About deceptive complexity and sub-prime mortgages

My understanding is that if one can’t simplify the basic principle into an understandable narrative, he either doesn’t possess good understanding of the subject, or is trying to bullshit you. In physics, the things that are really well understood can be made into a simple and straightforward narrative, while those that require head-spinning formulas and look more like c++ code than human language are the least well established and are most likely to evolve in the future.

The same goes with economy. Every time I’ve seen excessive complexity of the narrative, it was because someone had a vested interest in bullshitting everyone by adding layers of unnecessary complexity needed to hide some form of deception. For instance, the entire sup-prime mortgage crisis was essentially a scam, that was pulled off exactly because it was hidden in so much obscurity, unclear language, and, essentially, code. The complexity is not always there to hide foul play – mostly it is to create an illusion of great expertise, where simple concepts are intentionally related in overly complex terms in order to create an impression of user’s great knowledge and competence. I have the same issues with mathematics – some things are usually defined in such a complex way I usually feel very stupid for not understanding it, until I finally do, and then I can usually explain the concept in very simple, clear terms which completely dispel the “magic” of obscure terminology that actually made it almost impossible for me to understand the concept in the first place.

This is the reason why I explain things in a very simple, straightforward narrative. Of course, one can endlessly bitch about accuracy of this or that detail, but I find that unimportant. It’s essential for one to understand how the cogs and gears work, and then you can research the details as much as you like. I think that’s how all the good theories are made: by cutting through the pretense and irrelevant detail to the essence of what’s happening, and then you can model it mathematically to your liking. Essentially, Feynman and Nash formulated the basics of quantum electrodynamics and game theory in a canteen, one by playing with paper plates and watching the patterns of them falling, and the other by watching people interact and cutting through to the basic underlying motivations. It resulted in complex theories, but started by cutting through complexity in order to reach the simplicity of the basic principles which you could explain to a smart 10 year old.

The problem with economy is that when you don’t cut through bullshit, you lose money, and that can translate into losing a significant portion of your life. It is therefore essential that we really understand what is going on, how things work, why they work and why they fail. I am not alone in this belief – Warren Buffet, for instance, is a strong advocate of cutting through bullshit before you invest your money in something, because the quickest way to lose money is to invest in what you don’t understand, or to shift your money chaotically based on short-term events, instead of calmly implementing a long-term strategy. Essentially, great minds cut through bullshit, while small minds thrive in it.

So, as an example, I will break apart the 2008 crisis.

A derivative is, essentially, a paper that derives its value from an underlying real asset. For instance, paper money started as a derivative of gold, like today’s gold bonds. A mortgage loan contains a “security”, essentially a document which allows you to sell someone’s house if he doesn’t pay the installments regularly. These securities can be traded in their own right, and when you’re a big mortgage company, you can play very strange games, such as bundling many mortgage securities in a single package, in which bad mortgages (the ones where the loan shouldn’t have even been approved in the first place because he doesn’t earn enough money to be likely to repay the loan), euphemistically called “sub-prime”, are bundled together with the good ones in order to dilute the risk. This is very similar to the dangerous practice of some blood banks that pooled all the blood together before testing it for HIV. The resulting pool diluted the HIV positive blood below the threshold where the tests could reliably detect presence of the virus, but it was still infectious. That’s how the mortgage companies played the system: they understood the rules according to which risk-assessment was to be assigned to the entire bundle of securities by the rating agencies, and sold quite a large number of bad (“sub-prime”) mortgages to non-paying customers, and insured the entire package as a bundle to get a good insurance price and rating. However, this coincided with the point when the outsourcing policy backfired at the American economy, and a lot of people lost jobs. Having lost their jobs, they could no longer repay the loans. Combined with the already substantial number of the sub-prime mortgages on the market, this resulted in a huge number of defaults on mortgage loans. No problem, you’ll say, just repossess the houses and sell them, real estate is a good investment. But that’s the case only when the market as a whole is healthy and you sell individual houses. When you already exhausted the number of people who can afford to buy real-estate, to the point where you sold sub-prime mortgages for years, and now even the good ones defaulted, this means that the demand is zero and you just had a huge surge on the supply side, flooding the market with houses nobody can really afford. And then the banks said “no problem, the loans are insured”, and then the insurance companies defaulted because they played the system and lost. And then, when the loans themselves proved to be worthless, all the derivatives on those loans, including the emission of a significant portion of US currency, proved to be worthless. The American government had to choose between seeing the entire economy fold, and raising the stakes, and it chose the latter, printing trillions of new dollars in order to prop-up the corrupt and broken system. Since foreign currency is heavily based on US currency ever since Breton Woods and later the petrodollar, all hell broke loose, because America essentially transferred the cost of their crisis and of the rescue of their economy to the rest of the world, which had to buy those essentially worthless new dollars, unbacked by neither gold nor real assets, in order to buy crude oil on the market. This essentially pumped assets from the rest of the world into America, and created a chain of events which made the other countries reconsider their reliance on American currency as the basis of international trade, and as they attempted to save themselves from this vampire-transfusion event which created a never-ending global depression that threatens to pull everyone under, America intervened even more aggressively to bring the disobedient countries in line, mostly by instigating “color revolutions” and “springs” of all kinds, collapsing governments and fomenting civil wars in or near the “disobedient countries”, relying more and more on hard instead of soft power.

And the cautionary tale is that the reality of the situation was lost in the complexity of the narrative that has been told to the public. When you cut through the bullshit, you get to understand that the entire show of American prosperity is not due to their superior political or economic system, and that they don’t really practice either democracy or the free market. If they practiced democracy, the citizens would never vote for saving the greedy financial industry and the state by transferring the debt to taxpayers and foreign countries (in fact, Iceland showed what a real democracy would do). If they really practiced free market economy, nobody would be “too big to fail” and the state wouldn’t intervene to save failed bankers. This was such an enormous abuse of trust vested into America by its allies and friendly countries, that it essentially ended the petrodollar era and catapulted the world into very dangerous times that lie ahead. I wonder if the other countries think that America, like its banks, is too big to fail.

Currency, and how it is made

I recently ran into some weird theories about currency, from theory that only gold and silver are proper currency to the theory that one can simply create an imaginary currency out of thin air, as long as it remains scarce enough, and by the pure power of make-believe there goes the Bitcoin.

What I found out is that almost everyone is completely and utterly ignorant of what money is and how it works, so I’ll try to make things a bit clearer.

The concept of money became interesting when people initially began to trade. Since it was always a problem to decide how many chickens you need to give for a goat, and how many beaver furs are worth one bear fur, sooner or later people came up with some universally desirable item that can be readily traded for anything else. Before you think of gold, some other things were thought of first. Animal furs were apparently among the first forms of money, which is why Croatian money is called “marten” (kuna in Croatian). Of course, since carrying furs around and trading them for things isn’t always practical, the role of universally acceptable goods was soon taken by precious metals, as soon as their universal desirability and acceptability was established. Their main advantage was durability, in a sense that they could change hands many times without becoming much worse for the wear.

Paper money became interesting as a way of carrying more value with you than could be done practically and securely with precious metals. In Europe, the first to issue paper money were the Knights Templar. Since people were traveling frequently between Jerusalem and Europe, and often carried substantial amounts of money with them, being robbed was a genuine concern, so basically the Templars offered a service in which they would exchange your money for a paper, which you could exchange back for gold coins on the other end, minus a fee, of course. This became so popular, and they so powerful, that the Pope decided to get rid of them, but the principle served as a basis for the current methods of debt clearing. The banks started issuing promises to pay cashable by the bearer, that could be exchanged for metal coins, and soon those banknotes were traded among the people as proper money, because it was understood that they could be converted into “proper money” at any given moment. Soon, national banks started issuing such banknotes, exchangeable for gold on demand, and guaranteed for by the nation’s gold reserves.

But this is where the trouble started. You see, when people understood that paper money was as good as metal money, they stopped being in any hurry to exchange the banknotes for gold and were content to simply use them indefinitely. This means that the state came to the “brilliant” idea of printing much more banknotes than it had the gold reserves, which was actually necessary because of the immense industrial growth in the 19th century, which would otherwise be constrained by the insufficient amount of money in circulation.

This is an aspect of money that few really understand: that there must be enough money in circulation, that it can cover all needs of trade. Basically, if object a is traded for object b, and both are worth a certain amount of money, and both are independently traded for money, this mandates that the total amount of money in circulation necessary for unrestricted trade must essentially be equal to the value of all goods and services in circulation, basically that the amount of money in circulation must be some function of the gross domestic product (GDP) of the state. Since it’s unlikely that the state will manage to mine enough gold to exactly match its GDP, tying the exploding GDP of the industrial revolution to a finite resource was an immensely bad idea, because scarcity of money in circulation would artificially raise its value and therefore constrict commerce. Essentially, when one horse was commonly traded for x gold coins, if the GDP rose by the factor of two, the scarcity of money would mandate that the twice as large GDP would still be traded for the same amount of gold, basically artificially raising the value of gold and the horse would now be traded for x/2 gold coins. This kind of static monetary practice doesn’t acknowledge the fact that new value can be introduced to the market, and it therefore had to be reformed. This was done by acknowledging the fact that the state guarantees for its money not only with its gold, but with all of its assets, and the direct convertibility of banknotes to gold was first disabled (with laws that prohibited “gold hoarding”) and later completely ended.

This means that a state guarantees for its currency not only with its precious metal reserves, but also with its entire asset sheet, which includes foreign currency reserves, loans by the central bank to the commercial banks etc. This works basically like this: you want to buy a house. You deposit guarantees to a commercial bank, including mortgage to your house. The commercial bank then requests a low-interest loan from the central bank, and forwards your guarantees. The central bank creates new money, guaranteed for by the mortgage to your house, the commercial bank then insures the loan with an insurance company, adds cost of insurance, adds its own interest, and you pay for the entire package. The basis of the entire thing, of course, is the fact that you have a job, which allows you to pay installments monthly, so basically the true backing of this emission of money is GDP, which includes your job.

It’s not just printed out of thin air, or pulled out of one’s ass. It’s not “worthless” because it’s not backed by gold; no, gold is merely one of the metals traded on the free market, and its value relative to printed money is determined dynamically. It’s also not “bullshit”, so that it could be readily supplanted by other bullshit items such as Bitcoin. First of all, nobody’s mortgage guarantees for the emission of Bitcoin. Its quantity in circulation cannot be increased when the GDP increases, which means it is a finite resource which would restrict commerce and its value would artificially rise due to scarcity, and is therefore completely unsuitable for the role as currency. Something like Bitcoin could work, but only if it can be created based on guarantees by some real asset. Since it is unbacked by any assets, it is essentially worthless, and is accepted only because people are stupid idiots who don’t know shit about how money actually works. You can’t base currency on make-believe.

However, if you separate the currency from a single tangible asset, you make it more volatile and prone to fluctuations and abuses, which is a topic for the next article.

Capitalism, between Scylla and Charybdis

Wait a moment, you’ll say, why would I pay more wages when it is uncertain that this will directly translate into greater consumption of my goods and services? The consumption will be distributed across the entire market, so the market will benefit as a whole, while my shareholders will take the direct cost, which can hardly be justified?

I will only smile.

You see, the main reason why the so called free market economy works at all is the fact that it is state-regulated to a very large degree. But let’s start from the beginning.

There is an important aspect of capitalism which I haven’t yet mentioned, and it’s called the economy of scale. This means that if you produce more goods, you earn more profit for the same amount of investment in the production facilities; basically, if you sell 100 units of something and someone else sells 10 units, you both have the same expenses for the factory, you need to sell 20 units to break even. You are earning profits after the 20th unit, and the guy who sells 10 unit goes broke because he acquires a loss. What you then have to decide is whether it’s more useful for you to buy his factory and increase your production capacity, or to simply raise prices because you are out of a competitor. Essentially, as you grow larger, you increase your profit margin, which you can either collect, or use to pressure the competition by lowering the retail prices, forcing them to match and thus, because they are smaller, become unprofitable and either sell their business to you or go bust. When you killed everybody, you then control the market an can raise the prices as much as you like.

This is why capitalism initially produced the “captains of industry”, a phenomenon where all the manufacturing capabilities and all the capital were concentrated in a handful of monopolists who divided the market between themselves, thus determining the prices of everything and effectively ending the concept of free market.

This in turn forced the state to intervene, proclaim a “new deal” (a poker term, meaning the reshuffling of cards), break up the monopolists and legislate against such concentration of capital in the future. This is why I smile at the naivete of the free-market zealots: they don’t understand that the laissez-faire thing had already been tried, and that it lead to the point where all the factories, railroads, oil everything were owned by a handful of people, who then proceeded to dictate the way of life for all the others. The state, which the laissez-faire proponents so vehemently oppose, then intervened in order to re-instate at least some semblance of fair play into the market, assuring that nobody can get so big as to buy everybody else and thus have complete control.

I am not actually sure who initiated the process of legislating syndical rights, whether it was the state or the oligarchs, but the thing is, when a dozen people divide the market between themselves, it is quite easy for them to overcome the conundrum from the beginning of the article: when you’re so big that your consumers are in fact all consumers, for instance if you are Rockefeller and you own Standard Oil, you have no problem deciding that better wages for your workers mean greater marketplace for petroleum products. It is obvious, because the two essentially overlap. All your employees have petroleum lamps and need oil. It’s a no-brainer. And since the ten guys who owned the country already formed cartels to determine prices to mutual satisfaction, the precedent was already set for determining the price of labor. If the state did anything there, it was to assure them it was in their own best interest to have a marketplace that can actually consume goods.

So essentially, what I’m trying to say here is that a weak state results in strong companies which then take most of the roles of the state, and it didn’t prove to be a good thing. More often than not, the corporations will act in a very shortsighted manner and mess things up so hopelessly, that it will be up to the state to try and fix things. On the other hand, if the state grows too big, it will produce more legislation just to present an illusion of its usefulness, and levy more taxes to pay for all that paperwork, increasing the inner resistance of the economy to the point utter inefficiency, which then produces another dead end, and the pendulum turns to the free market proponents who rightly suggest weakening of the state and increasing the influence of the businesses. Unfortunately, once the state gets that much power, it will not willingly give it away, especially since big state means lots of employees, who vote, and have family members who vote, and this pressures the democratically elected leaders to preserve the status quo and increase pressure on the economy with more taxes and legislation until something gives.

It’s anyone’s guess how this may end. For instance, the first thing a state does when it can no longer pay for its expenses with taxes, is to go into debt. This goes on until it becomes financially insolvent, and then you get what’s happening to Greece: basically everybody works for the state, and despite all the propaganda about those evil capitalists who don’t pay enough taxes and the evil banks and foreign states who refuse to give them more free money, the fact is that there is really no reason for wealthy people to pay such excessive taxes at all, since they get nothing for it, really. It is fine to contribute to the common good with a tenth of one’s income, and even to contribute to the spiritual well-being of the community by contributing a tenth of one’s income to the church, but that’s 20% of one’s income. In today’s countries, you are taxed several times as much – both on the income side and on the expense side, until there’s really no motive for anyone to work anywhere but in government, because that’s where all the power seems to be. This, in turn, will collapse the economy and after the governments exhaust their last resort of printing money without backing, everything will go the way of the glorious Weimar republic, which was so bad that Hitler seemed to offer a good way out.

So basically, here we go again.

Capitalism, and why outsourcing is a bad idea

I’ve been asking myself something along the lines of “why does capitalism work, and alternatives don’t”, followed by “how does capitalism actually work”. I’m well familiar with the theory, but as we know from the case of Marxism, a theory can very poorly match reality. So let’s see what the system actually did, in case of Europe and America.

The original mechanism of supply and demand is well known and understood. You have initial scarcity, which creates demand; for instance, you need copper ore in order to manufacture bronze. That motivates someone to dig out the ore and offer it for sale. The first one that does it earns quite a lot of money. The others see it, get greedy and do the same thing, but now the supply is greater than the demand, and the ore can no longer be sold at a premium; it drops. Cheap copper ore motivates many people to think of ways it can be used for new things, because it is now cheaper and they can afford it. For instance, they make copper wires that can be used to produce magnetic coils. As they buy all the copper on the market, the new wave of scarcity is created and this raises the prices, motivating others to invest in copper mining.

The supply and demand of course works for the price of labor, as well. Initially, the process worked somewhat like this. Someone invented a way to automate a loom in a way that allowed one to connect it to a watermill or some other free source of energy, feed it wool or cotton and produce huge quantities of textile on the output. Since textile was usually produced quite slowly and laboriously by traditional means, its price on the market was quite high. By creating an automated method, one created greater demand for the raw materials and started buying them up on the market like crazy, raising the prices. Seeing that, the landowners decided to produce more of that expensive raw material, and since the traditional method of exploiting the serfs for ten percent of what they made doesn’t work for industrial monocultures (obviously, if you need to produce cotton or wool, you don’t need ten percent of milk, cheese, wheat and eggs, which is what the serfs would make, and you can’t make them produce cotton because they would decline, because it’s useless to them because they can’t eat it), the serfs were expelled from the land, which was transformed into something resembling industrial farming, driven by either slave or hired labor. This had three results. First, the labor in agriculture no longer worked on percentage of produce, but on money. Second, there was a huge excess of former serfs and their families on the labor market, which had neither property nor marketable skills, and became the proletariat, living in squalor at the outskirts of cities looking for work. Third, there was a surge in supply of raw materials, fed as inputs to the textile industry, requiring employment of additional labor, which can be cherry-picked from the proletariat for minimum wages, since the supply of labor far outweighed the demand. This abundance of cheap labor and cheap raw materials was wonderful for the manufacturers, at least initially, because the market was soon saturated; on one hand, when it was apparent that it worked and made some rich, everybody started doing it. On one hand, proletariat, which made up a huge portion of the population, was mostly priced out of the market because they lived on minimum subsistence wages, determined by the prices on the labor market. This is the makeup of a classical crisis of capitalism, and those crises repeat regularly and seem to be a normal part of the system, quite similar to what happens in nature on any given habitat: you have rabbits who eat grass, and hawks who eat the rabbits, and the number of predators is naturally limited by the numbers of their prey. When for some reason the population of rabbits explodes, the population of the predators grows to match the growing food supply. Then they overhunt the habitat, there is a decline in the rabbit population, and the predators die off. So basically the supply-demand economy mimics the natural evolutionary mechanisms, which is probably the reason why it is so flexible and why it works so well. Of course, some perceived the crises of capitalism as some great problem that needs to be solved, and in their shortsightedness created communism and its politically correct cousin called socialism, which basically stated that one should artificially manage the numbers of rabbits and hawks in the habitats and tell everyone what to do in order to avoid spikes in supply and the subsequent dieoffs. Of course, when you manage the habitat in such a way, both rabbits and hawks stop bothering to be efficient since they’re going to get the same results anyway, and the managers become increasingly powerful. Also, lacking positive motivation, the managers need to introduce artificial culling of the population and other forms of punishments for disobedience, which is why managed societies always turned into bloodbaths.

But I digress; let’s go back to capitalism. OK, so it has crises. It basically looks like this: some, essentially those who own the factories and the land for growing industrial crops, get immensely rich. Others, mostly the unqualified workforce, get immensely poor, due to great supply and low demand. This great social inequality creates great potential trouble which historically manifested in two forms: the communist movement which intended to revolutionize the society, introduce dictatorship of the proletariat and transform everything into a communist state, and the syndical rights movement, which used organized strikes as an instrument of displaying the important role of labor in the manufacturing process with purpose of using this control as a bargaining chip. The wealthy industrialists initially tried to solve the problem of unrests and strikes with repression – they sent the police to beat and kill the protesters. This never solved the problem, since the proletariat was already below subsistence income and had essentially nothing to lose, and in some cases, like in Russia, they actually lost control of the state. Having communism as an alternative to the syndicalist movement, they stopped to think about their options, and at some point someone said “Damn, this might actually solve our main problem. Guys, listen to this: those syndicalists demand better wages, and other things that essentially mean we can’t exploit them to death and rotate them. But if they get better wages, they will no longer be priced out of the marketplace and will actually start consuming the goods we produce, which will solve our problem of market saturation. In any case we lose a lot of profit trying to open foreign markets, and this might actually be cheaper in the long run. And besides, it’s not like we have many options; we can continue fighting the syndicalists and lose money doing it, and even risk the communist party becoming more popular among the proletariat, which already ended badly in Russia. Or we can redesign the whole system in a way that would institutionalize the syndicate in its role of bargaining for the price of labor on the market, and essentially grow ourselves a huge domestic population of new consumers ”. And so it was agreed.

The result of paying more for labor had complex results. The obvious result was that the level of prosperity of the workforce increased, to the level where it no longer met the definition of proletariat. This essentially removed the communist party from circulation, as the workforce no longer felt any need to overturn the system that gave them more prosperity than they have ever known, and hope that things might be even better in the future. Also, since child labor was outlawed, children could go to school and the level of education rose. Eventually this created a very substantial middle class – people who aren’t wealthy enough to own factories, but aren’t the poor uneducated laborers, either. This middle class opened the market for more sophisticated goods and services, consuming refrigerators, washing machines and TV sets, as well as babysitters, pool cleaners and cable TV installers.

And then someone in the upper management level of the companies looked at the expense chart of his company and said, “Damn, those labor costs are huge. But the unions don’t let us reduce the salaries, in fact they keep demanding more. If we could only get around the unions in some way… I got it! The syndical protections don’t apply to foreigners. We could outsource our call center to India, the labor is dirt cheap there, they speak English and it’s all legal, unlike what would happen if we tried it with the illegal immigrants here.” Since everybody forgot why there’s actually a middle class, why there is social prosperity and why the unions became so powerful in the first place, the outsourcing of labor to other countries looked like a great way of earning more profits. However, it undercut the entire construction that was established in the 1930s and now we are almost back to square one. If you don’t pay your local population big wages, they can’t afford your expensive products and you’re screwed, because the entire structure of social prosperity based on a distribution of profits to a larger demographic collapsed.

Furthermore, outsourcing actually exports the technological know-how needed for manufacturing the product to the foreign companies, and then IBM becomes Lenovo and Cisco becomes Huawei. They either completely take over your business or they start offering equivalent products for less, because they are smart enough not to be satisfied with selling you cheap labor; eventually they will want a share of the finished product market. So it’s basically a double-whammy – you priced your own workforce out of the market for your expensive products, and created a foreign competitor which now offers your own former customers cheaper equivalent products, which makes you doubly screwed.

Of course, I left out a few important things for the sake of brevity and I hope to revisit them in the following articles, but you probably get the basic picture.