Book Notes

From the Cosmos to Strings: Parallels of Economics to Physics

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The first macroeconomic model of the U.S. economy consisted of 20 boxes of punched cards at 2000 cards per box that I would wheel on a dolly stacked five feet high to the main frame computer center where it took about three days to get results back.

Mathematics is the language of physics. Graduating with a BS in mathematics in the 1960’s, I faced a choice between my two minors, physics or economics. Some famous physicists had already declared that the quest for a unified mathematical explanation of the cosmos and its smallest building blocks was at hand. In economics, the attempt to build a mathematical macro model of the U.S. economy and fully integrate it with the micro economic mathematical models of human behavior represented a new frontier. I chose economics.

In retrospect, physicists are still searching for a Grand Unified Theory (GUT) of the universe. In economics, mathematics and statistics have widened the disagreement about how the economy works and the proper role of government in economic management.

God and Physics: from Aristotle to Hawking

Aristotle (382-324 BC) described the cosmos of round bodies in motion circling around the earth. It took almost two millennia until the sun-centric Copernican model was popularized by Galileo, who was imprisoned by the Pope, the political enforcer of orthodoxy at the time, in 1633 for heresy, forcing him to recant. But only a half century later, Newton described the mechanics of the universe and sun-centric solar system in Principia Mathematica (1687), which remains the cornerstone of basic physics.

In Newtonian physics, motion and speed are calculated relative to what you are moving away from. Maxwell’s discovery in the mid-1800’s that the speed of light was “absolute” required an explanation that stumped many physicists until the young patent office clerk Albert Einstein, unaware of these efforts, provided the novel Special Theory of Relativity (1905) that if light speed was constant space and time must be relative.

His mathematical model proved over time to provide a more precise description of the movement of heavenly bodies, but the implication of his equations that the universe was expanding violated his belief in a master plan of a “creator,” so he inserted a mathematical cosmological constant (what economic model builders would subsequently call a “dummy variable”) to stagnate it. But other physicists confirmed his original model, which in reverse required a mathematical ”singularity” – a beginning of time with a “big bang” from an infinitely small spec. The Catholic Church approved this model in 1952 as consistent with its orthodox views of a creator.

In 1970 Stephen Hawking proved that the big bang theory was the only one consistent with the existing models of the universe, but he later challenged those models. First, the violent path of destruction and creation over billions of years subsequent to the big bang that ultimately produced the building blocks of life was a “million to one shot”- is ours just one of millions of universes? Second, macro models of the universe broke down at the mathematical singularity, which remains inconsistent with micro models of the very small – in my youth molecules then atoms made up of protons, neutrons and electrons, now subatomic “quarks” and more recently sub-quark vibrating strings.

The scientific method is a slog: to understand the universe, the models must not only be tested empirically but compared to all the potential alternative explanations. Pre-conceived orthodox ideology has at times set the investigation back centuries.

The Progressive Orthodoxy of Mathematical Models in Economics

Macro economics, the desire to understand and control the workings of the economy at large, developed in response to the Great Depression. The roots of the mathematical approach to economic management trace to the founding of the Econometrics Society in 1930. John Maynard Keynes published his General Theory of Employment, Interest and Money in 1935, the title invoking the universality and finality of Einstein’s General Theory of Relativity published two decades prior.

Paul Samuelson’s Foundations of Economic Analysis (1947) provided a mathematical model of micro economic consumer and business behavior. I was a regular reader of Samuelson’s Newsweek columns in high school and used his undergraduate economics text at UMass, where I worked on the first macro economic model of the U.S. economy developed at the University of Pennsylvania by Samuelson’s first PhD student Lawrence Klein.

As a student of former Federal Reserve Board economist Pat Hendershott, I worked on the first Flow of Funds model of the U.S. financial sector. The main frame computer at Purdue University would run the punch cards of a professor’s research overnight, a big improvement. Such macro economic models are “Keynesian” central government centric by design: fiscal and monetary policies are modeled to control the economy, mitigating recessions and unemployment.

But other models haven’t been ruled out. In The Forgotten Depression (2014) James Grant argues that the Depression of 1921 there was no official designating body at the time following the end of the Great War cured itself in 18 months due to official benign neglect. In Grant’s view (and many others, including economists living through it) what made the subsequent Depression “Great” was massive political intervention that prevented the required adjustments.

While the merits and long term effectiveness of “small scale” and “counter-cyclical” measures remain debatable, the merits of the socialist centrally planned economies are not: hundreds of millions died and the remainder suffered economic stagnation while the capitalist world prospered. Only self described democratic socialist Bernie Sanders openly touts the performance of the centrally planned economies, but there isn’t much difference in the government centric policy approach of progressive politicians.

This macro narrative is generally consistent with anti-capitalist progressive ideology of business, workers and consumers dating back to Marx that is accepted by the majority of more recent college graduates. Economic statistical research across a wide spectrum from discrimination and labor exploitation to income inequality and market failure is offered in support, albeit inconsistent with a competitive market system. The competitiveness of the U.S. economy implies that correlation is too often assumed to imply causation without rigorously considering alternative explanations.

Creative Destruction Produces Economic Expansion

Humans owe their very existence to the massive creative destruction of the Cosmos (whether or not by the grace of God) for we are all made from the dust of exploding stars. In the economic sphere, virtually all human economic progress is attributable to capitalist competition and creative destruction, favoring the adaptive over the sluggish. Mathematical models haven’t adequately described entrepreneurial innovation. Progressive intervention to mitigate downside risk of creative destruction, broadly or to specific political constituencies, is highly correlated with stagnation.

Historically, even natural disasters including pandemics such as the corona virus (I assume it was “natural”) have provided opportunities for creative destruction. Consider, for example, the requirement that university students study online during the pandemic. While traditional colleges aren’t yet offering rebates, we know from experience that without the room, board and administrative costs and with increased productivity of fewer professors, online degrees can be provided for as little as one tenth the cost of the traditional approach.

Progressive proposals for taxpayers to foot the entire bill for the high cost model may be called democratic socialism but are indistinguishable from democratic crony capitalism for the political elite.

Kevin Villani

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Kevin Villani was chief economist at Freddie Mac from 1982 to 1985. He has held senior government positions, has been affiliated with nine universities, and served as CFO and director of several companies. He recently published Occupy Pennsylvania Avenue on how politicians and bureaucrats with no skin in the game caused the sub-prime lending bubble and systemic financial system failure.

Book Review: The Year of the French (St Patrick’s day rerun)

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The Year of the French, by Thomas Flanagan

(This being St Patrick’s day, I’m again taking advantage of the hook to re-post this review, in the hope of inspiring a few more people to read this incredibly fine historical novel)

Ralph Peters calls this book “the finest historical novel written in English, at least in the twentieth century,” going on to say “except for ‘The Leopard,’ I know of no historical novel that so richly and convincingly captures the ambience of a bygone world.”

In August of 1798, the French revolutionary government landed 1000 troops in County Mayo to support indigenous Irish rebels, with the objective of overthrowing British rule in Ireland.  The Year of the French  tells the (fictionalized but fact-based) story of these events from the viewpoint of several characters, representing different groups in the complex and strife-ridden Irish social structure of the time.

Owen MacCarthy  is a schoolmaster and poet who writes in the Gaelic tradition.  He is pressed by illiterate locals to write a threatening letter to a landlord who has evicted tenants while switching land from farming to cattle-raising.  With his dark vision of how an attempt at rebellion must end“In Caslebar.  They will load you in carts with your wrists tied behind you and take you down to Castlebar and try you there and hang you there”MacCarthy is reluctant to get involved, but he writes the letter.

Sam Cooper, the recipient of the letter, is a small-scale landlord, and captain of the local militia.  Indigenously Irish, his family converted to Protestantism several generations ago to avoid the crippling social and economic disabilities imposed on Catholics. Cooper’s wife, Kate, herself still Catholic, is a beautiful and utterly ruthless woman…she advises Cooper to respond to the letter by rounding up “a few of the likeliest rogues,”  jailing and flogging them, without any concern for actual guilt or innocence. “My God, what a creature you are for a woman,”  Cooper responds. “It is a man you should have been born.”  “A strange creature that would make me in your bed,” Kate fires back, “It is a woman I am, and fine cause you have to know it…What matters now is who has the land and who will keep it.”

Ferdy O’Donnell   is a young hillside farmer on Cooper’s land.  Far back in the past, the land was owned by the O’Donnell family…Ferdy had once shown Cooper  “a valueless curiosity, a parchment that recorded the fact in faded ink the colour of old, dried blood.”

Arthur Vincent Broome  is a Protestant clergyman who is not thrilled by the “wild and dismal region” to which he has been assigned, but who performs his duties as best he can. Broome is resolved to eschew religious bigotry, but…”I affirm most sincerely that distinctions which rest upon creed mean little to me, and yet I confess that my compassion for their misery is mingled with an abhorrence of their alien ways…they live and thrive in mud and squalour…their music, for all that antiquarians and fanatics can find to say in its flavor, is wild and savage…they combine a grave and gentle courtesy with a murderous violence that erupts without warning…”’

Malcolm Elliott  is a Protestant landlord and solicitor, and a member of the Society of United Irishmen.  This was a revolutionary group with Enlightenment ideals, dedicated to bringing Catholics and Protestants together in the cause of overthrowing British rule and establishing an Irish Republic.  His wife, Judith, is an Englishwoman with romantic ideas about Ireland.

John Moore, also a United Irishman, is a member of one of the few Catholic families that have managed to hold on to their land.  He is in love with Ellen Treacy, daughter of another prominent Catholic family: she returns his love, but believes that he is caught in a web of words that can only lead to disaster.  “One of these days you will say a loose word to some fellow and he will get on his horse and ride off to Westport to lay an information with Dennis Browne, and that will be the last seen of you”

Dennis Browne  is High Sheriff of Mayo…smooth, manipulative, and devoted to the interests of the very largest landowners in the county, such as his brother Lord Altamont and the mysterious Lord Glenthorne, the “Big Lord” who owns vast landholdings and an immense house which he has never visited.

Randall MacDonnell  is a Catholic landowner with a decrepit farm and house, devoted primarily to his horses.  His motivations for joining the rebellion are quite different from those of the idealistic United Irishman…”For a hundred years of more, those Protestant bastards have been the cocks of the walk, strutting around on acres that belong by rights to the Irish…there are men still living who remember when a son could grab his father’s land by turning Protestant.”

Jean Joseph Humbert  is the commander of the French forces.  A former dealer in animal skins, he owes his position in life to the revolution.  He is a talented commander, but  the battle he is most concerned about is the battle for status and supremacy between himself and  Napoleon Bonaparte.

Charles Cornwallis, the general who surrendered to the Americans at Yorktown, is now in charge of defeating the French and the rebels and pacifying the rebellious areas of Ireland.   Seen through the eyes of  a young aide who admires him greatly, Cornwallis is portrayed as a basically kindly man who can be hard when he thinks it necessary, but takes no pleasure in it.  “The color of war had long since bleached from his thoughts, and it remained for him only a duty to be scrupulously performed.”

This book is largely about the way in which the past lives on in the present, both in the world of physical objects and the world of social relationships.  Two characters who make a brief appearance are Richard Manning, proprietor of a decrepit and debt-laden castle, and his companion Ellen Kirwan:  

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Ask Not …

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… whom the woke-mob bays for; it bayeth for thee… to paraphrase John Dunne. As no less than Woody Allan may testify at this point, as the article linked here outlines. So the woke mob claims another scalp; yay, wokesters of New York City Mainstream Publishing Division! Take a bow, having thrown a glorious temper tantrum and bent your employer to your will! Today, Woody Allen tomorrow? Who knows?! N.K. Jemison, a notoriously woke science fiction writer and beneficiary of the current system, weighed in on behalf of the mob, which is … not a good look for someone dealing in speculative fiction. She is supposed to possess some talent, but again encouraging the mob, even joining in not something which a thoughtful person with a sense of events and historical recall ought to do. But never mind.

Frankly, as far as I am concerned the mainstream publishing establishment, which is centered in New York (as if that wasn’t sufficient punishment) may ride off into the sunset any time now. Words like “incestuous” and “culturally-blind” come to mind, as well as “arrogant” and “exploitative.”

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Flashy Himself – A Literary Diversion

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So it took a link on Powerline last week to bring to my attention that George McDonald Fraser’s first Flashman book came out fifty years ago.

My, I don’t know how the time flies but it does. I must have read the first couple of Flashy’s adventures sometime in college, shortly thereafter, and being quite the history nerd even then, they were rowdy enough, and amusing enough that I read most of the rest of them when they came out, even if I had to order them from an English book catalog when I was stationed overseas. I do remember very well reading The General Danced at Dawn, in the back of one of my more boring lecture classes at CSUN and nearly self-strangulating in trying to not laugh uproariously out loud. The professor lecturer would not have been amused he was a medieval history expert with a thoroughly tedious interest in the most comprehensively boring of early dark age church confabulations and absent any detectable sense of humor.

My main regret as far as the Flashman series goes is that GMF never wrote of Flashy’s adventures in our own Civil War, which sounded from references in other books, as if Flashman conducted himself in the manner which we came to expect of him that is, purely and basely devoted to the preservation of his own skin, while dodging, lying, fornicating and back-stabbing on battlefields spread across three continents, as well as hob-nobbing socially or sexually with all sorts of likely participants. As one early reviewer put it, Flashy saw 19th century history briefly over his shoulder as he fled down the corridors of power at high speed. His adventures in our very own Civil War would have been … interesting, although when I touched on this matter before, a reader pointed out that a) Flashy was a British officer and hardly gave a toss as to what we recalcitrant ex-Colonials got up to, and that b) that all our native ACW experts, amateur and professional alike would have made passionate objection to any error or omission, fancied or with historical backing that GMF might have worked into the plot. So, the effort wouldn’t have been worth the candle to him … although I and most of his fans would have loved to read it anyway. Just to see the process by how Flashy got suckered into participation by Abraham Lincoln, fought on both sides, and wound up being pals with George Armstrong Custer and well-acquainted with General Grant, and how many other Civil War notables.

I myself would have loved to see Flashy entangled in some kind of partnership with Elizabeth Van Lew, the Richmond spy queen, or perhaps a much deeper entanglement with Allan Pinkerton, of the national detective agency … it all would have been great reading, no matter how contentious the fallout might have been with Civil War historians. His take on Robert E. Lee and other Confederate generals would have been interesting, as well. Because GMF had the eye, an absolute gift for writing 19th century dialog, and loved history enough to go into the deep weeds about it all … and most of all, make it interesting to the reader. Pop media is not downhill from culture, it’s in a symbiotic relationship with it. One shapes the other, mutually.

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Democratic Presidential Candidates Debate the Origins of the 2008 Financial Crisis and Systemic Failure

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Are greedy racist “Wall Street” bank lenders responsible, or progressive politicians?

The housing finance systems of some developed countries have failed, but only the U.S. federally dominated system failed systemically twice in two decades, the second time in 2008 with global repercussions. Then Republican Mayor of New York now 2020 Democratic presidential candidate Michael Bloomberg blamed politicians for pushing lenders to make loans to “poor people” in low income neighborhoods that they couldn’t afford. 2020 progressive Democratic presidential candidate Warren, apparently reflecting the views of the Party, responded to Bloomberg: “That crisis would not have been averted if the banks had been able to be bigger racists.”  

The Dodd-Frank Wall Street Reform and Consumer Protection Act passed in 2010 creating Warren’s proposed Consumer Financial Protection Bureau and the Financial Stability Oversight Council (FSOC) to Monitor and Mitigate Systemic Risk made up of the various financial regulators reflects the Warren/Democratic narrative. This narrative is the foundation of not just housing and financial sector policy proposals, but the entire progressive agenda.

I’m from the federal government and I’m here to help you.

That’s the punch line to the joke about the three biggest lies Pres Martin used to tell about a half century ago as past Chairman of the Federal Home Loan Bank Board (FHLBB) (hence Freddie Mac’s first Chairman) and Vice Chairman of the Federal Reserve System.

The first wave of “help” came after the repeated waves of bank failures with the creation of the Federal Reserve System in 1913. The second wave came during the Great Depression with deposit insurance and associated regulation of the banking and savings and loan industries. This was followed by the creation of FHA mortgage insurance: to stimulate FHA demand, Fannie Mae was created make a market for which there were few buyers or sellers. By the late 60’s, rather than end a failed experiment Fannie Mae was “privatized” and the public monopoly was subsequently expanded to a tri-poly with the addition of Freddie Mac and Ginnie Mae, all funding fixed rate mortgages (FRMs) first introduced by FHA. As Milton Friedman famously said, “there is nothing so permanent as a temporary government program.”

It didn’t help potential borrowers much. The resulting federally dominated U.S. Housing Finance System had been touted as the best in the world, a model to emulate for developed, developing and transitioning economies alike during the three decades prior to the 2004-2007 sub-prime mortgage lending debacle and globally systemic financial crisis of 2008. But the benefits are hard to identify: the U.S. homeownership rate is about the same as in the mid 1960’s under the prior savings and loan system in spite of a 50% increase in female labor force participation, a historically low real interest rate and a dramatic shift from detached single family to condo apartments.

Civil rights legislation culminating in the Fair Housing Act of 1968 made racial discrimination in home sales a federal crime. The black homeownership rate which rose more than that for whites during the 2004-2007 sub-prime lending spree has returned to about where it was during the 1960’s.

Market Discipline versus Public Regulation

It didn’t help existing lenders much either. In the 1970’s federally sponsored agencies competed directly with federally chartered savings and loans whose investments were limited by regulators hamstrung by politicians to FRMs, forcing them to borrow short and lend long with callable insured deposits. Systemic failure was assured when interest rates rose as they did in the late 1970’s, with failures strung out over the 1980’s as regulators seized but often didn’t close zombie institutions, often run by academics.

Systemic risk, the simultaneous failure of many or all firms (and households) in an industry or across industries, primarily afflicts mixed progressive financial systems, i.e., those with privately owned but publicly regulated financial institutions. Firms in an un-or-less regulated market economy may be fragile but “Wall Street” traders mitigate systemic risk by betting against weak firms and industries, either forcing corrective action or failure hence the derogatory political reference to “speculators.” At the other extreme, state owned financial firms generally fail financially but face only a political bankruptcy constraint.

Two types of progressive policies created systemic risk. First those intended to mitigate the failure of individual firms with public insurance and prudential regulation, making failure less frequent but more systemic. Regulators prevent commercial bank failures purportedly to protect public confidence in the payments mechanism. Second are those policies intended to universally favor borrowers and/or creditors – like requiring mortgages to have a fixed rate – making systemic failure more likely and more costly.

Underwriting Mortgage Credit Risk: Discrimination and “Disparate Impact”

With the exception of the Great Depression and 2008 financial crisis, home mortgage credit losses had been “Gaussian (normally distributed),” that is, they followed a predictable pattern that allowed them to be insured according to the law of large numbers, for all practical purposes eliminating uncertainty, hence risk.

Loan data during the sub-prime lending debacle unambiguously supports Bloomberg as minority lending skyrocketed. Progressives imputed racist motives to excessive minority lending, arguing that “predatory” lenders “tricked” minorities into accepting loans they couldn’t afford so they could later foreclose. There is some truth to the first part, as banks solicited minority borrowers with loans they had to know were risky. But they had little incentive to foreclose, as that always resulted in a deep loss. What did motivate lenders?

Homeownership was no more affordable for black households during the 2004-2007 sub-prime lending bubble than it was in the 1960’s for a variety of reasons. But current Democratic presidential candidate Deval Patrick argued in 1994 as Deputy Attorney General of the Department of Justice that any final lending distribution that contained racial disparities—disparate impact—relative to population was a violation of federal law unless the lender could prove otherwise. Such “proof” of non-discrimination would be difficult to produce at best, since the disparity itself was considered proof of racial prejudice, and the cost of a legal defense is generally crippling. This was called “confiscation by consent decree” at the time and later “extortion by consent decree” for which Gaussian credit risk models didn’t apply.

Avoiding Black Swans

Former trader now internationally recognized risk expert – Nicholas Nassim Taleb describes in his 2007 book The Black Swan “how high impact but rare events dominate history, how we retrospectively give ourselves the illusion of understanding them thanks to narratives, how they are impossible to estimate scientifically, how this makes some areas but not others totally unpredictable and unforecastable, how confirmatory methods of knowledge don’t work, and how thanks to Black Swan-blind “faux experts” we are prone to building systems increasingly fragile to extreme events.”

Was the 2008 systemic failure an unpredictable Black Swan event? Politicians and their regulators who push the “Wall Street greed” narrative argued that nobody could have foreseen it, but Taleb exempts only economist Nouriel Roubini Crisis Economics (2010) from that delusion, who (pg. 16) concludes “it was probable. It was even predictable…” based on the failure of prudential regulation. But how did that fail? Systemic failure had long been predicted (by me and others, including the Federal Reserve) based on the progressive policies that attributed illegal racial discrimination motives to traditional income and appraisal underwriting.

No Skin in the Game

The sub-prime lending bubble of 1995 through 1998 financed with opaque securities issued by independent finance companies that following SEC rules reported phantom profits burst with no systemic consequences. By 2000 many of these former sub-prime lenders and securitization practices had migrated to the federally insured commercial banks in part to finance Community Reinvestment Act (CRA) lending commitments. These increased 500 fold after the deregulation of interstate Banking in 1994 when discretionary regulatory permission for M&A activity was held hostage to a favorable public CRA Report. Pushed by regulators and pulled by the big potential M&A payoff, borrower down payment requirements were virtually eliminated and bank “regulatory arbitrage” minimized capital requirements, virtually eliminating any Skin in the Game (Taleb, 2018). This asymmetric “trade” was irresistible.

The Perfect Storm

The Big Short by Michael Lewis presents the progressive narrative of “greedy” speculators who were shorting the housing market but doesn’t explain why they failed to prevent the bubble from inflating to systemic proportions by bankrupting lenders. The reason is that the cheap Federal Reserve credit continued to be channeled to the housing bubble by Fannie and Freddie. Historically conservative, they were now led by politically anointed CEO’s who, facing no bankruptcy constraint, willingly followed the path to perdition. This path was paved by HUD’s “Mission Regulator” who not only ratcheted up the lending goals well beyond prudent limits but in 2005 imposed a new goal that they maintain a 50% market share with these private lenders. Propped up by the federal government, all the big players were going for broke simultaneously.

This was guaranteed to fail. Financial institutions reported several trillion dollars (pgs. 157-158) of home mortgage credit losses after the bubble burst and 10 million homeowners lost their homes over the next six years in spite of massive government efforts to avoid or delay foreclosure. Like the lending bubble, the foreclosure bubble was much bigger for minorities. Yet The Financial Crisis Inquiry Commission Democrat Majority Report (2010) spun the narrative that the systemic “risk” was due mainly to traditional liquidity concerns.

I’m from the federal government and I’m here to blame you.

That’s no joke. During the Obama Administration Patrick, then Governor of Massachusetts led the multi-state suit against lenders alleging discrimination in foreclosures based on disparate impact. At the same time, current DNC Chairman Tom Perez was pursuing “disparate impact” cases against lenders under the Fair Housing Act as Attorney General Eric Holder’s Deputy.

In a 2009 Financial Times editorial Taleb proposed ten principles to avoid a repeat of 2008:

What is fragile should break early, while it’s still small.

No socialization of losses and privatization of gains.

People who were driving a school bus blindfolded (and crashed it) should never be given a new bus.

Don’t let somebody making an incentive bonus manage a nuclear plant or your financial risks.

Compensate complexity with simplicity.

Do not give children dynamite sticks, even if they come with a warning label.

Only Ponzi schemes should depend on confidence. Governments should never need to “restore confidence.”

Do not give an addict more drugs if he has withdrawal pains.

Citizens should not depend on financial assets as a repository of value, and should not rely on fallible “expert” advice for their retirement.

Make an omelet with the broken eggs.

All good advice, all ignored by politicians and regulators who created the Rube Goldberg dystopia they rail against.

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Kevin Villani

Kevin Villani was Chief Economist at Freddie Mac from 1982 to 1985 and HUD from 1979-1982. He has been affiliated with nine universities, and served as CFO and director of several companies. He recently published Occupy Pennsylvania Avenue on the political origins of the sub-prime lending bubble and aftermath.