Anger Management

In response to David's excellent comment on Capitalism at the Brink, regarding the justifiable anger people have about the financial crisis:  I agree with almost everything you said.


Anger is a natural reaction. Heck - I'm angry about it. I have particular people in mind when I think of attitudes that "led" to this - and when I think of them, I get angry.  Unfortunately, I think my own anger gets mixed into my blog post - but in a weird way - I'm angry at my own anger.

Intellectually, I think the search for causes and villains is in at least some sense unfounded. What happened in the markets is like an earthquake, or avalanche, or like a panic in a crowded room. It is a natural byproduct of the physical and social structure which developed so successfully over the last 40 years. As we drove our economy to more efficiency, less redundancy, and fired anyone who didn't produce immediate results, we created a very successful economy, but also one that was reaching criticality. Was it inevitable that it would happen when it did and in that particular way - no. But it was inevitable it would happen sometime and in some way and when it did - it was inevitable that we would all be angry.

There was a  massive inflow of liquidity/financing made available over the last 30 years and it was this liquidity flow which ultimately stopped. But it was also this massive liquidity flow which led to the stock market and real estate rally over the same time. [And at least in part, these financial innovations were a response to the establishment of ERISA and pension plans in the 80's. Pension plans needed something new to invest in, and our capitalist system created it.] The same phenomenon that led to the economic success of which we are so proud as a nation was both the cause of and result of the processes and practices that blew up.

I am proposing that this crash - and all such crashes - are natural and inevitable byproducts of dynamic "living" systems. If you look hard enough, you may be able to find a triggering event of such a crash, but most likely, every major event was itself caused by a series of smaller and smaller inconspicuous triggering events. Pareto theorized that diverse systems of society and economies can result in a particular and relatively stable pattern of wealth distributions. I'm saying the same thing about how such systems behave over time.

I also believe that a good paradigm for thinking of such a living system is that of a dynamic network.

We see networks everywhere - in a wide range of natural and man made phenomenon. Networks occur naturally - simply as a response to things interacting with with their environment. We see these networks when look out the window at our ecosystem, when we have peaceful relationships with our neighbors, when we see our stocks rally and fall, when we turn on the power to our home. They can lead to amazingly successful growth (Google for example) and equally devastating failures. When things go our way - we think of them as natural and normal. When capitalism "worked" it was because of its inherent superiority and the work ethic of the American people. When it fails - lets find the culprit and string him up.

I also believe that networks display a signature - or fingerprint in their behavior. This signature is the power law distribution, such as the Pareto distribution.

So it is in this context I find the crisis so absolutely fascinating - so cool!  But at the same time -  Yes - those b____s on Wall Street are getting huge bonuses because We bailed them out. I just wish I weren't so angry about it.

[Note that the 80/20 rule is an example of a Pareto distribution - there can be any number of actual parameters - and the Pareto Distribution is just an example of a power law distribution - so when I say networks exhibit power law distributions - I don't mean they all have 80/20 Pareto distributions. Its just that the 80/20 rule is known and hopefully illustrates the point]

Capitalism at the Brink

Recent data released by the Federal Reserve sheds more light as to just how bad things really were in late 2008 - and arguably even today. This Washington Post article summarizes some of it: http://www.washingtonpost.com/wp-dyn/content/article/2010/12/01/AR2010120104658.html?sid=ST2010120106876.  As we all should know at this point,  the Fed was helping a lot more than was admitted to. I looked at what I think was the raw data behind this article (http://www.federalreserve.gov/newsevents/reform_cpff.htm )  and I looked at just the first 3 months of the data. Between the end of October 2008 and January 2009, the Federal Reserve purchased from securities dealers, banks and finance companies over $380 billion worth of commercial paper. Commercial paper is (was) typically considered to be the highest quality, most liquid type of capital market security. The fact that the Fed had to buy this paper means 2 things: 1) the banks, dealers and finance companies would probably not have been able to raise money (by selling these short-term investments they owned) without the Fed help (and therefore may have defaulted themselves). 2) The issuers of this commercial paper were most likely unable to borrow though the capital markets themselves, and thus may have also defaulted. The issuers (ultimate borrowers) of the paper included "good" companies like GE, Caterpiller, Toyota and Harley Davidson.  So in effect, by being willing to buy commercial paper issued by these companies, the Federal Reserve was telling the shell-shocked capital markets to "Please calm down! - Look!  We will buy assets from you if you get in a liquidity pinch yourself. So don't worry about buying commercial paper, because if you need to sell it you will always be able to look to us." This was just one small part of what was the implicit government guarantee of the financial system. It also is an indication of how quickly a financial crisis was going to translate into "real America".  Defaults of major US companies were imminent and would escalate rapidly.

By the way, I spoke to a couple of people recently who claim that they received no benefit from the bailout. I contend that while we can look at some evil individuals who unfairly benfited by this disastor, the biggest aggregate group of beneficiaries are : anyone with a bank account, retirement plan, money market account,  stocks, real estate and anyone who owns or works for a business who borrows money from anyone or who has customers with any of those assets.  In fact, I would go so far as to say anyone who relies on a functioning civilization was a beneficiary.

I am amazed at the number of people who have, say, a retirement income and bank accounts, and think they are insulated from this issue.   Just look at the balance sheet of a retirement fund or of a bank. You will not find your cash anywhere! Instead you will find things like stocks, real estate, business loans, commercial paper and deposits in other banks.

The Inequality Formula

As a follow-up to my discussion on the Pareto Distribution and the distribution of wealth in society, I note a recent article in Bloomberg Businessweek magazine from October 25, 2010.  ( http://www.businessweek.com/magazine/content/10_44/b4201008238184.htm ) This article "The Inequality Delusion" by Drake Bennet discusses an upcoming study by two psychologists [Dan Ariely from Duke and Michael Norton from Harvard Business School] on how wealth in the US is actually distributed and how starkly this distribution differs from most peoples' expectation. For example, when people in a large survey were asked what percentage of the nation's wealth was controlled by the richest 20%, the average response was 59%.  When asked what they believed would be an ideal percentage, the average response was that the richest 20% of the people should control just 32% of the nation's wealth.

The "actual" percentage of the nation's wealth controlled by the richest 20% is...... 84%!    Shocking!    Well, maybe not too shocking since this is essentially what Pareto found in his initial studies of the same phenomenon through history.  It is essentially the 80/20 rule as described by the Pareto Distribution.

I'll admit I was a little surprised by this article. First, do people on average really believe that the richest 20% of the people should control just 32% of the nation's wealth?  Wow!  Second, while my guess on the survey question would have been 80% because that is roughly what Pareto found, I am still surprised at how close it was to that number. As big a fan as I am about this whole concept, I feel there has got to be a tremendous data problem - specifically: "how do you measure wealth?" I would think that the variability of wealth measurement methods and quality of data would significantly shift the results from study to study. Also, socialist or communist societies have a whole different conception of wealth and ownership. My feeling is that in a communist society the same 80/20 rule may still hold, but only if you change the concept of wealth ownership to "ability to control resources" such as through political power. My understanding is that Pareto himself was socialist/communist earlier in his life but became disillusioned when he saw the politically powerful in these economic systems displaying the same wealth/power grabbing behavior as their non-socialist counterparts.

Pareto and the Role of Government

One of the things I like about Vilfredo Pareto is that he was interested in the organizational structures of society - particularly governments. Through his early career, he was at times a capitalist, socialist and a communist. But in his later years he came to believe that all forms of government result in the same distribution of power and wealth (though of course to different sets of people). All governments, whether a communist one or democratic capitalist one,  result in a massive underclass and a small elite group controlling an overwhelming share of power and wealth.  With all forms of government sharing this common flaw, the best government is the one that maintains order while at the same time producing the least drag on society - i.e the one that is most efficient. One of Pareto's students at the Italian university where he taught was Benito Mussolini - who later claimed Pareto was the ideological inspiration of his Fascist government.

To quote Wilkipedia:

Pareto's discovery that power laws applied to income distribution embroiled him in political change and the nascent Fascist movement, whether he really sided with the Fascists or not. Fascists such as Mussolini found inspiration for their own economic ideas in his discoveries. He had discovered something that was harsh and Darwinian, in Pareto's view. And this fueled both the anger and the energy of the Fascist movement because it fueled their economic and social views. He wrote that, as Mandelbrot summarizes:

"At the bottom of the Wealth curve, he wrote, Men and Women starve and children die young. In the broad middle of the curve all is turmoil and motion: people rising and falling, climbing by talent or luck and falling by alcoholism, tuberculosis and other kinds of unfitness. At the very top sit the elite of the elite, who control wealth and power for a time -- until they are unseated through revolution or upheaval by a new aristocratic class. There is no progress in human history. Democracy is a fraud. Human nature is primitive, emotional, unyielding. The smarter, abler, stronger, and shrewder take the lion's share. The weak starve, lest society become degenerate: One can, Pareto wrote, 'compare the social body to the human body, which will promptly perish if prevented from eliminating toxins.' Inflammatory stuff -- and it burned Pareto's reputation."^[4]

Pareto had argued that democracy was an illusion and that a ruling class always emerged and enriched itself. For him, the key question was how actively the rulers ruled. For this reason he called for a drastic reduction of the state and welcomed Benito Mussolini's rule as a transition to this minimal state so as to liberate the "pure" economic forces.^[6]

To quote Pareto's biographer:

"In the first years of his rule Mussolini literally executed the policy prescribed by Pareto, destroying political liberalism, but at the same time largely replacing state management of private enterprise, diminishing taxes on property, favoring industrial development, imposing a religious education in dogmas".^[7]

Karl Popper called him the "Theoretician of Totalitarianism".^[4]

source: Wikipedia

I'd like to think that Pareto was misunderstood.  He was an old man at the time and would die early in Mossolini's rule. I have read that Pareto also strongly favored freedom of the press and the rights of individuals. So rather than being a Fascist, he may have just as easily been ideologically closer to Goldwater Republicanism or libertarianism. But regardless of what you call him, I admire his intellectual curiosity, independence and courage. He stands apart from any particular form of government and instead asks questions about the properties of all governments and societies. He concludes that regardless of which particular government rules, there is a consistent underlying structure to society - one that follows the Pareto distribution.

I love the history of Rome

I was listening to Professor Bob ("History According to Bob" podcast) today talk about one of my favorite topics - the late Roman Republic, and he made an interesting point. He was talking about the first triumvirate  - the political alliance between Crassus, Pompey and Caesar which lasted roughly seven years following 60BC.  Prof. Bob's interesting point was that the triumvirate was formed in an attempt to break the stranglehold that ultra-conservative republicans had over the Senate.  The way Prof Bob described it was that a relatively small group of ultra-conservatives (which included Cicero and Cato the Younger) had banded together to block any reforms and any actions that appeared to lessen the control of the Senate.

Pompey and Caesar, independent of each other, were proposing certain reforms which were being blocked - in spite of the reforms' overall popularity and general senate support. But the ultra-conservatives, through coercion, filibuster and political dealing stopped every attempt. Prof Bob's point was that both Caesar and Pompey were not acting against the Republic, they were just trying to make needed reforms, and they were going through the normal channels. But because they couldn't get through the "no reform" wall, they had to go around it - and by acting together, and with the help (i.e money) of Crassus - they had the unified political power to force the reforms through.  The irony is that by stopping all reform, the ultra-conservatives made the First Triumvirate necessary. And the First Triumvirate can be thought of as one of the first steps towards the destruction of the Republic and the establishment of the Empire.

Reformists or Just Politicians?

Pompey had just come back from the eastern Mediterranean where he had just completed two very successful military campaigns. While in the east he negotiated several excellent treaties and had also promised settlement rights to his veterans.  Now he needed the Senate to ratify his deals - but Cicero and company were against this headstrong young man making such deals without the traditional Senatorial oversight and held them up. Had Pompey done what his predecessors had done (Sulla and Marius) he would have kept his army and marched into Rome and forced the Senate to approve his deals. And had he been Sulla or Marius, about 1/3 of the Senate would be dead by the end of this. But no - Pompey was a good Republican and was sick of the murder and mayhem of the prior 50 years - so he did everything by the book - only to be stopped by small group of "traditionalist".

Caesar at this point wasn't the military genius of later years but was nonetheless very popular among the general population. He had proposed some very popular land reforms to counter the trend of farm land falling into the hands of the wealthy Senators, leaving a growing population of unemployed, poor citizens in the city.  Again, Cicero and company were against all reform.

I don't know why Crassus was in the deal, though since he was by far the richest man around ("as rich as Crassus" is a phrase still used today), I can see why Pompey and Caesar where happy to have him around. Apparently Crassus and Pompey weren't on the best of terms and Caesar, the weakest of the three triumvirates, was the glue that held the three together.

So by standing in the way of the man with the army (Pompey), the man with the people (Caesar) and the man with the money (Crassus), the ultra-conservatives accelerated their own eventual downfall.

Or at least that is one conclusion. I must say that even as I wrap up this episode of history with a tidy bow, I know that such conclusions are not to be trusted. As much fun as it is to look back at history and say "event 'A' leads to event 'B' and then ultimately to 'C'", we really don't know. But it is still fun to think about.