(This brief history of regal extortion draws some parallels to today’s “sinister” Federal Reserve, though the links are less tenuous than Dr. Hoye and others often suggest…)
With a degree in geophysics and a number of fascinating summers in mining exploration, one winter in “the bush” quickly led Bob into the financial markets. This included experience on the trading desk and in the research department of a large investment dealer, which led to institutional stock and bond sales.
Bob’s review of financial history provided the forecasting models designed to anticipate significant trend reversals in the sometimes alarming volatility typical of the transition from rampant speculation in tangible assets to fabulous speculation in financial assets.
One would have hoped that financial rip-offs committed by medieval princes would have been permanently shelved when liberal enlightenment ended the divine right of kings. Recent imperious announcements by Chairman Bernanke to use the “printing press” to inflate anything they can should be considered startling only in the resort to honesty. Euphemisms for currency depreciations started with the original promoters of the Fed and the tout was that a “flexible” currency would prevent serious financial contractions.
Although policymakers have been convinced that currency depreciation would keep every “recovery” going, the 95 percent depreciation of the dollar’s purchasing power has exaggerated the booms and busts. This is particularly ironical as government intervention did not prevent massive contractions such as with the commodities collapse of 1921 and with the collapse of virtually everything after 1929. Moreover, the timing and percent declines on this fall’s crash replicated those of 1929 with remarkable fidelity. That infamous crash had replicated the 1873 example.
Pity the nation that wears a cloth it does not weave,
eats a bread it does not harvest,
and drinks a wine that flows not from its own wine-press.
Pity the nation that acclaims the bully as hero,
and that deems the glittering conqueror bountiful.
Pity the nation that despises a passion in its dream,
yet submits in its awakening.
Pity the nation that raises not its voice
save when it walks in a funeral,
boasts not except among its ruins,
and will rebel not save when its neck
is laid between the sword and the block.
Pity the nation whose statesman is a fox,
whose philosopher is a juggler, and whose art is the art of patching and mimicking.
Pity the nation that welcomes its new ruler with trumpetings, and farewells him with hootings,
only to welcome another with trumpetings again.
Pity the nation whose sages are dumb with years and whose strong men are yet in the cradle.
Pity the nation divided into fragments, each fragment deeming itself a nation.
(Over-the-counter gambling on the markets has been around much longer than modern derivatives pundits would have you believe. The New York Times was warning against “casino capitalism” as early as 1905, when side bets on market movements were both commonplace and unregulated, and won the attention of an American government still swaggering after its victory over the mega-trust companies of the late 19th century. The following 60 Minutes segment discusses both the nature of CDS instruments and how they’ve become just as dangerous today as they were in the “bucket rooms” or gambling houses of the 1920s…)
(With all eyes on traditional residential mortgages, analysts are now looking for clues in related asset classes for any signs of recessionary contagion. In his weekly review of the U.S. economy, Nouriel Roubini highlights the vulnerability of commercial mortgage back securities – which typically lag their residential cousins by 2 years – as well as plunging retail sales, a worsening inventory cycle, and the soaring fiscal deficit…)
The current U.S. and global economic conditions, remain at the very least quite challenging. The good news is that President-elect Barack Obama has unveiled a first rate economic team to drive the economy towards the recovery. Larry Summers, Tim Geithner and Christina Romer are certainly top rated experts and excellent choices to address this most severe financial and economic crisis. The bad news is that the recovery is not in sight yet and won’t be for some time.
The most recent set of events and the string of economic data are a clear sign that the crisis is not over, and the worst might very well be ahead of us. On the one hand, consumer confidence got a boost from falling oil prices and new leadership in the U.S. government. On the other hand, yesterday’s Conference Board report confirms that the economy is in a deep recession (the confidence index is still at the lowest level on record since 1975) and points to further consumer spending declines in the coming quarters. The release of preliminary Q3 real GDP growth in the U.S. (revised down to -0.5% from the initial -0.3%) displayed a downward revision to personal consumption from the original -3.1% down to -3.7%. Consumption is expected to be a significant drag on the economy for a while. Analysts estimate that the fall in energy prices – a reflection of falling U.S. demand and a by-product of the fact that this severe recession is a global one – will boost real U.S. income by roughly $200bn (1.5% of GDP) but it is also. On the back of this, U.S. home prices keep falling, equity prices may still be very far from the bottom and employment losses are mounting.
(Faith in the underlying mechanics of portfolio theory and market efficiency has certainly contributed to humanity’s greatest leap forward in wealth, productivity, private innovation, and global integration. But that same numerology has since crippled our aging financial system and triggered the worst global recession in nearly a century. Perhaps it’s time to reassess the value – and the logic – of bleeding edge finance.
As Professor Janeway points out in the following interview, treating securities like molecules, subject to the same variable distributions, “random walks”, differential equations, and reductionist math simply compounds the short-sighted actions of a few scientists-turned-gamblers. Not only does it greatly overstate the predictive power of econometric analysis, but it also understates the tremendous dangers of financial engineering.
Having studied the basic principals of both the capital markets and the broader macroeconomy at the peak and trough of our latest business cycle, these basic investment theses simply reek of oversimplification. Worse still, the theories have become irrefutable “laws” of finance and their creators knighted as Nobel prophets – names like Black, Scholes, Merton, Miller, Modigliani, and Markowitz – as balance sheets swelled and derivatives became increasingly complex.
As Janeway suggests,”It was a kind of religious movement, a willed suspension of disbelief.” For those interested in how so many bright people could make such bad decisions for so long, this is definitely worth the read…)
To continue our search for understanding as to the antecedents of today’s financial mess, we turn to one of the smartest private equity investors on Wall Street, William H. Janeway. Bill is a Managing Director and Senior Advisor of Warburg Pincus, and now a lecturer at Cambridge University, where he received his doctorate in economics as a Marshall Scholar. The youngest son of Elliot and Elizabeth Janeway, Bill’s friendship and advice are highly valued by his clients and associates. We asked him to put the current financial crisis in context based upon his nearly two decades as a professional money manager, banker and economist. We spoke to Bill in his office in New York several weeks ago as the financial markets were tumbling.
The IRA: So Bill, you picked an interesting week to be back in New York. We actually started posting equity volatility numbers on our web site just for kicks. They are mostly in triple digits. How did we get into this mess?
Janeway: It took two generations of the best and the brightest who were mathematically quick and decided to address themselves to the issues of capital markets. They made it possible to create the greatest mountain of leverage that the world has ever seen. In my own way, I do track it back to the construction of the architecture of modern finance theory, all the way back to Harry Markowitz writing a thesis at the University of Chicago which Milton Friedman didn’t think was economics. He was later convinced to allow Markowitz to get his doctorate at the University of Chicago in 1950. Then we go on through the evolution of modern finance and the work that led to the Nobel prizes, Miller, Modigliani, Scholes and Merton. The core of this grand project was to reconstruct financial economics as a branch of physics. If we could treat the agents, the atoms of the markets, people buying and selling, as if they were molecules, we could apply the same differential equations to finance that describe the behavior of molecules. What that entails is to take as the raw material, time series data, prices and returns, and look at them as the observables generated by processes which are stationary. By this I mean that the distribution of observables, the distribution of prices, is stable over time. So you can look at the statistical attributes like volatility and correlation amongst them, above all liquidity, as stable and mathematically describable. So consequently, you could construct ways to hedge any position by means of a “replicating portfolio” whose statistics would offset the securities you started with. There is a really important book written by a professor at the University of Edinburgh named Donald MacKenzie. He is a sociologist of economics and he went into the field, onto the floor in Chicago and the trading rooms, to do his research. He interviewed everybody and wrote a great book called An Engine Not a Camera. It is an analytical history of the evolution of modern finance theory. Where the title comes from is that modern finance theory was not a camera to capture how the markets worked, but rather an engine to transform them.
With a degree in geophysics and a number of fascinating summers in mining exploration, one winter in “the bush” quickly led Bob into the financial markets. This included experience on the trading desk and in the research department of a large investment dealer, which led to institutional stock and bond sales.
Pity the nation that wears a cloth it does not weave,
The current U.S. and global economic conditions, remain at the very least quite challenging. The good news is that President-elect Barack Obama has unveiled a 
As Professor Janeway points out in the following interview, treating securities like molecules, subject to the same variable distributions, “random walks”, differential equations, and reductionist math simply compounds the short-sighted actions of a few scientists-turned-gamblers. Not only does it greatly overstate the predictive power of econometric analysis, but it also understates the tremendous dangers of financial engineering.