Category Archives: Ideas

Ideas

Willful ignorance and the financial crisis – part 2

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Gretchen Morgenson writes on the roots of the collapse of Merrill Lynch in How the Thundering Herd Faltered and Fell as part of a New York Times series on the financial crisis:

“In 1997 and 1998, when we invented super senior risk, we spent a lot of time examining how much is too much to have on our books,” said Blythe Masters, who was on the small team that invented the synthetic C.D.O. and is now head of commodities at JPMorgan Chase. “We would warehouse risk for a period of time, but we were always focused on developing a market for whatever we did. The idea was we were financial intermediaries. We weren’t in the investment business.”

For years, the product that Ms. Masters and her colleagues invented remained just a mechanism for offloading risk in high-grade corporate lending. But as often occurs with Wall Street alchemy, a good idea started to be misused — and a product initially devised to insulate against risk soon morphed into a device that actually concentrated dangers.

… By 2005, with the home lending mania in full swing, the amount of C.D.O.’s holding opaque and risky mortgage assets far exceeded C.D.O.’s composed of blue-chip corporate loans. And inside even more abstract synthetic C.D.O.’s, the risk was harder to parse and much easier to overlook.

Similarly, in the same series on the financial crisis, Eric Dash and Julie Creswell write on the collapse of Citibank in Citigroup Saw No Red Flags Even as It Made Bolder Bets:

… many Citigroup insiders say the bank’s risk managers never investigated deeply enough. Because of longstanding ties that clouded their judgment, the very people charged with overseeing deal makers eager to increase short-term earnings — and executives’ multimillion-dollar bonuses — failed to rein them in, these insiders say.

…While much of the damage inflicted on Citigroup and the broader economy was caused by errant, high-octane trading and lax oversight, critics say, blame also reaches into the highest levels at the bank. Earlier this year, the Federal Reserve took the bank to task for poor oversight and risk controls in a report it sent to Citigroup.

… regulators have criticized the banking industry as a whole for relying on outsiders — in particular the ratings agencies — to help them gauge the risk of their investments.

“There is really no excuse for institutions that specialize in credit risk assessment, like large commercial banks, to rely solely on credit ratings in assessing credit risk,” John C. Dugan, the head of the Office of the Comptroller of the Currency, the chief federal bank regulator, said in a speech earlier this year.

Ideas

Pickering on science fiction and cybernetics

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Historian of science, Andrew Pickering (who wrote Mangle of Practice) while reviewing How We Became Posthuman by Katherine Hayles (in Technology and Culture 41.2 (2000) 392-395) writes about science fiction and cybernetics:

“Posthumanity” is not necessarily a bad thing. Following Donna Haraway, Hayles sees it as having a positive potential in freeing our imaginations from the hold of old dualisms and associated patterns of domination. But posthumanity can have a dark side, too. Haraway associates this with global capitalism and militarism, but Hayles’s bête noire is Hans Moravec, the computer scientist who talks about downloading consciousness into a computer. This equation of human-ness with disembodied information looks like another male trick to feminists tired of the devaluation of women’s bodily labor (from having babies to all the menial tasks that have traditionally made the “life of the mind” of the male scientist possible).

To put it crudely, then, Hayles wants to promote an embodied posthumanism and to fend off the Moravecian “nightmare” (p. 1). To this end, much of How We Became Posthuman is devoted to discussions of how scientists have struggled with notions of embodiment and information, in three waves, as she calls them, in the history of cybernetics: a first wave associated with the name of Norbert Wiener; a second wave from the 1970s onward, associated with Humberto Maturana and Francisco Varela’s idea of autopoiesis; and a third, 1990s, wave emblematized by work on artificial life. Hayles notes the different conceptions of the body and information that have surfaced in each wave, and seeks to emphasize the costs (intellectual, moral, and political) entailed in editing the body out. As is her wont, interspersed with these discussions are her readings of novels. Without claiming any necessary causation in either direction, she seeks to draw out parallels between fiction and science, coupling Bernard Wolfe’s Limbo with the first wave of cybernetics, Philip K. Dick’s mid-1960s novels with the second, and works by Greg Bear, Cole Perriman, Richard Powers, and Neal Stephenson with the third. I rather resisted these readings at first, but I find that the associations Hayles makes have stuck in my mind. She is certainly right that Limbo (which I had not heard of before) is truly amazing both as a novel and as a document of the early days of cybernetics and the cold war.

Greenlash, Millennium Ecosystem Assessment

Steve Carpenter on Black Swans

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Ecologist Steve Carpenter follows up on Don Ludwig’s comments on Nassim Nicholas Taleb‘s book The Black Swan:

Both of Taleb’s books are highly entertaining. But he over-reaches. There are some odd mistakes. For example, he makes much of a supposed kink in the integral of the Student-t distribution, (where tail probability declines linearly with deviation from the mean) but if you compute the integral using R software there is no kink — so Taleb evidently made a mistake.

Based on web sites, Taleb made his fortune using a kind of option trade. He purchases only options to buy securities at a certain price during a specified time window in the future. So if the security is trading above Taleb’s price, he buys it and then immediately sells at the market price, thereby making a profit. He says that his life involves long periods of time watching while nothing happens and his options to buy expire. But once in a great while he makes a killing. This is exactly like predators who specialize on very large prey, or fishing for big game fish, or hunting for rare but big game animals.

His writings have done a lot to publicize the importance of huge rare events. I think this is a good thing. But also he over-reaches. In some recent interviews he seems to be gloating over the current economic collapse. And (according to economist colleagues) some economists see his ideas as rather routine. Yet he is a provocative and entertaining writer; if sales measure impact he has made a difference.

To me, the most novel feature of the current ongoing collapse is the coincidence of huge shocks with apparently different triggers. Who would have thought that an epidemic of bad loans in America, steep ramp of energy prices, and biofuels tightening the link of energy to food prices would coincide, against a backdrop of lower economic firewalls between countries and increasingly intense food limitation of the human population, with almost no scope for growth of the food supply. It’s a wonderland for testing resilience ideas and a global tragedy, all at the same time.

For a recent talk I re-analyzed a bunch of information from the Millennium Assessment, to try to figure out if humanity had any chance at all for making it through the next few decades.

If everyone shifts trophic status to roughly herbivore level, and we educate all the world’s women to secondary level, we have a chance.

The difference between 12 billion and 9 billion people in 2050 is one child per woman. If all the world’s women were educated to secondary level, fertility would drop by about 1.7 children per woman. And we can probably feed 9 billion herbivorous people, if we can maintain the crop diversity of the major grain crops high enough to avoid catastrophic disease outbreaks.

Energy needs for agriculture and climate change could make it pretty hard to achieve the rosy scenario; climate heating, more variable precipitation and sea level rise have bad implications for agriculture. So the rosy scenario itself may be way out on the tail of the distribution. And what will happen to relations among people as the going gets rough? Human conflict can wreck agriculture. What are the chances that no one will use nuclear weapons? Even a few nukes would take out huge areas of arable land for millennia. And, as Will Rogers said about land, they ain’t makin’ any more of it. A Taleb-like fat tail breakdown seems not so implausible.

Ecological Management, Reorganization

Transfomation of the Klamath

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Many rivers are more valuable without their dams.  Years ago it was unthinkable, but now dams are scheduled to be removed on the Klamath River.  Robert Service writes in Science News (Nov 13) Four Dams to Come Down:

A tentative agreement has been reached to begin decommissioning four dams on the Klamath River, an issue that has been a hotbed of controversy in recent years. The news was announced today by top officials with the U.S. Department of Interior, the states of California and Oregon, and the utility company PacifiCorp. If the deal goes through, it’s expected to mark the largest dam-removal project ever undertaken.

The agreement marks a major shift in bitter battles over water that have racked the Klamath Basin in recent years and often placed scientists in the center (see Science, 4 April 2003, p. 36). PacifiCorp had been seeking to relicense its dams, and the Bush Administration has long opposed dam removal. The Klamath, which flows from the central portion of southern Oregon to the coast of northern California, is the third most important river for salmon in the West behind the Columbia and Sacramento rivers. Dams along the river provide cheap renewable energy, as well as vital irrigation water for farmers. A drought in 2001 led federal officials to shut off irrigation water, a move that sparked widespread conflicts among farmers, fishermen, and conservationists. With irrigation restored the following year, low river levels contributed to a disease outbreak that killed at least 33,000 salmon, according to a 2004 report by the California Department of Fish and Game.

In the NYTimes, Felicity Barringer writes:

All the parties had coped with worst-case situations in the past decade. In 2001, irrigators had their water shut off, crippling agricultural production. In the dry year of 2002, the Interior Department ordered water distributed to irrigators and tens of thousands of salmon in the Klamath died; in 2007, low salmon populations in the Klamath led to sharply curtailed commercial fishing.

“After living through moments that would tax the character of most anyone, the good people of the basin came together,” Mr. Kempthorne said.

…

The agreement also sets out a requirement for several years of scientific analysis of how removing the dams would affect water quality and fish habitat. The aim is to ensure that the environmental impact of the release of sediment would not be worse than leaving the dams in place. The oldest dam was installed more than a century ago.

Regime Shifts

Don Ludwig on the Black Swan

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The applied mathematician and scholar of uncertainty Don Ludwig reflects on the financial crisis, resilience, and The Black Swan:

This is a sort of book review. By now you may have heard of The Black Swan: the impact of the highly inprobable by Nassim Nicholas Taleb published by Random House (2007).

Taleb is from Lebanon, but he prefers to be called a Levantine. He worked as a trader in currencies, and maybe also derivatives. He claims that nothing of importance in finance can be predicted, except its unpredictability. His book will undoubtedly attract attention for its claim of an inevitable financial collapse, like the one we are experiencing.

He writes on p. 225:
I spoke about globalization in Chapter 3; it is here, but it is not all for the good: it creates interlocking fragility, while reducing volatility and giving the appearance of stability. In other words, it creates devastating Black Swans [events that are extremely rare and important]. We have never lived before under the threat of a global collapse. Financial institutions have been merging into a smaller number of very large banks. Almost all banks are now interrelated. So the financial ecology is swelling into gigantic, incestuous, bureaucratic banks (often Gaussianized [assuming normal deviations] in their risk measurement) — when one falls, they all fall. [lengthy footnote here, which includes the statement that “Fannie Mae, when I look at their risks, seems to be sitting on a barrel of dynamite”] The increased concentration among banks seems to have the effect of making financial crisis less likely, but when they happen they are more global in scale and hit us very hard. We have moved from a diversified ecology of small banks with varied lending policies, to a more homogeneous framework of firms that all resemble one another. True, we have fewer failures, but when they occur … [no deletion here] I shiver at  the thought. I rephrase here: we will have fewer but more severe crises. The rarer the event, the less we know about its odds. It mean[s] that we know less and less about the possibility of a crisis.

Taleb goes on to mention the power blackout of 2003 as an example of what happens when things are tied too closely together.  Taleb points out that all the experts use Gaussian assumptions for risk analysis, which delivers precisely the wrong answer. Hence I think that it is extremely likely that the favored solution to the world financial crisis will be to tie the financial system even more tightly together, thus ensuring an even bigger collapse next time. It seems to be happening already. There is no sign that Obama has twigged to the hazards of greater financial integration. There is no sign that the experts can learn from collapses: they don’t seem to have learned from past collapses, as Taleb points out.

I think we can learn from Taleb: he writes very forcefully, but exaggerates his points too much. It may be that if we confine ourselves to financial situations, then his statements are valid, even though they are extreme. Taleb seems to have been treated very nastily by the financial establishment: Scholes, Merton & Co. He seems to be both hurt and angry. Perhaps this causes his arrogance as well. I had to grit my teeth to get through to the later chapters, which have most of the substance.

Taleb offers some financial advice:
1. Above all try to protect yourself from the big drops that are coming (have already come). This implies investing a very high percentage in lower risk securities such as government bonds.

2. Try to participate in the big booms that are also sure to come. Taleb advises spreading some stuff in venture capital. In view of the behavior of the Vancouver stock exchange, I should think that it would be necessary to try to avoid scams. See David Baines in the Vancouver Sun for details (e.g.).

What has this to do with ecology?

Buzz Holling has been talking for years about “surprise”, which is just another name for Black Swans. Anyone who has ever looked at ecological data knows that deviations are not Gaussian. Of course, if we drop the Gaussian or some similar assumption, we lose most of statistics, and we lose all of “risk analysis”. So we lose just about all theory. Experts can’t function without theory, so they make unrealistic assumptions, and come up with the wrong answers in Black Swan situations.

Since Black Swans are rare, ordinary experience doesn’t show any, and the experts are confirmed in their misleading assumptions, until the next time.

We can use analogies instead of theory. I recall the raft analogy we used years ago to illustrate resilience: in order to survive on rough seas, we use loose coupling rather than strong coupling. Likewise, we guard against overconfidence: another of Buzz’ favorite themes. Managing for resilience involves guarding against collapses, even though they might be rare: it implies a precautionary principle. In light of the recent financial collapse, this latter point might finally be accepted for ecological management.

Reorganization

Financial crisis: bad models or bad modellers

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Australian economist, John Quiggin writes on Crooked Timber about the contribution of models to the financial crisis:

The idea that bad mathematical models used to evaluate investments are at least partially to blame for the financial crisis has plenty of appeal, and perhaps some validity, but it doesn’t justify a lot of the anti-intellectual responses we are seeing. That includes this NY Times headline In Modeling Risk, the Human Factor Was Left Out. What becomes clear from the story is that a model that left human factors out would have worked quite well. The elements of the required model are

  1. in the long run, house prices move in line with employment, incomes and migration patterns
  2. if prices move more than 20 per cent out of line with long run value they will in due course fall at least 20 per cent
  3. when this happens, large classes of financial assets will go into default either directly or because they are derived from assets that can’t pay out if house prices fall

It was not the disregard of human factors but the attempt to second-guess human behavioral responses to a period of rising prices, so as to reproduce the behavior of housing markets in the bubble period, that led many to disaster. A more naive version of the same error is to assume that particular observed behavior (say, not defaulting on home loans) will be sustained even when the conditions that made that behavior sensible no longer apply.

…More generally, in most cases, the headline result from a large and complex model can usually be reproduced with a much simpler model embodying the same key assumptions. If those assumptions are right (wrong) the model results will be the same. The extra detail usually serves to produce more detailed results rather than to produce significant changes in the headline results.

Ecological Economics, Ecosystem services

Creating new forest commons

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From Northern Woodlands Magazine an article about a forest commons movement the Vermont Town Forest Project – A Forest for Every Town:

Food is one of our basic needs, so it makes sense that many of these movements focus on it. No less essential to society, however, are other goods and services, which small groups of people in communities across the nation are trying to encourage with “buy local” campaigns. It makes sense that our other basic needs – water and shelter – can also be met locally.

That’s the basic premise behind the Vermont Town Forest Project, which was founded by the Northern Forest Alliance in 2004 “to help communities across Vermont maximize the community benefits derived from their town forests and to help support the creation of new town forests statewide.”

These benefits include everything from watershed protection, forest products, and wildlife habitat to public recreation and community rallying points. They function in the same way town commons have for centuries in New England and New York. Every community member is responsible for their stewardship, and every member also benefits from their presence.

The concept of town commons, and even town forests, is not a new one. In fact, the enabling legislation for creating town forests in Vermont was enacted in 1915. But these forests haven’t been on the top of everyone’s mind. At least until lately. Now, thanks to projects such as the Vermont Town Forest Project, they are experiencing an exciting revival.

… Hinesburg is fortunate to own not one but two town forests: the
“older” (it dates to 1940), composed of 837 acres of mixed woodlands,
and the “newer” (just purchased), with 301 acres boasting extensive
wetlands and calcium-rich soils.

Hinesburg’s forests exemplify town forest potential. They have
recreation: world-class mountain biking trails, along with skiing,
hiking, and horseback riding. They also serve as outdoor classrooms,
both for local teachers and for the University of Vermont, whose
students have conducted dozens of projects there.

And the older forest also has active forest management: one recent
harvest took out white ash, which was then milled and kiln-dried
locally and installed to replace the floor of the Hinesburg Town Hall,
which had been sanded so many times that the tongue of each
tongue-and-groove board was exposed. All this at a total cost of $2.48
per square foot, about what you’d pay commercially.

Adaptation, Reorganization

Björk discusses Iceland’s response to financial crisis

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From Pitchfork – the Icelandic musician and star Björk, on the Icelandic response to the financial crisis (which locked up Iceland’s imports as massive bank failures lead to a currency crash):

… the Náttúra Campaign, the Icelandic environmental movement co-founded by Björk. Náttúra’s original mission was to protest the construction of foreign-backed aluminum factories in Iceland, but in recent weeks, the movement has taken a dramatic turn. ….

Björk: For the last two weeks, Icelanders are getting a crash course in economics. I mean, I didn’t know about these things two weeks ago. The news is full of right-wing guys saying, “Stop the environmental value stuff! We should just build factories everywhere now, because that’s where the money is!” …

These aluminum smelters, nobody wants to build them in Europe, because there’s so much pollution. So it’s like, “Oh, just go dump them in Iceland.” We are getting them energy for so cheap that they are saving so much money by doing all this here.

Instead, what we are saying is, we’ve got three aluminum factories, let’s work with that, we cannot change that. Why not have the Icelandic people who are educated in high-tech and work already in those factories in the higher paid jobs, why not let them build little companies who are totally Icelandic with the knowledge they have? Then they get the money and it stays in the country. Then we can support the biotech companies and the food companies and all these clusters. I think that if you want to be an environmentalist in Iceland, these are the things you’ve got to be putting your energy into.

A lot of investors [are] coming, and I’m hoping they will want to invest in the high-tech cluster. There are money people here that did not lose a lot of money. For example, here is one investment company in Iceland only run by women. They are doing fine. [laughs] They aren’t risk junkies. They just made slow moves. The people who are crashing, they took a huge loan and then another huge loan, and so on. And it’s all just air. But these women didn’t build on air.

…

I’ve also been trying to get someone to Iceland to suggest green industries to Icelanders and introduce us to the companies that haven’t even been built yet in the world. This man Paul Hawken, who is famous in the States, he has agreed to come here in November. He’s supposed to be a green capitalist. He’s a functionalist, not just an idealist. I’m hoping he can unite these two polarized groups in Iceland. I’m setting up a meeting with him and the people in power. Because I think private money people can put money into those seed companies, but most of all, the government has to do it. It has to be a mixture of two things. It cannot just be visionary money people.

Ecological Economics, Ecosystem services

Losses from destruction of Nature dwarf losses from financial crisis

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At the IUCN meeting in Barcelona, the BBC interviews Pavan Sukhdev leader of the Economics of Ecosystems and Biodiversity an EU project intending to provide an economic assessment of global ecosystem governance in much the same way that the Stern review did for climate governance:

The global economy is losing more money from the disappearance of forests than through the current banking crisis, according to an EU-commissioned study.

…The figure comes from adding the value of the various services that forests perform, such as providing clean water and absorbing carbon dioxide.

…Speaking to BBC News on the fringes of the congress, study leader Pavan Sukhdev emphasised that the cost of natural decline dwarfs losses on the financial markets.

“It’s not only greater but it’s also continuous, it’s been happening every year, year after year,” he told BBC News.

“So whereas Wall Street by various calculations has to date lost, within the financial sector, $1-$1.5 trillion, the reality is that at today’s rate we are losing natural capital at least between $2-$5 trillion every year.”

…The first phase concluded in May when the team released its finding that forest decline could be costing about 7% of global GDP. The second phase will expand the scope to other natural systems.

Ecological Economics

Herman Daly on the Financial Crisis

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The Oil Drum has an article by the ecological economist Herman Daly on the Credit Crisis, Financial Assets, and Real Wealth. Daly writes:

The current financial debacle is really not a “liquidity” crisis as it is often euphemistically called. It is a crisis of overgrowth of financial assets relative to growth of real wealth—pretty much the opposite of too little liquidity. Financial assets have grown by a large multiple of the real economy—paper exchanging for paper is now 20 times greater than exchanges of paper for real commodities. It should be no surprise that the relative value of the vastly more abundant financial assets has fallen in terms of real assets. Real wealth is concrete; financial assets are abstractions—existing real wealth carries a lien on it in the amount of future debt. The value of present real wealth is no longer sufficient to serve as a lien to guarantee the exploding debt. Consequently the debt is being devalued in terms of existing wealth. No one any longer is eager to trade real present wealth for debt even at high interest rates. This is because the debt is worth much less, not because there is not enough money or credit, or because “banks are not lending to each other” as commentators often say.

Can the economy grow fast enough in real terms to redeem the massive increase in debt? In a word, no. As Frederick Soddy (1926 Nobel Laureate chemist and underground economist) pointed out long ago, “you cannot permanently pit an absurd human convention, such as the spontaneous increment of debt [compound interest] against the natural law of the spontaneous decrement of wealth [entropy]”. The population of “negative pigs” (debt) can grow without limit since it is merely a number; the population of “positive pigs” (real wealth) faces severe physical constraints. The dawning realization that Soddy’s common sense was right, even though no one publicly admits it, is what underlies the crisis. The problem is not too little liquidity, but too many negative pigs growing too fast relative to the limited number of positive pigs whose growth is constrained by their digestive tracts, their gestation period, and places to put pigpens. Also there are too many two‐legged Wall Street pigs, but that is another matter.

Growth in US real wealth is restrained by increasing scarcity of natural resources, both at the source end (oil depletion), and the sink end (absorptive capacity of the atmosphere for CO2). Further, spatial displacement of old stuff to make room for new stuff is increasingly costly as the world becomes more full, and increasing inequality of distribution of income prevents most people from buying much of the new stuff—except on credit (more debt). Marginal costs of growth now likely exceed marginal benefits, so that real physical growth makes us poorer, not richer (the cost of feeding and caring for the extra pigs is greater than the extra benefit). To keep up the illusion that growth is making us richer we deferred costs by issuing financial assets almost without limit, conveniently forgetting that these so‐called assets are, for society as a whole, debts to be paid back out of future real growth. That future real growth is very doubtful and consequently claims on it are devalued, regardless of liquidity.