Rarefied Air

A few years ago I was fortunate to attend a lecture given by Paul Wilmott challenging the wisdom of modeling derivatives on the assumption that there is no arbitrage. He floated an alternative approach (as but one of many possible heterodox approaches) outlining the pitfalls therein – chiefly the difficulty of convincing investors to bear with you until your thesis proves out – and toward the end he took questions. Some brave soul asked him, “Where does the money come from?”
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The following post is by Dealbreaker reader and commenter Infinite Guest.

A few years ago I was fortunate to attend a lecture given by Paul Wilmott challenging the wisdom of modeling derivatives on the assumption that there is no arbitrage. He floated an alternative approach (as but one of many possible heterodox approaches) outlining the pitfalls therein – chiefly the difficulty of convincing investors to bear with you until your thesis proves out – and toward the end he took questions. Some brave soul asked him, “Where does the money come from?”

“Thin air?” he replied.

Whether you consider money a medium of exchange, a store of value, a means of paying taxes or a means of keeping score, money in aggregate is a denominator. It purports to measure things like wealth and income. A “stable” currency in some sense is therefore desirable, and we all have a common interest in seeing to it that money is created or destroyed, made available to the economy or not, in some sort of equitable or at least responsible fashion, by people and institutions we feel can somehow be held accountable for their actions. In ordinary times one you would have very little motivation to question where money comes from but after being told every day of your life for a few years that the global financial system, having lately suffered a near-death experience, is a social ill, inherently flawed, fragile and corrupt, which might at any time blow up the economy and abscond with your job, your house and your savings in tow, then you might become if not strictly speaking curious at least concerned. You might seek safety in a gold standard or some other type of commodity money. You might get worked up about the national debt or the Federal Reserve. You might even, as IMF economists Jaromir Benes and Michael Kumhof have been doing with their excellent working paper “The Chicago Plan Revisited” search for answers in the creative past and, with the benefit of modern technology, conclude that the time has come to end fractional-reserve banking once and for all.

“The Chicago Plan Revisited” applies mathematics borrowed from quantum physics to a set of ideas generated by creative political economists reeling from the shocks of the Great Depression with confirmatory results. It relies on what’s called a DSGE model of the economy, a type of “bottom-up” model that evaluates macroeconomic conditions more-or-less microeconomically. The monetary recommendations of the original Chicago Plan were eventually articulated by Irving Fisher et al. as “A Program For Monetary Reform,” a thoughtful document that reads as relevant today as it must have then if not more so, although like many old manifestos its commitment to the inevitability of its own premises ironically undermines the credibility of its argument. That is to say, were fractional-reserve banking so inadequate to meet demand for money and the public debt so unsustainably high (in 1939!) that Chicago-style monetary reform would necessarily occur, why bother advocating for it? “The Chicago Plan Revisited” is in that sense more tentative than the original. Full-reserve banking is mathematically superior to fractional-reserve banking given the right initial conditions of leverage and provided that the right institutions have adequate technology and sufficient incentives to behave properly. Both papers assert that full-reserve banking would smooth out the business cycle, reduce public and private debt and consign banking panics to the dustbin of history. The more recent analysis finds, over and above the claims of its ancestor, that full-reserve banking would eliminate inflation and stimulate economic growth. While reasonable people may quibble, let’s assume for the time being that under the right circumstances they’re dead right about all that. What then?

Among many appealing features of the narrative present in “The Chicago Plan Revisited” is its understanding of money creation, a practitioner’s understanding true to its roots in Fisher’s view of endogenous money. The money we use is not created as a multiple of some pre-existing reserve on a stock of deposits but quite the opposite. Deposits chase lending. Lenders really do create money out of thin air. Reserve requirements from that perspective don’t have as much power as we might like. They don’t effectively constrain lending. Credit creation under such a regime being bound to money creation, reserve requirements don’t constrain that either. Given that somewhere down the line inflation is related to money supply, policy rates don’t appear likely to do much, either. Lending is presumably like any other business. Lenders create as much credit as the can at some premium to the policy rate, one of their more relevant input costs, and when it stops being profitable, they stop lending. Such a decision process on such a production function doesn’t necessarily lend itself to producing a “stable” currency.

That sums up the supply side of things anyhow. Implicitly lenders are trying to meet some kind of demand. If markets work, they work because they clear at some price level where supply and demand are identical. The authors recognize that the value of liquidity services concentrated within a small group of privileged parties who are authorized to create money may be quite substantial. They seem recognize further, at least with respect to credit, that markets do not always clear. Here they note that at the bottom of the credit cycle lenders tend to avail themselves of the contractual right they bought at the top of the cycle to seize the collateral assets of borrowers who default. In private hands, both the value of liquidity and the legal seizure of assets are presented as types of usury, “the calculated misuse of a nation’s money system for private gain,” the sort of definition that reveals more about the perspective of the people who wrote it than perhaps it intends.

Money per se owes its existence to the rule of law. It should be apparent that all kinds of property are created by law. That fact does not necessarily argue in favor of state ownership of all kinds of property any more or less than it argues in favor of state control of money. Good laws distinguish between private and public property. As part of the social contract, good management of public property serves the owners of private property rather than punishing them. Good laws restrict the power of government, protect private property and facilitate the orderly and equitable transfer of private property rather than impairing it. If it is socially undesirable to leave control of the money supply to a privileged few capitalists, it does not absolutely follow that it would be socially desirable to place that control in the hands of appointed officials, either. Economic models are explicitly intended to describe human behavior and within some limited scope to predict it, and of course, economic models rest on assumptions about human behavior. But more than rest on assumptions —here I can’t help thinking about Emanuel Derman’s Models.Behaving.Badly., an extended meditation on the subject — economic models comprise assumptions. The beginning, middle and end of a model economy, no matter how rigorous, complex and lifelike it may appear to be, are all collections of falsifiable statements about who people are, what we do and why. Having that in mind, it’s striking that for all their depth and attention to detail, Benes and Kumhof do not admit the possibility of gross incompetence on the part of their government monetary authority; and specifically excluded from the plan is the possibility that governments may wage war from time to time. The assumption that war is an exceptional circumstance that may be avoided by responsible government underpins both their analysis of monetary history and their model economy. With one gorgeous flourish of a hand-wave, the authors state:

To be fair, there have of course been historical episodes where government-issued currencies collapsed amid high inflation. But the lessons from these episodes are so obvious, and so unrelated to the fact that monetary control was exercised by the government, that they need not concern us here. These lessons are: First, do not put a convicted murderer and gambler, or similar characters, in charge of your monetary system (the 1717-1720 John Law episode in France). Second, do not start a war, and if you do, do not lose it (wars, especially lost ones, can destroy any currency, irrespective of whether monetary control is exercised by the government or by private parties).

On the contrary, one might imagine that banks exist precisely because in this world governments are by-and-large larcenous, murderous and stupid.

The plan itself, following a “transition period” whose brutality is buried beneath a thick carpet of relatively harmless-looking stochastic differential equations, would leave banks largely intact with the same relationships and inter-relationships, under the same management and capital adequacy constraints they now face, and enjoying most of the same privileges and profits they do today, except that ongoing profits from the liquidity services of money would be repatriated to the government in the form of seigniorage. Private debt would be necessarily constrained to a level supported entirely by equity. Unless we share the authors’ optimistic perspective that government can separately (and wisely) dictate the total volume of available credit, reducing banks to beneficent allocators of available capital, it’s not easy to see why we should be so sanguine about the prospects of such an arrangement: if lenders can only lend on equity then they need to show big profits, so that their market value increases, so that they can issue more equity, so that they can make more loans. Eventually they might make really risky loans in order to show big paper profits. When the value of their lending portfolio decreases, if recent history is any guide, they may turn out to be reluctant to take write-downs. They restructure. Only catastrophic collapse is sufficient to restrain them.

Supposing despite these reservations that full reserve banking of the type that leaves government firmly in control of money would eliminate inflation and smooth out business cycle, would that really be better than the way things are? Peaks of the business cycle encourage innovation. Troughs penalize untimely ideas. The business cycle is a crude motivator, and it isn’t always fair by some universal definition of fairness, but it’s only one element of a larger integrated system that includes other remedies through other institutions. Fair or not, the business cycle is part of a dynamic society in which today’s oligarch may at least potentially be tomorrow’s pauper. Come to think of it, periodic unexpected changes in inflation can be a natural way of keeping the rentier class in check. While a static society may be easier for economists to explain and predict, smoothing the business cycle and eliminating inflation seem likely to have the unfortunate side effects of strengthening the very oligarchy the authors apparently want to unseat.

What if instead of leaving control of money to the whims of the elite or handing it over to bureaucrats we regard the creation of money as a human right? Informal lending predates official government money, after all. The laws we live with around money really represent past and current governments’ largely successful efforts to take power away from individuals and potential competitors, placing it in the hands of trusted allies. We have available technology today that would allow anyone with a cell phone to create money if only we would remove the artificial regulatory fences that prevent such democratization. On a small but growing scale, we already create credit that way, with no special regulatory framework on reserves, capital adequacy or anything else, for instance through websites like Prosper. The same creativity and freedom that got us out of the Great Depression is today applied in socially beneficial ways to the allocation of credit and might some day soon be used to diffuse seigniorage so broadly that it loses the value associated with any special privilege, leaving only pure money with whatever “real” value it actually has.

Ultimately the source of our disappointments with money is not that the air it comes from is too thin. It's too closely contained. You might say it’s downright stuffy.


Opening Bell: 09.24.12

Germany Losing Patience With Spain as EU Warns on Crisis Effort (Bloomberg) Germany’s governing coalition showed growing exasperation with Spain, as a senior ally of Chancellor Angela Merkel said Prime Minister Mariano Rajoy must stop prevaricating and decide whether Spain needs a full rescue. “He must spell out what the situation is,” Michael Meister, the chief whip and finance spokesman for Merkel’s Christian Democratic Union, said in an interview in Berlin today. The fact he’s not doing so shows “Rajoy evidently has a communications problem. If he needs help he must say so.” Germany Dismisses Talk of Boosting Bailout Fund (WSJ) Europe is discussing ways to leverage the assets of its €500 billion ($649.05 billion) bailout fund through the involvement of private-sector investors, but reports that this could boost the firepower of the European Stability Mechanism to more than €2 trillion are "completely illusory," a spokesman for the German Finance Ministry said on Monday. Cost of Leaving Greece Rises for Crédit Agricole (WSJ) Crédit Agricole will likely have to pour a further €600 million ($779 million) to €700 million into its flailing Greek unit before it will be able sell the subsidiary, according to people from both the private and public sectors with knowledge of the sales process. Under Ben Bernanke, An Open And More Forceful Fed (WaPo) In what might be his final years as chairman of the Federal Reserve, Ben S. Bernanke is transforming the U.S. central bank, seeking to shed its reclusive habits and make it a constant presence in bolstering the economy. The new approach would make the Fed’s policies more responsive to the needs of the economy — and likely more forceful, because what the Fed is planning to do would be much clearer. A key feature of the strategy could be producing a set of scenarios for when and how the Fed would intervene, which would mark a dramatic shift for an organization that throughout its history has been famously opaque. Bernanke has already pushed the Fed far along this path. The central bank this month pledged to stimulate the economy until it no longer needs the help, an unprecedented promise to intervene for years. That’s a big change from the Fed’s usual role as a curb on inflation and buffer against financial crises. “It’s a re-imagining of Fed policy,” said John E. Silvia, chief economist at Wells Fargo. “It’s a much more explicit commitment than people had thought about in the past. It’s a much stronger commitment to focus on unemployment.” Economists Say US Needs More Taxes, Spending Cuts (AP) A slight majority of respondents — 59 percent — said that current U.S. monetary policy was "about right." The percentage replying that monetary policy was "too stimulative" fell slightly compared with the percentage that held that same view in March, while the proportion answering that policy was "too restrictive" edged up. Flight attendant brings revolver through Philly airport security (NYDN) Republic Airlines flight attendant Jaclyn Luby was walking through airport screening around 6:50 a.m. when she placed her carry-on bag through the X-ray machine. Transportation Security Administration screeners saw the gun, described as a .38 caliber Smith and Wesson Airweight revolver, and notified a Philadelphia police officer. Luby was in another screening room with police when the gun went off. The bullet fired into a TSA break room, where an employee was sitting, police told NBC 10 Philadelphia. The gun discharged when the officer tried to put the safety on. Luby, a flight attendant for more than five years, told authorities that she had a permit to carry a gun — but forgot hers was in her handbag...“We are human and everybody does make mistakes and I understand that, even though she’s a seasoned veteran, she needs to be careful,” US Airways passenger Andrea Burger said, adding, “I’m sure it will be a great learning opportunity for her.” Winkelvoss Twins Weigh In On Facebook IPO (NYP) Cameron and Tyler Winklevoss have put their $65 million Facebook lawsuit settlement money to work, starting Winklevoss Capital, a venture-capital firm focused on technology investments. The duo were asked by Yahoo!’s Daily Ticker what went wrong with the Facebook initial public offering. Cameron Winklevoss said the insiders got greedy and didn’t leave something on the table. “I think when you alienate a group of investors, it takes time to build that rapport back.” Tyler Winklevoss thought the hoodie and “hacker way” ethos didn’t play well with public investors. Mark Zuckerberg’s business model “might work in Silicon Valley with venture-capital firms, but when you go public and you’re talking to the Street, they’re much more concerned with numbers and bottom line and accountability.” Hedge Funds Cut Bets as Prices Drop Most Since June (Bloomberg) Hedge funds cut bullish commodity bets for the first time this month as weaker manufacturing from China and Europe eclipsed central banks’ efforts to boost growth, driving down prices the most since June. Money managers decreased their net-long positions across 18 U.S. futures and options by 1.7 percent to 1.307 million contracts in the week ended Sept. 18, halting two weeks of gains that had sent holdings to a 16-month high, U.S. Commodity Futures Trading Commission data show. Wells Fargo Should Buy CIT Group, Says Analyst (Reuters) FYI. U.K. to Set Up Business Bank (WSJ) The U.K. government is investing £1 billion ($1.62 billion) to set up a new state-backed business bank that it hopes will eventually support up to £10 billion of new lending for small and medium-size companies, Business Secretary Vince Cable will announce on Monday. The new wholesale bank, which will operate at arms length from the government, aims to attract more than £1 billion of private-sector capital to help tackle what it sees as the long-standing problem of a lack of credit for smaller companies. Houston Officer Kills Double Amputee in Wheelchair (AP) A Houston police officer shot and killed a one-armed, one-legged man in a wheelchair Saturday inside a group home after police say the double amputee threatened the officer and aggressively waved a metal object that turned out to be a pen. Police spokeswoman Jodi Silva said the man cornered the officer in his wheelchair and was making threats while trying to stab the officer with the pen. At the time, the officer did not know what the metal object was that the man was waving, Silva said. She said the man came "within inches to a foot" of the officer and did not follow instructions to calm down and remain still. "Fearing for his partner's safety and his own safety, he discharged his weapon," Silva told The Associated Press.

Opening Bell: 02.22.12

Fitch Downgrades Greece (WSJ) Fitch Ratings downgraded Greece's credit rating to C from triple-C Wednesday after confirmation of the country's second bailout package, which includes a debt exchange that will force bondholders to take a loss on their holdings of Greek debt. "The rating action is in line with Fitch's statement on 6 June 2011, which outlined its rating approach to a sovereign-debt exchange," the ratings company said. Fitch said it will lower its rating on the country's sovereign bonds to "restricted default" upon the completion of the debt exchange aimed at reducing the country's debt burden.

Opening Bell: 12.14.12

UBS Unit Said to Be Close to Guilty Plea in Rate-Rigging Scandal (NYT) Federal prosecutors are close to securing a guilty plea from a UBS subsidiary at the center of a global investigation into interest rate manipulation, the first big bank to agree to criminal charges in more than a decade. UBS is in final negotiations with American, British and Swiss authorities to settle accusations that its employees reported false rates, a deal in which the bank's Japanese unit is expected to plead guilty to a criminal charge, according to people briefed on the matter who spoke of private discussions on the condition of anonymity. Along with the rare admission of criminal wrongdoing at the subsidiary, UBS could face about $1 billion in fines and regulatory sanctions, the people said. Meet Them In St. Louis: Bankers Move (WSJ) Smaller cities around the nation have emerged as unlikely hives of financial-services hiring, thanks to lower wages, municipal-tax incentives and the misfortunes of older hubs that are home to companies ravaged by the 2008-2009 financial crisis. The beneficiaries are spread across the U.S., according to an analysis of data by The Wall Street Journal. In St. Louis, the 19th-largest U.S. metropolitan area, securities-industry employment surged 85% between January 2007 and September 2012 to a recent 12,190, according to figures compiled by Moody's Analytics. New York lost 9% of its jobs in the securities, commodities, asset-management and fiduciary-trust areas over the same period, leaving it with 195,000. Counter-Terrorism Tools Used to Spot Staff Fraud (FT) JPMorgan Chase has turned to technology used for countering terrorism to spot fraud risk among its own employees and to tackle problems such as deciding how much to charge when selling property behind troubled mortgages. The technology involves crunching vast amounts of data to identify hard-to-detect patterns in markets or individual behavior that could reveal risks or openings to make money. Other banks are also turning to "big data", the name given to using large bodies of information, to identify potential rogue traders who might land them with massive losses, according to experts in the field...Guy Chiarello, JPMorgan's chief information officer, said the bank was mining massive bodies of data in "a couple of dozen projects" that promised to have a significant affect on its business, although he refused to give further details. According to three people familiar with its activities, JPMorgan has used Palantir Technologies, a Silicon Valley company whose technology was honed while working for the US intelligence services, for part of its effort. It first used the technology to spot fraudsters trying to hack into client accounts or ATMs, but has recently started to turn it on its own 250,000-strong staff. Obama Meets Boehner at White House for Budget Talks (Bloomberg) President Barack Obama and House Speaker John Boehner met for a third time at the White House to discuss averting spending cuts and tax increases before a year- end deadline. Boehner and Obama met for almost an hour yesterday, with no public announcement of progress. In January, more than $600 billion in spending cuts and tax increases, the so-called fiscal cliff, are scheduled to begin. “The president and speaker had a frank meeting in the Oval Office,” Boehner spokesman Brendan Buck said in an e-mailed statement, adding that the “lines of communication remain open.” Britain's Queen Quizzes Central Bank on Financial Crisis (CNBC) During a visit to the Bank of England on Thursday, the Queen was overheard asking whether a "lax" attitude to financial regulation had contributed to the financial crisis. After touring the vast vaults of gold bullion that lie beneath the central bank in London, Queen Elizabeth reportedly asked the central bank officials whether the Financial Services Authority (FSA) that was meant to regulate the banking system had not been aggressive enough - "did not have the teeth" - in its response to the crisis...The Queen was then told that officials in the room were charged with ensuring the crisis did not happen again. The Queen's husband, Prince Philip, then jokingly asked "There's not another one coming, is there?" before telling the officials present "Don't do it again." John McAfee Returns to US, Admits Playing 'Crazy Card' (ABC) After three weeks ducking authorities in Belize, by hiding in attics, in the jungle and in dingy hotels, he turned up in Guatemala Dec. 3. Barely a day later he was detained for entering the country illegally. As Guatemala officials grappled with how to handle his request for asylum and the Belize government's demand for his deportation, McAfee fell ill. The mysterious illness, described by his attorney alternately as a heart ailment or a nervous breakdown, led to a scene with reporters chasing his ambulance down the narrow streets of Guatemala City and right into the emergency room, where McAfee appeared unresponsive. He now says it was all a ruse: "It was a deception but who did it hurt? I look pretty healthy, don't I?" He says he faked the illness in order to buy some time for a judge to hear his case and stay his deportation to Belize, a government he believes wants him dead. When asked whether he believes Belize officials where inept, he didn't mince words. "I was on the run with a 20-year-old girl for three and a half weeks inside their borders and everyone was looking for me, and they did not catch me," he said. "I escaped, was captured and they tried to send me back. Now I'm sitting in Miami. There had to be some ineptness." [...] He denies any involvement in his neighbor's death but adds that he is not particularly concerned about clearing his name. He is focused on getting his 20-year-old and 17-year-old girlfriends out of Belize and says he has no idea what he'll do next, where he'll live or how he'll support himself. CNBC v. Buffett (NYP) The “Oracle of Omaha” sent a terse e-mail to editors at CNBC yesterday after a reporter for the cable news network railed against his recent repurchase of Berkshire Hathaway shares. Gary Kaminsky, CNBC’s capital markets editor, took Buffett to task for the $1.2 billion stock buyback, calling it “hypocritical to the maximum level.” Kaminsky claimed that Buffett’s purchase allowed the seller — described by Berkshire as the “estate of a long-time shareholder” — to avoid potentially higher capital gains taxes next year...In his rebuttal e-mail, Buffett said capital gains taxes don’t apply to estates. “Mr. Kaminsky also made the statement that the estate that was a seller was better off by selling in 2012 than 2013,” he wrote. “This, too, was incorrect.” He said capital gains are wiped out by stepped-up basis rules, with assets marked at their current fair-market value at the time of death. Buffett also blasted Kaminsky for saying his buyback was hypocritical on principal as Buffett is known to eschew buybacks. Buffett attached a copy of Berkshire’s 1984 annual report showing he has outlined conditions under which he would favor buybacks. CNBC anchor Melissa Lee read a correction late Tuesday that thanked the famed investor for “watching and setting us straight.” Fisher: Fed Risks 'Hotel California' Monetary Policy (CNBC) Dallas Fed President Richard Fisher told CNBC that he's worried the U.S. central bank is in a "Hotel California" type of monetary policy because of its "engorged balance sheet." Evoking lyrics from the famous song by The Eagles, he said he feared the Fed would be able to "check out anytime you like, but never leave." Fisher said on "Squawk Box" that he argued against revealing the new inflation and unemployment targets set by the Fed this week, saying he's worried that the markets will become "overly concerned" with the thresholds. Euro-Zone Downturn Eases (WSJ) Data company Markit said on Friday its preliminary purchasing managers' index, a gauge of activity among euro-zone factories and services companies, rose to 47.3 in December from 46.5 in November. A reading above 50.0 would signal an expansion. The national measure for Germany picked up to 50.5 from 49.2 in November, indicating that activity rose in the euro zone's largest member. "The euro-zone downturn showed further signs of easing in December, adding to hopes that the outlook for next year is brightening," said Chris Williamson, chief economist at Markit. Residents find neighbor at their door with machete (KS) A 38-year-old Bremerton man was arrested by police Monday night for allegedly confronting his neighbors with a machete in response to alleged vandalism at his residence, according to documents filed in Kitsap County District Court. Officers were called to a Nollwood Lane address shortly after 8 p.m. Monday. Two residents said when they answered a knock at their door, a man was standing in the doorway holding a machete. The man, a neighbor, reportedly said he was tired of vandalism to his home and blamed it on a family member of his neighbors, police said. The neighbors attempted to slam the door on the man, but he reportedly put his foot into the door holding it open, police said. The neighbors were ultimately able to close it, though the suspect denies he put his foot in the door. Police interviewed the man, 38, who admitted he'd retrieved the machete out of anger after another incident of vandalism.