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  #1 (permalink)
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In the 1987 film “House Of Games”, written and directed by David Mamet, Lindsey Crouse 1/2questions-1/2 states to Joe Mantegna “a sucker is born every minute”, to which Mantegna replies, “and two to take him.” This exchange sets the stage for what is arguably one of the best films ever made about con men and deception, and also one of the most compelling movies about the unpredictability of human nature.

Drawn into Mantegna’s game, Crouse and the movie's viewers, become unwitting victims of Mantegna's deceit and deception, all the while thinking they are in on the game, only to find that inside every con is another one. What the viewer soon realizes, is there is an eternal gulf between the shark and the mark, between the con man and his victim. And there is a code to protect the secrets.

Not unlike the characters and viewers of Mamet’s movie, the American people have been victims of a very complex shell game perpetrated and perpetuated by the the banking system for many years. The chief ruse of this confidence game was convincing us to mis-allocate and over- leverage the majority of our personal wealth into homes we could not afford. They convinced us home prices never went down and always went up. And that the equity we "built up" in our homes would always provide us with a ready source of capital, and a long term retirement asset.

Unfortunately house prices like other assets in their giant Ponzi scheme, were artificially inflated as a result of the Fed keeping interest rates artificially low. The Fed continues to keeps interest rates artificially low by rigging the credit market. Continuing to rig the credit market without destroying stock prices means the Fed now has to artificially inflate stock prices by funding the primary dealers with money created "ex nihilo" to buy government and mortgage backed debt, so the primary dealers can buy large cap-high beta tech stocks and stock index ETFs. This unfortunately devalues our currency and raises the fear of inflation, so they manipulate the currency and precious metals markets in the Fed's own version of three-card Monte.

The barely perceptible uptick in the economy created by the economic stimulus, quantitative easing, and inventory restocking has all but disappeared. However, the Obama administration continues to try to con the American people with rhetoric about job creation and business activity. In reality unemployment remains stubbornly high and the problem is becoming structural in nature. Consumer credit continues to contract while small companies find it difficult to access new bank lines of credit. Housing activity is falling, and home values are poised for further declines as foreclosures increase. The trade balance has taken an ominous turn, with exports stagnating and imports surging.

The Fed and the Obama administration continue to apply Keynesian solutions to problems caused by Keynesian policies, failing to acknowledge that government controlled interest rates are the real cause of the boom bust cycles that have plagued our economy. Continuing to "bait and switch" the public by rigging the price of money is a solution that has failed miserably, but has made transparent Obama's real motive of replacing the free market system in favor of one controlled by the government.

Central to Mamet's theme but ignored by Obama and Bernanke,is that human nature is complex and human beings are not passive non-adaptive subjects.When money is too cheap or too available, you cannot count on individuals to invest wisely or frugally. And when confronted with the extreme trauma of the near total destruction of one’s wealth, you cannot count on individuals to re-inflate the economy with continued deficit spending.

Admittedly, Obama and Bernanke did not cause the problem that is before us today. However, they continue to "do the same thing over and over again expecting different results." As Albert Einstein said, this is the definition of insanity and the primary reason why the market is headed lower and the economy is going to continue to deteriorate for the unforeseeable future.


10) Continued Credit Squeeze- 2 years after the 2008 bailout, the economy continues to struggle with a lack of credit. Credit (or debt) is issued by banks and is the source of virtually all money today. When credit is not available, there is insufficient money to buy goods or pay salaries, so workers get laid off and businesses shut down, in a vicious spiral of debt and depression.

Even though liquidity was added to the banking system with QE1, banks did not provide loans, choosing instead to take advantage of a steep yield curve and play the carry trade. They continue to avoid risk and perpetuate this practice to date.

The central banks’ “central bank”, the BIS, recently raised Tier 1 capital requirements for commercial banks. The banks most affected by this decision are the banks that lend to small businesses thereby stifling bank lending and credit creation even more.

A majority of banks have been essentially marked to solvency through creative accounting. If they are ever "marked-to-market", they have the potential to be a catalyst for another crisis.

9) Lack of Consumer Spending/ Housing Market / Destruction of Wealth - 66% of Americans own their own home. But for +90% of them, their house is also their largest financial asset. House prices therefore drive a lot of the majority of Americans’ “wealth effect’ – the portion of their spending that is driven by how well-off they feel rather than how much they make.

It is estimated that there is 2 year inventory build up of homes indicating that home prices have further to fall.

401ks and pension plans have been decimated contributing to the additional destruction of personal wealth.

8)Slowdown in Industrial Activity- Key indicators (differences between indexes of new orders and inventories in various surveys, including the ISM’s) point to a significant deceleration in the near term.

7)Structural Unemployment/Labor Weakness- In past recessions employment bounced back rather quickly, signaling a recovery. This recession is glaringly different due to a structural change in the kind of worker. There is a shortage of skilled workers and a glut of unskilled workers, which will seriously inhibit recovery.

6) Inflation-Deflation Hybrid or Disinflation/Deflation- Not a threat? How come the Fed keeps printing money and the money supply isn’t growing and the velocity of money isn’t picking up? One possible reason is the gradual disintegration of the shadow banking system which was at one time larger than than traditional bank liabilities. It is collapsing at a rate of $4 trillion a year annualized rate.

The amount of leverage used and the opacity of the various transactions involved in this unregulated industry, surely contributed to the financial crisis, but also provided a source of liquidity that is obviously missing today.

5) Secular Bear Cycle - The markets and the economy are still in a secular bear market that began in 2000. Secular bear markets can last up to 15 years and we have neither seen a sufficient capitulation statistically nor in sentiment that would indicate a secular bottom.

4) Polarized Government- We are experiencing a period in history where the two major political parties have never been more polarized, preventing the passage of effective economic legislation.

The President's top economic advisers have been leaving the White House one by one as they fail to find a consensus solution to the nation's economic woes, nevertheless one that works.

3) Regulatory/Taxation Overhang- Business owners don’t know how much Obamacare will cost them, and along with financial services regulatory reform, CEOs don’t know what the future holds for their ability to access capital and what their labor cost structures will be like.

Higher income taxes for the wealth impaired, debt riddled consumer, would further restrict consumer spending.

2) Global Problem: Industrialized and Emerging Economies Offer No Help China’s private sector debt is as bad as ours. Housing in China has become unaffordable which may be leading to a bubble of their own.

While Beijing is implementing additional structural changes to reorient its economy toward domestic consumption, the pace remains measured; and will do little to help sustainably rebalance the global economy.

A protectionist administration may legislate a trade war with China.

Debt solvency in some eurozone countries (Greece, Ireland, Portugal and Spain) remain high.

1) Debt /Deficit Spending - The balance sheets of Americans, states, municipalities, federal government, much of the euro zone, corporate defined- benefit pension plans, are in various stages of near insolvency.

Total U.S debt is now $13.6 trillion with publicly traded debt running at $8.5 trillion, but estimated to grow to $14 trillion by 2015. Interest on this debt would be app. $1 trillion. Revenues in 2009 were app. $2.1 trillion. If they were to grow by 50% to $3 trillion by 2015 then, the interest payment on the 2015 debt would be 30% of 2015 revenues.

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  #2 (permalink)
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Abusing Game Theory to Sell Politics!

In the previous post game theory is only used as a catch-eye to introduce a ploitico.economical subject. Nothing is said what are the implications of game theory and how game theory could eventually be used to understand the problem and look for remediation.

Moral Hazard or TheTragedy of The Commons

The real phenomenon which has caused the trouble is moral hazard. Or in a slight variation, if applied to rare resources, it is called the tragedy of the commons. It is not just the economy which is affected, but in the first place it the exploitation of limited resources, such as raw materials, water, air. And indeed this is a case for game theory. I am not talking about Hollywood movies, but reality.

The tragedy of the commons was first evoked by Hardin in the journal Science in 1968. It describes a situation where there was no incentive for the for herders to reduce the number of cattle to avoid over-exploitation. So this is actually a prisoner's dilemma. The best solution for everybody would be to participate and to avoid overexploitation. But the marginal gain for each of the herders was positive, when they added to their cattle. So each of them had a marginal gain, but the sum of all their marginal gains was less than the common loss. This is a classic situation where the dominant strategies of all participants lead to a Nash equilibrium, albeit not an optimal one.

Now conservatives might claim that this explains the infortunate end of socialism, and indeed it does. Socialism was based on moral hazard. Land ownership, helped to solve the problem of the tragedy of the commons, as the negative incentive scheme of the undeerlying prisoner's dilemma was overcome. But does this really put forth an argument in favour of the invisible hand?

The Universal Weakness of Markets

The followers of the concept of the "Invisible Hand" claim that the market will regulate itself. This is true for a large number of cases, where negative feedback stabilizes systems that have statistical properties. What is often overlooked is, that there are also positive feedback mechanisms created by hording that counteract. The prisoner's dilemma further creates a situation that moves a system away from its equilibrium point. dynamic systems show properties of an instable equilibrium. Regulation is needed to create negative feedback mechanisms, which contain the centrifugal forces.

With Reaganism and its weaker and already degenerate reincarnations, America has lead the world on a dangerous path. Selfishness and lobbyism are promoted by the non-cooperative participants of the game. By seeking their individual advantage they do not benefit the common interest, but actually harm them. It is one of the fundamental misunderstandings that the community will profit from all individuals seeking fto maximize their own advantage. This simply does not work. America where this ideology is most supported suffers most.

Intelligent Regulation to Cope with Intelligent Design

Ressources - see tragedy of the commons - and Markets - see the financial crisis and the moral hazards which are linked to it., must be regulated. Regulation means to establish a mechanism which overcomes the prisoner's dilemma. Cutting down positive feedback mechanisms and replacing them with negative feedback mechanism can be achieved by changing the rules of the game. With changed rules the dominant strategy - the one that leads to a Nash equilibrium - should contribute to achieve an optimum solution. The most difficult trade-off is time, as represented by the generational gap. If you do not take into account all charges, such as cost of replenishment of resources, destruction of environment and national debt, the prisoner of the dilemma looks to increase consumption. This is just killing a minor disease with a major injury.

Intelligent design does not mean that we are intelligent. It means that the evolution of society follows its way as shown by computer tournaments. Non-cooperative strategies cannot survive in the long term. This is what I call intelligent design.

How to cooperate

There are two mechanism that contribute to cooperation. One is a learned behaviour that has proven successful in the past, it is called moral and provides us with some guidelines. A competing concept is law. Moral hazard is the abuse of laws and the unlearning of moral concepts that prevent lawful but selfish and uncooperative behaviour.

I have recently read a small little book that does not contain much, but the comparision of our political and economical systems with the game of soccer. To play soccer you need some sort of authority to set up the laws and to enforce their application, you need arbiters, and of course you need the guys that make the goals. Be sure that the soccer players will play foul, if you do not supervise them. This also goes back to the prisoner's dilemma. If you play foul and there is no sanction, you will be better off. The others will play foul as well. So nobodys better off in the end, as they all have broken legs. But the nash equilibrium tells us that there will be broken legs, so you have to create a disincenitve to commit those fouls.

American Society (and the rest of the world is following at some distance) has gone into a direction, where playing foul has become fashionable and the use of arbiters has been considered useless. This always happens if the actors become the regulators, because they follow their incentives. Overcoming the prisoner's dilemma means to separate regulators from actors. But now I am back to Locke and Montesquieu, and they had no game theory to analyze the problem.

Poor America

Poor America, you might follow Rome into agony.

Nota: Trading is non-cooperative behaviour as it does not help to improve the commons. Your excuse that you are creating liquidity that the market badly needs is nonsense.

Last edited by Fat Tails; October 7th, 2010 at 06:22 PM.
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  #3 (permalink)
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Fat Tails View Post
In the previous post game theory is only used as a catch-eye to introduce a ploitico.economical subject. Nothing is said what are the implications of game theory and how game theory could eventually be used to understand the problem and look for remediation.

Actually it's commonly referred to as an "apparent reference" which is a literary device that on first appearance clearly refers to one subject but on closer inspection frustrates that intention, and in this case, the reader also.

It may also be called a literary allusion, i.e., an indirect reference to another source. It is left to the reader to make the connection. "Allusion is bound up with a vital and perennial topic in literary theory, the place of authorial interpretation", but the fact that this particular allusion is understandable only to those with prior knowledge of the relatively esoteric reference in question, is a mark of your cultural literacy.

Please excuse the "abuse" of my literary license, but I claim author's prerogative in the use of this device.

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  #4 (permalink)
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Great post Tigertrader! I couldn't agree more with your thoughts. I'm absolutely amazed at the obvious intervention in the markets by the Fed via the primary dealers. The markets correlation is way out of whack and will most likely snap back at some point causing a massive correction and potentially allowing the Fed to make an ever bigger power grab to "fix" the situation.

I haven't seen so many days of panic buying in the month of September in a very long time (or if ever) and we've had zero retracements. No real volume except for down days. It's become hilarious. Don't dare go short on a POMO day .

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