naked capitalism

The solar industry is already suffering from significant overcapacity, yet incumbents are adding still more manufacturing to try to secure a cost competitive position after the shakeout. This chart, prepared by Digitimes using data from The Information Network (hat tip reader Michael), sums up the yawning gap between demand and capacity:

The Information Network forecasts that as many as 50% of the producers could fail in 2010 as prices plunge:

A key reason is increased supply from China, which added an additional 1GW of capacity. The price per watt has now dropped to US$1.80 for polysilicon-based products, which is lower than the US$1.85 level ….By way of comparison, the average selling price in the third quarter of 2008 was US$4.05 per watt.

The Information Network doesn’t expect other industry players to back down from increased competition from China. Other makers are expected to increase their capacities despite the low utilization rates in order to reach economies of scale and better compete against the Chinese…

Average selling prices could drop below US$1 per watt in 2010 and US$0.50 in 2011. As many as 50% of the more than 200 solar manufacturers, mired in red ink with current selling prices above US$2.00 per watt, may not survive.

By dint of good fortune, Satyajit Das’ new post at Wilmott (which he has graciously authorized us to reproduce) is on our occasional Sunday beat, and comments on some recent books, the theme being remakes. Enjoy!

From Das:

Remakes are rarely as good as the original but can sometimes add something, if only a nostalgic and sentimental longing for the ‘real thing’. Justin Fox’s The Myth of the Rational Market (2009; Harper Business) and Pablo Triana’s Lecturing Birds on Flying (2009; John Wiley) are both remakes.

The Myth of the Rational Market is by the author’s own admission modelled on Peter Bernstein’s Capital Ideas: The Improbable Origins of Modern Wall Street. It is a history of a fundamental tenet of finance theory – the efficient market hypotheses (EMH) – which, its critic’s argue, has come up short in the GFC. More strident commentators even blame the EMH for the crisis.

Fox, a well credential-ed financial journalist, has written a clear and accessible history that successfully targets the non-financial reader. Its rendition of history, which owes much to Bernstein, is essentially correct and identifies the ill-fated tendency to elevate the EMH to a status that heavily distorted academic theory and policy approaches to markets.

The Myth of the Rational Market is at its best when telling the story and somewhat weaker in dealing with the nuances of the theory itself. Fox puts a lot of faith in the challenge of newer theories – behavioural finance and the adaptive markets hypotheses – and sees these as the way forward. Time will tell but these theories may be just as flawed. Ultimately, hypotheses are just that and market behaviours and the animal spirits may prove difficult to model.

A significant advantage of Fox’s book is that it brings the story up-to-date (Bernstein’s book was first published in 1992). Fox also is perhaps more sceptical of the theory than Bernstein, who knew and was close to many of the proponents and was much less critical.

The wonderful titled – Lecturing Birds on Flying – is a remake of and a paean to the Black Swan, also known as Nassim Nicholas Taleb. The book is a polemic against the Black-Scholes-Merton option pricing model. Other major themes are frenzied criticism of financial economics, economists, business schools, tenure, academics turned practitioners, etc in no particular order of importance.

Like the apostolic epistles, Lecturing Birds on Flying is an extension of the liturgy that Taleb set out in Fooled by Randomness and the Black Swan. The premise is similar if less successful. The book’s ambitious objective, as set out in Taleb’s foreword, to “make society a better, safer and more risk-conscious place” is unlikely to be achieved.

A puzzling aspect of the book is the writing style employed. The reviewer at the Economist was especially taken by the final sentence: “Deliciously paradoxically, the Nobel could end up diminishing, not fortifying, the qualifications-blindness and self-enslavement to equations-led dictums that, fifth-columnist style, pave the path for our sacrifice at the altar of misplaced concreteness.” One reviewer on www.amazon.co.uk commented on the terms “tumultuous tumultousness”, “unconventional conventionalism” and “dogmatic dogmatism”. The reviewer was concerned about persistent double negatives and sought to establish that a reference to an argument as “non-incoherent” means “coherent”?

As neither a linguist or a literary stylist, I can only assume that the author and editor felt the need to experiment with the extremities of the English language and expression to reinforce the message. In A Clockwork Orange, Anthony Burgess created a special teenage slang of the not-too-distant future called “Nadsat”. The effect here is not dissimilar.

In both books, there is an essential contradiction – the idea that models and theories cause market chaos is inconsistent with the fact that both authors says traders and practitioners often ignore models.

Both books miss an essential point about economists and theories. As John Kenneth Galbraith pointed out the only point of economics is to provide employment for economists. The irony is that it is also provides fruitful employment to authors in explaining the theories (in good times) and debunking them (in bad times).

Generally speaking, academic insights, even if correct, can rarely be applied directly to financial markets. Smart traders and investors have always known this and theory and practice are rarely bed-fellows on Wall Street or in the City. Economists and economic theory should not be taken too seriously. After all Keynes’ only regret in life was that he: “did not drink more Champagne”

Reader Jason Pl pointed out this post from Jon Taplin, which starts with the less than cheery chart on US durable goods production courtesy Floyd Norris. As you can see, the only growth biz is military:

Military contracting procedures means that work will stay with domestic players. So one could take the cynical view that the US has been willing to cede every kind of manufacturing we could, and defense contracting is by nature off that list.

But does this split have to do with bona fide security concerns? Yes and no. Why have we let chip manufacture go overseas? We are outsourcing more of our chip manufacturing to China (Taiwan is the biggest single foreign fabricator, which may explain China’s keen interest in reasserting control). Trade in advanced technology products is heavily weighed in favor of China.

Taplin gives a dystopian view:

We have so hollowed out our industrial plant that the only thing we are now producing is weapons of war. The great British Historian Arnold Toynbee’s theory about the decline of the Roman Empire has lessons for our current age.

The economy of the Empire was basically a Raubwirtschaft or plunder economy based on looting existing resources rather than producing anything new. The Empire relied on booty from conquered territories (this source of revenue ending, of course, with the end of Roman territorial expansion) or on a pattern of tax collection that drove small-scale farmers into destitution (and onto a dole that required even more exactions upon those who could not escape taxation), or into dependency upon a landed élite exempt from taxation. With the cessation of tribute from conquered territories, the full cost of their military machine had to be borne by the citizenry.

This I know. We cannot continue on this course of decline.

Yves here. I have to interject. “Cannot continue?” I see tremendous inertia as far as the path we are on is concerned. We not only have bread and circuses, have version 2.0, with offerings targeted by income level and age group. Back to Taplin:

While many of the elite escape taxation with their brilliant “tax shelter” accountants, the middle class (Rome’s “small scale farmers”) are being asked to shoulder the economic burden of empire.

Shortly after the election President Obama made it clear that the chokehold of the Military Industrial Complex over our economy was not going to change on his watch–…After all, with 4% of the world’s people why shouldn’t we spend 45% of the world’s military spending?

While Obama makes symbolic cuts in the Military budget, the House threw in 550 new earmarks into a $636 Billion Military Budget. Lyndon Johnson thought we could have both Guns and Butter, but he was wrong. Both Jimmy Carter and Bill Clinton were afraid to take on the Military Industrial Complex that the Republicans have always favored. Eisenhower was right that continuing on this disastrous course is a form of generational theft. According to Catherine Lutz the U.S. Military has “909 military facilities in 46 countries and territories.” This is truly insane. We need to bring the personnel on these bases home and start selling off the precious foreign real estate to help liquidate our massive debt.

I have only one question–Where is the national politician with the courage to say we no longer have to act as the unpaid policeman of the world?

My simplistic view is quite different. Our economic power is past its sell-by date. US leadership is deeply committed to maintaining whatever hold on global authoirty that we can. Nukes and a big navy, which makes us the only country that cna land a large army, are very helpful in that regard. How do you think our little chats with China over what we owe them would go if were weren’t the world’s sole superpower?

If we don’t manage our way out of our debt mess, we may wind up in the long run having to sell our “precious foreign real estate.” Maybe it’s time for someone to tell the DoD that failure to rein in Wall Street will create a security risk.

One of the most remarkable aspects of the success of Wall Street in subordinating the real economy to its wishes and needs is the con job implicit in the application of the word “innovation” to what might more accurately be described as tax evasion, regulatory arbitrage, and chicanery. Martin Mayer once described innovation as “using new technology to do that which was forbidden under the old technology.”

Rob Johnson, former economist to the Senate Banking Committee, has a new article that parses how the financial services industry has managed to wrap itself in the mantle of progress, when if anything its new products have been a force for destruction rather than creation. We had a wave of new OTC derivative products sold, starting in the early 1990s, whose high profits for the most part depended on the fact that they allowed investors to game ratings or mask the economic substance of transactions or fob risk off on to people who really did not understand it. The industry managed to co-opt SEC chairman Arthur Levittt and fight a delaying action until the media got bored and went on to other matters, A collateralized debt obligation market blew up in the late 1990s only to be reborn in the new millennium in only slightly modified form to wreak havoc on a much greater scale. Abuses of off-balance-sheet vehicles by Enron did not lead to reforms that affected the financial services industry much, since huge carve outs were made so as to keep mortgage securitization alive. And I will admit to having been unable to keep up on the news as fully as I once did, but I don’t recall any of the proposed fixes for the securitization market calling for changes in deal structures and servicer contracts so as to make mortgage mods easier and more attractive.

From Johnson:

Innovation. It is a lovely word that teases the mind with the notion of expansive possibilities… A win-win game. Just as Americans once expanded westward to relieve social tensions, we are now exhorted to have a rather imprecise faith in the notion of technological change to deliver us from our current troubles. Embracing that starship to unlimited possibility and deliverance requires a faith that cannot be easily refuted: Who, after all, is against progress?

David Noble, who has written so powerfully about this in his series of books including America by Design, Religion of Technology and Beyond the Promised Land, has explored this mythology of redemption and salvation through changes in technique and deference to undefined dreams of “possibility.” It is time to apply his perspective to the religion of financial innovation.

We have seen the financial sector, with its massive resources and access to the best minds of public relations, work to create what Stuart Ewen calls “spin.” ….we have been ever-so-persistently encouraged to draw the comparison between developments in financial products and the great leap forward in social uses of computers and the Internet, or advances in biomedical research. Former mathematicians, physicists, and computer scientists redirected their energies and Ph.D. tenacity to the domain of finance. Financial innovation was presented to us in a way that suggested that great things were happening for mankind. The presentations were usually vague. To understand them, we had only the power of our own imaginations, or perhaps, failing that, our awe in the face of this powerful expertise, confidently propelling us to a greater future.

Skeptical questioning–”Where are the benefits to be found?”–was frowned upon or ignored. ”Just doesn’t get it,” the whisperers would say. The skeptic was discredited with the insinuation that he or she was either 1) jealous of those who were making money and progress at the same time, or 2) had fallen down like a tired horse and just could not keep up with the new breed of thoroughbreds on Wall Street. After all, what kind of human spirit would get in the way of progress?

The reason I bring forward the notion of “spin” is that I sense that the great benefits of financial innovation were not self-evident, and that some form of intimidation or coercion was needed to keep the genie of doubt in its bottle. If a great Wall Street luminary were actually forcefully questioned, could he really convince grandma and you and me that he was making the world a better place? The point of the exercise, the spin, was to create deference to this process, to deter questioning and create social license, to make what those rocket scientists were doing appear as though their work was not merely profitable but something that would benefit us all. It was presented like a free option to the public: Wall Street pays these guys and “shazam!” They do things that make us all better off. No reason to get in the way of that, or even suggest that your Congressman or friendly bank regulator keep an eye on the proceedings. The subtle message was, “Get out of the way.” Such was the Kool-Aid poured into our glass by the financial press and pundits. That capital avoidance and tax avoidance and regulatory evasion were involved in offshore and off- balance-sheet methods was rarely emphasized, as the notion of innovation was paraded like a badge of valor.

Then we had the crisis. The side effects and spillovers and bailouts reminded us that what we had allowed to unfold was not a free option on progress but something that had a downside, too. It’s funny how a crisis changes your perceptions….

Despite these recent protestations, I am witnessing the lingering hangover of deference to so-called “innovation.” It permeates the debate on regulation. We hear that getting in the way of new technique may cause more problems than it solves. Or that the innovators can always outrun the regulators. Or, and this is my favorite, that nothing you do to stifle these new derivative products like credit default swaps will (ominous music in the background) lead to “systemic risk.” Systemic risk is the new stun-gun phrase to impart dread to those who would tamper with this delicate machine.

Malarky. This is all code for defer to the wishes of those who make money from these techniques.

Financial engineers on Wall Street are employed to make money for Wall Street firms and themselves. There is no hidden code that says they will design their products to align private and social benefits and costs. That is precisely where a healthy role for regulation and laws and enforcement can be envisioned. At the same time, it is important not to be romantic about that vision, though. Regulatory policy often does not live up to the romantic appeal, as theories of collective action and regulatory capture have illuminated.

My takeaway is distinctly unromantic. It is that, devoid of these religious-like connotations, innovation simply implies the use of a new method or technique. It can be harmful or it can be helpful. Let’s keep score. It can benefit us both, or it can harm us both, or it can make you better off and me worse off, or vice versa. That sober reality, and the notion that we are a society, sets the stage for critical thinking about these methods. If credit default swaps serve a purpose and are economically viable when proper capital and margin requirements are in place, then let the proponents bear the burden of proof in convincing us of the benefits to society according to some real social goals, rather than the vague myth of intangible progress. Protecting the profit margins of large investment firms is not a social goal.

We have a serious and real problem right now as a society that employs complex technique. Experts in the financial, nutrition, energy, and health realms have been found wanting when the curtain is pulled back and their behavior examined. Trust, particularly in financial expertise, has been shattered. Early in the 20th century, the so-called Progressive Era was an attempt to bridge the gap between the oligarchs of industry and the populists. Deference to expertise was said to be in the interest of all. Delay gratification and let the experts allocate capital so that in the future we would all be better off was the mantra. It had a religious-like psychic resonance. Experts on economics and social planning were custodians of our future, not unlike the role that priests played in earlier times. Restrain yourself now to achieve the promise of the afterlife. The linchpin was the experts vision and integrity. They were trusted to make sure we all got to economic heaven together.
We just got handed a big bill and the perpetrators that led to the bailouts are back getting large bonuses. If experts cannot be trusted and governments are unwilling to change the rules, then we will once again be heading toward popular reaction. The cooperative game is breaking down. The population showed us a hint of that over the AIG bonuses. A volcano that is still today may yet explode tomorrow.

As I watch the stories of this newest revelation on the wonders of financial innovation, so-called high frequency trading (HFT), I scratch my head and wonder how we got to this place: That most profound mystical deity which we are asked to worship, “the market,” can now be rigged so that a few get to see orders beforehand. As Charles Duhigg wrote last week in the New York Times, “While markets are supposed to ensure transparency by showing orders to everyone simultaneously, a loophole in regulations allows marketplaces like Nasdaq to show traders some orders ahead of everyone else in exchange for a fee.”

This “innovation”–employing monster computing power and the apparent ability to buy your way to the front of the line–looks like old fashioned front-running to me. How can that contribute to the integrity of our marketplace? Bob Kuttner has written an illuminating piece on this subject. For my part, I just hope that our society can demystify (unspin?) this process. It is time to build a financial system that serves the real economy for the next generation. To do so, we may need to sweep aside some of the so-called innovations in financial practice that were born of this foolish era of market fundamentalism and its supervisory and enforcement laxity. Surely there are techniques that we should adopt. Yet in the aftermath of the crisis the burden of proof is on those who advocate them. Where are the benefits to society? What are the costs? To answer those questions, we must come out from the well spun power cloud of Wall Street and ask real questions. Regarding financial innovation, I am fond of the lyrics of Michael Stipe. It is time we start losing our religion.

Wow, I never thought I’d see the day when a company made a frontal assault on Microsoft’s core business. Google goes where the DOJ failed to penetrate (more accurately, Judge Thomas Penfield Jackson managed to steal defeat from the jaws of victory by making some remarks between the decision and the sentencing phase of the Microsoft antitrust case that got him removed from the case, and installed a particularly clueless judge, Colleen Kollar-Kotelly. as a replacement, who meted out vastly weaker sanctions that Jackson would have administered).

While competition is presumably a good thing, I’m not sure having one monopolist replace another is a great improvement. Google is already playing the FUD card (fear, uncertainty, and doubt) by putting this info out well in advance of launch (a product for low-end portable PCs, due out second half 2010. I wonder if this is part of a strategy to bridge computers and communications devices. Apple has a full OS of sorts in its iPhone, but this announcement says the ultimate aim is the PC market). Admittedly, part of FD was also announcing vaporware, while Google has much higher odds of delivering a real product on its timetable.

Having been a Google customer via Blogger, their customer service is non-existent. As a matter of policy, you cannot get a live person, hence you cannot get a problem resolved. When this blog was shut down (it was incorrectly tagged as a spam blog) I was lucky enough to know the brother of a C-level executive. Any other level of contact, and I would not have gotten any resolution. Trust me, I am better at getting past gatekeepers than most people, and the Google switchboard might as well be Fort Knox.

Google simply does not get the first rule of customer service: the perception of customer service is based not on the error rate, but the quality of problem resolution. People want a company that will admit to its errors, fix them quickly, and be pleasant about it. That does not seem to be how Google defines its product (not that Microsoft understand that either, mind you).

I’d be curious as to what the tech experts think (as a Mac person I can watch the blood sport with indifference), but Google presumably recognizes that Microsoft has a hugely bloated OS that it no longer even fully comprehends. That means the OS is inherently insecure. Linux has made inroads, but more in the corporate/institutional market, where it is easier to organize user support (although the irony is that one of the things that helps keep Microsoft going is that it is a tech support full employment act. Linux and Macs require vastly less support than Windows).

From the Wall Street Journal:

Google Inc. is preparing to launch an operating system for personal computers, a direct assault on the turf of software giant Microsoft Corp….. It said the software, which will initially target low-end portable PCs called netbooks, would be based on its Chrome Web browser and available to consumers in the second-half of 2010.

The post–by Google’s Sundar Pichai, vice president of product management, and Linus Upson, its engineering director — said the operating system would be “lightweight” and optimized for running Web-based applications. Google’s goal, they said, is to address shortcomings of PCs — including security problems and lengthy delays while computers boot up, the Google executives wrote.

“We hear a lot from our users and their message is clear — computers need to get better,” they wrote.

Eventually, Google hopes to scale the software to full-scale PC’s as well, they wrote.

The effort marks the latest attack by Google on Microsoft, which dominates the market for operating system software that powers computer applications. The Mountain View, Calif., company, which makes 97% of its revenue from online advertising, has been trying to compete with Microsoft and other software makers by offering more software that runs in a Web browser and isn’t downloaded directly to computers. Now it appears to be broadening its approach, in a move that could give it greater distribution of its own online software services, including word-processing and email software.

But whether it can chip away at Microsoft’s dominance in the market remains unclear. In the months since its launch, Chrome has done little to challenge Microsoft’s lead in the browser software. And some hardware companies have been slow to adopt Google software — like its Android operating system, which is targeted at running applications on mobile phones — arguing it isn’t robust enough to handle many tasks.

The Google blog post stresses that the Chrome operating system is a separate effort from Android — though, like Android, it will be “open source,” meaning other developers can have access to and modify the code.

The software is designed to work on PCs running x86 chips — the design used by Intel Corp. and Advanced Micro Devices Inc. used in most conventional PCs — as well as chips based on designs from ARM Holdings PLC that are the standard in cellphones and are expected to be used in netbooks later this year, the executives said.

Though the software will be based on the core of Linux, its “kernel” in programming parlance, the Chrome OS, as it is called, will add a new layer of windowing software to manage what a user sees on a display screen. Instead of requiring programmers to write programs specifically for the operating system — an uphill battle, at a time developers have many choices about where to focus their efforts — the Google engineers said that the Chrome operating system will simply run programs written for the Web.

“And of course, these apps will run not only on Google Chrome OS, but on any standards-based browser on Windows, Mac and Linux thereby giving developers the largest user base of any platform,” the Google executives wrote.

Google’s incursion into operating systems could galvanize its critics, including privacy groups and competitors, who argued that the online search company already collects vast amounts of information about consumers’ Internet use.

James Kwak, discussing a recent Bernanke speech defending financial innovation and a Ryan Avent post parsing it, underscored Avent’s observation that Bernanke had trouble coming up with an example of the sort that the financial services had in mind these days (ie, novel products making use of derivatives and other risk slicing, dicing, and distribution tools). His examples were pedestrian but important consumer products like credit cards and well seasoned advances, like securitization (dating from the 1970s).

The lone relatively current example? Subprime lending. Bill Black (via e-mail) has trouble seeing that as virtuous, at least in combination with securitization (which presumably was the innovative bit):

The very last thing any sentient being should want to do is restore a secondary market in nonprime loans.

Kwak made a useful distinction that innovation that is serves to increase access to credit may not necessarily be a good thing. Note that this runs contrary to the pre-bust mantra, that more credit availability was a virtue:

Where I come from (career-wise at least), innovation meant that you invented something that people wanted, or you figured out a cheaper way to make something that people wanted, or you figured out a way to improve something that people wanted….

Financial innovation, however, comes in two forms. There are financial innovations that make our lives easier. One is the automated teller machine (ATM)…

The other kind of financial innovation has to do with extending access to credit. Here I think it’s less clear that innovation is unequivocally good.

It is certainly possible for a society to be below the optimal level of access to credit. Consider the idyllic banking paradise that gets mentioned a lot these days, in which people deposited their savings with local banks which, in turn, lent money out to trustworthy local homebuyers and held onto those mortgages to maturity. The good thing about this model is it encouraged responsible underwriting. The bad thing is that it isn’t very good at moving capital (money) from one part of the country to the other. Imagine in Iowa no one needs a mortgage, so the banks have no place to lend and can only pay their depositors 0.1% interest. In Florida lots of people need mortgages, so the banks offer 4% on savings accounts, but they still can’t attract enough cash and people who would buy houses can’t. (Or, alternatively, people who would take out loans to expand their businesses can’t.)

Yves here. Matching deposits with loans demand across regions has been a non-trivial and sometimes contentious problem in American history. The impetus for the old state banking restrictions was the emergence of national banks that hoovered up enough local deposits in some areas as to be perceived to be depriving businesses (then usually farms) of needed credit. Back to Kwak:

The effect of securitization should be to moderate differences in interest rates – mortgage rates can come down as money moves into Florida, but they may go up as money leaves Iowa – and perhaps to lower them overall by making more money available to the market as a whole. If we were in a situation where too few people were getting mortgages, this is a good thing. But it is also possible for too many people to be getting mortgages, as we now know. Something similar happened with venture capital and startups over the last fifteen years. After the IPO rush of the late 1990s, billions of dollars of new money piled into the VC industry; that money flowed to thousands of companies that should never have gotten funded, resulting in lost money for investors and lost time and effort for thousands of generally bright and well-meaning entrepreneurs…

In short, financial innovations whose sole function is to increase access to credit do not in and of themselves make the world a better place.

While this is a useful distinction, and helps advance the discussion, I think we can go a good deal further.

One of the reasons economics have been lulled into viewing the widespread proliferation of new derivatives and risk transfer products is that it helps advance a fantasy put forth in a seminal paper 1954 paper by Nobel prize winners Kenneth Arrow and Gerard Debreu. The paper gave a rigorous proof (at an economist wet dream level of elegance) of the existence of a multimarket equilibrium in a decentralized economy. However, the model assumed that there were forward markets not simply for every commodity but also for all conceivable contingencies and that no one holds money for longer than a single time period.

This paper shifted attention in the discipline away from how economies and competition actually works, that is, the processes by which prices are set and adjusted, a dynamic process, to proving that a specified set of prices could clear all markets simultaneously.

It also had the effect of dignifying the development of more risk transfer products as “completing the markets”, when markets as complete as Arrow and Debreu envisioned could never be obtained. Individuals can’t anticipate how reality will unfold far out enough to ever specify the needed contingencies (say hedging the risk that you might be ten minutes late to a client meeting could cause you to fail to win a possible piece of business). As economic historian Mark Blaug put it:

Following the methodological standard learned sitting at the feet of Arrow and Debreu, a modem economist would rather say little precisely than much vaguely. If there is such a thing as “original sin” in economic methodology, it is the worship of the idol of the mathematical rigor more or less invented by Arrow and Debreu in 1954 and then canonized by Debreu in his Theory of Value five years later, probably the most arid and pointless book in the entire literature of economics.

Note how a prototypical discussion of the merits of financial innovation, from a speech by Timothy Geithner in March 2007, assumes the virtue of more advanced hedging tools:

One of the widely presumed benefits of the last go-round of what passed for innovation in the money world was that it allowed for more sophisticated hedging and risk sharing.

Over a long period we have seen innovations ranging from the syndication of bank loans and the direct provision of credit through the capital markets, to the spread of asset-backed securities and products that separate different parts of the payments stream and different dimensions of the risk in a credit obligation into different instruments.

These changes have contributed to a substantial reduction in the share of total credit held by banks. They have produced a greater separation or distance between the entity that first arranges a loan and those who end up holding the risk, and more intermediaries in that chain. And they have contributed to a dramatic increase in the number and diversity of creditors to any individual borrower, and a greater capacity to actively trade credit risk…

But there is a mundane and more subtle reason to be skeptical of these risk transfer arrangements. The fact that some is good does not necessarily lead to the conclusion, contrary to Arrow and Debreu, that more is better.

The first is that these new products were sufficiently complex and opaque that risks were too often dumped on the hapless who didn’t know what they were buying. We’ve seen everything from German Landesbanken, Norwegian villages, Australian pension funds, Jefferson County and a host of other municipalities buying products or entering into swaps they didn’t understand. Even the supposedly sophisticated Harvard endowment pushed way out on the risk curve with lots of illiquid investments and derivatives, to its undoing. For the first set, they were given assurances by salesmen and lacked the sophistication to make an independent assessment of the risks. In the case of Harvard and many of the other risk seeking endowments, true belief in the brave new world of finance, compounded by years of apparent success, led to overconfidence, a surprisingly naive pursuit of return with insufficient attention to the downside potential.

The less obvious concern is that the view that more hedging tools (which presupposes more hedging) is ever and always a god thing assumes the users can make smart decisions about to how to use them. The classic argument, offered by Myron Scholes among others, is that business people should worry about making their business run better and lay off the risks they can shed. The argument is that hedging is cheaper than equity.

But that presupposes a God’s eye view of when to pass those risks and how far out to hedge them along. Look at the (comparatively) simple case of airlines and fuel costs. Airlines watch the energy markets intently, yet regularly hedge (as in lock in, since my impression is that most use futures rather than the far more costly long dated options would be) fuel prices, often at the worst moment. How many panicked when oil went north of $110 a barrel?

In a competitive business, getting it wrong doesn’t merely mean a quarter or two of lower earnings than you’d have otherwise (and remember, if you muff it badly, you can show net losses). No matter whether the cash flow shortfall relative to competitors that did better is small or large, wrong footing it puts the company at a comparative disadvantage. It has less in the way of funds to invest or use as cash buffers (although with the until this year of companies running lean, many would have paid it out in some combination of dividends, share repurchases, and goodies for top management, so the competitive implications in reality were probably less than in theory).

If a company has exposures of any complexity and wants to hedge, assessing the alternatives of how to execute the hedges is not trivial, particularly one decides to manage the hedges actively. Thus the idea that you can have a tidy specialization, with businesspeople simply laying off risk onto more savvy risk management types, is spurious. To do an adequate job, you need to have at least a base level of competence. Given the propensity of financial firms to take advantage of widows and orphans, a caveat emptor posture and investment in attaining a higher level of expertise seems prudent.

When does the frictional cost of having these all these savvy and highly paid risk professionals (who may overengineer matters to justify their own existence) become counterproductive relative to the real performance gains? Funny that that the cutting edge quants haven’t turned their modeling skills loose on that question.

There are two schools of thought on financial innovation. One is the mainstream view, repeated faithfully by a compliant media, that financial innovation is really really important and under no circumstances must be threatened. Then we have the Old Fart view, best represented by two men who by any standards ought to have retired by now: Paul Volcker and Martin Mayer. Volcker deems the ATM to be the most important financial innovation of the last 30 years. Martin Mayer tartly noted,

Innovation allows you to go back to some scam that was prohibited under the old regime. How can you oppose innovation? The fact that the whole purpose of the innovation is to get around the existing regulation never seems to occur to regulators or members of Congress.

And the moderate view comes from a dead man, John Maynard Keynes:

When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.

While Keynes disapproves of side bets taking the pride of place in capital markets, th implication is that there is a level of trading and speculation that is positive for an economy. But how to determine where the threshold is?

I’ve been plenty skeptical of many of the financial innovations of the last decade and find myself hard pressed to put much stock in their defenses. I remember taking an instant dislike to credit default swaps. Increasing the liquidity of credit risk, even assuming it worked as advertised, seemed guaranteed to mean that everyone would be more casual about assuming it. If you are stuck with a lending exposure, even if you can sell the paper but it is not terribly liquid, you ponder taking it on more seriously than if you believe you can get out of it readily. And on top of that, CDS settlements in some bankruptcies have been lower than the expected loss on the bonds (witness Delphi).

Other defenses of CDS were that you could use them to create synthetic bonds. Did investors thought there was a shortage of corporate bonds? Another argument was that CDS would lower the cost of borrowing for corporations by making the markets more efficient. I’d be curious to see if there was any empirical evidence to support that contention. By contrast, there is considerable evidence that starting in 2006, CDS wound up increasing the cost of borrowing. The first except is from a Bloomberg story in early 2007:

The higher costs are an unintended consequence of securities that allow investors to speculate on corporate creditworthiness. So-called correlation models used to value them have become unreliable in the fallout from the U.S. subprime mortgage crisis. Last month some showed the odds of a default by an investment- grade company spreading to others exceeded 100 percent — a mathematical impossibility, according to UBS AG.

“The credit-default swap market is completely distorting reality,” said Henner Boettcher, treasurer of HeidelbergCement in Heidelberg, Germany, the country’s biggest cement maker. “…

The problem started in the second half of last year when subprime mortgage delinquencies started to rise, causing investors to retreat from complex instruments such as synthetic collateralized debt obligations, or packages of credit-default swaps that became hard to value. The swaps are contracts based on bonds and used to speculate on a company’s ability to repay debt.

As values of CDOs began to fall, banks that had sold swaps underlying the securities started to buy indexes based on them instead, a method of hedging their losses on portions of the CDOs they owned. The purchases are driving the cost of the contracts higher, raising the perception that company bonds tied to the swaps are suddenly riskier and leading investors to demand higher yields throughout the corporate debt market….

“The banks that have been using correlation to calculate their risk will have to go back to scratch,” said Janet Tavakoli, president of Chicago-based Tavakoli Structured Finance. “By using correlation models as the main means of risk management, the engineers threw out sound banking practices.”….

The mathematical breakdown is compounding the decline by creating a vicious circle. As the cost of the swaps on the CDX index increases, the models signal a greater risk of defaults, and vice versa. A bank holding $100 million of the highest-rated portion of a swap-based CDO now has to buy $60 million of swaps to maintain its hedge against losses, JPMorgan said. A year ago, it would have had to buy $10 million.

Note this problem started in 2006, and I suspect is due to AIG ceasing writing CDS.

Now I may be unfair and unimaginative, but I also react skeptically when I read stuff like this (from the Economist):

Enormous though the cost of bailing out the banks has been, there is nothing inherently undeserving about finance; even in their flawed state, more liquid markets have brought huge benefits to the rest of the economy. The lower cost of capital has made it easier for industry to invest, innovate and protect itself against interest and exchange-rate risk. Trying to single out financiers from entrepreneurs is a fool’s errand: you will end up hurting both.

The reason I have doubts about the ability of companies to use financial products as effectively as the Economist says is that there is plenty of evidence even with simple products that they don’t get it right (how many times have you read of an airline hedging oil at precisely the wrong time and raising rather than lowering their costs). And last year, lots of exporters to the US hedged against a falling dollar and paid for it.

And if you think investors got snookered by complex products, do you think corporate treasury departments are in a much better position? Yes, there are some that are world class savvy. But that is far from universal.

But the real problem is that in many cases, their underlying exposures have too much optionality for them to be able to be hedged affordably. Consider Motorola (I was involved an eternity ago in working with them after their treasury incurred big losses with wrong footed currency hedges (my client was a derivatives trading firm that was giving them access to their trading system on an ASP basis, this before ASP was an established concept). Motorola 15 years ago closed its books every two hours, an amazing feat. But even with an unheard-of understanding of its positions on a current basis, its ability to project out its exposures had important constraints.

Say it is assembling cell phones in Korea, with chips from Taiwan. But when the phones are made, they could be shipped to Italy or Norway or Poland. How do you hedge that? Not much of its business was subject to long term contracts or predictable orders. With extended supply chains and more and more companies moving to demanding more responsiveness from their suppliers, I suspect the number of companies in the sort of situation that Motorola faced has not gotten smaller.

Financial economics holds that creating more derivatives is ever and always better, but my instinct, per Keynes, is that there is a level beyond which more is in fact sub optimal. But I am certainly not able to prove that, much the less suggest how to ascertain when so called financial innovation is in fact at the expense of the real economy. Reader discussion very much encouraged.

This was too cool to leave as a mere Antidote du Jour.

Is this what geeks do for fun in New Zealand Wales?

If the video plays in a herky-jerky fashion, try viewing it here. Enjoy!

At the risk of losing all cred with tech enthusiast readers, let me use a suggestion (from Dwight) as a point of departure:

I thought I would recommend that you both consider adopting Twitter as part of your blogging presence in 2009.

Twitter was organized in 2006 and hit 6 million registered users by the end of 2008 a 600% increase over the prior year. Facebook recently offerred to purchase Twitter for $500 million in stock but the offer was rejected. Google has also been thinking about Twitter [many examples of who is using it and why, with links]…

At a minimum, even if you choose not to tweet on Twitter, you can at least feed your blog posts to Twitter via Twitterfeed.

Now even though I probably in the end relent and wind up feeding posts on Twitter, I am deeply troubled by a communication medium that limits messages to 140 characters, and I’ll return to that shortly.

But before readers brand me as a hopeless Luddite, let me stress that I am fussy about technology. Compared to other mere mortals (as compared to developers and serious technologists), I tend to be either bleeding edge or late and reluctant. I had a NeXT computer as soon as it was out of beta, was using e-mail and the Internet in 1991. I tried cell phones and the Palm early, concluded I didn’t have much use for either. I was in Verizon’s New York DSL trial (the first broadband available here, and the one and only time I have ever seen Verizon show up for an appointment promptly and perform efficiently). I was one of Vonage’s (VOIP) very early customers and went through the brain damage of making it work from Australia.

So why do I hate Twitter? Twitter is troubling reminiscent of Newspeak, the language being developed by Oceania in George Orwell’s 1984 to control thought.

Orwell, in an appendix, describes the principles of Newspeak, and they are directed towards simplifying language so as to void it of inconvenient (for the power structure) propensities of thought:

The purpose of Newspeak was not only to provide a medium of expression for the world-view and mental habits proper to the devotees of IngSoc, but to make all other modes of thought impossible. It was intended that when Newspeak had been adopted once and for all and Oldspeak forgotten, a heretical thought — that is, a thought diverging from the principles of IngSoc — should be literally unthinkable, at least so far as thought is dependent on words. Its vocabulary was so constructed as to give exact and often very subtle expression to every meaning that a Party member could properly wish to express, while excluding all other meaning and also the possibility of arriving at them by indirect methods.

Now what does that have to do with Twitter, one might ask? Well, while the main means by which Newspeak was implemented was simplifying and subtly changing the inference of words, another element was the extreme condensation of communication:

Regularity of grammar was always sacrificed to it when it seemed necessary. And rightly so, since what was required, above all for political purposes, was short clipped words of unmistakable meaning which could be uttered rapidly and which roused the minimum of echoes in the speaker’s mind…..So did the fact of having very few words to choose from. Relative to our own, the Newspeak vocabulary was tiny, and new ways of reducing it were constantly being devised. Newspeak, indeed, differed from most all other languages in that its vocabulary grew smaller instead of larger every year. Each reduction was a gain, since the smaller the area of choice, the smaller the temptation to take thought. Ultimately it was hoped to make articulate speech issue from the larynx without involving the higher brain centers at all…..

And it was to be foreseen that with the passage of time the distinguishing characteristics of Newspeak would become more and more pronounced — its words growing fewer and fewer, their meanings more and more rigid, and the chance of putting them to improper uses always diminishing.

Now the idea that have people communicate often within 140 characters and thought control seems awfully remote, no? Particularly since this is voluntary, customer driven, right?

I am not at all certain. I notice in reactions to my blog posts, which are often pretty lengthy, that readers sometimes miss important nuance in what I or readers I have cited say, or (just as bad) project onto what I have written something I never said (as I noted earlier today, I have written often about growing unrest in China, and too often, I get comments arguing that I am all wet to be predicting that China will fall apart. Huh? I never said anything about violent overthrow of the government).

Now this could just be normal comprehension issues. But I notice how the Internet has affected how I read. I have become impatient with longer stories (unless I am on an airplane). I spend most of my time on the Internet, and the vast majority of what I read fits within the browser window. I find that has conditioned my expectations. When confronted with a longer piece (say Sunday New York Times magazine feature or New Yorker length) I find after the first page wondering if it really had to be this long, and often not finishing the piece. Five years ago, I never would have responded this way.

You can’t say anything complicated or nuanced in 140 characters. I am sure readers will provide some cute counterexamples, but try explaining Plato’s cave in those confines. Can’t be done. You might allude to it, but you could not present it to someone who didn’t know about it already. And Twitter encourages people to accept a medium that severely constrains communication, and calls a defect a virtue.

Marshall McLuhan was right.

I have a second issue with Twitter, and mobile communications generally, I can’t control how they are used, but I see them as having a corrosive effect on interpersonal relations.

It’s one thing to take calls, check texts tweets, or the news when out and about by yourself. But it has become the norm to take them when meeting with others. That reduces the quality of the interaction and sends a message that the person you are with is merely an option, other options are ever present and must be assessed, maybe exercised.

For those in high urgency professions (doctors, traders) I can see this being acceptable. And everyone has occasions when they need to be on the alert for news, a call, or a text. But this has become routine.

Humans are a social species, with very big limbic brains (the emotional center) and smaller cerebral cortexes (the seat of higher reasoning). I cannot prove the connection, and doubtless many factors are in play, but the US is a society where enormous numbers of people take anti-depressants and brain chemistry altering chemicals, either to elevate their mood or improve performance in some way (and those are the legal drug users. BTW, the most recent data I could find was 2005, that anti-depressants are the most widely prescribed drugs in the US, with 118 million prescriptions written that year). That says something is deeply amiss.

We have a lot of other factors contributing to the erosion of social structures: high divorce rates, short job tenure (and now high unemployment), rising demands for on-the-job productivity (computers and the Internet are a double-edged sword: you can do more, but expectations have risen accordingly). These are clearly the big drivers, but I have to think that the degrading of routine interactions and the expectation (in at least some circles) that people multi-task, when the evidence is that it does not increase productivity, has to play a role.

Twitter feeds that addiction, that false sense of urgency. Most things can wait. Indeed, a lot of things are better off waiting. But we are encouraged to be plugged in, overstimulated all the time, at the expense of higher quality human relations.

I don’t want to contribute to the problem by participating in this sort of thing, but I suspect I will give in to practical realities.

The oil-rich countries of the Middle East have some advantages in pursuing the “green” energy market. First, they have pools of investment capital they can turn to this purpose. Possibly more important than access to money is that the funding sources may be willing to take a longer term horizon and lower returns than US investors.

Second, diversifying out of oil is a strategic imperative for the Gulf, and energy is a logical target The US may aspire to leadership in this field, but it does not appear that we have a Manhattan Project or Sputnik response level of urgency.

Offsetting this is the fact that the area is not known as a breeding ground of innovation, but if the Gulf States can attract a critical mass of talent, they might be able to turn that around. The New York Times article describes that they are forming relationships with top schools such as MIT.

From the New York Times:

….even as President-elect Barack Obama talks about promoting green jobs as America’s route out of recession, gulf states, including the emirates, Qatar and Saudi Arabia, are making a concerted push to become the Silicon Valley of alternative energy.

They are aggressively pouring billions of dollars made in the oil fields into new green technologies. They are establishing billion-dollar clean-technology investment funds. And they are putting millions of dollars behind research projects at universities from California to Boston to London, and setting up green research parks at home.

“Abu Dhabi is an oil-exporting country, and we want to become an energy-exporting country, and to do that we need to excel at the newer forms of energy,” said Khaled Awad, a director of Masdar, a futuristic zero-carbon city and a research park that has an affiliation with the Massachusetts Institute of Technology, that is rising from the desert on the outskirts of Abu Dhabi.

These are long-term investments in an alternative energy future that neither falling oil prices nor the global downturn seems likely to reverse….

This new investment aims to maintain the gulf’s dominant position as a global energy supplier, gaining patents from the new technologies and promoting green manufacturing. But if the United States and the European Union have set energy independence from the gulf states as a goal of new renewable energy efforts, they may find they are arriving late at the party.

“The leadership in these breakthrough technologies is a title the U.S. can lose easily,” said Peter Barker-Homek, chief executive of Taqa, Abu Dhabi’s national energy company. “Here we have low taxes, a young population, accessibility to the world, abundant natural resources and willingness to invest in the seed capital.”…

To hedge their positions, then, an increasingly sophisticated generation of largely Western-educated leaders in the Middle East are seizing on green business opportunities, by seeding research in faraway nations.

The crown prince of Abu Dhabi, the wealthiest of the seven emirates that make up the United Arab Emirates, announced last January that he would invest $15 billion in renewable energy. That is the same amount that President-elect Obama has proposed investing — in the entire United States — “to catalyze private sector efforts to build a clean energy future.”

Masdar, the model city that will generate no carbon emissions, is tied to the crown prince’s ambitions. Designed by Norman Foster, the British architect, it will include a satellite campus of the Massachusetts Institute of Technology, as well as a research park with laboratories affiliated with Imperial College London and other institutions.

In Saudi Arabia, the new state-owned King Abdullah University of Science and Technology, or Kaust, gave a Stanford scientist $25 million last year to start a research center on how to make the cost of solar power competitive with that of coal. Kaust, now in its first grant cycle, also gave $8 million to a Berkeley researcher developing green concrete.

And it has other agreements as well, with Caltech, Cambridge, Cornell, Imperial, La Sapienza, Oxford and Utrecht, to name just a few.

In November, the Qatari government signed an agreement with Britain’s visiting prime minister, Gordon Brown, to invest £150 million, or more than $220 million, in a British low-carbon technology fund, dwarfing the fund’s investments from home…

“The impact has been enormous,” said Michael McGehee, the associate professor at Stanford who received the $25 million Saudi grant. “It has greatly accelerated the development process.”