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A Nobel Prize in Economics a Climate Change Denier Might Love

It has been a scary month in climate science. Hurricane Michael and a frightening report from the U.N. Intergovernmental Panel on Climate Change underlined the potential costs of human-caused global warming. Then to add insult to injury, William Nordhaus won the economics Nobel Prize. Nordhaus wa...

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THE MATRIX MARKET


Thursday February 03, 2011

Eugene Linden

 

A well-trodden meme of TV and cinema has been the plot in which someone or something uses tantalizing illusions to sap humans of their will to resist while simultaneously pursing hostile ends. In The Martian Chronicles, the subtle race of Martians distracted the invading Americans with irresistible life-like illusions that spoke to their most intimate yearnings; in one episode of the X-Files, a fungus slowly digested an unlucky couple who lay in a field and were rendered completely passive by the fungus’ hallucinogenic properties. And then, most famously, the machines of the movie The Matrix ruled over a ruined wasteland and seduced people with a beguiling virtual reality in order to maintain their passivity while they tapped humanity’s body heat as an energy source.

Now, a lot of investors believe that life is imitating art in an alliance of the Federal Reserve and the big banks to create the illusion of healthy equity markets despite massive retail equity withdrawals in the years following the financial crisis. In this broadly-believed scenario the Fed’s motives are comparatively benign – to foster asset inflation that improves animal spirits, fosters a wealth effect, and restores access to the equity markets for financial institutions and other companies in need of capital.

The idea is that through its program of quantitative easing the Fed is buying treasuries from its primary dealers who then turn around some portion of the proceeds in the equity market. Data miners have discovered strong correlations between the Fed’s permanent open market operations (POMOs) and up days in the equity markets, with a statistically significant spike on such days during the final 45 minutes of trading. So strong is the perception that these operations pump the market that Bernanke’s announcement of a new quantitative easing program last August set off a rally that moved the market up over 14% before the program was scheduled to begin in November.

Whether or not there is a direct connection between QE and a bid for stocks, the mere fact that the link is so widely believed has played a non-trivial role in the equity markets. Which begs the question: if the markets have risen on this scenario, does it matter whether or not this connection exists? After all, millions of investors have been benefitting from the ride. The cynical answer is that it probably does not matter -- if such manipulations could continue in perpetuity.

There’s the rub: nothing continues in perpetuity. In fact, QE2 is scheduled to end around mid-year and if it is not extended, the markets will face a crunch whether or not there is a real connection between QE and the market. Thus, if the Fed will not (or cannot) extend QE past June, it behooves its officials to convince investors well beforehand that it has not provided the invisible hand supporting stocks. Regardless of the Fed’s role, there have been other, more disturbing bits of evidence that we are in a Matrix Market.

Exhibit One is the so-called “flash crash of May 2010 during which stocks fell by 600 points in five minutes before staging and equally vertiginous recovery. The crash offered evidence that something truly scary lay behind the reassuring façade of buoyant markets. Subsequent investigation revealed that High Frequency Trading, which relies on algorithms to execute superfast trades, exacerbated the collapse. Revelations about the extraordinary percentage (sometimes over 80%) of trading attributable to HFT programs in stocks such as Citi and AIG suggest that the metaphor of a Matrix Market may be literally as well as figuratively true, and also helped explain how a market suffering continuing retail withdrawals could still rise to a multi-year high during a very weak economic recovery.

Economist Michael Hudson of the University of Missouri calculated that the average time a stock was held during 2010 was 22 seconds, not exactly buy and hold. Of course it’s entirely possible that both HFT and the impact of the Fed’s easing program are overblown; that the market’s rise can be simply explained by solid corporate earnings and the perception of a real recovery. If that’s the case, the market will continue to plug higher so long as the recovery story remains credible to investors and earnings hold up. If, however, the rally is largely an artifact of the jet fuel supplied by the Fed and amplified by algorithmic trading, then watch out.

The recent example of the auction-rate securities market shows that fake markets can seduce and then trap the most sophisticated investors. Adapted for municipal finance in 1988 by Goldman Sachs, the market grew to about $300 bn before it collapsed amid a series of failed auctions when the main players – Citi, UBS, AG, MS, and ML – pulled back from their practice of being the bidders of last resort. What was revealed subsequently was that for several months before that, auctions had basically been a sham with the big underwriter banks supplying the majority of bids for the securities they helped issue. Given that the investors were institutions and high net worth individuals, it’s remarkable that this could carry on so long without being uncovered. The ARS market was doomed in March, 2007 when FASB announced that ARS should not be counted as cash on balance sheets and liquidity began to dry up. From that point on the auction rate securities market was a ghost.

Those who paid attention (which did not include me) saved themselves much grief. Others remained oblivious for eleven months before the axe fell, and when it fell, it fell suddenly – one week after the first cracks appeared in the market 80% of the auctions that priced the securities failed. In hindsight it’s obvious that during that “dead man walking” period it was in not in any underwriter or broker’s interest to say that the ground had fatally shifted under what had been a highly profitable market. This was not a grand conspiracy or racket, but, more likely, a series of individual crimes as like-minded players continued a game because they could see no alternative. I’m sure that many of the players were amazed that it continued as long as it did.

Something similar happened in the mortgage-backed securities market as firms such as Bear Stearns continued to package and push them on investors long after it became obvious that the underlying mortgages were going sour in unprecedented numbers (when the MBS market finally did collapse new issuance went from hundreds of billions annually to zero). Something very similar is going on right now in the commercial real estate market where lenders are extending maturities because no-one wants to face the consequences of setting off a cascade of defaults and subsequent massive write-downs in a weak market. Is something similar going on in the equity markets?

For sure, we’re gonna find out, probably by mid-year.

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Short Take

In Memorium: Koko the Gorilla

Koko the gorilla died on June 19. She and a female chimpanzee named Washoe (who died in 2007) played an outsized role in changing how we view animal intelligence. Their accomplishments inaugurated deep soul-searching among us humans about the moral basis of our relationship with nature. Koko and Washoe have made it much more difficult for us to treat animals as commodities, in any way we wish.

I knew the two great apes when I was young and they were young, and I”ve closely followed the scientific, philosophical and moral upheavals they precipitated over the last five decades. In the 1960s and ’70s, they learned to use American sign language, and they came to understand that words could be combined to convey new meanings. It threw the scientific world into a tizzy, implying that sentience and languagewere not ours alone, that there was a continuum in higher mental abilities that linked animals and humans.

The problem for science remains unresolved: 3,000 years into the investigation of signal human attributes and we still don’t have rigorous ways to define language and intelligence that are agreed on and can be empirically tested. There remain a number of scientists who don’t think Koko and Washoe accomplished anything at all. Even if a scientist accepts one of the definitions of language that do exist, it’s nearly impossible to test it in animals because what is being examined is inherently subjective, and science demands objective, verifiable results.

Consider how hard it is to prove a lie beyond a reasonable doubt in court. Then consider trying to prove lying in an animal in accord with the much stricter standards of science.

As difficult as proving it may be, examples of apes lying abound. When Koko was 5, I was playing a chase game with her. When I caught her, she gave me a small bite. Penny Patterson, Koko’s lifelong foster parent and teacher, was there, and, in sign language, demanded, “What did you do?”

Koko signed, “Not teeth.”

Penny wasn’t buying it: “Koko, you lied.”

“Bad again Koko bad again,” Koko admitted.

“Koko, you lied.” But what was Koko’s intent — a central issue when it comes to proving a lie. What was actually going on in her head when she made the gestures for “not teeth?” As if that weren’t inscrutable enough, one of the guiding principles of scientific investigations of animal intelligence is what’s known as Morgan’s Canon: Scientists must not impute a higher mental ability if a behavior can be explained by something more primitive, for example, simple error.

Analogously, about 50 years ago, on a pond in Oklahoma, Washoe saw a swan and made the signs for “water” and “bird.” Was she simply noting a bird and water, or was she combining two of the signs she knew to describe an animal for which she had no specific word? The debate continued for decades and was unresolved when she died.

Since Washoe made those signs, there have been many more instances of apes combining words to describe something, but these examples still don’t prove they can combine words to arrive at a novel term, even if it seems obvious that they can. Faced with these ambiguities, many scientists have moved to studying whether animals can accomplish specific cognitive tasks, and a welter of credible findings show sophisticated abilities in animals ranging from crows to elephants.

Although science struggles with questions of general intelligence, language and intent, the public is in the “it’s obvious” camp, readily accepting evidence of animal sentience. The latest objects of fascination are the octopus — a relative of the clam! — and fish. Stories of cephalopod escape and problem-solving regularly go viral, and to the consternation of sushi lovers , John Balcomb’s book, “What a Fish Knows,” provides copious evidence that fish know a lot.

We tend to see animals as either personalities or commodities, or sometimes, both. When I wrote about octopus intelligence, I was amused by one octopus-oriented website that divided its space between stories of smart octopuses and recipes for cooking them. Perhaps the most extraordinary example of our schizophrenic view of animals occurred some years back when a chimp colony that included sign-language-using apes was disbanded and many of these onetime celebrities were shipped to a medical research lab to be used in Hepatitis B and AIDS drug testing.

I knew these chimps too, and visited them in their new environment. They were desperate to communicate with their human captors, but the staff didn’t know sign language. So insistent were Booee and Bruno with their signing that one handler put up a poster outside the cages showing some basic signs to help the humans respond. When I was there, three days after Booee had arrived, he was signing agitatedly for food and drink. But what I think he really wanted was reassurance: If the humans would respond to “gimme drink,” things were going to be OK.

Teaching Koko, Washoe and other animals some level of human and invented languages promised experimenters insight into the animal mind. But the animals seemed to seize on these languages as a way to make their wishes — and thoughts — known to their strange, bipedal wardens, who had no ability or interest in learning the animals’ communication system. For Koko, I believe, sign language was a way to make the best of a truly unnatural situation, and so she signed.

Science doesn’t know if great apes can invent terms or if they tell lies. And the tension between whether we view and treat animals as personalities or as commodities lives on. The truth is, Koko, Washoe and many other animals who have had two-way conversations with the people around them shatter the moral justification for the latter.



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