Burning Question

I like "By Invitation," an "expert" polls feature at The Economist. The question this time is:
Will the financial crisis and its aftermath lower the world economy's potential rate of growth?

Answers by contributing guests include:
[Yes] "previous potential growth rate...was, we now know, artificially inflated by counting the upside of risky investments made without properly accounting for their downside potential"
"No. History suggests the global economy will snap back to its pre-crisis trend"
"I will focus on the question of permanent v temporary effects..." blah blah blah.
Read more and comment here.

Global Finance

Reblogging from Huffington Post: What is Goldman Sach's Thinking?

What Is Goldman Sachs Thinking?
Simon Johnson
MIT Professor and co-author of 13 Bankers
Posted: June 29, 2010 06:43 AM

The next financial boom seems likely to be centered on lending to emerging markets. Sam Finkelstein, head of emerging markets debt at Goldman Sachs Asset Management, summed up the prevailing market view - and no doubt talked up his own positions - with a prominent quote in Monday's Financial Times (p.13, front of the Companies and Markets section):

"Debt-to-GDP ratios in the developed world are about double those in emerging markets and they're growing. This makes emerging markets interesting because you're pick up incremental spread [higher interest rates compared with developed world rates], and in return you're actually taking less macroeconomic risk.

This is a dangerous view for three reasons.

First, against all historical evidence, it assumes that the only macroeconomic risks we should worry about - in general or for emerging markets - are related to standard measures of government fiscal policy. "Less risk" and "more yield" was exactly what securitized subprime mortgages and their derivatives were purported to offer; this combination typically proves illusory.

Second, emerging markets got into serious trouble through private sector overborrowing both in the 1970s (Latin America, communist Poland and Romania) and in the 1990s (many parts of Asia). In some crises, the government stepped in and ended up holding a great deal of debt - but this does not change the fact that the exuberance was all about private sector banks (in the US and Europe) lending to private sector corporations (financial and nonfinancial) in a mispricing of risk that started out at modest levels but grew over the cycle.

Third, when your ability to borrow depends in part on the value of your collateral - see the academic work of Ben Bernanke and the experience of Japan in the late 1980s (e.g., the classic Hoshi-Kashyap volume) - then rising asset prices enable you to borrow more. This does not necessarily have to go bad in a macroeconomic sense, but experience over the last 30 years is not encouraging. Global moral hazard - the idea that someone will provide a bailout - does not mix well with free capital flows and this kind of financial accelerator.

Goldman Sachs knows all this, of course. But, as they will tell you correctly, reforming incentives or even discouraging this kind of cycle is definitely not their job. Their role is to make money, pure and pretty simple given their market share.

It's the responsibility of government to make the world financial system less dangerous. Judging from the G20 summit (see my comments on the communique) this weekend, we are making no progress at all in that direction.

Perception is perhaps as important as Production in driving finance today.
It seems Africa (Nigeria too) will get a chance at some of that speculative money.
It's cool. It's risky but I guess the Obamas and bankers are telling us that we like the risk.

Derivatives, and Math

The New York Times reports that

George Soros, the prominent financier, avoids using the financial contracts known as derivatives “because we don’t really understand how they work.”

(Read More...)

Nor do I.

The world may be more curious in future to learn the true properties of derivatives, so that the knowledge can be applied to:
1. how they should be valued
2. what they evolve into over time, system wide
For a starter (non-mathematical), I liked Financial Derivatives and the Globalization of Risk (2004, by Edward LiPuma). The basic ideas were that world markets are more linked now, since derivatives got popular, and that we don't understand well how or how much.

Basically, Wall Street needs more mathematics.

The most important article I've read in ages is on the International Mathematics Olympiad. (Read the article.) The author decries that Math has is not embraced more by Americans.

Nigeria finally started running National Olympiads. The level of mathematics required to pass this exam is NOT AT ALL COMPARABLE to that required to tackle the International Competitions. Still, getting the channels/infrastructure for math competition in the country is a start.

It is very important for us to develop *excellent* engineers, technicians, and scientists. This, along with: 1. Power Supply and 2. Ensuring Wealth from Agriculture would be my priorities if I ran this part of the world ;)

Bubble bursting, or something else?

The current meltdown in global markets is driven by sub-prime debt. The following article from TIME.com is a short and readable explanation of the linkages:

Wall Street's Geniuses Blow Up the Lab
By RICHARD BOOKSTABER
Looks like Wall Street's mad scientists have blown up the lab again. The subprime mess that is cutting so wide a swath through financial markets can be traced to the alchemy of creating collateralized debt obligations (CDOs) compounded by the enormous amount of leverage applied by big hedge funds. CDOs are derivatives — synthetic financial instruments derived from another asset. (...Read More)

Bookstaber is a former hedge fund manager and the author of A Demon of Our Own Design. He blogs here.