Friday, March 27, 2009

Leveraging on the Back of Uncle Sam

The big news of the week is that rescue plan will form public/private partnerships in an effort to sell the "toxic assets" accumulated by banks. Supporters of crony-capitalism claim the plan is pro-market as the investors who grab the pearls from the barrels of toxic junk will make off like bandits, while those who place their bets poorly will be losers. It's like the free market, but with a Marxian twist.

I doubt this scheme of leveraged private/public partnerships will benefit society at large. The reason we have toxic assets in the first place is because banks were overleveraging their assets.

If the problem is leveraging; then having the Feds subsidize a new round of leveraged bets will just a set us up for future problems. I would only support the use of taxpayers' dollars if the effort was clearly aimed at helping banks de-leverage.

I don't like the news. But it did get me thinking about the nature of leverage, inequalities and the free market.

First let's talk about levers: For a lever to work, the person holding the lever needs something solid to leverage against. This is true in both physics and finance. A lever might work well on land, but if you are floating in the middle of a lake, you will find that the lever does not help much. Try leveraging a rock while floating in water. At best, you will splash about. At worst, you will sink.

One can move themselves about if they attach a lever to a boat and call it an oar. For a lever to work it must be attached to something.

A famous quote from Archimedes is "Give me a lever and a place to stand and I will move the earth."

Even the ancients realized that a firmament a necessary component of leverage.

Now to the market … The market is a creation of our mind. One can apply the metaphor of leverage to the market. In doing so, one must realize that leveraging in the market involves leveraging against the minds of others. Others, by their nature are trying to leverage back.

As minds and opinions change on a regular basis, a free market tends to be liquid.

Markets tend to seek parity. If one person comes up with an idea that significantly improves his lot, people will replicate the idea until the law of diminishing returns kicks in. It is hard to stay on top for long.

It is natural for people to reject the liquid nature of the free market.

We are egotistical little creatures. We all want to pull the levers that have the greatest impact. As such we desire big levers on a strong firmament. Likewise, when a person makes a gain, they will want to find ways to preserve their gain and maintain their social status.

To create a firmament people turn to the state and regulations.

The insiders who help write the regulations will use the regulation for leverage in the market.

What happens in a regulated society is that people will leverage against a regulation until the system becomes unstable.

When we look at the market collapse of 2008, we see that it wasn't simply the case of lack of regulation, but that insiders had leveraged the regulatory system until the thing became instable.

Creating a stable prosperity is not simply a matter of making new regulations. It involves detailed examination of the ways that investors leverage off the markets. Simply pumpling money into the system and offering insiders special securities that allow them to leverage off taxpayer's funds won't solve the problem.

It is interesting that, during the market collapse, the people with highly leveraged positions complained that the regulations they were leveraging against weren't strong enough. As I look at the collapse, it appears to me that our main problem was that the leverage positions were too strong.

I would suggest that before we burden the system with new regulations, we should remove the regulations that created destructive leverage such as the short sale, hedge funds and credit default swaps.

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