Ones and Zeros

In the various accounts of the ongoing financial debacle, including mine, there are amounts tossed around of how much money was lost or how much the stock market will decline.  I keep hearing the question of where did that money all go?  Money doesn’t just evaporate does it?  Someone has to have it!

Turns out that’s not so.  It can evaporate after all.  Remember that money isn’t real, value is.  And value is based on what we think is valuable.

This is partly confused because we think of things like stocks and bonds and other financial investments as money when they’re not money.  Money is either the bills in hand (or wherever) and the electronic numbers in your bank’s computer.  Investments are something you’ve bought with money that, you hope, will go up in value.  Stocks are part of a company, bonds are part of a loan to a company, city, or other government.

If you buy something with money, you don’t have money anymore, you have that quantity of something.  Now, if we all decide suddenly that what you bought is now worth less and you then try to sell what you bought, you end up with less money.  Basically, it evaporated and no one has it.

The key to keep in mind is value, not money.  Money is an imperfect way to keep track of value.  Since our idea of what’s valuable can change, the worth of your investments can change.  Money is also an imperfect measure of value due to inflation and other similar distorting factors.

Some things, like stocks and other investments, have volatile values that depend essentially on the average of what many people think about future prospects, and thus values, from day-to-day.  Other things, like bread or bricks, are relatively constant and their value is more related to the price of their ingredients.

As a result, money in the aggregate is something of a fiction.  It’s real since we all need it as a medium of exchange, but it’s fictional since it is based on our common sense of what has value and what doesn’t.  And people can be fickle.  Last summer and fall we decided that  the debt level of some of these banks wasn’t realistic and we didn’t really know what they were worth.  Suddenly, their value was much less than last spring.

In Gov. Jindal’s response to President Obama’s State of the Union address a while back, Jindal belittled the volcano monitoring program saying, “Instead of monitoring volcanoes, what Congress should be monitoring is the eruption of spending in Washington, D.C.” Now that Mount Redoubt in Alaska has erupted many people are pointing out the importance of volcano monitoring. Coming from Lousianna, Gov. Jindal should know better about the value of government services.

To make it clear, scientists had suspected conditions for an eruption based on that volcano monitoring program. And they were able to detect the eruption when it happened at night when it could not be seen. This is important since the smoke and ash from volcanos is very abrasive pulverized pumice. This has destroyed jet engines before and reduced large aircraft to gliders. The FAA’s air traffic controllers and the National Weather Service (NWS) were able to isolate that airspace and protect flights both to Alaskan airports and transit flights to Asia.

But the interesting point that’s not yet being made is this volcano monitoring is a prime example of an non-market value. No private company sees a profit motive in doing monitoring. This is an example of something useful and valuable - it probably saved several flights and their passengers earlier this week - but is not provided by the free market.  Market-based economics is valuable.  But it is one tool, and not the only tool, in providing useful and necessary goods and services.

One part of the role of government is as a provider of extra-market goods and services (primarily services). Providing the military for defense, Coast Guard for recovery of people and vessels, volcano monitoring, air quality monitoring, and many other services. The one I use daily and rely on when flying is weather services. Even the commercial weather services rely on the weather data collection, observations and predictions that the NWS provides. For example hurricane forecasts have made storm avoidance possible. Fifty years ago this was not true.

Reagan famously said, “government is not the solution to our problem; government is the problem”. But government is only the problem when it is preventing us from doing something we want to do. When government provides us with necessary services we can’t get elsewhere, we tend to consider it our right. Reagan’s quote is catchy and any institution run by people can have problems. But both the GOP and Gov. Jindal ignore the valuable and necessary services that the government provides that protect our life, our well-being, and our economy.

The stock market responded with almost 500 points of enthusiasm to the Obama/Geithner bank plan today. Somehow, given the last year of history in financial services, a plan that garners this much enthusiasm on Wall Street doesn’t inspire my confidence. After all if your friend bet big and lost, then assures you he know what he’s doing would you trust him?

In his NYT article Paul Krugman says:

“And now Mr. Obama has apparently settled on a financial plan that, in essence, assumes that banks are fundamentally sound and that bankers know what they’re doing.”

We have demonstrably proved that the bankers don’t know what they’re doing in our current situation. This plan is because they have no way to figure out the value of many of their assets. Valuing assets is a fundamental banking task after all.

I’m not taking a position on if Geithner should keep his job, that’s a separate question. And I’m not expecting that the Obama team will solve this in three-four months either. It took us a while to into this mess, unfortunately it’ll take a while to get out of it.  I want this plan to work, but I lack confidence.

Wired has a good article about the “quants” on Wall Street that precipitated the financial crisis.  David X. Li was the author of the formula that was used to manage the risk for bonds, mortgages, and other debt obligations.  However, the problem and crisis are not Li’s fault.  He routinely cautioned people, as did other math experts, that they were using the formula incorrectly.

The key points were that this formula tried to correlate the risk between different mortgages.  There were two sets of problems.  First, risk is not “normally” distributed.  The usual bell curve - a gaussian distribution - is called a “normal distribution”.  However not everything falls into this distribution.

Financial price series have been show to be fractally distributed, this is much wider so has more highs and lows than a normal gaussian distribution..  It’s not unreasonable to consider that risk also has a wider distribution too.

Secondly, correlation varies over time.  The Wired article goes into this in much more detail that I will repeat here.  But two separate loans that have a given correlation of risk over one time period may not always have that same correlation in a different period with different economic conditions.

In the end, the world is more complex that the Li formula allowed for.  This isn’t unusual.  Mathematical models don’t always model all aspects of a situation and they’re not necessarily intended to do so.  But if you ignore the discrepancies between the model and the real world you’re asking for trouble.  And trouble is where we ended up.