Category: economic failures

Top 4 assumptions that cause market failures

Many articles have been written (including my blog post) and much ink has been spent on this topic. Let’s now have a cursory look at the history of modern finance, which will help explaining how modern finance works, hence how the regular market crashes/failures (by the way, have a look at an excellent round-up economic history of finance and market failures by John Cassidy; also check out the article about the three recent Nobels for explaining market failure from an unemplyment perspective) happen.

You might or you might not know, but the modern financial theory is built upon a legacy of a son of a French wine merchant and diplomat,  Louis Bachelier. His doctoral advisor was Henri Poincaré, one of the most celebrated and influential mathematicians of all time. The defense of his 68-page thesis, “Théorie de la Spéculation,” took place in March 1900 and was about trading of government bonds on Paris exchange. In his thesis, he laid the foundations of financial theory, and more generally, for all theories of probabilistic change in continuous timeframe. The cornerstone of his thesis was to explain how the prices change.

Bachelier died unknown as his thesis was respectfully discarded in the annals of French academia and only by accident discovered in 1963 by Eugene Fama, the creator of Efficient Market Hypothesis, the foundation of the orthodox financial theory. What he proposed – and the his proponents Markowitz, Sharpe, Black and Scholes elaborated on – was a coin-tossing model of finance. He assumptions can be formulated as follows:

  1. People are rational (if this were true, there would be no science of behavioural economics)
  2. All investors are/think alike (ignoring different types of investors)
  3. Price changes are practically continuous (of course prices jump in a discontinous manner – almost every day, NYSE reports “imbalances” due to exogenous changes)
  4. Price changes follow Brownian motion (Bachelier proposed to use Fourrier formula of heat spreading to describe how bond prices change)

A little further elaboration on point #4. Bachelier’s adaption of Brownian motion had three critical implications: independence (prices last day/week/month have do not influence prices today); statistical stationarity (prices change in the same manner in the past/present/future); normal distribution (price changes follow Gauss’ bell-curve). The third implication, which underpins almost every tool of modern finance,  is the one most obviously contradicted by the facts.

Ever since rediscovery, utilisation and expansion of his theory in 1960s, Bachelier’s ideas found their way into virtually every aspect of modern financial theories. Capital Asset Pricing Model (one study suggested that about 75% of financial managers/CFOs use it to estimate cost of capital), Modern Portfolio Theory (the most widepsread method of selecting investments) and Black-Scholes formula (for valuing options contracts and assessing risk) are the three pillars of modern orthodox finance theory. All three are part of every MBA curriculum and are translations of Bachelier’s ideas into practical tools.

The above (wrong, or in the best case, narrowly applicable) assumptions being at the core of every modern financial tool, it is clear why markets failed and will continue to fail, unless a radically new approach, a paradigm shift takes place in the financial market. This tectonic shift has already started taking place…

The recent rise and (possible) fall of gold and e-gold

In 1944 at UN currency and finance conference at Breton-Woods, which aimed to redress the shattered post-war world economy, the economists have agreed that any monetary unit in the world should be backed with gold. But this resurrected gold-standard system ended in 1973 (with hugely devalued dollar) and has declared special drawing rights (SDR) in International Monetary Fund (IMF) –  SDR as world money. SDR became an international accounting unit with US dollar kept as the important currency. No one then thought to come back to any gold backed currency again. Money re-established itself again as a commodity.

Ever since,  investors known as gold bugs snapped up the metal and socked it away, betting that a colossal economic crisis would one day slam financial markets and send gold prices through the roof.

For many investors, that grim scenario is in full swing, except for one thing. After briefly hitting $1,000 an ounce, gold has fallen into a rut and shows no sign of budging anytime soon. Gold’s failure to flourish despite broad financial carnage has disappointed many of its champions. Others say it’s simply in a lull and is ripe for another big surge. But most gold buyers agree that the metal’s lackluster performance lately has been surprising.

So what happened? As the financial crisis pummels financial markets around the globe, hedge funds and other large investors who drove gold to dizzying heights earlier this year are now racing to unwind those positions to raise cash and cover huge losses. The massive deleveraging has pounded other commodities from crude oil to corn to copper.

“Gold is being pulled down by indiscriminate selling of virtually every asset,” says Jeffrey Nichols, managing director of American Precious Metals Advisors. “You could call it collateral damage.”

Instead of gold, investors are pouring money into the newest safe-haven asset, cash, pushing the dollar to multiyear highs against the Euro and the pound, hurting demand for gold among investors who buy the metal as a safe haven against inflation. Economists now warn that a world economic slowdown could bring about massive deflation of the world’s main currencies, or a sustained period of falling prices, and it’s unclear how the metal will respond in long-term. However there is some evidence that gold prices reached a turning point, a threshold, which may turn around its recent decline.

“Gold hasn’t been tested in a true deflationary crisis, so we don’t know what will happen to prices,” says Jon Nadler, precious metals analyst with Kitco Bullion Dealers Montreal.

In paralell, since 1996, another milestone event twisted the “gold vs. money” story even further. With advent of the Internet in 1994, online communication, business and information sharing has been exponentially gaining ground. Year 1996 saw birth of E-gold. The idea was simple. People would eventually believe in electronic money and use it more willingly if the money was provided/backed with gold. The funds on account of E-gold system convert in this metal by default. The payment system also provides an opportunity to back money on the account by other precious metals, such as silver, platinum and a palladium.

The history of e-gold payment system development is only twelve years old, however the company has already passed a way from conceptual idea of payment system to world service governed by American company Gold and Silver Reserve, Inc. Its one day turnover around $1500000. Such popularity is caused by the fact that in case of becoming an e-gold system user, a physical or legal person has an opportunity to perform an effective financial operations and calculations, because after funds transfer a simple redistribution of the rights to precious metal occurs while its physical location does not change. According to Gold and Silver Reserve, Inc. the e-gold gold reserves are in Brink’s Global Services, Transguard Security Services and MAT Securitas Express AG storehouses. It’s interesting to note that e-gold system isn’t tied to any currency and works with eternally liquid metals. This allows anyone to open an account free of charge. This democratic approach attracts to e-gold about 2500 accounts every day. As of July 2008, e-gold claims to host more than 5 million accounts. However, e-gold not only proved to be a favorite target of hacker attacks, but in December 2005, the US government froze its bank accounts and assets (cancelling freezing measures due to absence of inculpatory evidence one month later) and in July 2008 its directors pled guilty to charges of “conspiracy to engage in money laundering” and the “operation of an unlicensed money transmitting business.”

Nonetheless, there are optimists who are “confident that a regulated e-gold rebuilt to a more systematic specification will be less hospitable to criminals, and more attractive to mainstream business use without being less accessible to those disregarded by legacy payment systems.“

Transformation of Smith and his message

“Adam Smith, the father of modern economics”, pleaded for leaving all economic activities to be regulated by market forces without any restraint from state or any other organized group. He believed, “the invisible hand” would coordinate them and run them without any violent ups and downs.”

This paragraph or one along the same lines is leveled at those who question wisdom and efficiency of so-called free markets associated with the name of Adam Smith, father of modern economics, who originally propounded the idea in his Wealth of Nation. However, many proponents of the theory seem to have either very scarce idea of the original context and intended message of Smith’s work or a specific aim to befit it to an agenda fitting their narrow socio-political and economic aspirations. Below (with few additional links) is an elaboration on misconceptions arising from a paragraph above.

Errors:

1 “Adam Smith, the father of modern economics” – a cliché of lazy economists who have not read Smith’s works and confuse quotations attributed to him with modern economics – a sub-branch of applied mathematics – that ignores people and reduces complex behaviours to only one (so-called self interest), it being easier to manipulate mathematical functions, and erects an entirely false image of Smith (the ‘Chicago’ Smith) in contrast to the real Smith (the ‘Kirkcaldy’ Smith). Smith’s legacy, with few exceptions, is at variance with what is said in his name.

2 “…pleaded for leaving all economic activities to be regulated by market forces without any restraint from state or any other organized group.”

It was not in Smith’s style to ‘plead’ for or against any particular policy. The Wealth of Nations was a report of his 12-year ‘inquiry in the nature and causes of the wealth of nations’. It was not a manifesto in support of a change in the way society was run. He pointed out the consequences of running it the way governments tended to legislate.

He was not an anarchist or libertarian, as any number of modern libertarians will tell you (see Murray Rothbard for a particularly bad tempered denunciation of Adam Smith for his manifest failings to descend to the temper of a fanatic about how society works). He accepted certain stabilising aspects of ‘modern’ 18th century society. He did not believe it was practical to change everything before you could change anything. He dealt with the world as it was by contrasting it with the way it could be; change the causes and you changed the consequences, but nothing would change if everything had to change simultaneously. The fanatic – ‘the man of system’, he called him – was ‘very wise in his own conceit’, which describes Rothbard’s polemical style accurately.

Smith was not against state intervention. Justice was administered by the judiciary, an arm of the state, and was essential to individual freedom. Defence was the ‘first duty of government’. Markets were a preferred choice where they worked; he was not against state-funded activities and he left the decision on whether they were administered by state commissioners or private contractors to a pragmatic test: which worked most efficiently, not to an ideological test for or against the decision.

Smith was not a laissez-faire philosopher; he never used the word, yet was familiar with its concepts and with its exponents among the Physiocrats. He did not believe that ‘merchants and manufacturers’ could be free of ‘all restraints’ on their behaviours – most rapidly turned into ‘monopolists’ when left alone. That did not mean he favoured state intervention, unrestrained by laws of justice.

4 “He believed, “the invisible hand” would coordinate them [‘market forces’] and run them without any violent ups and downs.”

…The so-called invisible hand was a lone metaphor he used once in Wealth of Nations (and once in Moral Sentiments), and in neither case was he talking about markets. That is a conflation from Chicago trained economists. He was talking of the unintended consequences of individual motivations. He also wrote of many counter examples where the outcomes of individual actions had malign, not benign, consequences.

The power of Smithian markets is not based on something outside them (visible or invisible) ‘co-ordinating’ them. That is precisely his point about the relationship between ‘natural’ and ‘market’ prices – markets are self-regulating and their workings are well understood. Nobody designed markets, nor ordered them into existence, nor foresaw their utility. They evolved socially over many millennia from the ‘necessary consequence of the faculties of reason and speech’ (long before markets took monetary forms). What Mishra means by ‘violent ups and downs’ is not clear, but markets can move ‘violently’ on occasion dues to external events – Smith’s example is of the dramatic rise in the price of black cloth when there is a general mourning in the UK (presumably white cloth in some countries).

Furtheron, Paul Volcker, the former Fed chairman, recently admitted that while re-reading the “Wealth of Nations” he “had just come across a curious section in the text. Smith was discussing the threat that large Scottish banks posed to the public; given how intertwined they were with the rest of the economy, the shock waves from the failure of any large bank would be devastating. His solution? Have a lot of smaller banks, so one bank’s failure could never bring down the entire economy.” He contrasted this idea with the ongoing policy in America whereby smaller banks (including Wall Street ones) are/were bought by bigger ones (Merrill Lynch acquired by Bank of America, for example) in order to to secure their survival, sustain financial markets and restore confidence in the banking sector.

One has to wonder whether the long-term benefits of having few big banks instead of numerous middle and small will not have a reverse course as predicted by Adam Smith and as witnessed during the recent financial crisis.

Paulson mistakes and chapter 11

A brief but illuminating summary of recent blunders of Henry Paulson, an expert on the Great Depression.

Treasury Secretary Henry Paulson made some disastrous decisions that had major unintended consequences.

One of those was the decision to nationalize Fannie Mae and Freddie Mac. Once the government took over Fannie Mae and Freddie Mac, supposedly preemptively, shareholders of every other financial company that perhaps needed capital were left with no choice but to sell aggressively, fearing the government might decide to preemptively wipe them out also. This made it impossible for any company to raise the capital it needed or wanted.

About a week later Lehman Brothers filed for bankruptcy, Merrill Lynch was forced to sell to Bank of America, and AIG was extended a huge government loan, all completely or nearly wiping out shareholders.

Then Paulson forced nine major banks to receive capital infusions from treasury, effectively partly nationalizing them, and creating a huge American Sovereign Wealth fund.

The above referenced nationalizations created a bizarre situation where the government contended that financial institutions needed more capital, and that it should be private capital that will solve the problem. But the government also indicated that it stands ready to provide additional assistance in the future, thus destroying the equity stakes of those prospective capital providers. Why would private capital invest, if it believes it is the policy of the government to later intervene and dilute it?

Enter the pernicious crash of October-November 2008.

The smartest CEO, John Thain of Merrill, understood the new landscape before anyone else and quickly sold at the then still available price, albeit a fraction of his company’s value at its peak. In doing that he saved Merrill from the ignominious fate it was inevitably headed towards, the same fate that awaited Lehman Brothers.

And by letting Lehman Fail, the counterparty risk was unleashed on the economy of the world, as Lehman was involved in thousands of trades all over the globe and was much bigger than Bear Stearns. That brought to the forefront the systemic risk that is now looming above us like a dark cloud. All of a sudden even money market funds were losing principal. Secured bond holders are losing money (unlike the creditors of Bear Stearns, Fannie and Freddie, who emerged whole). Nobody knew who could be trusted, and short term credit markets ceased to function, severely impairing the economy further.I believe Secretary Paulson’s policies aggravated the crisis. At the moment, Citigroup and JP Morgan are struggling; locked out of the market for private capital and their shares are in free fall. Despite major capital infusions, most financial stocks are down sharply. The nine institutions that received the first cash infusion from Washington have seen their shares fall more than 40% since then. Goldman Sachs last week was trading at a value less than just the amount of money it raised recently. So many financial institutions are failing, making the federal government their built-in savior and enervating the Fed’s resources with their insatiable demand for fresh cash.All this is making it palpably clear that the Treasury’s policy did nothing to build confidence or stabilize the markets. The sickening, precipitous drop of the equity markets in October and November are the market’s judgment on the merit of Treasury’s policies.

Here is the original article from the Huffington Post.

He accepted his errors by saying, “We’re not proud of all the mistakes that were made by many different people, different parties, failures of our regulatory system, failures of market discipline that got us here.” His solution was then and now to “buy bad assets and the administration has allocated $US100 billion for that portion of the program,” referring to the $700 billion bailout program.

His approach however looks more like a band-aid, which will postpone but by no means prevent a near certainly future problems in the financial markets. As one shrewd expert admits, “The government cannot repeal the law of gravity and stop markets from falling. Nor can it turn back the clock to reverse our financial blunders.”

The currently prevalent and rather dogmatic approach of avoiding filing for the Chapter 11 is mostly due to a misconception. It is commonly thought that a company or an organization filing for the bankruptcy (immediately) ceases its activities and (virtually) its existence. This is wrong. Usually the causes (especially in high-tech cases) to file for Chapter 11 include overwhelming debt, defensive maneuver against temporary legal liabilities and need for reducing labor problems. For the duration of being under the Chapter 11 protection, the company/organization continuous its operations. The difference mainly comes in guise of added supervision and control. The debtor usually remains in possession of the company’s assets, and operates the businesses under the supervision and control of the court and for the benefit of creditors. The debtor in possession is a fiduciary for the creditors. The objective and desired result of the Chapter 11 protection is make the company cut costs, re-orient itself and streamline in resources in efficient manner in order to return to profitability. Although admittedly the rate of successful Chapter 11 reorganizations is low (estimated at 10% or less), it is still a better solution, and is not only considered by small and medium but by large multinational corporations such as GM (which follows the same path of peering into the public money instead of doing an internal restructuring, refocusing and cost cutting as was done to save IBM in a similar case in 1993). In addition to other benefits, for the GM case, Marketing expert Seth Godin goes to the extreme of proposing, “Use the bankruptcy to wipe out the hated, legacy marketing portion of the industry: the dealers.” And then adding, “We’d end up with a rational number of “car stores” in every city that sold lots of brands. We’d have super cheap cars and super efficient cars and super weird cars. There’d be an orgy of innovation, and from that, a whole new energy and approach would evolve.” I agree.

Companies coming out of the Chapter 11 (usually few years after the initial filing) are leaner, healthier and better positioned. The most famous case in point is WorldCom.

One way or another, financial policies so far espoused by the US Treasury and Fed not only come short of calming markets and inducing confidence in money-needing banks, but also continue wasting tons of taxpayer dollars, imposing a heavy financial burden on younger generations.

From the second hot war into Cold War

May 1945. The WW2 was over.

The shattered financial and industrial worlds were given band-aid remedies in guise of Bretton-Woods (giving birth to IBRD, World Bank and IMF). Soon enough, few new states emerged (Israel), few split apart (India and Pakistan) and in few, liberal discontents led the way eventually winding up with democratic governments (Egypt).

One socialist regime, based on narrow-minded dogmatic doctrines, emerged from WW2 as one of the two strongest nations in the world. This nation had not only a large conventional military base, but was also in the middle of developing its own nuclear weapons (first tested in 1949).

The other victor of WW2 became a superpower not least due to the war itself. It advocated neatly idealistic doctrines, had a constitution spelling out loud the commitment to highest social and moral values, respect for human dignity and equality and adherence to human rights and law.

The first General Assembly of the United Nations met in London in January 1946, and created the United Nations Atomic Energy Commission. Part of their charge was to eliminate all weapons of mass destruction, including the atomic bomb.

America’s first effort to define a policy on the control of atomic energy was Acheson-Lilienthal report (1946). Its premise was that there should be an international “Atomic Development Authority” which would have worldwide monopoly over the control of “dangerous elements” of the entire spectrum of atomic energy. Drawing heavily on the information in the report, the US proposal (July 1, 1946) to the United Nations on international controls on nuclear material (named the Baruch Plan) was presented. It called for the establishment of an international authority to control potentially dangerous atomic activities, license all other atomic activities, and carry out inspections.

The Soviets rejected the Baruch Plan, since it would have left America with a decisive nuclear superiority until the details of the Plan could be worked out and would have stopped the Soviet nuclear program. They responded by calling for universal nuclear disarmament. In the end, the UN adopted neither proposal. Seventeen days after Baruch presented his plan to the UN, the US conducted the world’s first postwar nuclear test. Two atomic tests – code named “Operation Crossroads” – were conducted at Bikini Atoll in the Pacific. These tests explored the effects of airborne and underwater nuclear explosions on ships, equipment, and material. Almost 100 surplus and captured ships were used as targets, including the Japanese battleship Nagato (flagship of the attack on Pearl Harbor). These tests were witnessed by hundreds of politicians and international observers, and 42,000 military and scientific personnel. The two bombs used in Crossroads were identical in design and yield to the bomb used on Nagasaki. Crossroads put pressure on Soviets to pour significant amounts of money into research and development of their nuclear arsenal.

This is how the Cold War started. It had two main axes, which were usually typified by one or some of following doublets:

USSR took on the challenge and a nuclear arms race, which became the determinant factor during the next 50 years, ensued. Nuclear race was followed and paralleled by development of strategic triad by Americans. This race got a new spatial dimension, when Soviets launched the Sputnik into orbit on Oct. 4, 1957. John F. Kennedy, despite his short tenure as American president, made few speeches, which resulted in creation of, among others, Peace Corps, and first (American) landing on the moon. As  crucial ideological battle against oppression, McCarthyism became a prominent movement, a sort of a “witch hunt” for communists and communist sympathizers inside America.

As Marx’s tenets had instructed, communism did not stay home; it had be to spread worldwide to achieve utopia. Some countries had adopted communism to help realize that goal, including Warsaw Pact nations, Yugoslavia (1945 – 1992), DPRK (1954 – present), Yemen (1969 – 1990), Somalia (1969 – 1991), Cambodia (1975 -1989). The communist governments in all of these countries (except DPRK) collapsed right around the same time as the Soviet Union. Communism also rose to power in the nations, where it is still alive today, such as China (since 1949), Cuba (since 1959), Vietnam (since 1976), and Laos (since 1975).

The tension between America and the Soviet Union wasn’t just restricted to technological and economic races. Few full-fledged crisis erupted during the Cold War, including the Korean War (1950 – 1953), Vietnam War (1959 – 1975), the Bay of Pigs (1961) Invasion and the Cuban Missile Crisis (1962).

Then Gorbachev came in 1985 with his Perestroika (reconstruction). At that time, all means of production were state-controlled, a fact which discouraged the initiative and innovation. The Soviet system was not adaptable by itself and perestroika was therefore doomed from the start. Gorbachev did not have the political capacity to push the desired reforms through (one of the most significant being Law on Cooperatives). His half-hearted efforts eventually triggered the collapse of the Soviet Union, which was completely unexpected.
The political system, like the economy, rested on a foundation of lies. Political leaders from cities and regions fabricated domestic and foreign policy statistics, using propaganda, including the newspaper “Pravda.” This newspaper later became a symbol of hype about Soviet productivity. In 1991, the Soviet Union officially came to an end (under Yeltsin elected a year before) and split into republics.

When the Soviet Union dissolved, it led to a domino effect of communist nations collapsing.

Cold War was over as well.

Failed states in 2008

The Fund for Peace is an independent nonprofit research and educational organization founded in 1957 by investment banker Randolph Compton. Since its inception, it aimed at prevention of conflicts and alleviation of causes of conflicts. Due to its historic role and analysis conducted in socio-economic, political and demographic fields, the Fund came up with the idea of evaluating countries based on indicators such as demographic pressures, economic development, and deterioration of environment, among others. From 2005 co-operating with Foreign Policy magazine, the Fund publishes its annual “Failed States Index” that provides results of analysing a large set of factors causing/contributing for a state to fail or become weak. While generally a good starting point of information for decision-makers, few criticize the notion of “a failed state” because its frequent references to countries considered a threat to the US government.

The index provides assessment only for sovereign states (determined by membership in the United Nations). Territories such as Taiwan, the Palestinian Territories, and Northern Cyprus are not figuring on the list until their political status and UN membership is ratified. Ranking is measured based on 12 indicators, which are divided into three categories: social, economic and political. For each indicator, the ratings are placed on a scale of 0 to 10, with 0 being the lowest (most stable) and 10 being the highest (least stable). The total score is the sum of the 12 indicators and is on a scale of 0 (least failed) to 120 (most failed).

Social Indicators

I-1. Mounting Demographic Pressures
I-2. Massive Movement of Refugees or Internally Displaced Persons creating Complex Humanitarian Emergencies
I-3. Legacy of Vengeance-Seeking Group Grievance or Group Paranoia
I-4. Chronic and Sustained Human Flight

Economic Indicators
I-5. Uneven Economic Development along Group Lines
I-6. Sharp and/or Severe Economic Decline

Political Indicators
I-7. Criminalization and/or Delegitimization of the State
I-8. Progressive Deterioration of Public Services
I-9. Suspension or Arbitrary Application of the Rule of Law and Widespread Violation of Human Rights
I-10. Security Apparatus Operates as a “State Within a State”
I-11. Rise of Factionalized Elites

I-12. Intervention of Other States or External Political Actors

In the words of the people from Foreign Policy:

Because it is crucial to closely monitor weak states—their progress, their deterioration, and their ability to withstand challenges—the Fund for Peace, an independent research organization, and FOREIGN POLICY present the fourth annual Failed States Index. Using 12 social, economic, political, and military indicators, we ranked 177 states in order of their vulnerability to violent internal conflict and societal deterioration. To do so, we examined more than 30,000 publicly available sources, collected from May to December 2007, to form the basis of the index’s scores. The 60 most vulnerable states are listed in the rankings, and the full results are available at ForeignPolicy.com and fundforpeace.org.

According to this year’s Index, Somalia is the number one failed state in the world while Norway is the most prosperous. Moreover, seven out of the ten most failed states in the world are from Africa (only exception being Afghanistan, Pakistan and Iraq). There are currently 35 failed states (marked in red) of which 19 are African.

The report claims Somalia is the most failed state in the world. Many researchers believe that Somalia is a collapsed state since the collapse of its national government in 1991. Somalia scored a record amount of points this year: 114.2 (out of maximum possible 120), which is also the closest a state got to complete failure since the Failed States Index was first published. The country report shows that none of Somalia’s indicators improved since the last year’s index.

Due to ongoing crisis in financial markets, Iceland (172nd on the 2008 list), considered one of the least failed or best countries in the world (the best country to live according to the UN Development Index 2007) turned in a matter of few weeks (mainly due to its almost exclusive economic reliance on the global financial markets) into a state on the verge of national bankruptcy.

Iceland is a glaring example of how “well” globalization works its magic in the modern era of interconnectedness and interdependence.

The greatest economic failure of 20th century

The Great Depression has central place in twentieth century economic history. All other depressions and recessions are from an aggregate perspective little more than ripples on the tide of ongoing economic growth. The Great Depression cast the survival of the economic system, and the political order, into serious doubt. A serious recession in modern times would be when gross domestic product (GDP) falls by 3% or 4% over two years. Between 1929 and 1932 America’s GDP fell by 30%.

Winston Churchill was on a visit to New York in 1929 on one of the worst days for share prices. Churchill was surprised not to see more frenzy among the brokers until he was told that rules prevented them from running, shouting or gesticulating. Churchill did witness something, though, that has become part of the grim history of the era: a man jumping to his death from a nearby hotel window.

Three days — Black Thursday, Black Monday, and Black Tuesday — come to to describe this collapse of stock values. The initial crash occurred on Black Thursday (October 24, 1929), but it was the catastrophic downturn of Black Monday and Tuesday (October 28 and 29, 1929) that precipitated widespread panic and the onset of unprecedented and long-lasting consequences for the US. The unemployment rate rose above 25%, with little social protection for the victims. Workers were idle because firms would not hire them to work their machines; firms would not hire workers to work machines because they saw no market for goods; and there was no market for goods because workers had no incomes to spend. Furthermore, the drought that occurred in the Mississippi Valley in 1930 was of such proportions that many people in the region became unable to pay taxes or other debts and had to sell their farms for no profit to themselves.

The crash followed a speculative boom of the American economy that had taken hold in the late 1920s, which had led hundreds of thousands of Americans to invest heavily in the stock market (in the period of 1923-1929 corporate profits rose 62%, dividends rose 65% and the average output per worker increased 32% in manufacturing), a significant number even borrowing money to buy more stock. The Roaring Twenties, as this period came to be known, was a time of prosperity and excess, and despite warnings against speculation, many believed that the market could sustain high price levels. The rising stock prices encouraged more people to invest; people hoped the stock prices would rise further. Speculation thus fueled further rises and created an economic bubble (at the market peak in September 1929 about 40% of stock market values were pure speculation). Shortly before the crash, Irving Fisher proclaimed, “Stock prices have reached what looks like a permanently high plateau.”

The euphoria and financial gains of the great bull market were shattered on Black Thursday, when share prices on the NYSE collapsed. Panic selling started. More than 12 million shares were traded in a single day as people desperately tried to mitigate the situation. This mass sale is often considered a major contributing factor to the Great Depression. The market lost $14 billion in value on that day. Some 9,000 banks, accounting for nearly half of America’s banking capital, failed in less than a year later.

The first instinct of governments and central banks faced with this crisis was to do nothing. Businessmen, economists, and politicians (Secretary of the Treasury Mellon who said ‘Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate’) expected the recession of 1929-1930 to be self-limiting. They expected workers with idle hands and capitalists with idle machines to try to undersell their still at-work peers. Prices would fall. When prices fell enough, entrepreneurs would gamble that even with slack demand production would be profitable at the new, lower wages. Production would then resume. Except that this scenario never materialized. Stock prices fell on Black Thursday and they continued to fall, at an unprecedented rate for a full month, bringing the entire economy to its knees.

When politicians and businessmen finally decided to act, their actions plunged the country into a longer, self-sustainable crisis. They reacted by introducing protectionist policies such as the passage of the Smoot-Hawley Tariff Act (raising import tariffs – in average by 60% – on more than 20,000 items and causing protectionist policies in the rest of the world in retaliation) through the Congress (purportedly resulting from Republican policies in 1928), causing more harm than the crash itself.

In 1931, the Pecora Commission was established by the Senate to study the causes of the crash. The Congress passed the Glass-Steagall Act in 1933, which mandated a separation between commercial banks and investment banks. After the experience of the 1929 crash, stock markets around the world instituted measures to temporarily suspend trading in the event of rapid declines, claiming that they would prevent such panic sales.

There is no fully satisfactory explanation of why the Depression happened when it did. The causes of the Depression are still actively debated among economists due to lack of consensus in describing the causal relationship between various events and the role of government economic policy in inducing or preventing the Depression. Milton Friedman and Anna Schwartz argued that the Depression was the consequence of an incredible sequence of blunders in monetary policy. Another popular theory is that the Depression was caused when investors became fearful of their stocks as markets expanded some focus to Europe, which still had nations that were economically damaged from WWI (war-induced inflation, brief recession in 1920 and 1921, chronic overproduction of food and resulting low prices, nationalistic selfishness).

China: change of policy in 15th century

The Greek name for the Chinese was Seres, from which the Latin word serica derives, meaning silk.

China has always viewed itself as being at the centre of its world, traditionally. The modern word for the country, Zhong guo (Central Realm), seems to say it all.

Writing materials such as rolls of silk came from the 2nd century BC, and paper from the 2nd century AD (Cai Lun, 105AD). Printing too was a Chinese invention: fixed blocks were cut to print whole pages (Feng Dao, 932AD), and movable type was introduced from the 11th century AD (Bi Sheng, 1041AD). China was the first to establish the enduring institution of public service examination (founded under Sui Dynasty, 605, till its abolition in 1905).

Additionally, Chinese advances in iron and steel manufacture were several hundred years ahead of Europe. Coal was being mined from 8th century and used in furnaces producing high quality iron and steel. Chinese are also credited for inventions of saddle and stirrup (5th century), compass (possibly 20-100AD), gunpowder (Taoist monks in search of “elixir for immortality,” 9th century) and porcelain (under Tang Dynasty, 7th century).

Maritime inventions credited to Chinese also include the anchor, the drop-keel, the capstan, canvas and pivoting sails.

By medieval times, China became the most intellectually sophisticated and technologically advanced country in the world.

Then came the year 1405 under the Ming dynasty (1368-1644).  Fleets of hundreds of immense Chinese ships  (28,000 people sailing on 300 ships. It was a fleet whose size and grandeur would not be matched until World War I) headed by admiral Zheng He traversed from the China Sea past Sumatra to Ceylon, India, Arabia and East Africa. Seven epic Chinese naval expeditions from 1405 to 1433 explored and brought under the Chinese tributary system the vast periphery of the Indian Ocean. However, less than a century after this Chinese maritime high water mark, it was a crime to even go to sea from China in a multi-masted ship.

The economic motive for these huge ventures may have been important, and many of the ships had large private cabins for merchants. But the chief aim was probably political, to enroll further states as tributaries and mark the reemergence of the Chinese Empire following nearly a century of barbarian rule. The political character of Zheng He’s voyages indicates the primacy of the political elites. Despite their formidable and unprecedented strength, Zheng He’s voyages, unlike European voyages of exploration later in the fifteenth century, were not intended to extend Chinese sovereignty overseas. The question therefore begs how could such a policy (containing enormous potential for growth and prosperity), started in 1405, come to an abrupt halt and reversal by 1433.

There is no definite answer to that question. However, few possible explanations were postulated.

  1. Political power struggle between two factions of the Chinese Imperial court (between the Confucian courtiers and the palace eunuchs), combined with an overwhelming demand for political centralization and unity.
  2. There was an Imperial decree to decommission decision the great navy over the whole of China, reasoning behind such a decision possibly that renovation turned into stagnation, and that science and philosophy were caught in a tight net of traditions smothering any attempt to venture something new. This decision became irreversible due to the loss of shipyards capable of turning out ships that would prove the folly of that temporary decision.
  3. There was an internal Chinese court policy struggle between competing theories of the commercial and technology benefits of foreign trade, against the benefits in social purity of isolationism. Isolationism won.
  4. The navy had become dependent in the 15th century on a meager set of maritime missions that were overly fragile and thus the Chinese navy was vulnerable to relatively minor changes in the strategic situation. The completion of the Grand Canal as a more efficient and safer means of grain transport became an important factor, which engendered the demise of the Chinese ocean-going navy.
  5. Maritime threats (piracy) were always considered secondary in China to continental or land-based threats, and thus in difficult economic and political times (threat to revival of Mongol power on the northern steppe) during the Ming period, the maritime solutions to national security (navy) lost resources to the continental solutions (army).

Perhaps several factors separately or their combination caused a Chinese rejection of sea trade and seapower in the mid-15th century. We can never know for certain.

What we do know is that traditional ethnocentric and culturally well-cultivated Chinese were ever so anticipative. It is no secret that a following maxim has been a byword of not only Chinese warfare but also other strategic maneuvers throughout the ages.

“Steal the beams, change the pillars” (from  “36 Strategems”).

China is on rise again. Let us see how far it will go this time.

No Industrial Revolution in Ancient Greece?

One of the oldest and hardest puzzles in economic history is the failure of Ancient Greek Eastern Mediterranean civilization to make some kind of breakthrough to more rapid development of labor-saving technology, to faster technological progress, and to an industrial revolution. There have always been three theories as to why this did not happen:

  • The “insufficient density” theory–not enough thinkers, not enough tinkerers, not enough ability to shape metal finely and precisely for the set of those interested in scientific progress and technological development to reach critical mass.
  • The “lack of a market economy” theory: those who would have sought wealth and power through entrepreneurship and enterprise in a modern market economy instead, because trade was small in volume and under the thumb of politics, went into the army or into politics. This misallocation of talent stalled human progress.
  • Fuzzier explanations based on the role of slavery in classical civilization and on the elective anti-affinity between the existence of slavery on the one hand and elite interest in boosting productivity on the other.

In 2002, there appeared an article in the Economist shedding light on Greek metalworking prowess and interest in astronomical models. According to the article, few corroded lumps — the last remnants of an elaborate mechanical device – were extracted by accident by a Greek sponge diver in 1900. The Antikythera mechanism, as it is now known, was an astronomical computer capable of predicting the positions of the sun and moon in the zodiac on any given date according to Yale scientist Derek Price. Price believed that the mechanism was strongly suggestive of an ancient Greek tradition of complex mechanical technology which, transmitted via the Arab world, formed the basis of European clockmaking techniques. This fits with another, smaller device that was acquired in 1983 by the Science Museum, which models the motions of the sun and moon. Dating from the sixth century AD, it provides a previously missing link between the Antikythera mechanism and later Islamic calendar computers, such as the 13th century example at the Museum of the History of Science in Oxford. That device, in turn, uses techniques described in a manuscript written by al-Biruni, an Arab astronomer, around 1000AD.

The origins of much modern technology, from railway engines to robots, can be traced back to the elaborate mechanical toys, or automata, that flourished in the 18th century. Those toys, in turn, grew out of the craft of clockmaking. And that craft, like so many other aspects of the modern world, seems to have roots that can be traced right back to ancient Greece.

Therefore the evidence chips away somewhat at first theory.

The Greek word oikonomia (οἰκονομία) designates mainly the oikos (οἶκος), meaning the home or hearth. Xenophon’s dialogue Oeconomicus is concerned with household management and agriculture. The Greeks had no precise term to designate the processes of production and exchange and no word describing or being equivalent of market-based economy.

However as famous American historian Murray Rothbard pointed out, Xenophon outlined the important concept of general equilibrium as a dynamic tendency of the economy by stating that when there are too many coppersmiths, copper becomes cheap and the smiths go bankrupt and turn to other activities, as would happen in agriculture or any other industry. He also saw clearly that an increase in the supply of a commodity causes a fall in its price. These thoughts correspond to the collective wisdom of modern market economy, chipping away on the second theory. There are other sources arguing the power of the market mentality attained in Ancient Greece.

There is no countering the third theory – not from my side at least!