Friday, February 19, 2010

MoneyPhysics Revisited

It has been a little over 20 months since my original posting on MoneyPhysics first appeared and given the current strident national debate over what has ensued since September of 2008; it might be an appropriate time for a brief review of where we stand financially as a nation. Again, my original intention for MoneyPhysics was to demonstrate the value in having a good set of effective theories for the behavior of the virtual substance we call money, in order to make the case for a good set of effective theories for the virtual substance we call software. One of the telling characteristics of a good effective theory is its ability to make valid predictions of future events, in addition to simply explaining the currently observed state of affairs, and I am glad to see that all the predictions I laid down in MoneyPhysics have come to pass.

1. We would not have another Great Depression.

2. Wall Street would continue to insist on being extremely overpaid, even for their nearly ruinous performance in 2008.

3. Wall Street would vehemently resist reforms and regulations to prevent another financial meltdown.

The good news is that the effective theories of Milton Friedman and John Maynard Keynes were successfully used to avert another Great Depression. Friedman’s monetarism was used to keep the money supply from crashing by propping up and bailing out the banking system, and Keynesian economic theory was used to keep aggregate spending levels up via the 2009 $787 billion stimulus package. Despite the fact that we successfully averted the decade-long financial disaster that my parents suffered through as children in the 1930s, most Americans seem to be extremely displeased, I suspect because they have no understanding of the magnitude of the disaster that was averted, and are only aware of the inequities created by my last two predictions. Personally, I find the last 20 months to truly be a triumph of economic theory. Through rational thought and actions we were able to avert a financial disaster through the application of good effective theories for the behavior of the virtual substance we call money. It certainly warms the heart of an 18th century liberal and 20th century conservative to see the fruits of the18th century Enlightenment put to such good use.

However, there presently is a great deal of controversy within the country and within Congress as to how to proceed with the necessary financial reform and regulation required to address my two last predictions. The current administration is proposing something along these lines:

1. Limit the capital size of banks. Currently there are 6 banks that control 70% of deposits and another 10,000 banks that control the remaining 30% of deposits. The cap limit would prevent banks from becoming too large to fail.

2. Limit the amount of leverage. Recall that leverage is borrowing money to invest in financial instruments that you hope have a higher rate of return than the interest you pay on the loans used to finance your investments. Recall that Lehman Brothers ended up running up a leverage of 30:1 before it went bankrupt because it was so overleveraged in mortgaged backed securities (MBSs) and collateralized debt obligations (CDOs) when the housing bubble burst. There are proposals to limit leverage to a maximum level of 15:1, meaning that for each $1 that an institution owns on its own, it can borrow no more than $15 to invest in financial instruments – still a very high level of leverage.

3. When a financial institution does take on great risks that do lead to insolvency, the following actions are taken by the government when the institution fails:

A. The CEO and top-tier of management is fired.

B. The board of directors is fired.

C. The stock of the institution is dissolved and the stockholders lose all their money.

D. The bonds issued by the institution are defaulted upon and the bond holders lose all their money.

E. The institution is put into receivership for dissolution. The institution is broken down into smaller pieces which are then sold off. This would adversely impact the career paths and fortunes of the institution’s lower-level management.

4. Set up a $50 billion bailout fund that is funded by the banking system to be used to bailout institutions that do fail, so that the U.S. government never again has to bailout financial institutions as it did in 2008.

The basic idea is to once again have Wall Street live up to its fiduciary responsibilities as caretakers of the U.S. money supply by punishing individuals who would foment another financial meltdown, rather than rewarding them for their reckless actions as we were forced to do in 2008. The hope is that the above measures would deter reckless behavior and allow for the dissolution of rogue financial institutions in a responsible manner. There is nothing radical about this effort; it is all covered under Section 8 of Article I of the U.S. Constitution which calls upon Congress:

To regulate commerce with foreign nations, and among the several states, and with the Indian tribes;

To establish a uniform rule of naturalization, and uniform laws on the subject of bankruptcies throughout the United States;

To coin money, regulate the value thereof, and of foreign coin, and fix the standard of weights and measures;

To provide for the punishment of counterfeiting the securities and current coin of the United States;

Now the 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), so 90% of the U.S. money supply is really just a large number of bits floating around in cyberspacetime, much of it under the control of Wall Street, so it indeed is the responsibility of the U.S. government to step in and secure the U.S. money supply.

Now some members of Congress are opposed to these measures because they contend that the $50 billion bailout fund would promote risky behavior and an ongoing series of continuous bailouts into the far distant future. Obviously, these members of Congress have never been fired or lost all of their money in a financial investment! These measures would surely work because the Powers That Be of Wall Street would certainly act in their own best interest and would not get us into another predicament that would also lead to their own financial ruin. I doubt that the $50 billion bailout fund would ever be touched.

Some, outside of the current administration, are also calling for the breakup of the large investment banks, in keeping with the 1911 breakup of the Standard Oil Trust under the Sherman Antitrust Act of 1890. My former employer, Amoco, emerged out of this breakup as Standard Oil of Indiana. There is an interesting story that goes along with this breakup. John Burton was Standard’s first chemist, who rose to become the general manager of manufacturing of the Standard Oil Trust in 1909. At the time, gasoline was a by-product of the manufacture of kerosene, used for lighting kerosene lanterns. But Burton was convinced that Henry Ford’s Model-T was about to change the petroleum industry forever and that producing more gasoline from each barrel of crude oil was essential. In those days, crude oil was simply heated in a distillation tower and whatever was already in the crude oil was simply distilled off as a fraction of the incoming crude oil. In naturally occurring crude oil, gasoline only represents about 15% of the total volume, so you cannot get very much gasoline from crude oil with simple distillation. Burton hired Robert M. Humphreys, Francis M. Rogers and others from Johns Hopkins University to conduct research at the Whiting Refinery in Indiana, which still produces a large percentage of BP’s American output of gasoline. Over a 16 month period, this team conducted many experiments and finally discovered that by heating crude oil to 850 0F at a pressure of 75 pounds per square inch, they could get the long hydrocarbon molecules in crude oil to break down into the shorter hydrocarbon molecules of gasoline. Today this is called thermal cracking, and what it did was to boost the amount of gasoline obtainable from crude oil from 15% to 30%. Burton went to the board of directors of the Standard Oil Trust with this monumental discovery, but they thought he was nuts. This was 10 years before the invention of electric welding, so Burton’s stills were composed of riveted steel containers containing flammable hydrocarbons heated to 850 0F at a pressure of 75 pounds per square inch! The board thought that he would blow up the Whiting Refinery and voted his idea down. Besides, the Standard Oil Trust controlled about 90% of the oil industry at the time and had little fear of outside competitors adopting Burton’s crazy idea. All that changed in 1911 when the Standard Oil Trust was broken up by Teddy Roosevelt into 30 smaller companies. Burton went back to the newly formed board of directors of Standard Oil of Indiana in 1911 and was able to obtain their support to build thermal cracking units at the Whiting Refinery. The rest is history. In a similar manner, busting up the large investment banks of Wall Street might lead to lower Wall Street salaries and consequently less expensive IPOs and cheaper stock and bond issuances.

All of the above seems to make sense to me as an 18th century liberal and 20th century conservative – something sensible that President Eisenhower might have come up with in the same situation. Yet, there seems to be such open hostility in the country, with little rational thought. As I have mentioned in the past, I think that many people seem to have such a hard go of it because they have such incredibly poor models of how the physical Universe actually operates. They have no user manual and are forced to rely upon the hazards of common sense. Personally, at this point in my life I only seem to have confidence in science and mathematics, and so I try to use them in all aspects of my life, including those that deal with the “real world” of human affairs. If we go back to The Fundamental Problem of Everything and Self-Replicating Information, we recall that the “real world” of human affairs is largely concerned with the eccentricities of self-replicating information in the form of the interplay between genes, memes, and software. Like all living things, we are DNA survival machines, far from thermodynamic equilibrium, with minds infected by meme-complexes that in turn are rapidly being domesticated by software. The meme-complexes began domesticating our minds about 200,000 years ago, and only in the past few decades software has begun to do so as well. Now this is not necessarily a bad thing. The domestication of our minds by meme-complexes has given us art, music, literature, moral philosophy, science, and mathematics and our domestication by software has enhanced all of these fine things too. But we also need to be aware that the genes, memes, and software are just mindless forms of self-replicating information that are not necessarily working in our best interests, and that certainly seems to be the case in today’s divisive national climate. Some very strange meme-complexes seem to be running around wild in the national psyche. Throughout history, mankind has been parasitized by some truly horrible meme-complexes, so it is always important to remain on guard by keeping an open mind and realizing that the memes in a meme-complex that you might subscribe to are only approximations of reality and not reality itself. It is important to remain engaged in a civil manner with those holding differing views, if we are to succeed as a nation.

So here is my take on the situation – just a working hypothesis that I know is only an approximation of reality. To begin with, let’s go back to the basic physics of it all. Because we are DNA survival machines, far from thermodynamic equilibrium, we need low entropy things like food and shelter to exist. In order to make low entropy things, like a car, ham sandwich or a piece of debugged software, we need matter, energy, and information. As you know, we can always use low entropy energy and information to transform matter into a state of lower entropy useful to mankind, like turning a pile of rust into a car, through a set of processes that dump entropy into heat, in keeping with the second law of thermodynamics. We call this activity an economic system. Actually, the biosphere has been doing this for about 4,000 million years on this planet, so in a sense, all economic systems are simply extensions of the biochemical activities of the biosphere. However, this has always been a hard thing to achieve because we are in a constant battle with the second law of thermodynamics, which tries to do just the opposite, like turning cars into piles of rust. The second law always turns low entropy matter, energy, and information into high entropy matter, energy, and unknown information. Recall that in The Demon of Software we saw how entropy itself can be viewed as a measure of disorder or unknown information that we call ignorance. As I pointed out in SoftwareBiology, the way that the biosphere and all economic systems manage to do this is through the Darwinian mechanisms of innovation and natural selection that yield the famous “survival of the fittest”. This is most evident in a capitalistic economic system, where businesses innovate and compete against one another, but is also found in feudalism, socialism, communism, and all the other economic systems. The only difference being that in non-capitalistic economic systems the “survival of the fittest” does not necessarily select for successful business activities, but more likely for individuals who succeed at working the system, and that is why other economic systems have historically yielded such very low levels of economic output because they stifled the initiative of the individual.

Sadly, despite the advances brought on by the 18th century Enlightenment, from which the government of the United States was spawn, there seems today to be afloat a very strident anti-government meme-complex running rampant throughout the country. It seems this meme-complex would have us return to the days of limited government, so limited that it might not even exist at all. This meme-complex would have us simply solve all problems through the free enterprise system of free markets, with no need of government interference whatsoever, and would forgo the regulation of the financial systems of Wall Street altogether. However, this meme-complex fails to recognize that all economic systems are really based upon domesticated versions of the Darwinian concept of “survival of the fittest”, and this includes modern capitalism, which actually benefits from government regulation. Without any government regulation at all, it would be quite permissible to enter a bank with an AK-47 to make a $100,000 withdrawal. After all, why should the government interfere with a private financial transaction between two parties? History has repeatedly shown us that, when carried to the extreme of a society with no government regulation at all, the Powers That Be of Wall Street would be rapidly replaced by an assortment of potential warlords lurking in our prison systems.

So it all boils down to a matter of degree. To what degree should capitalism be domesticated by government? The anti-government meme-complex would severely limit the level of domestication in the belief that a totally unfettered market place always leads to the optimal solution of all economic problems. But this is not always the case as Richard Dawkins pointed out in The Greatest Show on Earth (2010). Why are trees 100 feet tall instead of 10 feet tall? It takes a lot of mass and energy to build a 100 foot trunk to hold the leaves that gather sunlight. A 10 foot trunk with widely spreading branches would do the job just as well, and a 100 foot trunk is made mostly of cellulose, a tough substance that not even termites can digest – the bacteria in their guts do that for them. The reason that trees are 100 feet tall is that they grow in forests and compete for sunlight with other trees. A 10 foot tall tree species in a forest would be quickly shaded into extinction. So trees grow as tall as possible, until other factors enter into the calculation of survival and limit their growth. A 1,000 foot tree would have no competitors at all, until it blew over in a gentle breeze. So a forest does indeed work, Darwinian “survival of the fittest” guarantees at least that much, but it clearly is not the most efficient way of collecting sunlight. About 10,000 years ago we learned that by cutting down the trees and planting the exposed ground with domesticated seeds, we could dramatically boost the economic productivity of the biosphere by artificially changing the rules under which “survival of the fittest” operated. Similarly, over the past 100 years we have done the same thing with the rules under which capitalism operates, in a manner to allow capitalism to work its miracles in a manner useful to mankind. But capitalism needs a reliable money supply to do that, and only the government can provide it – that’s why they put it into the Constitution!

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Steve Johnston