Nostradoofus

What is transparency?  Even the most dogmatic laissez-faire advocates acknowledge it is necessary to efficient markets, but rarely define it. The usual definition is simply to make more information publicly available.  But this misses a fundamental observation: complexity diminishes transparency.

To appreciate this, consider an example we have all experienced.

In the past year, you have probably clicked through dozens of license agreements in various software programs and Web pages.  For example, on a Mac you clicked through more than a dozen agreements last year simply to run system software upgrades.

These are binding contracts.  But have you read all of them?  Any of them?

Of course not. There isn’t time. It could take 100 hours a year — about two weeks of work time — just to read your clickthrough agreements.  So you don’t.  Now you have a somewhat opaque business relationship with your software and Web service vendors, because the aggregate complexity of all such agreements exceeds your real-world capacity to absorb their meaning.

Similar examples include credit cards and insurance policies.  The typical homeowner has a half dozen of each, each with a binding agreement of 10,000 words or more, which is typically modified one or more times per year.  No one reads them, because no one can.

It turns out that the end buyers of mortgage-backed securities were in a similar position, but with a difference: they typically had a fiduciary duty to understand what they were signing.  Faced with the real-world impossibility of understanding the wildly complex MBS agreements — some of which are more than a thousand pages — they could have chosen not to buy.  Instead, they laid off the fiduciary responsibility to the rating agencies, simply assuming that AAA meant “safe,” as it had for the century prior to about 2004.

One could argue it was reasonable to believe the ratings, and that rating agencies blew it.  Or, one could claim (as rating agencies now do) that rating agencies were faced with the same problem:  the instruments are too complex to rate with confidence, and thus the buyer should fend for themselves.  But either way, the central problem is that the instruments themselves are so hard to understand that even professionals don’t get it.

This illustrates the complexity vs. transparency issue vividly.  By the traditional definition, MBS are utterly transparent, because you can obtain and read the entire agreement before buying.  But by any practical definition, they are opaque, because real-world buyers — even fiduciaries like bank investment managers — don’t have enough hours in the day, and possibly not enough theoretical background, to evaluate them.  Moreover, there is the well-documented psychological problem that almost everyone overestimates their understanding of complex things.

Caveat emptor?  The laissez-faire dogmatist might argue that those who don’t understand should simply not buy.  Again, true in theory, but again with a real-world, practical problem:  as MBS are currently prepared, if everyone who didn’t understand them didn’t buy, there would be no MBS industry.

“Well, maybe there should be no MBS, then!” some will say.  This is like saying, “fire is always bad because it burned me once.”  Fire is so useful that we tolerate occasional catastrophes.  Similarly, a stable MBS industry has such enormous benefits, from a capital efficiency standpoint, that we have an interest in seeing them presented simply enough to permit real-world transparency, and thus reliable ratings and comprehending buyers.  Tame the fire;  don’t extinguish it.

I conclude from this that federal regulation may want to focus on a “reasonable man” standard for simplicity in the presentation of financial instruments to certain types of buyer.  Not because careless buyers deserve it, but as a way to make complex instruments usable in the real world.

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The widely reported “imminent economic recovery” results mainly from:

1. Record high credit card default rates
2. Record high prime mortgage default rates
3. 70-year low US factory capacity utilization
4. 35-year high unemployment, still rising
5. 65-year high fiscal deficit, accelerating
6. Doubling of oil prices in 3 months
7. Magical thinking

There is essentially no evidence of recovery.  Even a single quarter of positive GDP growth, or employment growth, or income growth.  Anything.  The market is up 35% on sheer hope.  Beware.

I usually write about bigger themes, but FYI, an identity theft method popular for years in east Asia has recently hit US shores.  

It’s very clever.  Gangsters affix their own card reader over the card slot on your bank’s ATM machine.  When you insert your card, it passes through the gang’s reader and into the ATM.  You make your withdrawal as usual, and your card comes back.  Unbeknownst to you, the gang’s reader now has your card number, so they can create a duplicate of your ATM card.

But they still need your PIN, right?  Right.  That’s why they have a video camera installed across the street, with a telephoto lens aimed at the keypad.  They simply watch you type in your PIN.  Now they have a duplicate ATM card and your PIN.  Cha-ching.

This scam has been spotted recently in Orange County, California.  Fruits of globalization, I guess.  If you see something like it, do us all a favor and call the police.  Since the scam requires so much equipment, police have an excellent chance of catching the bad guys if they know where the equipment is.

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Proposed analytical framework for redesigning economic policy.  Common sense, but apparently not discussed anywhere else.

1.   Acknowledge history.  Current policy was essentially all forged in the 1930s. Forget deck-chair-rearranging debates about later initiatives:  the core assumptions — consumer-centrism, social safety net, regulatory structure, tax structure — were mostly crafted in the 30s.  

2.  Acknowledge changed circumstances.  In the 1930s, the United States was the lowest-cost producer of manufactured goods, the largest exporter, the largest creditor, had one of the highest savings rates, the best education system, and imported no energy.  Moreover, little was known about how to extend human life through medical technology or behavior.  All of these conditions have changed.

3.  Identify mismatched policies.  We went to a consumer-centric orientation in the 1930s in an effort to reverse deflation by unlocking America’s vast savings. Today, there are no savings to unlock, so consumer-centrism has nothing to unlock.  Securities regulation was designed around all securities that existed in the 1930s.  Many securities have been invented since then, so the old policy is unnecessarily narrow.  Medical insurance was developed piecemeal, in an era when there was very little that medicine could do.

4.  Choose one metric to optimize for.  I prefer median output per work hour, because it is simple, yet captures economic advancement and social equality at the same time.  Median productive life span might be a nice-to-have as well.

5.  Design new policies based on the above.

This leaves out some details, such as getting rid of policies that are bad under all circumstances (e.g. promoting consumer debt through tax subsidy), but the exercise will let almost anyone — even politicians — make smarter choices.

Fellow laissez-fairites, hang onto your hats…

Adam Smith’s “invisible hand” of free markets garners almost as much reverence as Isaac Newton’s laws of physics.  With good reason:  like Newton, his ideas are proven to govern most human-scale, real-world problems.

But of course, even Newton was wrong at the edges.  Small things and fast things do not obey Newton’s laws, much to Einstein’s and Feynman’s good fortune.  Newton is an approximation, albeit a very good one.

Similarly, it is interesting to at least ask the question:  under what conditions does Adam Smith describe the world poorly?  More specifically…

What if labor markets can actually be too flexible?

This might sometimes be the case in at least two ways.  First, in a deflationary spiral, if layoffs are very easy, then public companies will use them to stabilize quarterly earnings.  But in aggregate, this may actually accelerate the deflationary feedback loop, triggering a depression.

Second, what if too-easy substitution of cheap labor stalls domestic productivity growth per work hour — the only engine of long-term eocnomic advancement?

What if it’s actually a liability to have the reserve currency?

Having the reserve currency permits short-term interest rates to be held artificially low, while delaying the inflationary and exchange-rate consequences for many years.  Artificially low rates foster misallocated resources, including but not limited to investment bubbles.

1.   Individuals:  why save if you get a negative real return? Instead, pile into houses and stock.  If rates are really low, asset prices keep rising, so it’s short-run logical to borrow against your house and either double down on the stock market or buy an Escalade.
2.   Corporations:  why issue equity if you can issue debt almost for free?  Lever up, buy back the stock, go private.  Works great unless rates rise again someday, in which case the firm goes insolvent trying to roll over the debt.

Both of the above are short-run logical, long-run crazy.  But if rates are artificially low, and your currency artificially strong, for over a decade — a condition only possible for the reserve currency — then you start to get adults whose entire adult life has been governed by what should have been a short-run condition.  They know no other reality.

People thus learn lessons that cannot immediately be unlearned.  So if irrational conditions persist too long, their judgment is polluted for a long time. They are surprised, and slow to react and relearn, when rates suddenly spike, or assets suddenly crash.

Yes, this section is particularly heretical, yet fits the historical record:  the only two countries to experience massive industrial hollowing (US and UK) are also the only two modern reserve currencies.  No comparable hollowing occurred at industrial powers with no reserve currency (Japan, Germany).

So the reserve currency is not directly a liability, but perhaps is indirectly a liability, because it delays the consequences of bad financial policy for so many years.  This creates irresistible political temptation.  Riskless in the short run.  But then you get a whole generation of people trained to do dumb stuff.

The common thread of the above

Individuals heavily discount the future, even the likely future, if it is far enough away.  In these cases, Adam Smith may not operate efficiently when short-term optimization has long-term negative externalities.  

There is a very easy way to demonstrate this:  one day we’ll all be dead, but this future, though certain, is discounted to zero by most people day to day.  It is logical to assume the same discount applies to other futures, and thus that Adam Smith doesn’t work well under such circumstances.

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I thought Eric and I were the only ones who thought Aristotle and Plato were lame.  Turns out Lucius Seneca beat us by 2000 years, referring to Greek syllogistic game-playing as “childish fatuities.”

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The previous post on credit card issuer default rates deliberately avoids the question of ethics in lending.  I’ll mostly evade that again here, except for one point:  it would seem patently unethical to earn de facto interest in ways that are not readily understandable to the borrower.

By that standard, it would not necessarily be unethical to loan someone $100 revolving at 40% interest.  I give you $100 today, and you give me $140 next year, or pay $40 next year and roll it over to the following year, etc.  Ridiculously expensive, but explained up front, and readily understandable to the borrower.

But what if I instead lend you $100 at 5% interest, and buried in a long, complicated list of loan terms, in tiny print, is a fee of $30 for late payment, plus a 30% “default rate” that applies retroactively to the beginning of the loan in the event of late payment?  What if I then send no reminders?  Suddenly the effective rate is 60% for anyone who pays the first year’s interest just one day late.

A deal’s a deal.  Yes, it is.  But there is also a “reasonable man” provision in contract law, one I think has not received adequate attention in recent years.  It may be reasonable to expect someone to understand the consequences of 40% interest, but unreasonable to expect someone to understand and remember the dozens of complex features of the dozens of financial products in his life.  

We may have reached, or long passed, the point at which the complexity of personal finance exceeds the capacity of the reasonable man, who then by law cannot be considered negligent if he fails to understand something.  

Watch for something like this in coming years.  Nostradoofus has spoken.

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The Fewer, Nicer Things meme applies in particular to government.  Minimizing regulatory compliance expense is mainly a matter of simplifying complex, capricious, self-contradicting rules.

Do the endless, ever-shifting sands of TSA flight regulations actually make you safer?  Unlikely, because planes are too complex to survive a determined terrorist.  Instead, millions of people are inconvenienced, and billions of dollars in time and money wasted, for essentially political reasons:  so politicians can look like they’re helping.  Much of the inconvenience is in spending valuable time and mental effort to figure out what the rules are.  Even the enforcement officers can’t seem to figure it all out.  Not their fault — it’s just too complicated.

A well-designed, extremely simple regulatory regime would solve this.  For example, “Your carry-on must contain no metal, and must fit in a cigar box.”  This is an extreme pain, and still does nothing to make you safer, but is extremely easy to understand, comply with, and enforce.  Baby steps back toward sanity.

Thomas Jefferson argued that the entire body of federal laws should be thrown away and rewritten every 30 years, to keep them simple, current and reflective of the public will.  That’s extreme (hey, Jefferson was kind of an extremist), but a related idea in the Jeffersonian mold would be this simple Constitutional amendment:

“Every year for the next half-century, the US legal code shall contain 1% fewer words than the year before, and no congressman shall vote on a law he has not personally read in its entirety.”

This is a very simple way to limit complexity.  You could refine this rule, of course, but that would make it complicated.  The goal is simplicity.  Is this realistic?  Very.  Much of the legal code is obsolete, redundant, or consists of narrow exceptions to and refinements of existing law.  (As programmers would say, they have been applying patches and bug fixes, when they should be refactoring the code.)  Moreover, in the past 30 years, much law was written with almost no regard for complexity.  For example, the securities regulations of 1933-40 were relatively simple, but have been vastly expanded since 1970 by exceptions and refinements — apparently without effect on our financial safety.

Simple laws — as long as they are designed for measurability — require less time and effort to write, read, interpret and enforce, and thus make the entire system more efficient.

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Yet another example of the Orphans of the Sky scenario at Microsoft is Google’s use of Microsoft’s ActiveSync to synchronize your contacts and calendars among your mobile and cloud-based apps.

In case the buzzwords are unfamiliar:  Google provides free contact management and calendar functions through Gmail, its free email service.  ActiveSync is the data synchronization component of Exchange, Microsoft’s extremely expensive server application for contact management, calendar and email.  So one is free, the other extremely expensive.  Got that?  Let’s move on.

It is really hard to make synchronization like this work right.  This was Palm’s secret sauce for a while, and they still hold a bunch of patents on it.  Mighty Apple Inc. blew it here recently, accidentally erasing all contact data for thousands of customers during a routine software update.  Microsoft no doubt spent a lot of money and effort getting ActiveSync just right.  But they apparently forgot their most valuable skill of the 1980s and 1990s:  strategy.

As Palm learned to its disappointment, there is little strategic advantage in replicating data across devices.  The real advantage is in being the place where that data is generated and stored.  

If you use Gmail and its contact and calendar apps, then Google holds the strategic advantage (albeit a weak one, because everything can be exported to open formats).  They paid almost nothing for the synchronization features.  Microsoft paid a lot for synchronization features that actually facilitated their customers’ transition to Gmail.

If you synchronize via Exchange, but maintain all your contacts at Google Apps or Gmail, then Google has won another round against MSFT.

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Many inveterate readers I know have stopped reading their usual news.  The cause seems to be crisis fatigue.  Readers are going fetal.  

This points to an interesting instability in psychology:  up to a point, media gets more attention and credibility with vivid negative stories;  beyond that point, readers and viewer simply disengage.  The transition is abrupt, so it surprises industry experts when it happens.

Same thing seems to have happened in politics in the past year.  Negative, divisive campaigns, and fear of terrorism, nearly always work.  Except this time.