Sunday, April 25, 2010 104 Comments

Unarmed combat in the digital armchair

I apologize for the lack of content. I am working on a small deadline.

If you are really desperate for a fix, you can scroll down here and watch me work out, albeit laconically, on some Special Forces types. I get angry and have to use my Sith command voice. Fortunately, there is fire support - unedited:
No one who lived the life described above by 925 (or me, or others) would peddle that crap.

PC-COIN is what you tell children, at least the Surge narrative that was put out. Because Children is who we in no small part defend, and in large part comprise our "elites" and especially the current government. Callous, Callow, sanctimonious, snarky, and so instantly corrupted the instant an offer is made it makes you question the existence of the soul, and whether people are innately good at all or is it just learned behavior.

Or they walk away because "it's too hard." Really that may be the defining statement of this generation of elites.
Fortunately, it's not the defining statement here at UR! And we're as 31337 as it gets. Though not on actual military matters - where we always delegate our judgment to expert opinion. Reserving the right, of course, to choose which experts. I think I see some at the link above.

Anyway. Enough with the real guns and ammo. Let's get back to virtual warfare. Here is an open thread where people can talk about the Canon: Froude, Maine and Carlyle. Collectively, the most dangerous information device in human history.

Or so I'd like to think! But definitely a targeted munition. With one N only, the Canon is a literary device and not a military one. All it is is three old books: The Bow of Ulysses (1887), Popular Government (1885), and Latter-Day Pamphlets (1850). (These are full-view in the US, but may not be in other countries. Alternative links: Froude at; Maine at OLL; Carlyle at Gutenberg.)

(If you've already finished all three, I am preparing extension packs which will supplement and expand your new historical reality. For further directives from the Flounder - keep monitoring this digital channel.)

When discussing Froude, Maine and Carlyle, or any of the Froude Society authors, it should in general be kept in mind the point of the exercise is not to analyze or (heavens) criticize these writers, but to understand them. We want to understand them because we want to use their minds. We want to use their minds because we have real problems to solve.

How can we use the minds of Victorian thinkers? We can use their minds by showing them the 20th century, and asking them what they think. Since we cannot physically revive these dead white males, we cannot perform this exercise mechanically. It must be an exercise of imagination. Sometimes it takes a lot of imagination. Sometimes - not so much.

For instance, you could ask Froude, Maine and Carlyle what USG has to do in Afghanistan, if it My guess - no, my certainty - is that they would agree with Elihu Root and "Elf." They would be utterly confident in this answer, as am I.

One can reject the High Victorians' advice, of course. There are no mystic gurus at the Froude Society. (Carlyle is definitely channeling something, but it's probably just laudanum.) These great fossil whales of Victorian scholarship are tools for our living brains - not replacements.

And on some subjects, they have nothing at all to say. Froude, Maine, and Carlyle are not of great assistance in, say, the design of programming languages. How can they help you understand the 21st century?

Perhaps not at all. Once you read them, you can say. Take the challenge! Pass through the fire! You are already almost there. You will never be closer. Click the link; open the door. Your credit card will not be charged.

Sunday, April 18, 2010 56 Comments

Professors young and old: an involuntary debate

The young professor:
When I visited Jamaica in the Fall of 2009, here is how a knowledgeable observer described the political reality facing the government: Desperately needed policy steps—steps that any objective observer would recognize as being good for the country—would cost the government many votes in the next election.

Jamaica is located on important sea lanes. It is close to major markets. Its cultural, climatic, and natural amenities rival those of any other place on earth. It is ten times larger than Singapore. Though its potential for prosperity is tremendous, its history of bad policy has undermined its appeal as a place to live and work. One clear indication is its high levels of crime and violence, including one of the highest murder rates in the world. Given the level of violence, it is not surprising that many Jamaicans, particularly the ones with the most education, move away.

The Jamaican diaspora is now estimated to be well over 2 million, compared to a population still on the island of about 2.8 million. In each cohort of young Jamaicans, a majority of those who receive any education beyond secondary school leave to pursue opportunities elsewhere. Some estimates put the figure as high as 80 percent.

Competition for local votes now perpetuates criminal activity in what are known as Jamaica’s “garrison” communities. A garrison is an area in which criminal and political activity are tightly controlled by politically affiliated gang leaders. Historically, the political party that happened to be in power would use large-scale public housing projects to reward and geographically concentrate their supporters in garrison communities. Violent, politically affiliated criminal gangs would then enforce the political homogeneity of the garrison in exchange for a measure of exemption from law and order. At various points in Jamaica’s history both of the major political parties, the Jamaican Labor Party (JLP) and the People’s National Party (PNP) have created new housing projects that have turned into garrisons. Several seats in Parliament are now virtually guaranteed for each party by the garrisons they control.

According to a report commissioned by the Jamaican government (Kerr Report), the politically aligned gang leaders serve as unofficial brokers between the political leadership in parliament and the local communities. Residents who openly oppose the garrison’s dominant political party face violent retaliation from the gun-toting gangs. The gang leaders give their members of parliament an element of electoral certainty. The politicians who benefit return the favor by diverting government benefits to the garrisons in their constituency and turning a blind-eye to the criminal activities of the gangs.

The political arrangement allows many of the gangs to operate unchecked, with disastrous consequences for Jamaica’s poorest communities. Armed border disputes between garrisons make it difficult to maintain public infrastructure, exacerbating the slum-like conditions of the communities. Because gangs restrict movement between communities, they hamper labor mobility, transport, and the entry of new firms—entrenching an already deep level of poverty.
-- Paul Romer, Senior Fellow, Stanford Institute for Economic Policy Research, 2010.

The old professor:
The commonplace intrudes upon the imaginative. At moments one can fancy that the world is an enchanted place after all, but then comes generally an absurd awakening. On the first night of my arrival, before we went to bed, there came an invitation to me to attend a political meeting which was to be held in a few days on the savannah.

Trinidad is a purely Crown colony and has escaped hitherto the introduction of the election virus. The newspapers and certain busy gentlemen in 'Port of Spain' had discovered that they were living under a 'degrading tyranny,' and they demanded a constitution. They did not complain that their affairs had been ill-managed. On the contrary, they insisted that they were the most prosperous of the West Indian colonies, and alone had a surplus in their treasury. If this was so it seemed to me that they had better let well alone.

The population all told was but 170,000 less by thirty thousand than that of Barbadoes. They were a mixed and motley assemblage of all races and colours, busy each with their own affairs, and never hitherto troubling themselves about politics. But it had pleased the Home Government to set up the beginning of a constitution again in Jamaica, no one knew why, but so it was, and Trinidad did not choose to be behindhand. The official appointments were valuable, and had been hitherto given away by the Crown. The local popularities very naturally wished to have them for themselves.

This was the reality in the thing so far as there was a reality. It was dressed up in the phrases borrowed from the great English masters of the art, about privileges of manhood, moral dignity, the elevating influence of the suffrage, &c, intended for home consumption among the believers in the orthodox Radical faith.
-- J A. Froude, Regius Professor, Oxford Faculty of History, 1888. (Join the Froude Society.)

Friday, April 16, 2010 41 Comments

Join the Froude Society!

Again, I apologize for the sudden lack of content on UR. Type inference has consumed me. But while we wait to see whether I get the bear or the bear gets me, why not some required reading?

Therefore, I invite anyone and everyone to enter the exclusive Froude Society. (Froude rhymes with "dude.") The Froude Society is an exclusive and disorganized fellowship of fellow human beings united by intellectual nostalgia for the Old Order, ie, Western civilization before 1923. The Society, which is not an activist organization, expresses its refined saudade by reading works published before 1923.

Again, the Froude Society is exclusive. Whatever its purpose may be, the method of the Society is not to maximize its membership. It is certainly not a democratic organization. Rather, the Society exists to consider the Old Order collectively, and it measures its work by the quality of its thought. Which is not in any way dated, or at least not meant to be.

To join the Froude Society - actually, to become a deacon of the Froude Society - all you need to do is read three works of High Victorian political and historical criticism. I recommend this order: The Bow of Ulysses, by James Anthony Froude; Popular Government, by Henry Sumner Maine; and Latter-Day Pamphlets, by Thomas Carlyle. These books will change your life, or at least your mind.

There are more books, more authors, where these came from. Without blinking we could add Lecky, Stephen and Austin to this pantheon, for instance; nor are Ruskin, Arnold, and Kingsley to be sneered at. And the remaining oeuvre of Froude, Maine and Carlyle is no less vast. And this is not a random sample of Victorian thought, but the cream of a coherent tradition. And anyone can read it. It's free - thanks to Google. Now and for the foreseeable future, Froude is more accessible than Stephen King.

The task of the Froude Society is to restore High Victorian thought in the 21st century. And when I say restore, I mean restore to life - not study. The Society traffics not in critical formaldehyde.

The historical subject is always and everywhere a human being. If you had him in your living room, you could watch CNN with him. If you'd be surprised by what he'd say, perhaps you should have read more and studied less. If you disagree on some matter but are not prepared to grapple, don't be surprised if he throws you down. The past, while much studied, is little read - at least, not on these terms.

To restore an intellectual tradition, as opposed to merely studying it, demands you believe in it and adopt it as your own. Think of it as shooting on location - a critical test of authenticity. To restore the old farmhouse, you need to live in the old farmhouse. Otherwise, you are just a contractor. You can read the Froude Society canon without becoming a Froudean, but it takes a pretty considerable power of resistance, I feel.

The scholars of the European Renaissance did no less with the Greco-Roman texts they found in their monasteries. They saw: here was an alien civilization, now deceased, superior to their own. There was simply no comparing Virgil to the monks and professors of the medieval university. This comparison was one the scholastics would simply never win. And in a century or two, Church Latin was no more. The Italian upstarts didn't just visit the old villa; they moved in.

If you're restoring a tradition, as opposed to studying it, you maintain and update it. If Froude had lived another century, would his mind have changed? If he was not locked in a closet, most certainly. It is incorrect to reason from this fact, however, that his mind would have changed in any predictable way. It is certainly incorrect to assume it would have changed in any fashionable way. Old men, whatever their vices, are not terribly susceptible to fashion. Updating Froude is a task of great importance, but not an easy task.

A little while ago, someone emailed me and asked: are there any contemporary writers you admire? A disconcerting question, hard to answer in the yes or no. I could cop out, of course, and say that I admire Deogolwulf and Nihon Cassandra and Carter van Carter and Conrad Roth and Steve Randy Waldman. But this is really not what my correspondent was looking for.

No; he was looking for the sort of writers whose works are admired, promoted and discussed in the New York Times, the New Yorker, the New York Review of Books, etc, etc, etc. This in fact was his definition of writer, I think. It is certainly most people's definition, though few have really considered it.

I think the proper answer is: are there any Soviet writers whose work you admire? Who, for instance, is your favorite Soviet historian? What do you think of Soviet poetry?

But this is recent history, still loaded. Perhaps a better comparison is to the Greco-Roman era, from which we see almost no work of any lasting quality after 150 AD, and even less after 250 or 350. Why were these periods of intellectual decline?

Not because of a general shortage of education or intelligence - the likes of Sidonius had no shortage of either. Yet if you read Sidonius, even his private letters, what you find is flowery garbage. There is almost no content. Content is entirely reduced to style and formalized sentiment. Sidonius is living through the fall of the Roman Empire; every once in a while, he complains that the roads are becoming unsafe; otherwise, we learn nothing.

In early 21st-century America, just as in the late Roman world or 20th-century Russia, as in our society, each year many baby boys and girls are born who could grow up and become good writers - in the sense of, people paid to write, promoted by the Times, etc, etc. And if our system of government changes, perhaps they will. Otherwise, probably not. The baby boys and girls grow up, of course, but no man is an island. Or can teach himself to write. Or even, still today, can be his own publisher.

And this is why I cannot point to literary giants I respect, admire, and could never hope to equal. I can; but the only giants I can identify are giants of a different era. Just as, living in the Soviet Union, you might say that all the writers you like are American. Time, not barbed wire, divides me from my heroes; the principle is the same. I encourage others to adopt this line of thought. There is nothing egotistical about it, just the sad realization that, per Carlyle,
you are fallen in an evil, heavy-laden, long-eared age, and must resignedly bear your part in the same.
And this is why we read Froude and Maine and Carlyle. We read Froude and Maine and Carlyle because, when we read Froude and Maine and Carlyle, we sense ourselves in the presence of a civilization which is, in certain very important respects, superior to our own.

Carlyle's era had problems, sure. But not the problems we have. And, as Froude writes,
Each age would do better if it studied its own faults and endeavoured to mend them instead of comparing itself with others to its own advantage.
The professors of the later 20th century, as in so much, managed to find the polar opposite of Froudean good sense and extend it deep into pathological absurdity. Except possibly in the Soviet Union, past-hate has never been so common and widely-taught. This is no good sign.

There are many ways in which 21st-century civilization compares favorably to the Old Order. Its computing hardware, for instance, is far superior. Its physics is far more delicate and nuanced. Even I do not much care for Victorian fiction and poetry. And so on. We need not overlook these matters, and indeed must not; but to dwell on them is pathological.

Rather, if there are matters on which we must dwell, they are our faults. Which comparison with the Victorian order, or with any past, may not reveal; the past may have the same disease; all pasts may have the same disease. But this is not the case with all diseases! And if you cannot think of a case in which our age shows comparative disadvantage, much you have to learn. Much has been hidden, both present and past.

My point is: 20th-century scholarship on the Old Order, while sometimes valuable, must be treated with great caution, and the later it goes the more worthless it gets. The professors of the 20th century are quite sound on the 17th and before, increasingly weak in the 18th, highly unreliable and actively misleading in the 19th. By the 20th, you are reading journalism.

Thus it is essential to read the Victorians before you read about the Victorians. Once you have a strong grounding in Victorian thought and feel you could have a conversation with Froude, you can dabble in some of the modern commentaries, just to know what you're not missing. (Carlyle in particular is extremely distorted, largely by a focus on his least interesting work - I know of no modern biographer, not even Simon Heffer, who really takes his politics seriously.)

So, without further ado: The Bow of Ulysses; Popular Government; Latter-Day Pamphlets. These books will change your life, or at least your mind.

As an experiment, I will leave comments on this post off until April 23rd, then turn them on. Please don't comment unless you have at least started at least one of these works.

[Update - May 12: comments are now on. Again, please comment if and only if you have actually read one of these books.]

Saturday, April 3, 2010 106 Comments

The credit-default swap and the bullion banks; a question and a statement

I apologize for the unusual lack of content on UR. I have been visiting with family, have been working quite a bit on Nock/Watt, and sending too much email to Larry Auster.

(Ponder the fascinating, even (dare we hope?) historic, interaction between Auster and David Mills. I knew Mills had some kind of Hollywood job, but had no idea he was such a big shot. Undercover Black Man, RIP - a real-life Giant Negro. Alas, the real pass and the fake live on.)

Also, I note that the legitimacy of maturity transformation has somehow become a legitimate topic of public conversation. As Kling says:
Evidently some radiation from Mencius Moldbug has leaked into Harvard Yard.
Or not. Let's not forget that a discovery is not an invention. The truth, being true, is accessible to all - though not all will get it all. And so far as I'm aware, all priority is due to Mises (1912):
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."
Ie: maturity transformation considered harmful. And no one, except Professor Bagus, even gets this citation right. Such is scholarship, in the early 21st century.

Still, the truth is the truth and it is always nice to see people stumbling over the thing, even if they kick it in the wrong direction. And even though it contradicts my predictions and corrodes my pessimism. My pessimism is restored, however, by seeing how few of these distinguished professors understand the problem completely and correctly. More on this later.

We proceed to the matter of the title. I wanted to just briefly make one statement and ask one question. The statement is true, so anyone who cares to believe it may believe it or not. The question is one whose answer I do not know. The information is not public. However, it is quite important, so if anyone has it, they should feel free to disclose it to me. I have a guess at the answer, but I could easily be wrong.

The statement is: the credit-default swap is not a free-market financial institution.

The question is: are bullion banks net short in the metals market?

Let me deal with the question first. First, I know that bullion banks (ie, financial intermediaries which maintain a balance sheet in gold and/or silver - which, these days, are generally subsidiaries of much larger, more important banks specializing in funny-looking little pieces of paper) are transforming maturity in gold and/or silver. This is why they're called "banks." My question is not whether they are transforming maturity, but whether they are (as some claim) net short.

The conventional explanation of the bullion bank is that the bullion bank is not net short. Rather, it has a neutral position, with gold assets balanced by gold liabilities, so that the bank does not suffer automatic and trivial gains and losses, as accounted in either dollars or gold, when the gold-dollar ratio goes up and down. Similarly, a regular bank which calculates its accounts in dollars does not balance these with loans in euros, because then its solvency would be exposed to a highly unstable variable, the dollar-euro exchange rate.

The bank is a maturity transformer, however. It sells gold short and buys it long. Again, this is what a bank does. So, for instance, it balances a liability, such as a promise to deliver Comex gold in 3 months, with an asset, such as a promise by a gold miner to grind up that mountain over there and suck it through a pond of mercury, 3 years from now. The only difference between this and regular banking is that gold is a natural currency, not a fiat currency.

I respect this explanation considerably. One, it is very plausible. Two, I once asked a fellow blogger whom (a) I greatly respect and (b) has experience (albeit from the '80s) in bullion banking, and he confirmed that, from his perspective, it would be shocking if a bullion bank were to carry such a dangerous exposed position.

Against this we have the various disclosures made from GATA etc - including, most recently, the strange story of Andrew Maguire. The best I can say is that this is a noisy, untrustworthy source. For one thing, it does not appear to me that they have any individual or collective clarity on the distinction between maturity transformation (which is bad) and net shorting (which would be really bad). They strike me as honest, but not entirely and completely clueful.

For instance: when Jeff Christian says that there are "multiples of hundred times" more "paper gold" than actual gold in London, by "financial gold" does he mean "unbacked promises to deliver actual gold" (ie, "naked shorts") or "forward contracts to deliver actual gold?" Of course, mountains are hard to grind and so on, and not all contracts will be delivered. However, there is a very important qualitative distinction between these answers.

For those who feel the bullion banks are neutral, I ask: if Comex gold shorts are balanced by long forward hedges, why does the Comex open interest of commercial sellers, that is, bullion banks, fluctuate dramatically on a short-term basis? Forward mining sales, etc, wouldn't do that.

Where are all these legitimate hedges? How much gold has actually been sold forward? For the past few years, gold miners have been shrinking their hedgebooks. Has the amount of "paper gold" in London decreased accordingly? According to GFMS at the link above, there are only 236 tons of legitimate commercial promises to ship forward gold, half of which are financial in nature. There are 25 tons of actual gold due and presold from the gold mines in 2010; 30 in 2011. Annual gold production: 2,000 tons.

Why does bullion banking even still exist? And what was Jeff Christian thinking when he said, under oath,
August of 2008 when there was an explosion in the short positions in gold and silver held by the bullion banks on the futures market and he seemed to imply that that was somehow driving the price down. If you understand how those bullion banks run their books, the reason they had an explosion in their short positions was because they were selling bullion hand over fist in the forward market, in the physical market, and in the OTC options market. Everyone was buying gold everywhere in the world, so the bullion banks who stand as market makers were selling or making commitments to sell them material and so they had to hedge themselves and they were using the futures market to do that.
Translation: the short position of the bullion banks exploded. To balance this short position, they purchased a long position... from whom? "Themselves" is not a valid answer.

Everyone was buying gold. Therefore, the bullion banks had to sell a lot of paper gold. They sold so much paper gold that, even though everyone was buying gold, the gold price went down. Everyone was buying gold, but the bullion banks wanted to sell even more paper gold than everyone wanted to buy. Hence, in the unified actual-gold-and-paper-gold market, demand increased, but supply increased even more than demand increased. Hence the price went down.

Christian's theory, expressed later as a correction, that other random investors in August 2008 were liquidating long positions, does not strike me as reasonable. Who, exactly, holds all these long forward positions in gold? There is a name for an entity which holds long forward positions in gold: a bullion bank. Ordinary large investors, when they hold gold, seem to generally hold futures, sometimes ETF shares. (In the first case a dreadful mistake, in the second demanding strong due diligence.) If futures are liquidated, open interest goes down, not up. If ETF shares are turned into metal and sold to India, it does not change. But in fact, it went up.

This seems like convincing evidence that the bullion banks are net short. However, it just does not make sense to me that the bullion banks are net short. For one thing, I trust my source. For another, gold prices have generally been rising over the last decade. If the bullion banks were net short, they would have been losing money continually throughout this period. This perhaps could be offset by some pattern of manipulation, but it seems like a very ugly, un-bankerly way to make a dime.

When the impossible is eliminated, all that remains is the improbable. Therefore, my guess is that "paper gold" is effectively, although perhaps tacitly, backed by sovereign gold reserves, many of which were "leased" (ie, balanced with short sales - or, if you prefer, traded for paper gold, or "gold deposits," at bullion banks) in the '80s and '90s.

It is not clear whether the US gold reserve has ever been so encumbered. It would not need to have left Fort Knox to do so - given modern financial engineering. After all, by holding 8000 tons of gold, USG is long 8000 tons of gold. It can certainly afford to sell a few paper promises of gold, future or present. It is not exactly authorized to do so, but words have been bent before.

This would require a remarkable amount of collusion between bullion banks and governments - in the case of 2008, for instance, it would mean that it was actually USG (and friends) that was minting the paper gold, the banks just being low-level pushers of this paper. Without being net short, the bullion banks cannot manipulate the market; they can only profit (perhaps with a bit of front-running) from higher powers which manipulate the market. Short of aliens or Elvis, this can only be the OECD governments. It can only happen with at least the consent of Washington.

If this is a fact, it is not a fact calculated to attract serious and thoughtful investors to "paper gold." Basically, it means that these governments are surreptitiously using (and, inevitably, consuming) their gold reserves, to artificially increase the price in gold of their paper currencies. It is very easy for people who want to hold gold to exit from this scheme, by holding actual gold and not paper gold.

On a historical scale, this is not shocking at all. We know that the same thing was going on as recently as the '60s, with the London Gold Pool. But on a historical scale nothing we mention here at UR is shocking. On the scale of current events, this conclusion is quite shocking - because no such scheme can withstand any serious exposure. Again, those who want to get out, can get out. (Even the fact, acknowledged by all, that gold futures are maturity-transformed, is more than enough reason not to hold gold futures. RIP, bullion banking.)

Moreover, if my supposition is indeed correct, there are two questions. One: are the OECD governments, themselves, net short? Ie: have they issued less paper gold than the actual gold they hold, the same amount of paper gold, or more paper gold? The last would be madness for a mere private enterprise, but a sovereign can get away with a lot. Heck, it's pretty much the way we got the fiat currency we have. Also note that these governments have quite a bit of gold - but very little silver. And the same patterns are seen, even more distinctly, in the silver market.

The most significant fact about this mess, which I think almost everyone has ignored, is that USG and its little friends just do not have the political and economic strength to either (a) peg the price of metal to dollars, etc, (b) make dollars, etc, freely competitive with metal, or (c) prevent private citizens from hoarding metal (eg, with a 1933 style gold confiscation). Is there a (d)? There must be, but here my magic 8-ball becomes quite murky. It is also very unclear how long this game, if it is the game, can continue.

So on to the second point: credit-default swaps. This is quite clear. A credit-default swap is not a free-market financial instrument.

Why? Because there is only one reason why a party holds a CDS. They have government permission to overvalue these securities on their balance sheets. CDS are an artifact of incorrect government-mandated accounting (specifically, via the NRSROs).

What is the market value of a CDS? There are two answers, A and B, the wrong answer and the right answer. The wrong answer is: the market value of a CDS is the chance that the credit default will happen, multiplied by the face value of the CDS. X times Y.

The right answer is: the market value of a CDS is the chance that the credit default will happen, multiplied by the chance that the CDS issuer will not default, multiplied by the face value of the CDS. X times Q times Y. So, if you buy a CDS on an IBM bond from AIG, its market value is the face value, times the probability that IBM will go bust, times the probability that, if IBM goes bust, AIG will not go bust.

Now, the people who invented these things are not actually stupid. They didn't forget about Q. What they said was: Q is the probability that AIG will go bust. They then said: AIG has an AAA credit rating, which means it will never go bust, with 99.999% probability or whatever. Setting Q to basically equal 1, they then arrived at the desired calculation of value, ie, X times Y.

But this is just bad probability, which makes it bad accounting. The probability that AIG will go bust if IBM goes bust is a conditional probability. X and Q are not independent variables. For one, AIG, having written a lot of these IBM CDS, will lose a lot of money if IBM goes bust. And any event that affects IBM may affect other companies on which AIG has also written swaps.

The CDS buyers also required (or should have required) AIG to collateralize these positions. But collateral, too, is not a magic amulet against counterparty risk. If you've insured $3 billion worth of diamonds, and you only have $100 million to cover them, when the probability that the diamonds are stolen flips from very low to certain, someone will get burned. It's just math. Until capital equals exposure, someone has to end up holding the bag.

Collateralizing an undercapitalized insurance market does not protect the market from insolvency. It just means the market melts down in a flash, as all positions are liquidated - the price of CDS will rise faster than the sellers can buy back their CDS. Someone won't be able to; and whoever holds his CDS will experience the ugly stick of Q. If collateral is centralized through a clearinghouse, that clearinghouse must be able to cover all the diamonds it insures, or the clearinghouse has significant default risk.

As we saw in the case of AIG, of course, the problem was solved. Who wound up holding the bag? You, of course, dear taxpayer. And this is why I say that CDS are not a free-market instrument. The Q is all on you.

The basic problem with CDS as a free-market instrument is that, while there is quite a bit of demand for the product of exposure X * Y, there is little or no demand for X * Q * Y. For instance, if you buy an IBM bond and an AIG CDS against it, you have replaced your exposure to an IBM default with exposure to an AIG default.

In reality, no party (except USG) is really so much more financially secure than IBM, that it's worth writing insurance on IBM. The financial product that the market demands is not CDS, but CDS without counterparty risk. This is a useful product indeed, but not a free-market product. No free market can produce any such thing - it takes a fiat-currency issuer. To guarantee IBM's loans risk-free, you would need to cover every dollar of IBM loan with an insurance dollar, which would be ridiculous, unprofitable, stupid, and completely defeat the purpose.

Thus, people buy CDS because (and only because) incorrect accounting principles allow them to incorrectly disregard Q, the probability of the CDS issuer defaulting, thus assigning these securities excessive value on their balance sheets. When they become insolvent as a result of this miscalculation, USG's infinitely-flexible rubber-dollar absorbs the slack, and the Fed becomes the new team sponsor of Manchester United.

Well, thank god for funny money! If not for M. Danton's beautifully-engraved new assignats, there would be no commerce and no work for anyone, and we'd all be sitting around on our butts, blogging and watching Manchester United. Or so Paul Krugman would have you think.