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Monday, September 22, 2008

Econ 101

It has been a wild two weeks for the American economy, and we haven't hit bottom yet. We should prepare for the worst, and readjust our expectations that the good times are just around the corner. Many Americans have an asset problem right now. Their savings are tied into their homes and their 401ks, two products that have not grown for a few quarters. We do not have true savings, and thus zero liquidity. In an economic downturn, this is BAD news. My father taught me from an early age to always, always have cash at hand. We Americans must save our way through this economic crisis.

OK, but what about a macro economic view? Well, John Lanchester in last weeks London Review of Books gives a wonderful primer on exactly how we find ourselves in this mess:

The complexity is such that even the people who know what they’re doing don’t always know what they’re doing. Derivatives are extensively used in arbitrage. That’s the name of investments which effectively bet both ways on the market, exploiting small differences in price to make what should be risk-free profits. (It’s what Leeson was supposed to be doing, exploiting tiny differences in the price of Nikkei 225 futures between the Osaka Securities Exchange, where trading was electronic, and the Singapore International Monetary Exchange, where it wasn’t. The gap in price would last only for a couple of seconds, and in that gap Barings would buy low and sell high – a guaranteed, risk-free profit.) The complexity of the mathematics involved in derivatives can’t be exaggerated. This was the reason John Meriwether, a famous bond trader, employed Myron Scholes – of the Scholes-Black equation – and the man with whom Scholes shared the 1997 Nobel Prize in Economics, Robert Merton, to be directors and cofounders of his new hedge fund Long-Term Capital Management. (A word on the term ‘hedge fund’: it is misleading. Hedge funds are pools of private capital, operating without the legal restrictions that affect other forms of collective investment. Many of them make big bets on the markets, using super-sophisticated rocket-sciencey investment techniques.) The idea was to use these big brains to create a highly leveraged, arbitraged, no-risk investment portfolio designed to profit whatever happened, whether the market went up, down, sideways or popped out for a cheese sandwich. LTCM quadrupled in value in its first four years, then imploded in the chaos that followed Russia’s default on its foreign-debt obligations in 1998. The fund had equity – that’s to say, actual money you could put your hands on – of $4.72 billion, which sounds pretty healthy, except that it was exposed, thanks to the miracles of borrowing, leverage and derivatives, to $1.25 trillion of risk. So if it went broke, LTCM would leave a $1.25 trillion hole in the global financial system. The big brains had made a classic mistake: they treated a very unlikely thing (the default and its consequences) as if it were impossible. As Keynes once observed (he who made himself and his college rich by spending half an hour a day in bed playing the stock market), there is nothing so disastrous as a rational policy in an irrational world.

The global economy has been run by statisticians and professional gamblers for far too long. Individuals who believe they can model a market flawlessly will lose money flawlessly. It is that simple. If someone comes across as too bright for their own good, they most likely are. We should not bail out these individuals or companies because it only rewards irresponsible behavior. It is the same as giving a drunk the money to get his vehicle out of the city pound. I do not believe markets need to be heavily regulated, but I do believe that there should be appropriate consequences for ridiculous risks.

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