Friday, October 31, 2008 134 Comments

Another interpretation of Obama at Columbia

[Update: an intrepid UR reader behind the firewall managed to track down a few papers by Michael Baron, the seminar teacher who claimed to remember Obama. Baron, who got his PhD from Columbia in 1980 and left academia shortly thereafter, seems to have been a specialist in China, and his views seem to follow the liberal rather than Maoist/Chomsky/SDS line. To my mind, this makes it considerably less probable that he's a shill and considerably more probable that Obama's wallflower story is true. Activists are pretty strict about ideological discipline, or at least were in those days. And see also my last comment.]

This one is less incendiary, but probably more realistic. It is in response to the suggestion of free_thinker in the previous comments.

Perhaps Obama, as an activist at Columbia, was a little like a football player on scholarship. He is not ever seen in class, because he is not ever in class. It is generally understood, at least among the staff, that he has other things to be doing. And it might even be that someone else is doing his homework.

In other words, he might have been an intern/catamite/etc in some parallel, opaque world of activist politics. The goal is to have a capable young man for a couple of years who will do all kinds of odd jobs for you, while in exchange receiving a Columbia degree.

Note the extreme reticence, for example, in the interviews of people like the chairman of Obama's political-science department, Professor Chalmers. He says as little as possible. He says: "I don't remember Obama." He doesn't say: "I don't remember Obama! Now isn't that interesting? I suppose he must have been there at the time! Now isn't that odd? Why don't I call up some of my old colleagues, and see if they remember the 6'2 mulatto with the Afro, who was such a promising young man and is now the leading candidate for president? Why, how odd!"

Wouldn't you like to have that discussion? As Carlyle likes to put it, Satan's Invisible World Displayed...

What I think is going on is that, in 1968, there were three classes of professor: those who were willing to tussle with the activists, those who were neutral, and those who were on the activists' side. Obviously, the activists won. The first class was purged, the second was tolerated, and the third was promoted. Today, being with the Movement is basically a requirement for advancing one's career in any nonmathematical academic field. I suspect it is increasingly helpful (perhaps in the form of increased funding to "green" subjects) in science and engineering.

Therefore, Chalmers is like a professor at a state college who is caught between the football coach, the dean of arts and sciences, and the local capital's muckraking correspondent. He doesn't want to lie and say the kid was in his class, but he doesn't exactly want to make a big fuss about the issue, either. If the press is in its full carnivorous attack mode, anything goes, including him. If not, he's not going to go around dripping blood in the water.

So I am confident that Obama was working for something when he was in NY in 81-83. And whatever that something is, it (a) has some pull with the Columbia political science department, and (b) doesn't want this story to become news. And I am pretty confident that something relates, in some sense or part, to the New York radical community. Wouldn't you say this might be a bit larger, more stratified, complex and socially elite than, say, the local bowling club, Renne Faire, or what have you?

Because I am 100% sure that if Barack Obama was in a bunch of political-science classes at Columbia in 1981-83, he would have been widely noticed and remembered. If only because of his unusual name and unusual looks. A poli-sci program is not a civil-engineering department: it attracts people who are interested in people. And a Barack Obama who was not interested in school would not have gotten good grades - as I suspect he didn't at Occidental, either, where he is remembered as a party animal and soi-disant revolutionary. Not exactly the invisible man, in other words.

If the picture at Zombie's is accurate, there were at most, say, 40 black students per class at Columbia in the early '80s. Each one of these individuals either knows Barack or doesn't. Ted Rall says he saw Barack going in and out of the BSO occasionally, and that's our best observation of Obama at Columbia. I repeat: each of these people remembers Barack or doesn't. If they do, why aren't they talking? If they don't, how can a black student community of 40 possibly fail to notice a new black face on campus?

And, while I am convinced that Senator Obama is talented, I am not convinced that he is talented enough to get a political-science degree from Columbia without ever coming to class. Especially not since he was such a star student in Michael Baron's class - whose other six members, not counting Michael Wolf, also have ample opportunity to tell their stories, and dismiss this scurrilous smear. (Is there a way to submit a smear to Fight the Smears? Please help, Mr. Smears! Tell me all about these bad thoughts I've been thinking about our dear President-to-be, Senator Obama.)

Update: there are a lot of good comments, but here is one that adds some detail:
So if he did attend Columbia College at Columbia University, he would have taken the 4 Core Curriculum seminars, and there would have been a total of roughly 50 other students who sat with Barack Obama in small, discussion heavy seminars in which the articulate Barack Obama is likely to have been the only black student. And he would have spent two full semesters with half these students for about 4 hours a week.

The only 6'2" Afro sporting, well spoken, East African featured, unusually named, black student.

I find it highly unlikely that nobody out of this pool of seminar classmates would remember him.

It's a very small subset out of the larger class, but if he was a loner and monk as he describes himself, living off campus and not participating in clubs/orgs/social scene at Columbia, these people would most likely have the greatest contact with him and remember him.

Also the two year long seminars Literature Humanities and Contemporary Civ are taken during Freshman and Sophomore years, respectively. As a transfer, Barack would have either taken both of these during his Junior year, or Lit Hum during his Junior year and Cont. Civ during his Senior year, or both during his Senior year (least likely; Columbia usually pressures transfers to get started on the Core ASAP). This means his seminar classmates would not be members of the class of '83, but of '85, and/or '84, possibly '86.
I like the theory that the press should have pursued the classes of '84 and '85, not '83, because Obama would have been taking the core curriculum as a transfer. While not hugely compelling (surely Wayne Allyn Root's social network extends downward, for instance), it is by far the most innocuous explanation I can find.

I think the theory that Obama transferred to General Studies, not Columbia College, can be ruled out. The Columbia spokesman said Columbia College, and he knows the difference.

(He also mentions, or seems to mention - the Sun correspondent is not quite clear on the source - the mysterious graduation-ceremony brochure. Which, once one gets suspicious, seems like a very odd bit of corroborating evidence. Not the sort of thing one would mention if one was completely sure about the matter. Can we imagine a Naval Academy spokesman bothering to confirm that McCain was mentioned in the graduation brochure?)

Also, could we please have no further discussion of Lee Harvey Oswald on this thread? I may be a nut, or even a tar baby, but I'm not that kind of a nut. (And, as a racist, talk of "tar babies" makes me a little nervous. What is a tar baby, anyway? Is it what I think it is?)

And for comparative purposes, here is the LA Times on Obama at Occidental. This is the kind of story a reporter gets when he tries to track down someone who actually did go to the college he says he went to. The difference is quite conspicuous, I'd say.

Did Barack Obama go to Columbia?

[Update: please see the following post.]

I know. I swore that my evil demagogic talents would go unused in this volatile, historic, and deliciously operatic election. And we'll certainly have a fun discussion after the event.

At the moment, though, I find myself tussling with a question I'm not sure anyone has seriously asked. And I just can't resist.

My question is: was Barack Obama ever a student at Columbia? Because here's how one scurrilous compendium of racist smears puts it:
Obama graduated from Columbia College in 1983, and after spending a year in New York, moved to Chicago.

Wayne Allyn Root says, "I don't know a single person at Columbia that knows him, and they all know me. I don't have a classmate who ever knew Barack Obama at Columbia. Ever! ... Nobody recalls him. I'm not exaggerating, I'm not kidding.

Questioner: Were you the exact same class?

Root: Class of '83 political science, pre-law Columbia University. You don't get more exact than that. Never met him in my life, don't know anyone who ever met him. At the class reunion, our 20th reunion five years ago, 20th reunion, who was asked to be the speaker of the class? Me. No one ever heard of Barack! Who was he, and five years ago, nobody even knew who he was... the guy who writes the class notes, who's kind of the, as we say in New York, the macha who knows everybody, has yet to find a person, a human who ever met him. Is that not strange? It's very strange...

When asked about his undergraduate training at Columbia University, The New Times states that Obama "declined repeated requests to talk about his New York years, release his Columbia transcript or identify even a single fellow student, co-worker, roommate or friend from those years."

Many of his classmates don't remember Obama. He's not in the yearbook. Columbia couldn't find a picture of him at school.

What can be said with some certainty is that Mr. Obama lived off campus while at Columbia in 1981-83 and made few friends. Fox News contacted some 400 of his classmates and found no one who remembered him.
Does this ring true for you? Does it even pass the laugh test?

Barack or Barry - note that he is still Barry while at Occidental; at the next place we know he existed, Harvard Law, he has become Barack - spends two years at Columbia. He presumably receives two years worth of college credits. By taking two years worth of college courses.

Furthermore, in every other period of his life, he is known as the gregarious and charismatic young man he obviously was. Nor can his looks be described as ordinary. Nor is even his name ordinary. This man is a future president. And no one remembers him? No one?

What is the chance that a budding young politician of undeniable talent and promise spends his junior and senior years at Columbia, and no one remembers him? What is the chance that my right ass cheek, through spontaneous quantum vibration, suddenly transmutes into a hemisphere of polished gold? Don't you feel these probabilities are at least roughly comparable?

I can speak slightly to this issue, because while Obama (purportedly) was a transfer student at Columbia in 1981, I was a transfer student at Brown in 1989. It is certainly easy to disappear into the void as a transfer, because most everyone acquires their principal social networks as a freshman. I am also a naturally reticent person who was quite a bit underaged, and I have to say that if anyone "lived like a monk" it was me (although I was in the CS lab, not the library). And I certainly have no plans to seek political office!

Nonetheless, if you were a major media organization, and you went looking for people who were at Brown in the late '80s and early '90s, and asked them if they remembered Mencius Moldbug - giving my real name, of course - you would find them. Easily. Very easily.

So let me ask anyone who cares to comment below. How, exactly, do we - the American people, Lord help us - know that Barack Obama attended Columbia? Or, more precisely: why should we assume, on the basis of the evidence that we have, that he did? Do we seriously believe it is possible for a future President to be unremembered at his alma mater?

What we know is that a Columbia spokesman has confirmed that Obama attended Columbia. If we're lucky, this means precisely one thing: someone at Columbia went over to a file cabinet, opened it, and found a file that looked basically right. Which is more likely: that no one remembers one of the most articulate and talented black students on an Ivy League campus? Or that someone planted a file or two?

WikiCU, the Columbia wiki, in a paragraph which is of course completely unsourced, contains names of two individuals whom it claims claim to remember him (Michael Baron, a professor and contributor, and Michael Wolf, former president of MTV). They
confirm that he was a brilliant, standout student and that he was an active participant in seminars. Baron said he was one of the top one or two students in his class.
No wallflower, in other words. And despite this - no one else remembers him. (Nor did the NYT find Messrs. Baron and Wolf - at least, not on the first pass.) Does this make you less suspicious? Or more? WikiCU is also oddly tentative about a couple of other things:
Obama claims to have participated to some extent in anti-apartheid activities with the Black Students Organization, but no one is quite sure.

He majored in PoliSci, and claims to have concentrated in "International Relations," (now International Politics - this is a subfield of the PoliSci major and should not be confused with a "concentration," the Columbia term that substitutes for what most schools term a "minor").
"Claims." "To some extent." "No one is quite sure." And his concentration is not a concentration at all. You don't smell anything here? You don't detect perhaps a little teensy bit of an odor?

If we rule out the impossible, we have to accept the improbable. In my mind, knowing what I know (if anyone has better information, hopefully they will post it in the comments), it is close enough to impossible that Barack Obama went to Columbia, that I'm willing to say the unsayable and theorize about what else might have happened. Yes, I realize that this makes me a racist.

My guess is that young Barry dropped out of Occidental in '81, not to go to Columbia, but to go to New York and be a black revolutionary bohemian. We know he was a red-diaper baby (no shame in that - my father's parents were CPUSA members), and we know he was involved with an SDS splinter group at Occidental. Zombie has a very interesting timeline of his time in New York, during which it seems very probable that Obama met Bill Ayers. She also links to a completely unsubstantiated and irresponsible speculation that Obama was a roommate of Ayers and Dohrn - which I'm afraid can't help but remind me of this chilling story. Yes, these people are that evil.

What's certain is that whenever they met, Obama and Ayers did not just "meet." At least until Obama was actually elected to state office, their relationship cannot have been one of equals. Ayers was the warlord of the Weathermen. Since that time, probably everyone in his social network, and certainly everyone younger than him, has been a supporter, groupie, protege, or what have you. Ayers is a celebrity of the Left. Celebrities have peers, and celebrities have entourages. There is never any doubt over who is which.

And for those of you still convinced that Obama and Ayers were "neighbors," note that Obama almost certainly worked out of Ayers' office for three years. If you know anything about the granting process, the relationship between Ayers' "Small Schools Workshop" (educacion es revolucion!) and Obama's Annenberg Challenge is obvious: the AC was a funded grant proposal out of Ayers' office. An organizational bud or pseudopod, basically. So under this scenario, Ayers is Obama's professional mentor for at least fifteen years. (And if that doesn't bother you, cue up Larry Grathwohl.)

My guess - not because I have any reason to believe that this specifically is what happened, but just because every other explanation I can think of strikes me as less probable - is that Obama, as a young black radical with SDS credentials and obvious talent and potential, found it relatively trivial to earn quick admission to the inner circle, spent two years as a gofer, intern, catamite, or what have you for the Ayers crime family, and was rewarded by the gift of a Columbia degree and a ticket to Harvard Law.

Did Bill Ayers have connections in the administrative staff at Columbia? It would be remarkable if he didn't. Folks, the Movement was the center of the universe in 1968. If you were one of the top hundred people in it, let alone Bill Ayers, you were the giant glowing sun in the core of your social galaxy. You were a stud beyond studs. You had friends everywhere.

And would someone who blows up police stations blanch at planting a file? Honestly, can we even be confident that the staff at Columbia looked at the file? Who are they, and how do we know them? Again: why do we believe that Barack Obama attended classes at Columbia?

Moreover, a bogus Columbia degree is exactly the sort of thing an ambitious person can get away with in this world. Especially an ambitious black person. Everyone hates to be a racist. Of course, you have to have a serious pair of brass balls, but I think we know Obama has those.

But running for president? And, seemingly, winning? Is it possible? It would certainly be something new under the sun, that's for sure. But semper aliquid novi, as they say.

The story is easy to check. Just ask Barack Obama to tell us the names of some of his classes and professors at Columbia. He may not have had friends, but he took classes from professors. Then, find the professors and students. Not just one of each. All of them. (For example, there were apparently only seven other students, presumably all jealous of the One's rapierlike wit, in Michael Baron's seminar.) Interview these people. Take depositions, if needed. Ask them if they remember Barry. Or Barack. Or whatever he was calling himself at the time. If not...

Of course, the One is scheduled to be elected President in a few days. So he may not find the time to answer. But does it matter? All this will be so much more fun after the election.

And in case it matters, no: I don't really believe Barack Obama is the Manchurian Candidate. If I had to bet, I would bet that Steve Sailer has him pegged: Obama is Gatsby. I think Obama is a man without qualities, a person of no particular character or perspective, who is very good at conforming to the expectations of whatever context he finds himself in. I think he wound up in Ayers' circle just because he's a climber, and that was the handiest pole to climb. I think that in an Obama administration the White House will revert to its long-term trendline of becoming a basically ceremonial and functionless agency. I think, I think, I think.

But I don't know. And that worries me a little. Doesn't it worry you too? A little? Just a little?

[Update: see also the following post.]

Sunday, October 26, 2008 23 Comments


Silence! The world is rotting.
The buzzard, freest of birds,
Floats without flapping, dines without fee -
"The falcon cannot hear the falconer,"
Still others, with wider wings,
Follow not by sight but flavor.
But once this country had a master,
And a name: New Spain. Ichabod!
"Muebles de estilo colonial,"
Cheap and nasty. Ichabod! Ichabod!
"Tan lejos de Dios," as Diaz put it,
"Tan cerca a los Estados Unidos."
Here lords and ladies hawked and sang.
Here placid peasants put in corn
And lived to pick it in the fall,
Here Madrid's silver seal was law.
And you said: "Struggle! Iron! -"
And so on. In the future, we all
Are Protestants. We work at a
Nonprofit, we shop at Rainbow,
Our daughter is at Stanford -
All. Each human in every location.
And for this end, which remains
Through long, savage, solemn course
Not just possible but inevitable,
An egg or two has had to break. Liars.
I have eyes. I have seen the future:
Feral peons in filthy tanktops, sullen,
Half-drunk, any Sunday's mob
To bark some lie or vote for some thief.
So muscle to the kite's nose
Yeast-brown is the first claret,
Bone to his beak an obstacle,
Brains a bisque behind the eye.

Tuesday, October 14, 2008 62 Comments

The Misesian explanation of the bank crisis

I've addressed this subject before at greater length, but I want to put it in one post that people can easily link to and pass around.

Briefly: the fundamental cause of the bank crisis is not evil Republicans, lying Democrats, "deregulation," "affirmative-action lending," or even "ludicrous levels of leverage." A banking system is like a nuclear reactor: a complicated piece of engineering. If it's engineered right, it works 100% of the time. If it's engineered wrong, it works 99.99% of the time, and the other 0.01% it coats the entire tri-state area in radioactive strontium.

The bank crisis is an engineering failure. Its fundamental cause is a humble bug. Once we find the bug, we can start to ask: who is responsible for this bug? Who wrote the code? Who rolled back the fix? That discussion, though fascinating, is out of scope here.

Another analogy is the Space Shuttle disasters. Challenger had a bad booster O-ring; Columbia's wing was hit by falling foam. The level of discourse we're hearing now on the crisis tends to be "the Space Shuttle was Nixon's idea" or, at best, "Columbia's wing melted through and fell off." This is not an engineering analysis. It is point-scoring at best, anti-information at worst.

I believe I know what the bug is. It was first identified by the 20th-century economist Ludwig von Mises, capo of the Austrian School. Mises was an excellent writer, as eloquent as Marx and far more sensible, and it's unsurprising that there is a large Internet cult devoted to his work.

I am going to assume you are not a member of this cult. If there was a video of Mises walking on water, I might be tempted to take his pronouncements for granted. Since no such tape exists, they have to be explained and justified.

But we do need to start with Mises, because he was the first to solve the problem. Almost a hundred years ago, in his Theory of Money and Credit, he wrote:
For the activity of the banks as negotiators of credit the golden rule holds, that an organic connection must be created between the credit transactions and the debit transactions. The credit that the bank grants must correspond quantitatively and qualitatively to the credit that it takes up. More exactly expressed, "The date on which the bank's obligations fall due must not precede the date on which its corresponding claims can be realized." Only thus can the danger of insolvency be avoided.
Let's call the sentence in quotes Mises' rule. A banking system which obeys it is Misesian. We do not have a Misesian banking system - and that's the bug.

Basically, imagine that there were two kinds of nuclear reactors - fission and fusion, perhaps. Fission reactors work 99.99% of the time. Fusion reactors work 100% of the time. The reason our society gets its power from fission reactors is that our reactor experts are fission experts. Therefore, we have resigned ourselves to having fission reactors, plus a large fleet of mobile power-washers to clean up the radioactive strontium every ten or twenty years. If you ask either the reactor engineers or the cleanup crews about the possibility of switching to fusion, the best answer you'll get will be something like "waah?" There are many worse.

Let's consider the sentence again. "The date on which the bank's obligations fall due must not precede the date on which its corresponding claims can be realized." Mises' rule of banking. Let's explain these terms and the reasoning behind them.

A "bank" is a financial middleman. It borrows from you and lends to someone else. When you "deposit" money "in" a bank, you are actually lending money to the bank. The bank does not keep this money in a big cardboard box. (I really hope this is not news to you.) It lends it to someone else - call him Dwight.

The bank's "obligation" is its agreement to repay you your loan. Its "claim" is Dwight's agreement to pay back his loan. (And your claim is the bank's obligation.) So what Mises is saying is that the bank must not agree to return your money (plus interest) before Dwight returns his money (plus interest).

Because, duh, it doesn't have it yet. Sounds obvious, right?

Of course, banks do not match individual claims and obligations in this way. If this is the way it worked, you and Dwight could save time and money by cutting the bank out of the loop. In reality, a bank borrows from and lends to thousands if not millions of people, which allows it to meet its obligation to you even if a few Dwights turn out to be deadbeats. Nonetheless, we can make the same obvious statement: by the time the bank needs to pay you, it needs to have collected from enough Dwights in order to have the money to pay you. Duh.

A more general way to describe Misesian banking is that the bank's plan to fulfill its obligations must not involve any implicit transactions. For example, if the bank promises to give you your money back in a week, and Dwight promises to give the bank its money back in two weeks, the bank has an implicit transaction. At the end of the first week, it needs to borrow money from someone else in order to repay you. That someone else might just be you, in which case you are rolling over - that is, renewing - the loan. But this is your decision, and the bank cannot know that you will roll over. After all, presumably there is a reason you selected a one-week loan.

We observe that in Misesian banking, the duration of a loan is as important as its amount. To balance a one-week obligation with a two-week claim is to balance an apple with an orange. It is just, not, done. Recall Mises' statement: the credit that the bank grants must correspond quantitatively and qualitatively to the credit that it takes up. That means it can't have an apple on the right and an orange on the left. (And what happens if it breaks this rule? Ha. We'll find out.)

A more naive approach to banking might just add up the claims on the left side of the page, add up the obligations on the right side, note that the sum on the left exceeds the sum on the right, and be satisfied. This would be "corresponding quantitatively" - but not "qualitatively." In Misesian banking, the bank makes sure its structure of claims allows it to satisfy its structure of obligations, as is, without implicit transactions. (Another kind of implicit transaction might be a currency conversion.)

Let's look slightly more closely at the loan market. We'll start with the obvious and segue into the not so obvious.

When you lend, you are exchanging present money for a claim to future money. Even if you know that this claim is perfectly good, you have no reason to make the trade unless you are getting more money in future than you give up in present - otherwise, you would just keep the money in your big cardboard box. So, for example, you might trade $100 in 2008 dollars for $110 in 2009 dollars.

The $10, obviously, is your interest rate, or yield - 10%. If you thought the loan had a 10% chance of not being paid back - the default risk - you might add another $10 or so, to get the same expected return. And the year (from 2008 to 2009) is the maturity of the loan.

We are now in a position to ask a very interesting question: in a healthy lending market, assuming Misesian banking, and forgetting about default risk for a moment, how should yield vary by maturity? Should a longer-term loan carry (a) a higher interest rate, (b) a lower interest rate, or (c) the same interest rate?

I suspect that, just intuitively, you said (a). This is indeed the right answer. Let's see why.

The market for loans is set, like everything else, by supply and demand. Every loan has a lender and a borrower. The lender always prefers a higher rate. The borrower always prefers a lower rate. At any maturity, the market rate is that rate at which the number of dollars which lenders are willing to lend is exactly equal to the number of dollars borrowers are willing to borrow.

We can make a little graph of this market, putting maturity on the x-axis and yield on the y. The result is called the yield curve. At least in a free market, the yield curve will always slope upward - higher maturities will command higher interest rates. This is true for any set of lenders and borrowers, anywhere in the known universe. If they have Misesian banks in the Lesser Magellanic Cloud, their yield curves slope upward.

How can we possibly know any such thing? We know only one thing: interest rates are set by supply and demand. But we can make some elementary observations about lenders and borrowers, which are true by definition.

The first is that at the same rate, any lender will prefer a shorter maturity. Consider the choice between one-week and two-week lending. If both transactions had the same rate, you could just lend for one week, get the money back and lend it again. This gives you the option to use the cash at the end of the first week, an option that the two-week maturity does not provide. An option can never have negative value, so why not: you'll pick the one-week maturity.

The second is that at the same rate, any borrower will prefer a longer maturity. For a borrowing transaction to be profitable, some productive process must use the money and generate a return. The set of productive processes that can produce round-trip return at a maturity of one second is empty. Therefore, in Misesian banking, no one should want to borrow at a one-second maturity, because there is no lending at a zero rate and no way to finance a productive enterprise at any nonzero rate - however small.

As the maturity of the loan increases, so does the set of productive processes, and so does the demand to borrow. Without violating Mises' rule, you cannot finance a nine-month pregnancy with a one-month loan. You need a nine-month loan. Nine one-month loans in a row will not suffice, because the last eight are implicit transactions.

Thus, for a higher maturity there is less supply of lending, and more demand for borrowing. Less supply and more demand means higher price, which means a higher yield. Which means the yield curve slopes upward.

This concludes our explanation of Misesian banking. Now let's explain the crisis.

Again, we don't have a Misesian banking system. We have what might be called a Bagehotian banking system - after Walter Bagehot (pronounced "badget"), who wrote Lombard Street, the first description of how this system works.

Here is a nice, concise explanation of the Bagehotian system:
The essence of what banks do in normal times is to borrow short and to lend long. In doing so, they transform short-term assets into long ones, thereby creating credit and liquidity. Put differently, by borrowing short and lending long, banks become less liquid, thereby making it possible for the non-banking sector to become more liquid; that is, have assets that are shorter than their liabilities. This is essential for the non-bank sector to run smoothly.
This appeared in the Financial Times on October 9, 2008. The author is one Professor Paul de Grauwe, who like Professor Mises, and unlike me, got paid to understand this matter.

Note the perfect inversion between the Misesian and Bagehotian theories. Mises, writing almost a hundred years ago, describing a banking system that did not exist in his time any more than it exists in ours, says: "Only thus can the danger of insolvency be avoided." De Grauwe, writing now, says: "This is essential for the non-bank sector to run smoothly."

Hm. We may not be sure whom to trust here, but we do know that neither of these gentlemen is stupid. So what gives?

First, let's decode what Professor de Grauwe is saying. He's saying that banks routinely violate Mises' rule - they borrow "short" (ie, with short-term maturities), and lend "long" (ie, with long-term maturities). In other words, they engage in what we call maturity transformation.

Because we know the shape of the yield curve, we know why MT is profitable. Short interest rates are lower than long interest rates. So if the rest of the world is practicing Misesian banking and you're practicing Bagehotian banking, you make a mint.

In fact, we can say even more than this: we can say that MT lowers long-term interest rates. In our stodgy, Teutonic Misesian bank, if someone wanted to borrow money for 30 years, we had to match him with a lender who wanted to lend money for 30 years. In our fast-paced, Anglo-Saxon Bagehotian bank, we don't care - we balance our balance sheet quantitatively, not qualitatively. We can match the borrower with any lender, and get a better rate.

This is how a classic, Wonderful Life-style deposit bank works. A so-called "deposit" is really a loan of instantaneous maturity, continuously rolled over - by not "withdrawing" the cash, you are really renewing the loan. In the classical Bagehotian model, this might be used to finance, say, a 30-year mortgage.

Bagehotian banking seems like a just plain better idea. Its profits can be distributed to lender and borrower alike, producing higher rates for the former and lower rates for the latter.

Unfortunately, there is a slight downside. As we said earlier: "duh, the bank just doesn't have the money yet." When a bank borrows for a month and lends for a year, how exactly does it complete the transaction? Is there a little time machine inside the vault?

By violating Mises' rule, the Bagehotian bank makes itself dependent on an implicit transaction: viz., finding someone to loan it money for eleven months. Let's look at the ways in which it can implement that transaction.

The easiest way is just by inducing you to roll over your loan. It finds someone, and that someone is you. The reason Bagehotian banks work 99.99% of the time is that lenders, especially individual lenders, tend to roll over their loans a lot. You make a bank deposit rather than buying a six-month CD, even though the CD pays a higher rate, because you are not sure you won't need the money before the six months is up. Often you find you didn't. In retrospect you should have bought the CD, but you had no way of knowing this at the time.

The bank can also sell the 1-year loan. But selling a loan is equivalent to finding a new lender. Again, it cannot be known on what terms this implicit transaction can be executed.

What we've identified here is the wad of duct tape in the nuclear reactor. A Bagehotian bank is not contractually sound, because it does not have a complete plan to carry out its obligations. It relies on implicit transactions. And when these transactions cannot be executed on the terms expected - poof. The duct tape catches fire. The reactor melts down. The bank has a run.

In a bank run, the lenders start to doubt collectively that the bank will not be able to execute on its obligations to all of them. The origin of the doubt could be concern about the bank's quantitative solvency - eg, its 30-year claims are subprime mortgages. Or it could just be a suspicion that the bank will experience a run. If there is a run, you want to be the first out.

What happens as a Bagehotian bank experiences a run? Let's assume that, before the run, the bank was still quantitatively solvent - the current market price of its claims exceeds the sum of its obligations. The only problem is that the claims mature far later than the obligations.

So the bank sells the claims on the open market. If it can sell them all at the market price before the run, it is fine - it can raise enough cash to pay off all its depositors.

But a market price is a market price. It is not magic. Introduce new supply into the market, or withdraw demand - and the price drops like a stone. The bank run changes the price of the claims that are being sold. It has to find a lot of new lenders - but the market price of everyone's claims is dropping. So all banks which hold claims in this market are becoming quantitatively insolvent. The bank run spreads to the entire market. Lenders run in the other direction. And so on.

The idea of the yield curve lets us visualize this in a particularly elegant way. Recall that Bagehotian banking, by transforming maturities, lowers long-term interest rates. It flattens the curve. At least as compared to the Misesian yield curve.

Think of this curve flattening as putting pressure on a spring. A Bagehotian banking system is, at all times, a bank run waiting to happen. And when the run happens, the spring explodes in the other direction - well past where the Misesian yield curve would have been. It will not stop at the Misesian level, because a Misesian banking system would never have made so many long-term loans. It will produce astronomical long-term rates.

(This is exactly what we see now in the mortgage-backed securities market. It is impossible to get a read on exactly what the risk-free interest rate is in this market, because by definition there are no risk-free securities in it. Maturity-transformed demand is (at present) no longer buying mortgage securities, but not all the holdings have been liquidated, and there is no maturity-matched banking system to provide baseline demand. So neither interest rate nor default risk can be computed from asset price - you are trying to solve one equation for two variables.)

This metaphor of the spring lets us understand Professor de Grauwe's perspective. He believes "[maturity transformation] is essential for the non-bank sector to run smoothly" because he is thinking empirically, rather than deductively. He simply notes that every time MT stops, the reactor fails and melts down, and the tri-state area receives its coating of strontium. His thought is not intended as a comment on a Misesian banking system which never initiates MT to begin with, an idea that has probably never come to his attention. He is a fission expert, after all.

The difficulty in transitioning from Bagehotian to Misesian finance is immense, which is probably a big part of why it's never been tried. The Misesian sees an enormous set of financial structures which violate Mises' rule. He sees no way to unwind them. Other than massive liquidation - the bank run as a virtuous purge of "malinvestments" (pretty much any investment is a loss if it has to be financed at 80% interest) - there is no obvious way to get from here to there. The reactor just has to blow, and the strontium has to be swept up. Or so at least is the conventional wisdom, and no one is really working on the problem.

Moreover, there is another way to save a Bagehotian banking system: find a new lender who can print infinite amounts of money. (Or, in a metallic standard, compel the acceptance of paper as equivalent to metal.) This friendly fellow is generally known as "the government," or more formally as a "lender of last resort."

The end result of Bagehotian banking is that, without any government protection, it is incredibly unstable and will melt down at a drop of the hat. With full government protection, it is stable, and it drives down long-term interest rates - just as if the government itself had been making the loans itself. The lender of last resort might as well be a lender of first resort. (There are no modern schools of economics which believe, as far as I know, that governments should print money and lend it.) And with wishy-washy, informal, wink-and-a-nod protection - which is what we had until the other day - these toxic qualities are combined.

And this is how we continually stumble forward with a broken, Victorian-era banking system, suffering the slings and arrows of bad financial engineering. The whole thing needs to be rebooted, if not reinstalled, and we simply don't have a political system - or an intellectual system - which is capable of this. But I digress.

Friday, October 10, 2008 26 Comments

A regime-change signal: maturity crisis in gold?

As I said the other day, I support Barack Obama in the upcoming election. (In fact, at this point I'd like to see John McCain suspend his campaign in the name of national unity.) This means that, like many Americans today, I hope for change. And there's no change like regime change.

I mean financial regime change, of course. A financial regime change is a phase change in the markets for money - the end of an old era, and the beginning of a new. As I recall, they even had money in Mad Max II: Beyond Thunderdome, so there is always a new regime.

Many eras are ending in the financial industry, but there is one big one which hasn't happened yet: a regime change in the global currency market. Our current global currency regime is sometimes known as Bretton Woods II, or BWII. Perhaps if the new regime represented only a moderate change from the present one, it might be called BWIII. For policymakers at present, this outcome would probably represent success. In the event of failure, the phrase "Bretton Woods" is unlikely to convey positive brand equity.

No one really loves BWII. Since the term was coined, economists have made a parlor game of predicting its demise. BWII is not an architecture, it's a system of stable disequilibria. Saying "BWII is coming to an end" is like saying that in the future, California will experience a large earthquake.

A more interesting question is: if there is a market signal - ie, a price series, a number, a chart - that looks like the end of BWII, what might it look like? By definition, the end of BWII is the end of the world as we know it. So we are, essentially, looking for an end-of-the-world signal.

I am not an economic determinist, so I cannot go so far as to actually predict the end of the world. For one thing, all outcomes are contingent on official action. There are plenty of ways to stop this crisis instantly in its tracks - although most of them are not politically conceivable. At present. Politics is not in any sense predictable.

(Did anyone watch Hank Paulson's speech on Wednesday? Including the Q&A? You can see it here. Frankly, Bruno Ganz in Downfall is mostly more self-possessed. The kindest thing you can say about Secretary Paulson is that he came across as if he hadn't slept in three days, and at worst I was reminded of Ed Muskie and his notorious Ibogaine moment. Does Fort Knox come with an an "evidence locker"? Even the frame rate on the WMV clip is weird and twitchy, as if Treasury's IT farm is feeling the heat.)

However, we are now seeing a signal in the wild that, if it means what I think it means, could well be a predictor of global financial regime change. This signal is not one of your common or "headline" statistics. It is not a first-line number or a second-line number or even a third-line number. It is not printed in any newspaper. Nonetheless, you can find it with one click.

But before we say what the signal is, let's say what it should look like. What we are looking for is a phase change between one equilibrium, which is the equilibrium we have now, and another equilibrium, which is the equilibrium which has Tina Turner, bad hair, and lots of crossbows. From the standpoint of a modeling philosophy which assumes a single equilibrium, such a phase change looks like an indefinite-sigma departure from the original price regime.

There are all kinds of such departures in the markets today. Perhaps the most notorious is the TED spread, whose recent history looks like this:

Although this signal is very ominous, it is not our candidate. Note that if you graph the inverse of one of these she's-gonna-blow signals, it assumes the other appearance of an equilibrium-transition signal - the plateau that suddenly turns into a cliff. A lot of the prices of mortgage securities have this plateau-cliff shape.

Nassim Taleb has described these indefinite-sigma departures as black swans. This essay of Taleb's is required reading. While an equilibrium transition is not the only kind of black swan in the world, it is the bird that seems to be causing the problems we have now.

Here at UR, we think we know what this latest black swan is: a maturity-transformation crisis. Aka, a bank run. The previous essay is required reading to understand the rest of this one. If you're skeptical or even if you aren't, please also read the discussion at Arnold Kling's.

Here is the scary signal:

Again, if this isn't an indefinite-sigma departure, I don't know what is. But what is this signal? What are these funny lines, anyway?

This is a gold lease rate - basically, an interest rate for borrowing gold. The source is here. Note that if you scroll down to the long-term chart, you see two other spikes: in 1999 and 2001. The 2001 event is 9/11. The 1999 event was the Central Bank Gold Agreement. These events turned out to be transient, and they are qualitatively different from the current spike - as we'll see.

The current spike is explained, sort of, in this Financial Times story (also syndicated here). What is not explained is the context and the implications. Let me try to fill in the gaps.

The world's central banks have about 30,000 tons of official gold reserves. This does not mean they have 30,000 tons of gold in their vaults. No one knows exactly how much gold they have in their vaults. Estimates vary as to the discrepancy, but it is probably somewhere between 2,000 and 10,000 tons. For perspective, annual mining production is about 2500 tons.

The difference is in the form of "deposits," "loans," "swaps," etc: in a word, receivables. Where X is some number between 2000 and 10000, the CBs have (30,000 - X) tons of gold, and (X) little pieces of paper on which is scribbled "HAY CB, ITS OK - I PAY U GOLD."

The signatures on said pieces of paper are names of "bullion banks." A bullion bank is just like a regular bank, except that it does business in precious metals, not government currencies. In particular, bullion banks profit the same way regular banks do: maturity transformation.

In a typical transaction, the "deposited" gold is sold on the spot market, and the resulting cash is used to finance a long-term investment, typically gold mining, that produces gold. The result is that the bullion bank has short-term liabilities balanced by long-term receivables, both in gold. In particular, bullion banks generally do not expose themselves to fluctuations in the gold price, as they would if they used their deposits to finance dollar-yielding investments. When the ratio of gold to dollars changes, the bank's liabilities and assets change in unison.

A similar source of financing is the sale of near-term contracts in the futures market. These contracts promise delivery of gold in a matter of months. The proceeds from their sale can be used to finance production of gold over the course of years. Again, the resulting structure has gold on both sides, and so is balanced against changes in the gold price.

If you have read the essay on MT, all this will seem familiar to you. The bullion banks are maturity transformers. Moreover, they are unprotected maturity transformers - while the gold market is notoriously opaque, there is certainly no one who can print and lend an infinite amount. This being kind of the point of gold.

Note that at least until recently, gold lease rates have been well under 1%, often under 0.1%. Why do central banks participate in this market? The official interpretation is that they want to earn a yield, however small, on their assets. The conspiracy interpretation is that they want to suppress the gold price. In 1998, Alan Greenspan told us that "central banks stand ready to lease gold in increasing quantities should the price rise," which strikes me as fairly clear-cut. On the other hand, since 1998 the gold price has risen considerably, and gold lending has not.

Most gold enthusiasts, and especially most gold conspiracy theorists (there is no sharp line between the two, especially since gold-market intervention is one of the world's few practical conspiracies; the whole point of a central bank is to intervene in monetary markets) would have expected that a substantial spike in the gold price, especially one accompanied by general financial chaos, would have resulted in some kind of counter-intervention. Either this has not happened, or it has not been effective.

My bet would be on the former. There is no doubt that central banks once managed gold prices, and very aggressively indeed. But my impression is that the current generation of central bankers has - or had - come to believe its own story, that gold is an industrial commodity whose remaining place in the monetary system is a quirk of history.

As Google Trends suggests, this perception is changing - if nothing else, because BWII is obviously a sick puppy, and the obvious replacement for the dollar as international standard of account would be the material which preceded it. In the very short term, however, I think there are two forces which are causing the stress in the gold market which the curve displays.

One, due to the general financial crisis, there is an enormous increase in Western investment demand for gold, as seen in the now widespread retail shortages. This is sucking present or "physical" gold out of the general bullion-banking complex. While a shortage of coins, small bars, and other refinery products is distinct from a shortage of metal proper, it certainly can't be said to help.

Two, and much more seriously: as the FT article described, the major gold lenders, central banks, are refusing to roll over their loans. They are certainly not "ready to lease gold in increasing quantities." If the article is to be believed (and other sources confirm it), they are doing just the opposite.

In other words, they are behaving like rational lenders at the beginning of a maturity crisis. Think about this for a moment from the position of a central banker. You work at the Bank of Elbonia, let's say, in the gold department. Elbonia has 100 tons of gold left over from its days as a great colonial power, but these days it is pretty much an external province of the United States. For the last ten years, your goal has been to earn a maximum rate of return for the Elbonian people, be it only 0.1%, on these "unproductive assets." You have operated in an environment where it is essentially assumed that major banks, especially major American banks, simply don't fail.

Suddenly you realize that major banks, even major American banks, do fail. Moreover, you realize that your vault contains 50 tons of gold, and 50 non-tons of paper reading "HAY CB, ITS OK" etc. (If you don't understand, see this.) Moreover, you realize that you have not disclosed this ratio, making its disclosure, by definition, news - especially if the disclosure involves informing the public that the non-tons are non-tons. Moreover, you realize that, being a bureaucrat, your prime directive in life is to not get caught with your pants down, and especially not to go to jail, and really especially not to be torn to pieces by a mob in the street. And kind of the last thing the people of Elbonia want to hear right now is that half their gold reserves have gone up in smoke - thanks to you.

Moreover, even if you are not thinking these thoughts, your colleagues around the world are thinking these thoughts. And the logic of the bank run is inescapable: if everyone else is checking out, you want to check out too, and first. Thus, central banks around the world are not "leasing gold in increasing quantities." They are hoarding it in increasing quantities.

If this maturity crisis continues to develop - there is no guarantee that it either will, or won't - the inevitable result is what a Mr. Juerg Kiener describes in this helpful CNBC video: a bullion-bank default. Mr. Kiener appears to be what is generally known as a gnome of Zurich. I am confident that he knows much more about gold than I do, so I will take his guess that a delivery default implies a doubling of price as sound. It sounds conservative to me, though.

In a gold maturity crisis, any paper instrument with counterparty risk is unsafe. For example, the price of gold ETF shares, which are backed by 100% metal and have no counterparty risk, may diverge from the price of gold futures, which are essentially claims against bullion banks. It is not possible to predict whether or when this divergence will happen, but it is easy to predict which of the two will go up and which will go down.

From the perspective of BWII, the basic problem with a maturity crisis in the gold market is that it has the capacity to produce a substantial spike in the price of gold in dollars - doubling, etc. Any such spike attracts attention to the possibility of a return to gold as a currency. Because any return to gold as a currency involves an increase in the gold price of at least an order of magnitude, any such attention attracts a shift of dollars into gold. Which increases the price, etc, and so on. I believe this is what Mr. Soros calls reflexivity.

Moreover, the only way to damp a gold maturity crisis is to either find a gold lender of last resort - who would have to be remarkably public-spirited, and display a high level of sang-froid at the possibility of being torn to pieces in the street - or act coercively, confiscating or banning gold. It is not 1933, and present Western governments simply do not have the energy or popularity for this type of action.

So my guess is that unless the lease-rate signal is some kind of fluke (which it might well be), the gold market is likely to default and deflate, the gold price is likely to increase to a level which would at present appear absurd, and the BWII dollar standard will be pushed toward failure and a return to the gold standard.

How this pressure will be resolved depends on the actions of governments. Ideally, they would go with it rather than fighting it. But they certainly have the power to fight it - having, after all, thousands and thousands of tons of gold to sell. However the game plays out, hopefully it will at least play out quickly.