learning in progress ….

In 2003, Iceland’s three biggest banks had assets of only a few billion dollars, about 100 percent of its gross domestic product. Over the next three and a half years they grew to over $140 billion and were so much greater than Iceland’s G.D.P. that it made no sense to calculate the percentage of it they accounted for. It was, as one economist put it to me, “the most rapid expansion of a banking system in the history of mankind.”

Which begs the question, how can banks grow so rapidly, without reference to underlying activity?

i guess in a global world they reference some-one's elses activity; nevertheless such an imbalance between GDP and asset sheet seems to defy the common sense notion of what banking is for.

This imbalance seems, in slightly less skewed proportions, but which still don’t add up, to be affecting the whole world.

in 2006, the measured economic output of the entire world was worth around $48.6 trillion. ... The total value of domestic and international bonds was $67.9 trillion, 40 percent larger. Planet Finance was beginning to dwarf Planet Earth.
 (Niall Ferguson)

i can't see how that can be. Even if global GDP was somehow all in bonds, how could the bonds exceed total GDP? Something must be wrong when the paper assets are greater than all of the goods and services they can possibly represent?  I guess bonds don't have to be tied to the yearly timeline that is implied by GDP, but still, to a rank neophyte in high finance, since bonds are only one way to 'raise capital', the fact that it alone is bigger than GDP seems out of whack?

Another naive question - How can financial system float so far free from the underlying idea of buying and selling goods and services so that we hear that the financial crisis is now hurting the ‘real economy’.  What is the ‘real economy?’ contrasted to when this phrase is used? to the financial markets?  and if so what do they buy and sell?

Back to the window on the icelanders..

They inhabited their remote island for 1,100 years without so much as dabbling in leveraged buyouts, hostile takeovers, derivatives trading, or even small-scale financial fraud. When, in 2003, they sat down at the same table with Goldman Sachs and Morgan Stanley, they had only the roughest idea of what an investment banker did and how he behaved—most of it gleaned from young Icelanders’ experiences at various American business schools. And so what they did with money probably says as much about the American soul, circa 2003, as it does about Icelanders. They understood instantly, for instance, that finance had less to do with productive enterprise than trading bits of paper among themselves.

I like the idea of free markets as the exchange of money for goods and services in a way that leaves both feeling improved by the transaction  - the Adam Smith idea- i can appreciate that (although he used examples like buying bread) ...and the extension of ‘service’ to all sorts of management and financial services,  in principle, i understand that as well, seems like a good and reasonable thing.

I also get the idea of a farmer using a futures contract to lock in a price for his harvest 6 months down the track, and thus deal with the risk. 

But beyond some moderate role in risk mitigation, how can trading in this futures market actually generate new wealth that correlates to anything in the 'real economy'? At some point, it starts to look like speculating on what the price of something else might do, and spreading your bets accordingly. Which is ok - but the correlation to gambling doesn't suggest it actually creates anything?

Even when  option pricing works, surely there comes a point where the huge derivative market must be a burden on real productivity; can all those transactions grow any more bananas, or make any more software...  what underlying good or service corresponds to profit here?

[Ignoring the fact that even when it seems to work, the idea of correctly pricing options, hedging risk, has already lead to an earlier fiasco of massive investment companies needing government bail outs, lest their collapse take the system down with it ...apparently the Black Scholes pricing equation, was only referenced against a limited bell curve based on only 5 years of reasonably good data ... and so its assumptions couldn’t factor in the risk of the wild events the market is historically subject to...hence an earlier mid 90s bail out for the investment company that pioneered its use and got the system into serious hot water when one of those events occured.]

i guess while all markets are trending up, though, nobody questions it, and for that matter i didn't mind a modest slice of the housing bubble, even though i don't understand where that really came from either ...the market kept moving even when demand and supply hadn't changed ... where does a years wages of relatively sudden appreciation really come from?

i’ve wondered at times how much of what happens in many corporate financial towers can be translated to a good or service? That is, minus the glossy surface and complex acronyms, what translates to increased production of any sort, anywhere, in the 'real economy'?  Who pays for the wealth here? At some level its trading ownership, or shares, of real companies, i guess, and no doubt planning investment, and centralising  HR etc... but the profits involved in some of these 'services' can seem dispoportionate, speculative, to the production of anything. Trading on currency markets, for example, with computers wired to respond in fractions of a second - seems so detached from the canonical examples of buyers and sellers feeling improved by the exchange of a good or service for money - it stretches the colourful idea of 'market' into such an attenuated place, that maybe the mutual satisfaction idea stops working.  Some one still ends up happy, i guess, and maybe paid ridiculous bonuses for venturing here; but is it just compensation for playing with pools of money and betting on numbers, with no good or service in sight?

Similarly while its no doubt clever and innovative to aggregate mortgages - even those that should never have been issued -  and turn the aggregates into various complex securities, get them rated AAA, trade them, and their derivatives , around the world, on basis of the rating ... evidently that innovation and rating turns out to be not that well thought out..

back to the Iceland window...where one person spoke of his transition from fishing – where it took a long apprenticeship to become captain of fishing boat - to being a financial wizard.

It took years of training for him to become a captain, and even then it happened only by a stroke of luck. When he was 23 and a first mate, the captain of his fishing boat up and quit. The boat owner went looking for a replacement and found an older fellow....  “I took two trips with this guy,” Stefan says. “I have never in my life slept so little, because I was so eager to learn. I slept two or three hours a night because I was sitting beside him, talking to him. I gave him all the respect in the world—it’s difficult to describe all he taught me. The reach of the trawler. The most efficient angle of the net. How do you act on the sea. If you have a bad day, what do you do? If you’re fishing at this depth, what do you do? If it’s not working, do you move in depth or space? In the end it’s just so much feel. In this time I learned infinitely more than I learned in school. Because how do you learn to fish in school?”

This marvelous training was as fresh in his mind as if he’d received it yesterday, and the thought of it makes his eyes mist.

“You spent seven years learning every little nuance of the fishing trade before you were granted the gift of learning from this great captain?” I ask.

“Yes.”

“And even then you had to sit at the feet of this great master for many months before you felt as if you knew what you were doing?”
“Yes.”
“Then why did you think you could become a banker and speculate in financial markets, without a day of training?”
....

“I started as a … “—now he begins to laugh—“an adviser to companies on currency risk hedging. But given my aggressive nature I went more and more into plain speculative trading.”

and the punchline

“I think it is easier to take someone in the fishing industry and teach him about currency trading,” he says, “than to take someone from the banking industry and teach them how to fish.”

Now maybe Iceland is so exposed exactly because of this naiveté ...but i have a deep suspicion that on a lesser scale, that something of this short term aggressive guesswork, not always as skilled as a tradeperson with their tools, although wearing nicer suits, runs through a lot of the financial sector.

The fact that fund managers for example, apparently typically perform only marginally better - or on par  - with dart board stock picks, and get paid well anyway– investing other peoples money on a rising tide...

or maybe its my teacher background that struggles with some of this

high school teachers and hedge fund managers tend to have roughly similar levels of education actually, but the highest paid hedge fund manager in America was paid enough last year to pay the salaries of all 80,000 New York school teachers for five years (1)

i can’t see how the mismatch can be explained by productivity ...the market doesn’t price what teachers (or many other jobs) really contribute over the long term (i used to tell students we should tax them on future earnings) ...and nobody is really that much more productive, not by orders of magnitude – surely at core its just that lot of other people’s money is aggregated and they pick which way the market might lurch ... and backed by teams of smart analysts looking for info and with sophisticated tools, they might even get it right more often than the dart board.

I’m sure they’re dedicated and all that....but not thousands of time more than good music teachers or child care workers or nurses

this is not really meant as a deep critique of capitalism – the dynamism and creativity, incentive and opportunity of the market seems to be vitalising agent and has the best comparative track record – and i find i like some of the pro-active aspects of the business world - but i’m not sure that the creation of a virtual economy with its 'hypertrophic growth' of derivatives - makes any sense – and if i was of a Marxist bent, i could see a case for complaining against those who, rather than owning cotton mills, seem to have the system leaning their way in ways that may not actually be related to real productivity (at least not their own)  ...  it was a bank director who noted that the best way to rob a bank is to own one ...

by contrast, Bill Gates as the wealthiest individual i can appreciate ... even if he rode a fortunate wave, at least there is a real product  in there – and whatever its failings, at least real products are being developed and sold and used - thats the model i like and get -(and now Gates seems to be strategically giving it all away he might be remembered in the end for wiping out malaria, rather than creating windows )

(or take macs and ipods for another take on the same principle) ...or Google, though i don't quite get their business model yet ...but all these are paying reward for innovation and risk and creativity and boldness .. thats what i do like in the model of capitalism... just that its very imperfect in practice ... doesn't always reward or price these contributions in various sectors correctly ...maybe the assumption that people act rationally based on clear understanding of a complete set of information is the flaw in the real world

lastly, Niall Ferguson's thoughts on a Jubilee like approach to debt cancellation are interesting...
from a naive point of view that sort of restructure might make more sense than budgeting enormous amounts of extra debt.