Crisis. Thought of the Day 66.0

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Why do we have a crisis? The system, by being liberal, allowed for the condensation of wealth. This went well as long as there was exponential growth and humans also saw their share of the wealth growing. Now, with the saturation, no longer growth of wealth for humans was possible, and actually decline of wealth occurs since the growth of capital has to continue (by definition). Austerity will accelerate this reduction of wealth, and is thus the most-stupid thing one could do. If debt is paid back, money disappears and economy shrinks. The end point will be zero economy, zero money, and a remaining debt. It is not possible to pay back the money borrowed. The money simply does not exist and cannot be printed by the borrowers in a multi-region single-currency economy.

What will be the outcome? If countries are allowed to go bankrupt, there might be a way that economy recovers. If countries are continuing to be bailed-out, the crisis will continue. It will end in the situation that all countries will have to be bailed-out by each-other, even the strong ones. It is not possible that all countries pay back all the debt, even if it were advisable, without printing money by the borrowing countries. If countries are not allowed to go bankrupt, the ‘heritage’, the capital of the citizens of countries, now belonging to the people, will be confiscated and will belong to the capital, with its seat in fiscal paradises. The people will then pay for using this heritage which belonged to them not so long time ago, and will actually pay for it with money that will be borrowed. This is a modern form of slavery, where people posses nothing, effectively not even their own labor power, which is pawned for generations to come. We will be back to a feudal system.

On the long term, if we insist on pure liberalism without boundaries, it is possible that human production and consumption disappear from this planet, to be substituted by something that is fitter in a Darwinistic way. What we need is something that defends the rights and interests of humans and not of the capital, there where all the measures – all politicians and political lobbies – defend the rights of the capital. It is obvious that the political structures have no remorse in putting humans under more fiscal stress, since the people are inflexible and cannot flee the tax burden. The capital, on the other hand, is completely flexible and any attempt to increase the fiscal pressure makes that it flees the country. Again, the Prisoner’s Dilemma makes that all countries increase tax on people and labor, while reducing the tax on capital and money. We could summarize this as saying that the capital has joined forces – has globalized – while the labor and the people are still not united in the eternal class struggle. This imbalance makes that the people every time draw the short straw. And every time the straw gets shorter.

Conjuncted: Banking – The Collu(i)sion of Housing and Stock Markets

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There are two main aspects we are to look at here as regards banking. The first aspect is the link between banking and houses. In most countries, lending of money is done on basis of property, especially houses. As collateral for the mortgage, often houses are used. If the value of the house increases, more money can be borrowed from the banks and more money can be injected into society. More investments are generally good for a country. It is therefore of prime importance for a country to keep the house prices high.

The way this is done, is by facilitating borrowing of money, for instance by fiscal stimulation. Most countries have a tax break on mortgages. This, while the effect for the house buyers of these tax breaks is absolutely zero. That is because the price of a house is determined on the market by supply and demand. If neither the supply nor the demand is changing, the price will be fixed by ‘what people can afford’. Imagine there are 100 houses for sale and 100 buyers. Imagine the price on the market will wind up being 100000 Rupees, with a mortgage payment (3% interest rate) being 3 thousand Rupees per year, exactly what people can afford. Now imagine that government makes a tax break for buyers stipulating that they get 50% of the mortgage payment back from the state in a way of fiscal refund. Suddenly, the buyers can afford 6 thousand Rupees per year and the price on the market of the house will rise to 200 thousand Rupees. The net effect for the buyer is zero. Yet, the price of the house has doubled, and this is a very good incentive for the economy. This is the reason why nearly all governments have tax breaks for home owners.

Yet, another way of driving the price of houses up is by reducing the supply. Socialist countries made it a strong point on their agenda that having a home is a human right. They try to build houses for everybody. And this causes the destruction of the economy. Since the supply of houses is so high that the value drops too much, the possibility of investment based on borrowing money with the house as collateral is severely reduced and a collapse of economy is unavoidable. Technically speaking, it is of extreme simplicity to build a house to everybody. Even a villa or a palace. Yet, implementing this idea will imply a recession in economy, since modern economies are based on house prices. It is better to cut off the supply (destroy houses) to help the economy.

The next item of banking is the stock holders. It is often said that the stock market is the axis-of-evil of a capitalist society. Indeed, the stock owners will get the profit of the capital, and the piling up of money will eventually be at the stock owners. However, it is not so that the stock owners are the evil people that care only about money. It is principally the managers that are the culprits. Mostly bank managers.

To give you an example. Imagine I have 2% of each of the three banks, State Bank, Best Bank and Credit Bank. Now imagine that the other 98% of the stock of each bank is placed at the other two banks. State Bank is thus 49% owner of Best Bank, and 49% owner of Credit Bank. In turn, State Bank is owned for 49% by Best Bank and for 49% by Credit Bank. The thing is that I am the full 100% owner of all three banks. As an example, I own directly 2% of State Bank. But I also own 2% of two banks that each own 49% of this bank. And I own 2% of banks that own 49% of banks that own 49% of State Bank. This series adds to 100%. I am the full 100% owner of State Bank. And the same applies to Best Bank and Credit Bank. This is easy to see, since there do not exist other stock owners of the three banks. These banks are fully mine. However, if I go to a stockholders meeting, I will be outvoted on all subjects. Especially on the subject of financial reward for the manager. If today the 10-million-Rupees salary of Arundhati Bhatti of State Bank is discussed, it will get 98% of the votes, namely those of Gautum Ambani representing Best Bank and Mukesh Adani of Credit Bank. They vote in favor, because next week is the stockholders meeting of their banks. This game only ends when Mukesh Adani will be angry with Arundhati Bhatti.

This structure, placing stock at each other’s company is a form of bypassing the stock holders

– the owners – and allow for plundering of a company.

There is a side effect which is as beneficial as the one above. Often, the general manager’s salary is based on a bonus-system; the better a bank performs, the higher the salary of the manager. This high performance can easily be bogus. Imagine the above three banks. The profit it distributed over the shareholders in the form of dividend. Imagine now that each bank makes 2 million profit on normal business operations. Each bank can easily emit 100 million profit in dividend without loss! For example, State Bank distributes 100 million: 2 million to me, 49 million to Best Bank and 49 million to Credit Bank. From these two banks it also gets 49 million Rupees each. Thus, the total flux of money is only 2 million Rupees.

Shareholders often use as a rule-of thumb a target share price of 20 times the dividend. This because that implies a 5% ROI and slightly better than putting the money at a bank (which anyway invests it in that company, gets 5%, and gives you 3%). However, the dividend can be highly misleading. 2 million profit is made, 100 million dividend is paid. Each bank uses this trick. The general managers can present beautiful data and get a fat bonus.

The only thing stopping this game is taxing. What if government decides to put 25% tax on dividend? Suddenly a bank has to pay 25 million where it made only 2 million real profit. The three banks claimed to have made 300 million profit in total, while they factually only made 6 million; the rest came from passing money around to each other. They have to pay 75 million dividend tax. How will they manage?! That is why government gives banks normally a tax break on dividend (except for small stockholders like me). Governments that like to see high profits, since it also fabricates high GDP and thus guarantees low interest rates on their state loans.

Actually, even without taxing, how will they manage to continue presenting nice data in a year where no profit is made on banking activity?

Malthusian Catastrophe.

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As long as wealth is growing exponentially, it does not matter that some of the surplus labor is skimmed. If the production of the laborers is growing x% and their wealth grows y% – even if y% < x%, and the wealth of the capital grows faster, z%, with z% > x% – everybody is happy. The workers minimally increased their wealth, even if their productivity has increased tremendously. Nearly all increased labor production has been confiscated by the capital, exorbitant bonuses of bank managers are an example. (Managers, by the way, by definition, do not ’produce’ anything, but only help skim the production of others; it is ‘work’, but not ‘production’. As long as the skimming [money in] is larger than the cost of their work [money out], they will be hired by the capital. For instance, if they can move the workers into producing more for equal pay. If not, out they go).

If the economy is growing at a steady pace (x%), resulting in an exponential growth (1+x/100)n, effectively today’s life can be paid with (promises of) tomorrow’s earnings, ‘borrowing from the future’. (At a shrinking economy, the opposite occurs, paying tomorrow’s life with today’s earnings; having nothing to live on today).

Let’s put that in an equation. The economy of today Ei is defined in terms of growth of economy itself, the difference between today’s economy and tomorrow’s economy, Ei+1 − Ei,

Ei = α(Ei+1 − Ei) —– (1)

with α related to the growth rate, GR ≡ (Ei+1 − Ei)/Ei = 1/α. In a time-differential equation:

E(t) = αdE(t)/dt —– (2)

which has as solution

E(t) = E0e1/α —– (3)

exponential growth.

The problem is that eternal growth of x% is not possible. Our entire society depends on a

continuous growth; it is the fiber of our system. When it stops, everything collapses, if the derivative dE(t)/dt becomes negative, economy itself becomes negative and we start destroying things (E < 0) instead of producing things. If the growth gets relatively smaller, E itself gets smaller, assuming steady borrowing-from-tomorrow factor α (second equation above). But that is a contradiction; if E gets smaller, the derivative must be negative. The only consistent observation is that if E shrinks, E becomes immediately negative! This is what is called a Malthusian Catastrophe.

Now we seem to saturate with our production, we no longer have x% growth, but it is closer to 0. The capital, however, has inertia (viz. The continuing culture in the financial world of huge bonuses, often justified as “well, that is the market. What can we do?!”). The capital continues to increase their skimming of the surplus labor with the same z%. The laborers, therefore, now have a decrease of wealth close to z%. (Note that the capital cannot have a decline, a negative z%, because it would refuse to do something if that something does not make profit).

Many things that we took for granted before, free health care for all, early pension, free education, cheap or free transport (no road tolls, etc.) are more and more under discussion, with an argument that they are “becoming unaffordable”. This label is utter nonsense, when you think of it, since

1) Before, apparently, they were affordable.

2) We have increased productivity of our workers.

1 + 2 = 3) Things are becoming more and more affordable. Unless, they are becoming unaffordable for some (the workers) and not for others (the capitalists).

It might well be that soon we discover that living is unaffordable. The new money M’ in Marx’s equation is used as a starting point in new cycle M → M’. The eternal cycle causes condensation of wealth to the capital, away from the labor power. M keeps growing and growing. Anything that does not accumulate capital, M’ – M < 0, goes bankrupt. Anything that does not grow fast enough, M’ – M ≈ 0, is bought by something that does, reconfigured to have M’ – M large again. Note that these reconfigurations – optimizations of skimming (the laborers never profit form the reconfigurations, they are rather being sacked as a result of them) – are presented by the media as something good, where words as ‘increased synergy’ are used to defend mergers, etc. It alludes to the sponsors of the messages coming to us. Next time you read the word ‘synergy’ in these communications, just replace it with ‘fleecing’.

The capital actually ‘refuses’ to do something if it does not make profit. If M’ is not bigger than M in a step, the step would simply not be done, implying also no Labour Power used and no payment for Labour Power. Ignoring for the moment philanthropists, in capitalistic Utopia capital cannot but grow. If economy is not growing it is therefore always at the cost of labor! Humans, namely, do not have this option of not doing things, because “better to get 99 paise while living costs 1 rupee, i.e., ‘loss’, than get no paisa at all [while living still costs one rupee (haha, excuse me the folly of quixotic living!]”. Death by slow starvation is chosen before rapid death.

In an exponential growing system, everything is OK; Capital grows and reward on labor as well. When the economy stagnates only the labor power (humans) pays the price. It reaches a point of revolution, when the skimming of Labour Power is so big, that this Labour Power (humans) cannot keep itself alive. Famous is the situation of Marie-Antoinette (representing the capital), wife of King Louis XVI of France, who responded to the outcry of the public (Labour Power) who demanded bread (sic!) by saying “They do not have bread? Let them eat cake!” A revolution of the labor power is unavoidable in a capitalist system when it reaches saturation, because the unavoidable increment of the capital is paid by the reduction of wealth of the labor power. That is a mathematical certainty.

Sustainability of Debt

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For economies with fractional reserve-generated fiat money, balancing the budget is characterized by an exponential growth D(t) ≈ D0(1 + r)t of any initial debt D0 subjected to interest r as a function of time t due to the compound interest; a fact known since antiquity. At the same time, besides default, this increasing debt can only be reduced by the following five mostly linear, measures:

(i) more income or revenue I (in the case of sovereign debt: higher taxation or higher tax base);

(ii) less spending S;

(iii) increase of borrowing L;

(iv) acquisition of external resources, and

(v) inflation; that is, devaluation of money.

Whereas (i), (ii) and (iv) without inflation are essentially measures contributing linearly (or polynomially) to the acquisition or compensation of debt, inflation also grows exponentially with time t at some (supposedly constant) rate f ≥ 1; that is, the value of an initial debt D0, without interest (r = 0), in terms of the initial values, gets reduced to F(t) = D0/ft. Conversely, the capacity of an economy to compensate debt will increase with compound inflation: for instance, the initial income or revenue I will, through adaptions, usually increase exponentially with time in an inflationary regime by Ift.

Because these are the only possibilities, we can consider such economies as closed systems (with respect to money flows), characterized by the (continuity) equation

Ift + S + L ≈ D0(1+r)t, or

L ≈ D0(1 + r)t − Ift − S.

Let us concentrate on sovereign debt and briefly discuss the fiscal, social and political options. With regards to the five ways to compensate debt the following assumptions will be made: First, in non-despotic forms of governments (e.g., representative democracies and constitutional monarchies), increases of taxation, related to (i), as well as spending cuts, related to (ii), are very unpopular, and can thus be enforced only in very limited, that is polynomial, forms.

Second, the acquisition of external resources, related to (iv), are often blocked for various obvious reasons; including military strategy limitations, and lack of opportunities. We shall therefore disregard the acquisition of external resources entirely and set A = 0.

As a consequence, without inflation (i.e., for f = 1), the increase of debt

L ≈ D0(1 + r)t − I − S

grows exponentially. This is only “felt” after trespassing a quasi-linear region for which, due to a Taylor expansion around t = 0, D(t) = D0(1 + r)t ≈ D0 + D0rt.

So, under the political and social assumptions made, compound debt without inflation is unsustainable. Furthermore, inflation, with all its inconvenient consequences and re-appropriation, seems inevitable for the continuous existence of economies based on fractional reserve generated fiat money; at least in the long run.

Financial Forward Rate “Strings” (Didactic 1)

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Imagine that Julie wants to invest $1 for two years. She can devise two possible strategies. The first one is to put the money in a one-year bond at an interest rate r1. At the end of the year, she must take her money and find another one-year bond, with interest rate r1/2 which is the interest rate in one year on a loan maturing in two years. The final payoff of this strategy is simply (1 + r1)(1 + r1/2). The problem is that Julie cannot know for sure what will be the one-period interest rate r1/2 of next year. Thus, she can only estimate a return by guessing the expectation of r1/2.

Instead of making two separate investments of one year each, Julie could invest her money today in a bond that pays off in two years with interest rate r2. The final payoff is then (1 + r2)2. This second strategy is riskless as she knows for sure her return. Now, this strategy can be reinterpreted along the line of the first strategy as follows. It consists in investing for one year at the rate r1 and for the second year at a forward rate f2. The forward rate is like the r1/2 rate, with the essential difference that it is guaranteed : by buying the two-year bond, Julie can “lock in” an interest rate f2 for the second year.

This simple example illustrates that the set of all possible bonds traded on the market is equivalent to the so-called forward rate curve. The forward rate f(t,x) is thus the interest rate that can be contracted at time t for instantaneously riskless borrowing 1 or lending at time t + x. It is thus a function or curve of the time-to-maturity x2, where x plays the role of a “length” variable, that deforms with time t. Its knowledge is completely equivalent to the set of bond prices P(t,x) at time t that expire at time t + x. The shape of the forward rate curve f(t,x) incessantly fluctuates as a function of time t. These fluctuations are due to a combination of factors, including future expectation of the short-term interest rates, liquidity preferences, market segmentation and trading. It is obvious that the forward rate f (t, x+δx) for δx small can not be very different from f (t,x). It is thus tempting to see f(t,x) as a “string” characterized by a kind of tension which prevents too large local deformations that would not be financially acceptable. This superficial analogy is in the follow up of the repetitious intersections between finance and physics, starting with Bachelier who solved the diffusion equation of Brownian motion as a model of stock market price fluctuations five years before Einstein, continuing with the discovery of the relevance of Lévy laws for cotton price fluctuations by Mandelbrot that can be compared with the present interest of such power laws for the description of physical and natural phenomena. The present investigation delves into how to formalize mathematically this analogy between the forward rate curve and a string. We formulate the term structure of interest rates as the solution of a stochastic partial differential equation (SPDE), following the physical analogy of a continuous curve (string) whose shape moves stochastically through time.

The equation of motion of macroscopic physical strings is derived from conservation laws. The fundamental equations of motion of microscopic strings formulated to describe the fundamental particles derive from global symmetry principles and dualities between long-range and short-range descriptions. Are there similar principles that can guide the determination of the equations of motion of the more down-to-earth financial forward rate “strings”?

Suppose that in the middle ages, before Copernicus and Galileo, the Earth really was stationary at the centre of the universe, and only began moving later on. Imagine that during the nineteenth century, when everyone believed classical physics to be true, that it really was true, and quantum phenomena were non-existent. These are not philosophical musings, but an attempt to portray how physics might look if it actually behaved like the financial markets. Indeed, the financial world is such that any insight is almost immediately used to trade for a profit. As the insight spreads among traders, the “universe” changes accordingly. As G. Soros has pointed out, market players are “actors observing their own deeds”. As E. Derman, head of quantitative strategies at Goldman Sachs, puts it, in physics you are playing against God, who does not change his mind very often. In finance, you are playing against Gods creatures, whose feelings are ephemeral, at best unstable, and the news on which they are based keep streaming in. Value clearly derives from human beings, while mass, charge and electromagnetism apparently do not. This has led to suggestions that a fruitful framework to study finance and economy is to use evolutionary models inspired from biology and genetics.

This does not however guide us much for the determination of “fundamental” equa- tions, if any. Here, we propose to use the condition of absence of arbitrage opportunity and show that this leads to strong constraints on the structure of the governing equations. The basic idea is that, if there are arbitrage opportunities (free lunches), they cannot live long or must be quite subtle, otherwise traders would act on them and arbitrage them away. The no-arbitrage condition is an idealization of a self-consistent dynamical state of the market resulting from the incessant actions of the traders (ar- bitragers). It is not the out-of-fashion equilibrium approximation sometimes described but rather embodies a very subtle cooperative organization of the market.

We consider this condition as the fundamental backbone for the theory. The idea to impose this requirement is not new and is in fact the prerequisite of most models developed in the academic finance community. Modigliani and Miller [here and here] have indeed emphasized the critical role played by arbitrage in determining the value of securities. It is sometimes suggested that transaction costs and other market imperfections make irrelevant the no-arbitrage condition. Let us address briefly this question.

Transaction costs in option replication and other hedging activities have been extensively investigated since they (or other market “imperfections”) clearly disturb the risk-neutral argument and set option theory back a few decades. Transaction costs induce, for obvious reasons, dynamic incompleteness, thus preventing valuation as we know it since Black and Scholes. However, the most efficient dynamic hedgers (market makers) incur essentially no transaction costs when owning options. These specialized market makers compete with each other to provide liquidity in option instruments, and maintain inventories in them. They rationally limit their dynamic replication to their residual exposure, not their global exposure. In addition, the fact that they do not hold options until maturity greatly reduces their costs of dynamic hedging. They have an incentive in the acceleration of financial intermediation. Furthermore, as options are rarely replicated until maturity, the expected transaction costs of the short options depend mostly on the dynamics of the order flow in the option markets – not on the direct costs of transacting. For the efficient operators (and those operators only), markets are more dynamically complete than anticipated. This is not true for a second category of traders, those who merely purchase or sell financial instruments that are subjected to dynamic hedging. They, accordingly, neither are equipped for dynamic hedging, nor have the need for it, thanks to the existence of specialized and more efficient market makers. The examination of their transaction costs in the event of their decision to dynamically replicate their options is of no true theoretical contribution. A second important point is that the existence of transaction costs should not be invoked as an excuse for disregarding the no-arbitrage condition, but, rather should be constructively invoked to study its impacts on the models…..