May 2011 Archives

Black Swan, Lake Monger, 2010.

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'Black swan' is a term which is overused and under-understood. 

1) Evolutionary psychology: Humans aren't very good at math, but especially intuitions about probability, and improbable things happen more often than we expect.

2) Behavioral economics (or evolutionary psychology part deux) - we feel worse about negative outcomes - a small negative surprise is felt disproportionately sharply relative to a small positive surprise. When humans were evolving on the brink of survival, a small negative weather surprise was the difference between life and death.

So we are risk-averse, and more sensitive to downside risk. But 3) The universe is perverse. Edifices take years to build up. When someone screws up, they collapse or burn down in seconds. The character and probability distribution of downside risk is different from upside risk. When things go bad, they don't break gracefully, but with chain reactions and unintended consequences. Then they get worse, when people panic and do precisely the wrong thing at the wrong time.

Call it Murphy's law, or vol skew, the 'black swan' event is just another name for entropy in action.
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What is money?

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Plato

Cover of Plato

As far as the laws of mathematics refer to reality, they are not certain, as far as they are certain, they do not refer to reality. - Albert Einstein

This is all Plato's fault - he founded Western philosophy on a theory of absolute reality, which humans vainly attempt to discern, like cave-dwellers pondering the source of shadows dancing on a wall. 

A good metaphor, but modern science has given the existence of absolute reality a few hard knocks. Heisenberg showed that you can never perfectly know the location and velocity of an object. The more accurately you measure where it is, the less accurately you know where it's going. It doesn't even make sense to speak of particles as having absolute attributes, they are better described as clouds of probability distributions. Space, time, mass stretch depending on the motion of the observer.

Interactions between particles seem more tangible than the particles themselves; you either observe an interaction, or you don't. And what is a particle except how it interacts with other particles? Suppose there were only a single electron in the universe, would it still be meaningful to say that it has a charge of  -1.602×10−19  coulombs, if there were no other particles and fields for it to interact with? What is the sound of one hand clapping?

Is there a 'form' of a chair? Or is it a chair if it's something you can sit on? 

Which brings us to money. Money is not a paper bill, or a gold coin. It is not a physical object with some sort of divine blessing. It is a set of interactions and relationships: customs, rules, expectations, backed up by the laws of the state. It is the fact that you can go to a cash machine, get a piece of paper, and go into Staples and buy a pencil, setting in motion lumberjacks in Canada, graphite miners in Peru, and sweatshops in China.

The problem is not fiat currency vs. gold. The problem is the rules of money have been stretched to the breaking point. Ben Bernanke conjures up vast quantities of dollars to buy bonds to bail out banks and governments, which dollars are not equally forthcoming to help bankrupt and unemployed people who are also in bad shape. Through the shadow banking system, the government doesn't even seem able to control or measure money creation, and through derivatives and connivance of accountants and traders, companies like Enron and countries like Greece can make cash magically appear on their balance sheets, and if they're sharp, it will be a long time before anyone is the wiser.

There used to be an incomprehensible gnome named Alan who spoke cryptically about money and no one knew what he was talking about. But everyone heard him and figured there was a Really Smart Guy on it and they didn't have to worry about it. It turned out Alan didn't know everything, but one thing he did know was how to maintain an aura of mystery and wizardry. 

These days Ben Bernanke feels compelled to do press conferences to flack his policy. Ordinary people actually watch and worry and ask themselves, wait, that's the Really Smart Guy? And every time he says a strong stable dollar is in the interest of the United States and the world, it goes down another few notches, and gold goes up some more.

The underlying problem is the loss of the integrity and credibility of the system. If you're an individual, you think bosses and banks manipulating the system to screw you. If you're a boss, you think the government is manipulating the system to screw you. In fact, the system is broken, real imbalances like the twin deficits, and systemic rot like MERS and "too big to fail" built up for far too long, and major reforms and lifestyle adjustments are needed to sort them out.

The answer is not gold good, paper bad. The answer has to be to stop marching toward disaster capitalism and restore the integrity and trust in the system.

Until the real imbalances are straightened out, the US fiscal and monetary polices are back on a sound basis, and the US is consuming an amount that it can finance at a sustainable level of the USD and interest rates, and trust and animal spirits are restored, there will be a prolonged period of poor economic performance. Businesses will be reluctant to hire, and eager to make sure they have a good cash cushion and plenty of inventory of everything they need, and hedges for any financial risk that can be hedged. (It's not hoarding or speculation, it's risk management.)

At times it might look like sustainable recovery. But then any withdrawal of stimulus and it falters. Then stimulus is restored and you get hoarding and speculation and commodity inflation and China cost push inflation. Then you clamp down on inflation and Europe, and the banks and mortgage borrowers blow up.

Fasten your seat belts. It's going to be a bumpy ride - Margo Channing

So we beat on, boats against the current, borne back ceaselessly into the past - F. Scott Fitzgerald
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Ai Weiwei during documenta 12 (2007)

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The Chinese government has taken insecurity and paranoia up a notch in the wake of the Jasmine uprisings in the Arab world. They have 'disappeared' dissident artist Ai Weiwei and cracked down hard on human rights activists, meddlesome lawyers, and dissidents.

That is reason number one there will be no revolution in the near future: the government is perpetually on guard against any threats. China is not a police state like East Germany was. Individualism thrives. But the government sets down bright lines. You can do or say anything you wish, as long as you do not threaten the legitimacy of the Chinese Communist Party's hold on power. If you do, the full force of the state will be brought to bear.

Reason number two: The Chinese leadership is competent, and deploys the carrot as well as the stick effectively. It responds to protests, and reacts flexibly to sources of unrest, like the truckers strike.

Reason number three: The Chinese system has been successful. Relative to the West, it seems like economic and political oppression. But relative to where China was 30 years ago, the CCP has delivered an economic miracle, and there has been an uneven path toward liberalization, up to a point. The CCP delivers the goods, and no one wants to go back to the years of chaos.

Reason number four: Competence and success lead to legitimacy. Revolutions generally occur when the incompetence of out-of-touch leaders results in economic crisis or military disaster, intolerable disappointment for the masses, and loss of legitimacy for the leadership. The French Revolution is the archetype: it was probably not a great idea to summon the Estates General in a state of economic crisis, after years of mismanagement by the establishment, and after the moral authority of their rule had been undermined by intellectual and popular culture for decades. Even so, it was not until the king tried to flee, disguised as a butler, to link up with allied foreign armies, that the legitimacy of the monarchy was fatally compromised and its overthrow inevitable.

No one can argue that China has not 'stood up' in the last 60 years. Even disasters like the Great Leap Forward and the Cultural Revolution did not result in a serious threat to the CCP.   Despite what Westerners might see as oppressive dictatorship, the masses don't rise up against competent governments that deliver economic results.

Reason number five: there is no effective, nationwide organized grass-roots opposition, nor any history or tradition of one. There is a tradition of wise intellectuals speaking truth to power, like Ai Weiwei. There is a tradition of spiritual movements arising as an expression of dissatisfaction, like the Falun Gong. The CCP suppressed the Falun Gong harshly, even though it seems innocuous, because they know the history of the Boxers, the Taiping, the Red Turbans, the Yellow Turbans, etc. But their is no tradition of effective mass protest. The biggest reasons the 1989 Tiananmen protests failed was that the students were disorganized, feckless, and did not have nationwide support. If they had made modest, clear demands that could have been partly accepted, instead of vague demands for radical change, they might have gained legitimacy, built a lasting movement, and history might have been different. In many parts of Western Europe, organizing popular movements, general strikes, and barricades was practically a national sport. In China, suppressing noble but futile expressions of dissent is a national sport.

Reason number six: there is no tradition of grass-roots democracy. In the West, from an early age, everyone votes on everything, majority rule and self-determination have enormous legitimacy. In China unlimited individual freedom is not a universally accepted value, and the will of the people is not always seen as the wisest. Respect for authority and elders is a deep-rooted Confucian virtue.

On a generational time scale, Chinese people will travel to Hong Kong and the West, and wonder why their Internet is censored, why they can't criticize the government, and why so few of the benefits of growth filter down to the masses and so many accrue to princelings and corrupt officials. Eventually the economy will have a hard landing and the government will hit a wall. The government is like a white-water kayaker heading down the rapids - every time a cataract is navigated or a boulder is averted, there are more and bigger dangers downstream. Or, as the saying goes, like an elephant riding a bicycle...as long as the wheels keep spinning all seems well, but when there is trouble it will be a very big mess.

But until the wheels fall off, dissent is likely to be limited and local, and the government has clearly shown the resolve and lack of scruples to head off wider unrest.

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