Regulation and Financial Complexity

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CFTC Commissioner J. Christopher Giancarlo said,

At the heart of the 2008 financial crisis was the inability of regulators to assess and quantify the counterparty credit risk of large banks and swap dealers. The legislative solution was to establish swap data repositories (SDRs) under the Dodd-Frank Act. Although much hard work and effort has gone into establishing SDRs and supplying them with swaps data, seven years after the financial crisis the SDRs still cannot provide regulators with an accurate picture of bank counterparty credit risk in global markets. That is because international regulators have not yet harmonized global reporting protocols and data fields across international jurisdictions. Certain provisions of Dodd-Frank actually hinder such harmonization, despite widespread bipartisan legislative support for their correction over the past two Congresses.

Pointer from Timothy Taylor. Read the whole speech, which is wide-ranging and thought-provoking. Among other topics, Giancarlo discusses the significance of blockchain and the outsized role of the Fed in key securities markets due to its enlarged balance sheet.

My view is that the financial market is a complex, adaptive system, and attempts to reduce systemic risk will backfire. Several years ago, I focused on the discrepancy between knowledge and power. Regulators seek more and more power, and at times they get it. But what they really lack, and will never possess, is the information needed to understand market processes well enough to be able to predict the ultimate effect of regulation on behavior. That information is dispersed, so that no one individual or regulatory body can obtain it.

How to Defeat ISIS

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In most cases, civilized soldiers have defeated primitive warriors only when they adopted the latter’s tactics. In the history of European expansion, soldiers repeatedly had to abandon their civilized techniques and weaphons to win against even the more primitive opponents. The unorthodox techniques adopted were smaller, more mobile units; abandonment of artillery and use of lighter smaller arms; open formations and skirmishing tactics; increased reliance on ambushes, raids, and surprise attacks on settlements; destruction of the enemy’s economic infrastructure (habitations, foodstores, livestock, and means of transport); a strategy of attrition against the enemy manpower; relentless pursuit to take advantage of civilization’s superior logistics; and extensive use of natives as scouts and auxiliaries.

This is from Lawrence Keeley, War Before Civilization: The Myth of the Peaceful Savage, published in 1996, as quoted in Peter Turchin’s Ultrasociety. Turchin goes on to write,

There is no question that civilized states almost always prevail against tribal warriors in the end, but they do so primarily because they are large-scale societies fighting small-scale societies. . .guerrillas simply avoid battles against the numerically and technologically superior government forces.

Both primitive warriors and modern guerrillas rely not on brute force but on mobility, stealth, and surprise.

And a few pages later,

The distinguishing characteristic of human combat is the ability to strike from a distance coupled with mobility.

Actually, on the topic of defeating ISIS, I confess to being to the dovish side of President Obama at this point. I think that an actual war to defeat ISIS would be bloody and brutal. Meanwhile, it strikes me as wrong to be engaging in acts of war with no formal declaration of war and at best a vague commitment to winning.

If the point of not sending in our people (I hate the term “boots on the ground”–as if we were talking about inanimate leather artifacts) is that this is someone else’s war, then I think that is an argument for staying out of it altogether. The counter-argument is that ISIS are really bad people, they could get worse before they get better, and some of their badness spills over into this country. Maybe the counter-argument is right, and I could see myself making it at some point. But as of this moment, I think that on balance the better policy is to avoid involvement altogether.

Separately, Amar Bhide arrives at the same conclusion, but by a slightly different route, stressing the evils of colonialism. I think Bhide assigns too much blame to colonial history, when there are also other sources of problems in the region. For example, I doubt that anyone would try to trace the Sunni-Shi’ite conflict to western imperialism.

The Perils of Angel Investing

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You know I just had to read an article with the title Why I stopped angel investing (and you should never start). Tucker Max writes,

I can think of two portfolio companies specifically, both of which have raised major rounds from big name VC funds, where I have to actively refrain from punching founders in their stubborn, arrogant faces.

Actually, the sentences that I related to the most were these:

personally, I gotta be in the arena, competing, putting myself on the line. I can’t just watch. Once I understood this, the decision to stop angel investing was pretty clear.

I noticed this when someone put me in touch with the head of a firm that does early-stage investments. She showed me a few companies they were investing in, and I found that all I could think about was how I would position the companies differently and take different approaches in terms of staging their business. It does not matter whether I was right or wrong, but it showed me that I could not just sit back and watch someone else use my money to do things that I would not do if I were running the business myself. It would be way too stressful for me.

Finally, about successful angel investors, he writes,

they have the social clout to not get run over by VC’s and literally pushed out of an investment.

That’s the most frustrating part of angel investing. You manage to actually back a winner, and then a VC firm with clever lawyers just takes it away from you for nothing.

Opaque Leverage and Self-Deception

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Regarding the movie The Big Short, Tyler Cowen wrote,

There is no central villain, none whatsoever. The filmmakers succeed in showing how the collective actions of many, operating together, can give rise to structural problems and systemic risk. And yet the story remains suspenseful.

People prefer stories with villains.

I think that the story of the financial crisis has to include leverage. Individual home buyers did not put up much of their own capital. The lenders did not put up much of their own capital. The mortgage securities were structured and rated so that banks could hold them with minimal capital.

However, some of this leverage was opaque. People did not understand the way that AIG was contractually obligated to put up billions in collateral if prices moved against them. People did not understand that while Fannie Mae and Freddie Mac were reporting that their sub-prime exposure was less than 2 percent, their exposure to risky loans was closer to 30 percent. People did not understand that mortgage securities rated AAA were not really comparable to AAA-rated bonds. People did not understand that banks had created “structured investment vehicles” and other dodges that made them much more levered than they appeared to be. And by “people,” in all cases I mean regulators and investors.

But finally, the opaque leverage was less intentional bad behavior on the part of financial executives than it was self-deception. Suppose that you had asked executives in 2007 to answer honestly, “Relative to what people outside the firm think, how exposed are you to a decline in house prices and problems in the mortgage market?” My guess is that almost all of them would have said, “We are less exposed than other people think.” And they would have been telling the truth from their point of view.

That is what made the speculators in The Big Short so special. They managed to dig through to reality.

And don’t forget that I coined the term, “Suits vs. Geeks Divide.”

Socialism and Income Distribution

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John Hinderaker writes,

Only under socialism could Fidel Castro become the richest warlord, relative to his subjects’ wealth, in recorded history. (And that was the least of his sins.) Only under socialism could Maria Gabriela Chavez, daughter of socialist tribune of the people Hugo Chavez, beloved by the American left, waltz off with a $4 billion fortune. But then, she was a piker: Chavez’s Minister of the Treasury stashed $11 billion in Swiss bank accounts.

One way to acquire enormous wealth is to be perceived as an egalitarian.

Trolling Anarcho-capitalists

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That’s not what I’m really doing, although it may seem like it. A commenter writes,

things like eBay show that enabling cooperation (which does not require the use of force) provides advantages that overwhelm the costs of punishing defectors. In this regard economies of scale favor an-cap

Taking existing institutions as an existence proof for the feasibility of an-cap is not a valid argument. The fact is that eBay exists in a world with government. People who use eBay probably assume in the background that if a situation comes up where they think that they are getting shafted they can take the other party, or eBay itself, to a government court. That court will resolve the dispute, and everyone understands going in what that process will consist of. If we suddenly switched to an-cap tomorrow, that process would have to be worked out, and in the mean time, people might be a lot more cautious about undertaking transactions on eBay, or anywhere else for that matter.

I am suggesting that people see government as an institution that gives them confidence that disputes will be resolved in a reliable, peaceful way. If you take away government, you cannot be sure that people will still have that confidence, even if you think that in theory they should.

Jim Tankersley on Matt Ridley

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Tankersley writes,

Matt Ridley shares America’s eroding faith in institutions, but he doesn’t much believe in supervillains. He is a true libertarian, to an extreme you rarely see in American public discourse.

Similarly, I wrote that He offers full-frontal libertarianism.

Unfortunately, Tankersley goes on to say

In the world Ridley sketches in the book, everything will eventually work itself out for the better, thanks to free markets and survival of the fittest — so no one feels any obligation to try to change things for the good.

This is a straw man. No libertarian, including Ridley, expresses such a point view. Libertarianism is perfectly compatible with individuals feeling an obligation to change things for the good. What libertarianism rejects is the notion of equating “changing things for the good” with government planning and coercion. The day to day commercial activities of people change things for the good in an inexorable fashion, although the process works by trial and error, so it is never flawless. The attempts by politicians and government officials to change things for the good tend to work out less well on average.

Not So Renewable?

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Timothy Taylor writes,

annual global production of lithium has more than doubled from from about 16,000 metric tons in 2004 to over 36,000 metric tons by 2014. Even with this rise in quantity produced, the price of a metric ton of lithium carbonate has risen from $5,180 in 2011 to $6,600 in 2014.

He cites a report from Goldman Sachs on emerging themes, one of which is “Lithium is the new gasoline.” (The other claims in the report are also provocative.)

Changing our energy technology does not automatically eliminate scarcity. It is instead a form of substitution.

From the Comments

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On Debate is not about Debate

Back in the 1950’s, let’s say, I read your views in a book or magazine and wished to argue with them, I might have sent a letter to the editor or written an article of my own — preferably for a publication with high status (The New Criterion, say) or salience (Architectural Review) or visibility.(The Saturday Evening Post). I’d have to be reflective, I’d have to argue logically, I’d have to consider objections to my comments, etc. My piece would have to pass scrutiny by an editor and possibly be revised. And after that I’d have to wait for it to be published and for others to react, This was a slow process.

On the internet, I can react to opinions almost as quickly as I encounter them, with little screening for sense or relevance or accuracy. I can indulge my emotions IMMEDIATELY, which sadly provokes quick responses. And to make matters worse, a major source of satisfaction for internet commentators is getting their comments in particularly quickly, both to be noticed (“I’M FURZT DUDES!”) and to shape the discussion which follows.

I’m not sure if there’s a cure for this. My heart longs for the good old days of Little Magazines and earnest journalists living in garrets and Concerned Readers from the provinces penning their long Letters To the Editor. But that environment rested on exclusivity and economic supports of advertising and subscriptions which aren’t easily duplicated on the internet. It seems irrecoverable.

I would say that the Internet has given us three things, all of which are mixed blessings. I expect that Martin Gurri’s book, which I have just started [UPDATE: well, actually I have finished it, but as you know I work a lot with scheduling posts in advance, in part to discipline myself against reacting instantly], will speak to these.

1. More sources of information.

2. Less centralized filtering of information.

3. The ability to react instantly.

It is possible that all three of these are harmful to our culture. But I think that (1) and (2) can be more of a plus than a minus. (3) is what worries me. We are training people not to reflect, not to be charitable to those who disagree, not to try to open minds but to close minds–especially the minds of people who are inclined to agree with us. We encourage put-downs and “this one chart proves….” and ad hominem arguments.

My e-book The Three Languages of Politics describes the result: a strongly tribalized political culture, in which communication consists of signals that simplify issues so that they fall on each person’s preferred axis.