Does finance add much value?

For some background research on a new short film, I'm doing an excellent Yale MOOC course,  The Global Financial Crisis, led by Tim Geithner and Andrew Metrick.  It details the mechanics of the sub-prime mortgage crisis, why the mortgage products blew up, how this turned into a bank run, and then how the run turned into an economic crisis.

In one of the lectures I was struck by Andrew Metrick’s claim that though financial institutions have built up expertise in stock analysis, they have no expertise in analyzing bonds that are rated as "safe assets" (by rating agencies).  (Creating "safe assets"  to meet huge demand from international and US investors was a big part of the pre-crisis dynamic.) I was also reminded of the film "The Big Short" based on a book about the crisis by Michael Lewis.

Metrick's claim also reminded me of a paper by Andrew Haldane, chief economist at the Bank of England, about measuring finance-sector value added to calculate the sector's contribution to GDP.  Because many services offered by financial institutions don’t have an explicit fee, the value-added is estimated by a "formula" that equates it with the degree of risk-taking. Even as the crisis was underway in 2007, sector value-added, according to this formula, was at its peak - which is clearly wrong.  And as Haldane argues, a banking system that does not accurately assess price risk is not adding much value to the economy. So I have made a short film touching on this issue - accessible on my film page. 

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Mistaking the model

Economists are often mocked for using highly simplified models that do not reflect reality. The tone of this mockery got angrier after the 2007-2008 financial crisis, when critics argued that economists were blinded by a few highly mathematical models and an ideological belief in “free” markets.

In a new and compelling book “Economics Rules” Dani Rodrik, a Harvard economist, has come up with a defense of the economists’ toolkit – those maligned models.  Rodrik argues that reality is so complex you have to simplify situations to be able to analyze cause and effect:

“Simple models of the type that economists construct are absolutely essential to understanding the workings of society. Their simplicity, formalism, and neglect of many facets of the real world are precisely what makes them valuable. These are a feature, not a bug. What makes a model useful is that it captures an aspect of reality. What makes it indispensable, when used well, is that it captures the most relevant aspect of reality in a given context. Different contexts – different markets, social settings, countries, time periods and so on – require different models. And this is where economists typically get into trouble. They often discard their professions’ most valuable contribution – the multiplicity of models tailored to a variety of settings – in favor of the search for the one and only universal model. When models are selected judiciously, they are a source of illumination. When used dogmatically, they lead to hubris and errors. ”

— Economics Rules, Dani Rodrik, 2015

Prior to the financial crisis Rodrik was regarded by some economists as a bit of a maverick for the models he straddled. So he probably enjoyed writing this book.

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The Big Short

The Big Short is a new movie based on Michael Lewis’s book of the same name about the sub-prime mortgage crisis in 2007 - 2008.  The film tracks the actions of a handful of investors who predicted that the housing boom would blow up and create havoc in the financial sector.  They bet against the mountain of mortgage bonds and made fist-fulls of money.  As the story unfolds, thriller style, The Big Short does a good job of explaining why the sub-prime and related financial products came to a bad end.  This makes the film a good companion to an Oscar winning documentary Inside Job (2010) which takes a broader look at the financial crisis, the global economic crisis it triggered, and those who the filmmaker felt should be held accountable.

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Apple's GDP

Apple is the largest public company in the world – with a market cap of $540 billion as of January 8, 2016 and annual revenues in 2015 of $234 billion. But how do you compare this to say the size of a country, typically measured as GDP? (GDP is a measure of annual value added, subtracting out inputs.) The FT made an estimate in early 2015 of $87 billion. This put Apple’s GDP between Ecuador and Slovakia, which each produced about $100 billion and Oman at $81 billion, Azerbaijan at $78 billion, and Belarus at $77 billion.

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A classic film

Recenly I saw the classic, remarkable, Apu trilogy, a 1950s film in three parts by the India filmmaker Satyajit Ray. The film is about a boy growing up in a small village, his efforts to get an education and make a living, and along the way, the development of the India economy. It is fascinating both for the images of rural and urban India in the 1950s, and for the universality and timelessness of its story. The score for all three parts is by Ravi Shankar.

The film was an international hit when it first came out in the 1950s. According to a recent New York Times review the first part ran for 8 months at a New York cinema. The second part won the Golden Lion at the Venice Film Festival in 1957. The version I saw was a pristine, restoration.  But the story of the restoration is also astonishing. During the process a fire almost destroyed the original negatives. This short documentary reveals the challenges.  

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Images of disorder

What does"disorder" look like? Valérie Belin has won the Prix Pictet prize this year with photos on this theme. Her series features still-life arrangements of cheap junk, which she says is “a jarring commentary on the effects of our obsession with cheap objects.”

The Prix Pictet is an annual competition on a theme related to sustainability. (Previous themes have been consumption, growth, power, earth, and water.) 

Valérie Belin's Still life with mirror

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An early legal database

Kongo: Majesty and Power, Metropolitan Museum

In nineteenth century Congo, as European trading companies and colonizers (Belgium, France and Portugal) started to bypass the local Congolese chiefs, the chiefs tried to reassert their authority by creating a new instrument of law and order, the n’kondi.

To bring this system to life sculptors made a container that would house a spiritual force to enforce social and economic contracts. Each nail, blade or screw hammered into the container represents a contract. A metal tag signified a binding, witnessed agreement. Needless to say, the n'kondi was no match for the colonizers.

The n'kondi in this photo is part of a fascinating exhibit "Kongo: Majesty and Power" at the Metropolitan Museum.

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Ben Bernanke's courage to act

I’ve just read former Federal Reserve Chairman Ben Bernanke’s memoir - The Courage to Act - on the 2007-08 financial crisis.  (I’m guessing that the title is a comment on Congress which, he thinks, did not have the courage to act.)

Bernanke helped save middle and low income Americans from a devastating slump, but the book is disappointing. It reads like a long press statement. It doesn’t reveal anything that hasn’t been said already, by him and others.  And if you (wrongly) believed he did nothing to help ordinary Americans, and you have no sense of the counterfactual, what might have happened if he didn’t act, then this book is not going to change your mind.

I was hoping for a sense of the dynamics of the Federal Reserve. Why it behaves the way it does (including why the blind spots).  I was hoping for more light on America’s atomized and dysfunctional financial system governance.  And something revealing about what wiser behavior from legislators might have looked like.

He's reputably a very calm person and the only time he seems really worked up in the book is when he talks about members of Congress and the Senate.  Echoing Churchill, and in the context of a farewell dinner for Tim Geithner that included recent Treasury Secretaries and Federal Reserve Governors (Rubin, Summers, Paulson, Volcker, and Greenspan) he noted, revealingly, that

“In some respects it was an awkward gathering, colored by complicated personal relationships, strong egos, differences in policy views – and a lot of history …[But] the deepest frustration we shared was with government dysfunction itself. The founders had designed a system to be deliberative, instead it was paralyzed. Too often the system promoted showboating, blind ideology, and malice. Nothing productive could be done it seemed, until all the wrong approaches were tried first. ”

— Ben Bernanke, The Courage to Act, page 536

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Useful financial engineeering

I’m reminded daily of the decrepit state of New York infrastructure – the delayed subway trains and shabby stations, the broken water mains, the decaying bridges, and the ugly and dysfunctional airports. It’s not much different in the rest of the US.  But it feels bizarre in a city that is supposedly the world center of creative finance.

Most US infrastructure was built in the 1930s and 1950s and has been poorly maintained.  The American Society of Engineers estimates that between 2013 and 2020 the average family will lose $28,000 from ailing and inadequate infrastructure.

The problem with infrastructure projects is that costs are mostly upfront while the payback period is often in decades. Investors are nervous because they think governments will change the rules over this horizon altering the returns – and they have done so many times. Once the construction is done, the investors can be held hostage. Big infrastructure construction projects are often controversial and risky and getting pricing of services right over the long haul is very tricky. So while there are huge lists of projects and many long term investors such as pension funds wanting the steady returns that infrastructure should be able to provide, few projects get private sector funding.

Canada is experimenting with a new public-private partnership model where projects are run by pension funds.  The key idea is that the pricing will be less controversial if the public who pays the fees also benefit from the returns, so they are less likely to lobby for politicians to change the rules.. The head of the Canadian venture explains:

““The person getting on a tram or crossing a bridge and paying a toll is now paying a contribution towards their pension when they do that,” he says. “That’s a different thing — from a political perspective — than someone paying a fare to the Morgan Stanley infrastructure fund or whoever.””

— FT, November 9, 2015

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Is AI progress?

Winston Churchill once said, “First we shape our structures and then our structures shape us”. This is a good frame for a mind-stretching story in the latest New Yorker about AI, and in particular question of whether intelligent machines could threaten humanity – treating us much as we now treat ants. The story is woven around Nick Bostrom, Director of the Future of Humanity Institute at Oxford University and his new-ish book "Superintelligence." Bostrom is an AI optimist. According to the New Yorker:

“Perhaps the most radical of his visions is that superintelligent A.I. will hasten the uploading of minds—what he calls “whole-brain emulations”—technology that might not be possible for centuries, if at all. Bostrom, in his most hopeful mode, imagines emulations not only as reproductions of the original intellect “with memory and personality intact”—a soul in the machine—but as minds expandable in countless ways. “We live for seven decades, and we have three-pound lumps of cheesy matter to think with, but to me it is plausible that there could be extremely valuable mental states outside this little particular set of possibilities that might be much better.””

— New Yorker, November 23, 2015

Scientists are only now starting to debate the ethical and social implications of AI research. Meantime, as the New Yorker piece explains, many of the biggest and highest profile tech companies (such as Google) are in an “A.I. arms race," buying up AI firms and setting up special AI units. 

One researcher who is pessimistic about AI outcomes for humans was asked asked why he continues:

“ “[T]he truth is that the prospect of discovery is too sweet.” He smiled awkwardly, the word hanging in the air—an echo of Oppenheimer, who famously said of the bomb, “When you see something that is technically sweet, you go ahead and do it, and you argue about what to do about it only after you have had your technical success.””

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Code for life

The movie Gattaca is a futuristic story about life in a genetically engineered society. Lab-crafted embryos lead to a super sub-species, while the rest of the human race faces discrimination and limited prospects. But this future could be getting closer. Scientists have worked out ways to change human genes cost effectively. The plus side is that the technology can prevent disease but there are also huge risks. So, can our global community of such diverse values and governance capabilities work out a good set of rules to manage the technology? A recent story in the New Yorker explains:

“Inevitably, the technology will also permit scientists to correct genetic flaws in human embryos. Any such change, though, would infiltrate the entire genome and eventually be passed down to children, grandchildren, great-grandchildren, and every subsequent generation. That raises the possibility, more realistically than ever before, that scientists will be able to rewrite the fundamental code of life, with consequences for future generations that we may never be able to anticipate. Vague fears of a dystopian world, full of manufactured humans, long ago became a standard part of any debate about scientific progress. Yet not since J. Robert Oppenheimer realized that the atomic bomb he built to protect the world might actually destroy it have the scientists responsible for a discovery been so leery of using it.”

— New Yorker, Gene Hackers, by Michael Specter, November 16, 2015

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Minding treasures

The “tragedy of the commons” is the terminology economists use when resources are plundered in the absence of defined property rights. These rights can give owners the incentive to conserve resources to maintain their value. But property rights alone are not enough, obviously.

A recent FT story on the destruction of forests in Romania’s Carpathian mountains is a case in point. These forests are the “last great wilderness in Europe.” Some trees are reportedly more than 700 years old. As the FT explains:

“When the dictator [Ceausescu] was dispatched, the new government of free Romania set about restoring the ancient forests to those who could prove they owned them before the communists seized power. This was often easier said than done. While forests are embedded deep in the Romanians’ sense of themselves, the Carpathian Mountains marked the boundary between Transylvania and Wallachia, which held very different concepts of “ownership” in the Austro-Hungarian and Ottoman empires. It took years but, by the early 21st century, restitution was under way.

Local farmers and others now found themselves the owners of tracts of forest. So far, so good. But this is a story about capitalism and its consequences — good and bad, intended and unintended. For with ownership came liability for land taxes and for dues payable to the forestry authorities. These turned a restored asset into a liability.”

— FT, The Last Wilderness, Jeremy Paxman, November 14, 2015

The trouble is these local peasant farmers are very poor. The only way some can pay the taxes is to sell logging rights for cash. In came Europe's logging companies. Now this unique forest is being harvested industrial style, with clear felling. The treasure is vanishing.  Clearly, tax and conservation policies also matter.

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Rights help to prevent wrongs

In the small amount of traveling I’ve done in African country-side, what stands out for me is the under-utilization of land - except in Rwanda where population density is high, water is abundant and soil is fertile. One problem outside Rwanda may of course be water shortage. But a new online map called LandMark offers a lens on land ownership which may help explain what’s going on. According to WRI, a steering group member for this project:

“LandMark shows that 78.9 percent of Africa’s land mass is held by Indigenous Peoples and communities under customary tenure. About 21 percent is formally recognized, while the remaining 57.9 percent is not.”

— WRI, November 10, 2015

In this striking map of Australia (and Indonesia) it looks like most of the land area is indigenous land or pending petition by indigenous people. WRI also notes that solving indigenous land claims in Indonesia could help to reduce the fires currently causing atmospheric havoc in South East Asia (see post of October 20). (When land rights are clear and protected by courts there is more incentive for people to look after it.)

LandMark website (dark brown means settled rights, lighter colors mean pending)

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Invisible work is easier to ignore

McKinsey has estimated the value of the work women do at home at $10 trillion, about the size of China’s GDP. Currently home-making work done by women is not counted in GDP – unless the work is done by a paid housekeeper. If you are a believer in “what gets measured gets managed” then if work in the home gets measured, it can be managed and redistributed more efficiently. Some of the time saved would be used for education and more skilled work. This could add a huge improvement in living standards boost the global economy. According to  a scenario in the McKinsey report:

“We consider a “full potential” scenario in which women participate in the economy identically to men and find that it would add up to $28 trillion, or 26 percent, to annual global GDP by 2025 compared with a business-as-usual scenario. This impact is roughly equivalent to the size of the combined Chinese and US economies today. We also analyzed an alternative “best in region” scenario in which all countries match the progress toward gender parity of the fastest-improving country in their region. This would add as much as $12 trillion in annual 2025 GDP, equivalent in size to the current GDP of Germany, Japan, and the United Kingdom combined, or twice the likely growth in global GDP contributed by female workers between 2014 and 2025 in a business-as-usual scenario.”

— The Power of Parity, September 2015, Mckinsey Global Institute

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Country on fire

Forest fires to clear land for farming in Indonesia have in recent days emitted more green house gases than the entire US economy.

WRI explains:

“The burning of tropical peatlands is so significant for greenhouse gas emissions because these areas store some of the highest quantities of carbon on Earth, accumulated over thousands of years. Draining and burning these lands for agricultural expansion (such as conversion to oil palm or pulpwood plantations) leads to huge spikes in greenhouse gas emissions. Fires also emit methane, a greenhouse gas 21 times more potent than carbon dioxide (CO2), but peat fires may emit up to 10 times more methane than fires occurring on other types of land. Taken together, the impact of peat fires on global warming may be more than 200 times greater than fires on other lands.”

— WRI, October 16, 2015

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