Snapshots From Traders' Family Album

In more than one occasion in this blog I have written about the consequences of the genuflection of theorists to businessmen. The root of the problem is an improbably philosophical one, pertaining to the validation of theory. As a theory is a conceptual explanation of the working of the real world, it must coherently and consistently explain and foretell the real world event that it aims to explain. There is no other way to judge the accuracy of a theory.

For reasons well outside the scope of this blog, this self-evident truth was gradually turned on its head by a group of philosophers and economists in the West. Milton Friedman was the most outspoken proponent of this school (hence his fame). He elaborated his ideas in a small pamphlet called The Methodology of Positive Economics. In Vol. 1 of Speculative Capital, I spent some time on this subject:

The Methodology is a manifesto of superficiality which has cast aside its self-conscious defensiveness and assumed an aggressive posture. It is an in-your-face crudeness of unthinking, pushing to impose itself on the unsuspecting reader under the guise of philosophical thought. In it, Friedman strove to create a theoretical framework for a “pure economics,” or an economics for its own sake. The new discipline had to be independent of social constraints: He wrote: “Positive economics is in principle independent of any particular ethical position or normative judgments.”

But if ethical positions and normative judgments were to be set aside, how was one to construct or test economic theories? Economics had always been a social science. Normative issues, ethical positions and social aspects could not simply be ignored. For that, too, Friedman had an answer. He wrote:

Complete “realism” is clearly unattainable, and the question whether a theory is realistic “enough” can be settled only by seeing whether it yields predictions that are good enough for the purpose at hand or that are better than predictions from alternative theories. Yet the belief that a theory can be tested by the realism of its assumptions independently of the accuracy of its predictions is widespread and the source of much of the perennial criticism of economic theory as unrealistic.

By saying that the realism of assumptions did not matter in a theory, Friedman granted economists carte blanche to assume anything they wished as long as their theory produced “accurate predictions.” But how was one to know that the predictions of a theory were accurate? Well, the prediction could be checked against what was observed, i.e., what was given–the status quo. In the highly charged ideological atmosphere of the Postwar era, the implications of this reasoning went far beyond economics. Instead of starting from the observed evidence and arriving at a conclusion which could be unpleasant and controversial, Friedman espoused starting from the accepted system and then making whatever assumptions were needed to justify it.

In subordinating the realism of assumptions to predictions, Friedman turned scientific inquiry on its head. What he said, in essence, was that anything was permissible in economic theory as long as the theory produced acceptable results. The acceptable result was the confirmation of what was already in place. But if the assumptions of a theory did not matter, one could assume ghouls, ghosts and angels to explain economic phenomena. And in a way, that is what happened in the following years.

Friedman’s reasoning put the test of the validity of a model on a slippery slope. Little wonder, then, that the process went downhill immediately until it reached its logic nadir in the hand of theorists of Modern Finance who made the trade as the proxy for the "real world" and proceeded to weave a theory around his actions. The cult of trader worship which was the domain of financial journalist, spread to Modern Finance, a development that set the stage of its demise.

I remembered this history partly because I was working on Vol. 4 of Speculative Capital but also because in the past couple of weeks four traders came into my ken who were in the news under very different circumstances. Ordinarily, in the financial publications, I only come across stories about the Sage of Omaha and the Man Who Broke The Bank of England. Both these gentleman leave me strangely unmoved, as I know one is the cut-throat businessman behind the Geico business model, his folksy pretenses notwithstanding, and the other is the author of George Soros on Globalization, his intellectual pretenses notwithstanding!

Of the four traders, two were on their way to prison. One was dead, and one is alive and well in the pinnacle of his career. Yet, they all have something in common that we will be well advised to understand. Let us first meet the characters.

Sam Israel: Failed Faker

Sam Israel co-founded a hedge fund and from the get-go looted it to finance a lavish life style. He was not a good investor either and soon began losing money. To cover the losses, he produced fake audits and fake report. When the dust was settled, he had swindled $450 million from his investors. Convicted of fraud and sentenced to 20 years in prison, he jumped bail by faking his suicide. After a month of being a fugitive from justice, he turned himself in on the advice of his mother and also because he realized “that God didn’t want me to do that”.

What grabbed my attention more than Israel’s communication with God was his mental capacity as revealed in planning the fake suicide. He parked his car on a bridge, wrote "suicide is painless" in the dust on the hood and got away in his girlfriend's car that was waiting nearby.

I don’t have great expectations. I did not expect Sam Israel to plot like a character from a pre Berlin Wall Le Carre novel or hint at his suicide by drawing the first bar of Chopin’s Funeral March. But even accounting for his duress, the plan was downright embarrassing; a 12-year old with interest in crime stories could have done better. What is more, in post 9/11, post FISA world, he thought he could run and hide.

This man raised $450 million from investors.

Sir John Templeton: The Man Who Understood the True Character of Stock Markets

Sir John Templeton created the Templeton Fund in 1954 and sold it in 1992 for $400 million. In between, he delivered average annual return of 15% to his investors.

Sir John was a religious man. He started his business meetings with prayer “to clear the minds”. He engaged in philanthropy, created a fund to expand the frontiers of religion and started a foundation to support spirituality, giving money to spirituals like Mother Teresa and Billy Graham.

Iranian king gives a pile of gold to his vizir to distribute among the capital’s spiritual men. Sometime later, the vizir returns the gold, saying that he had not been able to find one. “How could it be?” asks a perplexed king, “I am told there are 10,000 spiritual men in this city.” “Your Majesty,” answers the vizir, “the spiritual men refused the money. And those who did not were not spiritual men.”

Money Magazine had called Sir John “arguably the greatest global stock picker of the century”.

Financial Times obituary described him as “the renowned investor and philanthropist who is credited with some of the best-known investment adages”. The paper went on to give an example of those adages:

• Bull markets are born on pessimism, grow on scepticism, mature on optimism and die on euphoria. (This, according to Financial Times, was the proof that Sir John “understood the true character of stock markets”.)

• ‘It’s different this time’ are the most expensive words in the English language, has become a maxim for investors.

• To buy when others are despondently selling and to sell when others are greedily buying requires the greatest fortitude and pays the greatest reward”.

Sir John said and did all those things before he died of pneumonia at age of 95.

Jeffrey Epstein: Multi-talented Jew

Jeffrey Epstein is not nearly as famous as Sir John. In fact his “angle” was to promote himself as a low key operator, of the kind you have to look hard and be somebody to find. He was in the news in relation with his conviction for prostitution involving an underage girl. The venerable Alan Dershowitz of Harvard Law School is being paid to represent him.

If Sir John started the meetings with a prayer, Jeffrey Epstein “starts his mornings with a secret-ingredient bran muffin prepared by his chef,” The New York Times informed its readers. Some like to clear their minds; some, their bodies.

The paper also said the following about “Mr. Epstein”:

His business is something of a mystery. He says he manages money for billionaires, but the only client he is willing to disclose is Leslie H. Wexner, the founder of Limited Brands.

As Mr. Epstein explains it, he provides a specialized form of superelite financial advice. He counsels people on everything from taxes and trusts to prenuptial agreements and paternity suits, and even provides interior decorating tips for private jets. Industry sources say he charges flat annual fees ranging from $25 million to more than $100 million.

As it became clear that he was headed for jail, Mr. Epstein has tried to put on a brave face. “Your body can be confined, but not your mind,” he said in a recent interview by phone.

Rumi himself could not have said it better.

Mohamed El-Erian: Greenspan-inspired Asinine

You cannot get more successful than John Templeton in fund management business, and you cannot get more successful than Mohamed El-Erian in both, practical fund management and markets analysis. For years, he was the president and chief executive of the Harvard Management Company, as well as a faculty member at the Harvard Business School and deputy treasurer of the university, where he delivered outstanding results to Harvard endowment fund. Last year, he left for Pimco, where he is now the co-CEO and co chief investment officer. Hardly a month goes by without him writing or talking about grave financial matters in some major publication.

I remembered him because there he was again, in today’s Financial Times, offering opinion about the current crisis in financial markets.

To say that it is difficult to understand what El-Erian is saying is to be charitable. The man has a knack for making the darkness opaque. Here is an entirely typical sample quote from the Financial Times (with the British spelling preserved):

The price shock will serve to undermine real incomes in the US and lower imports. On the policy front, it will accentuate the tug of war that the Federal Reserve faces on account of its now conflicting inflation and employment objectives. Emerging economies face greater inflation in the context of their buoyant liquidity conditions. Several will see their real effective exchange rates appreciate, by means including measures to allow the nominal exchange rate to appreciate markedly against the dollar. In Europe, growing demands for wage increases may force companies to step up structural reforms and will cause the European Central Bank to increase its hawkish rhetoric.

No fortuneteller ever spawned so much general nonsense. But even in this short paragraph he manages to show his ignorance of a critical point about the working of the Fed when he talks of “conflicting inflation and employment objectives” of the Federal Reserve. He is referring to Humphrey-Hawkins Act that mandates the Fed “to translate into practical reality the right of all Americans who are able, willing, and seeking to work to full opportunity for useful paid employment at fair rates of compensation.”

El-Erian probably heard of it back in school days precisely because then it was a topic of discussion. The Act is still on the books but the Fed simply ignores the part pertaining to the employment. The chief investment officer of a bond fund company, of all places, should know that.

This was not a one-time slippage. Here is El-Erian on the Fannie Mae and Freddie Mac crisis:

“The key is to stop the equity price debacle … from morphing into a full funding crisis for the two institutions,” Mohamed El-Erian, co-chief executive at Pimco, the bond fund manager, told the Financial Times.

It is astounding how a well-educated fund manager who, by virtue of his job, has his fingers on the pulse of the market, can get something so obvious about Fannie Made and Freddie Mac so fundamentally wrong. The equity price debacles is the consequence of the funding crisis, not the other way around. That is true for all corporations and not just financials: first the company runs into trouble, then the stock price drops.

The point here is not to critique El-Erian. I mention him precisely because he is among the best and brightest the real-life finance offers. Yet, this successful trader/fund manager/educator has nothing to offer us by way of insight into markets. That is what he has in common with the other characters in this story. A downright crook in communication with God, a multi-talented Mr. Epstein offering superelite advice for $25–$100 million a year and a knight who imagined the stock market as nothing but the result of the psychological state of investors (and dispensed banalities to that effect), all these men are the blind agents of a force that remains hidden from them. Their experiences are valuable as the instances of the manifestation of that force and its false reflection in the human mind. But that is the extent of the utility of such experience. Afterwards, abstract reasoning must carry us forward.

In unquestioningly and uncritically taking the actions of these men as its foundation and the starting point, the way the Times unquestioningly accepts the claim of $100 million a year superelite advice, Modern Finance set itself up for failure.

Revisiting Continuous-time Finance (Part 2 of 2)

I don’t know what finance textbooks say about arbitrage these days; I haven’t read one in years. But in the 1980s and well into the 1990s, they had only one example of arbitrage: buying IBM at New York Stock Exchange for, say, $120 and simultaneously selling it in the Pacific Stock Exchange for $120.5 and thus pocketing 50 cents profit. Just like that!

To say that the example flew in the face of the reality and insulted the reader would be an understatement. But I understand why the nonsense stayed around for so long. To really analyze arbitrage, to even define it, one has to know the Theory of Speculative Capital.

Arbitrage is a category in finance. It means buying low and selling high simultaneously. Obviously, that cannot be done with the same commodity or security; that would entail an infinite supply of rich fools. An arbitrageur, rather, must buy (or go long) one position and simultaneously sell (short) an equivalent position.

Equivalent means the equality of certain aspects of two qualitatively different things. In geometry, for example, a circle and a square are said to be equivalent if they have equal areas.

What makes two securities or positions equivalent in finance is the equality of their cash flows, Modern Finance declared. The equivalent positions, furthermore – securities or portfolios with equal cash flows – must trade at the same price. If they did not, an arbitrageur could buy the cheaper position, sell the more expensive position and secure a riskless profit – riskless because the equivalent positions hedged one another and profit because the two positions had to eventually trade at the same price.

That is the Contingent Asset Argument, the boldest and most important theory of modern finance.

Under strict conditions, the reasoning behind CAA is valid. But emboldened by the success of the Black Scholes model, the cheerleader of Modern Finance espoused it with an in-your-face aggressiveness that turned the “argument” into the inevitability of a natural law. “Greed is good,” the memorable line of “risk arbitrageur” Ivan Boesky perfectly captured this belief and attitude.

The focus on the cash flow is the view of a deal maker. It is finance as understood by Brooklyn business brokers. From the get-go, then, the arrogant pioneers of Modern Finance were in fact mouthpieces of half-educated traders and businessmen. The theoretical poverty helped set the stage for the rise of speculative capital and, from there, the systemic crisis in finance that we are witnessing. That is why Continuous-Time Finance merits a revisit.

I have shown in Vols. 2 and 3 of Speculative Capital and then briefly in Credit Woes series how, in blindly following traders, Black, Scholes and Merton entirely misunderstood options. But the reach of CAA goes beyond option valuation and touches all parts of markets.

The equivalency of positions and the deviation of their difference from the “norm” is established through either CAA or statistical analysis. Both methods are utterly unsuitable for the business in hand. In these methods, we have before us the fundamental contradiction between an arbitrageur’s business and his tools of trade. His business is quantifying qualitative differences. His tools of trade are purely mathematical, void of any qualitative content. It is that incompatibility which brings him to the gallows. There would never be an arbitrage-related loss, much less systemic risk, if the relation between the markets were purely mathematical and could be determined as such.

Defining equivalent positions in terms of cash flows is an egregious oversimplification. I will show in Vol. 4 of Speculative Capital how two positions with equal cash flows could have different prices with the difference remaining and even widening because of the impact of various factors.

The empirical evidence refuting the synchronous movement of equivalent positions was there even in the early days. Here is a Wall Street Journal story from 1996.

A Morgan Stanley trader took a $25 million loss on a position in Office Depot Inc. convertible bonds … [The trader] tried to hedge the … bond position by selling short...a mix of Office Depot common stock and call options...Office Depot reported worse-than-expected … earnings, sending its common stock tumbling 23% the next day. The trouble was that the convertible bonds fell more than expected, amid mounting concerns about the company.

The equivalent positions going the opposite way, the hedges behaving badly, is the main theme of the current crisis that has resulted in over $300 billion in losses with no end in sight. The latest victim was Lehman that lost $2.8 in June. The firm’s CFO, before she was let go, blamed the loss on the “divergence between the cash and derivatives market” and “ineffective hedges”.

The saga continues.

That is where Modern Finance now stands, with its intellectual palaces exemplified by Continuous-time Finance in ruins. Having faded, the insubstantial pageant leaves a wreck behind.

Revisiting Continuous-time Finance (Part 1 of 2)

If classic is the description of a work that stands the test of time, Robert Merton’s 700-page Continuous-time Finance is an apt example of unclassic. A mere 18 years after its publication, the book has fallen by the wayside, a colossal Ozymandias statue of ideas that lies in the ruins.

At the time of its publication in 1990, the book was meant as a celebration of the rise of “modern finance”. In a laudatory spirit, Merton elaborates, reworks and chronicles the ideas whose sum total defined the new discipline. The book’s size and heavily mathematical content is intended to show, if only unconsciously, that the foundation of modern finance was built on solid, scientific grounds.

All that is evident in Paul Samuelson’s Foreword to the book:

A great economist of an earlier generation said that, useful though economic theory is for understanding the world, no one would go to an economic theorist for advice on how to run a brewery or produce a mousetrap. Today, that sage would have to change his tune: economic principles really do apply and woe to the accountant or marketer who runs counter to economic law. Paradoxically, one of our most elegant and complex sectors of economic analysis – the modern theory of finance -- is confirmed daily by millions of statistical observations. When today's associate professor of security analysis is asked, “Young man, if you’re so smart, why ain’t you rich?”, he replies by laughing all the way to the bank or to his appointment as a high-paid consultant to Wall Street.

Yet, look closely, by which I mean actually read the book, and you would be struck by the shallowness of its content. What comes through is a Beckettian clerk who labors to formalize what has taken place around him without understanding the forces that drive the events. But Merton is no mere scribe. Like the general discipline he helped create, his formalization gives theoretical cover to the pragmatically crude action of traders. He validates and legitimizes them, making them acceptable and reputable. That is why Continuous-time Finance merits a revisit. An analysis of the current rot in the market cannot be complete without a look at the ideological cheerleaders who paved the way for it.

(This subjugation of theory to practice, the intellectual standing in awe of the ill-educated trader, is in plain view in Samuelson's foreword. Note his ideal of the relevance of modern finance: going to a “high-paid” consulting job on Wall Street, say, to Bear Stearns or Lehman. From Adam Smith to David Ricardo to Karl Marx to Samuelson. What a falling off was there.)

The pride of the place in Continuous-time Finance, as in “modern finance” itself, belongs to option valuation theory, or the contingent claims argument (CCA) in general, as Merton calls it. What is CCA? Simply this, that a riskless position must earn the riskless rate of return. In describing how he and his colleagues came up with the option valuation formula, Fischer Black wrote:

As the hedged position will be close to riskless, it should return an amount equal to the short-term interest rate on close-to-riskless securities. This one principle gives us the option formula.

The idea and the definition of hedging comes from the general accounting relation:

Assets = Liabilities + Owners' Equity

or

A = L + OE

If you have $100 in your pocket, either all of it is yours (OE = $100), or all of its is borrowed (L = $100), or a combination, say $40 borrowed and $60 your own so that $100 = $40 + $60. $100 in your pocket cannot have any other source.

The objective of hedging is to protect OE, the individual’s “net worth” so that its value would not change, no matter what happens in the markets. In mathematical terms, that means that the change in the value of OE must be zero:

change (OE) = 0

Since OE = A – L, for that condition to hold, we must have:

change(A) – change (L) = 0

or

change(A) = change(L)

The above equation is the necessary and sufficient condition for the hedge. It says that the change in the value of assets must be equal to the change in the value of liabilities. Students of finance know this condition under various names and guises, such as matching assets and liabilities or creating a riskless portfolio. The different names merely express the particular viewpoint of the person or entity engaged in the act; treasurers would speak of asset-liability matching, traders of creating a riskless portfolio.

The most consequential development here is the transformation of hedging to arbitrage. No better or more convincing example of a dialectical movement exists anywhere.

The purpose of hedging is preserving the owners’ equity. The hedger begins with an existing asset (liability) and seeks to find a liability (asset) which will offset its adverse price changes.

The purpose of arbitrage, by contrast, is profit. The arbitrageur has neither an asset nor a liability. He uses the hedge relation above to search for any two positions which will enable him to “lock in” a spread.

The difference between hedging and arbitrage, therefore, boils down to the purpose behind the trades, which translates itself to the sequence of execution of trades. When done sequentially, the act is defensive hedging. When done simultaneously, it is aggressive arbitrage. On the after-the-fact basis, an observer will only see a long and a short position.

Hedge fund managers and prop traders took the idea and ran with it. Speculative capital, capital engaged in arbitrage, was thus born.

One practical problem remained: how to create a “close to riskless” position? No one understood the significance of this question in theory or the implications of its execution in practice. It was left to hedge fund managers and prop traders and their quantitative underlings to find the answer.

They did.

I will return tomorrow with the second and final part.

An Excerpt from Vol. 3 of Speculative Capital

The following is an excerpt from the last page of Vol. 3 of Speculative Capital: The Enigma of Options. The book came out in 2006. The lines were written in the late '05 or early '06.

The role of speculative capital in the creation of the credit derivatives market cannot be overemphasized. Speculative capital is the conceptual rainmaker of this market, its underwriter. It brings the credit to the trading arena and ensures its staying power there by “grooming” it in accordance with the needs of the market.

The most outstanding handicap of credit in the new environment is the long time horizon. The traditional credit analysis is “through the cycle,” extending 5 to 7 years in the future to allow for the evaluation of an entity during a business cycle. Speculative capital would have none of it.

Having brought credit into its orbit, it trims its horizon to mere months. Credit, thus shortened and thrown into the market, seeks the confirmation of its price in the most short-term, readily available and actively traded instrument: stock. In this way, stock price comes to play a role in setting the price of credit. Traditional credit rating agencies are forced to take account of the development. They, too, shorten the time horizon of credit analysis.

A realization takes shape: if the stock price is an immediate measure of credit, perhaps credit and market price are more closely related than previously thought. This phenomenon plays out at the wholesale level as well, when corporations discover that they could sell their liabilities – and accounts receivable assets – in the market. So the tried and true concept of mortgage-backed securities (MBS) is extended to all forms of debt to create collateralized debt obligations (CDO), collateralized loan obligations (CLO) and, in case of accounts receivable, asset backed securities (ABS).

The rise of credit derivatives is the latest qualitative change in the evolution of finance capital that brings together its market and credit “dimensions.” We are currently witnessing the early stages of this development. But armed with the theory of speculative capital we could see what is happening, i.e., what is changing. We could also discern the cause, pattern and characteristics of the change. So while for others credit derivatives are the risk-diversifying, need-fulfilling products of an innovative Wall Street, for us they are the footprint of speculative capital on its march towards systemic crisis. The march, driven by the profit-seeking, inherently self-destructive movement of speculative capital, creates financial entropy on its path, one manifestation of which is closing the longest running, most structural arbitrage opportunity of all: between the credit price and the market price. But the ensuing state of inert uniformity cannot be tolerated; speculative capital cannot sit by idly and will not go gently into that good night. It must disrupt the equilibrium to create profit opportunities anew. That brings about the systemic risk.

Keeping Our Eye On the Ball

Speaking of Harvard, in today’s New York Times William C. Apgar, a “senior scholar” at the impressively named Joint Center for Housing Studies at Harvard University said, “People are beginning to understand that home ownership can be a very risky venture”.

The context of this story is the rise in foreclosures and the decline of the homeownership in the US during the presidency of George Bush, whose one stated goal was the creation of an “ownership society”. Yet, Harvard’s senior scholar speaks of home ownership risk in the same vein that one would speak of the risk of say, deep water diving. The social context of the event, if noticed at all, is completely cast aside.

A day before, two Bear Stearns fund managers were indicted in relation with the collapse of their funds in June ‘07. The near simultaneous collapses triggered the systemic crisis we have been witnessing for over a year. The indictment was given wide coverage; ex Bear executives in handcuffs being led to the federal court. The message was that unscrupulous individuals who had gamed the system were now being called on the carpet.

In these two stories we have the perfect example of the binary system of explanation that I have been writing about: the failings of fallible humans, and/or the can't-do-anything-about-it nature of things. Nothing else is entertained. Nothing else is permitted. The philosophy of philosophers of our time or the indictment of failed fund managers all serve to reinforce this message.

I am familiar with the funds in question and how they imploded. Without defending the propriety of the actions of the managers or denying the commonness of petty crimes in finance, their collapse was the proverbial Exhibit A in the subjugation of men to the laws of finance. For those not sufficiently convinced, the $200 billion plus losses that some of the largest and most sophisticated global financial institutions have suffered in the past year – institutions that by virtue of their presence tend to game the system – offers yet a more compelling evidence.

This brings me to Speculative Capital. The central point of my theory is that the crises of various form and intensity that we have been seeing since the mid 1970s are not a one time – or two time or three time aberrations – but the necessary consequences of the growth of speculative capital. Speculative capital is self-destructive; it tends to eliminate the opportunities that give rise to it. Hence, only a conscious change in policy would avert the crippling systemic failure that is in the offing. But any such change in policy, while in the realm of the possible, borders on impossible. Recall from the Credit Woes series that broker/dealers, for example, need to operate with a 30-to-1 leverage, or their business model would not be viable. But a 30-to-1 leverage is inherently unstable, as Bear Stearns found out and Lehman is in the process of finding out. That brings us to the inner contradiction of the system: to function, the system has to be unstable.

All this is detailed in Vol. 4 of Speculative Capital, The Dialectics of Finance. I have returned to the manuscript with a sense of urgency. That is why the blog entries might at times be delayed. By way of compensation, I will occasionally post excerpts from the manuscript.

The Real Conflict of Interest (at Harvard)

In a front page article today, The New York Times reported that Dr. Joseph Biederman, a world-renowned Harvard child psychiatrist, had received at least $1.6 million from the drug companies in relation with consulting services that involved promoting their antipsychotic medicine. The article went on to say that Dr. Biederman’s work

helped to fuel a controversial 40-fold increase from 1994 to 2003 in the diagnosis of pediatric bipolar disorder, which is characterized by severe mood swings, and a rapid rise in the use of anti-psychotic medicine in children ... Some 500,000 children and teenagers were given at least one prescription for an antipsychotic in 2007, including 20,500 under 6 years of age.

The moral and social issues involved here – that a society chooses to tackle the problem of children’s behavior with the magic of pills, or the fact the news of this abuse has been out there for years – is not my concern; the subject of this blog is finance.

So let us talk about finance.

Do you recall, in the past ten or twenty times that you have come across Harvard’s name, what was it in relation to? It is a good guess that it was one of the following:

• the size of the university’s endowment fund; or


• the rate return of its endowment fund; or


• the change in the management of the fund; or


• the portfolio mix of the fund; or


• the investment strategy of the fund.

You get the idea; money is not an unconsidered trifle at Harvard. Just google “harvard + mohamed el-erian” – he managed the fund until last year – and see for yourself.

Consider now, if you will, the situation of a professor at Harvard. To advance his career, he must constantly produce and publish high quality research papers in prestigious journals. Publish-or-perish maxim rules at Harvard as in other universities.

The pressure to publish never ceases. It in fact increases with the tenure. That is because the driver of research is not the abstract love of knowledge but money, in the form of research grants. The more research grants you bring into your university, the faster you advance and the richer you become. Research grants, in turn, favor renowned schools and scholars. Hence, the incentive to become a world renowned expert in a prestigious school. It is a self-feeding, self-perpetuating loop.

The problem is that the only way a scholar could produce first rate, topical research is by aligning his research interests with the agenda of the world renowned publications that have advertising ties to the grant giving corporations. In the same way that fashion magazines create and dictate the fashion taste, companies create and dictate the research agenda. "Dictate” has a social connotation. It works through the internalization of values and manifests itself in the free choice of independent minded, even critical, scholars. To take the case of Dr. Biederman, it is inconceivable that he engineered a 40-fold rise in the use of anti-psychotic medicine in children against his beliefs. He must have believed that his work was contributing to the well-being of the children. If it also happened that it made money for him and the sponsoring corporation, it was icing on the cake.

Against this background, an “independent” scholar wanting to follow his own path – to do what he thinks is important – will be laughed out as a an out-of-touch fool, as the last old fashioned editor of the New England Journal of Medicine found out to his chagrin.

Conflicts of interest in medical science, biology and genetics tend to get closer scrutiny. But they pale in comparison with what takes place in economics and finance. Setting aside the petty corruption that is common, every single research paper and every general research topic in economics and finance is set in motion by the interests of traders, fund managers, bankers, investment bankers, broker/dealers and arbitrageurs. These interests also determine the framing of the problems, in consequence of which the direction of research and its results become preordained.

In Vol. 3 of Speculative Capital, I spent considerable time on this subject. Analyzing the steps that led Black, Scholes and Merton to their option valuation formula, I wrote :

They set out to solve the problem of option valuation. They were theorists, but the theory at their disposal was not up to the task. So they chose pragmatism. More accurately, pragmatism was forced upon them. They went to the market and adapted the solution of traders that had developed from the practice. That choice set the direction and limitation of the work, as everything they later brought into the model, no matter how theoretical, served the end of mimicking traders’ actions. But traders were wrong about options. They though an option was a right to buy or sell. It is in fact a right to default. In faithfully and uncritically replicating what traders did, Black, Scholes and Merton thus replicated their error.

That is the heavy price of the subjugation of thought to “practical” business considerations: the universe of solutions is reduced, with the right answer at times being altogether excluded from consideration. As just one, but very timely, example look at the bafflement in the face of what is taking place in the financial markets. Where are the esteemed professors of economics and finance, Nobel laureates, think tank “resident scholars”, investment gurus and corporate chieftains with their solutions? The best they have managed to do is to describe the events – and that incorrectly. Sartre’s pointed question in Critique of Dialectical Reason comes to mind: How could practical man think?

As for Harvard, it has not gone unpunished either. It is now home to Alan Dershowitz, a law professor specializing in civil liberties, no less, who advocates torturing detainees for quick confession. That is the pragmatism taken to its logical end – attending to the practical matter in hand, say extracting a confession, without any thought.

In the Inferno, the deformities in the bodies of the damned correspond to the kind of sin they have committed. Even Dante could not dream a more fitting punishment on Harvard.

The Crisis Continues

It is about 7:00 am here in New York. I am going to watch the shares of Lehman Brothers. And keep watching in coming days. Let us see how this thing will play out in light of the precarious condition of the broker/dealers that I described in Credit Woes series.