the offerings said to be eaten by the idol were actually removed by Bel's fraudulent priests; feeding an unpalatable meal to a 'dragon' worshipped by the Babylonians, he caused it to burst and die. This narrative is the antecedent of Black Sea's scenario in which a primitive's supposition that a little man must be talking inside the transistor radio is refuted by opening it.

When Dawkins and other proselytizing atheists point out the errors, inconsistencies, and crudities of the Bible, they hope to be the doughty Daniels of their own True Faith. But by showing that there is a great deal of myth in scripture, all they are doing is to fault the people of two or three millennia ago for not being aware of current scientific theory and for using the means available to them to describe natural phenomena.

Serious adherents of the cults of Judaism or Christianity are not at all disturbed by this news. They are already aware of it. The theory of evolution, to cite one example, does not per se disturb any Christian who is not a literalist. What disturbs him is the neo-Epicureanism that frequently accompanies it (and for which there is no more empirical basis than there is for the idea of intelligent design).

The ultimate vindication of the truth of Daniel's faith, we may recall, came after his exposure of Bel and the Dragon. It was then that his enemies caused him to be thrown into the lions' den. It is unfortunate that Dawkins, Hitchens, etc. have so far, in their attacks on fundamentalism/salvationism, chosen to face only a few malnourished alley cats. They need to withstand sharper and bigger claws and teeth before their testimony is credible. Although I'm not a Roman Catholic, my suggestion is that they be thrown to the Jesuits.

Some years ago I read a transcript of an interview of the great scientific cosmologist Stephen Hawking. I do not recall who conducted the interview. At its conclusion the interviewer asked Hawking, did he believe that the universe had a creator? Hawking said that he did not. Why? the interviewer asked. Hawking responded, "Because I find it more aesthetic." There spoke both an honest atheist and one with a much better philosophical footing than Dawkins and his ilk.

-----------------

Black Sea, I did not say that you exemplified the type of proselytizing atheist I meant. I said that you and Aaron Davies illustrated the problem such people face. They think their task is as simple as breaking open the transistor radio to show the Amazon tribesman there is no little man inside. In representing the belief of theists as based in ignorance, and proposing themselves as instructors having the knowledge to remedy that ignorance, they both misrepresent the basis of religious belief and condescend to the believer, while expressing an undue confidence in their own intellectual superiority.

Of course there are simple and unsophisticated believers who are literalists. They understand their religion according to their capacity, and it is unlikely they would understand science any better.
There seems to be no appreciation amongst atheists of the Dawkins type that organized religion has always had to contend with excessivley credulous believers, and in many cases has served to restrain superstition rather than to encourage it. Chesterton is supposed to have observed (though no one seems to be able to find the source) that when men no longer believe in God, they don't believe in nothing - they believe in anything.

The wisdom of this observation is seen in the recent popularity of accounts of flying saucers, alien abductions, and similar uncanny experiences. It is evident to anyone who is familiar with their history that people have been seeing strange apparitions since time immemorial. It is also evident that they always see these things in culturally appropriate ways. The pagans of classical antiquity saw the gods, nymphs, satyrs, centaurs, sylphs, and so forth. Christians saw angels, demons, the Blessed Virgin, the saints, etc. Mohammedans saw djinn, efreets, and the other marvels related in the Arabian Nights. People began to see flying saucers and little green men in the late 1940s - after they had been culturally conditioned for several decades by the work of H.G. Wells and the pulps published by Hugo Gernsback. Enthusiasts of the extraterrestrial commonly explain the experiences of past visionaries with angels, demons, etc. as being 'close encounters' with aliens. They would no doubt bristle with indignation if it were suggested to them that the aliens they thought they saw were in fact messengers from God or the Devil, djinn, or the elementals described by the abbé Montfaucon de Villars in his "Comte de Gabalis."

Such credulous folk, who believe in anything, really ought not to be fair game for Dawkins and crew. They will always be among us even if atheism becomes the state religion. Under the former Soviet Union there was a widespread literature devoted to supposed extraterrestrial visitations. Since the press in that country was under the complete control of the state, one can only conclude that the powers-that-were wished to encourage belief in these manifestations, as a means of undermining the Christianity they had failed to supplant amongst ordinary people with the bald and unconvincing narrative of their Marxist atheism.

Let me make my own point of view clear - it is that the only position tenable from a viewpoint of strict empiricism is that the existence or non-existence of God are equally un-disprovable. Pointing to one or another scriptural absurdity iluustrates only that the man who wrote it long ago failed to understand matters properly; pointing out that many people still believe that absurdity, in the face of evidence to the contrary, proves only that there are still many simple and unsophisticated people. On the other hand, all the arguments customarily advanced by religious believers, such as the argument by design, are such as to be convincing only to people who already believe.

Yet all these things being taken into consideration, two points remain. The first is anthropological: there is no society known to history in which there is not some sort of spiritual belief. This coincides with the ancient Christian doctrine that all people are inherently aware of God even if they have not the knowledge of the Gospel. Physical explanations of instinctive spirituality ("the God gene") are not persuasive, because they run afoul of the mind-body problem. One is left with the nagging suspicion that there might be something to the spiritual, though just what is the great question.

The second point is aesthetic. Arguably, the highest achievements of the human species have been motivated by that instinctive spirituality just mentioned. The great cathedrals, the precious heritage of religious art and music, are not only monuments to religious belief, but more persuasive testimonies to and arguments for faith than the disputations of theology. Have you ever read the story of the conversion of St. Vladimir, the founder of the Russian Orthodox Church? He was, as the account goes, a pagan prince of the line of Rurik; and an enthusiastic pagan, having built several temples. Yet he was not quite satisfied with his religion, and agreed to hear deputations of Muslims, Jews, and Christians each deliver their respective sales pitches. The presentations of the first two were rather arid, but the Christians (who had come from Byzantium) put on by far the best show, high mass with all the smells and bells, rich vestments, singing, the whole nine yards. Vladimir was convinced - any religion that was so beautiful had to be the right one (it also didn't hurt that it had the least restrictive dietary rules, and no ban on booze). Accordingly, Russia became Christian, and Vladimir a saint - all on the basis of his aesthetic judgment.

I suppose these anthropological and aesthetic reasons explain why many people remain culturally Christian despite an abundance of doubts and discontents. They aren't willing to dismiss the spiritual out of hand; they see more benefit than detriment accruing to society from religion in spite of their doubts (as did Jefferson and Franklin); and they find Christianity aesthetically appealing (as did St. Vladimir). They are therefore unwilling to discard it in favor of the barren and austere horizon offered by the crusading atheism of a Dawkins. For my part, I'll wait to see whether Dawkinsianity produces anything equivalent to Chartres, Handel's Messiah or Mozart's Requiem, the Pietà or the Sistine ceiling. When it does we may re-evaluate it to see if it offers anything worthwhile.

------------------------------

The following is an edited compilation of comments on Brad Setser's blog in December of 2006.  The two original threads are here and here.

There are always purveyors of doom predicting economic collapse.  Occaisionally, they may be right, but that does not mean they are worth listening too (broken watches, etc).

What is unique about this thread it that the commenters found the exact financial instruments that posed the danger, and guess the exact political choices that the Fed will find itself faced with, and even make pretty good guesses about how the Fed will actually react.

All of these commenters actually have their own blog which are still active.  I highly recommend adding these blogs to your daily news sources, as they've proven they are more on top of things than the NYTimes/Economist.

The commenters are:

Cassandra -  a hedge fund manager in Japan.

Mencius Moldbug - a software engineer on sabbatical after a dot com IPO, he spends most of his time reading and writing.

Brad Setser - an academic economist who has worked for the Federal Reserve and the Council of Foreign Relations

Steve Waldman - another amateur economist.

-------------------------------------------------------------

Steve Waldman

(Last month I couldn’t help but be amused that I was writing about CPDOs while writing c3p0. I like the whole Kate-Moss-thin credit spread thing. I’m quite convinced — probably by reading this blog too much! — that much of the structured credit revolution is about absorbing all of what, er, bulemic central banks seem determined to keep spewing.)

------------------------------

Mencius

If anyone has a better explanation of CPDOs than Steve, I would like to see the link! But frankly, it is not clear to me that the thing can be done. Thank you, Mr. Waldman.

The big picture in CPDOs is that they are a classic example of government failure. Nothing like a CPDO could possibly exist in an unregulated economy. Of course, that doesn’t mean the best choice for this far-from-unregulated economy isn’t to find some way of regulating the damn things out of existence. But fortunately this is not my job.

CPDOs exist because Nationally Recognized Statistical Rating Organizations exist. Rating agencies (Moody’s, S&P) are not private actors. They are granted enormous official authority. Imagining the market price of NRSRO status, sold with no questions asked - for example, to a company which could shake down its clients for ratings - is one way to conceive of the scale of this delegation of power.

In a transparent, professional system of government such as ours, authority of this kind must never be personal and arbitrary. Old John Moody, perhaps, could tell his customers that Joe’s Railroad was a shoddy outfit run by notorious shysters, whose bonds shouldn’t be touched with a ten-foot pole no matter how many payments they’ve made. If his successors rate JRX, they have to justify their result with some serious math. Nothing else would be compatible with “nationally recognized” status.

As Mises pointed out in the ’20s, excessive dependency on calculation is the general flaw in central planning. The planners are constantly being forced to calculate things that cannot possibly be calculated. Credit default probabilities, especially aggregate spread projections, are a classic example.

So Moody’s can’t issue a report saying that these CPDO things just don’t smell right. It can’t call Stratfor, get a ballpark number on the chance of an Israeli-Iranian war, and factor that into the probability of a generalized credit panic. It has to do what it does - run the things through its models. Which predict, as usual, future results from past performance.

And it’s not just that Moody’s has to do this. It’s that it can do this. Because it is effectively a government agency, it has transferred all of its risk for this behavior to the state. It is Uncle Sam that will take the hit if the models fail, and rightly so. Moody’s only existential risk is failure to comply with its own properly approved policies and procedures.

Fortunately, Uncle Sam is perfectly capable of insuring the risk of the models. He can, after all, print more dollars. Which will then be used to buy bonds - keeping those spreads svelte. Moreover, with this same mechanism, he can stimulate the economy, keeping the people who actually have to make their payments flush.

This is a perfect example of an expansionary ratchet. It is a political mechanism that causes immediate pain if the presses are stopped. Hyperinflation happens because the political cost of a liquidating recession exceeds the political cost of continuing around the spiral. Systems that increase sensitivity to default, like the system that the CPDO is gaming, make the spiral harder to escape.

In other words, the more CPDOs are outstanding, the more stress the financial system will suffer in the case of a sharp credit spread widening that overpowers the “stabilizing” reaction when the CPDOs automatically react by selling protection. The CPDO machine sets up a critical point, below which it is a “stabilizing” feedback loop that causes spreads to converge (as CPDOs gear up), and above which it is a thoroughly destabilizing one, that causes them to diverge (as CPDOs max out and fail).

It is, in other words, major “bubble skin.” The lovely old metaphor of a bubble, which really just means “disequilibrium,” can easily be extended to other materials than the usual soapy water. If your bubble is made out of latex, for example, it can get much bigger and sustain a much higher internal pressure. It is harder to pop, but it makes more noise when it does.

With CPDOs, and ultimately with the power of the printing press, the bubble is the size of the Hindenburg, its interior could easily be mistaken for the atmosphere of Jupiter, and its walls are Kevlar and nanotubes. As Steve says, it is very hard to break.

And it is very important to note that it is not just the personal whim of “bulimic CBs” that supports it - it itself enforces exactly that bulimia. The bubble skin is not really the critical point of the CPDOs. It is the fact that CBs cannot allow spreads to reach that critical point.

For all the hawkish talk, they will accept any level of consumer price inflation first. It is much easier to tweak the index again (maybe it could just be the GCPI, the Game Console Price Index, measured in triangles per second per dollar) and suffer the occasional human-interest story in the Times or Post about how the man on the street thinks prices are too high, despite the fact that there is no inflation.

So fasten your seatbelts, everyone. If I am even close to right, there are no brakes on this thing, and we are headed north in a hurry. It may be a happy 2007 indeed.

And if you care to read a retrospective description of “Kate Moss credit spreads,” rendered in lovely old 1930s prose on crumbling yellow paper, you could do a lot worse than an original edition of A Bubble That Broke The World, by Garet Garrett. I am too lazy to type it in, Dave Chiang style, but there is a bit about Brazilian railway bonds that is as resonant, poignant, and hilarious as you’ll ever get - it makes our own dear Cassandra look like Greg Ip. Financial journalism, like a lot of things, isn’t what it once was.

-----------------------------

Cassandra

Mencius, once again, the tapestry you’ve woven dazzles. And not that I want to argue on behalf of Darth Vader (or Bear Stearns) but one must ask the question - truthfully and unjudgementally - precisely what IS it that we really have to be frightened about in respect of financial innovation?? Is is Herstatt risk? Is it moral hazard? Is it implied leverage? Is it complexity itself? For skeptical (ok, even cynical) as I am, it seems to me that the more things issued backed by more things (as opposed to reliable but, at the end of the day, empty promises), even cleaving off the highly volatile, combustible or merely unsavoury bits for consumption by the overtly bold, certifiably insane, merely gullible, or Agent of OPM (other people’s money) Shooting-the-Moon is bona fide progress. The 151 IS in the the gritty bar, or perhaps some Trader Vic concotion, that at worst makes some unsuspecting girls panties in danger of being removed, but at least its NOT being sold in school vending machines or the corner shop. The innovation may create a logjam of cross-default risk, or back-up claims, but I as I look out at the landscape, I see risk transference that will, in the event of a large Shia trebuchet lobbing this or that over Israeli or Saudi borders, make the mess easier to clean up, the logjam easier to break, markets finding clearing prices quicker, and the certifiable idiots meeting their Darwinian (or Amaranthian) fate that much quicker. A Panglossian view perhaps, but one that The Most Sensible Man in The Fed, Tim Geithner, would probably agree with. In a cataclysmic event/contraction/revulsion/crash, most of the financial innovation will sting the reckless, the feckless and the marauders hardest and where it hurts most, with a large chunk broadly socialized - reasonably equitably - amongst pension funds, insurance companies, and banks or all persuasion. And call me an optimist if you must, but this is not an excessive price to pay, and economy-wide, will WILL be an improvement over the mayhem and treacle-like consequences to lending and economic activity in comparison to when it was concentrated all within - and had to be worked out by - but a few lending institutions.

--------------------------------------------------------------

 Mencius

Cassandra,

My worry is moral hazard.

It seems to me that what these instruments are doing is taking ordinary risk and moving it down the tail into Herstatt (systemic) risk. The Fed then uses its power of the press to convert Herstatt risk into dollar risk. The foreign CBs use same to convert dollar risk into euro risk, yen risk, even RMB risk. At the end of the day everything has the same risk, which means there is no risk at all - and everyone makes money.

Or, as it were, mints it.

What all these structured financial techniques are doing is essentially legalized counterfeiting. It is capturing the printing power of the Fed to produce notes that are, in practice, as good as dollars. It is fractional-reserve banking on steroids. The lesson of fractional reserve is that if you can underprice risk, you can turn (n) dollars into (n + m) dollars. This is now being done in a much fancier way, but the principle is the same.

Our financial system does not actually allow you to cut a CPDO into dollar-sized units and buy coffee with them. But suppose it did. Suppose that besides the usual green bills, which are dollars due now and paying no interest, you had blue bills, which were slices of T-bill, red bills, which were slices of AAA bond, and orange bills, which were slices of CPDO. All prorated by their current dollar value, so that a $2.45 espresso was a $2.45 espresso, whatever the color of your bills.

In a credit catastrophe, then, all the orange bills and maybe some of the red ones disappear, or at least change their face value. (Perhaps with some kind of electronic ink.) As a result, people suddenly have less money in their wallets, cash registers, etc, than before.

Obviously, the ideal situation is that the bills are evenly mixed across the economy. Everyone has all different colors of bills. This allows the destruction to be broadly socialized.

At maximum homogeneity, this starts to resemble an event in which all dollar bills with serial numbers divisible (for example) by 3 are destroyed. It is the reverse of Hume’s Archangel Gabriel. Perhaps the Archdemon Beelzebub.

You could make this a completely neutral (absent psychological factors) redenomination by also redenominating debts. Then it would be no different from, for example, the replacement of 1 million old Turkish lira with 1 new TL. A proper redenomination requires the rewriting of contracts, so that if you borrowed 1 billion old TL you don’t now owe 1 billion new TL.

But note how far we have gone from the real world of CPDOs. If money is widely destroyed, but the effect is distributed nonhomogeneously (if, indeed, broadly), and there is no formal way to calculate the transformation from pre-crash money to post-crash money, there is no formal way to, for example, impose partial debt forgiveness. If there is no debt forgiveness, you are privileging lenders over borrowers, which is politically improbable. But the lack of a Schelling point which enables sensible agreement over the proper level of debt forgiveness ensures a long period of confusion and political turmoil. Not good.

The 151, to use your metaphor, is in the school vending machines. It has been diluted considerably. The little tykes are getting Zima, not Bacardi. But it has still spread out across the global economy and stimulated one heck of a lot of demand. An instant mass hangover is certainly not good politics, and I don’t even think it’s good policy.

If there is anything Bernanke is an expert on, it is how dangerous and unpleasant a debt deflation scenario is. At least from an abstract intellectual perspective, it is unfair to blame him for his helicopter metaphor - what he was saying when he said that made perfect sense. But say it he did, helicopters he has, and if the alternative is mass liquidation, to the air they will take.

My feeling is that the feckless will not suffer. The bubble will not pop. The 1929 crash will never happen. The CPDOs will not default. The political cost is too great.

Bernanke is right in a sense. The round of liquidation that started in 1929 happened because the Mellons who encouraged it did not realize what actual liquidation meant after a decade of modern, efficient Fed credit expansion. They were used to liquidating the smaller and more private booms of the 19th century. Politically, liquidation could not have worked in the ’30s, and it probably shouldn’t even have been tried.

And we have gone way past the roaring ’20s here. The more widespread these instruments that push risk into the CB-protected tail become, the better their protection is. Whether it wants to or not (surely not), the Fed has become the FHFIC - the Federal Hedgefund Insurance Corporation.

This is simply lawlessness. You cannot go on letting Wall Street print money while denying that privilege to ordinary folks with their little mimeograph machines. It is incompatible with every ideal held by our political system. It is ultimately incompatible, I think, with the continued existence of that system.

My personal view about how to return from lawlessness to law, which certainly differs from that of most libertarians, is that the only way to do it is to find a formal way to ratify past lawlessness and eliminate future lawlessness. All the land on Earth, for example, has been stolen many times over. You cannot give Massachusetts back to the Algonquins or Londinium back to the Welsh.

This is why I feel that, rather than a deflating crash which tries to sting the “reckless, the feckless and the marauders,” the best thing for all concerned is a “flag day” solution in which everything they have managed to steal is confirmed as their formal property, and no further stealing is permitted. Which means simultaneously printing a whole heck of a lot of money, and transitioning to a post-paper financial system in which no more money can be printed.

Think of it as the financial equivalent of “truth and reconciliation.” It is a very counterintuitive approach. Just as it goes against all our senses of justice to let the murderers of Steve Biko off the hook, it goes against all our senses to let the sharks of Wall Street keep money they have created through borrowing the Fed’s printing press. But if your priority is results rather than revenge, I think it becomes a more attractive solution.

------------------------------------------------------------

 Cassandra responds:

Moldbug,
At last we nail it down. And I am with you on that page (though all the teasers are plausible possibilities for concern).

The game is certainly unfair. It’s NOT unfair from the point of view that some clever dicks have stumbled upon the more optimal solution before most. That is simply goood business. What’s “unfair” distributionally is that - at present - the umpires and arbiters are insisting its a “fair game”. That there remains high credibility to the authorities’ fiscal and monetary policies and so one is deemed potty to believe otherwise. This is why I despire Kudlow and bubblevision. This is why I condemn the Chinese and Japanese, NOT for sheer cheap manufacturing advantage or clever engineering & production efficiency (which must be disheartening for a US manufacturer in the best of times) but for not letting the interest rate market signal to particpants - particularly the masses - that the game is not true. The lie (not to mention the housing bubble) would be much more difficult to perpetuate with rates at 7% or more. The market actually would work if it were allowed and rates (both FX & IR) not so bent. Of course Congress is rather culpable here for we needn’t have run massive fiscal deficits, not coincidental to uber-loose moentary policy. In the absence of that, the lie is perpetuated, so rather than tell the people: “folks, money illusion (dilution inflation etc.) of X% p.a. is essential to continued good times, and so - in the public interest - we just thought you should know in case, like you errr ummm thinking of putting your savings in money markets, buying a US Savings Bond or Treasury Bond, or, in fact being a creditor for anything less a few days unless recompensed for the almost certain inflation that we are bound to see at some point in the future, absence the discovery of cold nuclear fusion. So folks do what you ratonally must to compensate”. After which the people can establish rational expectations based upon sound information, and not Radio Pyongyang blathher and drivel and apology after apology. This caveat is not dissimilar to the placing of photos of gruesome scarred black lung tissue upon cigarrette boxes. But at least “the people” would be on equal fotting, adjustments made, and the lie would be exposed.

---------------------------------------------------------------

Moldbug, like charming cassandra, I am captivated by the web ye weave, and very deeply in agreement with most of what you write. It is a great delight to read plainly written that Wall Street is making its money quite simply because its players have been permitted to print it, and that the distribution of wealth has become largely a game of cleverness or connectedness in accessing central bank printing presses, rather than a matter of conributing to the production of goods and services in the world.

That said, i think there’s a bit of a contradiction in your flag day proposal.  So long as the dudes with the printing press control the terms of mainstream debate (as they do now), there will be no flag day. They’ll just keep printing themselves money. There has to be a problem for there to be a solution. What should that problem be? A great inflation, as more people with a higher propensity to consume, get hold of a mimeograph?  Or a deflation, in which some of that mimeographed money just disappears, and whoever was holding it loses? Something else?

I don’t think we need to ratify anything, as all that printed money, whatever its color, is already effectively legal tender. I don’t think we need to string up anyone for their inflationary synthetic portfolios either. but i think we’ve enetered a game where 1) the accumulation of relative wealth is deeply decoupled from the production of absolute wealth, 2) the game won’t change until there is some kind of a crisis, and 3) the longer the crisis is put off, the worse the putatively ratifiable status quo will be when the crisis happens, and the greater the likelihood it ends up looking like the French Revolution rather than that 80s S&L thing.

One way or another, we will have a great inflation or a great deflation, or both (monetary hypervolatility). I’d like to see at least some deflation, so that some of the right people get burned, but as you say, justice may be too much to hope for in this life and vengeance tends to burn indiscriminately. Whatever form the crisis takes, I just wish we’d get it over with. Only then will there be any hope of a “flag day”, or of any reasonable financial architecture that prevents this kind of thing from happening again.

So, here’s to a crisis, early and soon. And Happy New Year!

----------------------------------------------------------

bsetser :

Cassandra — very interesting set of observations.

Personally, I am worried by:

a)  The implied leverage … and the need to hedge in bad states of the world in ways that can augment moves.
This is something that I think Geithner (my former boss) worries about as well — see his comments on falling margin in his last big speech on systemic issues. Less vol means bigger positions to get the same returns (or put differently, smaller spreads require taking on more leverage to generate outside returns), which is fine so long as the fall in vol is permanent and not temporary …

b)  The complexity itself … I don’t understand 1/2 the products out there, let alone how various folks hedge the nuclear bits of their portfolios, and I would bet I am reasonably sophisticated for someone doesn’t have skin in the game.  From a systemic point of view, complexity introduces more model risk (something that Waldman/ interfluidity nicely highlights)

c) Leveraged, correlated positions — think of all the folks who were long local EM markets (debt and equity) hedged by holding CDS (default protection) on EM $ bonds in May/ June. Those selling the CDS protection were in a position to honor their obligations (they were big boys looking for a yield pickup) but that didn’t change the fact that the leveraged community was all basically long the same stuff (local em assets) and deleveraging meant selling. The correlation between EM local currency sell offs and EM $ debt spread widening held generally speaking, but I do wonder if this is a case where correlations that look good in a backward sense will eventually cause truoble, especially in a world were real EM $ bonds are disappearing …

d) Some concentrated positions in some key market segments. See the FT article on correlation and the CDO market. To generate the tranches that real money investors want, the I-banks of the world ended up being structurally massively long the equity tranches … which they hedged in various correlation trades (as I understand it). In the past I have called this Rajan risk … smart folks take on nuclear stuff to make money selling the less nuclear stuff thinking that they can hedge it … but that generates model risk/ complexity.

e) Is there any risk that some of the prime brokers could get into trouble in a bad state of the world? I.e. one of their clients cannot hedge/ liquidate so the prime broker has to take over the position — and say it isn’t just one client but several who all have the same trade on and cannot get out in time. then prime broker then wants to hedge, and it has touble without moving the market and so on … I am thinking things up but this strikes me as at least possible. I am not 100% that all risk has been dispersed rather than concentrated — there are only so many people who understand certain kinds of complexity and some complex positions may be very concentrated (ok that isn’t necessarily a prime broker point but it is a concern).

------------------------------------------------------

Mencius

The reason recessions and depressions happen, or used to happen, anyway, is that lenders became more reluctant to lend. It was traditionally thought that lending to people so that they can pay off their debts was not sound banking. Of course, we have entered a new era, so this may no longer be true.

So debt deflation requires either a suppression of monetary creation, or at least a redirection of the new money away from existing borrowers.

In the era of classical bank lending, for example, political authorities could trigger debt deflation by raising reserve requirements, or otherwise making lenders reluctant to lend. Or lenders could exhibit such reluctance despite the desires of said authorities - as happened in Japan. They could take the cheap money and lend it to New York, for example.

But most of today’s credit expansion is driven by derivatives. This is a very different phenomenon.

The hallmark of a credit expansion is that the value of dollar claims which are technically mature at any time T exceeds the number of formal dollars in existence at T. In a free market, this is only sustainable when the monopoly supplier of dollars has a clear willingness to print as many dollars as claimants care to redeem.

Obviously, if dollars are a closed system (no printing allowed), and you have a claim for a dollar on an entity E which has issued identical claims for yD dollars, where D is the total number of dollars in the world, and y is greater than 1, your claim cannot possibly be worth a dollar. Whether E is George Bailey, Citibank, or the entire US financial system makes no difference. You are best advised to redeem your dollar at once and secrete it about your person.

But when there is a lender of last resort L that can provide an arbitrary amount of financing to E, there is no need - or almost no need - to redeem the claim. The only thing that can cause a default on the part of E is a breach between L and E. Since E has every incentive to avoid such a breach, your claim is secured by its competence and compliance, which in the case of most financial institutions is very, very high. You have no need to look at E’s own financial position, because what matters is not E’s position, but L’s assessment of it.

The result of this implicit insurance is that claims on entities which fit the description of E are priced higher, relative to dollars, than they would otherwise be. Another way to say this is that if the claims are not mature, they will be priced higher, relative to dollars which are not mature, than otherwise. In other words, these notes will exhibit “unnaturally” low spreads over T-bills.

And in still more words, this process is exactly equivalent to the printing of money. It allows the total value of credit to exceed the total amount of money. These implicitly insured claims to money become, in Misesian language, “money substitutes.” If the insurance is less than perfect, they may be discounted by some fraction, but this reduces net money creation only by that fraction.

The same can be said for the frequently-cited defense that credit expansion also produces liabilities, which must be paid back. Indeed. But if the issuance of new credit exceeds the retirement of old liabilities, the net money flow is still positive. And this is generally the case.

A system with constant monetary creation becomes dependent on the flow of new money. Unless you are a Third World country, the process is unlikely to be as simple as taking out new loans to finance old ones. The new money sloshes around and creates a general feeling of well-being and prosperity. Individuals make different decisions than those they would have made absent this flow.

The challenge in keeping this kind of unstable monetary system alive is to avoid the Scylla of self-reinforcing shutdown and potentially lethal hangover (debt deflation), and the Charybdis of self-reinforcing dependency and potentially lethal overdose (hyperinflation). As a historical rule, the result is always the latter, because it can be selected at any time, and it feels a lot nicer.

Note that consumer prices have very little to do with either of these phenomena. Both debt deflation and hyperinflation, if they get out of control, will inevitably affect consumer prices. But there is no guarantee that they will do so before they get out of control.

Looked at from first principles, this bank-oriented model of credit expansion is a very complex and temperamental system. But it is extremely well-understood, and it affords quite a number of practical levers for administrative management.

In the age of the derivative, however, administrative constraints on liquidity are much less straightforward.

Take, for example, the notorious CPDO. How do you fix a system that assigns an instrument which achieves guaranteed return by exponentially “doubling down” an AAA rating? (Props to Steve Randy Waldman for his excellent explanation of these diabolical devices.) Efficient financial markets have efficiently discovered and exploited the inherent and essential absurdity of stochastic risk modeling.

For example, Citigroup has the incredible and unmitigated gall to describe CPDOs as a “stabilizing” instrument. This is because when the yield spread of the lower-rated instrument protected by the CPDO (eg, some index of A-rated credit) widens, the CPDOs that protect it will gear up and sell more protection. Reducing, therefore, the market-assigned risk of the instrument. So the more CPDOs are sold, the less likely spreads are to widen - making each CPDO inherently safer! This is financial alchemy at its best.

In other words, it reduces the Fisherine concept of “stability” to its natural absurdity. If you define stability as the absence of volatility it is precisely correct. Since this is the way our financial system does define stability, it is indeed correct. And it certainly can’t be perturbed by any force short of actual reality.

So the $64T question is: when this system, which in normal English usage would be defined as the exact opposite of stable, reaches the point of size and fragility where it comprises the overwhelming majority of bank assets, and it will explode if a dog farts in Burma - what happens when the dog farts?

In other words, when CPDOs and similar explosives start going off like firecrackers in the ammo dump, and a lot of people realize that the value of their asset portfolios may be much lower than they thought it was, what does the Fed do to offset this?

Does it try to reopen the floodgates of classical bank lending, relaxing regulations so that profoundly unsound institutions can still lend? Does it try to invent some new infernal financial instrument to take up the slack? Does it buy assets directly with money it prints itself - possibly even the CPDOs themselves, on the grounds that it itself encouraged this gross financial hazard? Does it lend its own money directly? Or does it just let the bankruptcies pile up?

In a recent John Derbyshire article, he publishes the following reader email.  I wanted to reprint just the first part of the email, without the surrounding politics, so that I could solicit intelligent comments from programmers.  So here it is:

-----------------------------------------------------------

Derb — Allow me to comment. I am one of those government employees you talk about. I was not always a government employee. For 25 years, I made a handsome living as a computer programmer until the DOTCOMBOMB and outsourcing took their savage toll. My wife was always a government employee and urged me to become likewise. I resisted her blandishments. I was making big money and putting it away. I was a sucker. She is now retired and I am still working!

After losing my job and pension six years ago, I became a government employee. My reaction was how could I have been so blind for so long?! The private sector has become a vast lie, a minefield where one must carefully consider every step and purse one's lips. You can be banished with a snap of the fingers. I used to work my a** off, 80 hours a week. I now work a precise 40. I used to worry about layoffs and downsizing. No more. I used to worry about my pension. No more. Indeed, I can plan with computer precision the day of my exit from the work force. I shall be 63, my birthday, and retire with Social Security and a very secure pension along with a medical care supplement. Let us be blunt, there shall be two classes of people going forward. Those who can retire and those who can't.

What a fool I was. It was all a vast waste of time. Time that could have been better spent building up pension credits, leading to an even more munificent lifestyle!!!! Oh, it was fun while it lasted but, seriously, I should have been a mailman out of high school!! Like yourself, I have advised my grandchildren accordingly.

Let me be clear, this is a catastrophic development for our country. When the private sector can no longer compete with the public sector, you know that society is on its way out.

-------------------------------------------------------------------

Any programmers/government workers out there who'd like to comment? Has the emailer overblown things, or is it really finanically prudent for an egineer to get a government job?

After watching an Inconvenient Truth and reading about the IPCC consensus, I assumed that global warming was an established reality.  But a little while ago I stumbled across a couple of curious blog comments by one Mencius Moldbug.  Mencius is a software engineer out in San Francisco.  After scoring in the dot com boom, he went on sabbatical in order to read, think, and write.  He studied the whole global warming debate and came away with some interesting findings.  Below I've tried to compile the long comment thread into one coherent post.  Mencius also writes a blog here.  Unfortunately, he has not blogged about global warming yet.  Since this is the single most compelling case for global warming skepticism that I have ever read, I wanted to re-post his comments in a place where everyone could read them.

---------------------------------------------------------------

Mencius:

The set of people who support or oppose a proposition is quite unrelated to its validity. So, even, are their motivations.

I'm sure there are some businessmen and politicians who oppose the global warming hypothesis for venal reasons. I'm sure there are some who oppose it for sincere reasons. And I'm sure both categories also apply to the large number of businessmen and politicians who support it. I don't see how any information can be deduced from these incontrovertible facts.

Do you have a minute to follow a link? You might find this page interesting. It is rather free of context, but perhaps its tone might spark your curiosity.

Now, what is your first question on reading this? Is it, by any chance, "Is Steve McIntyre a scientist?"

You see, there are two possible definitions of the word here.

One is that a "scientist" is anyone who follows a certain process which, in the past, seems to have been very effective at producing reliable information. This process is called the "scientific method," and while it is certainly not infallible - nothing is - it seems pretty good at eradicating error. And it works for anyone, black or white, Gentile or Jew.

Another is that a "scientist" is someone who has been awarded a certain credential by a certain institution, which entitles him to occupy one of a small number of prestigious positions. In this sense, calling someone a "scientist" is like calling him a "duke." The word "duke," from the Latin dux, originally meant a leader of fighting men, a warlord. There are still dukes today, and there are still warlords, but the dukes are not warlords and the warlords are not dukes.

As it happens, McIntyre is a scientist (I would say) in the first sense of the word, but not in the second.

His background is actually in hard-rock mineral exploration, which is one of the shadiest industries in the world. As a mining consultant with a strong background in statistics, he essentially made his living investigating bad numbers, and he developed an excellent practical sense of the ways data can be fudged.

One day out of pure personal curiosity he decided to take a look at the use of statistics in paleoclimatology. Paleoclimatology is a field which tries to estimate temperature trends from the time before we had scientists running around with thermometers everywhere. It does so by measuring "temperature proxies" which naturally record temperature effects - tree rings, for example, As you can probably imagine, before the rise of global warming, this was a rather obscure discipline, but it has since risen to great global importance.

The first result McIntyre looked at was the famous "hockey stick" curve associated with several notable paleoclimatologists, notably Michael Mann. If you have ever seen a headline saying "200x is the warmest year in XXX years," you have probably experienced the "hockey stick." On the basis of this result, Mann (no relation to the Miami Vice director) had become a star in his field, was named one of Scientific American's top 100 young researchers, etc, etc.

What McIntyre found was that this work was based on a pattern of bad statistics that came very close to simply being fraud. Mann had chosen nonstandard statistical procedures which amplified a single sample, from a set of trees (bristlecone pines) well-known to respond directly to CO2 rather than temperature, into a pattern that looked like it covered the entire world. Moreover, Mann's FTP site had a directory called "CENSORED" on it in which the same calculation was repeated without the bristlecones, showing no "hockey stick" at all.

Scientific misconduct happens. Just because a physicist, like Jan Hendrik Schön, pulls some stunt, doesn't mean Einstein was wrong.

But Schön was rapidly drummed out of his profession. Events in the Mann scandal have gone very differently.

The entire field of paleoclimatology has stonewalled on the "hockey stick." Mann is still very much an honored member of the field. And this despite the fact that two external reports, a National Academy of Sciences panel, and an independent report prepared by Edward Wegman, one of the US's leading statisticians, confirmed all of McIntyre's results.

What was the consequence of all this in the press? Funny you should ask.

The NAS panel, which included many of Mann's colleagues, came up with a very nice dodge. They admitted that Mann's results were useless, but claimed that, since other studies - many using the same flawed methodologies - reported the same results, the entire concept was vindicated. You may have heard the phrase "fake, but accurate."

As a result, the release of this report was actually an occasion for a new wave of "Earth is Warmest in 2,000 Years" stories. You had to be very, very savvy to understand the actual content of the report, which included a large dose of spin.

Wegman's report contained no spin at all. However, it also happened to be commissioned (pro bono, with no payment at all, etc, etc) by Joe Barton of the House Energy Committee. Therefore, it received no press coverage at all - despite the fact that it exposed one of the major scientific frauds of the last century, one which was lavishly promoted by the press.

In fact, not even Republican news outlets - like Fox News or the Washington Times - would touch the Wegman report. Why would they? Why go through another round of being attacked as shills for the oil companies? What's in it for them? Because they are, of course, shills - but for the Republicans, not for the oil companies.

The problem is very simple. It has nothing to do with Republicans or Democrats or whatever. McIntyre is a liberal. Wegman voted for Gore. He is not some kind of crazy AEI activist, he is the former chair of the NAS panel on statistics, who had never heard of any of this crap before Barton called him. Look at his CV - this is normal diligence for a statistician. Checking that people are using stats correctly is what a guy like Wegman does.

No. The problem is money and power and fraud, pure and simple.  Trillions of dollars are being reallocated on the basis of statistical work that would flunk a sophomore. And you're not interested? What kind of skeptical antennae do you have?

MBH99 is like a bad audit finding. When you find that Bear Stearns or Enron or Citicorp or whoever has fabricated some nonexistent asset on its books, you don't give it a slap on the wrist and tell it to cross the line out. You unleash the forensic guys. You don't find just one cockroach in a kitchen. And you don't tell the health inspector, "sorry, we'll kill it."

MBH99 is not an ancient, irrelevant result. It is the single most publicized piece of research in the history of IPCC climatology. It singlehandedly put Mann in Scientific American's list of America's 100 top young scientists. And it really is not a stretch to compare it to an ape jaw glued to a human skull. The thing reeks. It is data laundering of the worst kind.

Sure, the "hockey team" has "moved on." Despite the fact that the NAS panel chaired by North and the Wegman report, both of which concurred in all substantive opinions, both stated that further paleoclimate proxy studies should not use bristlecones or foxtails, we continue to see paleoclimate reconstructions full of them.

And when IPCC climatologists are actually willing to use phrases like "if you want to make cherry pies, you have to be willing to pick cherries" (d'Arrigo) to committees investigating their work, we really have no reason to believe that their results are generated from their data and not the other way around. Actually, we have considerable reason to believe the opposite. "Why should I make the data available to you, when your aim is to try and find something wrong with it?" (Phil Jones.)

The trouble is that the entire evidentiary case for AGW is nonreplicable and unfalsifiable. If you do not personally trust the researchers, you have no reason to trust the "science."

The first arm of the AGW case is paleoclimatology, which is trivially distorted by selection bias, ie, "good" results are published and not "bad" ones. The second is general circulation models or GCMs, which simulate the Earth's atmosphere. GCMs are the product of tuning - they are certainly not derived directly from the laws of physics. See Nir Shaviv on the fine art of fitting elephants.

Because of this episode I judge the IPCC "consensus" the way I might judge the collective views of, say, the IMF. As a bunch of very smart people who nonetheless have a very clear institutional agenda. If you insist on taking them at face value, perhaps I could interest you in an Argentine bond or two.

It would be wonderful if we lived in a world where there were these institutions, like "Science," or "The Church," or "The New York Times," which you could just trust. But such a world has never existed in the past. Why should it exist now?

The logic I've laid out is my motivation for treating the Scientific Consensus as epistemologically irrelevant to my own estimation of future climate trends. I believe I've described a social process that could produce the Consensus whether or not the AGW proposition is true.

If anything makes science Science, it's that the "scientific method" is a social process which, in the past, has shown a tendency to eradicate error from its own conclusions.

I believe McIntyre's work has shown quite conclusively that, at least in the field of paleoclimatology, this process is not now operating, at least not in the form that produced its reputation.

I also believe that, since the culture of climate modelers (such as James Hansen) does not appear to differ from that of paleoclimatologists, and since climate modelers have at least as much, if not more, of an opportunity to tune their models in the same way that paleoclimatologists tuned their statistics, I should treat the information generated by both with the same distrust.

Since AGW research consists (since it can only consist) of modeling and paleoclimatology (the former is much more important - the paleoclimate follies are very much a canary in the coal-mine kind of thing), I choose to ignore it.

For example, if climate modelers wanted me to change my decision on this, they would have to build a new climate model in a clean-room process, which (a) correctly simulated Earth's climate in the past and (b) was not made to do so after a very extensive process of tuning, with abundant opportunities for the introduction of unconscious bias.

To be more specific, the largest source of uncertainty in climate models (GCMs, general circulation models) is their handling of water. ("Besides that, Mrs. Lincoln...")

Water in the vapor phase is a greenhouse gas. Water in the solid phase, and aerosolized water in the liquid phase, reflect radiation back out into space and cool the earth.

The interaction between these phases, and the more common surface liquid phase (like WC Fields, I never touch the stuff) is chaotic, which essentially means unsimulatable.

All GCMs in operation today predict a powerful positive feedback effect from (clear) water vapor, which strikes me as a pretty convenient truth if ya know what I mean. As notorious climate-criminal Richard Lindzen points out, the increased temperature caused by CO2 can just as easily produce a negative feedback from increasing cloud cover.

I'll bet something like 1% of the people who read about global warming in the papers know that the effect is logarithmic. Doubling the CO2 concentration produces a global radiation increase that, in the absence of modeling, if you just run the numbers straight, would make Earth about 1C warmer. Double it again - same result.

In the last century, CO2 has gone from about 280ppm to about 380ppm. The level of positive feedback the GCMs need to assume in order to turn this into an epic human catastrophe is, obviously, quite nontrivial. In fact, with a little more tuning, the GCMs would probably be quite happy to turn us into Venus.

And if that result generated more funding for the people writing the GCM, that's probably exactly what it would print out. But there's a balance of credibility that has to be maintained. In fact, GCMs in testing apparently quite often turn the Earth into a snowball or a boiling planet. The fact that they work at all is a genuine accomplishment.

So what is my prediction of the weather in 2057? I have no idea, I am not a climatologist. But Nir Shaviv's view strikes me as pretty sensible.

Of course, Shaviv is just one guy. He's not a Consensus. I'm afraid I'm going to have to disappoint you on that one, although again, if you are interested in the subject, Climate Audit is the place to be.