An Orthogonal Development Theory

Worldly Philosopher: The Odyssey of Albert O. Hirschman by Jeremy Adelman

Conversation – Instalment 12: An Orthogonal Development Theory

Chapter 10. Columbia Years                                                                       

                                               

by

 

Howard Adelman

                                                                         A

 

 

 

 

 

 

 

 

 

 

 

                                                           

 

   C                                                                    B                                                             D

The lines AB and CD are orthogonal to one another.

If CB and BD represent two oppositional development theories, then AB, at right angles to both theories and illustrated as perpendicular to both, makes the third theory mathematically orthogonically related to the other two theories. On p. 322, Jeremy describes AH’s thinking as so “orthogonal”. (p. 322) By explicating and clarifying the key characteristics of AH’s development “theory”, I want to show that it is indeed a theory –contrary to Hirschman’s (and Jeremy’s) protests otherwise. As Jeremy put it, AH “began to think about development in Columbia from the ground up – with a style but with no theory.” (p. 303) As AH worded it, “I looked at ‘reality’ without theoretical preconceptions of any kind.” (p. 297)

This is correct if “theory” is exclusively restricted to sets of statements or principles which are abstract and in terms of which events or actions are explained and even can be predicted. But theory also applies to principles that guide action or a set of practices by means of which judgments can be made. So although AH never had a theory of development in terms of a general abstract model, he certainly did have a theory about interpreting the phenomenal world of experience.

The problem goes back to the Greeks, and Aristotle in particular, where theoria was contrasted and seen as wholly other than practice. This is one reason his theory of health and the humours was so messed up and his theory of humours was so misleading for health practitioners for centuries. Diagnosis of disease begins with identifying four sets of key variables: a set of symptoms or indicators, anatomical location, physiological functions and an interpretation of the aetiology of the disease. The theoretical designation of a disease is then modified in each of these categories in accordance with experience and actual practice. There is no abstract model of the disease. AH developed a theory of development in precisely these terms.

Beginning with a quote from Franz Kafka as usual, Jeremy begins his chapter on Hirschman’s work in Columbia, the country to which he went when his career in Washington was still encountering roadblocks. “You can hold yourself back from the sufferings of the world, that is something you are free to do and it accords with your nature, but perhaps this very holding back is the one suffering that you could avoid.” (p. 295) The quotes from Kafka are always very pointed, but this one I found to be particularly poignant. When Jeremy was still in high school during the seventies, he took a year off to serve as a volunteer with Canada World Youth and served that year in a very remote part of Columbia living with a poor peasant family and assisting them while, at the same time, he gained his mastery of Spanish, albeit with a Colombian accent.

While Jeremy was with the family, the mother gave birth. When the infant was very young, he contacted me from this remote part of Colombia. The infant was very ill. The family lacked the resources to travel some distance and take the infant to the nearest nursing station or infirmary. He felt helpless because the ideology of Canada World Youth ran on a doctrine of non-interference in the local situation other than providing volunteers. Infusions of wealth from outside would deform the local economy, introduce distortions and such interventions were actively prohibited by volunteers. Jeremy wanted to ask me for the money to help out but was conflicted since he felt bound by the principles he had accepted when joining Canada World Youth. He was deeply torn. The issue was clearly not the amount since it would have been a relative pittance even if the health fees were added to the travel costs. Instead of insisting on sending him the money and persuading Jeremy that, “To save one child is to save the world,” I also practiced non-intervention and did nothing. I felt terrible. He felt very much worse as he watched the infant die in front of him. I am convinced that we both acted improperly at the time. I believe, to this day, that this event scarred Jeremy, though I believe it instilled in him his first suspicions of abstract doctrine and his attraction to dealing with the present and the immediate demands of the moment. The event certainly scarred me.

Development theory has very direct consequences on the lives of ordinary families. AH arrived in a country torn by civil war (La Violencia). Jeremy characterizes AH’s years in Colombia as the best of his and Sarah’s lives, a place of adventure and cultural stimulation where Albert was intellectually reborn. The World Bank had already reinvented itself in the aftermath of the Marshall Plan as the vehicle to save the Third World from communism and ultra-ambitious state planning. Colombia was to be its first test case. AH brought a scepticism of abstract ideological formulations, an attraction to direct observation of small things and routine practices combined with the opportunity and continuity over time to make those observations, and a belief in learning by doing reinforced by Eugenio Colorni and his readings of Montaigne.

The World Bank formed a survey mission led by the Canadian-born economist from Nova Scotia, Lauchlin Currie, whom I met briefly at SimonFraserUniversity in the late sixties when I participated in developing a plan for student housing for the university. I regret that I never got to know him, especially since, in retrospect, he had developed, I believe, the theory of money similar and far more profound than the one I espoused. He also showed that he had an intimate acquaintance with cooperatives. He had attended St. of X (FrancisXavierUniversity) where he was undoubtedly infused with its Catholic teachings of social service and cooperation. Currie went to LSE and then earned his PhD at Harvard writing his thesis on banking and the money supply. He was an ardent Keynsian New Dealer adviser to FDR during WWII, a close adviser to Harry Dexter White at Bretton Woods and had been involved in the secret VENONA Project decrypting Soviet cables where he (inadvertently?) became a source to Soviet intelligence. He ran the World Bank Colombian Survey Mission from 1949 to 1953 and stayed on in Colombia when the USA refused to renew his U.S. passport.

For Currie, the object of economic planning was to raise the standard of living in Colombia and directly tackle the problem of poverty.  In one year, starting in July 1949, a team had been assembled, a comprehensive plan developed and a National Planning Institute initiated to implement the plan, The Basis of a Development Program for Colombia. The plan envisioned “aggressive and coordinated improvements on all fronts simultaneously to avoid distortions, bottlenecks, and lags.” (p. 300) The plan was based on the developmental conception of “balanced growth” and the “big push” only to have the grandiose expectations crash against “inconvenient realities”.

One of those very inconvenient realities was the clash of personalities and approaches. AH was hired as advisor to the National Planning Council. Currie, through the machinations of Emilio Toro, the Colombian member of the Board of Executive Directors of the World Bank, returned as an “adviser” to the Council so the Council now had two advisors though Hirschman was the one charged with overseeing implementation but, unlike Currie, did not have a Board member in his pocket to push his views. AH had left Washington’s skulduggery for Bogota’s. “Currie liked big plans, especially when they made administrative reform the condition for everything else; Hirschman preferred projects, even big ones – but the more specific, the better. Aligned with the Liberals, Currie tended to create animosity between the Council and the Conservative government; Hirschman eschewed partisanship and wanted to focus on problem solving.” (p. 301)

If Hirschman was burdened with the Currie-Toro duo undermining his authority and ability to act, the Council hired another outside economic adviser from Belgium, Jacques Torfs, who approached the problem of development from his own idiosyncratic abstract esoteric theory of minimizing capital-to-output ratios. In addition to rival abstract theorists posing problems, AH took seriously the principle of being an adviser to facilitate and advance local expertise and authority, while Currie believed that detachment as well as true expertise gave foreigners an advantage. AH did not have the same reverence for detachment. He preferred experience and close observation. He wanted to concentrate on what the country was doing right and not its grand pathologies. However, his proposed study on successful businesses and successful entrepreneurs and managers and their methods and means of financing never took place.

When General Rojas Pinilla’s military coup in June of 1953 quickly developed into the usual predatory military capitalism compounded by a slide in coffee prices, Colombia’s economy slipped quickly down hill. At the same time, austerism, the other end of the abstract theoretical economic spectrum, took command. Currie went off to raise prize Holstein cattle. AH determined he was now impotent. He resigned just when Senator Joseph McCarthy was at the pinnacle of his power heading the Senate Permanent Subcommittee on Investigations in 1953 and 1954. Prudently, AH went into private practice as an economic consultant in Bogota to help investors identify opportunities and solutions to problems. Opportunism (AB) had been developed as a counterpoint to both Keynesian master large scale planning and stimulus for a broad approach to balanced growth (BD) as opposed to austerism (BC), a policy advocating restrictions on money supply and reductions in deficits just when a country needed a stimulus.

Opportunism focussed on the openings for entrepreneurs, focussed on civil society initiatives rather than grand government policy of either the austerists or the Keynesians. The theory, in the second sense I specified at the beginning, stressed initiatives from the bottom rather than grand views from the top. This was precisely when Walt Whitman Rostow’s The Stages of Economic Growth: A Non-Communist Manifesto was published by Cambridge University Press and became must reading when I was an undergraduate. In spite of all Rostow’s bended intellectual knee to the uniqueness of each nation’s experience and the somewhat arbitrariness of the stages-of-growth and its limitations, his book offered a very positive law-like approach to understanding economic development that built on and went beyond Croce’s Historical Materialism and the Economics of Karl Marx in providing both a grand theory of economic development as well as a grand theory of history in terms of dialectics without Marx’s romantic revolutionary spirit. Rostow had proposed a grand theory of modernization depicting the worship of sustained long-term economic growth itself as a central part of the doctrine and the key determining forces at each stage of economic development.

Rostow’s treatise would soon be followed by Max Millikan’s 1963 volume, The Political Case for Economic Development and his 1966 even more influential book as far as I was concerned, Equity versus Productivity in Economic Development. Liberals had their antidote to Marxism and their own romantic versions of how to rescue impoverished countries from the debilitation of stagnant economic circumstances.

To a conference in October 1954 on the new theories and their implications for policy, AH brought the message that the emperor was naked and that the empirical date behind the theories were almost entirely lacking. The abstraction of balanced and comprehensive planning hit the shoals not only of a complete lack of sufficient evidence and too high a degree of abstraction, but a belief that the future was predictable and could be managed whereas AH had been too deeply steeped in the Hegelian dictum that we can only understand by looking backward. As Hegel wrote in the Preface to the Philosophy of Right, “One more word about giving instruction as to what the world ought to be. Philosophy in any case always comes on the scene too late to give it… When philosophy paints its gloomy picture then a form of life has grown old. It cannot be rejuvenated by the gloomy picture, but only understood. Only when the dusk starts to fall does the owl of Minerva spread its wings and fly.”

During this period in the philosophy of history, two major theories were in contention,. One was the positivist views inherited from Benedetto Croce of Carl Hempel who was then at Princeton. For Hempel, history should be akin to a science and explain events and actions by subsuming them under general laws that could be verified by their predictability. Opposed to the grand theories of the positivists were the theories of the verstehen school then led by the University of Toronto philosopher, William Dray, who thought that history was about re-enacting the thought processes of historical agents and, as I wrote in my PhD thesis, subsuming decisions about which actions to take under more general hypothetical imperatives to guide human conduct. Was history a subject matter for pure scientific reasoning or for hypothetical imperatives and practical normative reasoning? I, like Albert Hirschman, opted for neither. Both theories never even met the conditions of satisfying the cases each side cited. We do not explain historical actions by subsuming them under general scientific laws or subsuming them under normative imperatives. Further, we do not even explain actions or events; rather, we explain incongruencies. We deal with puzzles that face us and focus on problems not on actions abstracted from the context of the inquirer.  

Why do I call this orthogonal approach a theory when it so stridently disavows abstract modeling? Because it does not! It only disavows extending any generalization into the future without irrefutable solid evidence. In the interim, analysis can reveal patterns of contradictions and ways of resolving them, but the dialectical pattern revealed cannot be applied to futurology for the very essential dynamic of the model depends on innovation and re-inventing itself thereby creating new but unpredictable opportunities that will be taken advantage of on the ground while those actual innovations are entirely missed by the theorists rooted as they are in extrapolations from the past.

In sum, AH did have a theory of development, one not based on either supposedly scientific laws of explanation and prediction nor on empathetic re-enactment to reveal the moral imperatives governing agent’s choices and actions. The theory, loosely referred to as Opportunism or, more awkwardly, Possibilism, had the following characteristics.

1. Focus on problems or incongruencies;

2. Use detailed case studies and focus on acute observation of fine details and distinctions;

3. Establish concrete and routine practices that can be continued over time to test efficaciousness – learn by doing;

4. Try to locate and identify initiatives that will be game changers;

5. Bureaucracy, whether in a state or a private firm, inherently wears blinders;

6. Evaluations of development projects should not simply be about cost-effect studies but about assumptions, capacities, priorities and unintended as well as intended effects.

Both right wing monetarism and the stress on entrepreneurs, and left wing or liberal Keynesians stressing wide scale government economic interventions in bad economic time, are both correct, but monetarism must give up its vision of an ideal balancing point in a system at equilibrium, when, by its nature as an innovative enterprise, it is inherently unstable, and Keynesians must not allow stimulus and intervention to be transmogrified into “permanent revolution” and continuing governance (as distinct from regulation). AH provided the most important antidote to the excesses of both theories when applied to development.  

Chapter 8. Worldly Philosopher – The Anthill: Repressed versus Joyful Capital

Worldly Philosopher: The Odyssey of Albert O. Hirschman by Jeremy Adelman
Conversation – Instalment 9B: The Paradoxes of Economic Recovery
Chapter 8. The Anthill: Repressed versus Joyful Capital
Part II

by

Howard Adelman

My own theory of money began with my graduate course on political theory that I took with C.B. Macpherson. Brough’s book on Possessive Individualism had just appeared. In it he had argued that there was a contradiction between the state of nature as depicted in The Second Treatise on Government which was all peaceful and without conflict and the subsequent state of conflict depicted afterwards as the precursor for the social contract. After money was invented, hoarding, scarcity and conflict resulted and turned the state of nature into a state of war necessitating developing a social contract.

In my first paper for Brough, I argued that he had misread John Locke. The invention of money was not something like a deus ex machina that took place at the beginning of his story (rather than the end of the book) that turned humans into accumulators and protectors of their property. In Locke, men were possessive individualists from the get go. The world was peaceful and the laws of the state of nature dictated there was enough and sufficient for all because there was no mechanism for creating shortages. However, the drive to accumulate private property was so great that it impelled the creation of money. Suddenly, the products of one’s labours could be represented by a token that meant wealth could be accumulated. Humans were not restricted to hunting and gathering only what they could consume. The result – wealth accumulation, scarcity and a war of all against all – at least, according to John Locke – had been made possible.

The paper not only criticized Brough for imposing a contradiction on Locke when there was none. It argued that the primary doctrine in economics and politics was not the labour theory of value wherein humans inserted their labour into nature and what was given in nature combined with the labour to extract it and convert what is given into an artefact gave value to what was produced. Money was supposed to represent that value. Marx would inherit the same flawed idea of a labour theory of value via Ricardo and John Stuart Mill and add the theory of expropriation and exploitation of the worker. Instead, my paper suggested that value was not a product of mixing raw labour with the given material universe and converting it into artefacts, but was only present when it could be symbolized by abstract tokens – money – to which the collectivity directly or indirectly agreed to assign a value.

Beyond re-reading Locke in this light as not being self-contradictory, this implied the following:
a) possessive individualism in Locke was inherent and not a by-product of the invention of money;
b) value was itself a by-product of convention of the group and not an arithmetic calculation of labour expenditure invested into the natural world;
c) Two simultaneous and somewhat paradoxical actions had to take place to lead to a social contract: i) the desire to use one’s labour to change the given world; and ii) a society among whom agreement could be made how to represent the value of those goods through an abstraction deemed to be money.

Further, analysis suggested that Milton Friedman’s monetarism was correct in emphasizing the importance of the government as representing the social contract in governing the money supply as the most crucial input that could influence economic productivity over time. Setting aside his right wing economic ideology and his belief in “equilibrium” between growth in productivity and demand as the key measure for determining the money supply, the recognition that an abstraction, like money, was absolutely crucial to economic growth was foundational. The problem that remained was twofold. First, what was being measured was difficult since entrepreneurs with their ingenuity kept creating new debt instruments that effectively expanded the money supply when the government was not yet in a position to count it let alone regulate it. This happened with the last financial crisis in 2007 with the innovations of swaps, credit-defaults, securitization and tranching with respect to residential mortgage securities.

Without both the individual self-interest and the communal concurrence to create a convention, there would be no economic development. A social contract was a precondition of any economic system and not a product of violent conflict because of the absence of a social contract. What was the nature of that money and how did one determine its value? The nature of money could be any token – beads, gold, a national currency, personal debt, derivatives, future values of the sale of tulip bulbs. Societies did not determine the value of money through governments alone; markets, trade, exchanges were crucial contributors. But on what basis?

I was asked to give a paper at the John F. Kennedy School at Harvard at the beginning of the seventies. They wanted to use the techniques we used to develop student co-op housing to rebuild the slums in the northern cities then overwhelmingly occupied by the American Black population. From Halifax to Los Angeles we had shown how student housing could be built – mostly co-ops – without an initial infusion of capital by the owners. At the time, we built a total of about $100 million worth of student housing over a 3-4 year period (about $200 billion in value in today’s property values).

When I arrived at Harvard, I entered an overflowing room with graduate students and very renowned economists and faculty members. I was overwhelmed as I gave a talk called, “Joyful Capital”. The talk itself was a total bust – no one was in the least interested in my weird economic theory. The audience wanted to know technically how what we had done had been accomplished and became very animated in the question period. They ended up enthused. I left depressed.

The theory was not complicated. It argued that the token used for money was an abstraction based not primarily on past production where money supply had to be balanced with productivity but much more on an estimate of future possibility. Value was rooted more in hope and possibilities than in actualities, though a past record could enhance the strength given to that hope. The issue was one of faith – faith in what you could do and not primarily in what you had done. Never did this become as clear as in the .com revolution where enormous values were given to companies with relatively little track record. It was subsequently repeated in the American housing bubble of the twenty-first century based on the forms of mortgage derivatives and tranches in the United States and in the European state debt crisis. (My explanation for that crisis based on a fuller elaboration of this theory of money can be found in a paper that I gave in Scotland in 2009 and that was published in an edited collection the following year: “Trust and Transparency: The Need for Early Warning,” in Iain MacNeil and Justin O’Brien (eds.) The Future of Financial Regulation, Oxford: Hart Publishing, Ch. 18, 322-336.)

Let me recapitulate the theory.

First, on value, instead of emphasizing labour as the crucial input, stress was placed on technology and innovation through not only improving efficiencies, productivity and quality, but the most fundamental innovation of all, creating tools to represent future risk, that is, innovations that expand the money supply well beyond the amount of money printed or regulated by the state. That does not mean the value is independent of anything underlying it in the tradition of the theories of Thorstein Veblen and Jacques Ellul and that there is no reality referent whatsoever and that appearances alone determine value whereby an elite consciously distracts the public with endless superficial entertainments in a compelling cornucopia of illusory visions complemented by a plausible simulacrum of justice, equality of opportunity and good governance to foster a sense of identity in a celebrity consuming culture where outward appearance is seen as providing meaning in wearing the right labels and driving a “cool” car.

Thus, while rejecting the labour theory of value and the concept of money as an artifact that represents the value of labour beneath and past accumulated productivity, on one end of the spectrum, and the concept of money as the ultimate simulacrum, the tool in terms of which the values of all other simulacrums are denominated freed up from any connection to past productivity but representing only the degree of faith in the amount of future wealth that can and will be created, I have held the view that money is a force in its own right when it is freed up from any natural measure, such as a gold standard, and is, in fact, the most fundamental innovation of all connecting past accumulated value with future faith in the preservation and enhancement of that value. That is why any effort to balance the money supply with productivity gains is doomed to failure and why the money supply will continually be indirectly expanded to facilitate those productivity gains.
Joseph Schumpeter was an advocate of Werner Sombart’s thesis of creative destruction (Cf. Schumpeter, J.A. (1911; 1961 The theory of economic development: an inquiry into profits, capital, credit, interest, and the business cycle. See also Alan Greenspan (2007) The Age of Turbulence: Adventures of a New World and Thomas K. McCraw (2007) Prophet of Innovation: Joseph Schumpeter and Creative Destruction), that is, that radical innovation is the essence of capitalism that transforms and leaves behind the old order. Thus, the key player is the entrepreneur and innovator, in German, the Unternehmergeist, the entrepreneurial spirit that AH celebrated. Innovation is the key in the formula of the creative destructive process of capitalism. For innovation not only adds new wealth but has to make up for the diminishing returns of capital and labour invested in nature to produce artifacts. Capital (diminishing returns) + Labour (diminishing returns) + Innovation (greater than the diminishing returns of capital and labour) together produce a positive sum game.

This is the theory of Joyful Capital with the destructive aspect bracketed. Money in its various forms is thus the object of eminent possession given universality for its omnipotence as the ultimate pimp, the procurer between real needs and imagined ones mediating not only between one’s personal aspirations and real circumstances but relations with others. The last crisis was not, as Alan Greenberg, former head of the Federal Reserve, opined, a savings crisis – too much money chasing too few opportunities. Nor was it a debt crisis and a failure to prime the pump in a timely fashion through increased government spending. The sages from both ends of the spectrum said that the problem that turned a crisis into a catastrophe was not too much debt or not enough debt fostered by an increase in the money supply to prevent the crisis from spinning out of control.

Paul Krugman and Robin Wells (“Our Giant Banking Crisis – What to Expect, LVII:8, 13 May 2010, 113) provided another answer. The issue is not the amount of debt but the ability to repay it. The problem was not the rate of increase in debt but the slow rate of growth to repay the debt. Debt had to be aligned with productivity. Greed facilitated by creativity develops new instruments for expanding credit beyond the established instruments and regulations provided the foundation for the financial crisis that exploded.

Lack of regulation played a role in the financial crisis, not because the capitalist system is intolerant of regulation, but because the system of regulation is always playing catch up with the new creative forms of abstractly representing wealth and credit. In other words, the reason the risks are not recognized is because we currently rely on regulatory mechanisms that are designed for what has happened in the past. These mechanisms can only catch up to the destructive potential of creativity when the damage is done and the dangers recognized. Further, regulatory mechanisms are inherently incapable of recognizing systemic problems especially when we are increasingly incapable of measuring productivity gains.

For example, examine the productivity benefits of computers; they are grossly overestimated. Computers may perform a variety of tasks, but only do the old tasks faster rather than in any particularly new or efficient manner. That advantage is often offset by the fact that the mastery of computers requires time, the scarcest complementary human input. Further, the ´´productivity-revenues´´ are hidden by data; the ratios for input and output, and, therefore, the revenue benefits, are almost impossible to parse, particularly in the service sector. The net benefit of the incorporation of computers into the productivity process may not even be noticeable because their introduction will accelerate the diminishing returns of capital and labour resulting in losses in other divisions/departments of the company. The mis-measurement and displacement factors are compounded by a third element – the time lag. Productivity gains of computers are realized only after a lag period because complementary forms of capital investment must be developed to allow computers to be used to their full potential. For even if computers increase productivity by 50%, in the time lag for their introduction, the capital input may offset the benefit in the short run. Finally, even several decades into the information revolution, we do not have the data to either confirm or falsify any of these hypotheses. So it is not surprising that, in this “veil of ignorance”, managers mis-manage and cannot determine when and where to invest capital in communications technology. In the end, there may be a systemic problem: we lack the measures for calculating the increases in productivity due to computers, especially if the productivity gains are reflected in quality changes and new products.

This was at its simplest the basis for the last financial crisis. The specifics are just an elaboration. The first step was put in place in the early eighties with the institutionalizing of the “swap” by Salmon Brothers that involved trading obligations and rewards without the necessity to transfer the underlying security itself. When Jamie Dimon, CEO of J.P. Morgan, held his intense brainstorming session in 1994 with his “mafia” beside a pool in Boca Raton, swaps had grown into a twelve trillion dollar business. In their quest for new tools and new sources of profit in what had become a highly competitive business, the team came up with the idea of swapping the risk rather than the interest rate obligations of loans. Instead of arranging a loan to secure the debt, secure the risk itself requiring a fraction of the amount of the loan itself thereby drastically reducing the cash that needed to be held in reserve and enormously increasing the credit supply. The mechanism came to be known as the “credit-default swap”.

The third step in the development of this new mechanism of increasing the money-supply and the amount of credit available was based on securitization, bundling together different debts and, based on the law of averages, selling the risk of the bundled securities rather than that of a single loan, thereby ostensibly reducing the risk if a single loan failed. The fourth invention involved “tranching,” that is dividing the bundled securities into different slices and paying interest according to the degree of risk of that slice of the bundled securities. Safer tranches paid less interest and highly risky tranches paid higher interest. In this fourth step, an offshore company, a “Special Purposes Vehicle” to handle all the transactions involved in the tranching of these credit-default swaps, was created. The fifth step involved getting the rating agencies to go along with the risk analysis of this new mechanism called CDOs, synthetic “collateralized debt obligations”, which Moodys did for J.P. Morgan in 1997. However, the real large profits could only come when the whole process was streamlined and industrialized. This was the sixth and absolutely necessary step accomplished when a simple algorithm was created to calculate the risk.

Felix Salmon in 2009 branded this as the “Recipe for Disaster: The Formula that Killed Wall Street”. (Wired Magazine, 23 February 2009) David Li was the creator of applying the Gaussian copula function to financial risk applications.

Based on his research work at the University of Waterloo on loss modelling applied to insurance (after he graduated and when he was already a partner in J.P. Morgan’s Risk Metrics unit), he adapted the formula in 2000 to enable a new generation of risk-based securities to be leveraged. (See David Li (2000 “On Default Correlation: A Copula Function Approach,” The Journal of Fixed Income, March 2000, 43-51.) As Cathal Kelly wrote in The Toronto Star (“Meet the Canadian whose big idea felled Wall Street,” 18 March, A01, A17), “Li’s model sidestepped the problem of trying to correlate all the variables that determine risk. Instead it based its assumptions of the historic dips and swells of the market itself. In essence, Li used the past to map the future.” (My bold)

In the formula, the correlation “P” of disparate variants, where each variant has a maximum correlation of 100% or >1, is a multiple standard normal cumulative distribution function multiplied by these variable risks combined in a common formula, but one not based on independent assessments of risk but on historical patterns. The algorithm linked and correlated different disparate risks, that is, formulated a multivariant distribution (a copula) representing different degrees of interconnectedness to estimate probabilities of future occurrences of a bundled group of separate risk items based on traditional patterns. The bundling was supposed to reduce risk because of linking different degrees of risk. The formula explicitly did not reduce risk of any single occurrence and was not applicable where risks were systemic and applied to the whole system. By 2005, Li warned that the model was limited in its application for it could not predict what would happen in extreme economic environments. (Mark Whitehouse, “Slice of Risk,” Wall Street Journal, 12 September 2005) Nor did it predict that the formula itself was a crucial component in creating that extreme environment.

When Jamie Dimon and his “mafia” invented the “credit-default swap” in 1993, Felix Rohatyn warned derivatives were “financial hydrogen bombs built on personal computers by 26-year-olds with MBAs”. Ten years later, an economist at the bank for International Settlement, Claudio Borio, assisted by the acute analysis of data of Bill White, challenged the belief that financial innovation was an unadulterated good. Ignoring these warnings and the accumulating black clouds, the European Securitisation Forum at its annual meeting entitled, “Global Asset Backed Securitisation: Towards a New Dawn!” on 11 June 2007 in Barcelona celebrated the most profitable year in history for investment banks. The next day, Bear Stearns began to unravel and was eventually bought at a bargain price by JP Morgan Chase. Jamie Dimon, the CEO, fifteen years after the pool party where his team came up with the idea of the credit-default swap, held another party at the World Economic Forum in Davos, Switzerland, not to celebrate the fifteenth anniversary of that revolutionary innovation, but to hail the hundredth anniversary of J. Pierpont Morgan as the savior of the financial system in 1907.
I have argued since the sixties that entrepreneurship depends on playful creativity to try to see how to use existing rules in new ways to provide for future capital growth and accumulation rooted in our creative playful imagination. But the system has to be managed in terms of a recognizable set of rules so outsiders can trust the players. After a bubble of confidence bursts, the key and central problem remains how to restore faith in our material god, in this case, the very lifeblood and circulatory basis of the system itself, the financial sector. As Albert Hirschman argued, the core rules may be simple but their application to specific situations at specific times and places varies. The propensity of any entrepreneur will be to adapt the rules to favour his or her own style of play. When the mathematical model developed is a positivist one based on extending past experience into the future without taking into account the fact that the new model itself, let alone other new factors, confront principles of indeterminacy and the effects of cumulative chance factors to alter or even inverse previous patterns, we challenge fate.

A system had been created with an enormous range but one which did not and could not take into account systemic failure when batches of credit default swaps could themselves be combined into collateralized debt obligations (CDOs) without the necessity of purchasing bonds at all. Based on historic patterns, investors were betting on a group of players winning at a casino and banks were selling and trading these CDOs and significantly increasing their sources of profit. The insurance system had been turned into a lottery and the lottery became an item for investment, but an item that did not include the possibility of the casino burning down or the workers in the casino going on strike. Further, rating companies no longer had to do their homework but began to rely on the formula.

Thus, there is an inherent tension between the referee obligated to uphold the existing rules and the entrepreneur driven to adapt and alter rules to facilitate play. There never will be or can be a stable set of fixed rules, for the very nature of entrepreneurship as creative play will mean challenging and adapting the rules themselves. There will always be a tension between ensuring the rules are not utilized for either nefarious purposes or for products and ideas that are beyond the elasticity of the system to handle. But there is also a need to adjust rules to allow for creativity and new situations.