Cezary Salad

On April 27th, the US Senate, power of subpoena in hand, brought to its chambers executives from the world’s most powerful financial firm, Goldman Sachs, to testify on the cause of the biggest financial meltdown in decades – and their role in contributing to the disaster.

Eleven hours of testimony later, comedians had much more material for late night jokes and the Democrats had much more momentum for their financial reform bill.

But key questions about the financial crisis and Goldman’s activities remained unanswered, and solid financial reform is still far from certain.

It’s easy enough to see why. Take a look at the video from the hearing and you’ll hear Senators trying over and over again to get Goldman chief Lloyd Blankfein and other executives to admit that the firm had a conflict of interest vis-à-vis its clients. Reams of documents, hand-picked by the Senate’s Permanent Subcommittee on Investigations, were designed to show that the firm had shorted, or bet against, the US’ residential mortgage market, even though it was helping clients structure the opposite bet.

“You went short – big time,” Democrat Carl Levin of Michigan, the committee chairman, told Blankfein in his concluding remarks. “You don’t want to acknowledge it, I know. But that’s what your documents show.”

Now, why couldn’t Chairman Levin just get Blankfein to say as much? Or to just give up and say, “you’re right - we’re conflicted?” After all, the SEC had just accused the firm of committing fraud by not disclosing to one of its clients, German bank IKB, that Goldman had let another client influence the selection of a portfolio of mortgage-backed securities that IKB had bet on. IKB suffered heavy losses when the so-called “Abacus” portfolio went bad, while the other client, hedge fund Paulson & Co., got $1 billion off its short position and paid Goldman a $15 million fee in exchange for structuring the deal.

I think the reason Goldman was so coy – and why the committee wasted its time trying to corner the firm into admitting conflicts – boils down to something simple I heard a hedge fund manager say on the same night of the Goldman testimony.

I was at an event in New York (“Forgotten Lessons of Finance 101” put together by Ed Grebeck, a structured finance lecturer at the NYU School of Continuing and Professional Studies) where James Chanos, the short hedge fund manager famous for spotting the Enron collapse in 2001, was sharing his views.

I asked him what he thought about the SEC’s lawsuit against Goldman; he declined to comment on Goldman or the lawsuit, but he did make one remark that really put the hearing in perspective:

“I think Wall Street generally has a real, inherent problem . . . with conflicts of interest,” he said.

He pointed to equity underwriting as an example. “At its basic heart, in equity underwriting, is a conflict of interest because on the one hand you’re telling your corporate client, ‘this is a good time to raise equity money, it’s cheap, the ducks are quacking, feed them’ . . . on the other hand, you’re then telling your investment clients that this is a good deal.”

That doesn’t mean it’s all hopeless: “we build upon that and we have Chinese walls and we deal with it,” Chanos said. But it doesn’t take away from the basic fact that big investment banks of any stripe face very serious and real conflicts of interest that they have to work real hard to mitigate.

Which is why Goldman wasn’t going to go before the Senate and say anything that would indicate that it’s different from the rest of the pack by being conflicted with its clients. Democratic Senator Claire McCaskill of Missouri at least acknowledged that it wasn’t fair to single out the firm. But she still proceeded to ask the same leading questions aimed at cornering the firm’s executives into admitting conflicts of interest as all the other Senators.

Instead, here are three hard-hitting questions the Senators could have asked which, rather than trying to expose conflicts which are endemic to investment banking, could have given us a much better understanding of how to regulate the industry (fair disclosure - I used to work in investment banking and once interviewed with Goldman for a position):

1) Goldman said in response to the SEC lawsuit that it actually lost money on the Abacus deal with Paulson and IKB. Sure – they got $15 million, but lost $90 million on the transaction overall.

But how much money did the firm really make on the transaction?

Investment banks are very crafty when it comes to fees. Various divisions of an investment bank will work on one deal together and book fees from their individual contributions, though the bank may not (and often does not) disclose all the fees. Why? Because investment banks don’t have to. And if they did, telling their clients that they actually made many multiples more money than they said they did wouldn’t exactly make them look good.

Now, flip through the sales document for the Abacus deal (available here) and you’ll note on page 50 that different parts of Goldman provided interest rate hedges and collateral services for the transaction – fees that may not be included in the $15 million Goldman earned from Paulson.

So one thing the Senate could do to make the industry more transparent would be to require more transparency on fee disclosure and income reporting from all divisions working on a particular deal. Once investors see where the money is, they can make better choices about who to invest with and how to align interests.

2) Goldman’s lawyers said that ACA Capital, the third party it had contracted to select the securities in the deal, ended up not picking many of the mortgage securities Paulson suggested for inclusion in the Abacus pool. Paulson suggested 123 mortgage-backed securities but “ACA rejected more than half of the securities, and sent Goldman Sachs a revised spreadsheet listing 86 securities, including 55 from the list of 123,” the lawyers wrote in a letter to the SEC last year.

So don’t you think that the Abacus portfolio was doomed fail from the beginning?

The reason this is important is because Paulson wanted to take a short position on the deal. So obviously, the more of these securities they packed into the Abacus transaction vehicle, the better. But the structure of deals like Abacus – called synthetic collateralized debt obligations – is such that it doesn’t take many homeowners to stop paying before the equity in the transaction becomes worthless. Those 55 securities were most likely more than enough to poison the whole transaction for IKB from the outset. So Paulson’s influence on the deal may not be as small as Goldman claims it is.

The larger point:  investment banks who participate in these types of transactions can simply hide behind the fact that they are dealing with “big boys” – large, sophisticated institutional investors who know what they’re doing. But as the Abacus deal clearly shows, investors like IKB aren’t as sophisticated as they’re made out to be. Perhaps there’s a need to revisit this defense and require more disclosure where needed.

3) Goldman’s co-general counsel, Greg Palm, said on a conference call with reporters after the SEC filed its lawsuit that if Goldman “had evidence that someone here was trying to mislead someone, that’s not something we’d condone at all and we’d be the first to take action.”

But did Goldman notice the activities of the investment banker in question, Fabrice Tourre, and simply not think they were misleading or did it not notice his activities at all?

The latter option doesn’t seem like a big possibility since there are two ways to get noticed by your superiors in the world of investment banking: make a lot of money, or make very little money. If you make very little money, you’ll likely get fired. But if you make a lot of money, clearly, there is an incentive to keep you on and let you keep doing what you’re doing.

And Tourre was doing well. Anyone who brings in a $15 million fee on a single deal at the age of 27 is going to get noticed, whether it’s at Goldman or any other investment bank. And superiors will have an inherent incentive to overlook questionable dealings if overall they come out ahead on the deal. With each deal, you stretch a little more and take another step into whatever activity is minting the gold, until – like Lehman Brothers or Bear Stearns – you end up going under and are mired in lawsuits for ethical breaches.

Luckily, Goldman was able to escape that fate and is now going to re-examine its business practices. But that’s as clear an indication as any that there is a need for more accountability in investment banking from the top down and better supervision of twenty-somethings inking complex, billion-dollar deals.

With that in mind, none of the panelists at the “Finance 101” event were happy with the structure of the current financial industry reform package being championed by Democratic Connecticut Senator Chris Dodd.

“It doesn’t go far enough,” Chanos said, referring to the Dodd bill.

With hearings like these, I don’t wonder why.

Open up any paper today and you’re sure to read something along the lines of “the government’s leverage over US banks is weakening” because so many of them are exiting the Troubled Asset Relief Program (aka the bailout fund). With Citi and Wells Fargo announcing within hours of each other that they will be paying back their bailout packages, the banking sector as a whole will have paid back $161 billion of the $245 billion it received from the bailout fund, according to the Wall Street Journal.

To be sure, there is no denying that by repaying their bailout funds the banks are freeing themselves from the kind of scrutiny and tight control over pay and perks that comes with being a taxpayer-supported entity.

But let’s not kid ourselves: the US never really had much - if any - leverage over the banks it bailed out. I realized as much last week when I went to hear William Dudley, President of the Federal Reserve Bank of New York and a key behind-the-scenes player for bailout of insurer AIG, speak at my university (video available on the Columbia World Leaders Forum website).

Think back to September 2008. When Fed Chairman Ben Bernanke and former Treasury Secretary Hank Paulson went to Capitol Hill to ask Congress for the bailout funds, their rationale was simple: the very existence of the US financial system is at stake. As Dudley put it:

“The choice that faced us was financial Armageddon or saving the financial system. It was a choice between two bads and we picked what we thought was the less bad. But it wasn’t a great outcome - we agree with that.”

The reason it wasn’t a great outcome, of course, is that there was seemingly no way to separate saving the financial system from saving the financiers who nearly felled it. As a recent inspector general report uncovered, the US Treasury made its initial $85 billion loan to AIG last year knowing full well that substantial chunks would be used to make payments to the bankers it dealt with - i.e. Société Générale, Goldman Sachs, Merrill Lynch, Banc of America, among others.

Providing the loan was necessary to avoid the aforementioned Armageddon. But it also resulted in the so-called “backdoor bailout” of these banks, as they got their money and they got it at 100 cents on the dollar. So now that many of them are doing better and have either awarded or are about to award billions of dollars in taxpayer-funded bonuses, “wasn’t a great outcome” is putting it lightly.

Dudley acknowledged as much; he said multiple times that this was unfair, adding “if there were some way that we had the tools to save the financial system and not save the bankers, that would have been a better way to go. But we didn’t have that choice.”

New York Times columnist Paul Krugman thinks they did. In a scathing November 19 editorial, he accused the Fed of treating the financial industry with “kid gloves” because Dudley and his team did not exact concessions from the bankers who got AIG’s - rather, the taxpayers’ - money.

Krugman’s “kid gloves” comment was on my mind when I asked Dudley why he couldn’t wrestle even the slightest concession from, say, Goldman Sachs. After all, the investment bank held a call with business reporters in early March to say, in essence, that it had hedged its bets well enough that it did not need the $13 billion it received from AIG. Dudley was curt in his answer:

“If you’re preventing a bankruptcy, you’re supporting all the counterparties. You cannot pick and choose. And so whether Goldman Sachs was well hedged or not was immaterial.”

In other words, at the point when you say, “we’re going to avoid a bankruptcy,” you lose your leverage. The normal rules of the financial system apply and everyone gets paid what they’re owed, as opposed to a bankruptcy situation, where the senior creditors would have gotten their money first and counterparties like Goldman would likely have ended up empty-handed.

“To put it starkly, power in a negotiation comes either from being able to issue a credible threat or from coercion,” Dudley said in his prepared remarks. He freely admitted that the Fed clearly had neither tool at its disposal.

And so the financial system was saved - as were the bankers.

Lesson learned? Well, if the US gave $85 billion to an insurance company that then went on to post a world record $61.6 billion quarterly loss and reward the executives responsible for the loss with bonuses, that doesn’t say much about our ability to attach strings to bailout funds to limit these not-so-great-outcomes. Indeed, as with AIG, so with the other TARP recipients, who took when they needed and haven’t much changed their behavior.

And why should they? To paraphrase Dudley, power in negotiation comes from leverage. And the only leverage the US has these days is $12 trillion in national debt.

For anyone interested in emerging markets, the mot juste all of last year was the d-word: “decoupling”. In a nutshell, it’s the theory that emerging economies have gained enough critical mass to chart their own path to growth and prosperity independently of the developed economies in Europe and North America. In other words, a recession here shouldn’t automatically translate to a recession there.

In 2008, the concept became so controversial among economists that one could even catch the venerable Economist weighing-in on both sides of the debate (“Decoupling is not a myth” – March 6, 2008 print edition; “So much for decoupling” – 18 September, 2008 print edition).

This week, Newsweek’s international editor, Fareed Zakaria joined the fray. Zakaria, an astute observer of foreign affairs, argued in his June 8 Newsweek column (“Boom Times Are Back - Just not here in the United States”) that the global economy is increasingly going to become a tale of two worlds. In one camp, there will be the booming, hard-charging emerging economies like China, Indonesia, India and Brazil and in the other the lagging bastions of wealth and power like the US, Europe and Japan (unless, of course, the latter undertake drastic reforms to alter this inevitable fate).

For regular followers of Zakaria, this, of course, is nothing new; his bestseller, The Post American World, is an exposition on this very same paradigm. And he made the same point last year in an article for his previous employer, Foreign Affairs magazine.

But one paragraph caught my attention since, without naming the controversial d-word, Zakaria seemed to use it as a way to justify the tale of two worlds:

Over the past six months, much conventional wisdom about the economy has been discredited. The old experts who spoke with confidence about unending global growth—the boomsters—have been debunked. But the new pundits of pessimism—the doomsters—have demonstrated a similar hubris, ignoring any evidence that might complicate their story. Six months ago, stock markets around the world swooned in unison as the American financial system seemed on the verge of collapse. This led many to conclude that the emerging economies of Asia and Latin America had been growing only because of their exports to America and Europe; that they obviously had no independent strengths of their own and would in all likelihood collapse faster and more furiously than the sophisticated economies of the West. After all, these were Third World countries.

Not exactly. Zakaria’s got the big picture right – there is indeed a growing rift between these two worlds – but he oversimplifies the details of how this fits in vis-à-vis decoupling.

First, one ought to take a longer reference point than the last six months. After the credit markets exploded in August 2007, emerging markets were one of the first places investors went with their displaced capital. So then, like now, as markets peaked here in the US and in Europe, they continued to hum along in places like Brazil, Russia and China.

Then, of course, came the big crash in January 2008, when markets tumbled all around the world and the Federal Reserve made its emergency 75 basis point cut to stem a similar panic here in the US before markets opened on Tuesday, January 22, 2008. It’s that episode, much more than the post-Lehman collapse roller-coaster, that’s ground zero for any debunking. We saw then these “new pundits of pessimism” argue that the emerging economies would follow the US into recession and the “old experts” appeared debunked. Now, thanks to the recent bull market, it seems the opposite is true.

This, of course, sits well with Zakaria’s tale of two worlds. He cites China’s Shanghai index (up 45 percent this year), India’s Sensex (44 percent), Brazil’s Bovespa (38 percent) and Indonesia’s index (up 32 percent) as evidence of this debunking.

But it is more helpful instead to look at peaks and troughs. US markets (as measured by the S&P 500 Index), peaked in October 2007 and bottomed in March 2009. Stocks are a leading indicator, so this means that investors thought the US would enter recession around 1Q 08 and re-emerge sometime this year.

China’s Shanghai index likewise peaked in October 2007, but it troughed earlier – November 2007. India’s Sensex peaked in January 2008 and troughed in March 2009. Brazil’s Bovespa fared better, peaking in May 2008 and troughed in October 2008 (see chart below – interactive version is available here. Indexes are rebased to August 2007 and presented on a logarithmic scale; I left Indonesia out since I don’t know which index Zakaria was referring to in Jakarta).

What’s remarkable about this portrait is that all of these economies seem to have followed the US into recessionary bear markets, peaking after the S&P and recovering before or as it recovered. This begs the question: did these and other emerging countries begin to recover because of their own, innate strength or because investors saw recovery on the horizon in the US and other developing markets?

I certainly don’t claim to have an answer to this question and, as Zakaria wisely points out, stock markets don’t tell the whole story. But it just goes to show that this whole debate is a lot deeper and more complicated than he makes it out to be in his column.

In the long run, though, he certainly has a point: China, Brazil, Indonesia and other emerging economies are certainly in a better fiscal shape than the US and Europe right now and are poised to grab a larger share of the world’s wealth and power in the coming decades.

But how they get there and who follows who is far less clear than the black-and-white tale of two worlds.

I posted a new paper under the philosophy section of my blog in response to George Soros’s new book - The New Paradigm for Financial Markets: the Credit Crisis of 2008 and What it Means. I reproduce it below as a blog post.

Reflecting on Reflexivity

In 1962, a (now famous) philosopher of science named Thomas Kuhn drew much attention for his controversial claim that, when scientific theories of the world change, the world itself changes, too.

Since 1987, financier and philanthropist (and self-admitted amateur philosopher) George Soros has been making a similar claim, but with a focus not on the natural sciences that Kuhn spoke of but instead the social sciences – specifically, economics.

Soros’s dictum – the theory of reflexivity – asks that we set apart sciences which have thinking and non-thinking participants and those which have only thinking participants. A chemist studying a molecule can make independently valid statements about the molecule that may qualify as knowledge. An economist studying the behavior of crowds to make judgments about supply and demand can do no such thing: his theories, in the Kuhnian sense, will impact the world of his participants and thus put knowledge out of reach.

If Soros’ theory is true, it cuts a wide swath. It implies at once a need for a new ethics, a new epistemology and – of course – the need to tear up our classical economics textbooks.

Yet, as Soros confesses in his latest treatise on the subject - The New Paradigm for Financial Markets: the Credit Crisis of 2008 and What it Means – published a year ago in response to the financial crisis, philosophers, economists and financiers alike have failed to give his theory serious consideration.

Naturally, this begs the question: why? Is Soros wrong or is the establishment wrong?

When was an undergrad at Penn, I never thought there would be much synergy from being a philosophy major and a business student. Here, I found my challenge.

What follows is a critique of Soros’s philosophy that I hope can shed some light on where his theory of reflexivity excels and where it falters.

My main claim is very simple: Soros commits the same mistake as Kuhn did in his magnum opus The Structure of Scientific Revolutions: he carries a good idea to an unjustifiable conclusion.

Just as one can read Kuhn and be convinced by his account of how new scientific theories become prevailing paradigms, one can ready Soros and be convinced about his account of how markets influence and are influenced by our attempts to understand them. But when he concludes from this that market participants “cannot base their decisions on knowledge,” Soros makes the same mistake as Kuhn did when he said that our scientific theories change the physical world: he carries his theory a step too far.

Part I of this post outlines Soros’s theory in greater detail to make sure that anyone who has not read it can be on equal footing. Part II outlines my criticism of his theory. Part III, in good faith, contains some advice for how he can strengthen his theory.

Part I: Soros’s theory explained

First, some background: Soros’s theory of reflexivity is based on another theory – the correspondence theory of truth – without which his whole paradigm could not work.

In its simplest form, correspondence holds that a proposition is true when it corresponds to reality, and false when it does not (cocktail party tidbit for you: this is what philosophers term “altheic realism” – the notion that truth hinges not on us, but on the world in which we live).

Soros argues that correspondence works well in the world of natural science but breaks down when applied to social science:

I contend that social events have a different structure from natural phenomena. In natural phenomena there is a causal chain that links one set of facts directly with the next. In human affairs the course of events is more complicated. Not only are facts involved but also the participants’ views and the interplay between them enter into the causal chain (New Paradigm, pg. 7 – emphasis added).

Another way to view this is in mathematical terms: a function is uniquely determined (and therefore true) if it has one independent variable which determines the value of the dependent variable. In natural science, there is just one variable – the natural world – but in social science, there are two variables: our understanding of social phenomena and the impact that our actions have on them.

Soros terms the first variable the “cognitive function” and the second variable the “manipulative function”. In other words, we seek to understand social phenomena but, as a result of being participants in them, we can simultaneously change, or manipulate them. And as we manipulate them, our understanding of them changes. As our understanding changes, so does our interaction with them. So changes in one function are reflected in the other, and vice versa. Soros calls this “reflexivity” and hence the name of the theory

“Reflexive situations are characterized by a lack of correspondence between the participants and the state of affairs,” Soros writes (emphasis his). Participants are always manipulating the state of affairs, so as soon as they make a statement about it that purports to be true, their actions can render the statement false.

Soros provides the following example to make this distinction clear:

Consider a statement about the objective aspect: “It is raining.” That is either true or false; it is not reflexive. But take a statement like: “Your are my enemy.” That may be true or false, depending on how you react to it. That is reflexive (New Paradigm, pg. 28).

Reflexivity is best studied and demonstrated in the financial markets, Soros argues, because market developments are not independently given by natural phenomena but instead are driven by human expectations. Classical economics, he argues, ignores this insight:

Demand and supply curves are presented in textbooks as though they were grounded in empirical evidence. But there is scant evidence for independently given demand and supply curves. Anyone who trades in markets where prices are continuously changing knows that participants are very much influenced by market developments. Rising pries attract buyers and vice versa. How could self-reinforcing trends [bubbles] persist if supply and demand curves were independent of market prices? (New Paradigm, pg. 55).

Our expectations (cognitive function) are reflected in the market when we buy or sell (manipulative function), which in turn impacts our expectations (cognitive function), and so on, ad infinitum. One reinforces the other. This, Soros argues, is how market bubbles are born.

More importantly, he argues that reflexivity “introduces an element of contingency or uncertainty into the course of events, and it prevents the participants’ views from qualifying as knowledge” (New Paradigm, pg. 4). In other words, market decision markers cannot base their decisions on knowledge.

Part II: A critique of reflexivity

Given this background, there are two possible readings of Soros’s philosophy.

One, I would argue, is uncharitable and the other is charitable (in philosophy, these terms typically mean taking the philosopher’s argument at its most extreme meaning versus giving it the benefit of the doubt).

Let’s start with the uncharitable interpretation:

In social situations, reflexivity produces uncertainty and thus prevents our views from qualifying as knowledge. Social science can therefore only succeed in producing opinion, whereas natural science can succeed in producing facts about the world.

This implies that we cannot make any claim to knowledge from observing our behavior and creating Newtonian rules such as the law of supply and demand. And so much, if not all, of economics, sociology, psychology and other social sciences are futile exercises.

Carry this line of thought further and soon you end up being the caveman in Plato’s Allegory of the Cave, mistaking shadows on a wall for a true account of the world. As with the allegory, where concealed persons chatting and carrying various objects before a fire result in the false impression that they are the real world, studying social situations inevitably results in a false view of the world in this Sorosian paradigm.

But is that what Soros is really advocating? I think not; one very easy way to disprove this reading is just to assume that it is correct. If Soros’s observations about the human position are true and reflexivity obtains, then social science can indeed produce some sort of knowledge. After all, what is The New Paradigm for Financial Markets if not a work of social science?

The real question is therefore not the black-and-white, “can we as participants in the social world order come to gain knowledge about it?” but rather, “how perfect is that knowledge?”

Ponder that question vis-à-vis his philosophy, and a much more charitable interpretation results:

In social situations, reflexivity produces uncertainty and thus prevents us from having perfect knowledge. Social science, like natural science, can therefore help us better understand the world, but it cannot reveal the ultimate truth about the world we inhabit.

To his credit, I think Soros believes as much. In later parts of The New Paradigm, he seems to soften his stance, arguing that “people are participants, not just observers, and the knowledge they can acquire is not sufficient to guide them in their actions. They cannot base their decision on knowledge alone” (New Paradigm, pg. 26, emphasis mine).

To make up for this shortcoming, Soros argues that we use various techniques – generalizations, similes, metaphors, habits, rituals – to organize information and make decisions. In doing so, though, various biases, emotions and other non-factual elements can enter our reasoning.

Now think back to Soros’s discussion of financial markets and what results is a pretty convincing case against the efficient market hypothesis.

This hypothesis (which Soros loathes) is predicated on the notion of perfect information: stock prices always reflect all relevant information and therefore trade at their fair value.

But apply the notion of reflexivity to the markets and it soon becomes clear that markets don’t always price in everything they should or exclude everything they shouldn’t price in. Like a river that collects sediment along the way toward its mouth, market biases, emotions, rumors and fictions get swept in with actual facts about a stock, all of which impact participants’ views (cognitive function) and impact the market (manipulative function) when they buy/sell.

Market information is thus not perfect (like the dirty river, it is filled with impurities), markets are not efficient, and they certainly do not tend toward equilibrium; rather, they tend toward whatever prevailing biases preoccupy investors any given point (ex. housing prices will continue to rise) until the bubble pops and the market corrects itself.

Viewed this way, I think Soros’s ideas are far more serious than many economists realize. Reflexivity is not an argument against the very viability of economics (in which case it would be understandable why social scientists would want to thumb their noses at him), but rather a call to arms to better understand the fallibility of our existing paradigms, like the efficient markets hypothesis.

It seems, though, that philosophers, economists and social scientists alike have turned a deaf ear to him for the past 20 years, perhaps opting for the uncharitable interpretation argument of his work and dismissing it accordingly.

So with Kuhn. People originally interpreted his book as a crazy argument that we can change the world with our thoughts: Copernicus comes along and all of a sudden the planets realign around the Sun?  Surely not. Eventually, a more charitable reading of his work gained consensus and his account of how scientific revolutions occur is now a key consideration in any class on the philosophy of science.

Will the same thing happen to Soros? Only time will tell; but in the meanwhile, he can certainly do some things to make his theory more tenable.

Part III: Some advice

Here are some questions that I believe Soros should answer to strengthen his theory of reflexivity (with the important caveat that I’m not an expert; undergraduate degrees in philosophy and economics only – no fancy stuff).

Questions of interest to philosophers:

1. Does reflexivity solely rely on the correspondence theory of truth, or could it co-exist with another theory of truth, such as coherence or identity
2. Reflexivity implies that the Cartesian view of the world (separation of body and mind) is wrong, so what is the proper place of the mind in a reflexive world?
3. What are the boundaries of reflexivity? The theory in its current form implies that all social situations are reflexive. But what’s a social situation and what is not? (Philosophers are notorious for thought experiments; sooner or later, someone will throw a remote control robot into this discussion).

Questions of interest to economists:

1. One of the assumptions of the efficient market hypothesis is that no one market participant is big enough to influence the market on his/her own. Does reflexivity accept the same assumption? (Another way to phrase the question: does someone like Warren Buffet – who can say “the economy has fallen off a cliff” and slice 80 points off the Dow - have more “reflexive” power than some guy with an internet connection and a blog?)
2. Are some markets more reflexive than others? If so, what distinguishes a reflexive market from a non-reflexive market – is it the number of participants, the type of security, or what? For example: I can bet on fed fund futures all I want, but at the end of the day, unless I break into an FOMC meeting and force the Fed Governors to raise or lower the fed funds rate, my bets can do little to move the target. But if I own a large stake in a company, become bearish and start selling, my outlook can influence the market much more. So where do we draw the line?
3. If markets are indeed reflexive, does that mean that we are doomed to forever go through bubbles and busts and super-bubbles and super-busts, or does reflexivity allow us to forge a cure for this?

One last piece of advice for Soros: pick a discipline, because philosophers and social scientists often don’t see eye to eye. I learned the hard way: I once had to spend a whole summer re-writing a thesis because one of my philosophy professors thought the paper I handed in belonged more in the realm of political science than philosophy.

So as long as reflexivity is rooted in both disciplines, chances are that some philosophers and economists will inevitably choose to ignore it because it’s out of their realm.

Good luck, George.

Way down in New York’s financial district, tucked away inconspicuously on the southern end of Wall Street, there’s a little gem of a museum - the Museum of American Finance - filled with all kinds of goodies from 200+ years of booms and busts on, well, Wall Street.

With $8 admisson and a new exhibit about the credit crisis that just opened up this week, it is well worth a Saturday afternoon visit - followed up with a beer at Ulysses down the street.  

The museum’s been around since 1987 but it is only in the last two years that it’s held its current spot on Wall Street - an old Bank of New York branch converted into a giant exhibition hall.

Below are some of my highlights - enjoy.

Obscure monies

My favorite exhibit was the museum’s collection of obscure coins and notes spanning the pre-colonial era to the latest money coming out of the US mint.

We used to have a lot of higher-denomination notes in circulation but Nixon apparently axed them in 1969 in an effort to fight organized crime. McKinley graces the $500 bill and Grover Cleveland landed himself a sweet spot on the $1,000 bill.

You can still use them as legal tender but if you come across one, might as well sell to a collector: they sell for multiples of their face value these days.

I had no idea that these people sat on dollar bills:

$5,000 bill - James Madison

$10,000 bill - Salmon Chase (the banker who puts the “Chase” in JPMorgan Chase)

$100,000 bill - Woodrow Wilson (the president who created the Federal Reserve)

The Wilson note was only used in circulation among Federal Reserve Banks. It makes you wonder, though: if we’re so into putting obscure presidents on our higher-denomination bills, why isn’t there a Millard Fillmore note? It’s about time he got a seat on US currency.

The museum also has a fascinating selection of Depression-era currencies created by localities suffering cash shortages. My favorite was the hand-writtten 50 cent scrip (upper left hand corner in picture above) from Albany County, Wyoming.

Stock and bond certificates

They also have on display some famous stock and bond certificates that have been issued in the US, going back to an IOU signed by George Washington. My favorite, though, was this stock certificate for the Erie Railway, company:

The Erie was the focus of the legendary showdown between industrial tycoons Cornelius Vanderbilt and Jay Gould. Gould spurned Vanderbilt’s takeover of the Erie by issuing watered-down stock that was worth more than the value of the company - which, apparently, was legal back in those days.

This one’s signed by “the Devil of Wall Street” himself:

Also on display: some pretty interesting municipal bonds, like this one issued by New York for bridge repairs:

How Wall Street got its start

One of the coolest things I learned was how Wall Street - specifically, the New York Stock Exchange (below) got its start.

Apparently, back in the early days of the Republic brokers used to trade stocks in the open on Wall Street and would gather under specific lamp posts along the street to deal in specific securities. People would stand on roofs to make announcements and give signals, so it must have been a pretty hectic scene.

In 1792, a group of 28 brokers got tired of this system and organized a brokerage club that served as the beginning of what is today the NYSE.

Old equipment

The museum also has a lot of technological relics from the old days of Wall Street, including an early form of a calculator that belonged to the comptroller of Lehman Brothers - now itself a Wall Street relic. Below are some of my favorites:

A 1981 Quotron - one of the first computer systems used for trading stocks:

And, of course, the first stock tickers. They were invented in 1867 - this one vintage 1875:

Together, the stock ticker and the telegraph revolutionized the speed at which stocks could be traded. The two inventions put the New York Stock Exchange - and with it, American Capitalism - on growth steroids for decades.

Vintage newspapers

As a journalist, I was particularly drawn to the collection of famous editions of newspapers from panics and crises over the ages. To be fair, American printing presses have probably created their own collection of these future museum pieces just within the last 18 months, but it is interesting to look back to see how thoe events were covered.

An edition of the Daily News from 25 October, 1929 read: “Billions lost in Wall St. Debacle”. Much more interesting than the headline, though, is the advice given by the paper’s “Trader” columnist.

Four days before Black Tuesday - when the Dow Jones Industrial Average dropped 12% and officially heralded the beginning of the Great Depression-  his advice read as follows (emphasis added):

If half the suicides which were reported to “TRADER” yesterday had proved true, Wall Street would be a deserted village this morning.

Happily, however, they all turned out to be baseless rumors, although it was amazing how many stories were in circulation as to operators who jumped out of windows at 120 Broadway. The Equitable building certainly got a lot of free advertising, although it wasn’t the kind usually welcomed.

The market today is in the position of a convalescent who has just successfully passed a crisis in an illness which bid fair to be fatal.

Improvement is indicated, with the practical certainty of eventual recovery, but there will be relapses.

“TRADER” therefore advises against speculative purchases, although he expects prices will be materially higher today. If you have money to buy stocks outright, go in and do so, because current prices are bargains which probably will never be sustainable again as long as the United States continues its present prosperity.

Some parallels are clearly visible to today - especially in light of the recent debate sparked by Jon Stewart’s spoof of stock picker Jim Cramer and CNBC coverage of the credit crisis. People routinely call the bottom prematurely, so the only way to know for sure that stocks have hit a bottom is to read about it in a history book - not by reading “Trader” or watching Fast Money on CNBC. However, the sin isn’t calling a bottom too early or voicing an opinion. Stewart had a bone to pick with CNBC - as I’m sure the Stewarts of his day did with “Trader” - because there was so little humility in the way the opinion was being voiced and advertised. At the end of the day, “buy stocks” four days before Black Tuesday and “buy Bear Stearns” a couple of weeks before it collapses are calls that should be heeded as  just another piece of food for thought in deciding where the market might go; slogans like “In Cramer we Trust”, as if he were the god of stock-picking, go against that very important caveat.

It is also useful to point out that Stewart’s criticism of Cramer pales in comparison with what John Kenneth Galbraith had to say about “Trader” in his account of the 1929 crash:

. . . by 1929, numerous journalists were sternly resisting the more subtle blandishments and flattery to which they have been thought susceptible. Instead they were demanding cold cash for news favorable to the market. A financial columnist of the Daily News, who signed himself “The Trader,” received some $19,000 in 1929 and early 1930 from a free-lance operator named John J. Levenson. “The Trader” repeatedly spoke well of stocks in which Mr. Levenson was interested. 

Some progress was made, though. Fast-forward 58 years, and press coverage of the next big stock market debacle was much different:

Another noteworthy decaying newspaper was a copy of the very first edition of the Wall Street Journal: July 8, 1989: 

It is amazing how similar it looked in design until the recent face lift post-Newscorp acquisition.

The Journal’s first lead-left article? A laundry list of price movements: 

The second article from the top - ”The Market To-Day” - references a “bear party” that depressed American stocks. One of the videos at the museum explains that the terms “bull market” and “bear market”, used to describe down markets and up markets, respectively, originated from the way those two animals attack. A bear will claw down its prey, whereas a bull will strike up at its prey.

Strange but true or true but strange?

Credit Crisis

On March 25 the Museum of American Finance unveiled a new exhibit on the financial crisis: a giant timeline that organizes all the key events of the last two years into regulatory, financial, foreign policy and other buckets. It is accompanied by a brief video that sheds some analysis on the crisis’s causes and effects. 

It does a good job of objectively laying out what happened when and organizing it in a logical manner. But it doesn’t yet gel together the events into a cohesive narrative that lets you walk away with clear take-aways on what exactly is going on. I don’t think it is the museum’s fault though: perhaps it is just too early yet for us to completely understand all the dimensions of this crisis and how it will play out.

They should, however, update this exhibit - a chart of the DJIA over the years that has not yet taken the huge dive indicated on the crisis exhibit: 

This one could also use an update: a Bank of America family tree, conspicuously missing Merrill Lynch:

Other exhibits still reference Lehman Brothers as a bond trading powerhouse, etc. I’m sure these will all get corrected over time - after all, these days, if they were to wipe out defunct Wall Street names from their exhibits they might not have time for anything else.

These nips and tucks aside, if you’re ever free on a Saturday afternoon and looking for a good time, I nerdily suggest the MoAF. 

One of my readers - Morgan Oliviero from New Brunswick, Canada - recently commented on my three-part series on oil prices:

To the extent that energy is considered in many countries to be a national security interest, and thus to be heavily regulated, how does governmental interference affect the way that oil prices have been climbing?

Good question, and something well-worth considering given the current clamor from Democrats, including Sen. Obama, for an “excessive profits tax” to be levied on American oil companies.

Government interference in markets comes in two basic flavors: subsidies and taxes (spicy or mild, respectively). Both can have a significant impact on a market, though in opposite directions. Subsidies, by virtue of lowering prices, will have an upward impact on demand and incentivize suppliers to produce more to meet that demand. Taxes, by virtue of raising prices, will have a downward impact on demand and incentivize suppliers to produce less to match that decrease in demand.

How has this played out in the oil markets? Oil is traded on a global market, so energy policies in large world economies can have a marked impact on the price we pay for it in the U.S. And unfortunately, developing countries - particularly Mexico, Malaysia, India and China - heavily subsidize energy prices in an effort to keep inflation low and spur growth. Naturally, this drives demand up and decreases the incentive for oil consumers in those countries to conserve or replace their fuel consumption with greener alternatives. And that, in turn, offsets the demand destruction that we’ve been witnessing in the U.S. over the last year, making oil prices “sticky” on the way down. As Keith Bradsher of the New York Times pointed out in this well-written piece on the subject:

The oil company BP, known for thorough statistical analysis of energy markets, estimates that countries with subsidies accounted for 96 percent of the world’s increase in oil use last year — growth that has helped drive prices to record levels.

Other numbers in Bradsher’s piece are equally frightening: China devoted $40 billion to oil subsidies this year alone, Indonesia followed with $20 billion, and Malaysia - before it raised gasoline prices by 40% earlier this summer - was spending 7.5% of its GDP on oil subsidies.

How big are these numbers relative to global spend on oil? Doing some back-of-the-envelope calculations, the U.S. consumes about 20.7 million barrels of oil per day (2007 figure), which at oil’s current $114/barrel price tag comes to about $2.4 billion/day, or about a quarter of the world’s total daily spend (all these figures, and many more, are available on the EIA’s petroleum statistics page). So hundreds of billions of oil subsidies a year from developing countries are not just a drop in the bucket: a significant amount of the world’s daily spending on petroleum is subsidized, and hence insulated to some extent from the rising oil prices.

The U.S., of course, is not so insulated and hence we’ve been paying the price for rising demand in developing countries that subsidize gas prices. This is not to say that the U.S. doesn’t give out its own subsidies to the oil industry in the form of tax breaks, but that is far different from wholesale price controls on gas prices.

But despite Washington D.C.’s increasing pressure on developing countries to lower or discontinue their massive subsidies for oil prices, doing so is not so simple. Consumers who have grown accustomed to paying low prices won’t give up that right without protests or anger at the politicians who dare take it away. As Bradsher points out, the Malaysian government faced public anger and outcry when it raised the price of gasoline by 40%. So don’t expect these subsidies to go away anytime soon.

What can the U.S. do? Again, the only long-term solution to this problem is for the U.S. to decrease its reliance on petroleum and switch to home-grown alternative energy sources: all the more reason why the Pickens Plan stands out as a painful thorn in the side of Republican cries of “drill, drill, drill.”

Moving to the tax side of the equation, taxes on oil consumption have had the opposite impact and, as expected, the bigger the tax, the bigger the drop in demand for oil. But here it is important to consider at what level the taxes are being levied: the producers or the consumers. Taxes aimed at producers tend to decrease their incentive to produce more since they get less of a reward for their investment; taxes aimed at producers will tend to decrease demand when prices rise. One decreases supply, the other demand. Either way, consumption falls.

But it is important to consider these effects in concert with other market conditions. If oil prices are skyrocketing to record highs and demand abroad - thanks in part to the subsidies discussed earlier - shows no sign of abating, then oil producers have little incentive to cut back on their production just because they may be forced to pay a higher marginal tax rate on their output. In other words, the incentive to produce less as a result of higher taxes is outweighed by the incentive to produce more as a result of soaring prices and growing demand.

A perfect example of this is the situation with Canada’s Tar Sands - a lucrative source of petroleum in Canada’s Alberta province that ranks among the biggest oil reserves in the world. As Morgan points out:

Oil producers in Canada’s Tar sands have been preparing themselves for a potentially punitive redistributive carbon tax that the Liberal Party has vowed to implement should it take power . . . Aside from forcing the producing corporations to prepare for significantly increased overhead, fund managers on Bay Street have been understandably concerned that this new tax could significantly damage profits, and therefore share prices.

However, for the time being, those worries seem to be outweighed by the huge potential for greater profits from increasing oil exports in the current environment of sky-high prices and increasing demand abroad. As the AP reported last month, Canada’s TransCanada Corp. and Texas’s ConocoPhillips announced that they will spend $7 billion to nearly double the amount of oil flowing from Canada’s Tar Sands to the U.S. Gulf Coast. So rest assured, Morgan - Canada will remain the U.S. top oil exporter to the U.S. in the near future.

This implies, though, that now would be a great time to raise taxes for oil companies since their business is so profitable that they’d probably be willing to cough it up. After all, as Sen. Obama is fond of saying on the stump, ExxonMobil took home nearly $12 billion in profit last quarter. Hence the argument for a “windfall profits tax” or “excessive profits tax” that would clip the wings of their soaring profits and hand some of this money - which didn’t result from any technological innovations or greater efficiencies on the part of oil companies - back into the hands of ordinary Americans who made it possible.

But this ignores one obvious fact about the global oil industry: it is dominated by global, multi-national firms that don’t have an allegiance to any one tax code. They can just fold up their headquarters and move their tax burden elsewhere, in which case the U.S. would be worse off than it was before. More to the point, though, the flimsy concept of “windfall” or “excessive” profits is so subjective that it is likely to leave many in the business community wondering what defines “excessive” profits and whether they’re next in line for getting a haircut on their earnings from Uncle Sam. In other words, there has to be a better way.

Again, though, the better way involves hard choices and sacrifices that America as yet doesn’t seem prepared to accept. Investment in green technologies like wind and solar energy, electric and hybrid cars and just plain old conservation are not yet considered mainstream ideas on Main Street or in Congress.

Luckily, though on Wall Street - with many investment banks and private equity firms devoting talent and resources to capturing profits in green energy - the idea is catching on. And so if it is distortion of the markets from public funds that is making the oil crisis worse, it may well be private pockets that, in the end, help make it better.

I originally wrote this as one post reflecting on the trends and catalysts behind the rapid increase in oil prices. But after receiving feedback from readers, I decided to split it up into three shorter posts that examine each of the long-term trends more in-depth. The following post examines the first trend: dollar depreciation.

As oil prices continued their drop today, falling more than $18 since last Friday, analysts and commentators began to question whether oil is finally in retreat thanks to any one of a variety of pet causes and issues blamed for its dramatic rise.

But much to the chagrin of scapegoaters everywhere, unlike in years past - such as in 1973, when the OPEC oil embargo caused prices to spike - there really isn’t any one central factor that we can squarely pin the blame on for rising oil prices. Instead, three long-term trends that have been converging since the early 2000s - dollar depreciation, tightening global oil supply combined with rising demand, and increasing commodity price speculation - provided the powder keg, while the fallout from the credit crunch lit the fuse that caused oil prices to explode so fast and furiously.

Over the next three posts, I will examine each of these trends in turn - beginning with Congress’s current favorite: the depreciating dollar.

Mind the gap

As fears over Fannie Mae and Freddie Mac recently brought the dollar within a penny of its record low against the Euro, members of Congress have increasingly focused on the depreciating dollar as the source of and solution to all our woes. Witness Congressman Ron Paul (R-TX) informing us at Tuesday’s biannual Humphrey-Hawkins hearing that we don’t need “a world-class regulator that is going to solve all our problems” but rather “a world class dollar - a dollar that is sound, not a dollar that continues to depreciate.”

To be sure, as Chairman Bernanke acknowledged in his testimony, the falling dollar has definitely played a role in oil’s spectacular rise over the last year. To see why, just look at the gap that’s been slowly emerging between the price of oil in dollars vs. gold:

While the price of oil in dollars has nearly doubled, the price of oil in gold has risen by 50% over the same period. This discrepancy becomes an even more jarring 3-to-1 if we turn the clock back to late 2001, when the dollar began its tumble. Small wonder that in January of this year the Financial Times crowned gold as “the new global currency.”

This has led some economists - notably Stephen P.A. Brown at the Federal Reserve Bank of Dallas - to estimate that the depreciation of the dollar is responsible for a large percentage of the rise in oil prices over the last seven years. “If the U.S. currency had held its 2001 value against the Euro, oil would have traded at about $80 a barrel in early 2008, about $21 below its actual price,” Brown wrote in May. And as if that weren’t high enough, in early July - sourcing Brown - New York Times business columnist David Leonhardt cited this gap as $31.

Symptoms of addiction

The dollar depreciation trend only became exacerbated by the onset of the credit crunch, which forced the Fed to slash interest rates at a time when federal banks around the world were hiking interest rates to stem inflation pressures. Consequently, the already-weakened dollar plunged even more and the changes in dollar-denominated oil became even more pronounced.

To see why, think back to America’s “addiction” to foreign oil. The United States currently imports over 70% of its oil as a way to meet its energy needs. During times of elevated oil prices, this dependency leads to large capital outflows from the U.S. to the rest of the world (what Texas oil tycoon-turned-environmentalist T. Boone Pickens called “the largest shift of money in the history of mankind” in a recent interview with the Chicago Tribune editorial board). And just as strong capital inflows tend to strengthen the dollar - as they did throughout the 1990s and early 2000s when central banks around the world were selling their gold reserves and buying up dollars - strong capital outflows tend to weaken it. The result: a vicius cycle in which oil becomes more expensive but the U.S. continues to buy it at a higher price, adding more downward pressure on the dollar, upward pressure on oil, and so on and so on.

Possible cure

Naturally, one way to break that cycle is for the U.S. to import less oil. But as global oil demand from places like India and China surges, decreased domestic demand is unlikely to make a big dent in the price of oil. Oil demand is, after all, highly correlated to income and, as Brown of the Dallas FRB points out, China’s GDP per capita rose from $1,103 in 1990 to $4,088 in 2005 while India’s went from $1,202 to $2,222 over the same period (adjusted for inflation and purchasing power parity). Couple this with the sober fact that non-OPEC supplies of oil have consistently been lower than what the industry has expected and what results is the second long-term trend that’s been driving oil prices higher: tight global supply and demand conditions.

More on this in my next post in this series.

There’s an apocryphal tale about a nervous investor that’s made its way around Wall Street recently. The investor is nervous, the story goes, not because he sees turmoil in the markets but because he’s optimistic and doesn’t know whether his optimism is justified.

Sound familiar?

The month of May - colored with headlines like “As stocks rise, Wall Street turns optimistic,” and news such as the upward revision of Q1 2008 GDP growth from .6% to .9% - gave new strength to optimism that the worst of the credit crunch is now behind us, along with the expected backlash: what if it’s not?

It is against this backdrop that a newsworthy item published a few days ago by S&P Equity Research received little notice - perhaps dutifully so because these kinds of comparisons are all too common, but this one stood out for its optimistic tone:

“. . . the Standard & Poor’s 500-stock index advanced an average 19% during the 12 times since World War II after the Federal Reserve Board started a rate-cutting program. Indeed, the S&P 500 was higher 12 months after the first rate cut in 11 of the 12 observations, with 2001 being the only time in which the equity market benchmark was not higher a year after the initial cut.

This time around, even though the S&P is down 6.2% through May 16 since the Fed started its rate-cutting program on Sept. 18, 2007, the market was also still in negative territory six months after the first cut in four of the prior 12 observations, so we still have a chance for the “500″ to advance in the next four-and-a-half months.”

[FYI: a complete synopsis of market performance during post-WWII Fed easing cycles can be found here.]

The “glass is half-full” tone of this report may give investors confidence in light of the streak of positive news throughout last month, but I saw it much more as a warning of undue optimism in the market.

In February, looking at just the last four Fed easing cycles (2001, 1998, 1995, 1989), Bear Stearns estimated that, on average, the S&P 500 has gone up 5.7% and 7.6% during the first 6 and 12-month periods since the first rate cut, respectively. This time around, things look remarkably bleaker (see chart below):

Through the six-month period from the first Fed cut in September, the S&P was down a whopping 12.4% and - despite edging higher in the middle of May - now stands at about (8.00)% since the easing cycle started. That means that if the S&P is to break even for the 12-month benchmark since the Fed easing began, it will have to coast about 800 basis points higher in less than four months against the headwind of soaring oil and rising unemployment.

Possible? Sure. Highly unlikely? Definitely.

But the problem isn’t with the equity markets but rather with the economy’s fundamentals - which are the real benchmarks that investors should be paying close attention to. In the age of globalization, multi-national corporations and a weak dollar, U.S. equity indexes such as the S&P 500 just aren’t as good of indicators for the health of the economy as they used to be since it’s hard to tell whether they’re really reflecting domestic or international growth. But domestic unemployment - which recently jumped a steep .5% to 5.5% (up 1% year over year), rising inflation and soaring commodity price indexes continue to tell the real tale, and it should continue to make the optimistic investor plenty nervous about in the coming months.

[FYI: in case you are interested to see how the 10-year treasury yield has fared during the first half of the current Fed easing cycle, PIMCO provides a neat summary of that on their 2007 subprime timeline.]