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.