A low volume, high quality source from the demand side perspective.The podcast is produced weekly. A transcript is posted on the day of.

Monday, October 19, 2009

Transcript: Demand Side 318 - Senator Cantwell, George Soros, on health care reform and the way the world works:

The Fed IS the bad bank;
Then continuing our series on those who got it right, George Soros;
and finally a bubble alert from Demand Side for the benefit of the Fed

First, though, complete and unedited, the statement by Senator Maria Cantwell at the recent Senate Finance Committee hearing on Health Reform


You know, part of George Soros thinking which we are not going to get to today involves the need to hold politicians feet to the fire.  The public option, and indeed, single payer is the only economically sound answer to health care. When alternatives involving insurance companies and employer mandates and so on are introduced, it is an attempt by those in power to create a reality that will ultimately and in the not too distant future disappoint.  Electoral democracy is efficient only when the politicians interest in power corresponds to the public's interest in truth and reality.  We believe Senator Cantwell is in line with the public's interest.

Now, on to

The Fed is the bad bank.

In the casino of financial markets, Ben Bernanke was one of the most confident players.  His hypothesis was that the Great Depression could have been avoided if the banking institutions -- the National City's of the world -- had not been allowed to fail.  He produced a distinguished career on this premise.

And when the financial crisis approached and then overwhelmed the economies of the world, he methodically placed ever larger stacks of chips on this bet.  Now the Fed has $1.25 trillion in mortgage backed securities on its balance sheet. 

The Fed has become the bad bank.

The hypothesis that the Depression could have been avoided by saving the banks and banking institutions has come a cropper.  The banks and the unregulated securities dealers have been bailed out.  The banks are making profits.  Earnings from trading are up.  But there is no recovery.  There is no resumption of lending to the real economy.  Absent the Obama stimulus and recovery money, the cash for clunkers program, the first time home-buyers subsidy, there would be no positive action at all.

Cheap money and other Fed action are focused entirely on the banking sector.  A recovered banking sector was supposed to lead a recovery in the economy.  Hasn't worked.  Won't work.  Even the economists who supported the moves now admit any return to normalcy is years away.  Others are more positive.  We survived the storm.  Things are returning to normal.  Except that the Fed is the bad bank.  The unwinding of the mortgage securities on its books is not a repatriation to those from whom it bought them.  It is not parallel to the special lending facilities.  Unwinding means selling into a market that has no use for mortgage securities because they hide the worst of the nonprime mortgages.  So the unwinding is essentially taking the losses for the worst of the bad practices in the recent housing bust.

This history has yet to be accepted.  But it is a farcical irony that the Monetarists who lampooned the 1930s Fed for causing the Great Depression have blundered into a hole many times the size of that one. 

The Fed could make its tremendous errors without the consent of the representative government we purportedly have in the United States, because the Fed is independent as no other federal agency is.  It takes direction from its own governors and the presidents of its banks, which are all owned by constituent private banks and which serve the interests of the private banks.

On the blog is a link to the testimony of Patricia A. McCoy of the Connecticut School of Law, prepared for a Senate Subcommittee.  This piece is the clearest description of what securitization is and what went wrong with it that I have read.  It explains the incentives that led the worst of mortgages to be placed in these securities.  It does not explain why, rather than attempt to correct bad practices and unwind the securities themselves, the Fed chose to ratify the bad practices by buying them.

George Soros

Today we look at George Soros, the billionaire investor and philanthropist, who has a view of ever expanding bubbles.  Soros is notable for being rich, yet advocating normalization and structure to financial markets.

I am sometimes -- not so much recently -- asked, "If you're so smart, why aren't you rich."  I point to -- or pointed to -- Soros, replying, "He's rich, why don't you listen to him?"

Soros is famous for purportedly breaking the British Pound for his own enrichment, which earned him opprobrium from both sides along the lines of, "If you're so concerned with social welfare, Mr. Soros, Why did you do such a thing?"  Converted to an assertive statement, it might be, "It's all right to profit if you're greedy, but not if you have concern for others."

Let's begin from Soros most recent book, The New Paradigm for Financial Markets:  The Credit Crisis of 2008 and What It Means."


"... The central idea in my conceptual framework [is] that social events have a different structure from natural phenomena.  In natural phenomena there is a causal chain that links one set of facts directly with the next.  In human affairs the course of events is more complicated.  Not only facts are involved, but also the participants views and the interplay between them enter into the causal chain.  There is a two-way connection between the facts and opinions prevailing at any moment in time:  on the one hand participants seek to understand the situation (which includes both facts and opinions); on the other, they seek to influence the situation (which again includes both facts and opinions).  The interplay between the cognitive and manipulative functions intrudes into the causal chain so that the chain does not lead directly from one set of facts to the next, but reflects and affects the participants' views.  Since those views do not correspond to the facts, they introduce an element of uncertainty into the course of events that is absent from natural phenomena.  That element of uncertainty affects both the facts and the participants' views.  Natural phenomena are not necessarily determined by scientific laws of universal validity, but social events are liable to be less so."

It certainly is necessary to address this question of the difference between economics and a natural science.

Robert Skidelsky, Keynes most famous biographer, pointed out that if economics were a natural science it likely would have responded to the mathematical tools employed so enthusiastically on its behalf to produce some significant progress.  Unlike physics or biology, it has not.  Skidelsky notes we are having the same arguments today as were had in the 1930s.  The exact same, down to the level of vitriol between the parties.  He refers to Krugman v. the Chicago School.  Look for that Skidelsky interview on Bloomberg on the Economy with Tom Keene last week.

Here in Soros we see one explanation for the resistance (near complete resistance in the Demand Side view) of economics to the mechanical tools valid for the natural sciences.  Soros calls it reflexivity.

"I explain the element of uncertainty inherent in social events by relying on the correspondence theory of truth and the concept of reflexivity....

Knowledge is represented by true statements.  A statement is true if and only if it corresponds to the facts.  That is what the correspondence theory of truth  tells us.  To establish a correspondence, the facts and the statements which refer to them must be independent of each other.  It is this requirement that cannot be fulfilled when we are part of the world we seek to understand."


Demand Side has repeatedly referred to no independent variables within the mathematics, no closed system, hence no fulcrum from which to lever the hypothetical world.  If all variables in the model are dependent upon each other, and indeed can morph into each other, there is no causal chain that mathematics can produce.  It becomes radically dependent on its assumptions.

Soros is talking in a different sphere, although he describes a similar recognition he had in his early years at the London School of Economics, where assumptions were allowed in economic theory to:

"... produce universally valid generalizations that were comparable to those of Isaac Newton in physics."

As economics was forced to abandon one assumption, it replaced with others until,

"The assumptions became increasingly convoluted and gave rise to an imaginary world that reflected only some aspects of reality, but not others.  That was the world of mathematical models describing a putative market equilibrium.  I was more interested in the real world than in mathematical models, and that is what led me to develop the concept of reflexivity."


"I contend that rational expectations theory totally misinterprets how financial markets operate.  Although rational expectations theory is no longer taken seriously outside academic circles, the idea that financial markets are self-correcting and tend toward equilibrium remains the prevailing paradigm on which the various synthetic instruments and valuation models which have come to play such a dominant role in financial markets are based.  I contend that the prevailing paradigm is false and urgently needs to be replaced.

"The fact is that participants cannot base their decisions on knowledge.  The two-way, reflexive connection between the cognitive and manipulative functions introduces an element of uncertainty or indeterminacy into both functions.  That applies both to market participants and to the financial authorities who are in charge of macroeconomic policy and are supposed to supervise and regulate markets.  The members of both groups act on the basis of an imperfect understanding of the situation in which they participate.  The element of uncertainty inherent in the two-way reflexive connection ... cannot e eliminated, but our understanding, and our ability to cope with the situation, would be greatly improved if we recognized this fact."

Soros by his own admission desperately wants to be taken seriously as a philosopher.  He should be.  His conceptual framework brings forward the problem of understanding the world in which we exist by way of concepts that are necessarily symbols or shortcuts to reducing the mass of phenomena to a manipulable scale.  I would say that the exercise leaves us relating to something that is really our own projection.

Graduating from LSE with grades too poor to gain him entry into Academia, he finally hooked on as an arbitrage trader.  Soros interest in reflexivity and fallibility equipped him to handle the states of nonequilibrium, boom and bust, well enough to make one fortune after another.

And indeed, markets proved to be the perfect application of reflexivity, as market players create boom and bust by their participation, not their comprehension.  Perception created reality, a reality that folded back on non-market participants in often harmful ways.

Thinking about thinking and conceptual frameworks which try to define concepts are inherently subject to contradiction.  So when Soros assumes an objective aspect of reality, it may become more useful, but less accurate, just as his theory predicts.  Everyday events are predictable and reflexive processes are not, he says.  But it would seem that reflexivity can provide momentum in stability as well as instability. 

We'll leave Soros here, well short of full development, with the note that his assessments of markets and economic dynamics when he is making his calls is often simple and often intuitive, but what he does show in his practical looks adheres broadly to demand side functionalities.

We also note for the benefit of those who have complete confidence in their economic schemes, but view forecasts as a crap shoot, that Soros passes on the observation from Popper,

"Predictions and explanations are symmetrical and reversible."

Following Soros is a very good place to put up our bubble alert.  This is for the benefit of the Fed, which cannot seem to see them when they are in progress.

One necessary element of a bubble is, of course, cheap money and easy leverage.  The Fed is providing this currently to the big trading houses.  One must then look for asset prices that are rising in anticipation not of demand or supply parameters, but of further increases in prices. 

We find them today in the commodity markets and in the stock markets.  The bubble in these markets is underway, and is totally belied by the simultaneous upward pressure on bond prices.

Here are a couple of clips, first from Business Daily on the previous commodity bubble, which as far as I know, has yet to be acknowledged at the Fed or across the orthodox economic community.  We never tire of telling you (actually we do, but it's still good promo), Demand Side called the onset of the commodities bubble in late 2007 and the peak and collapse of the bubble as it happened in July 2008.


Now, here from Bloomberg last week, David Schork


Our Friends on Wall Street, indeed.

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