Personal Finance Portfolio should be dynamic

We often hear experts said

if you are young, you can take more risk, hence put your investment in equity.

then

if you are old, you should keep your capital in safer vehicle like bond etc.

But one important strategy they miss out is ... the dynamic of personal finance portfolio.

Says you are 25 years old, you will need a sum of money at 35 years old. Hence you can invest into equity. However, you must learn something about the equity market you are entering into. For example, you know that for every 10 years in your equity market, there will be a peak and a bottom. So perhaps by 3-4 years before your maturity date, ie. 31-32 years old. You should start considering withdrawing your equity investment and keep them in a money market or bond fund. This will preserve your capital and secure you from unexpected last minute change, ie. a sudden equity collapse.

for example;

age 25 : 90% equity, 10% bond

age 27 : 80% equity, 20% bond

age 32 : 40% equity, 60% bond

age 34 : 10% equity, 90% bond

Keeping a non dynamic portfolio expose you to risk the whole time. If bad luck hits you, you may lost all your 9 years of earning in the 10th year. So one must keep ones personal finance portfolio dynamic.

High Frequency Trading and Flash Crash – 3: How the Die Was Cast

Nathan Rothschild, head of the family’s London branch, had an agent in the Battle of Waterloo. Upon seeing that the tide of the war was turning against Napoleon, the agent rode to nearby Brussels and hired a sailor for the unheard sum of 2000 francs to take him across a stormy Channel to England and his boss. With valuable intelligence at hand, Nathan rushed to the London Stock Exchange and feigned selling. The crowd followed, on the belief that Wellington had lost. After the share prices had collapsed during the selling frenzy, Nathan Rothschild began buying, making millions.

Whether this is a true story or a legend is not the point here. The point is ethics.

No, I am not talking about Nathan Rothschild. Good for him, I say. If the goyims were slaughtering one another over money, why shouldn’t a Jew make few a pounds from the mayhem?

The question of ethics pertains to the Rothschild agent. What would you say if he had used a mule instead of a horse, or had waited for a “scheduled” ferry and calmer seas?

Why, such willful delaying tactics would amount to sabotaging his mission. That would be treason, a crime punishable by death at wartime.

Imagine now, if you will, that the Rothschilds had an equally sharp rival family. We call them Rosenzweig.

The Rosenzweigs, too, considered war a man-send opportunity for making handsome profits, but they could not place an agent in Waterloo. What they did, instead, was place a jockey with a fast Arabian horse at the ferry stop on the English side. They instructed their jockey to take a peek at the open message that the Rothschild agent was carrying and rush to the Rosenzweigs with that information ahead of Rothschild’s man.

The scenario is a bit contrived (for a really contrived scenario you have to read Friedman’s “government helicopter” dropping money on the rabble), but you see where I am going with it. Would the ethical dimension of the story change if the Rothschild agent had used a steamboat instead of a sailboat, or if the Rosenzweig man had used a car instead of horse, or one of them had used a cell phone to pass the message along or traveled with the speed of electrons?

These progressively faster means of “getting there” take us in principle from Waterloo to high-frequency trading (HFT).

In principle, but not exactly. That is because in HFT, the dialectical law that the accumulation of quantitative changes results in a qualitative change kicks in and creates a situation with its own peculiarities; there is a long way from the one off stunt of an ear-to-the-ground businessman to the way HFT works in modern, decentralized exchanges. But I started from a technical angle to show that “getting there first” – because there is money to be made from speed – is the driver of both scenarios and the sole purpose of the game. The “fairness” issue – as in the HFT not being “fair” to “others” – is a fig leaf to cover the self interest of those critics of the HFT whose interests the practice threatens. Long before the rise of HFT, brokerage firms touted their fast execution capabilities – like how news organizations tout their speed in covering “breaking news” – as a competitive advantage and selling point. It was only a matter of time before competition and technology would push the speed to its physical limit. That time having arrived, we could now focus on the financial aspects of HFT.

The practical man of finance who started the stock exchanges on both sides of the Atlantic knew that bringing buyers and sellers together, the way it is done in a flea market or a bazaar, would not in itself be sufficient for creating a viable exchange. That was only the first step, a necessary but not sufficient condition.

Why and how a stock exchange is different from a flea market or a bazaar is a relatively advanced topic in economics and finance theory. The space limitations of a blog preclude me from delving into it in detail. But I cannot give the subject a short shrift because its understanding is a condition for understanding HFT. Consider what follows a compromise.

A stock (share in the UK) is a security. A security is the evidence of ownership of notional capital.

Imagine an aspiring entrepreneur who approaches 10 people and raises $100,000 from each for a venture to produce widgets. He gives a receipt to each contributor.

After the completion of the fund raising, the entrepreneur has $1,000,000 in cash. The balance sheet of his corporation (which he has set up to produce widgets) would show $1,000,000 cash under Assets and 1,000,000 under Owners Equity. Separately, each one of the 10 people have a receipt indicating that they have given the entrepreneur $100,000.

Afterwards, the entrepreneur goes to work. He rents a space ($100,000), installs tools and machinery ($500,000), buys the raw materials ($200,000) and hires workers ($100,000). He keeps $100,000 cash for operations.

After these activities, the value of his company’s assets remains unchained at $1,000,000. But the composition of assets is different. Cash is used to buy the components of the production apparatus that will create the widgets. We could say that it is converted into those components. The conversion turns:

• The original $1,000,000 from money into capital.
• The people who gave money into investors.
• The receipts in investors’ hand into securities.

From here the definition of a security as the evidence of ownership of notional capital follows. Capital is notional or imaginary because it is already spent. If one of the investors has a change of heart at this point and wants his money back, he would be out of luck. The entrepreneur would remind him that his $100,000 is already spent – converted into the elements of production. What is more, it is impossible to determine which 10% of the total enterprise belongs to a particular investor. All $100,000s were combined to create a synthetic, organic whole.($100,000 cash is as much a necessary part of operations as wages and the raw material). That, of course, was the plan all along: to spend the money in a precise, purposeful manner which would make it capable of producing profit. It is to this profit that the holder of the security is entitled on a pro rata basis.

System-wide, though, the situation of the investor who wants his cash back is not hopeless. The economic system that creates stocks also creates stock exchanges precisely for that reason: for investors to sell their securities to other investors. The mechanism merely replaces the title of the ownership of the capital but otherwise leaves it undisturbed in the production process.

That is how the stock exchanges are different from a flea market or bazaar. In the latter places, the participants are consumers and producers and what is exchanged is a commodity – worked matter, generally.

In a stock exchange, the participants are capitalists. They are not buying and selling commodities but converting one form of capital into another.

The change of forms of capital signifies movement, which is the defining characteristic of capital – in the same way that breathing is the defining characteristic of live creatures. Yet, it remains unknown to professors and bankers. That is one reason for their profound and often embarrassing ignorance of events taking place around them.

Note, for example, what happens after the widgets are produced. The composition of the company’s balance sheet changes again, reflecting another change of form of the capital. Under Assets, raw material is reduced and the tools are depreciated. But there is now a new item: widget inventory. The widgets are produced and ready to be shipped.

To keep his factory working, our entrepreneur must begin a new cycle of production. He has to buy raw material, pay the rent, pay the workers and also pay the investors. But no one wants to be paid in widgets. They all want money, which means that he must sell the widgets. That is, he must convert his capital from commodity form into money form.

It is no exaggeration to say that, unless you are reading this in a remote village, everything you see around yourself is shaped by that process. A full chapter in Vol. 4 deals specifically with that topic. As a pitch for the book, but also as further background, let me quote a few paragraphs:

During production, the entrepreneur was in full command because he had paid for, and therefore, owned, everything within in the production process. Now, the sale must be affected by buyers – outsiders over whom he has no control.

It would be saying too much to say that like the Blanche DuBois character, our entrepreneur depends on the kindness of strangers to sell his widgets. No hawker of goods ever sat completely passive. Throughout the millennia, the craftsmen in the East and West have used various venues, with varying degrees of subtlety and aggressiveness, to attract buyers. The techniques in all forms revolved around a two prong strategy that is intuitively obvious to a seller: being noticed by the potential buyers and then actually “closing the sale” against the energetic pitch of competitors. The idea of bazaar that exists in one form or other in all early communities, is the practical realization of the strategy to bring all the buyers into one place, to affect what in the modern retail business is called “foot traffic.”

An entrepreneur of the 21st Century, where Capitalism reigns supreme in much of the world, must go beyond these passive measures. He has to actively seek buyers and then entice them to buy his product as opposed to the products of his competitors who claim to offer superior or cheaper alternatives.

***

Every entrepreneur begins the venture by asking probing questions about the sales prospects of the product he is planning to produce: Will it sell? Who would be the buyers? How long will they continue to buy? What price would they be willing to pay? Who are the competitors?

These are the intuitive and obvious questions. But the complexity of the modern markets demands more than an intuitive approach. It demands a systematic and methodical analysis of the markets, with the goal of turning the subjective, intuitive lesson of selling into a “science” with principles. Hence, the advent of marketing which, alongside finance, is the core subject of all the business schools.

***

Advertising is the ‘art’ of ‘effecting sales’. Note that there is no reference here to the product. Advertising is the means affecting the sales of any product. In the eyes of a salesman, houses, nuclear waste, electronic gadgets and plots of cemeteries are all products to be sold. Only the sales pitch varies, depending on the product and circumstances. In this way, in advertising, the fundamental, which is the product, becomes an incidental, to be addressed through the manipulation of the form, which is the way the product is promoted. The fundamental is the conversion into money of whatever that is being sold.

***

On the surface, “affecting sale” pertains to the product, but its target is in fact the buyer. It is the buyer who must be persuaded to part with his money in exchange for the product. What we have in “affecting sales”, therefore, is influencing the behavior of potential buyers – making them buy a product which they would not have otherwise bought. When the focus thus shifts to the buyer and the ways of influencing his behavior, it matters little whether the product serves a real need. If the advertising can create the need and persuade the customer to act on it, the goal of the exchanging product for money is accomplished.

Returning to our entrepreneur, if he cannot sell the widgets, the cycle of capital’s circulation, involving re-ordering raw material, extending the lease, keeping the workers, and distributing profits to investors, would be interrupted. That would translate to a crisis, a phenomenon whose analysis is beyond our subject. I merely note that while commodity-to-money form of capital’s transformation is the most intuitive and immediately accessible, the other forms and the ease of their transformation into one another are no less important in preserving capital’s cycle.

The practical businessmen who started the exchanges did not know these theoretical fine points but they did not have to, in the same way that a six year-old who rides bicycle need not know about the preservation of angular momentum that keeps the bicycle on two wheels.

The businessmen realized that a stock is a title and claim to future steam of incomes. Future profits being inherently uncertain, an element of speculation is always present in stock prices. At times, that aspect of stock trading could get out of hand and disrupt the “equilibrium” of the supply-demand. Under such conditions, the relation of the stock prices and the underlying physical reality of capital could be severed, as it happened in 1907’s Bankers’ Panic.

Then, J.P. Morgan prevented a collapse by ordering wholesale buying of stocks. But the crisis showed the need for a formal mechanism to stabilize the market. Markets were outgrowing the capacity of one individual or firm to control them. That experience led to the establishment of the Federal Reserve in 1913, an institution whose central mission was to act as the “lender of the last resort”.

The Fed was about lending and borrowing money. The stock exchanges needed a buyer and seller of last resort. So it came that the “specialist system” was established in the New York Stock Exchange. Each specialist was assigned a group of stocks in which he had to “make market”: bid for the shares of those who wanted to sell, and offer the shares to those who wanted to buy. Buyers and sellers could not trade with one another the way they did in a flea market. They had to go through the specialists.

Later when the Nasdaq market started, the same function was duplicated there, only in Nasdaq, the title was “market maker” and they were typically the arms of the Wall St. firms such as Goldman, Lehman and Merrill Lynch.

You can see the centrality of the specialist position and how lucrative and privileged it was. Profits were virtually guaranteed. An IBM specialist, for example, would buy the stock from A for $40.125 and sell it to B at anywhere from $40.25 to $40.625. A change in the stock had generally no impact on specialists’ profits. He could maintain the same “spread” between bid and offered prices if that stock rose to $43 or fell to $38. Assuming a daily volume of 200,000 shares, that translated to about $100,000 a day.

Sure, occasionally stocks went south and sell pressure forced the specialists and market makers to dip into their own capital and buy stocks where no other buyer was present. But these instances were few and far in between.

Far more important, the specialists could see the overall buy and sell orders for a particular stock and position themselves accordingly; they could buy for their own account if they saw a strong buy order or sell if there was a sell bias in the market. That is “front running” which has always been illegal. Occasionally a few small time brokers were charged with the practice, but it was virtually impossible to prove or enforce it in the case of specialists and market makers.

Then came the Crash of ‘87. On that fateful October day, as the unprecedented sell pressure mounted and the buyers disappeared, specialist and market makers refused to accept orders. In fact, they refused to answer the phones. And then, they walked out. They had little choice. Their capital was close to exhaustion, with no end to selling in sight. At 3pm on October 19, 1987, no one dared to buy because there was no telling how much further the stock prices could drop. The normal functioning of the market had broken down.

There is a large number of books, reports and studies on the cause of the crash of ‘87. Not a single one of them got the story right. You could not get the story right without knowing speculative capital. Quite a few mentioned “program trading” as the cause of the crash without realizing that “program trading” and its cousin, “portfolio insurance” are the particular manifestations of speculative capital. The rest offered drivel. Here is what Michael Steinhardt, a hedge fund manager who had become the all-purpose commentator on the markets, said: “The stock market is supposed to be an indicator of things to come, a discounting mechanism that is telling you of what the world is to be. All that context was shattered. In 1987, the stock-market crash was telling you nothing.”

Was he wrong! Oh, boy, was he wrong! Never was the stock market so prophetic. But how could a moneyman realize that the stock market was signaling the collapse of the stock exchange system – its destruction under the onslaught of speculative capital? That is what specialists and market makers leaving their posts signified.

High Frequency Trading and Flash Crash – 2: A Philosophical Prelude to Part 3

I sat down this morning to write the second and final part of HFT. I knew how the piece was going to end. It would end on a note of uncertainty and low-grade despair, that “nothing to be done” condition familiar to Beckett readers.

But the dialectics of finance is precisely about going beyond the passive acceptance of events just because they are, to influence and shape them. The inconsistency between the seemingly resigned ending and the active world view that drives the dialectics of finance called for an elaboration.

To purposefully shape events, we must know their dynamics and understand why and how they occur. A financial crisis, for example, has its roots in finance. Saying that the lenders’ stupidity or the borrowers’ greed caused it is saying nothing. After such “explanations”, the erudite explainers shake their head at human folly and go their way, leaving the subject exactly where they had found it. To understand the events, we must take them as they develop “on the ground”. Hegel’s assertion that what is real is rational shows us the way to proceed.

To Hegel, the real is what has happened; historical if it involves humans, natural, otherwise.

Rational involves reason and reason involves necessity.

Hegel is saying that what has happened: i)had to happen; and ii)[for that very reason] it can be logically explained.

The critical point in all this is that the “had to” part refers to the internal dynamics of the phenomenon and is defined within its confines and boundaries. There is “nothing to be done” only with the available (including permissible) means within the situation, because those means are either the results or the conditions of the situation in the first place. A cancer-ridden body cannot in itself fight cancer because it is the source of the cancer. The help must come from the outside in the form of dietary change, surgery or chemical intervention.

Far from being a passive justification of the status quo, “what is real is rational” is a call for knowledgeable action – “praxis” in Sartre’s terminology – when the “rational” proves undesirable.

Let me elaborate on this abstract point through an example from the ongoing mortgage/foreclosure mess.

Take a bank – Bank of America (BoA) would be a good example – with a large mortgage portfolio. As part of a CDO securitization, the bank sells 1000 of those mortgages to a Wall St. firm, say, Morgan Stanley. I described the process in the Goldman Case.

Borrowing money to buy a home is a process that must satisfy a variety of legal requirements, which is why the buyers must sign a thick batch of documents on the closing day. One of those documents is the “mortgage” which authorizes the bank to auction off the property and take its money in case of the borrower's default. Another document is the promissory note, which is the evidence and proof that the home buyer has borrowed money from the bank. Yet another document is the title insurance that guarantees that the home is the property of the seller and is now being transferred to the buyer and there is no dispute in that regard. With the rest, we are not concerned here.

Now, attention! Did the bank – the BoA in our example – transfer the notes to Morgan Stanley as part of the securitization process?

This is not a trick question. It does not involve gray areas, competing narratives, conflicting viewpoints and personal interpretations. Like the question of pregnancy, it is the quintessence of a binary question with a only ‘yes’ or ‘no’ answer.

If yes, if the bank did transfer the notes to the trustee and the CDO originator, then it does not have the notes, which means that it cannot foreclose on home buyers who are in default. The first step in seeking judicial relief from a court in relation with a claim is proving the claim. No proof of indebtedness, no case. Period.

If the bank did not transfer the notes to the CDO originator, then the originator – Morgan Stanley, in our example – never owned the mortgages. In that case, the securitization would not have been legal, with almost mind-numbing implications. For example, the originator would have the right to put the mortgages back to BoA. With the mortgages anywhere from 30 to 70 percent underwater, that would wipe out BoA many times over.

It is tempting to ask, Which one is it, then? But that is a sophomoric question concerned with winning a point. Hegel teaches us to look at the facts on the ground for understanding . From the National Mortgage News under the title B of A Disowns Its Own Lawyer's Argument in Fumbled Mortgage Case:

To quell doubts about its mortgage unit's handling of documents, Bank of America Corp. is distancing itself from … itself.

B of A now says that a senior litigation manager .. was out of her depth when she testified in a New Jersey courtroom about the unit's document practices ... In a series of unforced admissions, the B of A manager ... and ... the company's outside attorney described how Countrywide had failed to adhere to the most rudimentary of securitization procedures, such as transferring the original promissory note to the trusts that had purchased the loans, as required under the pooling and servicing agreement.

Both ... said it was standard practice for Countrywide to hold onto the original mortgage notes ... despite securitization contracts that require the notes be physically transferred to sponsors, trustees or custodians.

There! So the original mortgage notes were not transferred to the CDO trustee. But the CDO trustee had sold those notes to public and private funds. Who owns the promissory notes and, more to the point, how the title insurance company handles the title insurance?

From the Financial Times of November 29, under the heading US courts battle with backlog as foreclosures rise:

Florida’s legislature assigned $9.6m earlier this year to set up special foreclosure courts, labeled “rocket dockets”, with the aim of paying retired judges to clear 62 per cent of the backlog by next July.

The article reported that in a 3-month period between July 1, when the money was allocated and September 30, 65,000 cases were “cleared”. It added:

It is a truism that justice delayed is justice denied, but some say that high-speed courts are themselves risky and have an inherent bias towards the banks. “The system is designed to tilt towards the plaintiffs; the easiest, fastest, cleanest way to do this is to just grant summary final judgment and award the properties to them,” says Chip Parker, a lawyer who defended homeowners in Jacksonville.

Lawyers such as Mr Parker allege that these courts show leniency towards the sloppy bookkeeping of the banks, but crack down on homeowners who are ill-prepared.

What “sloppy bookkeeping” are the lawyers talking about? We just saw that the promissory notes were not transferred to the CDO trustees, so the banks could technically foreclose because they were holding the notes.

But often banks cannot locate the notes despite their claims to the contrary. That is the robo signing that you have been reading about.

Mr. Parker the lawyer told FT: “Countrywide was not the exception. Countrywide was the rule. Everyone did it that way, showing that securitization was never done properly.”

He then added: “After this, the judges in foreclosure cases are going to have to start ignoring massive systemic violations of law in order to grant foreclosures … Do we save the financial markets and sacrifice the rule of law? You can’t save both, you’ve got the sacrifice one for the other.”

The rule of law or the financial markets: only one can be saved. One has to choose.

Now you see the source of my interest in the breakdown of law. Starting from the very first post, O Judgment!, I have frequently written on the subject. See here, here, and here, for example.

The breakdown we are witnessing is pervasive and systematic. The Florida bankruptcy courts are merely following a trend set by the Supreme Court and the Federal Reserve.

Law is a mechanism set up to prevent social conflicts and antagonisms from being settled by force – or turning violent. As every thug knows, violence might be a necessary tool in the early stages of establishing a business, but it later becomes unnecessary and even detrimental to the business.

When the established legal system in a society is violated from the top, it is a sign that the dominant institutions of the society cannot continue business as usual under the relations that they themselves had drafted. These institutions force for even more favorable conditions which, through one off court decisions, ad hoc rulings and laws tilted towards the defendants translates in practice to lawlessness.

All these developments are rational. They all develop logically from the inner workings of the system. And they all gradually move the system towards instability and collapse.

HFT is one such development.

The Ultimate Retail Business Model in the U.S.

Today’s American Banker had an article titled What YouTube Teaches Banks About Customer Experience.

I do not know what YouTube teaches banks about customer experience. But I know what the iPhone and iPad have taught swindlers – hence the connection between the business and crime.

Apple’s business model is to provide cheap apps to a large number of users; about 250,000 apps to over 10 million users. You pay a few dollars for an app that often performs magnificently. Everyone is happy. You, because you got a good application at a next to nothing price, the vendor, who sold tens and maybe hundreds of thousands of apps, and Apple, which gets a cut from all this. The trick is the low price and large volume – the ultimate retail model.

Imagine now that you are a big company with a large number of customers and you go rouge: you begin to charge them a few dollars each month for no reason. Would anyone complain or notice? And if they did, would anyone have time to spend 45 minutes on the phone with “Mary” in Bangladesh to clear a $2 charge?

Exactly. (And if someone complains, refund their goddam few dollars.) So you get to make tens of millions of dollars a month swindling customers and hoping not to get caught.

How does this model work in practice? Click on the following links for the answer. You don’t have to read the articles. Just glance at the heading or the lead paragraph.

Click 1

Click 2

Click 3

Click 4

These are mere samples. Spend a few minutes goolging “class action lawsuit and telecom” and you will be surprised at the pervasiveness of the fraud.

Now comes the punchline: click here to see why your government has 3 branches and why the Supreme Court exists.

An Essay On the Emergence of India

During his recent trip to India, President Obama said that India “it not simply emerging. Indian has emerged”.

I concur in principle. But I am not the president of the United States and my assertions will not be accepted as proof. So, I am writing a short essay to explain my concurrence.

In the simple sentence India has emerged, we have no problem with India. The reference is clear and universally understood. But the “has emerged” part is vague because it is obviously metaphorical; as a large country, India was never hidden or submerged. I must then explain: i) what does emerge mean in the context or, to put it differently, in what sense can a large country “emerge”; and ii) what is the evidence that India in practice has accomplished the task, or fulfilled the requirements, of emerging.

Recall that capital takes social relations as it finds them and then, over time, turns them into capitalistic, i.e., transaction based, relations. The transformation is alternatively heralded as “improvement”, “reform”, “modernization”, “progress” and “development” – all words with positive connotations because the yardsticks of judgment are shaped by, and thus favor, capital-based relations.

Take modern. The word is nothing but a reflection and measure of the extent of the intrusion of capital into social relations, a point that Chaplin noticed and relayed in Modern Times. The more the intrusion, the more modern a society is said to be.

To make this point clearer, look at Cavallini’s 1290 painting, The Last Judgment.




Now compare it with Holbein’s 1533 painting, The Ambassadors.




The span between the two works is a mere 240 years. Cavallini’s work, furthermore, belongs to the Renaissance period which immediately preceded modernity. Yet, a sea change has taken place between the two. The Last Judgment looks “old” to us, with an unmistakable undertone of otherworldliness.

The Ambassadors, by contrast, is contemporary and modern. The two men confidently gazing at us could be models posing for a fashion journal in New York City.

The difference, as I previously remarked, is in the transformation of European society from the feudal to capitalist system. The Ambassadors are surrounded by a collection of valuable, traded commodities with the means of navigation symbolizing overseas trade. To capture all that, Holbein is forced to use the oil medium in the same way that modern advertisers use color picture: to accentuate the colors and fineness of the men’s wealth, including their wardrobe. Their pose and gaze is the pose and gaze of successful men of affairs, something that we see everyday in the business section of newspapers. That is why The Ambassadors looks modern to us.

Emergence has the same genealogy. The more capital-based relations intrude into the social fabric of a country, the more “emerged” it becomes. When even the far away villages are conquered in this way, the country can be said to have fully emerged.

Before taking up the case India, though, let us read this short passage from Vol. 3:

This confusing of moral, legal and financial is a common error among those looking at the appearances only. Here is the economic columnist of the New York Times [Paul Krugman] injecting morality into the subject of default: “Advanced countries – the status to which Argentina aspires – regard default on debt as a moral sin.”

In truth, “advanced countries” hold no such view. In the U.S., corporations use bankruptcy for a variety of strategic and tactical reasons – most commonly when they plan to renege on their pension liabilities. More fundamentally, in the Anglo Saxon jurisprudence, there is no inherently immoral or forbidden concept, of the kind one finds in religion. The foundation of this jurisprudence is the commercial consideration of the early stages of capitalism in England.

The “moral aspects” of default about which columnists and scholars of law are in the habit of sounding off are the indignation of the owners of capital at the prospect of losing their money. Because their views and interests set the social and cultural agenda, this view is gradually codified through casuistry and given a moral and ethical cover – and sold to the public as such.

Default is an incident in finance. Starting from the primitive societies in which “recalcitrant debtors … could be put to death and even hewn in pieces by their creditors or sold as slave beyond the Tiber” we arrive at Shylock at the dawn of capitalism who demands a pound of flesh in lieu of his money. His demand, nota bene, is legal, written into an enforceable contract. More humanitarian imprisoning of delinquent borrowers then follows, a “remedy” still in practice in many societies. As commerce develops, usury is recognized as impediment to business and outlawed. But the usurer continues to exist in the margins of the society, supplying the “weak credit” with funds and using various loopholes of the law to enforce payment.

As financial markets grow in size and sophistication, they take on the subject of default – itself a subset of credit risk – peel its social shell and turn it into a tradable commodity. The process begins with the most receptive and “logical” markets such as corporate bonds, where the relative value of credit and the possibility of default are an integral part of pricing; “cost of default” has long been a staple of this market: “Mr. Goldman [a fixed income strategist] says that a corporate bond’s interest rate spread over the government bond curve is the cost of issuer’s option to default.” Shaming, like jailing and maiming, is still used as a way of reducing defaults.

When I was writing these lines in 2005, microfinancing – lending a few hundred dollars to poor peasants to turn them into successful entrepreneurs – had captured the imagination of social reformers as the practical side of Mother Teresa’s dispensing of love to the poor. Its promoter, Muhammad Yunus, received the Nobel Peace Prize in 2006.

I was struck by the shamelessness and the absurdity of the idea. In the Inferno, the sinners’ physical deformities correspond to the kind of sin they have committed. I imagined that had there been a paradise with the same logic of reward, Mother Teresa and Muhammad Yunus would be present there, one with a large bleeding heart, the other with an oversized penis, both overlooking the wretchedness of the earth.

Five years later, the verdict is in, as reported in today’s New York Times:

Initially the work of nonprofit groups, the tiny loans to the poor known as microcredit once seemed a promising path out of poverty for millions. In recent years, foundations, venture capitalists and the World Bank have used India as a petri dish for similar for-profit “social enterprises” that seek to make money while filling a social need. Like-minded industries have sprung up in Africa, Latin America and other parts of Asia.

But microfinance in pursuit of profits has led some microcredit companies around the world to extend loans to poor villagers at exorbitant interest rates and without enough regard for their ability to repay. Some companies have more than doubled their revenues annually.

Now some Indian officials fear that microfinance could become India’s version of the United States’ subprime mortgage debacle, in which the seemingly noble idea of extending home ownership to low-income households threatened to collapse the global banking system because of a reckless, grow-at-any-cost strategy. Responding to public anger over abuses in the microcredit industry — and growing reports of suicides among people unable to pay mounting debts — legislators in the state of Andhra Pradesh last month passed a stringent new law restricting how the companies can lend and collect money.

Government officials in the state say they had little choice but to act, and point to women like Durgamma Dappu, a widowed laborer from this impoverished village who took a loan from a private microfinance company because she wanted to build a house.

She had never had a bank account or earned a regular salary but was given a $200 loan anyway, which she struggled to repay. So she took another from a different company, then another, until she was nearly $2,000 in debt. In September she fled her village, leaving her family little choice but to forfeit her tiny plot of land, and her dreams.

“These institutions are using quite coercive methods to collect,” said V. Vasant Kumar, the state’s minister for rural development. “They aren’t looking at sustainability or ensuring the money is going to income-generating activities. They are just making money.”

Reddy Subrahmanyam, a senior official who helped write the Andhra Pradesh legislation, accuses microfinance companies of making “hyperprofits off the poor,” and said the industry had become no better than the widely despised village loan sharks it was intended to replace.

“The money lender lives in the community,” he said. “At least you can burn down his house. With these companies, it is loot and scoot.”

The last point is crucial. There was always a village usurer. But however hateful he was, he lived in the community and was a part of it. It was inconceivable for him to force a widower to flee the village. He would gain nothing from it.

With the bankers and venture capitalists as usurers – they charge 30% per annum – the indebted widower must flee. There are grand designs for her village.

Has India emerged, then? I must say that it has, in principle. But we have not heard the last of this story yet.

A Footnote to the Post Below

Using footnotes in blogs is awkward. It forces the reader to switch back and forth between the main text and footnote, an extra step that disrupts reading. Hypertext suffers from the same drawback.

In a printed page, the matter is easier, but only if the footnote is at the bottom of the page. With a quick movement of the eyes then, the reader can read the footnote and continue with the main text.

In my books I use footnotes in two ways: to provide the source for a material I quote and to buttress the argument I make in the main body of the text. In the post below, I pointed out that when capital cannot generate profits, it will have no reason to borrow money, even if the money is offered at no cost. Under that condition the focus shifts to cutbacks, including dismantling the plant and equipment.

If I were writing that in a book, I would have footnoted it with the following Financial Times story. Under the heading US banks see demand for business loans drop, the paper reported today:

Bank loan officers say that demand for loans from small US companies fell in the past three months, casting doubt on how much the Federal Reserve can stimulate the economy ...every bank reporting a decline in small business loan demand said that its customers had caught back on their investment in plant or equipment.

There was a decline in loan demand from larger companies as well, with 25 per cent of loan officers saying it had fallen compared with 18 per cent who said that it rose.

Does Bernanke know this? That is the subject of the concluding part of the Time Preference/QE series.

Time Preference, Kim Kardashian, Quantitative Easing, Good Black Swan – 1 of 2

The depth, sophistication and musicality of Persian poetry is unmatched in any other language. Many of the great Iranian poets were believed in their time to have divine inspirations, so perfect is the fusion of form and content in their poems. And then there was the legendary spontaneity. A popular form of entertainment in the court or bazaar alike was throwing 4 impossibly unrelated words at a poet — toe, cow, ocean and Christ, for example — which he then used fil-bedaheh in a 4-line stanza to express an overlooked truth about life. Fil-bedaheh means on the spot, without thinking and contemplation. Such power I think had its roots in the poets’ philosophical and religious world view. If you believed that all things came from God, then all had commonalities, i.e., all were related. It was only the matter of perception of seeing the common link and the skill of putting them into a coherent whole.

The title of this post comes from that tradition, except that there is nothing fil-bedaheh about it. In fact, I made up the title after I had finished the piece, which is not quite the same thing! I, too, am a man of our time, writing in New York of 2010 where, like Ace Greenberg, everyone is looking for a little unfair advantage.

***

There is, in the standard economics theory taught to all freshmen, the notion of “time preference”. According to this conjecture, “people” — that would be all people: men, women and children everywhere — prefer “now” to “then”; they’d rather have $100 now than one year later. So if they wait one year to get the money, they would demand more, say $105, for their sacrifice. That is why interest rate exists! The difference between $100 now and $105 in one year is the 5% annual interest rate.

***

On Wednesay, the Federal Reserve announced phase II of its quantitative easing program (QE2), in which it will buy $600 billion of long-term U.S. government bonds over the next eight months. The idea behind QE2 is to “drive down interest rates and encourage more borrowing and growth”.

***

Gotcha, Ben Shalom Bernanke! Remember your Washington Post article, published just after the announcement of QE2 to soften the critics?

Easier financial conditions [by you pushing the rates lower via QE2] will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment.

Never mind that housing shows no sign of life. What is the story about lower corporate bond rate encouraging investment? You are saying that QE2 will spur growth because it will make money available to businesses now.

But if the rates are lowered, the time preference will be destroyed. That’s what you taught in your Princeton economics course. With zero or very low interest rates, there is no incentive to act now, because the difference between then and now is zero or very little. In that case, why would corporations choose to invest now instead of say, one year from now, huh? What do you have to say to that?

***

I believe in the narrowest interpretation of time preference: that in our mid to late 50s we tend to be more mature than third-graders. I know that it is not a general or inexorable law.

***

Between being hanged today and next year, people would choose next year. That is also true of having a colonoscopy, getting an eviction notice, losing one’s job and life's other unpleasantries. Why, the word procrastination would not exist if people always preferred “now” to “then”. But it does, thus pointing to the hidden hedonistic supposition behind time preference: it exists only in relation with acquiring and consuming pleasurable things. The mindset that conjures up time preference, in other words, is that of a Kim Kardashian or a Paris Hilton. The economists representing that mindset take the idea and dress it up in high language and mathematical notations for respectability. Paul Samuelson, whose name pops up whenever a vacuous idea comes up, was one of the most vulgar, and therefore the most outstanding, representatives of that lot. Look at the title of his paper and then read the drivel in the abstract to see what I mean.

Beyond empty-headed women and mountebanks, what gives rise to the illusion of time preference and helps sustain and institutionalize it is the commodity fetishism of a consumer society. That is why this moon-is-made-of-green-cheese nonsense that a first-grader could refute survives. No less than the “anti-establishment” author of the Black Swan divides black swans to good and bad groups. He calls Viagra a good black swan!

Here is a link to Wikipedia on time preference. Do not limit yourself to that site. Google “time preference” and take a look at some of the results — this one, for example, written by 3 inquiring minds from the nation’s premier institutions of higher learning — to get an idea about the level of scholarship and critical thinking in 21st century America.

***

There is no such thing as time preference in economics. Interest rates do not arise because humans prefer now to then. If that were the case, we would have billions of interest rates, corresponding to the subjective perception of every person on the planet. Quite the opposite: it is precisely because interest rate exists that time has “value”.

Interest is a deduction from profit. It is the share that finance capital claims from the profit of industrial capital. From Vol. 3:

When the rate of return of industrial and commercial capital falls, credit capital must likewise lower its rate. Otherwise, it would have to sit idle, having found no takers. Interest rates could indeed fall to zero and remain there for a long time if commercial or industrial capital cannot generate a profit. Under such conditions, they would have no reason to borrow, as borrowing would only aggravate the loss. In that regard, the Federal Reserve in the U.S. that raises and lowers interest rates to “cool down” or “stimulate” the “economy” merely reacts to market condition rather than shapes it.

These lines were written more than 5 years ago. What are the conditions now?

***

The industrial capital in the West has migrated to the East and South in search of lower labor costs and higher profits. (Capital has migrated, not its owners.)

Alas, the investment opportunities in the East and South cannot accommodate all the mass of ready-to-be-employed capital. So, a portion of capital in the West is left behind, sitting idle with no place to go.

That cannot go on. It cannot be allowed.

***

One way of generating employment opportunities for the idle capital is lowering labor costs in the West. If you are reading this in the Western hemisphere, everything you read in your local newspaper about economics and “politics” revolves around this issue. Cameron, Sarkozy, Papandreou, Zapatero, Cowen, Dombrovskis, even Merkel have no higher priorities. I have written about this issue. See, for example, here and here.

This idleness has a physical manifestation as well, but its most telling sign is the large pile of cash that corporations have amassed on their balance sheet.

Economics-professor-turned-the-Fed-chairman does not understand this process; at best he understands it superficially. He is trying to revive the activities of industrial capital by lowering the rates, fancying that with rates at zero or close to zero, the prospect of even low profit rate like 2% will induce corporations to borrow and invest. But the process is not reversible. Corporations cannot be induced to making investment – no matter how low the interest rates – if their investments would not generate income. That is why they have large spare, i.e., unused, capacity. Bernanke absent-mindedly admits that much when he writes that “low and falling inflation indicate that the economy has considerable spare capacity”. When corporations do not use the money they already have – because they cannot – what would they do with more money?

***

Corporations sitting on a large pile of cash which they cannot invest buy other corporations to benefit from “synergy”. That is the polite word for layoffs – hardly the stuff of economic recovery.

***

If QE2 will not influence investment decisions and economic recovery, what will it do?