Sunday, 28 September 2008

It will all end in tears

Posted by: Ian Angell

Bear Stearns, Lehman Brothers, Merrill Lynch, Fannie Mae, Freddie Mac, then AIG and Washington Mutual – and over here Northern Rock, HBOS, and Bradford & Bingley – and so many, many more. Newspaper headlines scream out that the markets have failed. Nonsense. The turmoil we are seeing is the markets finally operating properly again. For get one thing straight: they haven’t been working over the past few decades of greed and degeneracy. But you can always rely on markets to reassert themselves.

Since the early 90s I have been warning that all this nonsense would all end in tears – I am called “the Angell of Doom” because of my predictions about the control freaks who think they are immune to the uncertainty implicit in the real world. Number mysticism, aided and abetted by computer technology, has turned the world’s financial markets into a huge global casino. First we had ‘the chartists’, who claimed to predict stock movements by pattern matching, as if the market was some recurring dendrochronology. Then came the ‘Masters of the Universe’ and their mathematical models. Developed by the likes of Nobel Laureates Robert Merton and Myron Scholes, these methods are designed to beat the system. Accordingly, hedge funds leverage already huge amounts of money into astronomical sums that are then placed as bets. These ‘big swinging dicks’ of Wall Street and the City of London believe in the mathematical guarantee of ‘riskless risk’, that they can beat the system.

With the vast sums involved even very small percentage gains turn into a tidy profit. Indeed they did win big in the 1980s and 1990s, which is why the banks have been happy to ‘lend’ them ever-increasing sums of money. Then in 1998 along came Long Term Capital Management (LTCM), which had leveraged its $4.5 billion into a $1.25 trillion bet, suddenly lost 44% of its capital. Only swift action by the US Federal Reserve Bank avoided global financial Armageddon. Banks had to write off hundreds of millions of dollars, but that was child’s play to the subprime mortgage nonsense of 2008, the credit crunch, and the ‘shorting’ of bank stocks.

These financials models and assorted trickery can only ever be a pale shadow of what actually happens, and can never emulate the subtle, and not so subtle, checks and balances and the feedback of unknown and unknowable interactions. It seems that neither the chartists, nor the masters of the universe had ever heard of Goodhart’s Law. Charles Goodhart, a distinguished LSE Professor of Economics, says: “any observed statistical regularity will tend to collapse once pressure is placed on it for control purposes”. What he is saying is that you cannot mix up cause and effect. Any observed regularity in society is an effect, but the moment you measure it, and use that measure as the basis of control, you are making the false assumption that it, (the regularity), is the cause of your observation.

Underlying all the self-assured mathematics of financial instruments and hedge funds is a manipulation of observed regularities. However, once the sums involved had become so massive, the gamblers had in fact changed a bet into an attempt to control the system. Collapse was inevitable. How could they believe that computerised mathematical models are some kind of computerised Viagra for business? Ten years ago I labelled the bonus-swilling Masters of the Universe as just a bunch of dick-heads, although the damage they have caused is far worse than even I imagined.

The collapse we see is not the markets failing, quite the contrary – the markets haven’t been operating freely for quite some time, and this always creates tensions that eventually will be released, sometimes catastrophically.

All these government bailouts are yet another bunch of control freaks thinking they can manipulate the market, and deny Goodhart’s Law. Fat chance. Always, the will of the market will out. More tears before bedtime I’m afraid.


Tim Hannigan said...

Big-swinging dicks indeed.
I think it's shameful how the same fools who got us into this mess in the first place are reticent, if not skeptical of the proposed bailout plan upon the issue of caps on executive compensation.
What ever happened to the captains of industry? Self interest for the firm matching self interest for the employee?
I think the cult of asshole-capitalism is imploding. I was always aware of the organization being a tree of full monkeys, but how do we explain the primates on top leaping off the tree? Does the metaphor extend to the presence of loggers? Or has the tree full of assholes finally succumbed to the primate leaving the tree and walking the ground on two hind legs?

Afifov said...

I'd like to add to the point that not only markets are correcting themselves and shrinking back to normal size, but it's also a reflection of the shifting of balance of the world economy towards the East. The United States is still a motor for the world economy (for, but not only, the fact that 320 million US citizens consume as much- if not more- than 1.2 billion Chinese). But not for long. This is only part 2 of the LTCM saga- It all began when Russia defaulted on its bonds, and the East have come full circle since. They have learned why we have become greedy....
The financial crisis will bite us in the ass hard for the few coming years. Before the tears start pouring, once Americans stop being able to consume those burgers, well, imagine every McDonalds and Burger King in the world closed down. This is how its going to affect the common man, everywhere in the world. The big swinging dicks are coming home, drunk and hungry, and there is no McDonalds open to service them, and until those Curry Kings start springing up and staying open 24 hours, we all going to have really bad hangovers..... !

Omar said...

This is fantastic. It is people like you that maintain the spirit,integritiy and reputation of LSE. You say it as it is, no need for conformity.