What was the problem?

Since I have claimed that the derivatives involved in the financial system problems were not too complicated, what was the real problem?

There are many candidates, too many to cover right now. The use of irrelevant statistics to justify risky holdings, as I mentioned before, was a large part of the problem. The government pressure to make more and cheaper loans to less creditworthy borrowers has been widely commented on, and may have contributed significantly, but can’t excuse the banks’ errors.

The actual error made by the banks was very simple – embarrassingly simple, really. They bought mortgages to securitize them. They split the securities into high-risk, medium-risk, and low-risk bits. They valued the bits and found that they were more valuable than the original mortgages, which meant the process was profitable to them. They sold the high-risk bits to speculators and the medium-risk bits to long-term investors. But they kept the low-risk bits. Thats it! That’s the error!

Presumably, after they valued the low-risk bits, they found that nobody actually wanted to buy them at that valuation. What they should have done was price them down until people did want them, then re-evaluate the whole business on the basis of the actual market prices that they got for them. I have no idea whether that would have meant that securitization would have carried on or not. But either way, it would not have left the financial system dangerously exposed to the housing crash. At worst, it would have ended up as the “normal” sort of Wall St scandal – clever investment bankers sell a whole load of toxic crap to investors (see auction-rate, internet IPOs, etc. etc. etc.)

Why did the banks hang onto these investments, rather than sell them? I guess that they believed they were “really worth” pretty close to par value, and that buyers didn’t want to buy them at that price just because they were uninformed. Also, because they were rated as so safe, the regulators were happy to consider them non-risky for the purposes of capital requirements. That was the regulators’ biggest error. Because of course these two justifications contradict each other. If the securities can’t be sold at their alleged “real value”, then they are tying up the banks’ capital, and should be counted as such.

(I’m surprised we haven’t heard more about the mezzanine tranches that were sold to fund managers, pensions, insurance, etc. They were never seen as safe, so the bodies holding them could afford to take losses on them.)

It almost seems a shame that this whole crisis is caused by one such straightforward error. It ought to be something like “derivatives are too complex” or “regulators were subverted” or “government forced banks to make bad loans”. It’s a let-down that it was just “banks held one particular type of investment that it was never their business to hold, just as a by-product of one business line”.

Financial Complexity

I want just to grab one factoid out of the swirl of information and misinformation relevant to the current financial situation – the idea that the problems were caused by fiendishly complicated derivatives (see, e.g., here)

Horribly complex derivatives do exist: a “snowball”, for example, “is a structured swap with a funding leg and a coupon stream whereby the coupon paid on a given date is given by the sum of a fraction of the coupon paid in the previous period plus an amount determined by the realization of the rate process in the coupon period itself”

However, while estimating the value of a snowball requires so much computer power that researchers are designing custom hardware and offloading computation onto graphics chips, the difficulty of valuing a derivative does not depend on the derivative itself being complex. The mortgage backed securities which are the most obvious cause of the current problem are actually quite straightforward. That doesn’t make them easy to value.

The point of the complexity is in fact to make them easier to value. After all, no amount of differential calculus will tell you whether Mr Bloggs at number 11 will default on his mortgage, if you don’t know whether he has a job, and what his credit card balance is, and whether house prices on his street are going up or down. If you have good statistics, however, you might have a decent stab at how much a thousand mortgages are worth, or how much the best 400 out of a thousand are worth.

That was the theory. It failed, not because of the complexity of the derivatives, or because of errors in the mathematics, but because the statistics were crap. Statistics collected over ten years during which house prices only ever went up were not of much use when prices started to fall. Statistics collected on mortgages originated by lenders with their own money cannot be used to accurately model mortgages originated by lenders working only for commission. Et cetera.

The other bugbear instruments in some commentary are the “weapons of financial mass destruction”, credit default swaps. These are simpler still; just a guarantee by one party of a debt owed by another. The main problem with them is their very simplicity – rather than selling them on like securities, someone holding one would just create a new one to cancel it out. That’s what makes it so difficult to sort things out when a participant like Lehman defaults – its net position is manageable, but that net consists of astronomical credits and debits that almost, but not quite, cancel each other out. If the CDSs were more sophisticated (with central clearing), the problems would be smaller.

I think that this New York Times piece is very good, except for the one point, that the difficulty of valuing a mortgage derivative is not due to its inherent complexity, but mostly just because it’s made out of mortgages.

What are police?

The orthodox view these days is that police are the arm of the state responsible for fulfilling the state’s function of preventing crime (to the extent possible).

I think that is a catastrophic error. Preventing crime, as I’ve written before, is not a separate activity, but is an aspect of almost everything we do – something so inherent in the human condition that we aren’t really aware of the extent that it drives our behaviour.

What this means is that there’s no way to draw a line around “preventing crime” and thereby delimit the scope of the police. Every issue becomes a police issue. I think that is the real meaning of a “police state” – not one where the state uses the police, but one where the police take control of the state.

If the police are not agents of the state, what are they? I think it is healthier to see them as state-funded helpers of private citizens. We all work to prevent crime, but there are some jobs that come up which we are not able to do because they take to much time or special expertise. Detection of crime is the most obvious of these.

If we take this approach, what really changes is the difference between police and public. The police do not have a separate role, they just have greater capabilities owing to their skills and available time. The most significant implication is that they do not need special legal powers. The only things they should be doing are things that members of the public could do, but don’t have time for.

Another way of saying that is that police should be held to the exact same standard as anyone else. Which means that, in a case like this one, if the press reports are accurate, the issue is not about whether Mr Carter gets an apology or compensation, or about administration of police disciplinary procedures, but about why the PC in question is not facing criminal charges. The idea that it might be an internal police matter is quite incompatible with the police being assistants rather than masters of the population.

But the concept goes further. If the police are assisting the public, then whatever they are doing, it should be because someone has asked them to. Management should be a matter of which requests to prioritise, not setting an agenda independent of the public. Valid reasons for not doing something might be that it is too costly for the benefit, but might also be that people are already achieving what can be done without the police.

This is not meant to be an anti-police rant. I think we do need full-time, trained police, and I think there is a better case for them to be state-funded than there is for most branches of the state. I think many of them do a good job and I have sympathy with their difficulties. But I think it would be easier for them, and better for us, if we accepted the principles above.

And what really matters here is what people believe. I have said before that the police usurpation of the right of self defense, has, in the popular mind, actually outrun what the law really says. The police were founded on the principles I have stated, and while bad laws have been passed in the last few decades, they have generally not been controversial, because they are following rather than leading the change in attitudes – for the worse – about the role of the police.

The bad attitudes go beyond this. I was going to use as an example bin men – another arm of the state notable for actually having an important function. Bin men are not The Agents with The Responsibility for disposing of rubbish, which is something the rest of us should not need to think about. On the contrary, they take everybody’s refuse to the processing centre in one go because it’s a lot more efficient than having everybody chuck black bags into the boots of their cars.

I was going to say that, but even in that state function, the same error is appearing. I remembered this piece from 2004 which mentioned a man getting into trouble for collecting litter and taking it to a dump without a license. This is the real problem – not the idea that some things should be done by the state, but the idea that some things should only be done by the state.

The Georgian Side

The Georgian side of the Ossetian question is now coming out. Saakashvili is claiming that Georgia didn’t move against S. Ossetia until after Russian forces entered it. The cold war warrior element is making the point that S. Ossetia’s status for the last fifteen years has rested on Russian support.

I have no confidence in being able to get to the truth of the conflicting views. I dwell on the question because, as unclear as the facts of the matter are, the principles that should guide us are just as unclear too.

We can’t really talk about the reasons why South Ossetia might “deserve” to have independence from Georgia, without talking about why Georgia “deserved” to get its independence in 1991. I don’t recall any such principles being argued, but of course Croatia and Slovenia were getting all the attention at the time.

The argument for having clear and explicit rules is the formalist one that if you know in advance what position the most powerful actors are going to take, violent conflict is unlikely.

That is a weaker argument if the rules, clear-cut as they are, depend on facts which are unclear. But even so, I think it would help. One reason the facts are so unclear is that, at the end of the day, the outcome won’t depend on the facts. If it did there would be a more concerted attempt to determine what they actually are.

Retreating to what I can say in the absence of clear rules or reliable facts, I was interested that in his interview linked above, Saakashvili did not argue on the basis of Georgian claims to South Ossetia. Instead he emphasised the attacks by Russia on targets outside of Ossetia, and claimed that Ossetia was just a pretext for a Russian attack on the rest of Georgia.

Here, at last, we really do have the Kosovo precedents coming into relevance. If TV stations in Belgrade were legitimate targets in the protection of Kosovan rebels, then what gives the oil pipeline at Poti its immunity?

Another point is the effect of time. If outsiders now want to argue that Ossetia should rightly be controlled by Tbilisi, it’s too late. They’ve been successfully calling for ceasefires for over a decade, and the outcome of any genuine negotiation is never likely to be that one side totally gives in. A ceasfire is always tempting, but sometimes it can mean giving up without noticing. Sometimes the best route to peace is to fight it out. I’m not saying that was or is the case in Georgia – that depends on those pesky facts again.

Just in case you’re wondering, the sort of things I would be interested in, if there were any way of reliably establishing them, would be:

  • Why are the South Ossetians more friendly to Russia than to Georgia?
  • Would there be a reasonable way to establish borders for South Ossetia?
  • Are there internal conflicts within Ossetia?
  • What problems does independent South Ossetia cause for the Georgia? Smuggling, organised crime, control of resources?
  • What is the economic situation in Ossetia?
  • What provoked the recent Georgian offensive against S.O.?
  • How does the situation affect other issues in the region?
  • What are Russia’s other interests in the region? – I believe there were claims that Chechen terrorists were using parts of Georgia as refuges..
  • All the same questions again with respect to Abkhazia.

South Ossetia

So, Russia has sent its army into Georgia.

My mental first draft was all about how there was nothing anyone could do about this, because the precedents that had been set in Yugoslavia were all in Russia’s favour. Defending a breakaway region from the army of the country which it nominally belongs to is all the rage these days.

But it seems the Ossetians’ case is far stronger than that of the Croats or Kosovans. After all, they’ve never really been ruled by Georgia, except for a few years in the chaos of the Soviet disintegration. They’ve been de facto independent of Tbilisi for years. The chain of events was an invasion by Georgia last night, followed by Russia joining in today.

After all, we do hear these days that leaders must learn to think beyond borders. Putin & Medvedev seem to have got the idea.

I’m a bit old fashioned – borders are what keep armies apart, which is generally a good thing. The good case which the Ossetians appear to have is mostly the result of the support they have received from Russia all along. Arguably, had Russia always stayed within its borders, Ossetia would by now be a comfortable and stable province of Georgia.

It should be clear that, as with microgeneration yesterday, I’m playing with concepts here rather than real facts. I’m probably more than averagely knowledgeable about the situation out there, but that’s setting the bar very damned low. I would be seriously deluded if I thought I could come to sensible conclusions about policy in the region based on the factoids accumulated from a handful of news snippets and Economist articles over a few years, plus the occasional spy novel. The only places I would be less qualified to pontificate on would be somewhere really remote and obscure, like, say, Tibet. Somehow the Ossetians have never quite got the attention of the more distant Tibetans – maybe it’s something to do with the romance of a bunch of ancient monks what live on some mountain somewhere, or, to put it another way, that it’s much easier to have sympathy for separatist rebels when you’re never likely to actually meet them. Separatist rebels are bad news, however justified their cause.

Speaking of Tibet, this all blew up on opening day of the Olympics… coincidence? I would like to think it’s just that someone was so pissed off at the thought of the next three weeks of television that they started a war just to avoid the boredom, but the connection may be more serious. The “spirit of international unity” that’s supposed to imbue the whole binge makes it less likely that anyone will really make a stink. If nothing else, various world leaders are actually attending the stupid thing, making it that bit harder to make decisions. That would seem to play into the hands of the Russians, however, and my (wholly unreliable) impression is that this was actually triggered by Georgia. Perhaps Saakashvili thought that if he achieved enough fast enough, the Russians would be less likely to respond, what with the Olympics and everything.

Microgeneration

I mentioned microgeneration (of power) in my previous piece, just as a random Tory policy that I didn’t give a hoot about either way. But the revival of the concept calls to mind one of the first pieces I wrote here, back in 2005, in one of my rare forays into things I actually know about.

If a 500MW power station could only be built by putting fifty thousand small 10kW generators in racks, with expensive complicated machinery to try to keep as many as possible fueled and running at once, then I don’t think the concept of an electricity grid would ever have caught on. But that’s what a “computing” power station looks like.

There are some slight economies of scale to computer hardware, mainly in management overhead, but compared to the cost of putting your own computer at the other end of a wide area network, they’re negligible.

Now we are being told that central power stations are not, or at least will not be, a good idea even for power.

When I read about this in the Metro (yes, yes, I know), the idea was attributed to “a group of environmental and economics experts”, which in fact turn out to be a bunch of lunatic lefties. So it’s safe to assume that their facts are all rubbish. But the logic is sound, and just the same as my point about computers. For centralization to be efficient, the economies of scale have to outweigh the cost of having stuff a long way from where you need it.

The economies of scale are threefold: mechanical (a big turbine is more efficient than a small one), organizational (it’s easier to keep two big machines fed & maintained than 200 small ones), and pooling (If everyone has their own little resource, they each need enough capacity to meet their own peak demand, which is much more capacity than overall peak demand).

For computing, as I argued, the first is non-existent or negative, the second marginal, and the third not enough to outweigh transmission costs.

Power generation that is based on making things very hot (i.e. all current major methods except hydro, but not photovoltaic solar) have large mechanical economies of scale because capacity varies with volume, and heat loss with surface area. But on the other hand, transmission costs are very high – both in building and maintaining the Grid and in transmission losses.

(I also seem to remember reading that the seasteading people looked at OTEC and found that it couldn’t be made effective on a small scale, though it might on a larger scale. It still seems to be turbines and things, so perhaps it’s the same fundamental scale effect.)

The management scale issue is questionable.

The pooling is a big deal for power where the cost of production is large compared to the cost of having capacity – that’s fuel-burning but not most renewables (or nuclear). They talk about offsetting the pooling problem with small-scale grids, or hydrogen storage, but that brings in a whole lot more management overhead. If microgeneration becomes sensible it will be because generation methods which are all capital costs and no fuel costs take over.

And no, my reader who knows who he is, a national torque grid of spinning axles will never be sensible.

David Davis

One of the bigger stories I didn’t get round to writing about in the last two months was David Davis’s little stunt.

I don’t call it a stunt to disparage it or him – stunts are what it takes to get attention these days. If the government introduced a policy of sacrificing newborn babies to Beelzebub, the media would spend hundreds of hours of screen time on how it affects any possible leadership challenge by David Milliband, whether Boris Johnson and David Cameron are disagreeing about the best response, and what the effect will be on the voting patterns of Beelzebub-worshipers. Actual substantive discussion of the merits of baby-sacrificing would be left to a few vox pops and rentaquotes from the most ludicrous partisans on both sides. (It might be difficult to find a ludicrous anti-baby-sacrificing position, but they would manage it).

“Opposition spokesman objects to new police powers” is about as far away from being news as it is possible to get. To actually get anyone to notice, there must be a conflict, an election, a resignation. So, Davis gave us all three.

What has he achieved? That will become more obvious now that the fuss has died down. First, he has probably doubled the number of people who remember his name – no small thing for an opposition MP. I would assume the only Conservative MPs with any name recognition are Cameron, former leaders Howard, Hague and Duncan-Smith, and a few former ministers such as Redwood. The only other thing that would have got Davis as much publicity would have been a sex scandal.

That’s by the way. The main effect of the escapade has been to nail his colours to the mast. The reason his opposition to 42-day detention was not newsworthy or interesting was that oppositions always object to the government curtailing freedom, and then always go on to do more of it when they get into power. Nobody cares any more – it is just accepted that politicians are forced to go through the motions.

But nobody forced Davis to go through this. By taking this extraordinary step, Davis has actually succeeded in making a credible commitment. Will a Conservative government continue to generously fund public services as they promise? Buggered if I know – I hope not. Will they follow through their policies on micro-generation? Anyone’s guess. Will they push on with expanding the police state and replacing justice with administration? Not if David Davis is in the cabinet, they won’t.

Wow.

That’s really something. And that’s why the irrelevance of resigning as an MP and then being reelected doesn’t matter. The frankly obscure details of the 42-day issue don’t matter. All that matters is that one politician said “No further and I really mean it”, and we can believe him, not because he is unusually honest, but because he has found a way to make a commitment that, however much he might want to go back on in future, he won’t be able to.

Profession

Mencius Moldbug has been on good form while I’ve been quiet, but one particularly original and interesting idea he came up with was, as a transition to a new form of government, handing power to a member of a particular profession – he suggested pilots.

Let’s look at the advantages of this … I am not myself a pilot – I am neither wealthy enough, nor responsible enough. But everyone I’ve ever met who was a pilot, whether private, military or commercial, has struck me as not only responsible, but also independent-minded, often even adventurous. This is a particularly rare combination. To be precise, it is an aristocratic combination, and the word aristocracy is after all just Greek for good government. Pilots are a fraternity of intelligent, practical, and careful people who are already trusted on a regular basis with the lives of others. What’s not to like?

The reason I was so struck by this idea is not because it’s a particularly good one. It’s because it rests on one of those claims that is only ever denied, never asserted – the claim that one of the most important things you can say about any person is what they do for a living.

In fact, probably anything we deny as assiduously as we deny that should be assumed to be true.

Of course there is more to every professional than their profession, but few other single things say as much about someone. We all know what we think of Lawyers, Estate Agents, Accountants, Teachers… they are each more homogenous groupings than Lutonians, grandparents or Audi drivers.

Thoughtful people have probably already wondered what it means that Parliament consists overwhelmingly of lawyers, journalists and adminstrators – however they probably nevertheless underestimate the importance of that, by underestimating the significance of profession to a person’s habits and outlook.

Return

I’m back! Actually I’ve been here all along, I just haven’t posted for a couple of months. It would be nice to come back with some huge thesis, but I don’t have one, just a few things that have been nagging at me that I never seem to have the time, the inclination, and the opportunity to put down all at once.

So let’s warm up gently…

Myanmar

MM is back to form today after a weak outing last week. One point he makes in passing, which I have been meaning to say myself, is that the government of Myanmar would have to be completely nuts to let aid agencies stomp all over their country. It would be as stupid as the government of Iran refraining from supporting and arming its allies in Iraq.

Myanmar Faces Sanctions Unless Democracy Talks Begin, Bush Says – Bloomberg, Dec 2007

Brown calls for more EU sanctions on Myanmar – Reuters, Oct 2007

Now, it could be argued that the needs of the victim of the cyclone should outweigh political considerations. But if those needs should outweigh the desire of the Myanmar authorities not to invite their avowed enemies into their own power structure, then perhaps they should also outweigh the desire of Western governments to get their agents into Myanmar. Money could be given direct to the government, or else given to the Russians or Chinese to pass on. What’s that? We don’t want to give the money to any of those governments because we don’t like them? So much for humanitarianism over politics.

France, Britain and the United States, three of the U.N. Security Council’s five veto-wielding members, have indicated they want the council to take action to get Myanmar’s leaders to open its borders to more aid.

But China and Russia as well as some other non-veto-wielding members have opposed having the U.N. body that deals with peace and security take up a humanitarian catastrophe.

Now, it may well be that the West has good reasons for wanting to replace the government of Myanmar with one under its own influence. But the unspoken assumption is that this rightness means that the openly-stated aim of overthrowing the government should be ignored by everyone when the subject of disaster relief comes up. This is the exact same error I complained about with Iraq. “Supporting democracy” in a country that has a non-democratic government means being an enemy of that country. That isn’t necessarily bad, but it has to be remembered. The government in question is likely to remember even when we don’t.

Those people running Myanmar cannot reasonably be expected to overlook the fact that every government offering aid is determined to remove them from office in a process that is likely to end up with them being lynched. The mere fact that they ought to be lynched does not come into their calculations.

(Let’s throw this in for luck: …there is an increasing degree of chatter about the possibility of an American-led invasion of the Irrawaddy River Delta.)