Middle class, SMEs and Democracy

Sergey Guriev and Aleh Tsyvinski bundle them alogether to argue the ineluctable democratization of Russia: 

In short, the third main lesson of Russia’s transition is that state capitalism does not work (at least not without a strong meritocratic political party, as in China). Indeed, recent events have shown the system to be inherently unstable. As market reforms have brought substantial prosperity (average annual per capita GDP, at purchasing power parity, is now $17,000), a large middle class, based mostly in small and medium-size companies and the service sector, developed beyond the reach of the state-owned behemoths. Most of this middle class also lives in large cities – where the battle for Russia’s future is now taking place.

Hence the crucial importance of knowing more about how Russian SMEs are financed. Family  and friends are not sufficient, big Russian banks tend not to lend to SMEs. Foreign banks are supporting international commerce, small local bank are very inneficient. The lending technologies available in Russia are not manyfold, because their use depends on the institutional structure (courts, credit bureau) in place. It also depends on social relation. It has been proven that social relations help to reduce interest rate on loan, which is an advantage of relationship lending. However, little is known on how the social context structures creditors - lenders relationships in transition countries.

The financial transmission belt

Supposed to allocate capital is clearly broken. From the FT: 

The amounts of cash being deposited by eurozone banks at the European Central Bank increased further on Wednesday, just days after the ECB provided unprecedented levels of liquidity in an effort to reduce tension in the financial system.

 Happy 2012. 

Weberian thoughts on Orthodoxy and economic development

The Economist reviews the sacrosanct Weberian argument of the influence of religion on economic behavior. To cut a long story short (and this one is centuries old) the relationship is not direct. Linking prosperous economies with faith runs up against exceptions. The Greek example illustrates the issue rather nicely: 

Similarly, contemplating Greece’s economic woes, it is easy to dream up some theory that connects Orthodox Christianity (and its comparatively charitable attitude to human weakness) with corruption or cronyism. Orthodoxy has a less pessimistic view of “original sin” than the Christian West—and its prayers for the dead emphasise “no man lives who does not sin”. Does that imply winking at misdeeds? Possibly—but then try explaining why Greek-Americans, who are at least as devout as their motherland kin, do so very well in business, education and public service. The plausible reason lies in America’s institutions which make it easier to prosper in an honest way.

But institutions is not only formal rules. Institutions seen as encompassing worldviews and habit can then in turn be greatly influenced by religion. The Russian case offers a telling example. Its disrespect for the rule of law - and the economic consequences it implies - can be traced back to Orthodoxy. Newcity M. in "The rule of law and economic reform in Russia, edited by Sachs and Pistor" writes: 

Russia never developed a legalistic tradition. The reason for this is that is was Christianized by Byzantium instead of Rome. Western Europe did not receive Roman legal culture directly. It was transmitted and refracted primarily through the Roman Church, which fostered a legalistic, rather than mystical, world view drawn from Roman culture. This contrasts sharply with the world view fostered by the Russian Orthodox Church. The [Roman] Church was intent on establishing a universal body of ecclesiastical legal principles that would bind Western Christendom together regardless of secular divisions. The origins of the Western notion of law as an autonomous body of principles to which secular authorities are subject can be traced to this period. The Orthodox church, however, rejected the independence and supremacy of the papacy and remained an integral part od the state. In this way, Russia missed the most important foundations of the Western concept of the rule of law.

If faith can influence indirectly economic behavior. The way a religion is institutionalized (and its relationship with secular power) can have deep long-lasting influences on economic development.

Time of markets and time of politics

Krugman's Eurovenn, or notes reading Martin Wollf

Barclay's math says italy's down. Tyler Cowen posted a summary of Barclays Capital Inst sales:

1) At this point, it seems Italy is now mathematically beyond point of no return
2) While reforms are necessary, in and of itself not be enough to prevent crisis
3) Reason? Simple math--growth and austerity not enough to offset cost of debt
4) On our ests, yields above 5.5% is inflection point where game is over
5) The danger:high rates reinforce stability concerns, leading to higher rates
6) and deeper conviction of a self sustaining credit event and eventual default
7) We think decisions at eurozone summit is step forward but EFSF not adequate
8) Time has run out--policy reforms not sufficient to break neg mkt dynamics
9) Investors do not have the patience to wait for austerity, growth to work
10) And rate of change in negatives not enuff to offset slow drip of positives
11) Conclusion: We think ECB needs to step up to the plate, print and buy bonds

12) At the moment ECB remains unwilling to be lender last resort on scale needed

13) But frankly will have hand forced by market given massive systemic risk

Hint:Not Good.Sell EUR, Buy Gold

Bullet point number 8 points at the difference markets' and politics' time. Markets dynamics are on a different time level than politics. It takes longer to reach politically acceptable solutions, and even more longer to build institutions. This crisis speaks about a mismatch between financial systems and institutions and so the intersection between the later and what would be needed to solve the crisis is zero. 

It is NOT about inequality

The mechanisms that make economies create value are not based on equality, but cooperation. These are nicely explained in E.D. Beinhocker's book. Cooperation is crucial to the functioning of institutions (N. Fergusson's killer apps). Yet researchs point that fairness is a necessary element of cooperation. If some players feel the game is rigged, they simply want to end the game. S.F. Brosnan and F.B.M. de Wall showed that capuchin monkeys react the same way too:

Monkeys refused to participate if they witnessed a conspecific obtain a more attractive reward for equal effort, an effect amplified if the partner received such a reward without any effort at all. These reactions support an early evolutionary origin of inequity aversion. [...] People judge fairness based both on the distribution of gains and on the possible alternatives to a given outcome. Capuchin monkeys, too, seem to measure reward in relative terms, comparing their own rewards with those available, and their own efforts with those of others. They respond negatively to previously acceptable rewards if a partner gets a better deal. Although our data cannot elucidate the precise motivations underlying these responses, one possibility is that monkeys, similarly to humans, are guided by social emotions. These emotions, known as ‘passions’ by econom- ists, guide human reactions to the efforts, gains, losses and attitudes of others. Clearly if these reactions evolved to promote long- term human cooperation, they may exist in other animals as well.

Islamic finance watch

A good explanation of what a sukuk is provided by the Economist: 

A sukuk is structured to avoid the Islamic prohibition on interest payments. It manages this by paying bondholders with the cashflows generated by specific assets, which are put into a special-purpose vehicle (SPV) as part of the deal. Many seem to have thought that the bonds were “asset-backed”, giving them a claim on the assets in the event of a default. Most sukuk, however, are “asset-based”, handing investors ownership of the cashflows but not of the assets themselves. “Many sukuk holders have a perception that they hold a security that is collateralised,” says Anouar Hassoune of Moody’s, a rating agency. “In 90% of cases, that is incorrect.”

If the lionization of firms is unhelpful, how about gazelisation ?

The Mighty Middle by GOOD infographics

There has been a wave of skepticism against small firms. Charles Kenny exposes why support for SMEs in developed economies is not beneficial to the economy as a whole (but beneficial to politicians). Felix Salmon argues that lionizing small business is unhelpful. James Surowiecki compares the growth rate of different developed economies with more of less percentage of small firms:

The developed countries with the highest percentage of workers employed by small businesses include Greece, Portugal, Spain, and Italy—that is, the four countries whose economic woes are wreaking such havoc on financial markets. Meanwhile, the countries with the lowest percentage of workers employed by small businesses are Germany, Sweden, Denmark, and the U.S.—some of the strongest economies in the world.

These articles deserve a few comment. First, the debate over firm's size and growth started with D. Birch claiming that small firms generated a large share of net job creation. The literature on SMEs (here's an excellent review of it by Henrekson) and job generation separates now between "elephants" (large companies), "mices" (small one that tend to stay small) and "gazelles"(not nessarily small but fast growing). So it is not simply Big versus Small.  Second, the lacking component of this debate is the link with entrepreneurship. The praise of SMEs is attached to the notion developed economies have of it. Whereas a classification of firm's size is fixed in time, entrepreneurship as a concept captures a process. The benefits or disadvantages of small firms don't come exclusive from it size, but how the size relates to entrepreneurship and innovation, and the of "population" of firms. Perspectives from evolutionary economics would enrich the debate. Big is not necessarily better in evolutionary economics and you adaptive efficiency has to be taken into account. By te same token, as this study from Badudenko shows, reaching an optimal scale of production can be more important than technical efficiency.

Risky jobs

According to Carney,  the "too big to fail" debate should unite both side, up against the big banks, because they: 

have rigged the game so that they profit without creating value. In fact, they profit from activities that weaken the economy by creating instability. Today, big banks give capitalism a bad name. Believers in the free market should stop giving banks cover.

Unfortunately these story are all too often very simplistic. These lines of argument overlook the fact that today's unstable situation is the result of a long process of financial deregulation. The end of the Bretton Woods system meant companies had to cope with floating exchange rate and banks responded by providing risk management instruments. They have rigged the game because the rules have slowly changed. Some players now (high frequency traders for example) benefit from risks. In fact it has become their risky job to cope with uncertainty.  Whether or not that deters financial systems to carry on the main function they are supposed to fulfill - the efficient allocation of capital - is a question political economy. Arguing over the size of banks and trying to regulate it will be a useless debate unless we rethink the function of financial systems too.

New Economic Thinking

The Institute for New Economic Thinking attributed recently three grants demonstrating the linkages between finance and real economy. The interview of G. Epstein, who advanced the concept of financialization and  J. Crotty here:

They build on James Tobin's concept of functional efficiency to separate the financial sector's beneficial activities (mobilizing savings, financing investment, and reducing risk) from its socially inefficient activities (gambling, and distorting the political process).

K. Pistor's work on "law and finance" and how law is underconceptualized and W. Lazonick's on how finance might harm innovation (echoing Levenstein's study) are also recognized as fresh economic thinking. The questions these scholars ask are essential if economics is to regain its scientific added value. The fact that an institute has to name that "new thinking" - where in fact, it is just "thinking" is telling about the relationship between the dominant ideology and its critics in economics fields.

Theories and reality

A lively debate with a methodenstreit flavour about economics and its relationship with reality kicked off by John Kay's paper for Inet. Inet sent Kay's paper to some economists with the opportunity to respond. Their blog received plenty of it. The debate is timely for Christopher Sims and Thomas Sargent just won the Nobel Prize in Economics for their "empirical research on cause and effect in the macroeconomy". To put it crudely,  on how best finding macroeconomic things out ! Finding things out always implies having a map. The problem is which form this map should take.

Financial innovation with valuable social function ?

 

Peer-to-peer lending is on the rise. One could view this phenomenon through the perspective of a change of financial function. Traditional banks have a walk away from lending services and concentrate much more on transaction. The internet revolution aside, the rise of P2P might be a consequence of the move toward market-based systems. Wonga, a british P2P lending firm, has attracted much criticism. Its boss defends the firm's valuable social function:

They are picking on the wrong people. We are the good guys," Damelin says of his critics at Westminster, who refuse to meet him. "Yes, we're in a space that is controversial, that is polarising. But it is an important social service. To have social mobility you have to have credit available to people where its required and where it's appropriate .

The persistance of ideas

We heard that buy and hold is a looser's strategy so many times before, here and here, that it's not sure the new report by Deutsche Bank will convince any more people. DB's  long-term asset study shows that:

Over the last 50 years, the real returns from equities have been lower than those from bonds in Germany, Japan and Italy. In the Italian case, the gap is almost three percentage points, and that is despite the recent bond sell-off.

 The U.S. case, which inspired all investor's wannabe is an historical anomaly.Now, is owning stocks for a millisecond capital allocation ? My take is that this shift from long-term to short-term reflects a shift from capital allocation to risk allocation, which is what Krugman meant by "from boring banking to fancy finance".

The several masks of uncertainty

There are lately many comments about uncertainty. Becker in a WSJ op-ed argues that changing the rules of the game in a recession fuels uncertainty, which slows business even more. So the focus is here on regulatory uncertainty and the rationale is basically: "don't introduce more regulation, we don't know yet how it will impact on the economy". Livingston disagreed and provides data showing that what business cares about is too little demand, and not too much regulation.  This Economist's excellent post structures the debate about red tape and recession.

The entering the territory of uncertainty with regulations suggests a view on the function of institutions.  That demands a clarification, because uncertainty has many masks. In other words: Is the world uncertain because we don’t know enough yet or is the world uncertain because it is just how the world is? Regulatory uncertainty is epistemological uncertainty,  similar to Taleb's Black Swan. It however not the same than fundamental or ontological uncertainty, the kind of which Keynes had in mind. Ontological uncertainty is possible only in a transmutable or creative reality. As Davidson writes:  

This nonergodic concept of uncertainty (the ontological one) implies that the future is transmutable or creative in the sense that future economic outcomes may be permanently changed in nature and substance by today’s actions of individuals.

A clarification on uncertainty is necessary because institutions play a different role, regarding how we view uncertainty. In a world where uncertainty is quantifiable (risks)  institutions has not to be included in economic theory. The path of economic development is predetermined and human action and the social devices they design do not interfere with it. In the second type of economic reality, law and rules find a place so as to facilitate coordinations or reduce asymmetric information for example. By the same token, institutions can be seen as providing a deeper cognitive function only if we assume that uncertainty has an ontological nature.

Stock Markets shaped like the coast of England...

...are becoming more frequent. Volatility is increasing and some analysts say it is now the new standard. The New York Times collects a number of figures: 

Since the start of this century, The Times found, price fluctuations of 4 percent or more during intraday sessions have occurred nearly six times more than they did on average in the four decades leading up to 2000.

As for closing prices, the more-frequent jumps could also be clearly spotted. Thirty percent of trading days since the start of 2010 were up or down more than 1 percent at the time of the closing bell. That’s far more than the 20 percent of such jumps in the 1990s. 

“The last few years have been the most volatile for all of recorded history,” said Andrew Lo, professor of finance at the M.I.T. Sloan School of Management. For evidence, he says that 10 of the biggest 20 daily upswings and 11 of the largest 20 daily drops since the beginning of 1980 to the end of last month have occurred in just the last three years.

This has consequences - undermining confidence, detering long-term investments, feedback loop problems where volatility feeds upon itself. But volatility is also a source of profit for the high-frequency trading industry and the segments of financial sectors that welcome it because it has the appropriate technology and ressources to deal with it. How this new standard advantages some and prejudice other is still unknown. Also, if one accepts that violent market swings are the norms, one has to admit that Mandelbrot was right and that the Bell's curve is not the appropriate description of how stock markets behave. Finally, one cannot help but note the shrewd comment of Prof James J. Angel, professor of finance at Georgetown University: "When there is uncertainty in the world, there is uncertainty in the market ". It is quite ironic because Financial Economics built itself distinguishing between uncertainty and risk and taking into account the later only. It tried dangerously to isolate itself from this "uncertainty in the world" (because it cannot really be measured) that it cannot grasp with it now.

Economics is so f%&cked up, Krugman calls for sociologists to solve the profession's problems

Market Positioning by Lee Nielsen

Macroecomomics goes through a rough time to say the least. To steal Krugman's turn of phrase, it has entered a dark age,. Here's his address to the Eastern Economic Association and explanation of how economists failed. Good old sound (keynesian) knowledge about banking crisis and recession got lost througout the 1970' up to now. The dynamic at work he describes - a dominant approach casting aside academic production that doesn't correspond to the doxa it chose for itself - is one sociology of science knows well. So it seems reading Foucault's Archeology of Knowledge and Bourdieu's work on cultural and symbolic capital could be useful at last ;)

What we really need is a change in the destructive social dynamics that brought us to this point. And I wish I knew how to do that. But my problem is obvious: I’m an economist, and it seems that we need some kind of sociologist to solve our profession's problems.

Financing innovation or speculation

The amazing story of the rise and fall of innovation clusters. Margaret Levenstein's business history perspective proves to be a useful one to distinguish the role of finance in it.

The bank's functions

Kal's cartoon - The Economist

Is to finance the economy. That is, to efficiently allocate capital. It is usually taken for granted that risk allocation, another function of financial systems, goes hand in hand with efficient capital allocation. Could it be argued, however, that there is a limit beyond which too much risk allocation is beneficial (or even detrimental indeed) to the financial system only ? That passed this point, the tow truck risk loosing its wheels ? The question is important because the financial sector is linked to the rest of the economy. When it is broken, the economy is dysfunctional. Kal's cartoon couldn't have captured it better. 

A picture for sunday

Andrei Molodkin, Russia/Yes, 2007

Social mood as an underlying

U.S. mood throughout the day inferred from Twitter

Is there a better example of Keynes' "beauty contest" metaphor than Derwent Capital beating the market with a Twitter-based algorithm ? The underlying in Derwent's trading strategy is the feeling of the crowd. Bloomberg's Jack Jordan reports that the trading model is developed by computer scientists Bollen, Mao and Zeng and will gauge the mood of the market, tracking especially instances of word related to a calm mood:

Their results showed that rises and falls in the number of instances of words related to a calm mood could be used to predict the same moves in the Dow’s closing price between two and six days later, with a fall in these “calm” words being followed by a fall in the index. The other moods did not have the same predictive quality.

The algo is based on Bollen, Mao and Zeng's paper published by the Journal of Computational Science in March 2011:

Our results indicate that the accuracy of DJIA (Dow Jones Industrial Average) predictions can be significantly improved by the inclusion of specific public mood dimensions but not others. We find an accuracy of 87.6% in predicting the daily up and down changes in the closing values of the DJIA and a reduction of the Mean Average Percentage Error by more than 6%.

Nofsinger in 2005 published a similar paper in the Journal of Behavioral Finance . He notes that the "stock market is itself a direct measure or gauge of social mood". The causality is reversed in these perspective. Social mood is not just correlated with market, it moves it.  An algo based on Twitter would then allow its user to be ahead of the curve. In a world of constant media coverage, this has huge implications for our understanding of financial systems.

Buy on the rumor - sell on the rumor, also

What happened to Société Générale lately fits right in between the Efficient Market Hypothesis and the madness of crowd, in what is still a no-man's land, in spite of all the welcoming push of behavioral finance to take into account human behavior.

The Daily Mail in the U.K. asserted on Sunday on 7 August 2011 that the bank was in a "perilous state and possibly on the brink of disaster".  Needless to say that in the present frantic environment, it triggered a whirlpool of speculation dragging down SocGen stock price. The Daily Mail admitted later the analysis was unfounded and apologized in a public statement.

Zachary Karabell's point is that rumors have a lot more weight when financial sectors lack credibility and no one trust it anymore: 

We have, in short, arrived in Looking Glass world where no one believes anything that anyone in finance-land says. And for that, we have Dick Fuld, Lehman Brothers, and the entire culture of Wall Street, Washington, and European finance over the past five years to thank. They are the inverse of the boy who cried wolf, and no one now believes that the wolf is not at the door.

The return of Political Economy II

The downgrade of US debt by S&P and the commentaries following it took the debate on credit rating agencies (CRAs) added-value to a next level. It is worth reading the S&P's statement and spotting the key paragraph ( if you missed the "political risk" in the title): 

[T]he downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned when we assigned a negative outlook to the rating on April 18, 2011....

Compared with previous projections, our revised base case scenario now assumes that the 2001 and 2003 tax cuts, due to expire by the end of 2012, remain in place. We have changed our assumption on this because the majority of Republicans in Congress continue to resist any measure that would raise revenues, a position we believe Congress reinforced by passing the act.

It comes as no surprise that nobody is arguing about the U.S. debt ratios. It is understood that S&P downgrade has to be viewed within the current political context of the U.S. Here's Dan Drezner's rounds up of the initial reax to the downgrade and why he thinks S&P took an unjustified step. Micheal Cohen holds a different view from across the pond.

These arguments show that once in the "political economy" field however, one has to ask whether S&P has the knowledge and expertise to issue statements and ratings that are political in nature, hence subjective. CRAs gained their legitimacy partly due to a process "hardening of information" whereby financial information is quantified. The process is efficient if risks can be expressed numerically in the form of a debt ratios, but become problematic when politics has to be embedded in a three letter code. We might have reached the limits of what "hard information" can tell us.

Photographies of stock markets

Micheal Najjar's The Down Jones, from 1980 to 2009. Najjar drew an analogy between geologic structures and a social one, the stock market. As Mandelbrot have argued for a long time, financial markets movement are wild and cannot be captured by the Bell curve.  The fluctuations of markets, like the irregular shorelines of the English coast, are both better described by fractal geometry, which Mandelbrot invented.

As we have allegedly entered the anthropocene, and although is it a geological concept that signals that humans now shape the earth, is it interesting to note the parallel with financial math that were once extracted from markets, but which is now shaping it in the form of algorithms. For a 15 minutes talk about how algorithms influence our lives, listen to Kevin Slavin at TED.

How to tame the Leviathan ?

In a fantastic personification of the Dodd-Frank Act, John Oliver from the Daily Show exposes the difficult road ahead of financial regulation bills. The Leviathan just f#&{@  it raw in the  a¶#...

The Daily Show
Get More: Daily Show Full Episodes,Political Humor & Satire Blog,The Daily Show on Facebook

Credit Rating Agencies and the added value of information

 

The market for credit rating is an oligopoly with the famous big three dominating the entire industry, which is once again under fire, but some are detecting what could be a departure from the status-quo, paving the way for newcomers to enter the market and moving the business model whereby issuers now pay the CRA's to one whereby investors would do it. In essence, one feels that the motivation behind is to lessen CRA's power grounded in the sheer amount of financial markets participant paying attention to them. From the FT:

"The more people paid attention to these ratings the more it skewed the whole system. They take up an importance that is disproportionate to their value,” says Barbara Ridpath of the International Centre for Financial Regulation and former S&P executive.

The fundamental problem is that regulatory authorities and especially the Basel Committee, built their recommendations and rule for capital adequacy requirements on these very ratings some want now to reform. A U-turn is thus very unlikely in the near future.  

Trust and the internet

A report from Pew links the use of internet to trust. Social Networking Sites users are more trusting than others. As it has social implication implications for financial sectors and (see Guiso, 2008 and Zack, 2000), would it be interesting to investigate if SNS users are more inclined to invest in stock markets ?

Back to the future of lending

It sounds lovely. Bhidé is describing a world that once was:

Bank regulation, like lending, was once decentralized and judgment-based. Regulators relied mainly on examination of individual loans rather than capital-to-asset ratios. A typical bank exam would include scrutiny of every single business loan and a large proportion of consumer loans. Capital adequacy was a matter of judgment: examiners would figure out how large a buffer a bank ought to have, taking into account its specific risks.

But is he suggesting we should go back to the good old days of relationship lending ?

Smarter capital requirements – better Basel rules – aren’t the answer. Rigid, top-down uniformity is essential in the specification of weights and measures and the issuance of currency and coin. Bank lending and regulation, by contrast, must incorporate local knowledge, because, in a dynamic, unregimented economy, each borrower, loan, and bank is different (though some general guidelines can help). The seemingly objective top-down approach ignores the idiosyncratic nature of risk and assumes that one mortgage loan is like the next.

How do we ignore the financial revolution that took place supporting the use of "hard" over "soft" information? Incorporating local knowledge requires using soft information and is therefore costly. In contrast, hard information is easier to process. So the trend of information hardening that goes hand in hand with financial innovation and the use of mathematics in financial economics enhanced certain transaction based lending technologies, such as leasing or factoring, which benefited SMEs by raising credit availability. By the same token, this process is the cause of the increase in distance between small firms and their lender in the U.S. Consequently, distance is less an indicator of creditworthiness than before, which means that small firms at distance enjoy now a wider access to credit.

So this is a huge debate, which goes beyond regulatory issues. Too bad  Bidhé is not even mentioning it. 

The embeddedness of financial regulation

Vogel illustrated an interesting paradox - "freer markets, more rules" - looking at the British financial revolution of 1980s. The Financial Services Act (FSA) passed on November 7 after the Big Bang gave birth to a myriad of regulatories agencies. He also noted a change in “regulatory culture”: 

The FSA may have revolutionized life in the City even more than the Big Bang, for in matters of regulation it replaced the informal with the formal, the flexible with the rigid, and the personal with the legalistic” (Vogel, 1996:93).

This shows that financial regulation, also, is embedded in broader social and cultural structures that evolve over time.

The Crisis in drawing

David Harvey speaks about the crises of capitalism with an interesting take on the financial sectors around the 6:00 mark.

The return of Political Economy

Finns rarely make the headlines, but their support of euro-skeptic True Finns has pushed political risks into the spotlight. Political economy is back and yes, how people think, vote and the varying frameworks embedding how they organize still matter.

The added value of rating agencies

The S&P alarm on US debt on April 18th moved stocks markets and triggered a lot of comments. The recurring ones are about the added value of Credit Rating Agencies (CRAs). The very existence of CRAs is being questionned every time financial news put them in the front row because it still not clear whether or not they passed a “market test”. Do they provide any extra information?

If the added value of CRA’s in the US is still a questionable, no wonder the rating industry has suffered a lot of criticism with regards to applying ratings to developing economies, especially after the Mexican and Asian crises. Ratings could indeed favor procyclical behavior or could be sticky, in that they would simply react to macro-economic parameters or market news, reinforcing arguments which claim they are, evidently, behind the market, since they use publicly available data. For Powell

while the rating agencies do not necessarily add to the sum of underlying knowledge, they change the degree of “common knowledge”. In other words, each analyst may have known what S&P knew, but they did not know for sure what all the others knew. All are now sure that at least all know S&P’s views.

So S&P issued a “warning” on US debt, stock markets then plunged and I am still wondering how information is treated where it matters. Because, as Krugman noted, the 10-year bond rate did not seem to integrate the S&P signal.

Robots are going to the BRIC

HFT growth has supposedly peaked in Western Europe, so the industry is moving to the BRIC markets where exchanges are modernizing their systems to charm these players. The Russian legal system regarding financial transactions is incoherent and  full of contradictions and supervision of regular trading is already a challenge. If HFT is an issue in countries with sophisticated regulatory structures (notwithstanding the huge lack of funding) and has blurred the lines between cheating, betting and investing, I truly wonder how the practices associated with HFT will adapt to a weak institutional environment like Russia.

Hostages of Wall Street ?

The political weight of Wall Street - that increased over the past decades - could be viewed as a stage of a financialization process. Proponents of this concept have advanced the idea that the financial sector is increasing in size and taking a life of its own. The phenomenon can express itself in terms of the increasing level of debt as percentage of GDP. For example the total debt in the U.S. rose from 140 percent to 328.6 percent from 1973 to 2005. Pay increased dramatically, so did the financial-industry profits as a share of U.S. business profits. 

The U.S. financial sector gained so much power that S. Johnson, former chief economist at the International Monetary Fund and a professor at the MIT, actually argues that it has become a kind of oligarchy:

There’s a deeper and more disturbing similarity: elite business interests—financiers, in the case of the U.S.—played a central role in creating the crisis, making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse. More alarming, they are now using their influence to prevent precisely the sorts of reforms that are needed, and fast, to pull the economy out of its nosedive.

The inside job, a film directed by Charles Fergusson, does a great job at describing the rise of the financial leviathan, depicting the "Wall Street - Washington corridor" that Johnson wrote about. It has become a ideology battle that involves government and their regulatory agencies, investment banks and investors and academic. For the Universities - Wall Street corridor, see J. Fox.

Financial Terminator

High Frequency Trading is thrilling for someone interested in the social meaning and function of finance, because it now uses technology to bridge finance and philosophy. What are Quants to answer B. Ritholz' worries about the new Robot Uprising ?

The paradox of efficiency - Robot trading

High Frequency Trading strategies which use robots to trade is the result of a process of financial development and its quest for efficiency. But we begin to see the limits of this development which lead sometimes to contradictions, such as the "Hathaway effect”. The theory is still to be proven, but the bluntly put (from the FT):

if Ms Hathaway is in the news, Warren Buffett’s Berkshire Hathaway stock jumps too.

Mr Mirvish, the blogger who spotted the trend

pointed the finger at confused robotraders – the complex algorithms that execute 70 per cent of stock trades, sometimes by scanning news stories for trends.

A tale of two trials

The trial of Raj Rajaratnam, a billionaire hedge fund manager, for insider-trading has just begun. This trial strike at the heart of corporate America, for Rajaratnam was getting information from a managing director of McKinsey, Anil Kumar. As if finance, and especially hedge funds - the villain of financial sectors in the eyes of the public - needed more bad publicity to hit rock bottom. 

Zingales thinks that for the industry to avoid being associated with the growing list of rogue traders, legitimate hedge funds should proactively disclose their past trades that are at least two years old. That suggestion prompted a reply from Stone Street Advisors, invoking hedge funds's "trade secrets" to argue that Zingales should get out of his office a bit more. I think the interesting point is that trading strategies, which HF fear could be reverse engineer, are elaborated in the perpetual quest of some kind of modern philosophical stone: the Alfa. Patterson's book on Quants gives a good account of that quest and its sociological underpinning. That being said, I think the bottom line is that some think it's naive to expect disclosure from hedge funds, because HF view their trading strategies as intellectual property.  It would be akin to ask pharmaceutical companies to be allow generic drug. Which they do ! and the period of time protecting their Intellectual Property (IP) cannot enter the line of arguments, because, as Zingales reminds us, the life of most trading strategies is very short.  The IP card cannot be played here. The benefit of invention, a common good, is usually the rational to protect, temporarily, Intellectual Property. So after all, so what ? if other investors can reverse engineer strategies that are more than two year old. It is not like everybody has benefited of the marvelous inventions of financial engineering.

The other trial ended up in a ruling of the German Federal Court of Justice against Deutsche Bank and in favor of Ille Papier-Service. 24 pending cases are still to come. The Court considered the structured product which took a bet on interested-rate spread - with 4 % of commission in it - sold by DB to that company as inappropriate. The complexity of these products and the trials that follow highlight a fundamental question: who are the financial sectors to serve (or to screw) ? SME's don't (and shouldn't) have the necessary financial literacy to fully understand these financial products, whose structures are so complex that it can hide large commissions and make their market value so hard to establish, that we begin to see intermediaries appearing between issuers such as DB and customer. It seems financial engineering has not been beneficial to SME's either.

"Markets like totalitarian regimes"

Said Blackrock's Larry Fink who manages over $3 trillion, the world's biggest asset manager. This is the perfect example of a view that dismisses institutions and are bound to see totalitarian regimes as the only answer to confusion and uncertainty.

Because, yes, markets don't like confusion and uncertainty, but concluding that, therefore, markets like totalitarian governments, is firstly, logically incorrect, secondly, missing an entire world of social technologies to cope with uncertainty. 

And to quote, Mike Krieger: "Even if markets did like totalitarian governments, HUMANS DON'T".

London Vs Geneva

Regulation is not always what counts most.

What is Wall Street for ?

Felix Salmon looks at the falling number of publicly listed companies on US major domestic exchanges and sees a dangerous trend eventually leading to make stock markets irrelevant for the economy.

Put another way, as the number of initial public offerings steadily declines, the stock market is becoming little more than a place for speculators and algorithms to compete over who can trade his way to the most money.

This echoes an old debate about whether bank-based or market-based systems allocate capital more efficiently and one that should be revisited in the light of these past decades' financial innovation and its consequences.

 

The persistence of habits and stock exchange mergers

The Deutsche Börse and the NYSE/Euronext are negotiating a merger. The Economist noted a paradox which shows that it is hard to overcome differences in regulatory practices and that social structures of financial markets are not easily wiped off:

The reality is that the exchange business is unusually unglobal. Securities and derivatives are traded, by and large, in long-standing silos, with their own regulations, laws, working hours and critical mass of big, savvy market participants, who may not all be based in the same country but who share the same rules of engagement. Even if practical, the utility of being able to trade everything, everywhere, all the time is not clear.

The complexity of stock markets

The Nasdaq has been hacked. First the flash crash and now this: 

Hackers have repeatedly penetrated the computer network of the company that runs the Nasdaq Stock Market during the past year, and federal investigators are trying to identify the perpetrators and their purpose, according to people familiar with the matter.

Tyler Durden takes a retrospective look at its recent development and conclude that this stock market is nothing but a "daylight fraud":

The one exchange to first legalize frontrunning aka Flash Trading, to actively promote churning via HFT erection-inducing liquidity rebates in stocks and options, to create novel and ingenious ways to skirt Rule 611, and, most recently, to overtake the NYSE as host for greatest number of fraudulent Chinese reverse-mergers, the Nasdaq has never kept a secret that it cares far more about its clients than the investing public.

This shows just how critical and complex financial markets have become. They are viewed by officials as part of the basic infrastructure, like power companies or air-traffic-control operations. On the other hand, the SEC does not have the budget to regulate it like it should be (which does not excuse its staff downloading midget-porn). And wait, if stock markets like the Nasdaq are of strategic importance,  then the debate about how to regulate it should be viewed in this light as well. It boils down to how to manage complex financial system - algo trades and HFT are under scrutiny - so that investors and the public do not begin to think financial systems are big ponzi schemes.

From protest to global recession

Nouriel Roubini illustrates the point of my last post, and goes a step further. From the Arab street to oil prices, and from oil prices to global recession. Yes, international politics still matter. And it impact on stock markets too.

Political embeddedness and the price of oil

Prices of WTI went up significantly on Friday 29.01. Crottaz. O. asks if we are at the beginning of an increase in oil prices due to the risks of propagation of political unrest and revolution spreading throughout the arab world, especially into Algeria and Lybia, which produces together up to 5% of world oil.

The analysis reflects the political embeddedness underpinning this situation. In an excellent post, John Quiggin links the "Arab exception" - the idea that the concept of democracy is not really applicable in Arab countries and that foreign policy therefore amounts to a choice of which dictator to support - to the idea of oil as a special case. The idea of the "Arab exception"

...rests on the assumption that the existing governments are less than legitimate, and can be dealt with in terms of traditional Great Power politics, with spheres of influence, secret deals and so on. Even weak democratic states display much more effective resistance to external interference in their domestic affairs than do typical autocratic regimes. The point applies most obviously in relation to oil. The idea that the US can legitimately use its military power to ensure continued access to oil resources rests, in large measure, on the (not entirely unfounded) assumption that those controlling the resources are a bunch of sheikhs and military adventurers who happened to be in the right place, with guns, at the right time. Without the Arab exception, the idea of oil as a special case, not subject to the ordinary assumption that resources are the property of the people in whose country they are found, will also be hard to sustain.

Bankers have feelings too, you know

From the FT: 

"We need to stop authorities around the world throwing sticks and stones at us. We should be past that now" said one banker in Davos. 

As fear about inflation is mounting, some feel it is time now for governments and banks to make peace. But as the financial industry is complaining about regulation and low interests rates, it feels we are still in the "waaaaah Street" narrative Max Abelson described, where the issue is not entirely about policy, but about insults and emotions. Finance, after all, seem to care about the public's opinion (still from Abelson's piece): 

"We've been ostracized," another source said. "I went to jury duty about a year ago, and when I said I'm in investment banking, the people in the jury room were making ugh sounds, and I'm like, fuck you. I'm proud of what I do. And I think this firm did a lot to get the recovery going. Somewhere ranked below a pimp and well operator is not right."