Tuesday, September 09, 2008


Yes, I know this posting was supposed to be about how you could use softwarephysics on a daily basis as an IT professional, but the “real world” of human affairs has once again intervened with the current worldwide financial crisis, so as in The Fundamental Problem of Everything, I once again wish to take a slight detour along our path to IT enlightenment. I find the current worldwide financial crisis to be a wonderful case study demonstrating the value in having an effective theory for the behavior of the virtual substance we call money. Because in softwarephysics we also view software as a virtual substance to be modeled by effective theories, I believe there are some valuable lessons to be learned from our current economic problems. However, before we can analyze the current worldwide financial crisis using some of the tools we learned in our study of softwarephysics, we need to do a brief recap to refresh our memories.

Recap of Softwarephysics
Recall that in softwarephysics we view software as a virtual substance with observable characteristics that can be modeled, but not quite fully understood at the deepest levels. Just as the quantum field theories of QED and QCD of the Standard Model of particle physics provide very accurate effective theories for the behavior of the virtual substance we call matter, softwarephysics attempts to do the same for the virtual substance we call software. So softwarephysics is simply an attempt to provide an effective theory of software behavior that can be used to make predictions and provide a direction for thought that allow you to make better decisions as an IT professional. Recall that an effective theory is just an approximation of reality that only works over an effective range of conditions and only provides a limited level of insight into the true nature of the phenomenon at hand. With softwarephysics I have tried to pattern software behavior after the very successful effective theories of physics, most notably thermodynamics, statistical mechanics, the general theory of relativity, and quantum mechanics. These very successful effective theories produced very valuable models for the behavior of real things in the physical Universe in the 20th century. For example, QED has predicted the gyromagnetic ratio of the electron accurate to 11 decimal places, and the general theory of relativity has predicted the orbital decay rate of a binary system of neutron stars accurate to 14 decimal places, but unfortunately, both effective theories are totally incompatible with each other. The general theory of relativity works great for large masses interacting at large distances, but not for little masses interacting over very small distances like atoms, while QED works for very small things like electrons and photons over very short distances, but not for large masses over large distances. So we now know that although both theories are very accurate in making predictions over a limited range of conditions, they really are only models of reality and that neither one is a complete depiction of true reality itself. Over many of the previous postings, I have tried to convey this idea that all the current effective theories of physics are just models of reality, if indeed reality even exists, and are not what true “reality” really is. Similarly, in softwarephysics we take a positivistic approach to software behavior; we really don’t care what software really is, we only care about modeling how software appears to behave. Confusing “reality” with models of reality is a hard thing to let go of. I think this is perhaps the greatest challenge for IT professionals new to softwarephysics.

In SoftwareChemistry we also saw that chemistry is really just a very useful set of heuristic models sitting on top of QED that abstract and simplify the very difficult calculations of QED, and in SoftwareBiology we saw that biology is also a series of simplifying models that abstract the complicated models of biochemistry. So the physical sciences can be viewed as an onion-like hierarchy of simplifying models of reality that make exquisite predictions for the behaviors of the layers below. But in Software Chaos we also saw that for each layer of modeling, emergent behaviors can arise due to the nonlinear nature of the underlying phenomena. These emergent behaviors are the difficult ones to predict, without introducing another layer at a higher level. Similarly, we saw that software can be viewed as a series of layers of abstract models stacked on top of each other, with applications as the highest form of organized software, overlaying lower levels of software organization like systems software (Apache webservers, J2EE Appservers, DB2, Oracle, Mainframe Gateways, etc.), Unix shells, Unix kernels, machine instructions, and finally microcode. Emergent behaviors also seem to appear in software as we proceed up the hierarchy of software organization too, and we shall see that this applies to financial theory as well.

A Case Study in Virtual Substances - the Current Financial Crisis
Now we have all the tools to proceed. In Software as a Virtual Substance, I tried to relate the virtual substance we call software to the more familiar virtual substance we call money as a useful analogy that highlights the benefits of having an effective theory of software behavior. In truth, economics is just a collection of effective theories that try to describe the behavior of money and all its associated functions like the production and consumption of goods and services. So economics can really be viewed as a kind of moneyphysics. As I previously mentioned, I have always been fascinated with how real money seems to be for most people, when for the most part, it is just a large number of bits on a vast network of computers. For example, the total amount of U.S. currency in circulation is only about 10% of the M2 indicator of the U.S. money supply (currency + savings deposits + money market deposits + CDs), and don’t forget that currency itself is really just pieces of paper with certain ink markings. So money is really not real at all. Money is just another meme, and the very complicated world financial system is a gigantic meme-complex. Now don’t get me wrong, I have nothing against the concept of money. As an 18th century liberal and 20th century conservative, I am a strong proponent of capitalism because I see capitalism, despite all its faults, as the best defense against the abuses of the Powers That Be. But if we go back to my favorite definition of physical reality:

Physical Reality - Something that does not go away even when you stop believing in it.

we see that money really is not a part of physical reality. Once people stop believing in money, it simply disappears. That is why the current worldwide financial meltdown is so disturbing. In case you have not looked at the balance of your 401(k) lately, the concept of money is in real danger. Most of the Powers That Be in the worldwide financial meme-complex are in a desperate struggle to keep the illusion that money is real, alive in the minds of the Earth’s population, and I wish them all the best in this effort! Going back to barter would certainly not be a good thing for anybody. So let’s use the current worldwide financial disaster as a timely case study that shows the value in having an accurate effective theory of the virtual substance we call money, in hopes that it will raise the issue of why we need an effective theory for the behavior of the virtual substance we call software.

It seems that once again, we have gotten ourselves into quite a financial pickle through the ingenious development of arcane derivatives and the use of excessive leverage, just as we did in the stock market crash of 1929 and the ensuing Great Depression. An entertaining analysis of the 1929 stock market bubble, and ultimate crash, can be found in John Kenneth Galbraith’s famous The Great Crash 1929 (1954). In 1929, the derivatives and excessive leverage were based upon investment trusts and holding companies, which held common stocks that were inflating in price way beyond the profits generated by the underlying companies. This time, the derivatives and leverage were based upon MBSs (Mortgaged Backed Securities), CDOs (Collateralized Debt Obligations), and CDSs (Credit Default Swaps) invested in subprime mortgages on properties that were inflating in price way beyond a sustainable level.

In both cases, the financial community managed to take a linear financial system, that produced small changes in value from small changes in profits, to a very nonlinear financial system, which produced large changes of value from small changes in profits through the miracle of leverage. Leverage is borrowing money from somebody in order to invest the money in some kind of financial instrument, rather than using your own money to buy the instrument. The hope is that the borrowed money you invest will generate much more income than the cost of the money you borrowed. A simple form of leverage is buying stock on margin. In 1929 people were able to buy stock with a 10% margin, meaning that you could buy a $100 share of stock for $10 and owe your broker the remaining $90. If the stock quickly rose to $150 during the market bubble, you could then sell the stock for a quick $50 profit, less commission costs and the interest on the $90 you borrowed from your broker. In the current crisis, many speculators did the same thing, but instead of buying stocks on margin, they were buying real estate on margin by taking out low interest rate ARM (Adjustable Rate Mortgage) mortgages, with little down payment on houses and condos, and then flipping them for a quick profit before the ARM rate was scheduled to dramatically rise.

In 1929, the investment banks on Wall Street came up with an even more ingenious form of leverage through the invention of a derivative known as an investment trust. In finance, a derivative is a financial instrument whose value relies on the value of some other underlying assets, and is used to transfer the risk associated with the value of the underlying assets from one party to another. For example, a gold mining company and a jeweler could sign a futures contract to exchange a specified amount of cash for a specified amount of gold in the future. The benefit of the futures contract is that it locks down the future price of gold for both the gold mine and the jeweler, and thus, reduces uncertainty for both of them. The gold mine and the jeweler both reduce one risk and increase another risk at the same time when they sign the futures contract. The gold mine reduces the risk that the price of gold will fall below the price set by the contract, but takes on the risk that the price of gold might rise above the price set by the contract. The jeweler reduces the risk that the price of gold will rise above the price set by the contract, but takes on the risk that the price of gold might fall below the price set by the contract. Once the contract has been formed, it can be traded to other parties who are betting on the fluctuating price of gold. The market value of the futures contract depends upon the current price of gold and how close the contract is to the settlement date. But most futures contracts are never physically fulfilled – the gold is never really delivered; the party that is to deliver the gold merely buys another contract that cancels out the first one. So a futures derivative provides a mechanism to hedge risk and provides something that can be traded in the open market by speculators. Because most futures contracts are really never fulfilled, they are mainly a way of speculating on the future prices of commodities.

As I mentioned in The Fundamental Problem of Everything, there is good and bad in all things. After all, a vice is just a virtue carried to extreme. The concept of derivatives began in the commodities markets to help ameliorate the risk that farmers were subject to when bringing their crops to market, which is a good thing, but because derivatives can also be traded in an open market by speculators with no real interest in the underlying assets, they also can lead to market bubbles by obscuring the underlying assets. Also, because derivatives tend to spread risk around to a large number of people who have no real interest in the underlying assets, they also dilute the responsibility people have for evaluating and maintaining the value of the underlying assets.

So let’s compare how derivatives and extreme leverage led to financial chaos in 1929 and the present situation. In 1929, investment banks like Goldman Sachs would create an investment trust by issuing $100 million in bonds, $100 million in preferred stock, and $100 million in common stock. They then took the $300 million and bought common stock in real companies like RCA or Ford Motor Company. Now suppose the common stock held by the investment trust rose by 50% during the market bubble from $300 million to a value of $450 million. Since the bonds and preferred stock issued by the investment trust were static instruments, with more or less fixed values, they would still only have a total value of $200 million. The extra $250 million had to go somewhere and ended up being reflected in the value of the common stock issued by the investment trust. So the common stock issued by the trust would rise by 150% from $100 million to $250 million. This is where leverage comes into play for the investment trust derivative. Notice that by borrowing money from other people in the form of bonds and preferred stock, investment banks were able to create a derivative that increased in value by 150% when the underlying assets of the investment trust only increased by 50%, producing a leverage of 3:1. To make matters more interesting, Goldman Sachs then created new investment trusts with a 3:1 leverage that held the common stocks of other investment trusts, yielding a total leverage of 9:1. This continued on an on, by creating even more investment trusts that held the common stock of other investment trusts, which held the common stock of other investment trusts….., creating a gigantic Ponzi scheme. Now imagine that you took your $10 and used it to buy a $100 share in an investment trust with a built-in leverage of 9:1. This would give you a leverage of 90:1, and allow you to reap the benefits of a virtual $900 worth of stock! But the problem with leverage is that it is a two-way street, it magnifies profits but it also magnifies losses. So long as stocks kept rising during 1928 and 1929, things were great and everybody made tons of money on paper, without doing anything intrinsically productive. But all bubbles must finally burst, and when the market bubble of 1927 – 1929 came to an end, all the excessive leveraging of derivatives caused the market to collapse as everybody tried to sell all the fabricated paper at once. For example, if your virtual $900 of stock suddenly dropped by 30% to a virtual $630 as the market declined, your broker would make a margin call because your $100 share of the investment trust now only had a market value of $70. Suddenly your $10 investment turned into a $30 loss because of the downside of leverage. In October 1929, many investors could not make their margin calls, and had to sell their shares at a loss instead, which further depressed the market even more and greatly magnified loses because of leverage. The leveraged downward spiral caused the market to crash. For example, the Goldman Sachs investment trust known as Shenandoah Corp., which had been trading at $36 per share in late July 1929, fell to $0.53 by July 1932.

This time, Wall Street used subprime mortgages as the underlying instruments in a derivative called an MBS (Mortgage Backed Security). About 30 years ago I took out a mortgage on a house when we moved back to Chicago. At the time, the mortgage was held by a local bank in the suburb I had moved to, and I made monthly payments to the bank, so the bank originating the loan was very interested in my ability to repay the mortgage. But in recent years banks and mortgage brokerage firms, like Countrywide, originated mortgages, but then sold them off to Fannie Mae, Freddie Mac, or investment banks like Lehman Brothers and Bear Stearns, which then packaged them up into MBS securities, containing perhaps 1,000 mortgages. Now Fannie Mae was created in 1938 in the midst of the Great Depression by FDR precisely to do this sort of thing. In 1968, Lyndon Johnson privatized Fannie Mae to get it off the books because of the rising costs of the war in Vietnam, and in 1970, Freddie Mac was also created by the government to provide some competition for Fannie Mae in the growing secondary mortgage market. So why didn’t this catastrophe happen decades ago? The reason is that both Fannie Mae and Freddie Mac held high standards for the mortgages they bought, at least until recent years. When the dot.com bubble burst in the spring of 2000, and after 9/11 put additional pressures on the financial markets late in 2001, Wall Street was desperate to trade something – anything. So the “securitization” of mortgages – any mortgage at all, no matter how risky - in the form of MBSs sold by the investment banks of Wall Street took off. The selling off of mortgages by the originating local banks and mortgage brokers freed up more cash for the banks and mortgage brokers to originate and sell even more mortgages because the mortgages they sold off did not impact their mandated reserve ratios of cash, and they made a good living off the loan origination fees. Just like the investment trusts of 1929, large commercial banks and investment banks like Lehman Brothers used leverage to buy and hold huge amounts of these MBS derivatives. For example, they could borrow money at 4% from other people and use the funds to buy MBS derivatives with a yield of 8%. Since the underlying assets of the MBS derivatives were mortgages on homes that were continuously going up in value, the MBS derivatives were perceived to be a safe way to make an easy 4% on all the money that was borrowed. The more money you borrowed, the more money you made, so Lehman Brothers ended up running up a leverage of 30:1 before it went bankrupt.

The MBSs were further split up into another kind of derivative called a CDO (Collateralized Debt Obligation) by the investment banks. A CDO takes a bunch of MBSs and sets up a number of cash flow buckets or tranches. When you invest in a CDO, you invest in the cash flow from the MBSs and not the MBSs themselves. The tranches form a hierarchy of risk. The riskiest tranche gets paid last from the cash flow of the underlying MBSs, but it gets paid at a higher rate of return from them. The senior tranche is the first bucket in line for the cash flow, so it bears the least risk and the lowest rate of return. So now we had derivatives of derivatives like back in 1929. The end result of all this was that the banks and mortgage brokers originating the mortgages did not really care if the mortgages would go into default because they were selling them off, and because the investment banks were hungry for more mortgages for their MBSs, the local banks and mortgage brokers began issuing subprime mortgages to people who would normally never qualify for a loan. The packaging of mortgages into MBSs and CDOs further obscured the risk of these subprime mortgages.

Just as in 1929, everything was fine until the American housing bubble burst. As home values began to decline across the entire country, homeowners that were holding subprime mortgages with ARM rates about to rise discovered that, suddenly, the value of their homes was less than their outstanding mortgages. For these homeowners, the logical thing to do was to simply default on their mortgages and walk away. This caused the default rate on the mortgages within the MBSs to skyrocket and the cash flow from the MBSs to nose dive. The market value of the MBSs dropped dramatically, to the point where nobody wanted to buy them at any price, because nobody could tell how bad the mortgage default rate might get. But the financial institutions that had used large amounts of leverage to buy the MBSs still had to make interest payments on the billions of dollars they had borrowed to buy them, even though the cash flow from the MBSs had dropped significantly, pushing these institutions towards bankruptcy.

The insurance companies like AIG got into this mess by issuing an instrument called a CDS (Credit Default Swap) to the investment banks and financial institutions holding the MBS and CDO derivatives. A CDS is really an insurance policy against an MBS or CDO going into default, and like all insurance policies, the investment banks or financial institutions had to pay a premium to AIG for the CDS protection on their MBS and CDO derivatives. Because financial institutions were insuring their MBSs and CDOs with CDSs, that shielded the funds in their MBSs and CDOs from being at risk and did not enter into the calculation of their mandated reserve ratios. This freed up cash for the financial institutions to buy even more MBSs and CDOs. The reason the insurance companies called these contracts a CDS, rather than an insurance policy, is that if they had called them an insurance policy, the CDSs would have been regulated by the agencies that regulate insurance policies. Thus by calling these instruments a CDS, the insurance industry was able to create a very lucrative source of income with no regulation. You see, the agencies that regulate insurance companies require that an insurance company keep some cash on hand to make good on the insurance policies that it issues in order to protect the policy holders, but this was not the case for the CDSs, thus the insurance companies were able to take on huge CDS liabilities, with little cash reserve set aside to pay them off if they went bad. However, the CDSs did present two problems for the insurance companies. Firstly, they did not know how to accurately calculate the risk involved with the MBSs that the CDSs were insuring. Insuring an MBS was not like insuring a home against fire because it was very hard to estimate the likelihood of an MBS failure, so the premiums charged by the insurance companies were probably too low for the risk they took on. This was not a problem, so long as they were just taking in premiums and not paying off on bad MBSs and CDOs. Secondly, most loses that insurance companies suffer are isolated – not all homes in America will burn down at the same time. But this was not true of the MBSs and CDOs that the CDSs were insuring. As home values began to decline across the entire country and homeowners holding subprime mortgages with ARM rates about to rise began defaulting on their mortgages, essentially millions of homes across the country did burn down all at the same time from the perspective of the insurance companies issuing CDSs on MBSs. It is estimated that currently there are about $60 trillion of CDSs in the market today, which makes even the current U.S. national debt of $10.6 trillion look small.

All this was further obscured by the bond rating agencies like Fitch, Moody’s, and Standard & Poor’s. In a scathing July 8, 2008 Securities and Exchange Commission report, it was found that the bond rating agencies were rating these MBSs and CDOs as AAA even though they were filled with worthless mortgages. Believe it or not, these agencies are paid by the very same investment banks that issue MBSs and CDOs to evaluate the MBSs and CDOs! This has been going on for decades with bonds and other securities, but to maintain a semblance of objectivity, the rating agencies have always been careful to shield their analysts from external influence by the investment banks issuing securities. After all, if the rating agencies were viewed by the investment public as just biased extensions of the investment banks and on the take, then a AAA rating of a security would be worthless. Unfortunately, the July 8, 2008 S.E.C report found just that. In an infamous December 2006 email, one rating analyst confided to another “Let’s hope we are all wealthy and retired by the time this house of cards falters.” The report found that the rating analysts were under a great deal of pressure to quickly rate the MBSs and CDOs as AAA, without doing due diligence or fulfilling their fiduciary responsibilities. Other emails in the report showed that analysts were afraid that if they did not rate MBSs and CDOs as AAA, then they would lose business to competing rating agencies.

So all these very complicated and over-leveraged derivatives did a great job of spreading the risk of a huge number of subprime mortgages throughout the financial systems of the world. Indeed, these derivatives became so complicated and hard to calculate valuations for, that Wall Street turned to physics for help and hired many Ph.D. physicists, called quants, to help with the calculations and analysis of these instruments. These derivatives made quantum mechanics look simple, and the newly hired physicists from academia truly did become moneyphysicists. Unfortunately, the quants fell prey to a couple of predicaments familiar to all commercial scientists working in the real world of human affairs. The first was the pressure of MICOR (Make It Come Out Right), where you start with the result that you desire and work the analysis backwards to MICOR. Frequently, the desired analytical results of Quantitative Finance models were graciously provided by the Powers That Be at many institutions in a subtle manner, and the job of the quants was to MICOR the analysis. The second problem was that the quants did not take to heart that their Quantitative Finance models were just effective theories of reality and not reality itself. In How To Think Like A Scientist, I stressed the importance of the final step in the scientific method where you test your models:

The Scientific Method
1. Formulate a set of hypotheses based upon inspiration/revelation with a little empirical inductive evidence mixed in.

2. Expand the hypotheses into a self-consistent model or theory by deducing the implications of the hypotheses.

3. Use more empirical induction to test the model or theory by analyzing many documented field observations or performing controlled experiments to see if the model or theory holds up. It helps to have a healthy level of skepticism at this point. As philosopher Karl Popper has pointed out, you cannot prove a theory to be true, you can only prove it to be false. Galileo pointed out that the truth is not afraid of scrutiny, the more you pound on the truth, the more you confirm its validity.

Unfortunately, the quants became enamored with the power of their own models to make predictions, even if those predictions did not take into account the very nonlinear emergent behaviors of a worldwide financial collapse, like the avalanche that follows the final grain of sand added to a sand pile beyond its critical angle. See Software Chaos for more details on nonlinear systems. The really bad thing about all these derivatives was that nobody really understood them, not even the physicists. Nobody knew how to properly price them or evaluate their inherent risks, so the derivatives essentially released everybody from taking responsibility for the underlying subprime mortgages. If you watched any of the congressional hearings on the current financial crisis on CSPAN this became quite evident.

So now we see that in October of 2008, we are in a very similar situation to where we were back in October of 1929, with derivatives and extreme leverage running amuck. So are we heading for another Great Depression? I do not believe so because we now have much better effective theories for the behavior of the virtual substance we call money. Fortunately, both the Federal Reserve chairman Ben Bernanke and Treasury Secretary Henry Paulson are monetarists, in the tradition of Milton Friedman. Milton Friedman and Anna Schwartz, in their book A Monetary History of the United States, 1867-1960, argued that the Great Depression of the 1930s was caused by a massive contraction of the money supply and not by the lack of investment as Keynes had argued. In this book, Friedman contended that, in the 1930s, the Federal Reserve allowed 1/3 of U.S. banks to fail, which produced a 1/3 drop in the M2 indicator of the U.S. money supply, and this turned a mild recession into the Great Depression. This is why Bernanke, Paulson, and the other leaders of all the central banks of the world are desperately trying to prop up all the banks and financial institutions on the planet by guaranteeing deposits and bailing out investment banks, commercial banks, and insurance companies like AIG, and lowering interest rates.

But in 1929, the Federal Reserve System was new to managing the virtual substance called money, having only been recently created in 1913 to provide a stabilizing central banking system for the United States, following the “Panic of 1907”. Because the Federal Reserve was inexperienced, it took just the opposite actions, based upon the prevailing effective theory of money at the time. In 1929, the Federal Reserve felt that “times were tough” because of the recession that followed the October 1929 market crash. When “times are tough”, the Federal Reserve thought that it made sense to keep interest rates high, to ensure that only financially sound and trustworthy applicants applied for loans. It also felt that it should allow weak banks to go under in order for the strong banks to survive, and provide a sound financial foundation for the country. That is why, during the early 1930s, the Federal Reserve kept interest rates high and let commercial banks, investment banks, and other financial institutions go out of business. Now bank deposits were not insured by the FDIC in the early 1930s, so when a bank went under everybody lost the money they had deposited in the bank, so about 1/3 of the U.S. money supply went from being a virtual substance, to being a virtual vacuum by the end of 1932. In 1933, the Glass-Steagall Act was passed, which established the FDIC to insure deposits against bank failures and also introduced many banking reforms that separated commercial banks, the kind of banks you put money into and take out loans from, and investment banks which issue stocks, bonds, and derivatives for corporations. Unfortunately, the banking system reforms of the Glass-Steagall Act that regulated commercial and investment banking activities were repealed on November 12, 1999, by the Republican led Gramm-Leach-Bliley Act, based upon the assumption that the greed and stupidity of the 1920s were no longer with us – not a very prudent assumption.

The Value of Having an Accurate Effective Theory of Virtual Substances
So we now see the value in having good effective theories for the virtual substance we call money. But is software any less real than money? If we go back to my favorite definition of physical reality, I contend that software is certainly more “real” than money, and yet there are no softwarephysicists to speak of. In the modern world, software certainly plays as much a role in the storage and transfer of economic value as does money, so I find it strange that one can receive a Nobel Prize for modeling the virtual substance we call money, but not for modeling the virtual substance we call software.

Hopefully, the coordinated actions of the central banks of the entire planet will prevent the collapse of the world money supply and prevent another Great Depression because now we have a much better set of effective theories for the behavior of money. Everyone seems to agree that we are forced to bail out the institutions that got us into this jam, but we all know deep down that it sets a very bad precedent. In the 1930s, we let these institutions fail, and the people running them learned a hard lesson in the process. The CEOs of these failed institutions suffered dramatic personal economic consequences for their poor decisions, but that will not be the case for the current crisis, when the governments of the world bailout these institutions and their CEOs. As a 20th century conservative, I will gaze in disbelief around Christmas time this year when the CEOs of Wall Street will still demand year-end bonuses in the tens of millions of dollars for nearly bankrupting their institutions and the country, and those bonuses will be coming out of the pockets of U.S. tax payers this time! I was amazed to see the CEOs of Wall Street go from being staunch capitalists, to grateful socialists, in the span of a single week.

A Need For Reform and Regulation
As an 18th century liberal and 20th century conservative, I believe that the government that regulates least is the government that governs best. Capitalism and free markets are the easiest way to run an economy through the miracle of Adam Smith’s “Invisible Hand” because it allows people to work in their own self-interest, which is much easier than trying to force people to do things. It is also a “natural” economic system that naturally fights the second law of thermodynamics through innovation and natural selection, as noted by Charles Darwin in his theory of evolution. The simple beauty of capitalism is that billions of people, all working in their own self-interest, will naturally create a complex and dynamic world economy, with no need for an external designer. In fact, the 20th century has shown us, through the failure of socialism and communism, that it is essentially impossible for any human intelligence to design the complex world economy that we have today. But capitalism does have its limitations. Because capitalism is a Darwinian economic system, it is subject to the same constraints we find in the Earth’s biosphere. Darwinian systems evolve through small incremental changes to adapt to the environment which presently confronts them through innovation and natural selection. Thus, Darwinian systems do not have a teleological or anticipatory nature; they cannot foresee dramatic environmental changes, like an asteroid impact killing off the dinosaurs, or a worldwide financial meltdown killing off the world’s financial markets. In the Tragedy of the Commons (Science - 1968), Garrett Hardin proposed that capitalism and free markets do not work very well for things that have no explicit owner, like the Earth’s atmosphere or the world’s money supply. For example, the financial meltdowns of both 1929 and 2008 were both caused by large numbers of people all working in their own self-interest, with no thought to the Tragedy of the Commons. Just as it is currently in everybody’s self-interest to pollute the Earth’s atmosphere with unchecked emissions of carbon dioxide, in recent years it was in the self-interest of all to pollute the worldwide financial system with toxic subprime mortgages. Everybody benefited, so long as American home values kept rising - low income home owners, real estate speculators, local banks, mortgage brokers, Fannie Mae, Freddie Mac, investment banks, bond rating agencies, insurance companies like AIG, and private investors all benefited from the leverage and complex derivatives, hiding the impending catastrophe of subprime mortgages, until the bubble burst. Having everybody working in their own self-interest does amazing things, so long as we pay attention to the Tragedy of the Commons. So capitalism does need some help from government in order for it to work its miracles in a sustainable manner. Capitalism cannot exist in a lawless society, like the extreme of Russian capitalism, where simply killing your competitors is considered a smart marketing strategy.

On November 15, 2008 the leaders of the world financial system will be meeting to start work on such a legal framework to ensure this financial disaster never happens again. My hope is that the new American administration will also convene a similar meeting for the impending disaster of climate change. After all, we seem to be taking unprecedented measures to preserve the world’s money supply, which we have seen is not even a part of physical reality. Wouldn’t it make sense to do the same for the Earth’s climate, which is indeed a part of physical reality? Unfortunately, left to its own devices, world capitalism will optimize the burning of every economically recoverable drop of oil and lump of coal, yielding an atmosphere with 2400 ppm of carbon dioxide. Sure Antarctica will gain a nice balmy climate, like present day Florida, as we melt the polar ice caps and the permafrost of the Earth, producing a sea level rise of 300 feet, allowing my descendants to frolic on the beaches of the new seacoast in southern Illinois, but the economic costs of trying to adapt to this new climate or fix it will be staggering. This is where government can help capitalism achieve its miracles by simply levying a stiff carbon tax on all carbon based fuels and a carbon tariff on imported goods from countries spewing carbon dioxide into the atmosphere. The income from the carbon tax and tariffs could be offset by an income tax credit to all citizens to make these taxes revenue neutral. This would provide an incentive to repower the U.S. economy with low carbon footprint sources of energy and provide citizens with the funds to buy low carbon footprint products via income tax credits. And for the common defense, the government should also create incentives and fund efforts to rebuild our electrical grid with a superconducting infrastructure and promote nuclear, solar, geothermal, wind, and ocean current sources of energy, so that we do not spend the rest of the 21st century fighting wars over Persian Gulf oil with China, India and the other rising economies of the Earth. Being energy independent is certainly as important as funding B1 bombers or nuclear aircraft carriers.

Similarly, for national security purposes we need to ensure that the U.S. monetary system is never again placed into such jeopardy, by bringing back the Glass-Steagall Act separating commercial and investment banking, and introducing new legislation regulating MBSs, CDOs, and CDSs. And injecting a little realistic capitalism into the world of Wall Street CEOs would also be beneficial. Theoretically, the stock holders of a corporation are supposed to elect the board of directors, who then hire a management team to run the corporation, but in the real world of human affairs, it seems that the CEOs of Wall Street and the top layer of the corporate management team seem to hire the board of directors, who then appoint compensation committees of underlings, to tell them how much the CEO and top managers should be paid, and they also award outlandish bonuses for incredibly poor performance to these executives. There seems to be a bit of conflict of interest here, but I do not know how to fix it.

Sir Isaac Newton - the First Moneyphysicist
Wall Street and the banking industry will surely object to these measures as being too harsh, but they should be grateful that they never had to deal with the very first moneyphysicist, Sir Isaac Newton! Newton published is famous Principia in 1687, in which he outlined Newtonian mechanics and made him renown throughout the kingdom as the Einstein of his day. In 1696 Newton was made warden of the Royal Mint, a figurehead patronage job with no real duties, as reward, and in 1699 Newton became the Master of the Mint when his predecessor died in office. To the surprise of all, Newton took these figurehead patronage jobs seriously, and became a bit of a loose cannon for the Powers That Be running the Royal Mint. At the time, England was at war with France and perhaps 20% of the English coinage was counterfeit, which made it difficult to pay for the costs of war. Also many of the English coins were clipped – people were shaving silver off the edges of the coins. In 1688, the average circulating silver coin was about 15% underweight because of clipping, and by late 1695, over one-half of an average circulating coin was gone due to clipping. To remedy these problems, Newton oversaw the Great Recoinage of 1696, a massive recoinnage effort to replace the untrustworthy coins of the realm with authentic coins of standard weight and silver content that had milled edges to prevent clipping. In 1705, Newton was knighted by Queen Anne as Sir Isaac Newton, not for his great scientific achievments, but for his services to the Crown at the Royal Mint.

Newton was also in charge of tracking down and prosecuting counterfeiters and clippers. Counterfeiting was considered High Treason and a capital offense at the time because it undermined the national defense and thus counterfeiters were viewed as traitors to the Crown. Newton used to disguise himself and walk the streets of London at night, looking for counterfeiters, and actively pursued their arrest and punishment. He attended public executions of counterfeiters for High Treason, which were gruesome affairs in England prior to their ban in 1814. The condemned were drawn and quartered as described in the Wikipedia:

1. Dragged on a hurdle (a wooden frame) to the place of execution. (This is one possible meaning of drawn.)

2. Hanged by the neck for a short time or until almost dead (hanged).

3. Disembowelled and emasculated and the genitalia and entrails burned before the condemned's eyes (this is another meaning of drawn).

4. The body divided into four parts, then Beheaded(quartered).

As you can see, this was far worse than presiding over any annual shareholders meeting filled with angry shareholders! So when the CEOs of Wall Street receive their massive Christmas bonuses this year, funded by taxpayers, and millions of taxpayers are similarly rewarded with devastated 401(k)s and pink slips, the CEOs should be very grateful that Sir Isaac Newton is no longer running about dispensing justice!

Next time we will definitely sum things up with a lessons learned from softwarephysics for IT professionals with a list of tips on how you can improve your performance and make your IT job easier by using softwarephysics on a daily basis.

Comments are welcome at scj333@sbcglobal.net

To see all posts on softwarephysics in reverse order go to:

Steve Johnston

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