What was that famous Adam Smith quote, the one that made the case for free trade better and more concisely than ever before, or ever since?

It is the maxim of every prudent master of a family, never to attempt to make at home what it will cost him more to make than to buy. The tailor does not attempt to make his own shoes, but buys them from the shoemaker. The shoemaker does not attempt to make his own clothes, but employs a tailor.

What is prudence in the conduct of every private family, can scarcely be a folly in that of a kingdom. If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry, employed in a way in which we have some advantage.

But, you know, the “prudent master of a family” does not engage his tailor and buy his shoes on credit, for prolonged periods of time and with no forseeable means of repayment. Debt securities do not represent the produce of our industry. Sometimes the wisdom of crowds is not found in central-bank manipulated markets, but in the messy kinds of preferences expressed by voters in elections.

I’m all for free trade. But what many businesses and economists refer to as free trade, in this real world circa 2006, is not trade at all. Trade implies two parties exchanging value. I’m a long-time, knee-jerk anti-protectionist. But at this moment, I don’t know who to be more afraid of: US politicians catering to paleolithic economic xenophobia, or economists who’d describe as “free trade” the United States’ growing addiction to goods and services it cannot pay for and the nation’s ongoing, humiliating “soft default” on debts public and private via real depreciation of the dollar.

A man standing in line at a soup kitchen is involved in a voluntary transaction between two parties. He may think he’s outsmarted the guy with the ladle, working the system, getting something for nothing. But that man in line at the soup kitchen is neither admirable nor prudent, and it is that guy with the ladle who holds the power. The problem with a free lunch is that it may not be there tomorrow. And a free lunch, however long it lasts, is not free trade.

This rant was inspred by a post by the very excellent Mark Thoma.

Via Brad Setser, Steve Johnson describes the recent sell-off in world markets:

The selling was largely driven by a sharp rise in volatility, with the Vix index, often referred to as Wall Street’s “fear gauge” hitting a two-year high.

This increased the “value at risk” of leveraged investors such as hedge funds, forcing them to cut long positions. Many of the assets that had made the strongest gains this year, such as emerging markets, fell most sharply as a result.

This issue of VAR-driven sales on increasing volatility bring up a very general point about risk mitigation in financial markets: Any single risk-mitigation scheme widely adopted to reduce the risk of individual participants increases systemic risks to the market. Runs on banks, programmed stop-loss sales, and now sales at VAR thresholds are some examples of this that we’ve seen. All are dangers of risk management monocultures.

Dangers of derivative-based risk control are more subtle, because derivatives allow the party that would otherwise bear risk to hold their “insured” positions rather than scrambling for the doors. But if the bearers of transferred risk manage their exposures very similarly, then their collective behavior creates systemic risks that come back to bite holders of the underlying. For example, if bearers of credit risk in swap arrangements mechanically short the credit market to hedge risk as credit spreads grow, bond prices will fall and credit spreads widen just as surely as if uninsured bondholders had sold-off themselves. Derivatives allow for greater diversification and dispersion of risk, ideally to those who best placed to bear it. This probably does push back the thresholds at which dangerous risk-mitigation herd behavior kicks in.

But if the buyers of risk all turn out to look alike and act alike, if their tolerance for bearing risk is limited, if they have underpriced risk in tranquil times, then everybody had better watch out. Even for those who have trimmed exposure rather than assuming risk, derivative-based risk management, like diversification, can only protect against security or sector-specific risks, not against systemic risk. If everyone bearing any important category of risk has similar (“industry best practice”) ideas about how to cut incipient losses, that’s a source of systemic risk. Beware risk management monocultures.

In a conversation about a recent post of Michael Shedlock’s, Eugene Linden likened financial risk to environmental toxins. His very astute observation was that the use of derivatives to disperse risk is much like the strategy of managing toxic chemicals by flushing them to the sea. At first blush, this is eminently sensible, because poisons when sufficiently diluted are not poisonous at all, and may be harmlessly absorbed by the environment. But in fact, the strategy is fraught with peril. Some toxins don’t stay dispersed, particular agents accumulate them, and become poisoned and poisonous. In a bay, shellfish might accumulate dangerous levels of heavy metal, and become unfit for human consumption. In the financial world, we know that lots of risk has been created and “dispersed” via derivatives, but we don’t have good information on whether all this financial risk is harmlessly diversified, or has concentrated dangerously in the hands of some speculative agents. The accumulation of metals by seabed mollusks does harm not only to the mollusk. Similarly, ill-advised accumulation of risk by hedge funds or investment banks could lead to consequences extending far beyond the risk-accumulator.

I thought this was a particularly good analogy, and have been thinking of other pollution metaphors in finance. “Global imbalance” is a shorthand commonly given for the situation in which some countries — in particular the United States — are spending more than they collectively earn, while others (China, Saudi Arabia, Russia) are selling their goods and services for debt. These habits have become embedded structural facts of various economies, implying changing the pattern — the US builds up debt, China and the oil states — will require “economic adjustment”. Economic adjustment is a euphemism for hard times, and this arrangement is not just a private matter between a few countries. In today’s interlinked global economy, US consumers provide a great deal of world demand and the US dollar is the global “reserve currency”. China’s population represents nearly one quarter of the world population, and its political stability depends upon economic growth. If “adjustment” doesn’t occur smoothly, there could be a global economic downturn, political instability, resource wars, you name it. These are all improbable events, but they are risks borne by the entire world, and risks that grow with continued unbalanced world growth.

So, in a sense, “global imbalance” is also a lot like pollution. The United States, China, the elites who run the petrostates, are all “getting something” out of the present arrangement. (The US gets to consume inexpensive goods paid for with low-interest IOUs that may never be fully paid; China gets export-led rapid-fire development; and the petrostates get high oil prices without crimping demand, since the US is buying with debt and China is taxing and subsidizing oil consumption.) But, at the same time, they are poluting their own economic and political environment, and that of the rest of the world, with risk. Like polluters generally, “global imbalancers” continue to do what they’re doing because in the short-term it’s profitable, long-term costs are uncertain and won’t be borne solely by the polluter. In economist-speak, global imbalance, like pollution, is an “externality”.

Of course, with respect to pollution, industrial societies have been dealing with these problems for a long time. There’s no formula for preventing pollution, but one approach that’s worked very well both environmentally and politically are so-called “cap and trade” programs. I got to thinking about how we might “cap and trade” global imbalances.

I’m not the brightest bulb on the tree, but Warren Buffett just may be. He proposed a scheme called “import certificates”, way back in October 2003. Revisiting it, what does it amount to? It is precisely a cap and trade scheme for global imbalance. I read this way back when, and thought it was kind of loopy. Rereading it now, it seems kind of brilliant. This Buffett guy, he’s not so shabby. Why did this proposal get so little notice? It’s remarkable in that it permits markets to determine who can most efficiently bear the cost of global rebalancing, and permits gradual application, as the initial “cap” on the US trade imbalance could be set at something like the present level, with a commitment reduce US overspending only gradually. It’s financial innovation at its very best. Why hasn’t this been done? Why don’t we do it now?

Today I’m into nutshells.

Asset markets and central banks are control systems, intended to provide incentives that encourage the effecient use of human and economic resources. I believe these “macro” control systems are malfunctioning, badly. Structural weaknesses in these institutions have permitted some classes of agents to profit from the misallocation and expropriation of resources, creating strong constituencies for the continuation and exacerbation of those structural weaknesses.

Why has nothing really obviously bad happened, if the world’s macroeconomic control systems are so out of whack? Economies are big, slow things. They have a lot of intertia — they like to keep doing whatever it is they do. They can be tortured a good bit and bounce back. They have a great diversity of control systems, much more fine-grained, local, and efficient than the large scale capital markets and games played by central banker finance ministers. There are margins for error. But those margins are not infinite. Self-correcting control system failures are okay. Autocatalytic failures, where ineffeciencies promote even greater ineffeciencies, are not. That’s where I think we are now.

When describing the problems, they sound very big, central, “macro”: currency manipulation, artificial liquidity, leverage, asset bubbles, commodity inflation. But central banks are not the answer to the problems they’ve helped to create. Reform, when it comes, won’t be with a Plaza Accord, an IMF/G-7/OECD initiative. The solution, eventually, will involve changing the definitions of money, corporate stock, and other financial assets, and the structure of the markets on which they trade, to be less prone to self-reinforcing malfunctions, and far more grounded in specific, local, and concrete knowledge. These will be fairly radical changes, though there may be incremental paths to get there. Understanding what more robust and effective market-based control systems would look like, and developing a rich, quantitative theory relating information-work to efficient decision-making, are perhaps the crucial challenges of our time.

Existing home sales (seasonally adjusted) were flat in March, after a jump in February that seemed counter to notion of a popping housing bubble. Rising to flat existing home sales are definitely better news than plummeting values. But, the news is not really as okay as it seems.

Houses differ from many commodities in that sales should be affected by inventory, even at constant prices. Why? Because an inventory of houses is not like an inventory of identical widgets. No two homes are exactly alike. Cautious buyers seek homes that must match very idiosynchratic criteria. Holding “pickiness” constant, the likelihood that any buyer finds a suitable home will corelate positively with the number, and therefore “selection”, of homes is target neighborhoods. Therefore, all else being equal, existing home sales should be expected (as an absolute number) with increasing inventory.

Even with February’s “jump”, existing home sales didn’t keep up with rising inventory. Flat sales in the face of rising inventory this month is suggestive of a weakening home market.

Here’s a graph of existing home sales in absolute numbers (seasonally adjusted):

And here’s existing home sales as a fraction of inventory:

In the context of rising inventories, the graph of sales in absolute terms would be expected to “better” than reality, because sales should rise with inventory. The graph as a fraction of inventory looks “worse” than market reality, because even in a healthy housing market, the increase in sales attributable to higher inventories would not keep up with the increase in inventory when there is already a fairly reasonable selection of homes available.

Hat tip: Calculated Risk

Update: Commenter tryuj notes, correctly, that I’m off by a year on the months graphed. I’ll try to redo these graphics soon… Okay, they’re fixed now. Thanks to tryuj and qwerty.

The one thing that the current leadership of the United States and the current leadership of Iran have in common is an interest in high oil prices. Iran’s government and ruling elite live off of oil revenue. At present, macroeconomic conditions are such that high oil prices lead to a redistrubution of wealth in the US towards the Bush administration’s personal and political friends without (so far, so good) damaging the broader economy in any obvious way.

A gentlemanly game of saber-rattling seems to be in the interest of both parties. Perhaps that is why we have one.

A nuclearizing Iran may be a real issue. The world is full of real issues. The current crisis might have come up any time in the past decade, and might have been delayed five years with the smallest amount of fudging and dissembing and rhetorical moderation on Iran’s part. Why now?

I’m not alleging a conspiracy here. In a game of two players with a mutual interest, there need be no secret handshake to seal a deal. Nor am I alleging that everything is fabricated. Perhaps the new Iranian President really is driven by domestic power considerations in his boastful cretinism. The Bush Administration probably does want to see regime change in Iran and an end to its nuclear program, and Sy-Hersh-style deniable brinkmanship may be a defensible strategy to get there. But it can’t hurt, from either perspective, that the athletes in this little game of nuclear chicken are very, very well paid.

Commenter “jm” to a Brad Setser post remarks…

Because such a large fraction of any rise in the prices we pay the oil producers is immediately lent back to us — and in dollar-denominated loans — the effective drag on the US economy of higher oil prices is less by that fraction.

If we pay $10 more per barrel for oil, but $8 of that is immediately recycled back to us through purchases of US securities…

His analysis is right on, but perhaps it doesn’t go far enough. As a thought experiment, let’s make a bunch of assumptions, and see what happens:

1. Following JM, we posit that 80% of oil revenue is neither consumed nor used to fund domestic investment by oil producing countries, and is instead used to purchase debt securities on international markets.
2. We presume that the US has an 80% market share in the international debt securities market, and that this will remain constant over the short term. (Even if Iran, for example, buys only Euro debt, we assume that indirectly 80% of all international lending finds its way to the US.)
3. We guesstimate that the US accounts for 25% of the world’s petroleum consumption, and that oil demand is perfectly inelastic (short term).
4. We assume that US current economic activity is cash constrained. That is, US agents will consume or invest all the cash that they borrow, without regard to the total debt load they are racking up in the process.¹
5. We assume for simplicitly that cashflows are instantaneous, that effects are not at all lagged.

Now, when a US consumer purchases that a dollar’s worth of oil, the US economy sees an outward cashflow of $1. Oil producers see an incoming cash flow of $4 (since the US represents 25% of the world market by assumption). Oil producers lend $3.20 of that revenue to international markets. US borrowers take on $2.56 worth of debt. What’s the net cashflow to the US economy associated with a purchase of oil? For ever dollar spent on oil, Americans get their dollar right back in lendings, plus an extra $1.56 of new lending to purchase homes, vacations, and SUVs with. In other words, an increase in the price of fuel is cash flow positive to the US economy! By assumption 4, this means that despite the reduction of net exports represented by high fuel prices, an increase in the price of oil leads to an increase in US GDP! It’s a great deal, until something changes.

The assumptions above are not quite right. Probably something less that 64% of every dollar in the world spent on oil ends up repackaged as loans to the US. World oil demand is likely to be price elastic, especially outside of the US where funds spent on oil are not offset by incoming debt-driven cash flows. But I think the overall point stands. So long as the US collectively is not worried about its increasing debt load to the rest of the world, high oil prices may well be a current stimulus, and not a drag at all, on the US economy.

(For more on this topic, see Brad’s post, the Nouriel Roubini post Brad was responding to, this post by “Calculated Risk” on his own blog, another post by CR on Angry Bear.)

Update: I think I should add that my personal opinion is that there is some truth to this story, in describing the recent past, but that the world is changing, the US is getting skittish about taking on more debt and the world is getting skittish about lending so cheaply, so that relying on high oil prices as a “stimulus” going forward would be a bad idea.

¹ Assumptions 4 and 2 are all mixed up, as the US “market share” of debt sales, which I’ve assumed constant, has something to do with Americans’ willingness to increase their indebtedness, and with the price Americans can get for securitized debt, that is with the low yield Americans pay. For the past while, US long-term debt prices have been nearly constant, and the US share of sales to international debt markets has been consistently high. But as the price of Americans can command for taking on long-term debt is finally beginning to subside, assumptions 4 and 2 lose even the very modest contact with reality that they may once have had.

As anyone who’s studied finance even casually knows, the most celebrated principle of investing is diversification. In particular, purchasing multiple securities with low or negative covariance diminishes the risk an investor faces in owning a portfolio. Risk, in financial parlance, is operationalized as volatility, the variability of a security’s value. Covariance means the tendency for two securities to move simultaneously. Holding multiple securities of low covariance reduces risk, because if one security drops in value, low or negative covariance implies that it’s unlikely that all will drop in value simultaneously. The the risk — the variability in value — associated with a particular security is diluted in the portfolio by the likelihood that when one security falls, others are will rise or at least hold their value, damping any change in value of the portfolio as a whole. This is the principal of diversification.

In practice, investment managers construct portfolios by estimating the return prospects, the risk (volatility), and the covariances of various securities, and computing the portfolio that, based on these estimates, maximizes the ratio of risk to return. If managers were able to forecast expected return, variance, and covariances with 100% accuracy, rational investment would be a science, and there would be a clear “best” portfolio. To the degree that within a universe of securites, there are ample choices with low or negative covariances, investors would see great benefits to diversification. But unfortunately, future return, risk, and covariance can be forecast imperfectly at best. Portfolio managers understand this, especially with respect to return. Few professionals would rely on the naive forecasting strategy of guessing that this year’s return on some stock will simply be the same as last year’s. But variance and covariance are different. Historical values for the volatility and comovement of securities are in fact very frequently used as “best guesses” of future covariance. Investors are urged to hold portfolios that include stocks, bonds, commmodities, precious metals, currencies, and real estate, because historically these asset classes don’t typically move together.

But guessing future covariance from past covariance can be as hazardous as expecting a stock to do great this year because it did last year. Over the past while, there has been an odd spate of covariances. US stocks, real estate, precious metals, and oil have all done well. The US dollar has also done well, despite the historical negative covariance between USD and precious metal. Bonds have, until very recently, been flat. US wage perpetuities, the stream of future wages that represents most Americans’ core asset, are not directly priced. But wage growth, the value driver of this asset, has been flat, unusual in the face of rising stocks, commodities, and real estate.

In other words, covariances over the last year, viewed in terms of annual return, have been weird. There’s been a lot of simultaneous zigging where ordinarily a bit of zig and a bit of zag would have been expected. These are ahistorical covariances. Most investors haven’t minded, because nearly everything in their diverse portfolios stayed put or went up, rather than the usual won-some-lose-some scenario. It’s almost as if there’s some magnet or wind pulling normally independent spirits in the same general direction. Covariance is nice when it’s a general updraft.

But beware ahistorical covariance if the wind changes direction. The most professionally crafted portfolio won’t protect an investor from wild swings in value, if its holdings were based on historical covariance assumptions that suddenly fail to hold.

Glenn Reynolds writes…

ARNOLD KLING ON fear of confrontation: “Unfortunately, large segments of American society no longer have the ability to confront real evil. People lack the confidence and moral clarity to stand up to intimidation. . . . One can view Islamic militants as armed versions of unruly teenagers. We should not feel guilty toward them. We should demand reasonable and decent behavior from them, rather than excuse their tantrums or their crimes.”

That would require thinking of ourselves as adults, which is unacceptable to many.

I want to think of “us” as the adults. In fact, in the run-up to the Iraq war, which I supported despite the clear disingenuity of the war’s justification, I took a similar, explicitly paternalistic view of the world. The Europeans in particular were behaving like petulant teenagers, protesting “the system” while enjoying a vast subsidy, in financial terms and as “moral comfort”, by letting America do the dirty work ensuring their security. And I viewed much of the Middle East as locked in a kind of post-Marxist, post-colonial, Che-T-shirt-style adolescent radicalism, which mixed with Islamism and pan-Arab nationalism, and unfortunately real explosives. My view at that time was that the United States was an arbiter of reason and civilation, imperfect but sufficient to enforce certain standards and keep the peace.

But, owing partly to the incompetence which with Iraq’s reconstruction has been managed, but primarly to the fact the United States has allowed the soundness of its own economy to become badly undermined, I no longer believe we are credible adults. My estimation of the Europeans and the Islamic world have not changed. I’ve little flattering to say about either. But now the United States reminds me of an alcoholic parent trying to keep its delinquent kids in check. Tipsy, blustering America might be well-intentioned, it might in fact know better what’s right and what’s wrong, but its constant bumbling, its ability to throw tantrums but incapacity to lead or to guide, and its self-destructive partying on cheap capital render it an ineffective role model. The US is in for a bad financial hangover from its subsidized home-equity binging. While I have complete faith in America’s ability to take a cold shower and figure out how to right itself economically, that will take several years, and those will be years in which the US will be weakened, and manifestly in crisis. America’s security burdens will weigh heavily in an era of financial pain at home and escalating US dollar prices for anything and everything in foreign lands. I’m afraid we may not have the wherewithal to carry the load.

And then I am haunted by Osama Bin Laden’s tale of the weak horse and the strong horse. In a world where America is weakened and Europe is senescent, let’s hope that it is India, or the Pacific Rim, or even Red China itself that rides tall for a while, and not some destructive amalgam of religion, nationalism, and fascism.

Stephen Den Beste once wrote about electrical power:

…electric power has unique properties, and one of the most important is that at any given instant the amount of electric power being generated will always exactly match the amount of power being consumed. If you don’t deliberately balance the system, the laws of physics will do the balancing for you in ways you won’t like.

Electric power has to be generated at the time it is needed, and the electric power grid overall has to have the ability to add generation capacity as demand rises, and to reduce generation when demand falls again.

But this property is not unique to electrical power. Wealth in general must also be generated at or very near the time at which it will be consumed. Just as electrical power can be stored in batteries, but it’s inefficient, wealth can be stored (durable goods, commodities like gold or oil), but only very imperfectly. Here’s a thought experiment: Imagine you have a million dollars today, and a reliable single-use time-machine. You buy a million dollars worth of gold, cart it into the device, and set the dial to Y3K. When you step out, you find that some apocalypse has occurred. Fortunately, humans are not extinct. The locals still like gold, and they respect your property. You live out your life, but as a very rich man would have in Neanderthal times. Your gold was perfectly storable. But your wealth was not. You are much poorer now than then. The same story would hold with any commodity, or with any practical mix of commodities, by which a person might try to store wealth. An individual’s real wealth is a function of the claims he can muster on the products and services provided by a diverse current economy. Without such an economy, whatever one has, whether financial assets or real stuff, will have only very temporary and limited value.

Americans perceive themselves as very wealthy, and as Alan Greenspan used to say Americans’ balance sheets have never been healthier. But “health”, in this sense, means equity, stored wealth. But this is only the illusion of wealth, truckfulls of gold in a time machine.

The US economy is not producing a sufficiently diverse range of goods and services to support its apparent stock of stored wealth. Foreigners who produce what Americans need have progressively diminishing incentives to exchange their current products for claims on US wealth, as what the US economy produces is increasingly useless to foreigners. There may be all kinds of political reasons, domestic and international, for foreign countries to treat US money as valuable, but there are precious few economic reasons. Thus it is not private citizens in foreign countries who value US claims, but their governments.

Fundamentally, whether a country is wealthy or poor has little to do with what it “has in the bank”. A country’s real wealth is nothing more than its capacity to produce goods and services that make its citizens feel wealthy, or that can be exchanged outside the country for what its citizens want. The US economy is dynamic and productive in the broad range of goods and services. But for the moment, the US is neither producing all that it wants, nor producing what others want in exchange for what it fails to produce. Whether the US is rich or poor is unknowable at the moment. That will be put to the test, when other nations stop providing free goods and services and Americans are asked to actually produce or trade for all that they wish to consume.

There’s a difference between being on an expenses-paid vacation and being rich. And the longer the vacation, the harder it may be to get back to work. Or not. We’ll see.