Felix Salmon

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The economic miracle of the BRICs, which are estimated to account for more than half of global growth in the last three years, could be coming to an end.

Today we learned that India’s economy grew at a rate of 5.3% in the first quarter, down from 9.2% over the same period last year and the slowest pace of expansion in nearly a decade. Walter Russell Mead sees the causes for the falloff as internal and  self-inflicted: “Parliament is paralyzed, economic reforms stall before takeoff, and the government is plagued by corruption scandals”.

India is, of course, the vowel that anchors the BRICs, and expectations are high. As Sober Look highlights: “one could argue that 5% is still respectable when it comes to GDP growth. Not for India.” And certainly not for China, where there are not just concerns over the validity of economic data but also the fear that the economy may have been knocked off its 8% growth trajectory and into a recession. Chinese Premier Wen Jiabao has called for the government to increase its focus on “stabilizing growth”, but it’s uncertain whether or not that means stimulus is on the way.

And as the US economy continues its tepid recovery and European growth concerns intensify, Matt Yglesias is dire and direct on the potential effects of slowing growth in the BRICs: “This time around, if the rich countries can’t get our act together, the whole world will spiral into recession”. – Ben Walsh

On to today’s links:

Facebook
Facebook’s SecondMarket muppets – Felix

Goldbuggery
Gold is just another commodity until it trades like a government bond – Sober Look

Remuneration
Meet the Missouri woman who blew the whistle on Citi’s mortgage department and won $31 million – Bloomberg

Housing
Rental yields in US cities are climbing above 10% – Modeled Behavior

JPMorgan
JPMorgan divisions had different ideas of how to value money-losing credit default swaps – Bloomberg

Draconian
Bloomberg plans to make it mildly inconvenient for New Yorkers to drink large amounts of soda – NYT

Startups
Welcome to the era of the secret IPO, thanks to the JOBS Act – WSJ
Kayak reportedly delaying its IPO after Facebook’s messy debut – Bloomberg

EU Mess
The IMF is maybe, possibly preparing contingency plans for a bailout of Spain – WSJ
To lure young depositors, Bankia is giving away Spiderman towels – Reuters

Indicators
Drudge Report financial headlines as contrary indicators – Bespoke Invest
What to make of the massive collapse of US interest rates – Business Insider
Tomorrow’s jobs report is even more crucial than normal – NYT
A new unit of media attention: The Kardashian – Ethan Zuckerman

Politicking
Reagan’s gone. You’re old. Get over it – Mark Dow

Wonks
Today’s market fear as a “massive failure of our economic institutions” – Brad DeLong

Mark Dow has found an astonishing set of results from a February opinion poll in Greece; it’s hard to imagine that Greek attitudes to Germany have improved since then. Here’s just one of the 13 slides:

The final question, in particular, renders rather unfunny the joke about the German Chancellor flying to Athens for some meetings, and being stopped at immigration. “Name?” she’s asked. “Angela Merkel.” “Occupation?” “No, I’m just here for a couple of days.”

For his part, Dow seizes on a different question — one which shows that 51% of Greeks attribute Germany’s strong economy to corruption, and only 18% attribute it to competitiveness. Greek public opinion, it seems, is decidedly of the view that the only way Greece can compete with Germany is to become a lot more corrupt.

Stephan Faris, in his profile of Alexis Tsipras’s far-left Syriza party, writes:

Tsipras possesses not just a deep knowledge of the Greek electorate but a populist’s knack for channeling mass emotion…

Polls show Greeks are pulled by two seemingly contradictory desires. Roughly two-thirds of the country opposes the bailout conditions. Yet almost 80 percent say they want to stay in the euro…

Tsipras’s demand that other EU countries — namely Germany — renegotiate the bailout deal on Athens’s terms reflects a seeming indifference to the very real failures in Greece’s economy.

Looking at the poll, I see something different. The overwhelming majority of the Greek electorate believes that Germany, quite literally, owes Greece money. In the decades since World War II, Greece has been waiting patiently for its rightful reparations — and instead it’s finding itself in the midst of another attempted takeover by Germany, a Fourth Reich. Looked at through this lens, the Syriza position doesn’t seem contradictory or indifferent to the realities of the Greek economy. Instead, it’s noble resistance to a dangerous hegemon.

All of which is to say that the relationship between Germany and Greece is irredeemably oppositional, at this point. The Germans think of Greeks as corrupt scroungers, who just want to live on the fruits of Germany’s productive labor; the Greeks think of Germany as, well Nazis. (Check out page 2 of the opinion poll: when asked “What is the first word that comes in your mind when you hear the word Germany?”, and given one spontaneous reply, 32% of Greeks said something about Hitler, Nazism, or the Third Reich. And in general, again, the overwhelming majority of answers were highly negative.

This is not, in any real sense, a European Union: if two people with these feelings for each other were married, everybody would agree that they should get divorced.

Looked at from the US, it’s easy to see Tsipras as playing a deeply tactical game: he’s advocating that Greece call Germany’s bluff, and thereby continue to get EU financing while reducing the amount of austerity that Greece has to impose on itself in return. But looking at this poll, I don’t see tactics: I think that Tsipras is simply reflecting very real Greek attitudes to Germany — attitudes which consider Germany to be not only fascist, but also deeply corrupt. If you think you’re owed money by such a country, you’re not going to be particularly willing to accept onerous bailout conditions in order to receive it.

All of which says to me that Grexit is inevitable, sooner or later. These two countries have pretty much nothing in common, bar their current currency. And now the tensions caused by that common currency are surfacing in particularly ugly ways. Before things get much worse, it would surely be better for both of them if Greece decided to go its own way.

And yet, there’s a silver lining, here. As far as I know, these attitudes to Germany are not shared by most people in Spain, or Portugal, or Italy. It makes sense for the EU to allow Greece to leave the euro, and then to put a big and credible firewall up around Iberia. Greece really is a special case. And the other 14 members of the euro, if they join together, still have the ability to remain together.

Remember how excited SecondMarket was about the Facebook IPO? I’ll bet they’re not nearly as excited any more. Because if anything demonstrates that there’s a venture-capital bubble in Silicon Valley right now, it’s Facebook.

The chart above shows the valuation of Facebook on SecondMarket, every month from January 2011 through April 2012; the red bar shows the valuation of Facebook at the close of trade today.

Now it’s true that if you bought Facebook shares on SecondMarket before 2011, then you’re in the money right now. But the chances are, you didn’t:

This chart, from SecondMarket, shows that fully 78% of all transactions in Facebook took place in 2011 or 2012. What’s more, pretty much everybody who bought Facebook shares on SecondMarket is still locked up. They never got the opportunity to exit at the IPO price of $38; indeed, they’re going to have to wait long painful months before they can sell at all. (They can of course now short the stock, or buy puts, to try to protect their downside from here on out; that in turn is only going to further depress the price of the stock.)

Mary Meeker explained the consequences, today:

Valuations in the private market are going to make it “difficult to go public.” The valuations make it “difficult to justify the goals.” The prices are going up and up. And the businesses are not keeping up.

So, when these companies start to look for public market exits, there’s a good chance the “private market will lose money.”

When Meeker’s talking about the private market, she means investors like her own firm, Kleiner Perkins, rather than the kind of people who buy shares on SecondMarket. But the principle is the same. An IPO can be looked at as another fundraising round, and no one likes a down round. In the case of Facebook, it seems as though Facebook’s share price is still just higher than its last official capital-raising round, when it raised $1.5 billion at a $50 billion valuation. But that’s going to come as little solace to anybody who bought Facebook shares in the past 16 months.

What’s more, I can easily see how the frothy Facebook valuations being seen on SecondMarket contributed to the debacle that was the Facebook IPO. Facebook executives with vested equity had the opportunity to sell their Facebook stock in early 2012 at valuations north of $80 billion; at the peak of Facebook fever, just before the IPO, the shares traded as high as $44 each. Given that Facebook was by far the most liquid stock on SecondMarket, and had weekly auctions from November 2010 onwards, it was pretty reasonable to consider SecondMarket to be a reliable price discovery mechanism.

What’s more, basic economic theory suggests that if a stock has buyers at $44 privately, then its public value will be higher than that, since the universe of potential buyers expands enormously. Given that theory, it would have been really hard, I think, for Morgan Stanley to price the IPO below the levels seen on SecondMarket for most of the previous year — a valuation of $80 billion or so.

In reality, however, it’s increasingly looking as though shares in private tech-companies are a bit like fine art prices: a place for the rich to spend lots of money and feel great about owning something very few other people can have. The minute they become public and democratic, they lose their cachet. And a lot of their value.

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US and German government debt, the WSJ reports, is now “trumping gold as a safe haven”. (Please update the contents of your Doomsday Bunker.)

In fact, today a host of government bond yields around the world approached new lows. Yields for 10-year Treasuries hit 1.625%, a new record. As Joe Weisenthal notes, German, British, Finish, Swedish, Australian and Canadian borrowing costs have never been lower. German two-year bond yields even hit zero.

As one analyst said:”This is fear.” Edward Harrison, for his part, warns that low rates could force the US into a Japanese-style state of “permanent zero” that punishes savers and hamstrings banks. And Matt Yglesias wonders: If inflation-adjusted interest rates on US debt are actually negative, why bother collecting taxes at all?

While the world is willing to lend to the US for next to nothing, it’s worth revisiting the last time 10-year Treasury yields hit 60-year lows. In September, as America was fresh off the debt ceiling debacle, Martin Wolf reminded us that the market was not particularly worried about deficits, at least not in the US, UK and Germany. (Ezra Klein had similar things to say in August.) The bond market, Wolf wrote, is “loudly saying” we should

use cheap funds to raise future wealth and so improve the fiscal position in the long run. It is inconceivable that creditworthy governments would be unable to earn a return well above their negligible costs of borrowing, by investing in physical and human assets, on their own or together with the private sector.

Translation: Never let another country’s debt crisis go to waste.

And on to today’s links:

New Normal
Americans are increasingly spending their “prime working years” not working – WashPost

EU Mess
Europe “effectively lending Greece money so Greece can repay the money it borrowed from them” – NYT
Greece’s energy options: Iran, Glencore or blackouts – FT Alphaville
European leaders propose a “banking union” – WSJ

Wonks
Federal lines of credit: Improving fiscal stimulus by extending credit directly to citizens – Miles Kimball

Mischaracterizations
Taleb: A breakup of the euro is “not a big deal,” will create “a lot of fun currencies” – Bloomberg
Taleb “massively angry” at Bloomberg for quoting him out of context – Business Insider

Facebook
Facebook and the sad case of ethical bankers – Bronte Capital
Investment banks’ function in an IPO is to equally satisfy or equally dissatisfy issues and investors – The Epicurean Dealmaker

Regulations
A better way to restrict leverage and make banks pay for their own resolution – Deus Ex Macchiato

American Decline
When biking to school is against school rules – Bicycling

Data Points
Kleiner Perkins’ 112-page report on the Internet trends of 2012 – KPCB

Interstellar Domination
The Rockefellers and the Rothschilds have formed a strategic partnership – FT

Reversals
Bit.ly isn’t really a link shortener anymore – The Atlantic Wire

What exactly does the EU’s José Manuel Barroso mean, when he says today that the EU should move towards “a full economic union”, which would include “a banking union with integrated financial supervision and single deposit guarantee scheme”? In a simultaneous EC report, there was also talk of “direct recapitalization by the ESM (European Stability Mechanism)” when banks run into solvency issues.

The big idea here is simple, and relatively easy to understand. Banks in Europe’s peripheral countries, most importantly Spain, are understandably seeing their deposits move to countries like Germany, where there’s no risk of devaluation. But that kind of a slow bank run — Mohamed El-Erian calls it a “bank jog” — inevitably weakens those banks’ balance sheets, and the straitened PIIGS governments are in no position to shore up their banking systems with billions of euros in bailout money.

Here’s Mohamed’s suggestion, which seems to be extremely close to what the EC is now signing on to:

An incredibly disruptive situation could be avoided if Greek depositors were given quick access to a region-wide (as opposed to just national) deposit insurance scheme that is unambiguously supported by the fiscal authorities in the strongest eurozone countries. This would need to be coupled with even larger liquidity support from the European Central Bank, along with direct capital injection into the Greek banks from regional funds (e.g., the European Stability Mechanism, or ESM) and multilateral institutions (namely the International Monetary Fund).

I have a funny feeling that this is exactly what’s going to happen, but that implementation is going to be carefully timed so that it happens after Grexit, and not before. First you wait for Lehman Brothers to go bankrupt, then you give investment banks full access to the Fed discount window.

The problem is that deposit-guarantee schemes need to be tested before they’re trusted. Even with an EU-wide guarantee in place, at the margin German banks are always going to be safer places to put your money than Irish banks — and of course a guarantee would only cover relatively small six-figure retail deposits, it wouldn’t cover the huge corporate cash balances which only the most foolish of corporate treasurers would still consider leaving on deposit at, say, Bankia.

All of which is to say that although the degree of risk and uncertainty in Europe is high and can come down, there’s also a limit to how far it can come down. As Walter Russell Mead masterfully explains, Europe’s politics — much of which are playing out at the national level within multi-nation states — will inevitably and fatally trump whatever theoretical economic union the Eurocrats attempt to put in place. And because that risk is now so clear, the one thing that no one has to worry about is the kind of complacency where enormous systemic risks build up quietly without anybody noticing or worrying about them.

That’s the point that Nassim Taleb was trying to make in his Montreal speech yesterday — a speech which got reported by Bloomberg as simple investment advice. I know Nassim reasonably well, and I can promise you that he would never say that he “favors investing in Europe over the US” — he has nothing but disdain for anybody who makes such grand and stupid pronouncements. He would be happy, however, to reprise the theme of of his Foreign Affairs article last year, on the subject of “How Suppressing Volatility Makes the World Less Predictable and More Dangerous”. Clearly, the US is much better at suppressing volatility than Europe is, right now.

That essay has disappeared behind a paywall now, but I excerpted a bit of it here:

A robust economic system is one that encourages early failures (the concepts of “fail small” and “fail fast”)…

Consider that Italy, with its much-maligned “cabinet instability,” is economically and politically stable despite having had more than 60 governments since World War II (indeed, one may say Italy’s stability is because of these switches of government).

During the global economic crisis, the US was happy to see many more domestic bank failures than Europe was — and on top of that was happy to put its big automakers into bankruptcy. Those decisions served America well. Now, Taleb’s saying, the tables are turned: the volatility in Europe has become unavoidable, while the US appears to be a beacon and a safe haven. And whenever you achieve safe-haven status, the short-term benefits (the 10-year Treasury bond now yields just 1.65%, which more or less amounts to the markets begging the US government to borrow more) are always offset by hidden tail risks which tend to bite very hard indeed when they finally materialize.

None of which, of course, is or should be taken as investment advice. A long-Europe, short-US trade would be highly risky right now, with a greater-than-even probability of losing money. Now back in his trading days, Taleb specialized in putting on trades with a greater-than-even probability of losing money: he reckoned those trades were generally underpriced, and that the amount you made in the minority of cases where the bet paid off could more than cover the amount you lost in the majority of cases where it didn’t. But Taleb’s not a trader any more, and in any case none of that kind of sophistication made it into the Bloomberg article.

If you want a safe place to put your money, the conventional wisdom remains correct: Germany and the US are definitely safer than Spain and Greece. Nassim’s new book isn’t going to help you find a new, undiscovered safe haven. But it might serve to remind you that the stronger you think a political economy is, the more violently it tends to break.

I’ve been spending much more time than usual on Facebook, over the past week — you’d think the company has been in the news, or something like that. And so I found myself this evening clicking on a classic clickbait headline — “Two Lists You Should Look at Every Morning” — which had been shared approvingly by my ex-boss, and which came with the somewhat respectable logo of the Harvard Business Review.

The article in question isn’t long, but it is pretty much everything you hate about the HBR. It’s written by some consultant who loves to talk about “leadership” a lot, and who loves to use phrases like “platform for talent”. What’s more, he’s ever so keen on focus, and eliminating distractions. Apparently, when you’ve got some dead time while standing in an elevator, the wrong thing to do is to use that time for something productive, like dashing off a quick email. Email, you see, is a distraction from more important things, like, um, working out who else might be in the elevator. Or, single-mindedly trying to win some pointless gong:

After the CEO busted me in the elevator, he told me about the meeting he had just come from. It was a gathering of all the finalists, of which he was one, for the title of Entrepreneur of the Year. This was an important meeting for him — as it was for everyone who aspired to the title (the judges were all in attendance) — and before he entered he had made two explicit decisions: 1. To focus on the meeting itself and 2. Not to check his BlackBerry.

What amazed him was that he was the only one not glued to a mobile device. Were all the other CEOs not interested in the title? Were their businesses so dependent on them that they couldn’t be away for one hour? Is either of those a smart thing to communicate to the judges?

There was only one thing that was most important in that hour and there was only one CEO whose behavior reflected that importance, who knew where to focus and what to ignore. Whether or not he eventually wins the title, he’s already winning the game.

This one story is reasonably impressive in that it inadvertently tells you everything you need to know about the leadership industry. For one thing, the people who are most successful, in this industry, tend to be obscene flatterers: whatever your client does, he does it better than any of his competitors, and he’s “winning the game”. When CEOs ask for advice, what they really want is flattery: they want to be told how brilliant their decisions are, and that the only thing which would make those decisions even more brilliant would be if they were made even more decisively.

And secondly, CEOs will go to extraordinary lengths to be flattered: not only by paying consultants enormous sums of money to tell them how brilliant they are, but also by putting enormous effort into maneuvering to be awarded a profoundly meaningless title like Entrepreneur of the Year. Our CEO, here, could have tried to get something vaguely useful out of the meeting, by trying to learn from the various other entrepreneurs and judges who were there; instead, he treated it as a zero-sum competition, where there could be only one winner.

Such a person laps up stuff like this:

The speed with which information hurtles towards us is unavoidable (and it’s getting worse). But trying to catch it all is counterproductive…

A study of car accidents by the Virginia Tech Transportation Institute put cameras in cars to see what happens right before an accident. They found that in 80% of crashes the driver was distracted during the three seconds preceding the incident. In other words, they lost focus — dialed their cell phones, changed the station on the radio, took a bite of a sandwich, maybe checked a text — and didn’t notice that something changed in the world around them. Then they crashed.

The world is changing fast and if we don’t stay focused on the road ahead, resisting the distractions that, while tempting, are, well, distracting, then we increase the chances of a crash.

This being an HBR blog post, and therefore more of a book excerpt than an actual blog post, there’s no link to the study in question. But it comes up pretty easily with a Google search. And guess what:

It turns out, if you look at all of the crashes in the survey, just one third of them were associated solely with the “secondary tasks” being talked about here, and only about 40% had secondary tasks as a contributory factor at all. The only way you can get anywhere near 80% is in the fact that 78% of crashes were associated with secondary tasks or non-specific eye glances, or driving-related inattention to the forward driveway (for instance, looking to the side when changing lanes), or drowsiness.

Evidently, what happens when you really focus on your work, when you start every day by making “good time to pause, prioritize, and focus”, what you end up with is stupid exaggerations and errors like saying 80% when the true number, freely available online, is only 40%.

Or maybe what you end up with is a life lived in a bubble of self-affirmation, where the glorious serendipity of Twitter or Facebook — even the occasional link emailed to you by a well-meaning friend — is ruthlessly pruned from your life, so that you can digest only information pre-chewed for you by subordinates and consultants, all of whom are extremely well versed in the art of telling you exactly what you want to hear.

So what does it mean that this self-evidently ignominious blog post, two three years after it was written, is still being passed around the upper echelons of the consultant-sphere, complete with its 270 comments? (“Wow this is incredible story for me . I will do my best to apply this in my everyday life.”) Part of it is that the post seems to have turned into something of an HBR evergreen, a bit like “Six-pack abs! See results in just 9 days!” over at Men’s Health. And that fact, in itself, is telling. HBR’s readers, it seems, are perennially starved for little blog posts telling them that they’re not self-centered enough, and that they should try to cut down on annoying things like paying attention to unexpected things the outside world might send their way.

If you want to be a leadership guru, pay attention. Don’t say anything which requires actual thought: just give your clients permission to do as little as possible, while remaining magnificently untroubled by self-doubt. Then you, too, might end up with lucrative consulting contracts for “Allianz, American Express, Brunswick Group, Goldman Sachs, Morgan Stanley, Deutsche Bank, JPMorgan Chase, FEI, GE Capital, Merck, Clear Channel, Nike, UNICEF, and many others.” Yeah, I noticed how finance-heavy that list was, too.

In the wake of its fabulous report about how investors in VC funds are stupid, the Kauffman foundation has released another report, this time about IPOs. This one comes with a very bad press release, which says in breathless fashion that “nearly 1.9 million new jobs forfeited in the past decade as fewer entrepreneurial firms join ranks of public companies”. In fact, the report itself is much less alarmist, and a single chart does a very good job of debunking the idea that if we had more IPOs, we’d automagically have much more employment.

What this chart shows is that during the dot-com bubble, companies like Amazon and eBay would go public and promptly reinvest the proceeds, using them to grow as fast as they could. Both of them were just three years old at IPO, and used their equity capital to carve out dominant positions in their respective corners of the internet. As the report says, the market’s mantra during the dot-com bubble was “grow rapidly or fail”, and so all companies which went to market adopted pretty much that strategy.

With hindsight, many of those companies would have been better off conserving their capital, preserving a bunch of liquidity for a rainy day, and going for sustainability over growth. But that didn’t happen, and what you can see in the chart is a spectacular failure of public companies to create jobs after the dot-com bubble burst. The older companies certainly didn’t: total employment in companies which went public in 1996, for instance, actually fell significantly between 2000 and 2003. And even newly-public companies, if they went public in 2001 onwards, basically gained no jobs at all; the only exception was 2004, the year Google and Salesforce went public.

So yes, the number of companies going public after the dot-com bubble burst was lower than the number of companies which went public during the bubble, when equity capital was dirt cheap. That doesn’t mean that jobs were forfeited as a result: if more companies had gone public, there’s no way they would have grown their payrolls at the rate that the cohorts of 1996 and 1997 did.

Indeed, the report itself explains very clearly that the 1.9 million number is not remotely something to be taken literally:

Since the number of years in which to grow would have been shorter than for the firms that went public in the late 1990s, the jobs created through 2010 probably would be lower. Second, there is an assumption that the average quality of firms going public would remain the same as those that actually did go public. In other words, that there would have been additional eBays, Amazon.coms, and Googles if there had just been more IPOs. Third, that the people that would have been hired would not have been doing something else. In other words, there is an implicit assumption that a mass army of would-be engineers, scientists, and marketing experts is sitting at home watching television. And fourth, that the capital invested when a company raises funds in an IPO would not otherwise have been invested in job-creating activities. The average company that conducted an IPO during our sample period raised $162 million in inflation-adjusted dollars, and if there were 2,288 more IPOs of the same average size, $370 billion of capital would have been pulled from other uses.

Instead, the point of the 1.9 million jobs number is that it’s low, not high: it’s being presented in order to contrast with insanely overinflated figures elsewhere, such as Grant Thornton report which says (slide 15) that the decrease in IPOs “may have cost the United States 22 million jobs over the last decade”.

In fact, what has happened over the past decade or so is that companies have been getting older and older at IPO, and have been able to raise, in some cases, billions of dollars in venture capital before going public. As such, IPOs have not been a way of raising growth capital, so much as a way of creating an exit for VC funders. Or, to put it another way, there are still lots of hot 3-year-old technology companies raising huge amounts of equity and using it to hire loads of people. They’re just doing it in the private markets rather than the public markets.

What’s more, the fast-growing technology companies which are going public now, or which have gone public in recent years, are hiring precisely the one group of people where there’s no unemployment problem at all: computer engineers in general, and Silicon Valley computer engineers in particular.

Once upon a time, when IPOs were primarily ways for young, fast-growing companies to raise the capital they needed to continue to grow, there was a strong case to be made that they helped create jobs. Today, however, IPOs are something else entirely. If there were more IPOs, that might be a good thing, but it’s silly to believe that we’d have more jobs that way. IPOs, like leveraged buyouts, are financial tools used by financial professionals to make money. Those financial professionals surely like to think of themselves as job creators. But their real job is to make money, not jobs. And so while there are reasons to bemoan the lack of IPOs in recent years, this idea — that we’d have many more jobs right now if there had only been more IPOs — isn’t one of them.

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In a new report, Deloitte cites no fewer than eight different definitions of a sector that’s anywhere between $10 trillion and $60 trillion in size. Welcome to the amorphous world of “shadow banking.”

The Deloitte Shadow Banking Index attempts to estimate the size of an assortment of financial activities that happen, at least in part, outside the normal world of  regulated banking. Shadow banking, as Ben Bernanke put it, is how your car loan – or, before the crisis, your mortgage – gets chopped up, sold to investors and might even end up in your neighbor’s mutual fund. It includes the kind of securities-lending operations which helped to blow up AIG, and it’s vulnerable to a relatively new and dangerous kind of run.

Under Deloitte’s own definition, the US shadow banking system has essentially been cut in half since 2008, to roughly $10 trillion at the end of 2011. This figure is significantly smaller than previous estimates, including one by New York Fed staffers, which put the size of the US shadow banking system at $15 billion.

So is it good news that the ominous-sounding shadow banking system has shrunk? Mostly, yes. But this is a notoriously hard market to define. Deloitte’s definition of shadow banking excludes some “financial intermediaries” (read: the next AIG), agency mortgage-backed securities (owned by taxpayers through the government’s takeover of Fannie and Freddie) and money market mutual funds. It also, of course, doesn’t account assets at real banks, like the derivatives that recently lost JPMorgan billions.

What’s more, it’s hard to be consoled about the shadow banking system’s $10 trillion size when marquee regulators likeAdair Turner andDaniel Tarullo are still calling for more reforms.

And on to today’s links:

Must Read
“Spain is an unhappy federal structure held together by subsidies and crooked accounting” – Walter Russell Mead

Hackers
One of the most complex cyber threats in history is infecting Iranian computers – Wired

Politicking
Last year’s congressional debt ceiling debacle hurt consumer confidence more than Lehman’s collapse – Bloomberg

JPMorgan
The hedge fund manager who outsmarted JPMorgan – NYT
JPMorgan’s move to cover its hedging losses begins with a $25 billion sale – Reuters

Tax Arcana
Christine Lagarde, who recently chided Greek tax evaders, pays no taxes on her $551,700 annual compensation – The Guardian

EU Mess
A frightening guide to the increasingly likely end of the euro zone – The Baseline Scenario
Eurobonds would be a “noble expression of European solidarity,” if anyone knew how they’d actually work – NYT
The European repo curve has gone inverted – FT Alphaville

Facebook
We’re “witnessing a significant shift in power from shareholders to entrepreneurs and managers” – New Yorker
“The stock market is no longer the common ownership of the means of production” – Felix

New Normal
US manufacturing is recovering – thanks, in large part, to stagnant wages – WSJ

Old Habits
New Yorkers’ love of coffee, quantified – Massive Health

Ouch
Dewey & LeBoeuf files the largest law firm bankruptcy in history – DealBook

Retro
Revisiting a “making a living from blogging” post 10 years later – Blogads

Bold Moves
Chicago’s ambitious plan for zero traffic fatalities – The Atlantic Cities

Stuff We’re Not Linking To
The plight of Harvard graduates includes telling people they went to Harvard – Boston Globe
Henry Blodget wants to know why people hate Jews – Business Insider

There are a few different ways to look at the seemingly-unstoppable rise of the amount of “excess deposits” that JP Morgan ended up handing to its Chief Investment Office, rather than lending out to individuals and businesses needing loans. Maybe big corporations are flocking to deposit their billions at Chase because they know it’s too big to fail. Maybe Chase just can’t find anybody who both wants to borrow money and is likely to pay it back. Maybe — and more likely — Jamie Dimon funneled increasing sums to the CIO just because the CIO could generate a higher internal rate of return than his plain-vanilla lenders could.

But as Roger Lowenstein explains today, a large part of what we’re seeing here is the way in which lending has morphed into investing. All of us intuitively understand that there’s a difference between lending someone money, on the one hand, and buying a bond, on the other. The former is a bilateral contractual relationship which lasts until the loan is repaid; the latter is an anonymous purchase of securities which can be flipped for a profit (or sold at a loss) after weeks or days or even minutes.

The CIO, playing in the bond and derivatives markets, is very much in the latter camp rather than the former, as you can guess by looking at its name. It makes investments, rather than disbursing loans. But the danger here is not just that $400 billion of JP Morgan’s assets are being put to work gambling in the markets rather than extending loans to clients. The danger is that as the CIO gets bigger, it effectively turns the JP Morgan Chase loan portfolio into an investment, too.

It’s worth quoting Lowenstein at some length, here:

The new Jamie, and the people working for him, don’t have to worry quite so much. They know that if they become uncomfortable with the loans they can always hedge them in the derivatives market…

When JPMorgan hedges, it doesn’t get rid of the risk. That only happens when the customer repays the loan or, say, improves its balance sheet. JPMorgan’s hedges didn’t make the risk disappear; they merely transferred it to someone else.

Jamie had an escape hatch, but hedging doesn’t offer an escape for markets as a whole…

JPMorgan still issues loans but with half an eye on their “hedging” potential, that is, on the willingness of traders who may be halfway around the globe to assume the risk. These traders are less well-placed to evaluate the risk. They don’t know the customer and, of course, they haven’t the faintest concern for character. By habit and preference, their involvement is apt to be brief.

They assume risk by writing a swap contract in the full knowledge that they can unwind it via another swap days or even hours later. Someone may get stuck with the bad coin but, each trader is certain, it won’t be him or her. So the approach of these traders is inherently short-term — too short to invest the time and effort to evaluate the risk. Too short, we might say, to really care.

The plasticity of modern finance — the ease with which institutions can transfer risk — is a major cause of the heightened frequency of meltdowns and increased volatility.

To put this another way: liquidity is dangerous, because it breeds complacency. All you need to do is set a stop-loss, and you’ve protected yourself from large losses. Until, of course, the markets seize up and bids simply disappear from the market altogether. Or until your elaborate and complex hedging operations turn out to have been badly constructed, and you wake up in the morning with a loss pegged at $2 billion and growing.

Alan Greenspan famously said in 2003 that “what we have found over the years in the marketplace is that derivatives have been an extraordinarily useful vehicle to transfer risk from those who shouldn’t be taking it to those who are willing to and are capable of doing so.” In practice, if you look at the actions of the CIO, derivatives were used to transfer risk from those who should have been taking it — big lenders — to hedge funds who make money only when JP Morgan turns out to have fundamentally miscalculated its risk basis.

Entities who want to really take on credit risk are called banks, and they do so by lending. People who sell credit protection in the markets, by contrast, are traders and speculators who trust in the liquidity of the CDS market and who are sure that they will be able to get out quickly if things turn against them. And thus is the CDS market used shunt risks off, unseen, into the tails.

Liquidity isn’t just dangerous in the loan market. Look at houses, which used to be highly-illiquid investments characterized by a long-term relationship between a homeowner and a lender. When did things fall apart? When that relationship was replaced by a frenzy of securitization and refinancings, with even 30-year mortgages lasting for just a year or two before they were paid off by someone flipping their house or deciding they needed a cash-out refinance. The more liquid housing became — the closer it came to being piggy bank, to be tapped for cash at any time — the more dangerous it became, as well.

Lowenstein’s proposed solution — banning credit default swaps entirely — is not going to happen. But it’s a useful lens through which regulators should be looking at the banks they regulate.

Activity in the CDS market, on this view, is a sign of weakness, not strength: it’s a sign that the bank doesn’t have much faith in its own relationships and underwriting standards, and is reduced to having to buy protection from speculators in order to feel comfortable with the risks that it’s taking. Since those speculators, by definition, don’t have remotely as much information about the bank’s borrowers as the bank does, and since they certainly can’t put covenants into loans protecting them from profligacy at the borrower, such trades make very little economic sense in theory.

Regulators should remember this the next time a bank starts boasting about its sophisticated, state-of-the-art risk management systems. Most of the time, those systems involve complex bets in a zero-sum-game derivatives market, where the bank’s counterparties charge a premium for the fact that they’re on the wrong side of an information asymmetry. At best, in such cases, the bank is merely abdicating responsibility for its risks, rather than properly managing them. And at worst, it thinks that it has gotten the credit risk off its books, when in fact it’s just pushed that risk into the tails, where it’s bigger than ever.

Either way, regulators should have precious little time for such antics. They should force banks to go back to basics, instead, and manage their risks the old-fashioned way, by building strong relationships with their borrowers. Lending those borrowers money right now, when such lending is sorely needed, would be a good start.

The bad news is that the Greek stock market is down 58% over the past year; the good news is that it’s up 7% today. So far, so uncontroversial: while it’s possible to quibble with the standard CNBC convention that rising stock prices are always good and that falling stock prices are always bad, in the case of Greece it’s much harder.

In the U.S., for instance, investors with a reasonably long time horizon should like it when they can buy shares in productive companies at low prices, and dislike it when they’re forced to pay through the nose for such things. In Greece, by contrast, the level of the stock market gives a very good indication of just how bad the outlook for the country really is.

Which brings me to Andrew Gelman’s blog post yesterday, taking issue with Jim Surowiecki’s latest column, on Facebook. Surowiecki says that “there’s reason to be concerned at the spread of the dual-class structure”, on the grounds that companies with dual-class share structures tend to underperform the market. Gelman replies:

Who’s supposed to be “concerned” here? As a New Yorker subscriber, am I supposed to be concerned that dual-class firms underperformed the market? I just don’t get it. Why should I care? If the shares underperform the market, people can buy a piece of Facebook for less. That’s fine too, no?

I’m with Surowiecki on this one. For one thing, the stock market is the means that capitalist economies use to approximate what old-fashioned socialists like to call common ownership of the means of production. Surowiecki’s point here is that when you’re dealing with companies which have dual-class share structures, ownership is divorced from control, and a small group of self-selected owner-managers seize control which rightfully belongs to the majority owners of the institution. And when that happens, society as a whole loses out, because the company doesn’t generate as much value as it would or could under a more conventional ownership structure.

As for the discount which the stock market will give to companies under a dual-class structure, that’s not “fine too”. Sometimes, such discounts are OK. For instance, when I wrote about B-corps, I said that there is no reason that shares in such companies shouldn’t perform like normal shares. If company X trades at a constant discount to company Y, and both grow at the same pace, then shares in X will return just as much as shares in Y. But Surowiecki’s point is that companies with dual-class structures don’t grow at the same pace as the companies in the rest of the market. Which in turn means that the discount will go up and not down — and that, in turn, means that buying shares in such a company is not fine, and that you’d be better off not doing so.

And yet, in a world where more and more of us simply invest in index funds rather than picking our own stocks, the vast majority of us have an increasing amount of exposure to Google and Facebook and other relatively new-vintage companies with dual-class share structures. Insofar as those companies underperform their single-class peers, they’re dragging down stock-market returns for all of us.

The reason to be concerned about the rise of companies with dual-class share structures, then, is not all that dissimilar to the reason to be concerned about the rise of big private companies more generally. The stock market is no longer the common ownership of the means of production: it’s a place where early-stage investors can exit to a group of muppets and high-frequency traders. Here’s what I wrote just over a year ago:

At risk, then, is the shareholder democracy that America forged, slowly, over the past 50 years. Civilians, rather than plutocrats, controlled corporate America, and that relationship improved standards of living and usually kept the worst of corporate abuses in check. With America Inc. owned by its citizens, the success of American business translated into large gains in the stock portfolios of anybody who put his savings in the market over most of the postwar period.

Today, however, stock markets, once the bedrock of American capitalism, are slowly becoming a noisy sideshow that churns out increasingly meager returns. The show still gets lots of attention, but the real business of the global economy is inexorably leaving the stock market — and the vast majority of us — behind.

And here’s Surowiecki:

Public companies aren’t going to disappear, but we are witnessing a significant shift in power from shareholders to entrepreneurs and managers, one that may make the stock market less central to American capitalism.

What we’re saying here is that there’s a significant shift going on, and that it’s worth examining and worrying about. Insofar as the stock market is a dog-eat-dog world governed by caveat emptor, maybe there’s nothing to worry about. One person’s loss is another person’s gain. But insofar as it’s bigger than that — insofar as it’s an engine of capitalism and of capital formation and of efficient capital allocation — there are reasons to be less than ecstatic about the Facebook IPO. Because Facebook is Exhibit A in any thesis proposing that all of those things are broken right now.

One of the hardest questions to answer, when people ask about the European crisis in general and the Greek crisis in particular, is “why should we in the US care?” The simple answer is that well, this is an important part of the world, and it’s big news. But if you only care about news insofar as it directly effects the US, then the answer is harder.

One possible answer — I’ve heard this given in a number of places — is that another major crisis in Europe would spill over into the US, cause serious economic damage here, and could quite possibly make the difference between an Obama and a Romney victory. But just how likely is that? I’m no expert when it comes to assigning probabilities to events, but we can at least come up with a general framework which lets us answer the question.

Let’s start with the fiscal pact. Will all of Europe credibly commit to fiscal austerity going forwards? If so, that increases the chances of crisis and Grexit, since southern European countries in general, and Greece in particular, simply can’t operate under an austerity regime in the way that, say, the Baltics have managed, painfully, to do. On the other hand, everybody seems quite likely to break the fiscal pact in one way or another — which means that there has to be a good chance the pact will end up being honored mostly in the breach. Let’s call the probability of a Europe-wide austerity regime A; my best guess for A is roughly 15%, or 0.15.

So the next question is — what is the probability of Grexit, any time soon? That’s really two questions. First, what is the probability of Grexit if there’s Europe-wide austerity. Let’s call that B, and I’ll peg it at 85%, or 0.85. Second, what’s the probability of Grexit if Europe-wide austerity slips a bit? We’ll call that C, and I’ll say it’s 65%, or 0.65. Overall, we can define the chance of Grexit, D, as A * B + (1-A) * C. If you’re playing along at home, that’s 0.68, or 68%.

But just because Grexit happens, doesn’t mean it will necessarily affect the US election. For one thing, by definition, Grexit can’t affect the US election if it hasn’t happened by the time the election takes place. So the next question is: if there’s Grexit, what are the chances that it will happen by November? The Europeans have proven themselves very good at kicking the can down the road, so even if Grexit is inevitable, it’s still not inevitable by November. In any case, let’s define E as being the conditional probability of Grexit by November, given Grexit. I’ll say that’s 50%. Which means that the overall probability of Grexit by November, F, is D * E, or 34%.

Grexit, if and when it happens, will cause a lot of disruption in European markets, and certain deposit flight out of Spanish and Portuguese banks. Again, there are two ways this can play out. Either it will cause a series of further dominoes to fall, or else it will concentrate the Europeans’ mind and force them to build a large and genuinely effective firewall, drawing a line in the sand and saying “this far, but no further”. Will Europe let the Grexit crisis go to waste? Let’s say the probability of a credible, coordinated and constructive pan-European response to Grexit is G. Then the probability of Grexit causing a big European crisis is 1-G. What’s G? That’s a tough one, but I’ll put it at 35%.

For the purposes of this calculation, we’ll assume that Greece alone is too small to cause a big global crisis: you need contagion, for that. So we’re looking for H, the chance of a big European crisis before the US election. We can calculate that as F * (1-G), or 22% — that’s the chance of Grexit before November, multiplied by the chance of a bigger crisis if Grexit happens. (Note that a big European crisis can happen at any time; the chance of that is D * (1-G), which works out at 44%.)

If we have a big European crisis before the election, then that will certainly send US stocks falling. But will a sharp drop in the US stock market have any effect on the outcome of the election? Probably only if the election is reasonably close — and certainly not if Romney is in the lead. A European crisis, and consequent plunge in US stocks, would only be good for Romney and bad for Obama, just as the crisis in the fall of 2008 was good for Obama and bad for the incumbent Republicans. So what we’re looking for, here, is I, the probability that Obama will have a narrow lead over Romney — one small enough to be erased by a big stock-market plunge. I’ll peg I at 65%.

And thus, finally, we get to the big answer: what is X, the probability of Grexit toppling Obama? That is H * I, which using my off-the-top-of-my-head probabilities, works out at about 14%. But you should work this out for yourself. Come up with your own values for all these:

A: What is the probability of a Europe-wide austerity regime?
B: If we get Europe-wide austerity, what are the chances of Grexit, any time soon?
C: If we don’t get Europe-wide austerity, what are the chances of Grexit, any time soon?
D: What, then, is the probability of Grexit? This is calculated as A * B + (1-A) * C.
E: If we have Grexit, what are the chances it’ll happen before the election?
F: This is the overall probability of Grexit before the election, and is D * E.
G: If we have Grexit, what are the chances of it eliciting a credible, coordinated and constructive pan-European response?
H: This is the probability of a big European crisis before the election, it’s F * (1-G).
I: What is the probability of Obama having a narrow enough lead over Romney that it would be erased by a plunging stock market?

Put these all together, and you can finally come up with a number for:

X: The probability of Grexit toppling Obama. It’s H * I.

I’d be interested to know what results you get, but my guess is that most of them will come up with a number which is low and yet still significant. It’s something to bear in mind, but of course it’s also something which is pretty much entirely out of Obama’s control. That’s the way that crises work: individual politicians are rarely personally responsible for them, but whomever’s in power when they happen nearly always ends up getting the blame.

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Sheila Bair, never too shy to make modest proposals, thinks that JPMorgan Chase should voluntarily split itself up:

[The] bank is worth more in smaller, easier-to-manage pieces. Let’s face it, making a competitive return on equity is going to become even harder for megabanks as their capital requirements go up, their trading and derivatives activities are reined in, and their cost of borrowing rises as bond investors recognize that too-big-too-fail is over.

Or, as David Merkel puts it in a different context: “complexity has a price; avoid it unless well compensated for it”. And, Felix notes, setting the Volcker Rule aside, if a business requires complexity and opacity to generate profit, it should be spun out of too-big-to-fail institutions. That would be a complex task, but things only grow murkier once a firm has failed.

The FDIC continues to clarify its resolution authority and currently thinks the best method to handle the failure of a large, complex financial institution is to place the “parent company into receivership and to pass its assets, principally investments in its subsidiaries, to a newly created bridge holding company”. Stephen Lubben doubts that the hundreds of billions of dollars in private debtor-in-possession financing required for a tidy resolution to work would be available during a financial crisis.

Daniel Tarullo, the Fed’s resident guru on such matters, argues that it’s not simple to preserve short-term funding and market confidence without an injection of government capital. – Ben Walsh

On to today’s links:

Housing
Armed with special privileges, the Department of Agriculture is an unusually hard-nosed debt collector – WSJ

EU Mess
Bankia, Spain’s fourth-largest lender, expected to ask for an additional $19 billion bailout – Reuters
German bonds are turning Japanese – FT Alphaville

Facebook
People said Wall Street research was worthless – now we’re worried that it’s too valuable – The American Conservative
Reminder: Spending a month’s salary on an IPO is always a bad idea – Bloomberg
Henry Blodget reports that Morgan Stanley bashed Henry Blodget on a firmwide conference call – Business Insider

JPMorgan
None of the directors on JPMorgan’s risk committee have worked at a bank or as financial risk managers – Bloomberg

Comparisons
Pakistan provides 12 weeks more paid maternity leave than the US – Think Progress

Unfortunate Because It’s True
Study confirms that Germans are incapable of enjoying life – Der Spiegel

Bubbly
AOL campus squatter receives seed funding – CNET

Stuff We’re Not Linking To
Comparing Facebook to Bernie Madoff – Barry Ritholtz

When I spoke to Kauffman’s Diane Mulcahy, the main subject of conversation was her fabulous report on how investing in venture capital is broken. And I wondered whether investors’ consistent desire to throw money at the asset class, even after 15 years of consistent underperformance, was attributable to some kind of weird nostalgia for the 1990s, when the dot-com bubble briefly made a handful of VC investors very wealthy.

But there’s something else going on here, too, I think, surrounding the whole concept of illiquidity. It’s clearly a bad and undesirable thing, in any investment, and it only takes a glance at the market for say Treasury bonds to understand that highly-liquid assets trade at a premium. In theory, then, the converse should be true as well: highly-illiquid assets should trade at a significant discount. And so long-term investors like the Kauffman foundation, who can afford to sit out market fluctuations and don’t need much in the way of immediate liquidity, should be able to buy attractive assets at a low price, and capture that extra yield for themselves.

I’m a long-term investor, too. I have retirement savings I won’t need for a good 30 years; as such, I’m in the market, should such a thing exist, for a long-term, illiquid investment which I can put money into, forget about, and then — if things go according to plan — find waiting for me in 2042 or so worth some vast amount of money which will then fund a lavish retirement. Well, a chap can dream.

The fact is, however, that such investments simply don’t exist: as Mulcahy has found out the hard way, it’s almost impossible to find an illiquid investment which even so much as manages to keep up with the highly-liquid Russell 2000 index. Alternatively, look at the incredibly low yields on syndicated loans, compared to the yields that the same companies pay in the bond market: there’s not really any indication of an illiquidity premium there, despite the fact that loans are much harder to liquidate than bonds are.

And when you do find illiquid investments, such as hedge funds with lock-up periods, or venture capital, or private equity, you invariably find a 2-and-20 fee structure which more than obliterates any premium for illiquidity which ought by rights to be going to the investor rather than the money manager.

Which leaves the one large and illiquid investment which is still made by most American households — housing. If I take out a 30-year mortgage on a house today, then — again, if things go according to plan — I’ll find waiting for me in 2042 a fully paid-off asset which will be able to provide shelter for the rest of my life. It might not have gone up in value, but at least I’ll have dealt with the natural housing short that all living humans need to cover somehow.

If I’m interested in a purely financial investment, however, it’s dangerous and probably a bad idea for individuals or even institutions to look too hard for illiquidity. Because although it pays off over the long term in theory, it’s incredibly hard to find people able of making it do so in practice.

Update: A fantastic comment from Stevensaysyes is worth promoting here:

The illiquidity premium is countered by the fact that certain market participants prefer illiquidity. Financial advisors who bought venture capital over the Russell 2000 were probably happier over the last market cycle, even though the returns were lousy:

-Illiquid investments report quarterly, so clients don’t see the daily lows, and they are less likely to call you with every swing of the Dow

-When clients do see their assets fall, they can’t liquidate everything until the end of the lockup period

-Since illiquid investments don’t have an active market to price them, you can report to clients “optimistic” estimates of their value, and also charge on it

If I were a cynical advisor, I’d put my clients in a portfolio of private equity, venture capital, hedge funds, and private real estate funds regardless of whether I expected them to outperform stocks.

There are two stories often told of hedge fund managers, and they’re pretty much diametrically opposed. In the popular imagination, such managers are risk junkies, putting on massive bets in the hope that they’ll have huge payoffs, making a fortune for their investors and even more so for themselves. But that’s not the story told to — and bought by — big institutional pension funds and insurance companies and endowments, who lap up stories of state-of-the-art risk management, carefully-calibrated hedges, aggressively maximized Sharpe ratios, and returns which not only beat the stock market but do so with significantly lower volatility along the way.

So which is true? Read Lawrence Delevingne’s account of how Michael Geismar gambled away his time at the SALT conference in Las Vegas, and it’s pretty clear that the hedge fund manager of popular imagination is a very real creature indeed. He throws $1,000 tips around like confetti, he books a $20,000 private jet home on a whim, he wins and then he loses $70,000 and then he just keeps on playing, and ends the conference up $710,000 or so.

“He was jumping into the pit screaming ‘we’re going to need more chips over here!’” O’Leary recalls, laughing. “It was insane.”

The young dealer was visibly sweating with tens of thousands of dollars now being bet on every round of cards. A small crowd had formed around the table. At one point a casino pit boss came over, worrying that the players Geismar was backing up weren’t actually betting their own money. The table quickly convinced the man they were, and play resumed. The pit boss conferred with a superior, who O’Leary recalls saying “We’re never going to win our money back, but screw it, let’s let it roll.”

Well, yes. This is why SALT will always be in Vegas, and why Vegas will always welcome SALT with open arms. I’m sure the casinos made very good money on SALT even after accounting for Geismar’s winnings, and they’ll probably make money from Geismar too, on net, over time. If nobody ever won big money, no one would gamble at all. But in the end, the house always wins — and all of these hedge-fund managers are smart enough to know that. And still, left to their own devices, what they do is gamble, and they even layer on silly “risk management” techniques which don’t reduce risk at all — in this case, after a losing hand, Geismar would bet a little less, reckoning that somehow “laws of averages” would help him as a result.

Delevingne’s story makes for great reading, but it’s also pretty much impossible to imagine why anybody would invest in hedge funds in general, or Geismar’s hedge fund in particular, after reading it. SALT is the brainchild of our old friend Anthony Scaramucci, of course — and while I’ve definitely met people who like Scaramucci, or are charmed by him, I haven’t met anybody who thinks that Scaramucci’s fund-of-funds is near the top of any list of the best places to invest money. Whatever you think of gladhanding and gambling, they’re not really the kind of behaviors you’re primarily looking for in a fiduciary.

All of which brings me, inevitably, to JP Morgan’s Chief Investment Office, which, the WSJ reports, has been making all manner of highly-risky bets, including bets on LightSquared. There’s lots of hair-splitting in the story about whether or not the bets are funded with excess deposits, but ultimately money is fungible, and in any case the reason that JP Morgan can fund this Special Investments Group so cheaply is just that it’s a big commercial bank which is too big to fail. And if it’s entirely right and proper to look askew at hedge funds exhibiting symptoms of gambling addiction, we certainly shouldn’t stand for JP Morgan Chase to be engaging in anything like that behavior.

This is a Volcker Rule question, of course, but it’s not only a Volcker Rule question. There’s a much deeper issue here as well — which is whether big commercial banks should have hotshot trading desks staffed by the likes of Achilles Macris and Bruno Iksil at all. Both Peter Eavis and Jonathan Weil have new columns decrying the opacity of JP Morgan’s public disclosures: the bank seems to make it as difficult as possible for its owners to find out just how much risk it’s taking and where. And not just its owners, either: the owners’ representatives on the board, JP Morgan’s risk committee, is deliberately staffed by muppets.

There’s a good reason for that, of course: hedge funds need to operate in secrecy, because if the market can work out what their positions are, it will move sharply against them. JP Morgan’s CIO is a hedge fund in all respects except the fees it charges, and clearly the CIO (and the CEO) want its activities to be effectively unsupervised. That’s almost certainly the reason that the CIO is effectively based in London: it’s largely outside the scope of US regulators, there, while UK regulators tend not to care too much about the actions of foreign banks, when those actions don’t present a big risk to the UK economy.

So here’s another principle, which might be helpful alongside the Volcker Rule, in any principles-based regulatory regime: if you’re a too-big-to-fail commercial bank, you shouldn’t have any desk which needs to operate in secrecy in order to do its job effectively. In practice, as Sheila Bair says, that means that JP Morgan should be broken up. If hedge funds want to gamble, fine, let them do that. But not when they have an implicit US government guarantee.

A couple of weeks ago, Artnet officially launched Artnet Indices — what it calls “the world’s first comprehensive set of art indices“. According to the press release:

It is now possible to measure price performance and other important market metrics for individual artists and artworks with the same rigorous standards used in financial indices.

Artnet’s Thomas Galbraith is quoted in the release as saying that “the artnet Indices provide quantitative market reports on the performance of artists like Andy Warhol or Damien Hirst, just as you might track a Fortune 500 company”.

I had a long lunch with Galbraith on the day that the indices were launched, and I’ve been going back and forth with him since then, trying to get a feel for how they really work. And as you might imagine, I have quite a few problems with these things.

To put this in perspective, here’s the chart that Artnet loves to send out to reporters, featuring its first index, the C50 index of contemporary art.

The message of this chart is very clear. Contemporary art is an asset class, it’s a strongly performing asset class, and if you go back to 1988, it has significantly outperformed the S&P 500. If you start them both at 100 in 1988, for instance, then by 2009 the S&P would only have reached 354, while the C50 would have reached 578 — even after a big plunge from almost 1,000 in 2008.

In fact, however, an investment in the S&P 500 would have done much better than that: it would be 638 in 2009, thanks to the fact that stocks (unlike art) pay dividends. If you chart the C50 against the S&P 500 with dividends reinvested, the outperformance shrinks markedly:

What’s more, this chart takes the C50 at face value, as a vaguely investable index — when it simply isn’t. Here, for instance, are the top 15 artists in the C50 right now: there are lot of names there (Zao Wou-Ki, Zeng Fanzhi, Chu Teh-Chun, Zhang Xiaogang, Wang Yidong) who simply weren’t investable in 1988, and certainly weren’t in the C50 index back then.

I can’t show you a chart of how the 50 artists in the C50 index would have fared if you just bought those 50 artists and held them, because Artnet’s tools won’t let me combine more than 10 artists in one list. But here’s the next best thing: the middle 10 artists from the C50 list in 1988, charted, again, against the S&P 500. These are pretty big-name artists: Alexander Calder, Jim Dine, Helen Frankenthaler, Franz Kline, Robert Motherwell, Louise Nevelson, Kenneth Noland, Theodoros Stamos, Cy Twombly, and Richard Lindner. If contemporary art in general has done well, you’d expect these names to have done well. And, they have! But they haven’t outperformed the S&P 500.

Now the components of the S&P change over time, too — but the changing components have much less effect on the S&P’s performance than they do on the C50′s. And in fact, if you just buy and hold all the components of the S&P 500, you’re likely to outperform the index as a whole. Hot stocks enter indices, and undervalued ones drop out: I don’t have a chart here for the performance of the 500 components of the S&P 500 in 1988, but it would probably do better, not worse, than the index.

Not that that matters: the S&P 500 is investable. You can buy index funds or ETFs which very closely track the performance of the index, with stocks going in and out: they’ll sell the stocks which drop out, and buy the ones which come in. Since September 1989, there have been a total of 587 additions to the S&P 500: that’s about 25 per year, or 5% of the total.

By contrast, since 1988, there have been 111 additions to the C50: that’s about 5 per year, or 10% of the total. Which means that the C50 churns twice as fast as the S&P 500. And in the S&P 500, that churn can be positive: it can happen when when one constituent gets acquired. By contrast, churn in the C50 only occurs when one artist drops out and is replaced by another.

The result is massive survivorship bias. To demonstrate just how massive the bias is, here are the middle 10 artists of the C50 in 1988, charted against the middle 10 artists of the C50 in 2012: Alexander Calder, Damien Hirst, Roy Lichtenstein, Joan Mitchell, Pierre Soulages, Wang Guangyi, Christopher Wool, Rudolf Stingel, Liu Xiaodong, and Liu Wei. You can see that the current members of the index, had you bought them back in 1988, would have performed spectacularly well. The performance of the C50, then, is largely a function of the fact that hot artists keep on getting added — after they’ve become hot. It’s a classic case of investing with hindsight: if you only bought things which performed extremely well, then you would have made lots of money. Well, thanks for that.

The difference here — the 1988 artists end up at 477 in 2012, while the 2012 artists end up at 2,183 — makes a mockery of the idea that contemporary art is some kind of homogenous and investable asset class, or that someone who simply bought contemporary art in 1988 would have seen their assets perform in line with the C50 index.

What’s more, you’re actually seeing treble survivorship bias here. Artnet’s art indices are created by combining its individual-artist indices, and those individual-artist indices have their own survivorship bias built in. That’s because they break down an artist’s work into groups of “Comparable Sets”, and then combine the Comparable Sets in a price-weighted manner to get the artist index. As a result, if Gerhard Richter abstracts, say, suddenly go on a tear, then those abstracts will start making up an ever-greater part of the overall Gerhard Richter index. Both on an artist level and on the index level, whatever does well becomes highly weighted, and things which don’t do well essentially get ignored. (For instance, you can’t even draw up a chart on Artnet of the bottom 10 artists of 1988, because for some of them, Artnet hasn’t even bothered to put together an index yet.)

Finally, it’s no coincidence that Artnet’s first public index is its contemporary art index — the one part of the art world which has been on fire of late. It’s the third level of survivorship bias: if and when Artnet starts publishing its Old Masters index, say, you can be sure the numbers won’t look nearly as impressive.

But even within the contemporary art world, I would be shocked if one collector in a hundred actually saw the kind of returns that Artnet is implying are typical. The thing about the S&P 500 is that it’s meant to be reflective of the market as a whole: while some stocks will do better and other stocks will do worse, broadly speaking stocks perform pretty much in line with the S&P 500. And that’s simply not true of the C50. The overwhelming majority of contemporary art does not perform nearly as well as the C50. Even if you confine yourself to works bought at auction, if you hypothetically bought every work of contemporary art that was sold at auction in 1988, you wouldn’t come close to matching the performance of the C50 since that date.

In other words, stock indices like the S&P 500 are useful precisely because they act as a benchmark: something an investor can reasonably hope to achieve. No sensible contemporary-art collector, by contrast, could ever reasonably hope to see their collection appreciate in value in line with the C50.

The real point here is that contemporary art is always full of here-today-gone-tomorrow art stars, who create art which goes from being white-hot to being pretty much unsellable. In 1988, for instance, the C50 included where-are-they-now names like Theodoro Stamos, Pierre Alechinsky, James Havard, Jean Fautrier, and even Saul Steinberg, the New Yorker illustrator, who appeared just above Robert Rauschenberg on the list. Last year, the most expensive Steinberg sold at auction reached just $28,750.

And that was a much more staid time, when very few really contemporary artists ever appeared at auction. (There was no Basquiat on the list, for instance; no Schnabel, no Fischl.) Today, the list is not only very China-dominated, but also includes names like Rudolf Stingel, Christopher Wool, Mark Tansey, and Glenn Brown — true heirs to the kind of hype that surrounded the likes of Schnabel in the 80s. You can buy their art at auction, if you really want. But you’d have to be insane if you really thought you were making an investment.