Saturday, September 8, 2012

They Know Not What They Talk About


Mitt Romney and his running mate, Paul Ryan have unleashed a new slogan in their campaign to unseat President Barack Obama and his Vice President Joe Biden, and take their place at the helm of the American ship of state. Speaking of economic matters, the slogan they employ is this: “They don't know what they are talking about.” In fact, much is uttered in the economic field by many of the characters who have proven to know very little or nothing at all of what they talk about. And so, we must ask the question: Which of the two campaigns is more at fault?

Given the nature of political campaigns, we would stand on thin ice trying to figure out what these people mean when they say what they say in sound bites. Thus, the best way to evaluate them is to look at what is said by the surrogates who have expertise in the subject. To this end, we have the speech that was given by Elizabeth Warren at the Democratic National Convention of September 2012. And we have the response to it, published on September 7, 2012 in the National Review Online by Patrick Brennan under the title: “Warren's Web of … Confusion” and the subtitle: “Yes, Elizabeth, even the little people have benefited from wall Street's 'risky bets.'”

After introducing herself to the delegates, Elizabeth Warren spelled out what her point of view boils down to: “I'm here to talk about … people who work their hearts out but are up against a hard truth – the game is rigged against them,” she said. And from the looks of it, Patrick Brennan does not deny that the game is rigged but that the little people whose causes she champions are benefiting from the way the game is set up – rigged or not.

To better understand what these two are saying, we need to know what the game is about, and how it is played. It is a game that has many aspects; any one of which can be studied in isolation to reveal a great deal about all the other aspects thus expose the reality of the entire game. Warren chose to emphasize the role that the banks have played to defeat her attempt at creating a consumer protection agency in financial matters. The point she made was that President Obama's intervention saved her brainchild from being destroyed “before it ever saw the light of day.” Brennan, on the other hand, chose to defend the role that is played by the financiers. He thus tried to soften the blows that were directed at Mitt Romney concerning the shady dealings that were attributed to him fairly or unfairly.

So then, what is involved in the economics game? A good way to answer this question is to imagine a fictitious example. Here is one: You and I and Johnny play a game, sitting round a table on which there exist 100 apples. I play the role of the banker, having a printing press at my disposal. We first agree that the game we are about to play must simulate the real economy, therefore all the money I give you must be used to buy all the apples on the table. This said, I begin by printing 100 bills denominating a dollar each. I give 50 of them to each of you and ask you to bid for the apples.

You initiate the buying process by bidding 10 cents an apple. But doing the math you realize that not all the money will be used to buy all the apples, and so Johnny raises the bid to 15 cents. You find that this too will not use all the money to buy all the apples, thus the bidding continues a few more times till the price of an apple hits the one dollar mark. Now, you calculate that 100 apples at a dollar a piece will use all your 50 dollars as well as Johnny's 50 – and all the apples on the table will be bought.

We call what happened thus far the first round of the game, and start playing the second round. This time I print 200 dollars, give you 50 dollars and give Johnny 150. You both get into the bidding process once again, at the end of which you find that the price of an apple has hit the 2 dollars mark. But you personally end up acquiring only 25 apples whereas Johnny ends up acquiring 75 of them. You protest that by giving more money to Johnny than to you, I rigged the game in his favor. At first, I reject your protest and call you a jealous person engaged in class warfare, but you convince me that I was wrong on many levels. First, I caused price inflation, you say. Second, by protecting Johnny from its consequences and not you, I played favoritism. Third, I added insult to injury by calling you jealous. Fourth, I falsely accused you of engaging in class warfare.

Upon this, I modify the game in such a way as to inject a modicum of meritocracy into it. To this end, I remove the apples from the table, throw them away and point to the orchard behind you. I say that this time, you will have to go harvest the apples yourselves upon which I'll buy what you bring to the table, and pay each of you accordingly. You go to harvest, you come back and sit at the table, and you bid for the apples using the money you earned. When this is all done, you find that each of you ended up getting back exactly the number of apples that you harvested in the first place. And you realize that this was an expression of a true meritocracy. We play several rounds of this modified game while tweaking it a little each time so as to learn a few more lessons from what comes out of it.

For example, we learn that there are moments when you will get ahead of Johnny, and moments when he will get ahead of you. We also learn that neither of you being a superman, neither can harvest at any time more than twice what is harvested by the other. And we learn that no matter by how much I price an apple, each of you will end up buying back exactly as many apples as you harvested – which is true meritocracy – as long as I pay each of you the same price buying them, and I charge each of you the same price selling them back to you.

We now decide that instead of having only apples on the table, we shall have apples and oranges. I set a price for each of them, you go harvest both kinds, and come back to sit at the table so as to bid for them. This time, however, the price you pay for each item may not necessarily be the same as I paid you, and you will not necessarily buy back as many of each item as you harvested. You may buy more apples and fewer oranges, and Johnny may do the opposite. The only condition that remains the same as before is that between the two of you, you will have spent all the money you possess to buy all the items on the table.

We now multiply the number of tables, multiply the number of players around each table, and multiply the number of items that we put on the tables – some being goods and some being services – all of which being provided by the players themselves who will represent both the producers and the consumers in a modern economy. Because I cannot play the role of banker to all these players, I call myself the central banker and keep the printing press under my control. I license other people to play the role of bankers, and assign to each of them a table to look after. They give themselves names like: commercial bank, chartered bank, investment bank, trust company, savings and loans, household finance, acceptance corporation – and so on and so forth. Whatever their names, they are collectively referred to as financiers.

I explain to them that they are to operate like utility companies. That is, they should consider themselves a conduit through which money will flow from the central bank to the players at the tables. To get paid for the work they do, they will be allowed to charge a commission for each transaction they handle. This understood, they go to work, and I monitor what they do to make sure that they play by the rules we made together, and wrote them down. But the operation being too big for one person to handle alone, I hire a number of regulators to assist me in auditing the financial institutions, and make sure that everything is done according to the rules.

For some reason, I doze off and do not wake up till many years later. I look around and discover that the operation is not running the way it was meant to; the way I had designed it in consultation with the financiers  long ago. These people are no longer just conduits channeling money from the central bank to the producers and the consumers sitting at the tables; they have become players in their own right sitting at their private tables inside their own premises where the pipes that carry the money from the central bank discharge their content instead of taking it to the tables of legitimate players, the producers and consumers of the economy.

In addition, many of the regulators who used to work for the central bank now work for the financial industry, and many of the financiers who used to work for the industry now work as regulators. In fact, the relationship tying these two factions has transformed into a giant bordello where incest, sadism, masochism and sodomy is practiced as a matter of course. But to appear like they are conducting legitimate business, and to look like they abide by the rules, the institutions encourage their clients to ask for loans so as to work on something -- anything at all. When this happens, the institutions start to work on inflating the value of what the client is working on thereby creating the bubble that allows their balance sheet to balloon. When they feel they have amassed enough, they puncture the balloon, grab all the money they can grab and leave the clients holding an empty bag.

And these people never stop inventing new tricks, called derivatives, to put them in a position where they can siphon off as much as possible of the money they ask the central bank to print for their clients. And when there is this much money out to represent a finite amount of wealth such as the apples and the oranges as well as the other goods and the other services, the financiers who produce none of that take the lion's share of it while the rest of society which produces the wealth gets the leftovers. And this is why Elizabeth Warren has deemed it that the game is rigged against the latter; against the little people.

As to Patrick Brennan's assertion that the little people are benefiting from the existing system, I have a personal story to tell in this regard. I had known for sometime that the super fast computers of today made it possible for a handful of traders on the stock market to do what is called “high frequency trading,” a practice through which they realize big profits. But I could not figure out how the speed of the computer alone could be taken advantage of to help those traders accomplish such feats. And then, one day, I stumbled on something by accident that revealed the secret. However, before I tell what happened, I must explain what the setup is supposed to be. So let me do that first.

Aside from the average investors such as myself, there are the semi-professionals who call themselves day traders, and the full time professionals who call themselves arbitrageurs, specialists or market makers. Because these people sit or stand inside the “pit” of the stock market, they have the advantage of seeing the “buy” and “sell” orders as they come in. Thus, the law forbids them from getting between a buyer and a seller where there are matching orders. For example, if the bid to buy a stock now stands at $28, and an offer to sell comes at that price, no professional can come between them and place a counter-bid to buy at say, $28.05. If the clock of the stock market indicates that the bid of the professional came after that of the other bidder by even one second, the latter gets the stock and the professional is out of luck even though his bid was higher.

But if a high frequency trader has a super fast computer that is plugged into the system of the market, or any of the brokerage firms, he can program his computer to detect the incoming orders, and place a counter order in nanoseconds. This would be too fast for the clock of the stock market to show a difference in time between the two orders. They will be registered as having come simultaneously, thus give preference to the one that bid $28.05. Consequently, the high frequency trader will have his order filled, and the other bidder will be out of luck.

And so, it happened one day that I had access to the stock market through two different methods, one safe and one unsafe. I noticed that when I requested the quotations for a stock that was volatile but not trading too actively, the safe method indicated that the last trade happened anywhere between say, a minute ago and an hour ago. But when I requested for the quotes of the same stock through the unsafe method, it would indicate that the price had changed at the exact moment that I made the request. Not only that but the stock had risen considerably if the trend was bullish on that day; something that would force me to chase it up. Or it would have dropped considerably if the trend was bearish on that day, something that would have caused me to panic, and forced me to sell at a very low price.

From this, I concluded that a high frequency trader out there had programmed his computer to take advantage of the people who follow the trend; not a contrarian like me. And this gave me the chance to turn the table, and take advantage of the sucker. To this end, I did the following: If a stock I always wanted to buy was coming down, I would bid a price that is much lower than the current bid using the safe method. I would then request the quotes for that same stock using the unsafe method so as to prompt the sucker's computer to sell at a very low price. Most of the time, I would get my order filled after the first try but if the stock did not come as low as I wanted, I would wait a few minutes and make the request for quotes again. Most of the time, my order would get filled by the second request. And I also used the same trick to sell a stock at a much higher price than I would normally have sold if there was not a high frequency sucker out there trying to trick me.

Did I benefit from the system the way that Patrick Brennan put it? I bet he didn't have that in mind but then again, not every one is doing what I'm doing waiting for the day when high frequency trading will be recognized as the deliberate breaking of existing laws, and dealt with accordingly.

But this is the sort of thing that Elizabeth Warren is working on. It says that the campaign with which she is associated is doing the right thing. It also says that the campaign which Patrick Brennan is defending is at fault.