risk


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BEIJING — What worries you about the coming world of artificial intelligence?

Too often the answer to this question resembles the plot of a sci-fi thriller. People worry that developments in A.I. will bring about the “singularity” — that point in history when A.I. surpasses human intelligence, leading to an unimaginable revolution in human affairs. Or they wonder whether instead of our controlling artificial intelligence, it will control us, turning us, in effect, into cyborgs.

These are interesting issues to contemplate, but they are not pressing. They concern situations that may not arise for hundreds of years, if ever. At the moment, there is no known path from our best A.I. tools (like the Google computer program that recently beat the world’s best player of the game of Go) to “general” A.I. — self-aware computer programs that can engage in common-sense reasoning, attain knowledge in multiple domains, feel, express and understand emotions and so on.

This doesn’t mean we have nothing to worry about. On the contrary, the A.I. products that now exist are improving faster than most people realize and promise to radically transform our world, not always for the better. They are only tools, not a competing form of intelligence. But they will reshape what work means and how wealth is created, leading to unprecedented economic inequalities and even altering the global balance of power.

It is imperative that we turn our attention to these imminent challenges.

What is artificial intelligence today? Roughly speaking, it’s technology that takes in huge amounts of information from a specific domain (say, loan repayment histories) and uses it to make a decision in a specific case (whether to give an individual a loan) in the service of a specified goal (maximizing profits for the lender). Think of a spreadsheet on steroids, trained on big data. These tools can outperform human beings at a given task.

This kind of A.I. is spreading to thousands of domains (not just loans), and as it does, it will eliminate many jobs. Bank tellers, customer service representatives, telemarketers, stock and bond traders, even paralegals and radiologists will gradually be replaced by such software. Over time this technology will come to control semiautonomous and autonomous hardware like self-driving cars and robots, displacing factory workers, construction workers, drivers, delivery workers and many others.

Unlike the Industrial Revolution and the computer revolution, the A.I. revolution is not taking certain jobs (artisans, personal assistants who use paper and typewriters) and replacing them with other jobs (assembly-line workers, personal assistants conversant with computers). Instead, it is poised to bring about a wide-scale decimation of jobs — mostly lower-paying jobs, but some higher-paying ones, too.

This transformation will result in enormous profits for the companies that develop A.I., as well as for the companies that adopt it. Imagine how much money a company like Uber would make if it used only robot drivers. Imagine the profits if Apple could manufacture its products without human labor. Imagine the gains to a loan company that could issue 30 million loans a year with virtually no human involvement. (As it happens, my venture capital firm has invested in just such a loan company.)

We are thus facing two developments that do not sit easily together: enormous wealth concentrated in relatively few hands and enormous numbers of people out of work. What is to be done?

Part of the answer will involve educating or retraining people in tasks A.I. tools aren’t good at. Artificial intelligence is poorly suited for jobs involving creativity, planning and “cross-domain” thinking — for example, the work of a trial lawyer. But these skills are typically required by high-paying jobs that may be hard to retrain displaced workers to do. More promising are lower-paying jobs involving the “people skills” that A.I. lacks: social workers, bartenders, concierges — professions requiring nuanced human interaction. But here, too, there is a problem: How many bartenders does a society really need?

The solution to the problem of mass unemployment, I suspect, will involve “service jobs of love.” These are jobs that A.I. cannot do, that society needs and that give people a sense of purpose. Examples include accompanying an older person to visit a doctor, mentoring at an orphanage and serving as a sponsor at Alcoholics Anonymous — or, potentially soon, Virtual Reality Anonymous (for those addicted to their parallel lives in computer-generated simulations). The volunteer service jobs of today, in other words, may turn into the real jobs of the future.

Other volunteer jobs may be higher-paying and professional, such as compassionate medical service providers who serve as the “human interface” for A.I. programs that diagnose cancer. In all cases, people will be able to choose to work fewer hours than they do now.

Who will pay for these jobs? Here is where the enormous wealth concentrated in relatively few hands comes in. It strikes me as unavoidable that large chunks of the money created by A.I. will have to be transferred to those whose jobs have been displaced. This seems feasible only through Keynesian policies of increased government spending, presumably raised through taxation on wealthy companies.

As for what form that social welfare would take, I would argue for a conditional universal basic income: welfare offered to those who have a financial need, on the condition they either show an effort to receive training that would make them employable or commit to a certain number of hours of “service of love” voluntarism.

To fund this, tax rates will have to be high. The government will not only have to subsidize most people’s lives and work; it will also have to compensate for the loss of individual tax revenue previously collected from employed individuals.

This leads to the final and perhaps most consequential challenge of A.I. The Keynesian approach I have sketched out may be feasible in the United States and China, which will have enough successful A.I. businesses to fund welfare initiatives via taxes. But what about other countries?

They face two insurmountable problems. First, most of the money being made from artificial intelligence will go to the United States and China. A.I. is an industry in which strength begets strength: The more data you have, the better your product; the better your product, the more data you can collect; the more data you can collect, the more talent you can attract; the more talent you can attract, the better your product. It’s a virtuous circle, and the United States and China have already amassed the talent, market share and data to set it in motion.

For example, the Chinese speech-recognition company iFlytek and several Chinese face-recognition companies such as Megvii and SenseTime have become industry leaders, as measured by market capitalization. The United States is spearheading the development of autonomous vehicles, led by companies like Google, Tesla and Uber. As for the consumer internet market, seven American or Chinese companies — Google, Facebook, Microsoft, Amazon, Baidu, Alibaba and Tencent — are making extensive use of A.I. and expanding operations to other countries, essentially owning those A.I. markets. It seems American businesses will dominate in developed markets and some developing markets, while Chinese companies will win in most developing markets.

The other challenge for many countries that are not China or the United States is that their populations are increasing, especially in the developing world. While a large, growing population can be an economic asset (as in China and India in recent decades), in the age of A.I. it will be an economic liability because it will comprise mostly displaced workers, not productive ones.

So if most countries will not be able to tax ultra-profitable A.I. companies to subsidize their workers, what options will they have? I foresee only one: Unless they wish to plunge their people into poverty, they will be forced to negotiate with whichever country supplies most of their A.I. software — China or the United States — to essentially become that country’s economic dependent, taking in welfare subsidies in exchange for letting the “parent” nation’s A.I. companies continue to profit from the dependent country’s users. Such economic arrangements would reshape today’s geopolitical alliances.

One way or another, we are going to have to start thinking about how to minimize the looming A.I.-fueled gap between the haves and the have-nots, both within and between nations. Or to put the matter more optimistically: A.I. is presenting us with an opportunity to rethink economic inequality on a global scale. These challenges are too far-ranging in their effects for any nation to isolate itself from the rest of the world.

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Portfolio management involves much more than just an investment idea. For sophisticated investors, it is also about diversification, volatility management, and exposure mitigation.

For a Bridgewater client, the investment process isn’t as much about the hedge fund as it is about the client’s risk management needs. After explaining how the fundamental investment machine works – which operates like a systematic, logic driven machine – Prince explained a portfolio customization method typically reserved for the most sophisticated of algorithmic investors.

While the core investment analysis and “truths” upon which investments are based does not change from investor to investor, the level of volatility and beta benchmark exposure can be adjusted like a dial on an oven. If an investor determines they want 7% volatility, for instance, Bridgewater customizes their investment based on this benchmark by keeping the mix of alphas the same, but adjusting their size. All other performance factors – absolute returns, drawdown, risk exposure – are driven by this volatility dial to various degrees.

The beta benchmark offers investors a method to calibrate the effectiveness of their investment to any one of 22 different benchmarks.

Bridgewater’s strategies are fundamental in nature but driven from a systematic standpoint. In fact, Ray Dalio, the fund’s founder, is credited with being among the early hedge fund leaders to embrace systematic, logic-based algorithms.

The fundamental investment process starts by developing a timeless and universal investment thesis based on “how the world works.” Each performance driver and the logic behind the investment is made entirely transparent to the investment analysis team. Engaging in “radical transparency,” a strong critique and even attack of the investment thesis – modeling through positive and negative market environments – is encouraged. It is not an environment for those who take offense at their ideas or principles being challenged can typically handle. In this respect, it is a survival of the fittest environment to various degrees – and only the strongest uncorrelated ideas rise to the top.

After the research idea makes it through a strong due diligence process, strategies are assessed for goodness and correlation based on a series of qualitative and quantitative metrics. These fundamentally based systems measure the pressure on each market, with pressure dials that scale from fully bullish to fully bearish with smooth gradations in between.

This research, for which Ray Dalio, Bob Prince and Greg Jensen are intimately familiar, is then handed off to the asset management team where portfolio exposure impact is assessed. At each stage of the portfolio management process there are idiosyncratic methods that Bridgewater utilizes to deliver uncorrelated performance improvement.

After asset management, the third and final step of the process is trade execution. Bridgewater doesn’t invest in individual name stocks to the extent of most hedge funds but rather engages in significant derivatives exposure. In large part this is done for the sake of exposure efficiency but also allows the degree of volatility and risk management customization, much of which is done through various leverage adjustments.

Bridgewater is a machine, but a machine based on a systematic logic that is firmly run by humans. The output has been some of the most uncorrelated performance in the history of major hedge funds.

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Volatility tends to drop when market risk is building up and leverage is rising, luring investors into complacency. Indeed, the lower volatility justifies investors taking on more leverage; if volatility has dropped by a third, why not take one and a half times the leverage? This pro-cyclical dynamic arising from lower volatility in times of increasing risk-taking is the volatility paradox. The main take-away from the volatility paradox is that we shouldn’t use shorter-term, contemporary risk measures when they are very low.
But there isn’t really a paradox, and we shouldn’t ignore the low volatility. Unusually low volatility has value, it is just that if it is being viewed as a typical volatility measure it is being looked at in the wrong way. We can rely on short term volatility as a risk indicator, not as an exogenous measure of risk, but rather as endogenous manifestation of the dynamics of the market because low volatility may be telling you that everyone is levered to the hilt and is willing to snap up any asset that moves, that everyone is casting aside negative information with hardly a second thought.
When viewed as endogenously determined by the behavior of the market, the relationship between risk of crisis and unusually low levels of volatility is simple: If people are levered and are at the ready to snap up positions, if they are ready to arbitrage out price differences and make markets oblivious to risk at razor thin margins, then it won’t take much of a price move to find the other side of a trade. If people don’t care about negative information, then the information flows will hardly move prices. The result is low volatility, and this in turn leads to more leverage and then another round of the dynamics that feed the low volatility. The result will be a descending level of volatility that is telling you that the market had been lulled into complacency, or worse, is in full-speed-ahead risk taking fervor, and hence is vulnerable.
Of course even if it is more the latter, it still will be the case that a low volatility derived from recent history will likely reflect low volatility in the near future, because if people are levered and ready to buy anything, if they are at a level of exuberance that leads them to discount anything negative in the market, the odds are high that that the same behavior will persist for the next while. But then suddenly it won’t. There is the chance that the floor will fall out and a crisis will be unleashed, and more than anything else, that is what we need to know for risk management.
We can see this when we think look at things from the other direction: what happens to volatility when the crisis finally hits. At that point no one wants to take on any risk, delevering has led to a reduction in liquidity, and so prices have to move a lot to entice buyers. The market is skittish, and so any news or rumors find everyone scurrying for cover. So for both liquidity and information reasons, prices move a lot more and thus volatility rises to the point that it is again not a useful measure for risk, but for the opposite reasons..
The diversification paradox
Related to the volatility paradox is what we can term the diversification paradox, which I discussed in a post some time back. As with volatility, correlations are low pre-crisis. So as is the case with low volatility, the low correlation and resulting apparent potential for diversification will lull investors into taking more risk. And because of the dynamics that create the low correlation, this in turn will feed into further reductions in correlation, thus adding to pro-cyclicality.
At least this is what will happen if we take the correlations as exogenous – that is if we say “they correlations are what they are, so let’s throw them into our variance-covariance matrix and then let the optimizer rip”. But as with volatility, if we look at the correlations as being endogenous to the dynamics of the market, they give us warning signs. Low correlation tells us that everyone is evaluating the most subtle differences between assets – for example, are the transportation costs for the Ford’s supply chain dropping relative to those of GM’s – and is also searching out opportunities in hinterland, esoteric markets. One asset is being finely differentiated from the other, correlations are therefore low, and investors take more leverage and more exposure because of the apparent potential for risk reduction through diversification.
Of course we all know that when the crisis hits the correlations suddenly rise and the benefits of diversification go out the window. Thus, as I wrote in my earlier post, diversification works all the time, except when it really matters.
When the crisis finally hits, correlations shoot up from the same endogenous dynamics. Suddenly, the only thing that matters is risk, not the subtleties of earnings and the opportunities in Malaysian onyx mines. It is like high energy physics, where matter become an undifferentiated white-hot plasma; assets that are risky are all viewed the same way, all of the risky assets meld together. So correlations rise.
The Paradoxes and Risk Management
There are two points from this discussion of the volatility paradox and the related diversification paradox.
The first and well-known point is that if investors take these measures as exogenous – that is, if the data are treated as a given in the computation of the statistics and the statistics are then applied based on their statistical interpretation – then they will lead to pro-cyclical behavior. Higher leverage and risk taking in general will be apparently justified by the lower volatility of the market and by the greater ability to diversify as indicated by the lower correlations.
The second is that just because the volatility is not a good indicator of the risks lurking in the market doesn’t mean it is not useful. If we recognize that volatility and correlation are endogenous measure that are a manifestation of market dynamics rather than exogenous statistics of market risk to be thrown into our risk management engines, if we dig deeper into the dynamics that are generating them as endogenous parts of the market dynamic, we will find that they actually are telling us far more about the markets.

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Hedge funds, you read here in June, are often riskier than they are made out to be. Putting your money into ‘a fund that blows up, closes down or disappears with all your money’, I suggested, is a real risk for the unwary investor. The danger, I could have written, is that you will find your money being looked after by Brian Hunter, a 32-year-old energy trader from Calgary who last month single-handedly accounted for the largest hedge-fund meltdown since records began.

In the space of two short weeks, Mr Hunter worked his way through some $6.5 billion when his complex strategy of forward bets on the price of natural gas went badly wrong, wiping out 70 per cent of the capital deployed by his hedge fund employers, Amaranth Advisors. In one day alone, Mr Hunter and his colleagues on the energy trading team lost $560 million as the price of natural gas futures plunged and they were unable to liquidate their positions fast enough to meet their margin calls and preserve their lines of credit.

The fund is now attempting to close down what remains of its operations in an orderly fashion. The energy trading positions have been sold to other market participants and what is left of its $9 billion of capital (not much) will be returned to investors. This being North America, a carrion-seeking flight of lawyers is hovering over the scene, looking to institute a legal action of some sort for the unhappy victims.

Aside from wealthy individuals, those feeling the heat from the meltdown include the San Diego county pension scheme, which has lost some $100 million, and two fund-of-hedge-funds run by Morgan Stanley and Goldman Sachs, whose allegedly sophisticated monitoring systems proved unable to spot the trouble ahead. Man Group, the quoted UK hedge fund group, also had a small exposure to Mr Hunter’s trading activities.

The losses at Amaranth dwarf even those of Long Term Capital Management, the now infamous hedge fund that boasted two Nobel Prize-winning economists among its founders yet still went down in flames in 1998. It lost $4 billion in a few weeks when an even more complex series of bets on a range of financial derivative contracts proved to be less fireproof than its ultra-sophisticated risk modelling had suggested. LTCM was eventually bailed out by a consortium of leading Wall Street banks at the instigation of the Federal Reserve.

The failure of Amaranth has fortunately had few such repercussions. While there is no question that hedge funds are here to stay, the Amaranth case is an unwelcome setback for the industry at a time when its advocates are pitching hard to persuade pension funds that hedge funds are a valuable new investment class, and regulators that private investors should be allowed much broader access to these new and poorly understood investment vehicles.

Amaranth was not some fly-by-night bucket shop, but an A-list fund operating from Greenwich, Connecticut, the hedge fund capital of the world, a place cutely described at a recent industry dinner as ‘New York on steroids’. Morgan Stanley and Goldman Sachs were both happy to put clients’ money with Amaranth — and if they can’t spot a blow-up coming, we may well ask, what hope has anyone else?

All hedge funds trumpet the fact that they have sophisticated risk systems that allow them to pursue absolute returns — that is, make money in both up and down markets — in a controlled manner. The best, to be fair, do just that, but the lure of big bucks is now attracting a much more diverse crowd of wannabes, to the point where even veteran hedgies such as Steven Cohen, founder of SAC Capital Advisors, says that it is getting harder to make outsize returns. ‘We’re entering a new environment. The days of big returns are gone,’ he told the Wall Street Journal this summer.

At Amaranth Mr Hunter routinely held hundreds of positions in an array of derivative contracts linked to future prices in the natural gas market. These bets were ‘geared up’ by using borrowed money and margin calls to magnify the gains and losses. As so often happens, it appeared for a while that he had the Midas touch. In 2005 Amaranth made $1.3 billion from his trading activities, and $2 billion more in the first four months of this year.

But there were warning signs too. In May he lost nearly $1 billion. At his previous employers, after a similar period of success, he departed abruptly having lost two thirds of his gains in the last month of the year, something he apparently attributed to faults in the bank’s trading systems. Some seasoned hedge fund investors, it now appears, declined to invest in the Amaranth fund because of its flawed risk controls.

In September, triggered by a sharp fall in energy prices and a disappointing (for some) absence of hurricanes, the whole operation blew up in Mr Hunter’s face. According to his boss, the dramatic losses were the result of a highly improbable combination of events, a sharp decline in the future price of natural gas coupled with the rare inability of the fund to unwind its positions in the market. The reality, everyone else in the business suspects, is rather different.

Hubris and overconfidence surely played a part, as evidenced by the ever bigger bets that Mr Hunter appeared to be taking. Whatever risk systems the hedge fund had in place, losing two thirds of the firm’s capital in two weeks suggests a certain (shall we say) inadequacy on that score. Judging by the way that natural gas prices have bounced back up since the Amaranth meltdown, other traders were happy to put the squeeze on when it became clear that the firm’s trades were not working out. Mr Hunter’s fall from grace is further proof of the adage that in investment, as in the Battle of Britain, ‘there are old pilots and there are bold pilots, but there are no old, bold pilots’.

There is a more fundamental issue too, one that increasingly exercises regulators who worry about the damage that so much highly leveraged trading could do to the financial system the next time something goes wrong — as it surely will. Taking huge leveraged bets on such volatile phenomena as future natural gas prices, where the weather is a major factor, is in truth more akin to gambling than investing, as properly understood.

The lopsided reward structure of hedge funds — heads the fund manager wins, tails the investor loses — actively encourages aggressive managers to take big bets with other people’s money, a factor that industry apologists typically neglect to mention. There is nothing wrong with the hedge fund concept, nor with taking calculated risks, but investors who have the gambling instinct, as Keynes perceptively wrote some 70 years ago, ‘must pay to this propensity the appropriate toll’.

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Scarcely more than a year since it was signed, the Smithsonian Agreement, the “greatest monetary agreement in the history of the world” (in the words of President Nixon) lay in shambles. And so the world vibrates, with increasing intensity, between fixed and fluctuating exchange rates, with each system providing only a different set of ills. We apparently live in a world of perpetual international monetary crises.

In this distressing situation, the last few years have seen the burgeoning of a school of economists who counsel a simple solution for the world’s monetary illness. Since fixed exchange rates between currencies seem to bring only currency shortages and surpluses, black markets and exchange controls, and a chronic series of monetary crises, why not simply set all these currencies free to fluctuate with one another? This group of economists, headed by Professor Milton Friedman and the “Chicago School,” claims to be speaking blunt truths in the name of the “free market.” The simple and powerful case of the Friedmanites goes somewhat as follows:

Economic theory tells us the myriad evils that stem from any attempt at price controls of goods and services. Maximum price controls lead to artificially created shortages of the product; minimum controls lead to artificial unsold surpluses. There is a ready cure for these economic ills; they are caused not by processes deep within the free market economy, but by arbitrary government intervention into the market. Remove the controls, let market processes have full sway, and shortages and surpluses will disappear.

Similarly, the monetary crises of recent years are the product of government attempts to fix exchange rates between currencies. If the government of Ruritania fixes the “rur” at a rate higher than its free market price, then there will be a surplus of rurs looking for undervalued currencies, and a shortage of these harder currencies. The “dollar shortage” of the early postwar years was the result of the dollar being undervalued in terms of other currencies; the current surplus of dollars, as compared to West German marks or Japanese yen, is a reflection of the overvaluation of the dollar compared to these other currencies. Allow all of these currencies to fluctuate freely on the market, and the currencies will find their true levels, and the various currency shortages and surpluses will disappear. Furthermore, there will be no need to worry any longer about deficits in any country’s “balance of payments.” Under the pre-1971 system, when dollars were at least theoretically redeemable in gold, an excess of imports over exports led to a piling up of dollar claims and an increasingly threatening outflow of gold. Eliminate gold redeemability and allow the currencies to fluctuate freely, and the deficit will automatically correct itself as the dollar suppliers bid up the prices of marks and yen, thereby making American goods less expensive and German and Japanese goods more expensive in the world market.

Such is the Friedmanite case for the freely fluctuating exchange rate solution to the world monetary crisis. Any objection is met by a variant of the usual case for a free market. Thus, if critics assert that changing exchange rates introduce unwelcome uncertainty into world markets and thereby hinder international trade, particularly investment, the Friedmanites can reply that uncertainty is always a function of a free price system, and most economists support such a system. If the critics point to the evils of currency speculation, then Friedmanites can reply by demonstrating the important economic functions of speculation on the free commodity markets of the world. All this permits the Friedmanites to scoff at the timidity and conservatism of the world’s bankers, journalists, and a dwindling handful of economists. Why not try freedom? These arguments, coupled with the obvious and increasingly evident evils of such fixed exchange rate systems as Bretton Woods (1945–1971) and the Smithsonian (1971–1973), are bringing an increasing number of economists into the Friedmanite camp.

The Friedmanite program cannot be fully countered in its details; it must be considered at the level of its deepest assumptions. Namely, are currencies really fit subjects for “markets”? Can there be a truly “free market” between pounds, dollars, francs, and so on?

Let us begin by considering this problem: suppose that someone comes along and says, “The existing relationship between pounds and ounces is completely arbitrary. The government has decreed that 16 ounces are equal to 1 pound. But this is arbitrary government intervention; let us have a free market between ounces and pounds, and let us see what relationship the market will establish between ounces and pounds. Perhaps we will find that the market will decide that 1 pound equals 14 or 17 ounces.” Of course, everyone would find such a suggestion absurd. But why is it absurd? Not from arbitrary government edict, but because the pound is universally defined as consisting of 16 ounces. Standards of weight and measurement are established by common definition, and it is precisely their fixity that makes them indispensable to human life. Shifting relationships of pounds to ounces or feet to inches would make a mockery of any and all attempts to measure. But it is precisely the contention of the gold standard advocates that what we know as the names for different national currencies are not independent entities at all. They are not, in essence, different commodities like copper or wheat. They are, or they should be, simply names for different weights of gold or silver, and hence should have the same status as the fixed definition for any set, of weights and measures.

Let us bring our example a bit closer to the topic of money. Suppose that someone should come along and say, “The existing relationship between nickels and dimes is purely arbitrary. It is only the government that has decreed that two nickels equal one dime. Let us have a free market between nickels and dimes. Who knows? Maybe the market will decree that a dime is worth 7 cents or 11 cents. Let us try the market and see.” Again, we would feel that such a suggestion would be scarcely less absurd. But again, why? What precisely is wrong with the idea? Again the point is that cents, nickels, and dimes are defined units of currency. The dollar is defined as equal to 10 dimes and 100 cents, and it would be chaotic and absurd to start calling for day-to-day changes in such definitions. Again, fixity of definition, fixity of units of weight and measure, is vital to any sort of accounting or calculation.

To put it another way: the idea of a market only makes sense between different entities, between different goods and services, between, say, copper and wheat, or movie admissions. But the idea of a market makes no sense whatever between different units of the same entity: between, say, ounces of copper and pounds of copper. Units of measure must, to serve any purpose, remain as a fixed yardstick of account and reckoning.

The basic gold standard criticism of the Friedmanite position is that the Chicagoites are advocating a free market between entities that are in essence, and should be once more, different units of the same entity, that is, different weights of the commodity gold. For the implicit and vital assumption of the Friedmanites is that every national currency—pounds, dollars, marks, and the like—is and should be an independent entity, a commodity in its own right, and therefore should fluctuate freely with one another.

Let us consider: what are pounds, francs, dollars? Where do they come from? The Friedmanites take them at face value as things or entities issued at will by different central governments. The British government defines something as a “pound” and issues or controls the issue of whatever number of pounds it decides upon (or controls the supply of bank credit redeemable in these “pounds”). The United States government does the same for “dollars,” the French government the same for “francs,” and so on.

The first thing we can say, then, is that this is a very curious kind of “free market” that is being advocated here. For it is a free market in things, or entities, which are issued entirely by and are at the complete mercy of each respective government. Here is already a vital difference from other commodities and free markets championed by the Chicago school. Copper, steel, wheat, movies are all, in the Friedman scheme, issued by private firms and organizations, and subject to the supply and demand of private consumers and the free market. Only money, only these mysterious “dollars,” “marks,” and so on, are to be totally under the control and dictation of every government. What sort of “free” market is this? To be truly analogous with free markets in other commodities, the supply of money would have to be produced only by private firms and persons in the market, and be subject only to the demand and supply forces of private consumers and producers. It should be clear that the governmental fiat currencies of the Friedmanite scheme cannot possibly be subject only to private and therefore to free market forces.

Is there any way by which the respective national moneys can be subject solely to private market forces? Is such a thing at all possible? Not only is the answer yes, but it is still true that the origin of all these currencies that the Friedmanites take at face value as independent entities, was, each and every one, as units of weight of gold in a truly private and free market for money.

To understand this truth, we must go back beyond the existing fiat names for money and see how they originated. In fact, we need go back only as far as the Western world before World War I. Even today, the “dollar” is not legally defined an independent fictive name; it is still legally defined by U.S. statute as a unit of weight of gold, now approximately one-forty-second of a gold ounce. Before 1914, the dollar was defined as approximately one-twentieth of a gold ounce. That’s what a “dollar” was. Similarly the pound sterling was not an independent name; it was defined as a gold weight of slightly less than one-fourth of a gold ounce. Every other currency was also defined in terms of a weight of gold (or, in some cases, of silver). To see how the system worked, we assume the following definition for three of the numerous currencies:

1 dollar defined as one-twentieth of a gold ounce;
1 pound sterling defined as one-fourth of a gold ounce;
1 franc defined as one-hundredth of a gold ounce.

In this case, the different national currencies are different in name only. In actual fact, they are simply different units of weight of the same commodity, gold. In terms of each other, then, the various currencies are immediately set in accordance with their respective gold weights, namely,

1 dollar is defined as equal to one-fifth of a pound sterling, and to 5 francs;
1 franc is defined as equal to one-fifth of a dollar, and to one twenty-fifth of a pound;
1 pound is defined as equal to 5 dollars, and to 25 francs.

We might say that the “exchange rates” between the various countries were thereby fixed. But these were not so much exchange rates as they were various units of weight of gold, fixed ineluctably as soon as the respective definitions of weight were established. To say that the governments “arbitrarily fixed” the exchange rates of the various currencies is to say also that governments “arbitrarily” define 1 pound weight as equal to 16 ounces or 1 foot as equal to 12 inches, or “arbitrarily” define the dollar as composed of 10 dimes and 100 cents. Like all weights and measures, such definitions do not have to be imposed by government. They could, at least in theory, have been set by groups of scientists or by custom and commonly accepted by the general public.

This “classical gold standard” had numerous and considerable economic and social advantages. In the first place, the supply of money in the various countries was basically determined, not by government dictates, but—like copper, wheat, and so on—by the supply and demand forces of the free and private market. Gold was and is a metal that has to be discovered, and then mined, by private firms. Its supply was determined by market forces, by the demand for gold in relation to the demand and supply of other commodities and factors; by, for example, the relative cost and productivity of factors of production in mining gold and in producing other goods and services. At its base, the money supply of the world, then, was determined by free market forces rather than by the dictates of government. While it is true that governments were able to interfere with the process by weakening the links between the currency name and the weight of gold, the base of the system was still private, and hence it was always possible to return to a purely private and free monetary system. To the extent that the various currency names were kept as strictly equivalent to weights of gold, to that extent the classical gold standard worked well and harmoniously and without severe inflation or booms and busts.

The international gold standard had other great advantages. It meant that the entire world was on a single money, that money, with all its enormous advantages, had fully replaced the chaotic world of barter, where it is impossible to engage in economic calculation or to figure out prices, profits, or losses. Only when the world was on a single money did it enjoy the full advantage of money over barter, with its attendant economic calculation and the corollary advantages of freedom of trade, investment, and movement between the various countries and regions of the civilized world. One of the main reasons for the great growth and prosperity of the United States, it is generally acknowledged, was that it consisted of a large free-trading area within the nation: we have always been free of tariffs and trading quotas between New York and Indiana, or California and Oregon. But not only that. We have also enjoyed the advantage of having one currency: one dollar area between all the regions of the country, East, West, North, and South. There have also been no currency devaluations or exchange controls between New York and Indiana.

But let us now contemplate instead what could happen were the Friedmanite scheme to be applied within the United States. After all, while a nation or country may be an important political unit, it is not really an economic unit. No nation could or should wish to be self-sufficient, cut off from the enormous advantages of international specialization and the division of labor. The Friedmanites would properly react in horror to the idea of high tariffs or quota walls between New York and New Jersey. But what of different currencies issued by every state? If, according to the Friedmanites, the ultimate in monetary desirability is for each nation to issue its own currency—for the Swiss to issue Swiss francs, the French their francs, and so on—then why not allow New York to issue its own “yorks,” New Jersey its own “jersies,” and then enjoy the benefits of a freely fluctuating “market” between these various currencies? But since we have one money, the dollar, within the United States, enjoying what the Friedmanites would call “fixed exchange rates” between each of the various states, we don’t have any monetary crisis within the country, and we don’t have to worry about the “balance of payments” between New York, New Jersey, and the other states.

Furthermore, it should be clear that what the Friedmanites take away with one hand, so to speak, they give back with the other. For while they are staunchly opposed to tariff barriers between geographical areas, their freely fluctuating fiat currencies could and undoubtedly would operate as crypto-tariff barriers between these areas. During the fiat money Greenback period in the United States after the Civil War, the Pennsylvania iron manufacturers, who had always been the leading advocates of a protective tariff to exclude more efficient and lower cost British iron, now realized that depreciating greenbacks functioned as a protective device: for a falling dollar makes imports more expensive and exports cheaper.1 In the same way, during the international fiat money periods of the 1930s (and now from March 1973 on), the export interests of each country scrambled for currency devaluations, backed up by inefficient domestic firms trying to keep out foreign competitors. And similarly, a Friedmanite world within the United States would have the disastrous effect of functioning as competing and accelerating tariff barriers between the states.

And if independent currencies between each of the fifty states is a good thing, why not go still one better? Why not independent currencies to be issued by each county, city, town, block, building, person? Friedmanite monetary theorist Leland B. Yeager, who is willing to push the reductio ad absurdum almost all the way by advocating separate moneys for each region or even locality, draws back finally at the idea of each individual or firm printing his own money. Why not? Because, Yeager concedes, “Beyond some admittedly indefinable point, the proliferation of separate currencies for ever smaller and more narrowly defined territories would begin to negate the very concept of money.”2 That it would surely do, but the point is that the breakdown of the concept of money begins to occur not at some “indefinable point” but as soon as any national fiat paper enters the scene to break up the world’s money. For if Rothbard, Yeager, and Jones each printed his own “Rothbards,” “Yeagers,” and “Joneses” and these each amng billions freely fluctuating on the market were the only currencies, it is clear that the world would be back in an enormously complex and chaotic form of barter and that all trade and investment would be reduced to a virtual standstill. There would in fact be no more money, for money means a general medium for all exchanges. As a result, there would be no money of account to perform the indispensable function of economic calculation in a money and price system. But the point is that while we can see this clearly in a world of “every man his own currency,” the same disastrous principle, the same breakdown of the money function, is at work in a world of fluctuating fiat currencies such as the Friedmanites are wishing upon us. The way to return to the advantages of a world money is the opposite of the Friedmanite path: it is to return to a commodity which the entire world can and does use as a money, which means in practice the commodity gold.

One critic of fluctuating exchange rates, while himself a proponent
of “regional currency areas,” recognizes the classical argument for one world money. Thus, Professor Mundell writes:

It will be recalled that the older economists of the nineteenth century were internationalists and generally favored a world currency. Thus John Stuart Mill wrote in Principles of Political Economy, vol. 2, p. 176:

… So much of barbarism, however, still remains in the transactions of most civilized nations, that almost all independent countries choose to assert their nationality by having, to their own inconvenience and that of their neighbors, a peculiar currency of their own.

… Mill, like Bagehot and others, was concerned with the costs of valuation and money changing, not stabilization policy, and it is readily seen that these costs tend to increase with the number of currencies. Any given money qua numeraire, or unit of account,fulfills this function less adequately if the prices of foreign goods are expressed in terms of foreign currency and must then be translated into domestic currency prices. Similarly, money in its role of medium of exchange is less useful if there are many currencies; although the costs of currency conversion are always present, they loom exceptionally larger under inconvertibility or flexible exchange rates. Money is a convenience and this restricts the optimum number of currencies. In terms of this argument alone, the optimum currency area is the world, regardless of the number of regions of which it is composed.3

There is another reason for avoiding fiat paper currency issued by all governments and for returning instead to a commodity money produced on the private market (for example, gold). For once a money is established, whatever supply of money exists does the full amount of the “monetary work” needed in the economy. Other things being equal, an increase in the supply of steel, or copper, or TV sets is a net benefit to society: it increases the production of goods and services to the consumers. But an increase in the supply of money does no such thing. Since the usefulness of money comes from exchanging it rather than consuming it or using it up in production, an increased supply will simply lower its purchasing power; it will dilute the effectiveness of any one unit of money. An increase in the supply of dollars will merely reduce the purchasing power of each dollar, that is, will cause what is now called “inflation.” If money is a scarce market commodity, such as gold, increasing its supply is a costly process and therefore the world will not be subjected to sudden inflationary additions to its supply. But fiat paper money is virtually costless: it costs nothing for the government to turn on the printing press and to add rapidly to the money supply and hence to ruinous inflation. Give government, as the Friedmanites would do, the total and absolute power over the supply of fiat paper and of bank deposits—the supply of money—and we put into the hands of government a standing and mighty temptation to use this power and inflate money and prices.

Given the inherent tendency of government to inflate the money supply when it has the chance, the absence of a gold standard and “fixed exchange rates” also means the loss of balance-of-payments discipline, one of the few checks that governments have faced in their eternal propensity to inflate the money supply. In such a system, the outflow of gold abroad puts the monetary authorities on increased warning that they must stop inflating so as not to keep losing gold. Abandon a world money and adopt fluctuating fiat moneys, and the balance-of-payments limitation will be gone; governments will have only the depreciating of their currencies as a limit on their inflationary actions. But since export firms and inefficient domestic firms tend actually to favor depreciating currencies, this check is apt to be a flimsy one indeed.

Thus, in his critique of the concept of fluctuating exchange rates, Professor Heilperin writes:

The real trouble with the advocates of indefinitely flexible exchange rates is that they fail to take into sufficient consideration the causes of balance-of-payments disequilibrium. Now these, unlike Pallas Athene from Zeus’ head, never spring “fully armed” from a particular economic situation. They have their causes, the most basic of which [are] internal inflations or major changes in world markets.

“Fundamental disequilibria” as they are called … can and do happen. Often however, they can be avoided: if and when an incipient inflation is brought under control; if and when adjustments to external change are effectively and early made. Now nothing encourages the early adoption of internal correctives more than an outflow of reserves under conditions of fixed parities, always provided, of course, that the country’s monetary authorities are “internationally minded” and do their best to keep external equilibrium by all internal means at their disposal.4

Heilperin adds that the desire to pursue national monetary and fiscal policies without regard to the balance of payments is “one of the widespread and yet very fallacious aspirations of certain governments … and of altogether too many learned economists, aspirations to ‘do as one pleases’ without suffering any adverse consequences.” He concludes that the result of a fluctuating exchange rate system can only be “chaos,” a chaos that “would lead inevitably … to a widespread readoption of exchange controls, the worst conceivable form of monetary organization.”5

If governments are likely to use any power to inflate fiat currency that is placed in their hands, they are indeed almost as likely to use the power to impose exchange controls. It is politically naive in the extreme to place the supply of fiat money in the hands of government and then to hope and expect it to refrain from controlling exchange rates or going on to impose more detailed exchange controls. In particular, in the totally fiat economy that the world has been plunged into since March 1973, it is highly naive to expect European countries to sit forever on their accumulation of 80-odd billions of dollars—the fruits of decades of American balance-of-payments deficits—and expect them to allow an indefinite accumulation of such continually depreciating dollars. It is also naive to anticipate their accepting a continually falling dollar and yet do nothing to stem the flood of imports of American products or to spur their own exports. Even in the few short months since March 1973 central banks have intervened with “dirty” instead of “clean” floats to the exchange rates. When the dollar plunged rapidly downward in early July, its fall was only checked by rumors of increased “swap” arrangements by which the Federal Reserve would borrow “hard” foreign currencies with which to buy dollars.

But it should be clear that such expedients can only stem the tide for a short while. Ever since the early 1950s, the monetary policies of the United States and the West have been short-run expedients, designed to buy time, to delay the inevitable monetary crisis that is rooted in the inflationary regime of paper money and the abandonment of the classical gold standard. The difference now is that there is far less time to buy, and the distance between monetary crises grows ever shorter. All during the 1950s and 1960s the Establishment economists continued to assure us that the international regime established at Bretton Woods was permanent and impregnable, and that if the harder money countries of Europe didn’t like American inflation and deficits there was nothing they could do about it. We were also assured by the same economists that the official gold price of $35 an ounce—a price which for long has absurdly undervalued gold in terms of the depreciating dollar—was graven in stone, destined to endure until the end of time. But on August 15, 1971, President Nixon, under pressure by European central banks to redeem dollars in gold, ended the Bretton Woods arrangement and the final, if tenuous, link of the dollar to redemption in gold.

We are also told, with even greater assurance (and this time by Friedmanite as well as by Keynesian economists) that when, in March 1968, the free market gold price was cut loose from official governmental purchases and sales, that gold would at last sink to its estimated nonmonetary price of approximately $10 an ounce. Both the Keynesians and the Friedmanites, equal deprecators of gold as money, had been maintaining that, despite appearances, it had been the dollar which had propped up gold in the free—gold markets of London and Zurich before 1968. And so when the “two-tier gold market” was established in March, with governments and their central banks pledging to keep gold at $35 an ounce, but having nothing further to do with outside purchases or sales of gold, these economists confidently predicted that gold would soon disappear as a monetary force to reckon with. And yet the reverse has happened. Not only did gold never sink below $35 an ounce on the free market, but the market’s perceptive valuation of gold as compared to the shrinking and depreciating dollar has now hoisted the free market gold price to something like $125 an ounce. And even the hallowed $35 an ounce figure has been devalued twice in the official American accounts, so that now the dollar—still grossly overvalued—is pegged officially at $42.22 an ounce. Thus, the market has continued to give a thumping vote of confidence to gold, and has brought gold back into the monetary picture more strongly than ever.

Not only have the detractors of gold been caught napping by the market, but so have even its staunchest champions. Thus, even the French economist Jacques Rueff, for decades the most ardent advocate of the eminently sensible policy of going back to the gold standard at a higher gold price, even he, as late as October 1971 faltered and conceded that perhaps a doubling of the gold price to $70 might be too drastic to be viable. And yet now the market itself places gold at very nearly double that seemingly high price.6

Without gold, without an international money, the world is destined to stumble into one accelerated monetary crisis after another, and to veer back and forth between the ills and evils of fluctuating in exchange rates and of fixed exchange rates without gold. Without gold as the basic money and means of payment, fixed exchange rates make even less sense than fluctuating rates. Yet a solution to the most glaring of the world’s aggravated monetary ills lies near at hand, and nearer than ever now that the free-gold market points the way. That solution would be for the nations of the world to return to a classical gold standard, with the price fixed at something like the old current free market level. With the dollar, say, at $125 an ounce, there would be far more gold to back up the dollar and all other national currencies. Exchange rates would again be fixed by the gold content of each currency. While this would scarcely solve all the monetary problems of the world—there would still be need for drastic reforms of banking and central bank inflation, for example—a giant step would have been taken toward monetary sanity. At least the world would have a money again, and the spectre of a calamitous return to barter would have ended. And that would be no small accomplishment.

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Our current state of affairs – this is an overgeneralization – two versions of the American existence are emerging as separate entities.

There’s the Knowledge Economy and there’s Trumpism, with a lot less overlap between the two with each passing day. We’re not exactly forced to pick the one around which we’ll coalesce, it’s more that we increasingly feel compelled to. Your choice depends on where you live, what your community looks like, which media outlet you get your news from, how religious you are, what level of education you’ve attained, the industry you work in and the amount of exposure you’ve had – in real life – to people from different walks of life and ethnic backgrounds.

Social media has aggravated these differences and recent political contests have hardened them.

Former Vice President Joe Biden spoke at the Cornell commencement last week, akin to making a direct address to the Knowledge Economy. The crux of his remarks:

I thought we had passed the days when it was acceptable for political leaders at local and national levels to bestow legitimacy on hate speech and fringe ideologies. But the world is changing so rapidly…

There are a lot of folks out there who are both afraid and susceptible to this kind of negative appeal. We saw the forces of populism not only here but around the world call to close our nation’s gates against the challenges of a rapidly changing world…

The immigrant, the minority, the transgender, anyone not like me became a scapegoat. Just build a wall, keep Muslims from coming into the United States.

‘They’re the reason I can’t compete, that’s why I don’t have a job. That’s why I worry about my safety.’ And I imagine, like me, many of you have seen this unfold. It was incredibly disorienting and disheartening.

Biden’s audience – remember, we’re talking about Cornell graduates and their families – is extraordinarily divorced from Trump’s audience. They won’t compete for jobs or real estate or potential mates with the Trumpists. They’ll consume information from different sources and have an almost entirely different life experience as they build their careers and raise their families in the coming years.

It’s sad that this is where we are. I don’t think most people want to be compelled to choose a team within one country, but the environment we’re in now practically demands it. This is deeper than political affiliation or just the usual city versus rural heuristic. It’s cultural. We’re supposed to be one culture, generally speaking. Maybe once we were. Or maybe we never were and it’s only becoming more obvious now. Differences in income and opportunities, magnified by Instagram glamor shots and Facebook status updates, are driving people crazy and forcing them onto teams. And teams discourage independent thought.

There is an implicit conceit within the Knowledge Economy that if everyone would just get with the program, the future would be brighter. From the outside, this can be taken as a chide or a scolding. We know what’s best for you. You shouldn’t be surprised that the kneejerk reaction to this sort of thing is a big f*** you and even votes cast out of spite. No one wants to be lectured by people who presume to be better than them. No one wants to be constantly presented with evidence that their life choices have been self-destructive – especially on social media, which is like one giant, raw nerve ending, continually being rubbed the wrong way.

But what if it flipped?

What if, all of a sudden, the Knowledge Economy didn’t look so hot. By publicly denigrating climate science and prioritizing the re-opening of coal mines, it sometimes seems as though this is an explicit aim of the Trumpists – a reactionary counter-revolution rolling back decades of social progress and industry-specific obsolescence. Re-shuffling the deck of cards. Flipping over the roulette table. Letting the chips fall to the ground and the players starting from scratch.

One current White House advisor said last year that “2016 is the Flight 93 election: charge the cockpit or you die. You may die anyway. You—or the leader of your party—may make it into the cockpit and not know how to fly or land the plane. There are no guarantees.” The implication being that complete destruction is preferable to allowing things to keep going in the current direction. This is a desperation that is utterly inexplicable to those who are currently toward the top of the income and education scale.

In the event of a “complete destruction” of society, how would the denizens of the Knowledge Economy fare?

I came across an extreme example in the novel World War Z. Author Max Brooks explored this idea back in 2006, a full decade before the election that would crystallize these two renditions of American life. His narrator interviews the fictional Director of the Department of Strategic Resources in the aftermath of a global zombie epidemic, which humanity has just barely managed to survive. Having non-Knowledge Economy people as instructors may have saved the world…

America was a segregated workforce, and in many cases, that segregation contained a cultural element. A great many of our instructors…these were the people who knew how to take care of themselves, how to survive on very little and work with what they had. These were the people who tended small gardens in their backyards, who repaired their own homes, who kept their appliances running for as long as mechanically possible. It was crucial that these people teach the rest of us how to break from our comfortable, disposable consumer lifestyle even though their labor had allowed us to maintain that lifestyle in the first place…

Imagine the typical Cornell grad in this sort of scenario. What is she bringing to the table? I imagine my own paltry set of skills and realize how unhelpful they would be as the Department of Strategic Resources classifies us all and puts us to work in staving off the undead hordes at the gate…

You’re a high-powered corporate attorney. You’ve spent most of your life reviewing contracts, brokering deals, talking on the phone. That’s what you’re good at, that’s what made you rich and what allowed you to hire a plumber to fix, which allowed you to keep talking on the phone. The more work you do, the more money you make, the more peons you hire to free you up to make more money. That’s the way the world works. But one day it doesn’t. No one needs a contract or a deal brokered. What it does need it toilets fixed. And suddenly a peon is your teacher, maybe even your boss. For some, this was scarier than the living dead.

Substitute “corporate attorney” for graphic designer or evening news anchor or financial advisor or web developer in your mind. Imagine a world in which those skills suddenly had no meaning, no utility. Now think of the millions of your fellow Americans who have been made obsolete by technology or foreign trade over the last few decades – or live in constant fear that they are about to be.

Once, on a fact-finding tour of LA, I sat in the back of a reeducation lecture. The trainees had all held lofty positions in the entertainment industry, a melange of agents, managers, “creative executives,” whatever the hell that means. I can understand their resistance, their arrogance. Before the war, entertainment had been the most valued export of the United States. Now they were being trained as custodians for a munitions plant in Bakersfield, California.

100,000 retail jobs have been lost over the last year. Hiring in e-commerce positions – from web design to fulfillment and shipping – does not offset these job losses on a one for one basis. And if these workers remain out of work for long, or end up doing something they’re unhappy with, whose message will they be more susceptible to, the Knowledge Economy’s or the Trumpists’? Which team will they join?

How about the 3 million Americans who list their occupation as “driver”? As automated vehicles take their place on the road, will Biden’s appeal resonate? I don’t think so. It’s much more likely that the rhetoric of “the experts were wrong, burn it all down” will get through and take hold.

Can anyone or anything turn this tide of our growing separation from each other? I can’t imagine what could do it in the short-term. And I still can’t change an oil filter.

 

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Staying in the game, not blowing up your account, is the way to approach the markets. Your risk must always be controlled, ultimately that’s all that you can control.

This week’s trade will have a trading component to it. The risk will be defined and controlled. Just adding the last touches.

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