Sleepwalking into The Upside of Down

“Our societies’ rising connectivity and speed have a final disturbing effect. In the past, cascading failures usually occurred within single systems—like electrical grids or banking systems—but now these failures are more likely to jump system boundaries. If, for example, terrorists use a new genetically engineered organism to contaminate a Western country’s food supply, the disruption will spread in a flash beyond the food system to our larger economic and political systems. Because today’s communication technologies vastly multiply our emotional reaction to shocking events—something we saw in full force in the wake of the 9/11 attacks and anthrax letters—this kind of terrorism could easily cause a financial panic and even civil disorder, despite the fact that the threat posed to any one person from the attack might be very small. The scale, connectivity, and speed of our modern food-supply system could also spread a new bio-terror organism far and wide before authorities have figured out what’s going on, increasing the chances that it would jump from the food system to affect ecological systems in nature.”

Excerpt From: Thomas Homer-Dixon. “The Upside of Down.” Knopf Canada, 2006. iBooks.

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Whiskey: Instant Expert by John Lamond #ScotchSunday Review

When one is starting out exploring the world of whiskey one inevitably turns to authors like Michael Jackson, Charles MacLean, Dave Broom, Robin Tucek.
Of course, any list of whisky experts is incomplete without Master of Malt John Lamond.

While the internet, smart phones and being connected 24/7 makes navigating the whiskey world easier, there is still nothing like the experience of reading a real book. This is where Lamond’s book, Whiskey, published under Princeton Architectural Press’ “Instant Expert” series is a terrific addition (represented in Canada by Raincoast Books).

Whiskey: Instant Expert fits in the palm of your hand

Measuring 4.71″ x 6.61″ and at 144 pages, Whiskey: Instant Expert fits into the palm of one’s hand but it isn’t meant to be an exhaustive database of whiskeys and reviews available around the world — there are simply too many combinations and expressions. However, it provides insight for those looking to learn a lot quickly, from the very basic to the esoteric:

Whisky vs. whiskey
Scotch whisky is spelled “whisky” and must be from Scotland to be called scotch. With Irish whiskey –which has had perhaps an even longer history– the word is spelled “whiskey.”

Traditional partners for whiskey
…found in the west coast of Scotland where the fisherman would traditionally have a dram of malt whiskey with their oysters — not to the side but poured on the shell like we do today with Tobasco.

Ardbeg distillery
Ardbeg’s make is the most heavily peated of all Scotland’s whiskies, at 50 parts per million. Its make has always been a favourite of Islay aficionados, but it was closed more often than it was open in the 30 years prior to being taken over by Glenmorangie in 1997.

Glenmorangie distillery
One of the leading malts around the world, it has the tallest stills in Scotland, at just under 17 feet. The height of the still means that only the finest and most delicate of flavours fall over the lyne arm, which runs from the head of the still to the condenser.

Scotch and Irish whiskies
The malt for Scotch whiskey is dried over an open peat fire, which means the smoke permeates the grains and this smoky taste carries right through to the final whisky. By contrast, in Ireland, the malt is dried in closed kilns so that only hot air dries the grains, not smoke.

The citations above are a sampling of what the book contains. The contents range from the fundamentals to colourful stories about discovering, collecting and storing.


Contents of Whiskey: Instant Expert by John Lamond

If there is anything that could be improved it is the indexing: some of pages numbers (in the index) didn’t seem to match. Whiskey: Instant Expert makes a nice gift for a budding Malt Master this holiday season and retails for $14.40 from Amazon.ca

Level: Beginner to Expert
Writing Style: 4.5 / 5
Reviews: 3.5 / 5
Value: Very High
Sukasa Stars: 4.5 out of 5

(Reviewed by Arijit Banik for SukasaStyle)

Less is (sometimes) more

Economists make an exception when information is not free: more information is always better unless the costs of acquiring further information surpass the expected gains. My point, however, is stronger. Even when information is free, situations exist where more information is detrimental. More memory is not always better. More time is not always better. More insider knowledge may help to explain yesterday’s market by hindsight, but not to predict the market of tomorrow. Less is truly more under the following conditions:

 A beneficial degree of ignorance. As illustrated by the recognition heuristic, the gut feeling can outperform a considerable amount of knowledge and information.

 Unconscious motor skills. The gut feelings of trained experts are based on unconscious skills whose execution can be impeded by over deliberation.

 Cognitive limitations. Our brains seem to have built-in mechanisms, such as forgetting and starting small, that protect us from some of the dangers of possessing too much information. Without cognitive limitations, we would not function as intelligently as we do.

 The freedom-of-choice paradox. The more options one has, the more possibilities for experiencing conflict arise, and the more difficult it becomes to compare the options. There is a point where more options, products, and choices hurt both seller and consumer.

 The benefits of simplicity. In an uncertain world, simple rules of thumb can predict complex phenomena as well as or better than complex rules do.

 Information costs. As in the case of the pediatric staff at the teaching hospital, extracting too much information can harm a patient. Similarly, at the workplace or in relationships, being overly curious can destroy trust.

 Note that the first five items are genuine cases of less is more. Even if the layperson gained more information or the expert more time, or our memory retained all sensory information, or the company produced more varieties, all at no extra cost, they would still be worse off across the board. The last case is a trade-off in which it is the costs of further search that make less information the better choice. The little boy was hurt by the continuing diagnostic procedures, that is, by the physical and mental costs of search, not by the resulting information.

 Good intuitions ignore information. Gut feelings spring from rules of thumb that extract only a few pieces of information from a complex environment, such as a recognized name or whether the angle of gaze is constant, and ignore the rest. How does this work, exactly?

Gerd Gigerenzer, Gut Feelings: The Intelligence of the Unconscious, (New York: Viking Penguin, 2007), 37-39.

Gut Feelings: The Intelligence of the Unconscious

Let loanable funds R.I.P.

The Global Economic Crisis brought about a questioning of economic orthodoxy, no meaningful introspection from the Ivory Tower establishment, and a catalyst to those interested in economic ideas to search the econ blogosphere. Economic blogs come in all shapes and sizes, the 200 most influential are listed here yet many take the unabashed position to posit ideas “as they should be” from the perspective of the bloggers beliefs and preferences rather than as they are.

A particular point of contention is the discussion of money, banking and money market operations. People who have actually worked in this sector, be they on the sell side as a broker or dealer in the capital markets function of an investment bank or on the buy side on a treasury desk for a bank or a major corporation understand the vagaries and nuances of origination, funding, loans and deposits. Some may view money from a metallist perspective while others from the chartalist perspective and all have their own innate beliefs as to whether the US Federal Reserve’s actions are for the greater good or for nought but in the end, most should not have time for drivel such as loanable funds theory or the fairy tale that is the money multiplier. Banking does not work that way.

If yours truly were a student today interested in the money markets then the indispensable text remains Marica Stigum’s Money Market, currently in its Fourth Edition and co-authored by Anthony Crescenzi. None of this stuff may be glamorous –after all MBA hot shots want to be Masters of the Universe and PhD Quants want to run the latest black box hi-frequency algorithm– but it is essential. The USD sits atop the hierarchy of money in the global financial system. If you understand the plumbing, you understand the connectedness thereafter when it seizes up as it would have done if the out of politicians in Washington had not reached a deal (however temporary).

What follows is a short explanation of the Fed Funds market “as it is” not as future and past winners of the Sveriges Riksbank Prize “believe it to be.”

(Emphasis in the passages below added by me]

The Federal Reserve requires that all commercial banks and depository institutions maintain reserves against their liabilities in the form of deposits at the Fed. Any vault cash such institutions hold also counts as reserves.

Prior to 1984, the reserves that a bank had to maintain during the current settlement week were based on the average daily deposits it held over a seven-day period two weeks earlier. Monetarists pushed for contemporaneous reserve accounting on the theory that it would reduce short-term fluctuations in money supply by forcing banks to adjust their reserves and thereby their lending to their current, not their previous, deposits. This was a naïve notion based on some Econ 101 text’s outmoded description of banking: a bank gets a deposit, and says, “Gee, I automatically make a loan.”

In real life, banks did not and do not operate that way. When loan demand was strong, money center banks adjusted their loans not to what deposits they received, but rather to the level of loans that their valued, creditworthy customers demanded of them; these banks then funded their loans, to the extent necessary, by buying money in the money market. This is a luxury that today’s bankers enjoy because both the supply and the demand for money have been strong for a few years. For example, the amount of commercial and industrial loans outstanding was at a record level in the middle of 2006, having increased by about 25% from two years prior before demand began to surge. Moreover, the banking system has been highly profitable, as evidenced by the FDIC’s Quarterly Banking Profile, which has shown that FDIC-insured banks earned record profits for five years straight through 2005, with earnings of $134.2 billion that year.

In any case, at the time of the switch to contemporaneous reserve accounting, banks objected on the grounds that the switch would be operationally expensive for them and, to boot, serve no useful purpose.

A second problem bankers saw with contemporaneous reserve accounting was that, while the Fed might get more current information, it might be less accurate because even a small error rate would amount to a large amount of money.

Despite bank protests, the Fed went ahead in 1984 with contemporaneous reserve accounting, some said as a sop that then Chairman Volcker felt he had to throw to the monetarists, who were at the time a vocal, in-fashion group.

Today, the reserves that a bank must maintain during the current settlement period are based on the average daily deposits it held before the settlement period began. This has been the case since July 1998 when the Fed adopted this lagged reserve accounting structure. Specifically, Federal Reserve rules state that a bank’s average reserves over the settlement period must equal the required percentage of its average deposits in the two-week period ending the Monday 16 days earlier. Banks receive credit (up to 4% of its required) in one two-week period for small amounts of excess reserves they held in the previous period; similarly, a small deficiency in one period may be made up with excess reserves in the following period. The carryover privilege is, however, limited to one period. A bank cannot go red (have a reserve deficiency) two periods in a row; and if it goes black (runs a reserve surplus) two periods in a row, the second period’s surplus becomes excess reserves for which it gets no credit. Thus, a bank’s settlements with the Fed tend over time to follow a pattern, alternating red and black settlement periods.²

For reserve calculation purposes, the reserve period begins on Thursday and ends on Wednesday. In settling with the Fed, a bank starts with a certain required average daily level of reserves. It need not hit its required level every day, but its average daily reserve balances over the reserve period must equal this figure. (Stigum et al. 2007)

Footnote

² The 4% surplus or deficiency that a bank may carry forward equals 42% of the total reserves it must hold over the reserve period, which in turn equals the bank’s required reserves multiplied by 14; this is so because a bank’s “required” refers to the average balance it must maintain over a 14-day period. Thus, if a bank’s required were, for example, $1 billion, it could carry forward a reserve surplus or deficit equal to: $1 billion × 14 × 4% = $560 million.

Reference

Marcia Stigum, and Anthony Crescenzi, Stigum’s Money Market, (New York: McGraw-Hill, 2007), 492-493.

Surplus Recycling 101

The United States accommodates and offsets whatever the rest of the world throws at it because, as issuer of the world’s key currency, it suffers from no external constraint: it has been able, at least up to now, to borrow as much as it wishes in its own currency, at modest interest rates… The result is that the Federal Reserve [the US central bank] is free to pursue policies that balance the US economy and, in doing so, also balance the world’s, by absorbing the excess savings and so the surplus of goods and services, at given real exchange rates, of the rest of the world. (Wolf, 2009: 110)

What does this mean? Don’t markets work in equilibrium, going from one equilibrium to another so that rates ebb and flow constantly in search of the right price, be it in terms of foreign exchange, real assets, policy rates, and asset markets? The truth is stranger than the concocted fiction.

Whether we want to believe it or not, markets are the constructs societies make them to be. The concept that Martin Wolf touches upon above in his book, Fixing Global Finance, remains alive and well to this day. Of the books that have tried to explain this abstraction perhaps Yanis Varoufakis’s The Global Minotaur comes the closest in explaining its importance in an accessible manner. Fundamentally, it is the notion of “Surplus Recycling” which Varoufakis skillfully writes about here:

(Varoufakis, 2011: 64-65)

References:

Varoufakis, Yanis, 2011, The Global Minotaur: America, the True Origins of the Financial Crisis and the Future of the World Economy (Zed Books)

Wolf, Martin, 2009, Fixing Global Finance: How to Curb Financial Crises in the 21st Century (Yale University).

George Cooper on the market for assets versus the market for goods and services

1.3 A Slight Of Hand

Now re-read Samuelson’s passage, only this time look out for the slight of hand in the final sentence:

 What is true of the markets for consumers’ goods is also true of markets for factors of production such as labor, land, and capital inputs.

The passage provides a convincing explanation of how equilibrium is established in the marketplace for goods, but when it comes to the markets for labour, land and capital inputs, there is no explanation of the mechanisms through which equilibrium is established. For these markets we are offered nothing better than proof by assertion. This logical trick is pervasive in economic teaching: we are first persuaded that the markets for goods are efficient, and then beguiled into believing this to be a general principle applicable to all markets. As the failure of Northern Rock and Bear Stearns show it is unsafe to assume that all markets are inherently stable.

1.4 The Market For Bling

We can easily find a counter example to Samuelson’s well-behaved supply-and-demand driven markets. In the marketplace for fine art and luxury goods, demand is frequently stimulated precisely because supply cannot be increased in the manner required for market efficiency: Who would pay $140,000,000 for a Jackson Pollock painting if supply could be increased in proportion to demand? The phrase “conspicuous consumption” was coined by the economist Thorstein Veblen to describe markets where demand rose rather than declined with price. Veblen’s theory was that in these markets it was the high price, the publically high price, of the object that generated the demand for it. Veblen argued that the wealthy used the purchase of high-priced goods to signal their economic status. (Footnote: “The Theory of the Leisure Class” Thorstein Veblen, first published 1899.) Veblen was the original economist of bling – if you’ve got it you want to flaunt it.

Fortunately for the high priests of market efficiency, Veblen’s observations can be dismissed as minor distortions within an overall economic environment that responds in a rational manner to higher prices. That is to say, even at a price of $140,000,000, the market for Jackson Pollock paintings is irrelevant to the wider economy.

1.5 When The Absence Of Supply Drives Demand

While the markets for bling can be dismissed as economically irrelevant, there are other much more important markets which also defy the laws of supply and demand, as described by Samuelson. While Veblen identified the rare conditions in which high prices promoted high demand, we can also consider the much more common situation in which low or falling supply promotes high demand.

Today’s oil markets are a case in point, where constrained supply is prompting higher speculative demand. While consumers of oil are reducing their oil purchases in response to supply constraints and higher prices, speculators (investors) in oil are moving in the opposite direction and increasing their purchases.

This simple observation of how consumers and speculators respond in different ways to supply constraints gives us the first hint that a fundamentally different market mechanism operates in the markets for assets to that which dominates the markets for goods and services. This effect is not confined just to today’s unusual oil market: Who would invest in the shares of a company if that company were in the habit of issuing more stock whenever its share price rose above a certain level?

As a rule, when we invest we are looking for an asset with a degree of scarcity value, one for which supply cannot be increased to meet demand. Whenever we invest in the hope of achieving capital gains we are seeking scarcity value, in defiance of the core principle that supply can move in response to demand.

To the extent that asset price changes can be seen as a signal of an asset becoming more or less scarce, we can see how asset markets may behave in a manner similar to those of Veblen’s market for conspicuous consumption goods. In Veblen’s case it is simply high prices that generate high demand, but in asset markets it is the rate of change of prices that stimulates shifting demand.

Frequently in asset markets demand does not stimulate supply, rather a lack of supply stimulates demand. Equally price rises can signal a lack of supply thereby generating additional demand, or, conversely, price falls can signal a glut of supply triggering reduced demand.

George Cooper, The Origin of Financial Crises: Central banks, credit bubbles and the efficient market fallacy, (Petersfield: Harriman House Ltd., 2008), 6-8.