Ali’s blog

Mostly quant stuff with occasional digressions

The black box economy

Posted by alifinmath on January 27, 2008

An article in today’s Boston Globe that’s in line with what I’ve been saying and suggesting on this blog for a while: no-one really understands the economy today because no-one understands the web of financial instruments that interact with our real world. There are no conceptual tools around to get a bird’s eye perspective of the financial world, if indeed it’s even possible. Anyway, an excerpt from the article:

A handful of financial theorists and thinkers are now saying we shouldn’t (be so confident this time that the downturn will correct itself). The drumbeat of bad news over the past year, they say, is only a symptom of something new and unsettling – a deeper change in the financial system that may leave regulators, and even Congress, powerless when they try to wield their usual tools.

That something is the immense shadow economy of novel and poorly understood financial instruments created by hedge funds and investment banks over the past decade – a web of extraordinarily complex securities and wagers that has made the world’s financial system so opaque and entangled that even many experts confess that they no longer understand how it works.

The scale and complexity of these new investments means that they don’t just defy traditional economic rules, they may change the rules. So much of the world’s capital is now tied up in this shadow economy that the traditional tools for fixing an economic downturn – moves that have averted serious disasters in the recent past – may not work as expected.

In tell-all books, financial blogs, and small-circulation newsletters, a handful of insiders have begun to sound the alarm, warning that governments and top bankers may simply no longer understand the financial system well enough to do anything about it.

“Central banks have only two tools,” says Satyajit Das, author of “Traders, Guns and Money: Knowns and Unknowns in the Dazzling World of Derivatives,” who has emerged as a voice of concern. “They can cut interest rates or they can regulate banks. But these are very old-fashioned tools, and are completely inadequate to the problems now confronting them.”

“A lot of financial innovation is designed to get around regulation,” says Richard Sylla, professor of economics and financial history at NYU’s Stern School of Business. “The goal is to make more money, and you can make more money if you don’t have to keep capital to back up your investments.”

(By the way, Sylla has coauthored a book, “A History Of Interest Rates,” that’s well worth looking at for background knowledge.)

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3 Responses to “The black box economy”

  1. Chris Prouty said

    The Globe should be ashamed that they allowed such a poorly written and researched article make it onto their pages. As is often the case with journalism involving complex topics, the writer in this case has taken a highly sophisticated issue and reduced to a series of ignorant jabs and scare tactics. Allow me to point out a few glaring problems with this piece.

    “That’s not how the economy is supposed to work – or at least that’s not what they teach students in Economics 101.”

    Pray tell, how is an economy “supposed” to work? An economy working in a “supposed” way implies determinism. If the lessons learned in Economics 101 allowed its students to make accurate predictions of the economy, every Economics 101 gradate would be filthy rich within months. The author’s dazzling lack of knowledge begins to reveal itself with this line.

    “…estimates that investors worldwide hold more than $500 trillion worth of derivatives. This number now dwarfs the global GDP, which tops out around $60 trillion.”

    This statement indicates to me that the author of the article has never heard the term “notional value”. A corn futures contract specifies 5,000 bushels of corn. If corn is trading at $4/bu, then the notional value of that contract is $20,000. That $20,000 bears little relation to the *risk* implied by holding the contract. Additionally, the derivatives of which he speaks are a *zero-sum game*. That means that if I am short one corn futures contract, someone else is long. If corn drops to $1/bu, my counterparty loses $15,000 but I *make* $15,000. The money doesn’t evaporate, it just changes hands. I’ve seen this $500 trillion figure tossed around in the financial press quite a bit, and it is used solely to illicit fear and awe among those who don’t understand what the figure is referring to.

    “…and unpredictable effects on financial markets.”

    The implication here is that a marketplace is a machine like any other – when you press the red button a gumball predictably drops out. The marketplace is not a formula with simple inputs and a predictable output, like y = x + 1. The world is littered with bankrupted smart guys who thought that it is. Anyone who views the marketplace as a predictable system with inputs and outputs is alarmingly naive.

    “The market for one product alone – the credit default swap, or CDS – dwarfs this country’s economy.”

    This is another red herring which seeks to illicit fear and indignation from the reader who doesn’t know what “notional value” means.

    This article is a miserable collection of half-truths and platitudes aimed at drumming up hatred and resentment for an industry that is already hated and resented, usually without basis. The deeper fundamental problem with this article is the suggestion that up until recently the marketplace has functioned as a predictable money machine, chugging along reliably printing profits for the sage captains at the helm, and now the evil pirates of Wall Street threaten to destroy all that is holy about our formerly virgin stocks and bonds. This article belongs in the children’s section.

  2. alifinmath said

    Opinions vary (though I’m mildly surprised to see this piece has evoked such a vehement response from you). Like you, I’ve taken macroeconomics in my time and let me try to defend the journalist (though acknowledging he may not be an economist). As I learned in macroeconomics, we’re supposed to have some handle on causes and effects: if house prices go down, we’re supposed to relate those to other phenomena such as unemployment, demographic changes, a slowing economy, and so on. This has become more difficult in the last so many years because of artificially low interest rates but also because of a proliferation of financial instruments such as MBS, which package and commodify mortagages thus helping to make mortagages available to people who can’t repay them (banks in the old days would never have lent money to such poor credit risks; today the originator of the loan hastens to pass it on to someone else who packages and sells it). One can argue that these instruments are not only divorced from the “real economy,” but in some sense have been driving it in the sense of artificially propelling house prices to untenable levels (and hence sustaining “real” economic activity at untenable levels). The journalist is wrong, however, to state that these instruments have become the most important determinant of house prices in the last few months.

    The journalist is also guilty of misinterpeting Satyajit Das — as you have pointed out. But Das is a recognised expert in quant finance, and the author of several quant texts by Wiley (which I have consulted). He knows what he is talking about when he talks of the inherent and increasing volatility of financial markets and the destructive impact they have on real economies and the lives of real people: financial engineering is not some online game with no repercussions on the outside world. Look at the impact LTCM’s demise could have had, had it not been nipped in the bud.

    And some other experts also are saying similar things. The journalist quotes Sylla and Gross — surely you would not accuse them of being novices and ignoramuses? Another is Richard Bookstaber, with a Ph.D. in economics from MIT, and a hedge fund manager. I quote from his recent book, “A Demon of Our Own Design”:

    QUOTE The financial markets that we have constructed are now so complex, and the speed of transactions so fast , that apparently isolated actions and even minor events can have catastrophic consequences.

    …More often than not, crises are not the result of sudden economic downturns or natural disasters.Virtually all mishaps over the last decades has their roots in the complex structure of the financial markets themselves.

    …There is another troublesome facet to our modern market crises: they keep getting worse.

    …One of the curious aspects of worsening market crises and financial instability is that these events do not mirror the underlying real economy.

    …These breakdowns come about not in spite of our efforts at improving market design, but because of them. The structural risk in the financial markets is a direct result of our attempts to improve the state of the financial markets….The steps that we have taken to make the markets more attuned to our investment desires — the ability to trade quickly, the integration of the financial markets into a global whole, ubiquitous and timely market information, the array of options and other derivative instruments — have exaggerated the pace of activity and the complexity of financial instruments that makes crises inevitable. Complexity cloaks catastrophe.UNQUOTE

  3. Chris Prouty said

    I certainly did not mean for my post to be an attack on anyone other than the author of the article. Those folks he quoted are surely very qualified, and in fact I’ve enjoyed a number of things I’ve read by Bill Gross.

    My gripe is that too often I read articles such as this that simultaneously propagate an unfair view of what a marketplace is and vilify those who participate in it. A marketplace is not intended to be predictable…if it were then there would be no need for the market, the government would simply set prices. The argument that 20th century economics no longer applies to our economy and that therefore we need to shoehorn global markets into something more familiar is invalid. It is akin to saying that we’re simply not going to acknowledge sub-atomic particles because they don’t adhere to Newtonian physics, and rethinking that would be a real bother.

    Instead of journalists wringing their hands about the big bad Wall Street traders creating an “unpredictable” marketplace, why are they not chastising the economists for not keeping their theories up to speed? Why are they not chiding regulators for doing what it takes to hire qualified people who can keep their finger on the pulse of the market?

    The reality is that this latest blow up was *not* unpredictable, as evidenced by the substantial number of hedge funds and in fact a huge investment bank, Goldman Sachs, taking positions to profit from the inevitable melt-down. Even the dolts in the occasional financial periodical were getting a bit skittish during the summer in the face of looming foreclosure statistics.

    One other thing:

    “There is another troublesome facet to our modern market crises: they keep getting worse.”

    This is simply not true. The great depression was far and away the worst market crisis in America and none has approached it since. Even if that were not true, drawing a trend line and extrapolating the conclusion of: “Ah ha! It’s the derivatives!” is flawed logic. I’d expect that kind of argument out of the global warming camp 🙂

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