The train now arriving in Fantasy Gulch...

My God, it's only two days since I wondered how long it would be before market enthusiasts started trumpeting how wonderful market economies were after all, and already the Financial Times has responded with one of those I-wouldn't-believe-it-if-I-hadn't-seen-it-with-my-own-eyes pieces they are so very good at.

In today's edition, Philip Stephens has penned a piece entitled 'Crisis? What crisis? The market confounds the left'. Leaving aside the drivel he talks about 'the left' (of which, pace Mr Stephens, the Labour and Democratic parties are decidedly not members), he manages to boast that the return to profitability of various banks proves that liberal market capitalism really is the bee's knees.

Pace the doomsayers who predicted imminent Armageddon, liberal market capitalism has survived: somewhat humbled and, in the case of the financial services
industry under much tighter official supervision, but recognisably much as it was.

Indeed it is - and we will pay for it again, the next time it goes wrong. But the idea that this proves that the system is basically OK? Oh really? And that little detail of the trillion dollars we gave them? The millions of unemplyed? The wrecked businesses? The tens of millions around the world these bankers have thrust into an absolute poverty smug Mr Stephens cannot imagine? I could go on about this at enormous length (again), but if there is one thing that doesn't prove that a system is healthy, it is when it recovers from a completely self-induced disaster by being fixed by someone else.

But what can we expect from a paper that is so utterly incapable of rational thought about market economics?

Booking a trip to Fantasy Gulch

Now that we have bailed them out to the tune of a trillion-odd pounds/euros/dollars, surprise surprise, the banks are returning to profit. Meanwhile, the various government institutions who are supposed to be deciding how to avoid another train wreck are stumbling around trying to grasp what really needs to be done, but are so thoroughly tarred with the same brush as the financial sector that they cannot even conceive of what is required.

And every time governments make a move, another little patronising missive comes from entirely non-credible banking body bemoaning how any new regulation on capitalisation or bonuses will only hamstring the system – as though the last couple of years were not warning enough that what ‘the system’ needs is not just hamstringing but evolution into a completely new kind of animal.

How long can it be before the banks start issuing press releases claiming that the current crisis is just a flash in the pan and that everything is really all right? I give it until the end of June at the latest.

Duck!

My love affair with the Financial Times continues unabated, and this time I find that their scientific reporting is as spot-on as their analysis of business and capitalism. In today’s on-line edition, Clive Cookson’s report on the huge new European telescopes launched yesterday from Guyana (‘Huge telescopes aim to solve mysteries’) tells us that the telescopes ‘will operate in close proximity at a point in space called L2, 1.5km from earth’.

I hope they chose their orbit carefully. 1.5 km means that they will miss Ben Nevis pretty comfortably, but as Everest is rather over 5 times that height, it might be a bit of a white-knuckle ride elsewhere. The authoritative SatNews.com suggests that 1.5 million kilometres may be nearer the mark.

Of course, the FT is not a science paper, but you’d hope journalists and editors could manage to spot such a blindingly wrong number. It also raises the question of whether the current economy downturn is in fact a very reasonable reaction to the FT misreporting economic data by six orders of magnitude?

Markets and the Return of the Economic Zombie!

As someone or other once said, generals always plan to fight the next war with the weapons of the last. Much the same seems to be true of economists. In the light (if that is the word) of the last year or two, the idea that market economics is still a contender for the basic model for the economy is quaint to say the least. Even if you take capitalism for granted (which, for the time being, I think we can), markets and market theory are hardly contenders for tools for managing it. The reason I say this is because a) markets don’t really exist, and b) even if they did, standard market theory is at best half-baked and at worst simply false.

Perhaps I should restate the claim that markets don't exist. Markets don't exist as market economists imagine them. The assumptions market economics is based simply do not apply to current economic conditions, and have not been relevant for at least half a century. Market theory has always assumed a number of things (the various perfections of 'perfect competition'), most of which only really exist in minimal, distorted and illusory forms.

For example, 'perfect information' was always nonsense and we have a whole raft of industries - marketing, advertising and lobbying - on hand to keep things that way. The recent history of financial engineering also demonstrates amply how easy it was for markets to be dominated by mechanism that many players plainly did not understand, so that they had little idea what they were doing from day to day. Even George Soros said he had kept clear of derivatives because he did not understand them. Recent developments such as ‘deep pools’ can only worsen this situation by deliberately concealing market information. There are some areas where markets are still quite real, but I doubt that plumbers and fish markets command much of anyone’s GNP.

As for another key condition for markets to be efficient, ease of entry, this ceased to make any sense when economies reached the scale where only major corporations and governments could summon up enough capital to enter any major industry. Conversely, ease of exit was rendered irrelevant with the arrival of large-scale fixed capital as the sine qua non of most industries. Fixed capital is notoriously difficult to dispose of at a decent price even when it is still usable, and if you are keen to exit a market it is probably because it is shrinking, so you won’t find anyone to buy it.

Likewise for all the other key assumptions of market economics. They make a neat, if narrow, theory, but none of them actually applies under modern economic conditions.

As for the idea that market theory is at best half-baked and at worst simply false, market economics claims that markets will always tend towards equilibrium. This is hardly what history would suggest, and it ignores at least two intrinsic features of market economies.

Firstly, the various kinds of market imperfection I have just mentioned all serve to push markets into disequilibrium, because they create special interests (often very widespread or of involving very large players) who are keen to seek, create and exploit disequilibrium.

Secondly, the real tendency of markets is not towards equilibrium but towards bubbles and monopoly. Bubbles arise when it is not the intrinsic value of goods and services that are being invested in but movements in the market itself (i.e., when, as Keynes put it, the speculative froth on the surface of the stream of solid investments is inverted into a maelstrom of speculation that drowns out real investment). This inversion became inevitable as soon markets become a forum for making money by speculation rather than for allocating scarce resources. When this orgy of money-making has reached the point where market players start to notice just how far this process has diverted the formal ownership of resources from any economically plausible use, collapse ensues as inevitably as the original bubble.

Given how market economists like to define the market as an efficient mechanism for distributing scarce resources, inveterate leftists like me find it grimly ironic to note that it capitalism itself, whose sole rationale is to make money, that ensures that markets lead inevitably to bubbles, the misallocation of resources and collapse.

As Oscar Wilde said, a cynic is a man who knows the price or everything and the value of nothing, so it’s nice to see that even in the impersonal world of the market, the inherent cynicism of market theory gets its comeuppance. Pity about the millions of ordinary people whose lives it destroys.

As for monopolies, as we all know, productivity is generally much improved by economies of scale. That in turn generally demands large-scale investment, typically in machinery and rationalisations that are closed to small players. But this reduces the number of businesses that can afford to operate in this market, or for which the size of the market leaves elbow room. And so the spiral starts and continues until only a handful of players is left. Not technically a monopoly, so there is still some limited competition, but even an oligopoly consists of a small number of players whose interests vis à vis their customer are identical – and identically predatory. And certainly any notion of a free market has long since disappeared.

Another nice irony of market capitalism then: as with bubbles, monopolies show how it is the very workings of historic markets that rendered modern market theory irrelevant. Not in this case because they create bubbles that destroy the value even as they generate lots of money, but because they create an economic universe in which, far from a large number of small players buying and selling, a small number of truly vast players distort the entire economy to suit themselves.

Basically, Adam Smith’s enthusiasm for the market was based on an economy of small players with small, easily liquidated investments in a large market. A nice dream of a cosy middle class world. Market theory persists with this dream. But we don’t live there any more.

Is Asian capitalism different?

What I hope is a last word on derivatives. Apparently in 2000 Gao Xiqing, an adviser to the then Chinese premier, said that:

if you look at every one of these [derivative] products, they make sense. But in aggregate, they are bullshit. They are crap. They serve to cheat people.

[Quoted in an article by Kishore Mahbubani in today's FT.]

On a somewhat wider stage, however, Mahbubani's piece claims - quite rightly for the moment, perhaps - that there are various distinctively Asian versions of capitalism, all of which are a good deal more conservative than the ‘western’ model. For example, Asian societies have much higher levels of savings, since the Asian financial crisis of 1997-98 have restored a degree of government regulation, they have learned to ignore the IMF’s market fantasies, and so on.

Which is very sensible indeed. But how sustainable is it? As Mahbubani notes, the high savings level is the product of centuries of economic and social uncertainty. But the same might be said of westerners, whose personal prudence in these matters was once legendary. Indeed, some economic historians have claimed that our high ‘propensity to save’ was one of the foundation stones for capitalism itself. Likewise for regulation: it is not so very long ago that no one in the West would have dreamed of deregulating our economies to anything like the extent that we have.

But things change. Once consumerism – rapidly emerging in the east as in the west – takes command, the vast marketing machines will make sure that savings are quickly eroded. There will come a time when Asian economists will recommend the deregulation of markets, and there will come a time when Asian governments will be so exposed to global economic pressures that they will be unable to resist. That’s how capitalismworks – not western capitalism or Asian capitalism - just capitalism. After all, what we have in the west is not a specifically western model at all – it is simply capitalism completely let off the leash. When it is let off the leash in Asia too, they can fully expect the same tribulations.

And plainly Asian capitalism can be fooled into playing along with the western model, because for a long while they did. In 1997-8 they learned better – but to what extent did even that happen because there are at least two major global players in Asia – India and China – neither of which has really been absorbed not the global capitalist network at every level of society? They are both heading – indeed, sprinting – that way, so why should we expect them not to succumb to the 'western' model?

There is an answer. It's a combination of peak oil, climate change and the ecological devastation that is already making itself felt all across Asia. But Asian capitalism? No, I doubt very much that that can resist effectively on its own. Why should it? 'Western' capitalism didn't, even though philosophers and historians and politicians and pundits of every stripe claimed the same virtues for the west as Mahbubani does for Asia.

Overdosing on Dr Li’s Magic Formula

One persistent theme in my experience of business over the last quarter-century is how wrong-headed it is to rely on what suits business to determine the direction of the economy as a whole. A second is that intellectual narrow-mindedness can make otherwise apparently clever people do some very dumb things.

It is not that most business people aren’t clever or that they don’t understand economics; rather, it does not matter how clever they are or what they do or don’t understand, because once business is allowed its head, the natural tendency of markets toward monopoly, bubbles and assorted other economic irrationality and social disaster is inherent in business itself.

The basic principles of investment ensure that, even for a democratically minded investor, a financial return – a profit - must be extracted sooner or later, while the equally basic rules of risk management mean that the shorter the term over which that profit is made, the greater the chance of not losing it to serendipity, market vagaries or the other guy being smarter/meaner/luckier than you. Add to that the extent to which most companies – and certainly all economically significant ones – rely on investment and re-investment from bodies such as investment banks, pension funds and insurance companies, whose sole interest lies in maximising the returns on their investments, and no sooner do you leave business to its own devices than they all start rushing towards the cliff.

For allowing business to have its head is rather like shouting Fire! in a theatre: everyone rushes in the same direction, because that is where survival – which is to say, the profit - lies. And when people all start running in the same direction, two things happen. Firstly, things start to get distorted. And secondly, people start to notice that they can rely on people running that way, even though there is no obvious reason way they are. Hence bubbles: things start to rise, then people start to buy not because they can see intrinsic value in what they are buying but because they have confidence that other people will soon be willing to pay even more for what they have just bought, and they will make a tidy profit selling it to them.

Add to that the extent to which market economics became an all-conquering ideology from the 1980s onwards, and it soon became inconceivable that the interests of business and the plans of its leaders could be wrong for society as a whole. In reality, it turns out, they were completely opposed. Follies such as the Private Finance Initiative or rail privatisation should have been enough to convince any disinterested onlooker, but as far as deregulating markets was concerned, nothing was too much. So regulators had spent half a decade mouthing oxymorons such as ‘light-touch regulation’ and declining to be firm with whole industries because ‘business wouldn’t like it’.

This could only happen because the free market fantasy went right to the top. Thatcher, Reagan, Clinton, Blair, Bush and Brown all expressed a quasi-religious passion, and did not the upright Senator Phillip Gramm say, ‘Some people look at sub-prime lending and see evil. I look at sub-prime lending and I see the American Dream in action’. Indeed - where but in a dream could anyone couple human happiness with unbridled market capitalism with an untroubled mind? Or how about, ‘When I am on Wall St and I realise that that’s the very nerve centre of American capitalism and I realise what capitalism has done for the working people of American, to me that’s a holy place’. I trust someone has engraved such fine words on Senator Gramm’s retinas for future reference.

Where did all this lead to? Inevitably, right into the heart of (cliché alert!) the perfect market storm.

The absurdity of this situation is illustrated by the enthusiasm with which markets adopted David X. Li’s now-notorious equation for calculating just how risky buying and selling really were. This (somewhat medical-sounding) ‘Gaussian copula function’ in fact allowed them to work out the probability that a borrower would default on their payments. Once you have a simple answer to this question, it becomes much more profitable to lend to them (or at least, lend to a whole class of borrowers of the same kind), because you know exactly how much you can risk. You certainly don’t have to understand or pay regard to the underlying economic situation. With that, the market is reduced to a casino – from the individual punter’s point of view, most people lose their shirt, but from the house’s perspective, it’s almost impossible not to clean up.

Or at least so it seemed once Li had performed the seeming miracle of replacing all that intractably complex analysis of interacting variables and erratically fluctuating intangibles with a single neat number. This number was extremely easy to understand – a little too easy, it turned out – and allowed bankers and their minions to create a complete parallel universe populated with exotic beasts such as ‘collateralised debt obligations’ and ‘credit default swaps’. And rather like the real universe, it grew by a fantastic process of inflation that defied mere time and space, with the derivatives market quintupling in size from $100 trillion in 2002 to $500 trillion – that’s $500,000,000,000,000 - in 2007. George Soros might admit that he didn’t understand these fancy new kind of derivative and Warren Buffett might call them ‘financial weapons of mass destruction’, but the really smart guys weren’t fazed: what the hell – there was money – lots and lots of money – to be made.

But, like unicorns, CDO’s and CDS’s – not to mention still more mysterious animals of the genus ‘CDO-squared’ - turned out to be beautiful, magical and mostly fictional. There was something there, but once the lights came up, they turned out to be little more than dead donkeys. What is more, the vast sums these true believers made were conjured up not, as it seemed both to City and Wall Street financiers and to their political accomplices, by the magic of the market, but by those very same bankers allowing a combination of ignorance and greed to create a market treadmill it was all but impossible to get off. With that, they broke all connection between business and the economy, to the point where the two became fundamentally opposed.

Hence both the illusory nature and the market triumph of David Li’s formula and the hypnotically simple ‘correlation’ it generated. For this clever tool offered to replace with a single, precise, eminently intelligible number any kind of analysis of the connection between a product’s price and the complex and imprecise underlying economic realities that gave it material value. The mere fact that the result was simply a single number should have started the alarm bells ringing – it is completely unbelievable that anything of economic significance could be meaningfully defined in such simple terms. But then the markets aren’t trying to manage the economy - they are looking for safe, swift and above all spectacular profits.

Which is what they got, for a while at least. But what was David Li’s magic number really based on? Two things: short-term thinking and the market feeding on itself. Not that David Li's model was unusual in that respect. The Bank of England director for financial stability, Andrew Haldane, has commented that 'With hindsight, the stress-tests required by the authorities over the past few years were too heavily influenced by behaviour during the golden decade' (i.e., 1998-2007). Not very smart, given how exceptional everyone knew this period really was.

Yet Li's model took this process to its extreme, by taking into account only right now.Underlying Li’s equation is the assumption that, far from trying to understand the value of an investment – which is to say, its true economic value – it is only necessary to know how much the market is currently pricing it at. Once you know that, you can estimate the risk you are taking when you buy or sell it. But such an approach can only work while the market is buying or selling in unison and is either completely static or continuously changing in the same direction. The former is almost unheard of in recent decades, while the latter can only endure while the market is in bubble-mode, and people are buying and selling at silly prices primarily because other people can be relied on to sell and buy at sillier prices still.

Eventually, however, the strains this creates are too much even for these florid times. Eventually, investors start to realise that a) they no longer have any idea what anything is really worth, b) whatever it is, it is a lot less than what the market is saying right now, so c) the prices of their assets makes no sense at all. With that, Li’s reassuringly singular equation starts point firmly downwards, and everyone starts shouting Fire! And heads for the exits. The market burns down with most people still inside, and the central mechanism for manage truly huge swathes of the entire global economy goes up in smoke.

This is yet another instance of the notorious ‘mark to market’ strategy, of course – of valuing something solely by current price rather than taking into account any notion of material (social, economic, etc.) value that might sustain its price. As the current crisis has amply demonstrated, this has the disastrous effect of exaggerating a company’s value enormously when a bull market is in progress and asset prices are all going up. This in turn allows that company to borrow far more than they would have been allowed in less bullish conditions, even though the economic value of the company has not changed. Conversely, as soon as the market turns, the company’s assets are worth less and less, its credit collapses and all those loans are called in. What has changed in the economy? Nothing. What has changed in the market? Everything. So what then happens to the economy, at whose heart these unfettered markets sit? Disaster.

And all this is epitomised in Li’s formula. It’s timescale is not so much short-term as instantaneous, so any rapid market shift can bring on a catastrophe. By reducing everything to a single index it demonstrates that its sole purpose is to price risk and feed short-term speculation, rather than calculate realistically complex economic values, and so support true investment. Its simplicity concealed far more than it revealed, to the point where 30% of the US mortgage market could be made up of sub-prime mortgages and no one noticed. By being nice and simple, it seduced mathematically illiterate managers into believing they could do magic. Which, like the sorcerer’s apprentice, they could – they sprinkled Dr Li’s fairy dust over the financial sector, and it disappeared. Finally, it values risk based solely on what the market says it is worth, which (like all speculation) is both economically trivial and completely circular. So as soon as it starts to be widely used it is almost designed to generate a bubble, and the very nature of bubbles is that they take make everyone believe that they can defy economic gravity – just like they could with the dot.com boom, the supposedly ever-expanding ‘knowledge economy’ and a host of other booms and busts. The fate of bubbles was Economics 101 then and it is Economics 101 now.

But it would be quite wrong to blame David Li and his equation. Many experts warned against taking it seriously. So did David Li - though that didn’t stop him making his fortune out of it. In fact it makes more sense to ask not how the Li formula destroyed the financial markets, but how the financial markets, with their superficiality, their collective egoism, their indifference to long-term consequences and their power to strong-arm anyone caught up in them to play economically and socially insane games, created an audience for Li’s formula.

But what about all those clever business people who declined to heed the many warnings? The regulators who endorsed its use, even though one Standard + Poor analyst remarked ‘Let’s hope we are all wealthy and retired by the time this house of cards falters’? The politicians who gave business the ‘light-touch regulation’ it wanted? All those clever free-market acolytes from the Wall St Journal, the FT and the Economist? Yes, I think we can blame them. Not that I blame them for being wrong; but I do blame them for being so utterly uncritical, so deaf and blind, so patronising to those who questioned their shallow fantasies and so cowardly when the end was in sight. Unlike explorers searching for Eldorado, they had every reason to know exactly where we were heading.

They just preferred not to notice until it was too late – for all of us.

Free and frank for whom?

Jack Straw declines to allow us 'free and frank' coverage of Cabinet discussions because this will inhibit them from having 'free and frank' discussions. What can this mean, other than that they are afraid that their real opinions will be so shocking to the people that they might elect them out of office? There is no issue here about protecting their freedom of speech - we want them to speak their minds, but as public servants we are entitled to eavesdrop. In fact, perhaps all Cabinet discussions should be on prime-time TV - would this be worse than Big Brother?