Questioning the “markets” – part 1

Over the past three and a half years, I have had a ring-side view of the finance industry. I have been involved in developing a market risk-management software product targeted at banks. This product has now morphed into a far more mundane corporate treasury management software. In the process, I have developed a great distaste for financial modeling and all the elaborate math that goes into modern finance. I have come to question the role of the finance industry and its foundations – the currency, equity, credit and derivative markets. Note that I am not questioning the role of the finance industry in the recent “crisis” or any such thing; I am questioning the very existence of the finance industry in its current form; I am questioning the role of the finance industry in the free market system as such.

What led me to ask such fundamental questions? Here are some observations/experiences in no particular order.

Banks vs Corporates:

  • It is a lot easier to make money in the finance industry by catering to banks.
  • Banks are a lot less concerned with the accuracy or soundness of the results produced by our software.
  • Banks are interested in far more complex analyses than corporates are. However, unlike the people at corporates, people at banks do not necessarily know what they are doing or how the analyses are to be interpreted.

Money:

  • There is far more money to be made in the finance industry as compared to other industries.
  • Many engineering graduates from IIT have some certification or the other related to finance (NCFM or some other acronyms that I don’t care to remember). These were unheard of when I graduated in 2006.

Math:

  •  Highly sophisticated math is required for any non-trivial analysis. Very few people have the capacity to understand the math.
  • A lot of the math is circular. Mathematical models are often calibrated to market prices of assets. The market is made by people who use mathematical models to price assets.
  • A lot of the math is essentially unfounded. Correlation trumps causality because the causality is too complex to model mathematically.

It is clear to me that the finance industry is sick. What made it sick? How long has it been sick? Can it be cured? If so, how? I will consider these questions in future posts. (I have a history of starting a post with part 1 in the title and failing to follow up. This time however, I am sure there will be more posts on this theme.)

Government and Industry

A government that controls industry is necessarily a government that is controlled by industry. Just thought of this as I was reading this review of the movie Food Inc.

I admit my expectations were somewhat low. I was anticipating something more along the lines of a Michael Moore’s emotional yet analytically vapid productions, such as Sicko and Capitalism: A Love Story. This film had quite a few negative things to say. However, it is a bit more sober and interesting, even for a laissez-faire capitalist like me.

To see why, consider a few of its themes:

  1. A negative view of the large size of food industry businesses.
  2. A positive view of government power when it’s used to mandate food industry practice.
  3. A negative view of the control of government by the food industry.
  4. A positive view of small/organic/non-factory farming.

Holding both views 2. and 3. involves a contradiction.

Dr Rodger’s testimony against subsidies

I came across this testimony delivered by Dr Rodgers, CEO of Cypress Semiconductor via this essay by Paul Graham. 

Rodgers begins his testimony with

In my right hand I have a data-communications chip made by Cypress Semiconductor. We call it HotLink. It is capable of transporting information over a wire, or through an optical fiber, at the rate of 330 million bits per second. In my left hand I have a 4,196-bit static random-access memory (SRAM) chip made by Cypress. It is capable of storing and retrieving data in three nanoseconds–about the time it takes light to travel one yard. It is the fastest SRAM of its type available from any company in the world. Our HotLink chip would undoubtedly be part of any data communications network created in the United States–and in high volumes. Our super-fast SRAM is currently being used in conventional supercomputers.

Another excerpt:

So please allow me to reintroduce myself: I am an excess of the 1980s. Based on my ownership stake in Cypress, I am one of the people who, in the President’s words, “profited most from the uneven prosperity of the last decade.” I became a paper millionaire in the 1980s–eight times over, in fact.

How did I profit? I started a company in Silicon Valley. I obtained stock in that company when it had one employee (me) and one used computer. I worked with that company for a decade–sixteen hours a day, six days a week–to help get it where it is today.

And where is it? Over its ten-year history, Cypress has generated over $1 billion in cumulative revenue, made over $160 billion in profits on which we paid $60 million in taxes, created 1,500 jobs which paid cumulative salaries of nearly $500 million, on which our employees paid further taxes of $150 million. We have shipped cumulative exports worth $300 million. We have generated a market value of $500 million for our shareholders and employees–all of whom own stock in the company.

Vow! That reads like Henry Rearden’s courtroom “defense” in Atlas Shrugged. It is great to know that there are people like this in the real world. From some of the other public statements by Rodgers (links can be found on the wikipedia page on Rodgers), it is clear that Rodgers has read Rand. This is what great works of art can do.

Ayn Rand’s contradictory life?

Via Muse Free, I came across this article in the NY Times by Adam Kirsch. From the article

When Bennett Cerf, a head of Random House, begged her to cut Galt’s speech, Rand replied with what Heller calls “a comment that became publishing legend”: “Would you cut the Bible?” …
In fact, any editor certainly would cut the Bible, if an agent submitted it as a new work of fiction. But Cerf offered Rand an alternative: if she gave up 7 cents per copy in royalties, she could have the extra paper needed to print Galt’s oration. That she agreed is a sign of the great contradiction that haunts her writing and especially her life. Politically, Rand was committed to the idea that capitalism is the best form of social organization invented or conceivable…
Yet while Rand took to wearing a dollar-sign pin to advertise her love of capitalism, Heller makes clear that the author had no real affection for dollars themselves. Giving up her royalties to preserve her vision is something that no genuine capitalist, and few popular novelists, would have done. It is the act of an intellectual, of someone who believes that ideas matter more than lucre.

Anyone who has read and bothered to understand The Fountainhead should remember the scene where Howard Roark refuses a contract for a building to protect the integrity of his vision when that contract is the only thing that can save him from bankruptcy. When asked “Do you have to be quite so fanatical and selfless about it?” Roark replies “That was the most selfish thing you’ve ever seen a man do.”

Perhaps Kirsch missed it or perhaps he just took it as an unbelievable part of the plot. “The plotting and characterization in her books may be vulgar and unbelievable, just as one would expect from the middling Holly­wood screenwriter she once was.” Either way he has no conception of what Rand meant by selfishness or capitalism. Kirsch should read this excerpt from The Fountainhead

“Dominique,” he said softly, reasonably, “that’s it. Now I know. I know what’s been the matter all the time.”
“Has anything been the matter?”
“Wait. This is terribly important. Dominique, you’ve never said, not once, what you thought. Not about anything. You’ve never expressed a desire. Not of any kind.”
“What’s wrong about that?”
“But it’s…it’s like death. You’re not real. You’re only a body. Look, Dominique, you don’t know it, I’ll try to explain. You understand what death is? When a body can’t move any more, when it has no…no will, no meaning. You understand? Nothing. The absolute nothing. Well, your body moves–but that’s all. The other, the thing inside you, your–oh, don’t misunderstand me, I’m not talking religion, but there’s no other word for it, so I’ll say: your soul–your soul doesn’t exist. No will, no meaning. There’s no real you any more.”
“What’s the real me?” she asked. For the first time, she looked attentive; not compassionate; but, at least, attentive.
“What’s the real anyone?” he said, encouraged. “It’s not just the body. It’s…it’s the soul.”
“What is the soul?”
“It’s–you. The thing inside you.”
“The thing that thinks and values and makes decisions?”
“Yes! Yes, that’s it. And the thing that feels. You’ve–you’ve given it up.”
“So there are two things that one can’t give up: One’s thoughts and one’s desires?”
“Yes! Oh, you do understand! So you see, you’re like a corpse to everybody around you. A kind of walking death. That’s worse than any active crime. It’s…”
“Negation?”
“Yes. Just blank negation. You’re not here. You’ve never been here. If you’d tell me that the curtains in this room are ghastly and if you’d rip them off and put up some you like–something of you would be real, here, in this room. But you never have. You’ve never told the cook what dessert you liked for dinner.
You’re not here, Dominique. You’re not alive. Where’s your I?”
“Where’s yours, Peter?” she asked quietly.
He sat still, his eyes wide. She knew that his thoughts, in this moment, were clear and immediate like visual perception, that the act of thinking was an act of seeing a procession of years behind him.
“It’s not true,” he said at last, his voice hollow. “It’s not true.”
“What is not true?”
“What you said.”
“I’ve said nothing. I asked you a question.”
His eyes were begging her to speak, to deny. She rose, stood before him, and the taut erectness of her body was a sign of life, the life he had missed and begged for, a positive quality of purpose, but the quality of a judge.
“You’re beginning to see, aren’t you, Peter? Shall I make it clearer. You’ve never wanted me to be real. You never wanted anyone to be. But you didn’t want to show it. You wanted an act to help your act–a beautiful, complicated act, all twists, trimmings and words. All words. You didn’t like what I said about Vincent Knowlton. You liked it when I said the same thing under cover of virtuous sentiments. You didn’t want me to believe. You only wanted me to convince you that I believed. My real soul, Peter? It’s real only when it’s independent–you’ve discovered that, haven’t you? It’s real only when it chooses curtains and desserts–you’re right about that–curtains, desserts and religions, Peter, and the shapes of buildings. But you’ve never wanted that. You wanted a mirror. People want nothing but mirrors around them. To reflect them while they’re reflecting too. You know, like the senseless infinity you get from two mirrors facing each other across a narrow passage. Usually in the more vulgar kind of hotels. Reflections of reflections and echoes of echoes. No beginning and no end. No center and no purpose. I gave you what
you wanted. I became what you are, what your friends are, what most of humanity is so busy being–only with the trimmings. I didn’t go around spouting book reviews to hide my emptiness of judgment–I said I
had no judgment. I didn’t borrow designs to hide my creative impotence–I created nothing. I didn’t say that equality is a noble conception and unity the chief goal of mankind–I just agreed with everybody.
You call it death, Peter? That kind of death–I’ve imposed it on you and on everyone around us. But you–you haven’t done that. People are comfortable with you, they like you, they enjoy your presence. You’ve spared them the blank death. Because you’ve imposed it–on yourself.”

But then, Kirsch probably won’t understand it anyway.

And while I am at it, consider this from Kirsch’s article

Rand’s particular intellectual contribution, the thing that makes her so popular and so American, is the way she managed to mass market elitism — to convince so many people, especially young people, that they could be geniuses without being in any concrete way distinguished. Or, rather, that they could distinguish themselves by the ardor of their commitment to Rand’s teaching. The very form of her novels makes the same point: they are as cartoonish and sexed-up as any best seller, yet they are constantly suggesting that the reader who appreciates them is one of the elect.

Mass market elitism? Talk about contradictions. Elitism, by definition, cannot have a mass market. Yet, Kirsch is desperate to label Rand’s ideas as elitist. Why?

Externalities

My last post on Social Planning did not address the issue of externalities as well as I would have liked so I decided to write some more on it.

For the first part of the arguement, consider the example of a lighthouse from George Reisman’s book Capitalism: A Treatise on Economics (pdf version available here. Note: I have not read it fully). A lighthouse benefits all the ships that use its light whether their owners have paid for the construction and maintenance of the lighthouse or not. So there is no immediate incentive for any individual shipowner to pay. In such cases, it is claimed that lighthouses will be under produced. Reisman writes that ship owners could make their payments contingent on the payment of a sufficient number of other ship owners’ payments thus creating an incentive for everyone who wants a lighthouse to pay for it. These kinds of solutions do not figure in economic models based on the assumption that individuals act to maximize their utility, with no consideration for what effect their acts have in a wider context. This is simply not true. How would such a model explain the existence of this blog, activist groups, charities etc? Man is not homo-economicus. He is capable of a wider understanding of the world. Stripped of all the mathematics, the externalities arguement is essentially a claim that men are too short-sighted to act for their long term good. It is ironic that proponents of social planning use economic models based on short-sighted decision making to “prove” that the free market must fail and then use this “proof” to argue that people should elect a government which will magically not be hampered by short-sightedness. How do the votes of millions of short-sighted men result in an elite group that is not short-sighted? The fact is that governments voted into power by short-sighted men are far more short-sighted than any of the voters. Witness the incredible spending sprees that governments around the world are indulging in, with no thought of who, when and how will create the goods to support all the extra money being created and what will happen to the economy when the money is finally presented for consumption. Witness the fact that the liabilities of all social support programmes keep on increasing.

Secondly, as I mentioned briefly in my previous post, the solution suggested by the proponents of social planning – taxing/subsidizing – necessarily violates the property rights of individuals. Once the government has the power to violate property rights, a different kind of “externality” sets in. Henry Hazlitt describes the process

Special interests, as the history of tariffs reminds us, can think of the most ingenious reasons why they should be the objects of special solicitude. Their spokesmen present a plan in their favor; and it seems at first so absurd that disinterested writers do not trouble to expose it. But the special interests keep on insisting on the scheme. Its enactment would make so much difference to their own immediate welfare that they can afford to hire trained economists and public relations experts to propagate it in their behalf. The public hears the argument so often repeated, and accompanied by such a wealth of imposing statistics, charts, curves and pie-slices, that it is soon taken in. When at last disinterested writers recognize that the danger of the scheme’s enactment is real, they are usually too late. They cannot in a few weeks acquaint themselves with the subject as thoroughly as the hired brains who have been devoting their full time to it for years; they are accused of being uninformed, and they have the air of men who presume to dispute axioms.

Each time such a project gets through, it establishes a further precedent for the violation of rights. This leads to ever increasing government interference until government becomes nothing more than an unstable coalition of special interest groups. The proposed cure for economic “externalities” ends up creating a political “externality”.

Economics in one unlearnt lesson

I recently found the time to read Henry Hazlitt’s book “Economics in One Lesson” (available online here). The book conclusively demonstrates that any attempts to coerce the free market can only result in the short term gains of special interest groups at the expense of everyone else and that even these short term gains are more than canceled out in the long term. The value to me in taking the time to read it was not in learning anything particularly new but in knowing that a detailed and very well-written explanation of a number of statist ideas exists in one place. Hazlitt writes that all statist fallacies essentially consist of considering only the immediate and visible consequences of a particular policy while ignoring the secondary and not-easily-visible consequences – an idea that was expressed by Bastiat long ago in 1850.

More than the book itself, what is interesting to me is the fact that the fallacies in statist ideas have been exposed long ago (Hazlitt’s book was published in 1946 and Hazlitt himself takes no credit for being original) and yet these ideas continue to be widespread among the general public as well as among trained economists and policy-makers. In fact, the financial crisis we are seeing at the moment is the inevitable result of some of these same fallacies (more on that in future posts) and the alleged cure is more of the same. The inescapable question then is: Are statist ideas really fallacies or mere rationalizations? Are they really held out of genuine ignorance and/or confusion or is there some other explanation? Hazlitt seems to think that they are genuine fallacies caused by the fact that the immediate consequences of interventionist and coercive policies are all too obvious while the secondary and long term consequences are not so obvious. I think that is a far too charitable view. It is inconceivable to me that simple arguments cannot be grasped by trained economists or intelligent laymen. Hazlitt also mentions how the paid spokesmen of special interest groups are able to drive out “dis-interested” writers simply because of their dis-interest (a mechanism also discussed by Zakaria in his book The Future of Freedom). While this is certainly part of the reason why special interest groups can control the government, it does not explain the support for statist ideas among the dis-interested public.

As an example, a few days back, I had a long and futile argument with some colleagues about the ineffectiveness of statist policies. Now these colleagues are certainly intelligent enough to grasp the fallacies inherent in statist ideas. Moreover they have no reason to support such ideas for any special interest. Yet they continue to defend them. And inspite of any concessions they may have made during the argument, I am sure that the same points will come up in the next argument. As one of them put it, (paraphrasing) “I am not opposed to capitalism, but I am a socialist at heart.” To me, that is the source of the persistence of these fallacies. Altruism is totally incompatible with the working of the free market. But as long as it is accepted, no amount of rational argument (such as the ones in Hazlitt’s book) can genuinely convince a person that collectivist and socialist ideas always achieve the opposite of their stated purposes.

Hazlitt shows how raising prices of a particular product (whether by tarrifs or other methods) to create employment penalizes all the consumers of that product (the public interest?), how lowering prices of a particular product drives out all the marginal producers (the disempowered?) and also creates shortages so that only those with more purchasing power can afford the product, how minimum wages cause unemployment by preventing people whose services are worth less than the minimum wage from being employed at all (the most needy?), how rent controls raise the rents in new buildings enormously (housing for the poor?) while simultaneously removing all incentive for (or even ability to) improve/repair existing buildings, how inflation – necessitated by deficit spending to fund all the welfare programs – essentially acts as a tax whose impact is felt highest by the poor etc, etc, etc… not to mention that all these measures also reduce the total product of the economy (the public interest?)

But the point is that the cure suggested by all these fallacies – regardless of any evidence – the free market, where every individual is free to pursue his own interests and is not legally responsible for the “welfare” of others is morally unacceptable to the altruists, and no amount of merely economic arguments can change that.

A new blog on business, economics and free enterprise

Simply Capitalism (feed) is a new blog on business, economics and free enterprise.

Here is an excerpt from their first post

Today, we live in a mixed economy made up of both semi-free markets and government controls. We live in a culture that views business and businessmen as a necessary evil. While the ability of capitalism to bring general prosperity is begrudgingly acknowledged, big business and naked “greed” are routinely blamed for the country’s problems. Calls continue for more government controls and regulations to fix a “broken” system. We think this view is flawed.

When it becomes difficult to determine which effects are due to government interference and which are due to free market influences, our goal is clarity and proper identification. When we hear calls for pragmatism and “balance” in our approach, our goal is to find the principles that illuminate the proper course of action. When we see a system of political pull and coercive government replacing a system of merit, productivity and voluntary trade, our goal is to defend the individual rights that make the latter possible once again.

Among its contributors are two bloggers I have regularly followed for some time

Galileo Blogs, author of Property Rights and the Crisis of the Electric Grid

Kendall Justiniano who also blogs at The Crucible

I am looking forward to getting new insights and good discussion on this blog. Highly recommended for anyone who wants a better understanding of the economy.

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