Commodity Speculation and Middle East Turmoil

Here is an excerpt about the subject

The short answer with regard to the role of speculation in the Middle East turmoil (and the spike in gas prices) is that speculation is obviously playing a large role. Everyone I’ve spoken to seems to think this is a virtual replay of 2008, only the larger spike here is in food commodity prices. Wheat and corn are both up more than 75% over the last 12 months; cotton is up over 125%; coffee up 85%. Meanwhile oil prices are soaring and there’s talk again of futures maybe hitting $200 a barrel – oil futures are trading at about three times what they were in February 2009. The blame for all of this is going to be laid at disruptions in the Middle East and other factors, but the inescapable fact is that commodity index speculation was up $80 billion last year, meaning that there was $80 billion of new money coming on the market betting on the rise of commodity prices. The total amount of commodity index speculation approached $400 billion last year, meaning the amount of speculative money on the market was roughly twenty times pre-2003 levels – and again, this is all “long-only” speculation, i.e. money betting on prices to go up. Obviously disasters and political unrest and other factors (a very weak harvest in Russia last year was a factor in the wheat price spike, for instance) play a part in all of this, but I think in the end what we’re going to find out is that index speculation was a huge factor in both the skyrocketing food prices that led to the Middle East crisis and this current oil-price situation.

Can we predict future?

Ragu Rajan of University of Chicago Booth School of Business tries to explain who is responsible for not forewarning about the financial crisis that has engulfed the entire financial world.

At the height of the financial crisis, the Queen of England asked my friends at the London School of Economics a simple question, but one for which there is no easy answer: Why did academic economists fail to foresee the crisis? There have been several responses to that query. One is that economists simply lacked models that could account for the behavior that led to the crisis. Another is that economists were blinkered by an ideology according to which a free and unfettered market could do no wrong. Finally, an answer that is gaining ground is that the system bribed economists to stay silent. In my view, the truth lies elsewhere. I would argue that three factors largely explain our collective failure: specialization, the difficulty of forecasting, and the disengagement of much of the profession from the real world.

He reluctantly accepted that forecasting future events is difficult, if not impossible. Here is another study that shows, why it is so difficult.

Stossel cited a study in the journal Economics and Portfolio Strategy that tracked 452 managed funds from 1990 to 2009, finding that only 13 beat the market average. Equating managed fund directors to “snake-oil salesmen,” Malkiel said that Wall Street is selling Main Street on the belief that experts can consistently time the market and make accurate predictions of when to buy and sell. They can’t. No one can. Not even professional economists and not even for large-scale market indicators. As economics Nobel laureate Paul Samuelson long ago noted in a 1966 Newsweek Column:  “Commentators quote economic studies alleging that market downturns predicted four out of the last five recessions. That is an understatement. Wall Street indexes predicted nine out of the last five recessions!”

Even in a given tech area, where you might expect a greater level of specific expertise, economic forecasters fumble. On December 22, 2010, for example, the Wall Street Journal ran a piece on how the great hedge fund financier T. Boone Pickens (chair of BP Capital Management) just abandoned his “Pickens Plan” of investing in wind energy. Pickens invested $2 billion based on his prediction that the price of natural gas would stay high. It didn’t, plummeting as the drilling industry’s ability to unlock methane from shale beds improved, a turn of events even an expert such as Pickens failed to see.

Why are experts (along with us non-experts) so bad at making predictions? The world is a messy, complex and contingent place with countless intervening variables and confounding factors, which our brains are not equipped to evaluate. We evolved the capacity to make snap decisions based on short-term predictions, not rational analysis about long-term investments, and so we deceive ourselves into thinking that experts can foresee the future. This self-deception among professional prognosticators was investigated by University of California, Berkeley, professor Philip E. Tetlock, as reported in his 2005 book Expert Political Judgment. After testing 284 experts in political science, economics, history and journalism in a staggering 82,361 predictions about the future, Tetlock concluded that they did little better than “a dart-throwing chimpanzee.”

The said study concluded that expertise in one area of study leads to narrowed focus and increases confidence but also blurs the value of dissenting views and transforms data collection into belief confirmation. One way to avoid being wrong is to be skeptical whenever you catch yourself making predictions based on reducing complex phenomena into one overarching scheme.

Having said so leads us to nowhere. Since the world is a very complex phenomena and there are many intervening variables, we shall never be able to predict future whatsoever may be at our help. There will always be surprises.

A Hadith of Prophet (PBUH) - Narrated Abdullah Ibn Umar (RAA)

Allah's Apostle said, "The keys of the Unseen are five:

1. Verily with Allah (Alone) is the knowledge of the Hour,
2. He sends down the rain and
3. knows what is in the wombs.
4. No soul knows what it will earn tomorrow, and
5. no soul knows in what land it will die.

Verily, Allah is All-Knower, All-Aware." (31.34) 

Sahih Al-Bukhari  6.151

Pakistan Economy and Loopholes

A balance of payment crisis compelled Pakistan to seek $11.3 billion IMF loan in 2008. Strings attached with the loan invited harsh criticism from the political parties and business groups. The three-point reform agenda requires implementation of reformed sales tax, reduction in budget deficit and end to government subsidies. At present, Pakistan is in a peculiar situation today. Fiscal deficit is high, debt is increasing rapidly, growth is minimal and unemployment on the rise. The mounting debt and liabilities, approaching Rs11,000 billion, doubling in the last three years, is being used for non-productive expenditure. The budget deficit is set to hit 7.5 percent against the targeted 4.7 percent for fiscal 2010/11 (July-June). Pakistan badly needs to generate additional revenue to meet its budgetary deficit and conditions agreed to IMF. That is why the Govt. is doing all what it can to win favors for RGST but still it looks a far cry. While the IMF forecasts emerging economies, notably China and India, to drive the global growth, Pakistan’s economic sovereignty is facing serious challenges. The debt profile of the country is worsening day by day with fears of a looming debt trap. With over half a billion debt increase in the first quarter of FY11, shared equally by domestic and foreign components, the country’s total debt reached Rs10.7 trillion. With fiscal deficit threatening to reach Rs1.5 billion for FY11, according to the Finmin, a significant rise in the country’s debt is inevitable.

But on the other hand there are many loopholes that if plugged can generate all the necessary revenue without resorting to increase in power tariff and RGST. One such case is “ISAF Missing Containers”.

The International Security Assistance Force (ISAF) is a NATO-led security mission in Afghanistan established by the United Nations Security Council on 20 December 2001 by Resolution 1386 as envisaged by the Bonn Agreement. It is engaged in the War in Afghanistan (2001–present).

ISAF started importing goods through Karachi and established Forward Mounting Base (FMB) unit at Karachi in 2002 as part of co-ordination mechanism by designating one of the its officers at Karachi to regularly co-ordinate customs clearance matters with Additional Collector Customs Karachi Port. But this co-ordination system fizzled out when the FMB was shifted by ISAF to Kabul within a year of its establishment at Karachi. In June 2010, it was leaked to media that over 11,000 ISAF containers with equipment worth Rs220 billion went missing during the last two years or so.

The FBR data showed that during the period June 2005-2010, a total of 558,141 containers were transited to Afghanistan. Of these, 166,949 (30 percent) containers belonged to the US Military; 52,929 (9 percent) to ISAF/Nato and the remaining 338,263 (61 percent) were commercial ATT consignments. The biggest aspect of the ISAF Containers Scam is the non-availability of the data on the movement of ISAF containers. The FTO report on the scam shows that in response to data requisitioned from FBR for the period January 1, 2007 to October 15, 2010, Pakistan Revenue Automation Limited (PRAL) confirmed that Karachi Customs had handled a total of 306,267 transit containers during this period. For 71,202 containers, there is no information regarding either their departure from Karachi or their arrival at the border customs stations. In case of 27,871 containers, that did arrive at the destinations, their departure information from Karachi is not available. Another 55,140 containers are shown to have left Karachi but have no entries of arrival at the border stations. A total of 152,054 containers have records for departure from Karachi and arrival at the border customs station, but no record of crossing into Afghanistan. Finally, not a single container, out of 306,267, is recorded to have ever crossed over to Afghanistan during the almost four-year period under reference. According to one informed insider, the arrival or otherwise of the ‘missing containers’ could be verified from the ISAF Kabul officials. The containers that were meant to go missing after availing of ISAF duty-tax free clearance by Customs were never meant to reach ISAF warehouses in Kabul and therefore the ISAF headquarters could easily confirm whether they ever arrived in Kabul or not.

It is estimated very conservatively that the scandal involving the ISAF containers have caused a huge loss of over Rs 37 billion to the economy. Chief Justice Iftikhar Mohammad Chaudhary on Wednesday hearing the embezzlement of billions of rupees in International Security Assistance Force (ISAF) containers case observed that revelations made in the Federal Tax Ombudsman report is just the tip of the iceberg, as further investigations could divulge much more. He said because of smuggling the national exchequer faces a loss of $2 billion every year.  The Chief Justice further said that even the Islamabad markets are flooded with the smuggled goods. Justice Ramday said that the domestic barrowing have reached Rs4008 billion since 2008 to 2010. The court wondered that besides the smuggling of alcohol and arms, what else is being smuggled on the pretext of Afghan trade.

The Afghan Transit Trade Agreement (ATTA) scam is bleeding our beleaguered economy dry to the tune of up to Rs37 billion per year . The ATTA allows goods destined for Afghanistan to transit through Pakistan duty free but ATTA goods, amounting to an estimated $2 billion, either stay in Pakistan or are smuggled back in. Described as the “main source of smuggling” in Pakistan, the ATTA scam is hemorrhaging our economy on several fronts. The ATTA has become an unmitigated source of customs duty evasion. When the Federal Board of Revenue (FBR) enhances duties on any product, official imports to Pakistan decline as people shift to import the same product, fraudulently, under the ATTA. Such was the case with stainless steel imports, which doubled under ATTA within six months, immediately after duties were increased on it. So the ATTA has dented the FBR authorities’ ability to accrue revenue via customs duties which, when combined with the stranglehold of the feudal and political classes on preventing income tax collection, has stymied Pakistan’s tax-to-GDP ratio to an eye-watering nine per cent. This is a critical issue for the nation’s economic future. The extent of the problem with ATTA is borne out by the fact that Afghanistan’s per capita imports are 72 per cent higher than Pakistan, even though its GDP per capita is almost 300 per cent lower. The statistics reveal the extent of smuggling into Pakistan. The Afghan economy cannot sustain such high imports. In fact, 80 per cent of these goods are smuggled into Pakistan, damaging local industry and destroying legal businesses here. Worse still, Pakistan’s high-value edibles are smuggled into Afghanistan, bleeding our exchequer further, as both fertilizers and flour are heavily subsidized by the government. The resultant shortage in Pakistan drives up prices — another body blow for the Pakistani people, already bludgeoned by food inflation.

Revenue loss on account of smuggling of Afghan transit trade alone, as estimated by the World Bank, amounted to US$ 35 billion during nine years from 2001 to 2009. It is no secret that Pakistani tax evaders have been transferring to Swiss banks huge amounts of money generated through illegal activities by some politicians, bureaucrats, terrorist networks and businessmen to Swiss banks. White-collar crimes are also responsible for facilitating transfer of capital towards informal economy either from the black market or the formal economy with the connivance of FRB’s officials. Due to Pakistan’s low productivity resulting from massive exemptions, poor administration, low threshold, and lack of transparency and enforcement, the country faces a massive challenge of balancing low revenues and the avaricious politicians, corrupt bureaucrats, and greedy businessmen, who are mostly crook, corrupt and tax evaders, succeed to remit this black money to their hidden accounts in Switzerland and other European countries. On the one hand parallel economy in Pakistan is growing at an alarming rate of 20 percent per annum and on the other hand, according to an estimate, the money lying in Swiss banks of Pakistanis has reached to the tune of US $200 billion. The volume of black money generated in the year 2008-09 alone has been measured by the independent sources which is not less than $ 40 billion. The rent-seekers and beneficiaries of loan write-offs in Pakistan have also shifted funds worth billions of dollars to Switzerland.

What caused food inflation?

In 2008, the government pushed the procurement price of wheat up from Rs. 625 per 40 kg to Rs. 950 per 40 kg. This action immediately triggered inflationary pressures that have continued to persist as food accounts for just over 40% of Pakistan's consumer price index. According to State Bank of Pakistan (SBP) analysis, cumulative price of wheat surged by 120 per cent since 2008, far higher than the 40 per cent between 2003 and 2007. it is also many times greater than the international market price increase of 22 per cent for wheat in the same period. Similarly,sugar prices have surged 184 per cent higher since 2008, compared with 46 per cent increase during 2003-07.

Some have attributed this rise in prices to recent flood and global food crisis. Yet some relate this price increase to poor harvest and strong demand from emerging economies.

This food inflation is a cause of concern for the policy makers and it is suggested that underlying the sudden, volatile uprising in Egypt and Tunisia is a growing global crisis sparked by soaring food prices.

Here is an excerpt from an article that throws flood light on to the causes of food price escalation.

The cause of the recent jump in global food prices remains a matter of debate. Some analysts blame the Federal Reserve’s “quantitative easing” program (increasing the money supply with credit created with accounting entries), which they warn is sparking hyperinflation. Too much money chasing too few goods is the classic explanation for rising prices.

The problem with that theory is that the global money supply has actually shrunk since 2006, when food prices began their dramatic rise. Virtually all money today is created on the books of banks as “credit” or “debt,” and overall lending has shrunk. This has occurred in an accelerating process of deleveraging (paying down or writing off loans and not making new ones), as the subprime housing market has collapsed and bank capital requirements have been raised. Although it seems counterintuitive, the more debt there is, the more money there is in the system. As debt shrinks, the money supply shrinks in tandem.

That is why government debt today is not actually the bugaboo it is being made out to be by the deficit terrorists. The flipside of debt is credit, and businesses run on it. When credit collapses, trade collapses. When private debt shrinks, public debt must therefore step in to replace it. The “good” credit or debt is the kind used for building infrastructure and other productive capacity, increasing the Gross Domestic Product and wages; and this is the kind governments are in a position to employ. The parasitic forms of credit or debt are the gamblers’ money-making-money schemes, which add nothing to GDP.

Prices have been driven up by too much money chasing too few goods, but the money is chasing only certain selected goods. Food and fuel prices are up, but housing prices are down. The net result is that overall price inflation remains low.

While quantitative easing may not be the culprit, Fed action has driven the rush into commodities. In response to the banking crisis of 2008, the Federal Reserve dropped the Fed funds rate (the rate at which banks borrow from each other) nearly to zero. This has allowed banks and their customers to borrow in the U.S. at very low rates and invest abroad for higher returns, creating a dollar “carry trade.”

Meanwhile, interest rates on federal securities were also driven to very low levels, leaving investors without that safe, stable option for funding their retirements. “Hot money” – investment seeking higher returns – fled from the collapsed housing market into anything but the dollar, which generally meant fleeing into commodities.

At one time food was considered a poor speculative investment, because it was too perishable to be stored until market conditions were right for resale. But that changed with the development of ETFs (exchange-traded funds) and other financial innovations.

As first devised, speculation in food futures was fairly innocuous, since when the contract expired, somebody actually had to buy the product at the “spot” or cash price. This forced the fanciful futures price and the more realistic spot price into alignment. But that changed in 1991. In a revealing July 2010 report in Harper’s Magazine titled “The Food Bubble: How Wall Street Starved Millions and Got Away with It,” Frederick Kaufman wrote:

The history of food took an ominous turn in 1991, at a time when no one was paying much attention. That was the year Goldman Sachs decided our daily bread might make an excellent investment. . . .

Robber barons, gold bugs, and financiers of every stripe had long dreamed of controlling all of something everybody needed or desired, then holding back the supply as demand drove up prices.

EMH and Financial Bubbles

From the starting point of rational investors came the idea of the efficient market hypothesis, a theory first elucidated by my colleague and golfing buddy Gene Fama. The EMH has two components that I call “The Price is Right” and “No Free Lunch”. The price is right principle says asset prices will, to use Mr Fama’s words “fully reflect” available information, and thus “provide accurate signals for resource allocation”. The no free lunch principle is that market prices are impossible to predict and so it is hard for any investor to beat the market after taking risk into account.

In the world of the EMH, as it is known, bubbles are nothing to seriously worry about because prices cannot deviate from proper valuations for too long.

In economics, the invisible hand, also known as the invisible hand of the market, is the term economists use to describe the self-regulating nature of the marketplace. This is a metaphor first coined by the economist Adam Smith in The Theory of Moral Sentiments, and used a total of three times in his writings. For Smith, the invisible hand was created by the conjunction of the forces of self-interest, competition, and supply and demand, which he noted as being capable of allocating resources in society. This is the founding justification for the laissez-faire economic philosophy.

But what if that invisible hand is working in its own interest rather than for the interest of all the participants in the market.

Can Goldman Sachs, the profit-seeking missile of high finance, really make money by investing $450 million in Facebook, at a vertigo-inducing price that values the social-networking company at $50 billion? Facebook’s shares were said to be trading on a private-market exchange at a valuation of $42.4 billion. Thanks to Goldman’s imprimatur, Facebook’s value increased 20 percent virtually overnight. Can Goldman really expect to squeeze more water from this stone? Sadly, yes. To understand why, we have to go to the heart of the many problems in the way the Wall Street cartel does business, despite the promised reforms of the Dodd-Frank law. With Goldman’s investment in Facebook, we have a front-row seat to the process by which Wall Street creates and inflates financial bubbles. Goldman has almost certainly locked up the role of lead manager of the inevitable Facebook initial public offering. Fees for underwriting public offerings are generally about 7 percent of the value of the stock sold. Facebook could easily sell $2 billion of stock or more, generating fees to Goldman and the other underwriters of at least $140 million. The other benefit for Goldman in leading the public offering — aside from major bragging rights — is that it can use its marketing, sales and distribution muscle to make sure the value of Facebook at the time of the offering exceeds the $50 billion valuation at which Goldman invested.

It seems that Goldman has set up a "special purpose vehicle" and alerted top clients that through this SPV they will have the opportunity to invest in an as-yet-unnamed company, which reportedly is Facebook. The way this looks to Felix Salmon over at Reuters, and his explanation makes a lot of sense to me, is that this SPV is potentially a way around SEC reporting requirements for publicly-traded companies. But to me this just looks like a funky retro take on many of the IPO scams of the late nineties and early 2000s, where the investment bank sucks in herds of overstimulated investors, hides the true value of the firm in question from everyone, and then roasts the whole cattle-crowd of wealth-seekers to a crisp through fees and commissions and hidden markups. Back then the carrot was a wave of excited news-media coverage about the "new paradigm" that was going to make financial behemoths out of every online university for dogs or web-based dental floss warehouse that came up the IPO pipeline. This time around it's fantasies like the notion that Facebook is somehow worth fifty billion dollars (it's been interesting to watch which news outlets credulously report that figure).

The first thing you need to know about Goldman Sachs is that it's everywhere. The world's most powerful investment bank is a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money. In fact, the history of the recent financial crisis, which doubles as a history of the rapid decline and fall of the suddenly swindled dry American empire, reads like a Who's Who of Goldman Sachs graduates. The bank's unprecedented reach and power have enabled it to turn all of America into a giant pump-and-dump scam, manipulating whole economic sectors for years at a time, moving the dice game as this or that market collapses, and all the time gorging itself on the unseen costs that are breaking families everywhere — high gas prices, rising consumer credit rates, half-eaten pension funds, mass layoffs, future taxes to pay off bailouts. All that money that you're losing, it's going somewhere, and in both a literal and a figurative sense, Goldman Sachs is where it's going: The bank is a huge, highly sophisticated engine for converting the useful, deployed wealth of society into the least useful, most wasteful and insoluble substance on Earth — pure profit for rich individuals. They achieve this using the same playbook over and over again. The formula is relatively simple: Goldman positions itself in the middle of a speculative bubble, selling investments they know are crap. Then they hoover up vast sums from the middle and lower floors of society with the aid of a crippled and corrupt state that allows it to rewrite the rules in exchange for the relative pennies the bank throws at political patronage. Finally, when it all goes bust, leaving millions of ordinary citizens broke and starving, they begin the entire process over again, riding in to rescue us all by lending us back our own money at interest, selling themselves as men above greed, just a bunch of really smart guys keeping the wheels greased. They've been pulling this same stunt over and over since the 1920s — and now they're preparing to do it again, creating what may be the biggest and most audacious bubble yet.If you want to understand how we got into this financial crisis, you have to first understand where all the money went — and in order to understand that, you need to understand what Goldman has already gotten away with. It is a history exactly five bubbles long — including last year's strange and seemingly inexplicable spike in the price of oil. There were a lot of losers in each of those bubbles, and in the bailout that followed. But Goldman wasn't one of them.

Financial institutions that are large in absolute size may have deep and well-filled with which they can among other things hire lobbyists, support individual political parties and election candidates, and, under the recent Supreme Court reinterpretation of the U.S. Constitution's first amendment, mount advertising campaigns in direct support of or opposition to election candidates.  In Federalist Paper No. 10, James Medison warned against the political power of factions resulting from "the verious and unequal distribution of property" ... " who are united and actuated by some common impulse of passion, or of interest, adverse to the rights of other citizens, or to the permanent and aggregate interests of the community."

Here I offer only one additional strand of historical evidence ‐‐ Figure 1, drawn by artist Joseph Keppler for Puck magazine, January 23, 1889 ‐ a year before the Sherman Act was passed. 

One cannot view it without recognizing that the U.S. public was alarmed at the time about the political power of the great trusts, for which we might now substitute bloated figures for JP Morgan Chase, Bank of America, and Goldman Sachs.  It would be hard to deny that public concerns over the trusts' power in federal and state legislatures were an important stimulus to the Sherman Act's passage.   And now, 120 years later, there is abundant reason to fear the enormous political power of the financial institutions, said by one writer to own Washington "lock, stock, and barrel."   In 2008, for example, the finance lobby is said to have contributed $475 million to political candidates and their supporting party organizations ‐ more than twice the level of contributions from the second largest lobby, the health care industry.

Financial Crisis and Academic Conflict of Interest

Islam prohibits a behavior that is in conflict of one’s responsibilities. Here is an Aya from Quran and commentary. The Aya and commentary is very relevant to the subject under discussion.

And do not eat up your property among yourselves for vanities nor use it as bait for the judges with intent that ye may eat up wrongfully and knowingly a little of (other) people's property. Aya 188 of Sura Al-Baqara

Besides the three primal physical needs of man, which are apt to make him greedy, there is a fourth greed in society, the greed of wealth and property. The purpose of fasts is not completed until this fourth greed is also restrained.
Ordinarily honest men are content if they refrain from robbery, theft, or embezzlement. Two more subtle forms of the greed are mentioned here. One is where one uses one's own property for corrupting others - judges or those in authority - so as to obtain some material gain even under the cover and protection of the law.
The words translated "other people's property may also mean "public property". A still more subtle form is where we use our own property or property under our own control - "among yourselves" in the Text - for vain or frivolous uses. Under the Islamic standard this is also greed. Property carries with it its own responsibilities. If we fail to understand or fulfil them, we have not learnt the full lesson of self-denial by fasts. Commentary By Abdullah Yusuf Ali

Academicians are the forerunners of practitioners. They observe a certain phenomena and try their best to explain it so that behaviors of practitioners can be moulded accordingly for the benefit of public at large. Rules and regulations are the outcome of such observations, empirical analyses, academic debate etc.

In the wake of current financial crisis, there is a need for an unbiased analyses by the academia so that causes for such crises in the future can be controlled. But unfortunately there are some grey areas that need to be addressed like biasness for example. There are growing reports that academia was involved in the financial meltdown.

Here is an excerpt from an article

Over the last thirty years, academic economics has been penetrated by special interests, particularly financial services, in the same way that America’s political and regulatory systems have been compromised by campaign contributions and the revolving door.  In fact, the “revolving door” is now a triangular trip between industry, government, and academia.

Prominent economists are now routinely paid to testify in antitrust cases, criminal trials, and regulatory proceedings; to testify in Congress; to give speeches to the industries and firms they study; to serve on boards of directors and as advisors; and to write supposedly objective analyses of industries, companies and policies. These payments and the conflicts of interest they generate are rarely disclosed, except when required by Federal law.

These activities are not marginal; they are now, literally, a billion dollar industry, managed by firms such as the Law and Economics Consulting Group (LECG), The Analysis Group, Compass Lexecon, Charles River Associates, and others.  Professors’ income from such groups often dwarfs their academic salaries.  That neither universities nor most publications require such disclosure was one of the most shocking facts I learned while making Inside Job, my documentary on the financial crisis.

More recently, American Economic Association has recognized this moral hazard and has announced to adopt a code of ethical standards for its members. Following is an excerpt from The New York Times article on the subject.

Academic economists, particularly those active in policy debates in Washington and Wall Street, are facing greater scrutiny of their outside activities these days. Faced with a run of criticism, including a popular movie, leaders of the American Economic Association, the world’s largest professional society for economists, founded in 1885, are considering a step that most other professions took a long time ago — adopting a code of ethical standards.

The proposal, which has not been announced to the public or to the association’s 17,000 members, is partly a response to “Inside Job,” a documentary film released in October that excoriates leading academic economists for their ties to Wall Street as consultants, advisers or corporate directors.

Here is another excerpt from an article

In October, Gerald Epstein and Jessica Carrick-Hagenbarth released a paper documenting potential conflicts of interests among academic economists writing about the financial crisis and financial reform. Focusing on the Squam Lake Working Group on Financial Regulation and the Pew Economic Policy Group Financial Reform Project, they found that a majority of the economists involved had affiliations with private financial institutions, yet few of them disclosed those affiliations even in academic publications (where they do not face the word constraints imposed by print newspaper editors), preferring to identify themselves by their universities and as members of prestigious institutions such as NBER. To be fair, they did not find a strong relationship between economists’ affiliations and their positions on financial reform, perhaps because of the small sample and the limited amount of variation in the positions of members of these groups.

Following is an excerpt from a letter written by Epstein and Carrick-Hagenbarth to the president of the AEA asking for the adoption of a code that requires economists to avoid conflicts of interest and to disclose ties that could create the appearance of a conflict of interest.

More specifically we propose that the AEA adopt a code modeled on that of the American Sociological Association. This code could state that: “Economists should maintain the highest degree of integrity in their professional work and avoid conflicts of interest and the appearance of conflict. Moreover, economists should disclose relevant sources of financial support and relevant personal or professional relationships that may have the appearance or potential for a conflict of interest in public speeches and writing, as well as in academic publications.”

This issue has taken on greater salience as the recent financial crisis has highlighted economists’ potentially conflicting roles that may have affected their real or perceived impartiality as analysts and experts. For example, in an assessment of 19 economists who have played prominent and influential roles in recent public policy debates, Gerald Epstein and Jessica Carrick-Hagenbarth found that 13 out of 19 economists had private financial affiliations indicative of some possible conflicts of interest, but only 5 had clearly and publicly revealed their affiliations. A Reuters study of Congressional testimony by academics (many but not all of whom are economists) analyzed “… 96 testimonies given by 82 academics to the Senate Banking Committee and the House Financial Services Committee between late 2008 and early 2010 — as lawmakers debated the biggest overhaul of financial regulation since the 1930s.”  They found that “…roughly a third (of the academics) did not reveal their financial affiliations in their testimonies, based on a comparison of the text of their testimonies available on the Congressional committees’ websites with their resumes available online.”

From reading all the above reports, one can easily get that there is something wrong and under the existing arrangement of academia and financial industry, it is hard to accept that they will come up with some un biased analyses and reforms that are in the interest of the public at large. Unless and until the profession does not enforce transparency and code of ethical standards, ill advised policy is a real danger.

Markets can be manipulated

Here is an excerpt from an article which throws some light on the causes of bubbles in finance. Clever people take advantage of human brain flaw and succeed in creating bubbles and bubble are destined to burst, which is as sure as daylight.

Why are bubbles such a persistent feature of financial history? Economists argue that these speculative frenzies are caused in part by market failures like too much liquidity or lax regulation. Cognitive psychologists, meanwhile, see bubbles as a case of pattern recognition gone awry, as people extrapolate the past into the future. In recent years, neuroscientists also have become interested in bubbles, if only because the financial manias seem to take advantage of deep-seated human flaws; the market fails only because the brain fails first. Read Montague, at Baylor College of Medicine, has spent the last few years trying to decipher the bits of brain behind our irrational exuberance. It’s microeconomics at its most microscopic.

At first, Montague’s data confirmed the obvious: our brains crave reward. He watched as a cluster of neurons acted like greedy information processors, firing rapidly as the subjects tried to maximize their profits during the early phases of the bubble. When share prices kept going up, these brain cells poured dopamine into the caudate nucleus, which increased the subjects’ excitement and led them to pour more money into the market. The bubble was building.

But then Montague discovered something strange. As the market continued to rise, these same neurons significantly reduced their rate of firing. “It’s as if the cells were getting anxious,” Montague says. “They knew something wasn’t right.” And then, just before the bubble burst, these neurons typically stopped firing altogether. In many respects, these dopamine neurons seem to be acting like an internal thermostat, shutting off when the market starts to overheat. Unfortunately, the rest of the brain is too captivated by the profits to care: instead of heeding the warning, the brain obeys the urges of so-called higher regions, like the prefrontal cortex, which are busy coming up with all sorts of reasons that the market will never decline. In other words, our primal emotions are acting rationally, while those rational circuits are contributing to the mass irrationality.

Unfortunately this tendency is exacerbated by other people. Montague has also found, for instance, that subjects in the investment game are extremely vulnerable to what he calls “the country-club effect,” which occurs when we try to make more money than someone else. “This is what happens when you’re sitting around with your friends at the country club or watching cable TV, and everybody is talking about their huge profits,” he says. “Those conversations are going to change the way you think about risk.” Men seem especially vulnerable to this foible: When they competed against strangers, they were much more likely to get swept away by the financial speculation.

Efficient Market Hypothesis

Efficient Market Hypothesis (EMH) - An hypothesis which states that the price of a security is a reflection of all available information about it and thus represents its true value. It states also that the current price of a security is the most appropriate measure of future returns. 


But in real world there is no such thing. Investment bankers, brokers, vested interests all use all the weapons including academia to ensure that people believe in the EMH. Here is an excerpt from an article that makes the point clear.


" We already know that Lehman and other firms used fake accounting to hide liabilities and inflate assets; that lenders and securitizers frequently knew that the loans they sold and packaged were fraudulent or defective; and, of course, we also now know that Goldman Sachs and other investment banks sold securities they knew to be defective (they were often sold to pension funds for low-paid government employees, by the way) -- and that they designed many of these securities so that they could profit by betting against them after they were sold."

Another "Inside Job" Revelation

Business news followers will already be familiar with much of the film's main turf. And, of course, we all now know Alan Greenspan's heinous role in the whole mess. Even close readers may be surprised, however, at some of Ferguson's revelations. I was particularly struck by the complicity of the academic world in providing the intellectual underpinnings for the theories that led us off a cliff (for example: "It's a good idea to deregulate derivatives!")--for money. Larry Summers, Harvard's Martin Feldstein, and Columbia'sGlenn Hubbard come across as particularly culpable.

Intellectual Conflict of Interest

Here is an excerpt from an article by the director of "Inside Job" that throws some light that not all research is done objectively there may be compromises.

Over the past 30 years, the economics discipline has been systematically subverted, in much the same way as American politics - by money, especially from the financial services industry. Many of the most prominent economists in America are now paid to testify in Congress, to serve on boards of directors, testify in antitrust cases and regulatory proceedings, and to give speeches to the companies and industries they study and write about with supposed objectivity. This is not a marginal activity; it is now an industry, run by a half dozen large companies.

Some prominent academics have close ties to financial services yet neither their university employers nor the journals in which they publish require them to disclose their conflicts of interest, their financial positions, or the relationship between their financial interests and the policy positions they take.

It is time to end this. At a minimum, federal law should require public disclosure of all outside income that is in any way related to professors’ publishing and policy advocacy. It may be desirable to go even further, and to limit the total size of outside income that potentially generates conflicts of interest.

the justice is “half baked at best,”

An excerpt from Break the Banks

During the last two decades, major U.S. and European banks have paid fines to settle charges of, among other things, accounting fraud (Fannie Mae, Freddie Mac), assisting Enron’s fraud (Citigroup, J.P. Morgan), assisting people in tax evasion (UBS), using bribery to sell financial products (J.P. Morgan), money laundering (Citicorp), and fraudulently recommending stocks in exchange for business (10 investment banks in the dotcom era). In paying the fines, none of these banks acknowledged wrongdoing.

Now we’re witnessing another round of this shameful routine. President Obama and Attorney General Eric Holder Jr. have said they would hold Wall Street accountable for the crash, warning “unscrupulous executives,” in Holder’s words, that “we will investigate you, we will prosecute you, and we will incarcerate you.” But despite fraud on a scale possibly unmatched in history, the Justice Department has not charged a single executive or firm. The Securities and Exchange Commission, meanwhile, has extracted only fines from a handful of big banks. Three of the federal judges who oversaw these cases—none of which included an acknowledgment of guilt—protested from the bench, saying the fines are “not enough to deter anyone from doing anything,” the justice is “half baked at best,” and the banks are getting “a free ride.” (Holder has defended his financial-fraud task force, stressing “the totality” of its efforts, including cases against mortgage fraud and insider trading; SEC chairwoman Mary Schapiro has noted that the bulk of its investigations are “not necessarily” done.) 

Deficit Terrorists

The financial sector, which controls the money supply and can easily capture the media, cajoles the populace into compliance by selling its agenda as a “balanced budget,” “fiscal responsibility,” and saving future generations from a massive debt burden by suffering austerity measures now. Bill Mitchell, Professor of Economics at the University of New Castle in Australia, calls this “deficit terrorism.” Bank-created debt becomes more important than schools, medical care or infrastructure. Rather than “providing for the general welfare,” the purpose of government becomes to maintain the value of the investments of the government’s creditors.

England’s new coalition government has just bought into this agenda, imposing on itself the sort of fiscal austerity that the International Monetary Fund (IMF) has long imposed on Third World countries, and has more recently imposed on European countries, including Latvia, Iceland, Ireland and Greece. Where those countries were forced into compliance by their creditors, however, England has tightened the screws voluntarily, having succumbed to the argument that it must pay down its debts to maintain the market for its bonds.

Deficit hawks point ominously to Greece, which has been virtually squeezed out of the private bond market because nobody wants its bonds. Greece has been forced to borrow from the IMF and the European Monetary Union (EMU), which have imposed draconian austerity measures as conditions for the loans.

DEFICIT TERRORISTS STRIKE IN THE UK - USA NEXT?

There is only one solution to current debt based financial crisis

"In an interview with CNN's Fareed Zakaria to be aired today, G-Pap has threatened he may sue US banks for "contributing" to his country's debt crisis. For those of you lacking in analogy skills, Greece is in the same shoes as a bankrupt debtor who wants to sue his creditors for daring to hike up his interest rate when the only means he has to roll his debt is by using another credit card (this one issued by US and European Taxpayers), even as bankruptcy is literally hours away."


"Allah will deprive usury of all blessing but will give increase for deeds of charity: for He loveth not creatures ungrateful and wicked." Aya 276 of Sura Al-Baqara


"O ye who believe! fear Allah and give up what remains of your demand for usury if ye are indeed believers. If ye do it not take notice of war from Allah and his Apostle: but if ye turn back ye shall have your capital sums; deal not unjustly and ye shall not be dealt with unjustly. f the debtor is in a difficulty grant him time till it is easy for him to repay. But if ye remit if by way of charity that is best for you if ye only knew." Ayat 278 - 280 of Sura Al-Baqara

Greece Prepares To Sue Wall Street | zero hedge

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The Great American Bubble Machine - Goldman Sachs

Here is an excerpt from an article by Matt Taibbi

The First thing you need to know about Goldman Sachs is that it's every-
where. The world's most powerful investment bank is a great vampire squid
wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money. In fact, the history of the recent financial crisis, which doubles as a history of the rapid decline and fall of the suddenly swindled-dry American empire, reads like a Who'sWho of Goldman Sachs graduates.


By now, most of us know the major players. As George Bush's last Treasury secretary, former Goldman CEO Henry Paulson was the architect ofthe bailout, a suspiciously self serving plan to funnel trillions of Your Dollars to a handful of his old friends on Wall Street. Robert Rubin, Bill Clinton's former Treasury secretary, spent 26 years at Goldman before becoming chairman of Citigroup - which in turn got a $300 billion taxpayer bailout from Paulson. There's John Thain, the asshole chief of Merrill Lynch who bought an $87,000 area rug for his office as his company was imploding; a former GoIdman banker, Thain enjoyed a multibillion dollar handout from Paulson, who used billions in taxpayer funds to help Bank of America rescue Thain's sorry company. And Robert Steel, the former Goldmanite head of Wachovia,
scored himself and his fellow executives $225 million in golden parachute payments as his bank was self-destructing. There's Joshua Bolten, Bush's chief of staff during the bailout, and Mark Patterson, the current Treasury chief of staff, who was a Goldman lobbyist just a year ago, and Ed Liddy, the former Goldman director whom Paulson put in charge of bailed-out insurance giant AIG, wbich forked over $13 billion to Goldman after Liddy
came on board. The heads ofthe Canadian and Italian national banks are Goldman alums, as is the head of the World Bank, the head of the New York Stock Exchange, the last two heads of the Federal Reserve Bank of NewYork - which, incidentally, is now in charge of overseeing Goldman - not to mention ...


But then, any attempt to construct a narrative around all the former Goldmanites in influential positions quickly becomes an absurd and pointless exercise, like trying to make a list of everything. What you need to know is the big picture: If America is circling the drain, Goldman Sachs has found a way to be that drain - an extremely unfortunate loophole in the system of
Western democratic capitalism, which never foresaw that in a Society governed passively by free markets and free elections,organized greed always defeats disorganized democracy.

The bank's unprecedented reach and power have enabled it to turn all of America into a giant pump-and-dump scam, manipulating whole economic sectors for years at a time, moving the dice game as this or that market collapses, and all the time gorging itself on the unseen costs that are breaking families everywhere - high gas prices, rising consumer credit rates, half eaten pension funds, mass layoffs, future taxes to payoff bailouts. All that money that you're losing, it's going somewhere, and in both a literal and a figurative sense. Goldman Sachs is where it's going: The bank is a huge, highly sophisticated engine for converting the useful, deployed wealth of society into the least useful, most wasteful and insoluble substance on Earth - pure profit for rich individuals.


They achieve this using the same playbook over and over again. The formula is relatively simple: Goldman positions itself in the middle of a speculative bubble, selling investments they know are crap. Then they hoover up vast sums from the middle and lower floors of society with the aid of a crippled and corrupt state that allows it to rewrite the rules in exchange for the relative pennies the bank throws at political patronage. Finally, when it all goes bust, leaving millions of ordinary citizens broke and starving, they begin the entire process over again, riding in to rescue us all by lending us back our own money at interest, selling themselves as men above greed, just a bunch of really smart guys keeping the wheels greased. They've been pulling this same stunt over and over since the 1920s - and now they're preparing to do it again, creating what may be the biggest and most audacious bubble yet.


If you want to understand how we got into this financial crisis, you have to first understand where all the money went - and in order to understand that, you need to understand what Goldman has already gotten away with. It is a history exactly five bubbles long - including last year's strange and seemingly inexplicable spike in the price of oil. There were a lot of losers in each of those bubbles, and in the bailout that followed. But Goldman wasn't one of them.

High tech Financial Modeling

One of the many theories that are being put forward in relation to financial crisis of 2007 - 10 is high tech financial modeling. Here is an excerpt from an article from The Economist.

Thanks to Black-Scholes, options pricing no longer had to rely on educated guesses. Derivatives trading got a huge boost and quants poured into the industry. By 2005 they accounted for 5% of all finance jobs, against 1.2% in 1980, says Thomas Philippon of New York University—and probably a much higher proportion of pay. By 2007 finance was attracting a quarter of all graduates from the California Institute of Technology.

These eggheads are now in the dock, along with their probabilistic models. In America a congressional panel is investigating the models’ role in the crash. Wired, a publication that can hardly be accused of technophobia, has described default-probability models as “the formula that killed Wall Street”. Long-standing critics of risk-modelling, such as Nassim Nicholas Taleb, author of “The Black Swan”, and Paul Wilmott, a mathematician turned financial educator, are now hailed as seers. Models “increased risk exposure instead of limiting it”, says Mr Taleb. “They can be worse than nothing, the equivalent of a dangerous operation on a patient who would stand a better chance if left untreated.”

Modelling is not going away; indeed, number-crunchers who are devising new ways to protect investors from outlying fat-tail risks are gaining influence. Pimco, for instance, offers fat-tail hedging programmes for mutual-fund clients, using cocktails of options and other instruments. These are built on specific risk factors rather than on the broader and increasingly fluid division of assets between equities, currencies, commodities and so on. The relationships between asset classes “have become less stable”, says Mohamed El-Erian, Pimco’s chief executive. “Asset-class diversification remains desirable but is not sufficient.”


In some areas the need may be for more computing power, not less. Financial firms already spend more than any other industry on information technology (IT): some $500 billion in 2009, according to Gartner, a consultancy. Yet the quality of information filtering through to senior managers is often inadequate.

The way forward is not to reject high-tech finance but to be honest about its limitations, says Emanuel Derman, a professor at New York’s Columbia University and a former quant at Goldman Sachs. Models should be seen as metaphors that can enlighten but do not describe the world perfectly. Messrs Derman and Wilmott have drawn up a modeller’s Hippocratic oath which pledges, among other things: “I will remember that I didn’t make the world, and it doesn’t satisfy my equations,” and “I will never sacrifice reality for elegance without explaining why I have done so.” Often the problem is not complex finance but the people who practise it, says Mr Wilmott. Because of their love of puzzles, quants lean towards technically brilliant rather than sensible solutions and tend to over-engineer: “You may need a plumber but you get a professor of fluid dynamics.”

One way to deal with that problem is to self-insure. JPMorgan Chase holds $3 billion of “model-uncertainty reserves” to cover mishaps caused by quants who have been too clever by half. If you can make provisions for bad loans, why not bad maths too?

http://www.economist.com/specialreports/displaystory.cfm?story_id=15474075

All about current financial mess

In my search for the answer (s) regarding the current financial melt down, I stumbled upon a blog from Tompeters. Here is his suggestion as a starting point to see through the fog that surround the mess.

"My favorite came from the Financial Times' prize-winning reporter–editorialist Gillian Tett. Namely: Fool's Gold: How the Bold Dream of a Small Tribe at J.P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe. (Hats off to the FT in general for reporting on the crisis—my FT "take" beats my Wall Street Journal take 4 days out of every 5.) (Ms. Tett notwithstanding, I believe the best way to get your reading head around the current mess is to readMichael Lewis's 1989 classic, Liar's Poker.)

As to best book by a "finance guy," it's no contest! The gold to Vanguard Mutual Fund Group founder John Bogle for Enough. The chapter titles tell the story. Here's a sample:

"Too Much Cost, Not Enough Value"
"Too Much Speculation, Not Enough Investment"
"Too Much Complexity, Not Enough Simplicity"
"Too Much Counting, Not Enough Trust"
"Too Much Business Conduct, Not Enough Professional Conduct"
"Too Much Salesmanship, Not Enough Stewardship"
"Too Much Focus on Things, Not Enough Focus on Commitment"
"Too Many Twenty-first Century Values, Not Enough Eighteenth-Century Values"
"Too Much 'Success,' Not Enough Character"

As to the overarching theme of the book, Mr. Bogle begins with this vignette: "At a party given by a billionaire on Shelter Island, Kurt Vonnegut informs his pal, Joseph Heller, that their host, a hedge fund manager, had made more money in a single day than Heller had earned from his wildly popular novel Catch-22 over its whole history. Heller responds, 'Yes, but I have something he will never have ...
enough.'"

tompeters! management consulting leadership training development project management

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How the tax code encourages debt: newyorker.com

How the tax code encourages debt: newyorker.com

John Kenneth Galbraith wrote that all financial crises are the result of “debt that, in one fashion or another, has become dangerously out of scale.” The recent financial crisis was no exception, with everyone—homeowners, private-equity investors, our biggest banks—taking on enormous amounts of debt. If it’s frustrating that the government is footing the bill to clean up the mess, it’s even worse that the government helped pay for the debt binge that created the mess in the first place, thanks to a tax system that actually subsidizes borrowing. Debt didn’t get dangerously out of scale because the system was broken. It got out of scale, in part, because the system worked

Read more: http://www.newyorker.com/talk/financial/2009/11/23/091123ta_talk_surowiecki#ixzz0XfTASpak

Proposed Solution to Global Financial Crisis

Ellen Hodgson Brown in his book "Web of Debt - The Shocking Truth About Our Money System and How We Can Break Free" says that in a system in which money comes into existence only by borrowing at interest, the system as a whole is always short of funds, and somebody has to default.

He cites from a case law "In his court memorandum, Justice Mahoney stated:

Plaintiff admitted that it, in combination with the Federal Reserve Bank of Minneapolis, . . . did create the entire $14,000.00 in money and credit upon its own books by bookkeeping entry. That this was the consideration used to support the Note dated May 8, 1964 and the Mortgage of the same date. The money and credit first came into existence when they created it."

Startling revelation about the current banking system comes from Bernard Lietaer who helped design the single currency system (the Euro):

"[G]reed and competition are not a result of immutable human temperament . . . . [G]reed and fear of scarcity are in fact being continuously created and amplified as a direct result of the kind of money we are using. . . . [W]e can produce more than enough food to feed everybody, and there is definitely enough work for everybody in the world, but there is clearly not enough money to pay for it all. The scarcity is in our national currencies. In fact, the job of central banks is to create and maintain that currency scarcity. The direct consequence is that we have to fight with each other in order to survive."

In the 1990s, a young team at Wall Street investment bank JP Morgan pioneered a new way of making money – credit derivatives. Within a decade, the market for these exotic securities had exploded to more than $12,000bn – and some people later blamed them for fuelling the global financial fiasco. In the first of two extracts from her book, Fool’s Gold, the FT’s Gillian Tett reveals how the innovation genie was first let out of the bottle – and eventually devoured the system, to the horror of its creators.

Christina Romer says that "Also important was an accidental switch to contractionary monetary policy. In 1936 the Federal Reserve began to worry about its “exit strategy”. After several years of relatively loose monetary policy, American banks were holding large quantities of reserves in excess of their legislated requirements. Monetary policymakers feared these excess reserves would make it difficult to tighten if inflation developed or if “speculative excess” began again on Wall Street. In July 1936 the Fed’s board of governors stated that existing excess reserves could “create an injurious credit expansion” and that it had “decided to lock up” those excess reserves “as a measure of prevention”. The Fed then doubled reserve requirements in a series of steps. Unfortunately it turned out that banks, still nervous after the financial panics of the early 1930s, wanted to hold excess reserves as a cushion. When that excess was legislated away, they scrambled to replace it by reducing lending. According to a classic study of the Depression by Milton Friedman and Anna Schwartz, the resulting monetary contraction was a central cause of the 1937-38 recession."

Ben Funnell proposed " What can be done? First, although it is not ideal, we should not be too hasty about abandoning the capitalist model. It is less bad than any other system yet invented. But we should redouble our efforts to increase productivity through innovation and creating new markets; simply squeezing lower-income workers is a bad option, which helped get us into this mess in the first place. This requires investment in education and research. Second, we have to learn to live within our means. This means spending less than we earn, perhaps doing without the BMWs, flat-screen television sets and leather sofas. Third, we should be careful in distributing the higher tax burden that we will inevitably have to bear over the coming decade. Very high marginal tax rates did not work in the 1970s and will not work now. That said, income disparity at current levels is a political time-bomb that needs to be dealt with. Finally, we should all come to terms with the fact that these are structural issues needing structural solutions; they need to be enforced over a longer time period than any one government’s term. So we need a new political consensus, one aimed at reducing overall debt levels while reducing inequality by encouraging education, entrepreneurship and investment in innovation."

Nassim Nicholas Taleb offers "No socialisation of losses and privatisation of gains. Whatever may need to be bailed out should be nationalised; whatever does not need a bail-out should be free, small and risk-bearing. We have managed to combine the worst of capitalism and socialism. In France in the 1980s, the socialists took over the banks. In the US in the 2000s, the banks took over the government. This is surreal."

"Do not give an addict more drugs if he has withdrawal pains. Using leverage to cure the problems of too much leverage is not homeopathy, it is denial. The debt crisis is not a temporary problem, it is a structural one. We need rehab."

George Soros say that since markets are bubble-prone, regulators must accept responsibility for preventing bubbles from growing too big.

Quran offers "Allah has laid His curse on usury and blessed charity to prosper. Allah does not love any ungrateful sinner. " 2:276 "O You who believe! Fear Allah and waive what is still due to you from usury if you are indeed believers;" 2:278 "or war shall be declared against you by Allah and His Rasool. If you repent, you may retain your principal, causing no loss to
debtor and suffering no loss. " 2:279 "If the debtor is in a difficulty, grant him time till it is easy for him to repay; but if you waive the sum by way of charity it will be better for you, if you understand it. " 2:280