Naked Capitalism

I want to give a huge shout out to Yves Smith's blog Naked Capitalism and also to her book Econned. The book is slow reading but it seems essential to me to understand what was going on on Wall Street. Here is a particularly good article on Goldman. The comments are also interesting. And here is a very good article on Goldy by Steve Randy Waldman at Interfluidity.

There are some great books coming out now about the financial crisis and Washington is even getting excited. It is too bad that more people don't really understand this stuff (including said politicians). But I am cheered by the fact that Michael Lewis' The Big Short is now the number one nonfiction bestseller. Jonah Lehrer has a piece today at The Frontal Cortex about psychopathic behavior. The Goldy boys looked like the type to me.

13 Bankers

I'm now on page 135 (of 222) of this very clearly argued and compelling book by Simon Johnson and James Kwak. Best analysis I have seen so far. Seems that the repeal of Glass-Steagall was to allow Citigroup and Travelers to merge and to allow all the megabanks to get into the investment banking and insurance industries. I am coming slowly around to the conclusion that new regulations cannot work. At the least, they should not be about giving regulators more discretion. Regulators always end up getting captured by the industry. Thus, the solution is to break up the megabanks. They have too much economic and political power and have managed to bend the law to their advantage for too long.

Mike Konczai has a very nice reponse here to Paul Krugman. It is not either-or, regulations or break-up. Do both. But put a cap on size. At the risk of being blunt and boring, I see that as the message of Taleb's elephant story, too.

Johson and Kwak have argued that capital requirements will not work on their blog, and here is a more complicated version of the argument. Basically, megabanks can use accounting rules to hide their debt, which is what Lehman did with their repo 105 accounts. Which is what all the banks did with SIV's. There is a NY Times article today which argues that ultimately what we need is civil liability for such accounting lies.

The story of the move to deregulation is much more complicated than the progressive myth that it is all Reagan's fault. Carter supported it, too, and it worked for the airline industry. Deregulation movements began even earlier and arguments by economists began even earlier than that. John Cassidy captured some of the movement of ideas in his excellent How Markets Fail.

In spite of the fact that laissez faire was an ideology largely adopted by conservatives, which greased the wheels for financial deregulation, every solution that I seem to consider involving greater regulation seems futile, and thus pushes me to a more conservative position. More government won't work. What is needed is the Teddy Roosevelt solution. Megabanks have too much political power and must be broken up to preserve democracy. This also once again points to the fact that the ideology floating around in pop culture is mostly a distraction, as most "news" is noise. We cannot trust the politicians to fix it, nor the Supreme Court. We cannot trust the Fed, either. What is left?

Banksters and Black Swans

"Ward, we all want to be optimistic, that is why we get up in the morning every day even though we know what the end will bring, more taxes." That was a comment to me by a friend. Pretty funny stuff.

The Big Short by Michael Lewis was a page-turner that I had difficulty putting down. About the guys who really foresaw the financial crisis coming (no, not Thom Hartman). Now I have started 13 Bankers by Simon Johnson and James Kwak, who argue that Wall Street is the newest oligarchy and that the big banks need to be broken up, much like Standard Oil was during T.R.'s time. So far, so good. They recognize that Hamilton was essentially right about finance and Jefferson was wrong.

A debate seems to be coalescing around this issue. Here, Paul Krugman thinks this position is wrong and that regulation is what is needed. I find his argument that because small bank failures in the 1930's led to a crisis, it is not "bigness" that counts, not very convincing, just as I find his arguments for taxing Chinese goods unconvincing. Here, here and here are three Johnson/Kwak posts arguing their position. The jury is still out for me, but I am hoping regulation can work.

The unintended consequences of an action or inaction are always difficult to ascertain. My uncle argues that we never should have based a retirement system on the contributions of current workers to previous generations. This may be fundamentally correct. But Social Security is here to stay. I wonder if the principle, though, of fixing the current by imposing upon future generations does not contain a general lesson that we should learn. He thinks people will wake up someday and not be so "greedy." I am more pessimistic about the human condition. People believe that it would be unjust to take away benefits that they have been promised (like Madoff investors?).

Here is another possibly surprising unintended consequence. What if we had not funded the muhjadeen in Afghanistan and Russia still ruled the country? No weapons for crazy Islamist terrorists. No place for Al Qaeda to train for 9-11. No need to be there now.

I am not a big supporter of Thomas Friedman, but I think that here he is on the mark. Why should we expect anything to change in Afganistan or Palestine? Same old stuff. I think Obama's mission is going to fail. I guess the question is what were the real options? There are those who say we should stay until it is fixed. After all, "the surge worked." It seems rational to give it a chance, but I am glad that it is supposedly time-limited.

The Cold War strategies in general have had huge unintended consequences. The U.S. and Russia ended up arming the rebels of the world in their "the enemy of my enemy is my friend" type of thinking.

We truly have great difficulties predicting the future. Maybe this calls for a couple of quotes from Nassim Taleb, who has added a new chapter for the paperback edition of The Black Swan, which is available on-line by going to his website or The Browser at the bottom of this page.

"Second, Mother Nature does not like anything too big. The largest land animal is the elephant, and there is a reason for that. If I went on a rampage and shot an elephant, I might be put in jail, and get yelled at by my mother, but I would hardly disturb the ecology of Mother Nature. On the other hand, my point about banks in Chapter 14—that if you shot a large bank, I would “shiver at the consequences” and that “if one falls, they all fall”—was subsequently illustrated by events: one bank failure, that of
Lehman Brothers, in September 2008, brought down the entire edifice. Mother Nature does not limit the interactions between entities; it just limits the size of its units. (Hence my idea is not to stop globalization and ban the Internet; as we will see, much more stability would be achieved by stopping governments from helping companies when they become large and by giving back advantages to the small guy.)...

I was once selected to be one of a group of a hundred who went to Washington to spend two days discussing how to solve the problems of the crisis that started in 2008. Almost all the biggies were included. After an hour of meeting, and during a speech by the prime minister of Australia, I walked out of the room because my pain became intolerable. My back would start hurting upon looking at the faces of these people. The center of the problem is that none of them knew the center of the problem.

This makes me convinced that there is a unique solution for the world, to be designed along very simple lines of robustness to Black Swans—it will explode otherwise."

The Ancestor's Tale

I recently finished Richard Dawkins’ The Ancestor's Tale. It is a readable opus on evolution back to the beginning of life. It looks at history backward; each species came from a certain past but there was no inevitability that any species would survive. Evolution is a story of who has survived and there were many possible ways the world could have been. The advantage of looking backward is that we can avoid the temptation to attribute to our ancestors any drive to progress or other teleological mechanism which suggests our destiny.

All apes share an geneological ancestor (concestor) who lived about 18 million years ago (18,000,000). All known life forms can be traced to a single ancestor (concestor) who lived more than 3 billion years ago (3,000,000,000). The continents were still joined together 150 million years ago. Human agriculture began about 10,000 years ago and human civilization (the Sumerians) about 7,000 years ago. I write the actual numbers because it is so hard for us to conceive geological time in its vastness. Tasmanian aboriginals, a form of homo sapien, were isolated from Australia about 13,000 years ago on the island of Tasmania, when land bridges were flooded by rising sea levels. This was the most recent isolation that lasted to modern times. They were discovered in about 1800 A.D., and exterminated by 1876 by agricultural settlers who viewed them as vermin.

What is the most recent common ancestor (MRCA) of all surviving humans today? It is quite clear that if we go sufficiently far back, everybody’s ancestors are shared. This makes geneology seem to me to be a bit parochial, although I have gotten sucked into the process at various times. Unfortunately, most of our family tree will remain unknown, so we need to estimate this by use of mathematics.

Assuming that population size is kept constant and mating is random, the surprising answer is only 12.3 generations ago. Assuming four generations per century, this is less than four centuries ago. It is even less if people reproduce younger than 25, which they probably did.

You can trace male genetic evolution through the Y chromosome and female genetic evolution through mitochondrial DNA. Once the last Tasmanian died, the most recent common ancestor of all of us alive today instantly jumped forward 10,000 years. By traveling up the tree father to father, the common male to all of us (Adam) dates back about 60,000 years while doing so mother-to-mother the common female (Eve) dates back 140,000 years. How can this be?

And here is another stunner: for particular genes, you are more closely related to some chimpanzees than to some humans.

Much of human knowledge defies “common sense,” or “conventional wisdom.” And I think these facts show that many of our moral or political stereotypes are based on very unscientific thinking. How can one claim a large division between races? Between religions? Between national identities? Between ourselves and other living creatures? It seems like you need to rely on some sort of creationism that marks humans or some kind of humans as a separate kind of thing. This is belied by DNA research and the fossil record. We share 98% of our DNA with chimpanzees. Get over it! You aren't that special.

That is just from the first 40 pages. Things get stranger and more interesting the further back you go.

On Being Certain

Neurologist's Robert Burton’s book, On Being Certain, addresses some questions I have been struggling to understand. How can people adamantly believe they are right even when it is clear they are not? How could such cognitive deficits survive? Could they have evolutionary value? How far can reason take us in a discussion considering various points of view? How can we know what we know?

An initial insight is that the feeling of knowing is a primary mental state like fear or anger. One can cause it by stimulating a particular area deep the oldest part of the brain, the limbic system. It is involuntary. It is pleasurable. When it follows some attempt at reasoning, we believe that reasons are the cause. The conviction that our conclusion is a conscious choice is illusory.

How could such a process arise? How could pleasurable feelings evoked by false beliefs further survival? Often reasoning takes time without immediate rewards and involving wrong turns. The feeling of knowing could have arisen as a reward for thinking, even where the thinking rests on false beliefs. The results of useful thinking are so beneficial that the process helps us survive. Thus, an unwarranted feeling of knowing might have a positive evolutionary role.

It also has the adaptive function of reducing the uncomfortable state produced by cognitive dissonance; when a person’s actions or beliefs are inconsistent with other beliefs. As Leon Festinger noted, the more committed we are to a belief, the harder it is to relinquish it, even in the fact of contradictory evidence. These belief systems become emotional or cognitive habits.

One interesting possibility that arises from this view concerns the know-it-all personality. Could he be addicted to the feeling of knowing, as this is pleasurable on a basic unconscious level? Indeed, for most people, recognizing and criticizing their beliefs is, if not impossible, unpleasant and difficult. As Burton says (p. 101), “the feeling of knowing, the reward for both proven and unproven thoughts, is learning’s best friend, and mental flexibility’s worst enemy.”

This helps us understand disputes between science and religion. A deeply felt sense of purpose and meaning is also a mental state. He considers Richard Dawkins’ arguments against religion. Dawkins can only believe that his powers of introspection and self-assessment allow him to understand why the world and we exist by assuming the myth of the autonomous rational mind. This misunderstands the biology of belief. Much of our cognitive processing goes on at an unconscious level and cannot be directly accessed. “Whether an idea originates in a feeling of faith or appears to be the result of pure reason, it arises out of a personal hidden layer that we can neither see nor control (p. 195).” “If most of us were forced to choose between a sense of purpose and reason, most would side with purpose (p. 221).”

The Selfish Gene and Altruism

I just finished Matt Ridley's book The Origins of Virtue. It was a great pleasure to read because it consistently managed to stand particular ideas of mine on their heads. Ridley persuasively argues that humans have social instincts, ultimately to be trustworthy. Virtuous behavior has been selected for by our genes.

The Selfish Gene is, of course, a famous book by Richard Dawkins (which I have not read) about a revolution in biology. At its core, the idea is that "individuals do not consistently do things for the good of their group, or their families, or even themselves. They consistently do things that benefit their genes because they are all inevitablly descended from those that did the same. None of your ancestors died celibate."

This conception solved some mysteries in biology. Social insects who help their sisters to breed rather than trying to breed themselves, left more copies of their genes in the next generation. "From the gene's point of view, therefore, the astonishing altruism of the worker ant was purely, unambiguously selfish." But how does that leave space for altruism?

Classical economists had supposed that people act out of self-interest. However, this idea revealed a much more powerful engine of behavior. "Selfish genes sometimes use selfless individuals to achieve their ends. Suddenly, therefore, altruism by individuals can be understood." People really do act selflessly because this tendency is selfishly useful for their genes.

What makes human beings different is culture, which leads to a different kind of evolution; a competition not just between genes, but between culturally different individuals or groups. "A person may thrive at the expense of another not because he has better genes, but because he knows or believes something of practical value."

There is one kind of cultural learning that makes cooperation more likely: conformism. It must be remembered that we evolved as small groups of hunter/gatherers, so conformisn strengthened the group. Thus, we get the tendency that it is usually cheaper and better to do what other people say. Humans have always fragmented into hostile and competitive tribes. This leads to our tendency to perceive the world in terms of us or them (the competing group). And war. This is the dark side of our social instincts.

The book also makes use of game theory; in particular, strategies for dealing with prisoner's dilemmas, a difficulty that occurs whenever there is a conflict between self-interest and the common good. This is a situation where each indidividual in a group will rationally choose a course of action that is not really in his own self-interest, another mind-boggling concept.

The book is full of wonderful anthropological studies, including many hunter/gatherer societies we have encountered in the modern age, and comparative biology between species. Once again, I am forced to realize how little I know, but that just means that there are more interesting surprises in store. On to Genome.

The Post-American World

Fareed Zakaria’s The Post-American World turned out to be a lively and informed book. Or maybe I just agree with him about a lot of things. He sees America’s hegemonic position as disappearing not because of weakness in America, but because of the rise of other countries out of poverty. The emerging economies of China and India are the clearest examples of challenges to our economic hegemony (not military). I am going to list some points that struck me as insightful or obviously correct.

(1) War and organized violence in the world over the last two decades have declined dramatically, while per capita income has risen dramatically. According to Steven Pinker, we are probably living in the most peaceful time in our species’ existence.

(2) Iraq weakened Al Qaeda because in order to attract Sunni support, it morphed into an anti-Shiite group, thus depriving it of its claim to represent Islam. We ought to be recognizing the distinctness of many of the jihadist groups. The improvised strategy has a crippling weakness; it kills locals, thus alienating ordinary Muslims.

(3) The best counterterrorism policy is resilience; if we are not terrorized, then it doesn’t work.

(4) The financial force that has powered the new era is the free movement of capital around the world. This was largely due to the removal of fixed exchange rates. And the hyperinflation of the 1980's was curtailed due to monetary and fiscal discipline.

(5) The most acute problem of increased wealth in the world is the impact of global growth on natural resources and the environment.

(6) In many countries, there is a pent-up frustration with Western or American narratives. For instance, the standard narrative about World War II is how the U.S. and Britain heroically defeated the Nazis. But the Eastern front involved more land combat than all other theaters of war combined and many more casualties. It was where three-quarters of Germans fought and where they sustained 70% of their casualties. The war is portrayed as a heroic struggle of good over evil, but Britain committed many troops from its empire while denying those people freedom at home. However, the world is currently moving from anger to indifference, from anti-Americanism to post-Americanism. Now that the Cold War has ended, the emerging strong economies can go their own way.

(7) Globalization and outsourcing have actually helped America’s bottom line. Growth (3% vs. 2%) and productivity (2.5% vs. 1.5%) have averaged a full percentage point higher than Germany or Japan. U.S. exports as a percentage of the world have dropped only 1% since 1980 (from 10% to 9%) and the U.S. remains the most competitive economy in the world.

(8) Most Americans (less so for the young) are ignorant of the world beyond their borders and remain convinced that they do not need to learn about others. Thus, they remain convinced that their way must be the best and most advanced. This makes us increasingly suspicious (afraid) of the emerging global era. We are the only country in the world to issue annual report cards of every other country’s behavior. This isn’t just confined to the chest-thumping machismo of the neocons.

(9) The view of multinational companies is far more positive elsewhere. We want the world to accept American companies but when other companies with overseas bases come here, it is a different matter.

Those are from the first two chapters. He goes on to give an account of how the West became supreme which will be quite recognizable to anyone who has read Germs, Guns and Steel. Early in the 20th century, the process of domination culminated with a handful of Western capitals ruling 85% of the world’s land. He then has a couple of very insightful chapters on China and India. They are different in significant ways from the West. Neither Hinduism nor Confucianism believes in universal commandments or the need to spread the faith. And for practical reasons, they are far more interested in economic development to feed the vast number of poor than to engage in traditional western-style military hegemony.

The Chinese-American relationship is one of mutual dependence. China needs the American market to sell its goods; the U.S. needs China to finance its debt. It would be in the interests of each to cooperate. Ironically, while China’s central government allows it to complete grand projects, India’s multi-ethnic democracy makes such projects difficult. Instead, it’s growth comes from a U.S.-style capitalism now that they jettisoned their failed experiment with socialism. Surprisingly, 50% of their GDP is services and their level of personal consumption is second only to the U.S. (67% vs. 70%). Unwittingly, the legacy of Britain’s English language is a great asset in a world economy. The organized minorities are even more powerful in India than here. Only Americans have a more favorable view of the U.S. than Indians (71% vs. 83%).

The last two chapters trace the passing of the world’s hegemonic superpower status from Britain and lay out principles for approaching changing times. We need to learn from Britain’s successes and failures. A number of sensible reforms could be initiated here (e.g. diminished wasteful spending and subsidies, increased savings, achieving significant efficiencies in energy use, etc.), but our political process seems to have lost its ability to create broad coalitions on complex issues. Politics has been “captured by money, special interests, sensationalist media and ideological attack groups.” We have thrived because of our openness to the world–to goods and services, ideas and inventions, people and cultures. Unfortunately, much of our population has been gripped by fear and loathing that fails to recognize what a positive position historically we are in the world today.

Best Books of 2009

Everyone is coming out with their lists. Here are my top 12 books published in 2009.
(1) How Markets Fail by John Cassidy
(2) The Evolution of God by Robert Wright
(3) Lords of Finance by Liaquet Ahamed
(4) The Good Soldiers by David Finkel
(5) Create Your Own Economy by Tyler Cowen
(6) The Media Relations Department of Hizbollah Wishes You A Happy Birthday by Neil MacFarquhar
(7) The Healing of America by T.R. Reid
(8) Guardians of the Revolution by Ray Takeyh
(9) Dangerous Games by Margaret MacMillan
(10) How We Decide by Jonah Lehrer
(11) Justice by Michael Sandel
(12) In Fed We Trust by David Wessel

There are some books that I haven't started or finished which may end up on the list:
The Inheritance of Rome by Chris Wickham
Empire of Liberty by Gordon Wood
The Arabs by Eugene Rogan

Here is my top ten published in 2008:
(1) Fixing Climate by Wallace Broecker and Robert Kunzig
(2) Predicatably Irrational by Dan Ariely
(3) The Purpose of the Past by Gordon Wood
(4) Nixonland by Rick Pearlstein
(5) The Ascent of Money by Niall Ferguson
(6) The Trillion Dollar Meltdown by Charles Morris
(7) The Great Warming by Brian Fagan
(8) The Man Who Loved China by Simon Winchester
(9) The Shadow Factory by James Bamford
(10) The Ayatollah Begs to Differ by Hooman Majd
Also considered are Outliers by Malccom Gladwell, The Logic of Life by Tim Harford and While America Aged by Roger Lowenstein.

Here are top three (or so) for other years:
2007: The Black Swan by Nassim Taleb; A More Perfect Constitution by Larry Sabato; The Forgotten Man by Amity Schlaes
2006: War of the World by Niall Ferguson; Omnivore's Dilemma by Michael Pollan; The Prince of the Marshes by Rory Stewart
2005: Postwar by Tony Judt; Collapse by Jared Diamond; My Year of Magical Thinking by Joan Didion; Blink by Malcolm Gladwell and The Undercover Economist by Tim Harford
2004: Ghost Wars by Steve Coll; The Americanization of Ben Franklin by Gordon Wood; The Anatomy of Fascism by Robert Paxton; Under the Banner of Heaven by Jon Krakauer
2003: Master of the Senate by Robert Caro

Who can believe that it has been nine years since Gladwell's The Tipping Point and over ten years since Germs, Guns and Steel by Jared Diamond and Righteous Victims by Benny Morris? Time flies. And The Guns of August by Barbara Tuchman was published in 1962. Hard to believe this wasn't taught in our boring high school history classes. But we now know, as my friend Vern says, that everything we were taught about history there was a lie.

In Fed We Trust

This is a book I just finished by David Wessel on the meltdown of the last couple years mostly from the view of Bernanke and the Fed. It covers how the stage was set going back to August 2007 and is very good on the events of last fall. It is amazing how much was going on that even very knowledgeable people did not understand. And the extreme measures the Fed had to take.

There are some funny moments, too. When Bernanke and Paulson had to go to Congress to request money, Harry Reid commented that it would take the Senate two weeks to pass a bill to flush the toilet.

I'm not sure what to read or finish next. I've got several books started, but either lost interest or they were too long or intimidating. I am feeling intellectually bored and need to find some outlet. So I signed up for the Osher Program at the University of Utah, which is for we seniors over 50 years of age. They have six-week classes that meet once a week for an hour and a half during the daytime. I am taking a class next semester on the history of Iran and how it relates to the present. If anybody has some other ideas, I'd love to hear them. Lifelong learning at the U is too artsy-crafty and I am not sure I want to devote the effort to taking a real class, especially if it meets more than once a week. The great joy of graduate school was reading books and discussing them...with a very knowledgeable instructor. I need to figure out how to replicate that kind of experience.

Rational Irrationality

How Markets Fail by John Cassidy is one of the best books I’ve read in the last couple years. It is first about ideas. It then integrates them in helping us understand what went wrong with our financial system. The first third of the book contains a history of economic thinking from Adam Smith, Hayek, Keynes, Arthur Pigou, von Neuman, Kenneth Arrow, Milton Friedman, Robert Lucas, Kahneman and Tversky and many others. It details the increasing use and sophistication of mathematics in economics and the revolutionary insights of game theory. The stagflation (the inflation rate jumped into double digits but unemployment did not fall) of the 1970's was an event that mainstream Keynesians could not explain, paving the way for the revival of conservative economics. Friedman’s view that the real culprit of the Great Depression was the Federal Reserve’s failure to counteract the decrease in the money supply also paved the way.

Cassidy then shows how these ideas got incorporated into theories about finance (efficient market theories). Finally, he explains how this led to the financial meltdown, including the seizing of credit markets, which continues to affect us today. In doing so, he explains some of the complicated financial innovations such as structured investment vehicles (SIV’s) and credit default swaps. This sounds daunting, but Cassidy is so knowledgeable and such a good writer that he pulls it off.

John Von Neuman, a genius who made significant contributions in many areas, formulated game theory. Game theory is an inquiry as to how actors will behave when they have to take into account the actions (or expectatios) of others. The prisoner’s dilemma is a commonly occurring situation in which rational individuals will choose an outcome that is not in either’s best interests even in something as simple as a two-person game. With ten people in becomes virtually impossible to sustain a cooperative outcome. In the economic arena, it helps explain situations where rational self-interest in the marketplace leads to socially damaging outcomes. A general manifestation is the Tragedy of the Commons; a more particular outcome is destroying the planet by industrial pollution. This is one type of “market failure” (externalities). Since one of the insights of classical economics is seeing how rational self-interest can lead to mutually beneficial outcomes (the invisible hand), it poses a potential problem for this theory.

Frederich Hayek’s big insight is that prices convey information which allocate resources. Firms do not need to ask consumers what to make and how much; prices transmit the information. This results in what he calls an “economy of knowledge.” Individual participants in the market need to know little to be able to take the right action. Hayek later expanded this efficiency of the market into a political theory; he viewed the free market as the only effective guarantor of individual freedom. The failure of communism only reinforces this view. However, just because central planning failed, how can we be sure that the price signals the market sends are the right ones? The general equilibrium theory was supposed to answer this question by showing the existence of a set of market prices at which all goods will be supplied in exactly the quantities that people demand. This can be done, but only by assuming that each industry contains many competing firms and that the firms are not able to lower the unit costs merely by raising output. At these prices, it is not possible to make anybody better off without making someone else worse off. This theory was very persuasive to economists because of its mathematical elegance.

However, in any economy, even the most efficient, some people will fare off better than others. How do we decide which economic outcome is preferable? Who decides? Kenneth Arrow’s work showed how the models could do this. I will leave out the intriguing details, but he showed how the free market could generate a Pareto-efficient outcome (meaning you cannot make one person better off without making someone else worse off. However, the difficulty in applying the theory to reality was not only the restrictive assumptions, but later work showed that in order for such a formal model to work, people would need access to an infinite amount of computation capacity (there had to be perfect information). The axioms of individual rationality and perfect competition were not sufficient to determine what would happen.

On top of this, the work of behavioral economists following Kahneman and Tversky have shown many of the foibles of human reasoning. We are not able to approach making the calculations required by classical economics. We are very bad at probability. Instead, we use “rules of thumb” (heuristics) to reach conclusions. These are “wired-in” and have been selected for by evolution. For much of human history, it was more important to think quickly than to deliberate. One of the irrational responses is to go with the herd despite available contrary information. This leads to bubbles. But it is rational for financial actors to go along with the herd. They continued to take such risks because everyone else was doing it and making a lot of money. If they didn’t, they would not have had jobs. But this just made the bubble bigger. As opposed to the negative feedback loop of general equilibrium theory, this is a positive feedback loop.

George Akerlof showed how hidden information can lead to market failure (adverse selection). This is potentially an issue in any market where the quality of goods is difficult to ascertain other than by casual inspection. The problem of hidden information eventually shows not only is there not a single set of assumptions under which markets are Pareto-efficient, but that with real economies (all those that exist outside of economics textbooks), they are never Pareto-efficient. There is always a potential policy intervention that could improve the welfare of at least one person while leaving nobody worse off. Just as externalities lead the system to issue the wrong price signals, so does hidden information.

Instability is true in most markets but most important in financial markets, for its failure has cascading effects on the rest of the economy (it is also important in the health care market, leading some people to not be able to get any insurance, not just expensive insurance). In an economic downturn, lenders have difficulty ascertaining which borrowers are good risks. This was amplified in recent history by financial innovation; the markets for items like credit default swaps disappeared, making it impossible to value them, which was exacerbated by the opacity of various large financial actors like hedge funds and investment banks. And because of the opacity of credit default swaps, it was difficult to determine who owed what to whom. This implosion was also exacerbated by the myth that financial institutions could mathematically model risk (hello Nassim Taleb), which contributed to rising leverage levels and more risk. A house of cards getting bigger all the time as well as more fragile, with the big players surfing the bubble.

In the efficient market view of finance, speculators play a stabilizing role, purchasing undervalued assets and selling short overvalued ones. However, during bubbles speculators play a destabilizing role (it seems like they do when the bubble bursts, too). Hyman Minsky went beyond Keynes in describing how booms and busts are created. The process does not depend on any external shock. The primary causes come from the competitive forces that are at work in the financial sector. Any period of stability “leads to an expansion of debt-financing,” with innovation and novel financial assets. Efficient markets theory turned on its head. This is a theory of rational irrationality, with the individual rational actions of banks and other financial firms serving to destabilize the entire system.

Cassidy argues that the current crisis is similar to the S & L crisis of the 1980's. The central causes are the same; a misguided faith in the free market, deregulation that was heavily influenced by industry lobbyists (and the conservative movement) and an unsustainable real estate boom. This does not mean that government is usually better than markets at allocating resources or that markets are not a means for driving prosperity. However, the debate should not be between laissez faire capitalism and a command economy. Markets do enable people to make mutually advantageous deals (win-win games). The place to begin looking for appropriate government action should be centered on market failure, which Cassidy calls reality-based economics (vs. utopian economics). The primary source of economic instability is the short-term rational (at the individual level) actions of the financial sector. Wall Street should be one of our biggest concerns and it needs to change. Business as usual is no longer rational for our society.

Ghost Wars

I am reading Ghost Wars by Steve Coll, an account of Afghanistan from the Soviet invasion of 1979 through 9/11. It is page-turner, with the first quarter of the book setting the background, with some great chapters on the history of Saudi Arabia, bin Laden, William Casey and the years leading up to 1986. Covert funding for the Soviet opposition increased dramatically in the mid-80's due to Congressional appropriations to the CIA (led by Charlie Wilson), which were matched by official Saudi contributions by their intelligence agency, and by massive private Saudi contributions. The CIA did not even have an outpost in Afghanistan in 1979 and for years we funneled all our money through the Pakinstani intelligence agency, the ISI. Although there were many groups fighting the Soviets, most of this massive surge in funding went to the Islamist groups such as Hekmatyar's. The Pakistani border ended up being a huge enclave of ISI, Arab volunteers and Wahhabi madrasses. They trained 6000-7000 jihadists a year.

The U.S. promoted these jihadists and the recruitment of Arab volunteers. The focus of the Reagan administration and especially Casey, was the defeat of the Soviets at all costs. Casey saw links of revolutions to Russia everywhere, including the IRA, Basque nationalists, Palestinian terrorists, and others. He was also very religious and saw a natural coalition of Christians with the Islamists against the atheistic communists.

The Islamist movement had been becoming more radicalized over the years, initially from the Muslim Brotherhood in Egypt in the 1920's. Cairo was the intellectual center from which the radical views spread, eventually to the university bin Laden attended in Saudi Arabia, but also to Afghanistan. However, most Afghans were primarily influenced by Sufiism and little in common with the Wahhabi-led extremists. They were a diverse bunch and included Ahmed Shah Massoud, the most formidable Afghan military leader who headed a northern alliance. Robert Gates, then second in command at the CIA, remarked in his memoir in 1996, that "no one should have any illusions about these people coming together politically."

The Saudi budget for 1969-74 was $9.2 billion. For the next five years, it was $142 billion. A generation removed from nomadic poverty, they were now powerful players. From the beginning, Ibn Saud had linked his power with the Wahhabis. Sensing the threat from Islamic radicalism, he embraced it, hoping to control it. There seemed to them to be no plausible politics but strict official religiousity and many of the royal family were true believers. Their state was, after all, the only modern nation-state created by jihad. In Afghanistan, bin Laden was just one of a variety of actors. But he began to ask the question of whether the jihad should not be just against the communists, but also against the corrupt governments of the Middle East, the U.S. and Israel. He was well-connected, wealthy and moved freely in circles of Saudi intelligence.

The Soviet introduction of the elite Spetsnaz, along with their Mi-24D Hind attack helicopters, seemed to be winning the war in 1984. But along with the increased funding, Afghan rebels now got satellite reconnaissance and Stinger hand-held missiles. On September 26, 1986, they were first put into use, detroying three Soviet helicopters.

Review of Three Kings

Lloyd C. Gardner’s Three Kings; The Rise of An American Empire in the Middle East after World War II is a highly readable account of U.S. policies regarding the Middle East beginning before the end of the war and continuing up to around 1980. It was interesting enough that I ordered his previously published The Long Road to Baghdad; A History of Foreign Policy from the 1970's to the Present. It focuses mainly on two episodes, one dealing with the crisis in Iran in 1951-53, when Mossadegh came to power, the Shah fled, and Iran threatened to nationalize their oil industry. In response, we (through the CIA) organized a coup which led the Shah back into power. The second centers on our dealings with Nasser in Egypt.

The main lesson I take is that the turbulent situation in the Middle East was caused partly by our policies. After the war, the British wanted help controlling the Middle East (they wanted to keep their empire) and the U.S. was only too willing to help, eventually replacing the Brits as the reigning power. After all, the oil that lay under the ground was a source of military power. We promoted stable governments by supporting dictators. Not only the Shah, but we also helped install Saddam in Iraq in 1963 and made it possible for the family of Ibn Saud to rule Saudi Arabia. One of the unintended consequences was that these dictators thereafter were able to blackmail us for money and arms. This was inconsistent with our professed aim, which was to promote self-determination of countries leaving the colonial era and democracy. What we did was to work to thwart Arab nationalism and it led to an arms race. It retarded political change, but when that change came it was virulently anti-U.S., such as during the Iranian revolution in 1979. After that, we tried to use Saddam to prevent the spread of such theological revolution by helping to fund the eight-year war with Iraq. We all live with the consequences today.

The ultimate justification for these actions was the “war against international communism,” even though Russia was not really a threat in this region and there was no universal communist threat as China and Russia were opposing powers. No one doubts the power of Russia in Eastern Europe at the time, but we made our conflicts into an ideological war in order to mobilize public opinion. In promoting these policies, various presidents acquired more power for the executive branch by funding wars without Congressional approval. Whatever you think of the communist threat, the success of these policies in the Middle East was temporary at best.

Irony abounds in this tale. As another example, Truman, in order to win the 1948 election, needed Jewish finance, so he opposed the British, who had the mandate on Palestine and tried to limit Jewish immigration. Ultimately, the Brits tired of this role (they could no longer afford their empire) and abruptly gave up the mandate, after which Israel declared itself a state. And, of course, we ended up being the fund of Israel’s military power, too. Our dealings with Nasser actually drove him to accept Russian assistance in the late 1960's. By keeping Saud in power, we also indirectly empowered the Wahabbis, who Saud had to appease because of the presence of Mecca in his country. Now we also have a dictator in Egypt, are supporting a corrupt government in Afghanistan, and are heavily involved in propping up the governments of Pakistan and Iraq.

These policies involved a uniting of political and economic interests. I imagine that those on the left believe it was the corporate interests that controlled. While this has certainly been the case in the past in some places, such as our invasions of various Latin American countries, I think that here the main force was a misguided effort at keeping the world safe. Of course, the oil companies benefitted, too, at least for awhile. Those on the right would have had us become more directly involved militarily, which ultimately we did in Iraq, partly justifying the action as spreading democracy! Whatever this history teaches us, it at least shows why they don’t trust us. Is it also partly responsible for the rise of violent Islam?

Addendum: This book would be better described as a history of US State Department and executive policy toward the Middle East from 1947-1960, during the Truman and Eisenhower years. Gardner implies that during these years we set the policy that we would follow for years to come.

The Good Soldiers

I started The Good Soldiers by David Finkel earlier this week. I would read a chapter and then have to go blow my nose and wipe tears out of my eyes and that was usually enough for one day. Last night I picked it up and couldn't put it down until I finished at about 1 a.m. This is very powerful book. It is written by a reporter embedded with the 2-16 batalion in East Baghdad during "the surge," and takes place from April 2007 to March 2008. I don't believe that anyone who has not been in a situation like that can really imagine it, but this book gives you a vivid sense of the human consequences of war on soldiers. This particular war, with multiple deployments, better medical care in the field, and better armor has led to many more soldiers being saved, but many more damaged in different extreme ways, including severed limbs, closed head injuries from explosions and PTSD. I'm not sure how a human being couldn't have some PTSD after going through that. A great piece of writing.

History

I just finished a wonderful little book by Margeret MacMillan called Dangerous Games; The Uses and Abuses of History. She has lots of great contemporary examples of using and misusing history, from the Chinese government's emphasis on their recent history of humiliation to promote nationalism to the oft-repeated justification of our policies by referring to the appeasement of Hitler or other bad guys (you can see a version now in right-wing attitudes about Afghan policy). At the end of the book she asks the question what can history teach us? Some quotes: "Since history relies on a skeptical frame of mind, whether toward evidence or comprehensive explanations, it can also inculcate a healthy propensity to question our leaders." It can teach us humility. "One of history's most useful tasks is to bring home to us how keenly, honestly and painfully, past generations pursued aims that now seem to us wrong or disgraceful." "History also encourages people in the present to reflect on themselves." "Bad history ignores...nuances in favor of tales that belong to morality plays but do not help us to consider the past in all its complexity." She also has a lot of interesting things to say about nationalism, a state of mind that has historically only recently existed, and how leaders use this impulse of group solidarity.