Felix Salmon

When mathematician and blackjack expert Jonathan Adler saw my post about hedge fund manager Michael Geismar’s antics at the Vegas blackjack tables, he offered to explain just how silly Geismar was being. I jumped at the chance. So enjoy:

Like most stories dealing with probability, this one starts with a coin flip. If you take a fair coin and flip it, you would expect it to have a 50/50 chance of landing heads. But let’s say that you flipped the same coin ten times, and on a wild streak of luck each of those times it happened to end up being heads. What are the chances that the eleventh flip will also be heads? While it may feel like you’re “owed” a tails, the odds of it being a heads are still 50/50, since the coin didn’t change in any way. Each flip is what mathematicians call an independent event: the outcome of each flip has no impact on the outcome of any other flips. The idea that after seeing a bunch of one side of the coin on past flips you are more likely to see the other on future flips is called the gambler’s fallacy. The fallacy comes from the confusion between the long run outcome (with a large enough sample size, I expect half of my coin flips to be heads and half to be tails) and the outcome on any one flip (since I have seen a bunch of heads before, I need to start getting tails to balance things out in the long run).

While there are many different rule sets for blackjack depending on the casino, the core game is generally the same: the payout, if you win, is the same as your wager, unless the player has a blackjack — a face card and an ace — in which case the payout is one and a half times the wager.

While in each round the player has several choices on what to do, once the player sees their hand and the dealer’s card there is generally a single best action for them to maximize their potential payout. This set of best actions is called “Basic Strategy” and is well known. The player really doesn’t have much choice in terms of what they do on a single round; any decent player will just take the optimal move based on what’s showing. Assuming the player always takes the best possible action, for every dollar they bet in a round they should lose around half a cent.

Blackjack is a game where it is easy to fall prey to the gambler’s fallacy. As a player, if you receive several losing hands in a row it is easy to think that you’re “due” for a winning hand. However since each hand is essentially an independent event (and I’ll get back to this later), the number of losses you have had in a row doesn’t change chance of you getting a win on your next hand. Even if you get a run of bad hands in a row, your next hand is still just about as likely to lose as the previous one, similar to the situation with flipping a coin.

If you go to the casino with the goal of burning a little time and money in exchange for the atmosphere and free drinks, then the fact that the house has an edge isn’t too distressing. But if you go to Vegas and want to try and win as much money as you can, the expected loss on each hand seems like a problem. There are two main ways to legally attempt to overcome the fact that each hand on average loses you a bit of money. You can either change the odds to be in your favor, or you can try and change your bet amounts to make it less likely you will lose. Only one of these methods actually works.

By changing the structure of the game, you can make it that your average hand has a positive return. This was famously done by a group of MIT students using a method called card counting. The students exploited the fact that unlike our coin tosses from earlier, hands of blackjack aren’t truly independent events. That’s because each round of blackjack comes from the same shoe of cards, so if you keep track of what cards have been played in earlier rounds, you will have a small amount of knowledge on what cards you are likely to see in future hands. When there are mostly face cards and aces remaining in shoe then the player is actually at a slight advantage to the dealer. If you only place bets when the deck is to your advantage then you can make yourself money. The MIT students counted the number of face cards that had been seen already to estimate what proportion of remaining cards were face cards. When there were a high proportion of face cards left in the shoe they would make large bets. Card counting is completely legal since you aren’t technically altering the game nor are you using any mechanical devices to aid you. All that is involved in card counting is exploiting a weakness in the design of the game, although in practice this is extremely difficult to do.

Another way to try and overcome the expected loss on each hand by having the casino change the rules for you. If you’re a high enough roller, sometimes casinos will entice you to play by giving you discounts on your losses. When they offer these discounts on losses, they attempt to run the math to ensure that you should still be expected to lose money on your trip, however as described in the article it’s not clear they always get it right.

Most people don’t have the skill and manpower to count cards, they don’t have enough money to warrant a discount, nor do they have any other way to get the odds on each hand in their favor. So to try and overcome the house edge, they will try to cleverly alter the amount they are betting on each hand. A betting strategy, or a martingale, is a set of rules to determine how much a player should bet on each hand to try and compensate for previous wins or loses. This is different from counting cards because it doesn’t take into account what cards are left in the shoe; it only uses how many times the player has won or lost.

For example, let’s say you and your spouse go to a blackjack table with $1,024 $1,023 and hope to win an additional dollar. Your spouse suggests you just play one hand and if you lose then walk away, but you have a better idea in mind. On your first hand you bet a single dollar. If you win you do walk away, but if you lose you bet two dollars. If you lose twice in a row you bet four dollars, if you lose three times in a row you bet eight dollars, and you continue to double your bet until you get a win. Any time you win a hand you will wipe out all of your previous losses and you’ll get a dollar in winnings. The only way not make of money is to lose 10 straight hands in a row, and since losing 10 straight hands in a row is extremely unlikely, you expect to almost always make the dollar you were hoping for. Or in terms of the coins from before, instead of betting a dollar that a coin will flip heads, you bet $1,024 that out of ten flipped coins at least one will be heads. If you win you get an extra dollar, otherwise you lose all of your $1,024 $1,023.

If you followed your spouse’s advice, you would have slightly less than a 50% chance of winning a dollar, and slightly greater than 50% chance of losing a dollar. By not following their advice, you have around a 99.9% chance of winning the dollar, and a 0.01% chance of losing all the money you walked in with. In fact because the amount you would lose when you get ten bad hands in a row is so catastrophically high, the expected amount you win overall is still negative. Your clever betting strategy didn’t actually change the house’s advantage over you; all it did was push the risk out so that you lose very rarely and when you lose you lose big. You can mathematically prove that any betting strategy you use, no matter how hard you try and optimize it, will fail to change the fact that the house has an advantage – you’ll still lose money by playing.

The two methods of trying to adjust the outcome of the game have parallels in investing. When a large investment firm develops a new method of trying to predict the stock market, say by trying to incorporate people’s emotions from twitter, they are using new information to increase the chance that they can call which way a stock will move. This is analogous to how the MIT team was trying to predict how a hand of blackjack will play out before it gets dealt. In both cases they are using special knowledge of the situation to increase the underlying probability of success.

Alternatively, when a bank sets up a hedge against one of their investments, they are trying to decrease the number of possible outcomes in which they lose money. For example the bank may hedge its investment in Microsoft by shorting Google. If they both drop in price, the short on Google will cancel out the losses on Microsoft. But at this point, to get the same level of return as investing in just Microsoft, they will have to increase their leverage.

Once the bank has increased their leverage, this becomes similar to the betting strategy in blackjack. Most of the time, the bank’s pair of investments will yield a decent return. Every once in a while, Microsoft will decrease in value while Google increases, and the bank will lose much more money than if they hadn’t hedged at all. Just like the person using a betting strategy, they have pushed their risk to the tail events: only when the market moves in a particular way will they lose money, but when it does, they’ll lose big.

As Wall Street has created more and more complicated financial products, it has become nearly impossible for a buyer to determine how much of the product’s return is due to shifting risk to the tails. In terms of blackjack, consider a person who tells you they can get an average return of five cents for every dollar you give them to play, but doesn’t tell you how they do it. Unless you watch them play, there is really no way for you to know if they are actually changing the game like the MIT students, or if they are just employing a betting strategy and at some point will lose all of your money. This lack of information is a problem for clients trying to get a good return from a bank, and also a problem for banks CEOs trying to ensure their company has a good return.

The JP Morgan case is a good example of how investing in Wall Street is actually worse than Vegas. Bruno “the London Whale” Iksil made a series of hedges to try and ensure that the case where he would lose money was unlikely to happen. Unlike at a blackjack table where the dealer has a fixed set of actions she has to follow, on Wall Street there are other investors looking to exploit other people’s mistakes. Once other investors saw that the Whale left a chance for his investment to go sour, they were able to take actions to exploit this, and caused the event that seemed unlikely to come to pass.

Lawrence Delevingne’s story on Michael Geismar’s time in Vegas is a great anecdote showing that people in charge of billions of dollars on Wall Street don’t understand the idea of shifting risk. After hearing Ben Mizrech speak, Geismar was seen using a betting strategy to try and improve his winnings at the blackjack table. After every winning hand, he would increase his bet by $1,000. After a losing hand he would lower his bet. The article doesn’t say by how much, but let’s assume after losing a hand he would reset his bet to $1,000.

This betting strategy has the opposite effect the one described before; instead of having a single win wipe out previous losses, a single loss will wipe out much of the earlier winnings. On most sequences of hands Geismar would lose money, but occasionally he will have an unlikely winning streak and make a very large amount. Instead of shifting the downside risk to the tail events, Geismar shifted the upside risk to tail events. Over time this betting strategy is expected to lose Geismar money, just like all other betting strategies. But Geismar fell victim to the gambler’s fallacy: he thought that a run of winnings changed the chance of getting another winning hand.

Just to be clear, despite having perhaps been inspired by Mizrech, this betting strategy is not at all the same as card counting. The amount Geismar was betting was unrelated to the proportion of face cards remaining the deck; it was only changed by the numbers of wins and losses he had seen. It may be that he would get a losing hand and reset his bet to $1,000 even while the deck is still hot, or similarly he may have increased his bet when the remaining shoe was mostly low cards.

This misunderstanding of how probability works didn’t stop Geismar from winning several hundred thousand dollars on his trip. But if he were to keep going to Vegas he would lose money in the long run. His lack of understanding is distressing since he is the co-founder and president of a $4.6 billion hedge fund, and the mistakes he made in Vegas could easily be made in other forms of risk management.

The lesson here is that whether on Wall Street or the strip in Las Vegas, it’s easy to confuse increasing the chances of winning with shifting risk. Increasing the chances of winning improves the amount you should expect as payout. Shifting the risk makes it so that most of the time you get a good payout, but every once and a while you lose catastrophically. As a culture, we should be trying to ensure that the people making financial decisions are looking to do more of the former and less of the latter, especially given the systemic consequences of recent catastrophic market collapses.

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The Center on Budget and Policy Priorities has a report out concluding that talk of a fiscal cliff is misguided and counterproductive. The CBPP prefers the idea of a fiscal slope: that’s more accurate, they say, because the “economy will not immediately fall off a cliff into recession the first week in January if the policy changes mandated by current law take effect”.

The aim of this well-intentioned re-characterization is to discourage the idea that any action, regardless of long-term effects, is preferable to the disastrous Jan 2 consequences that inaction would bring. Still, cliff or slope, the medium-term consequences are the same.

As we’ve seen with the jobs crisis, the longer that a crisis continues, the more that the Fed, Congress and the president can delay action or make do with partial measures. The European crisis has had a similarly long fuse – and an equally hodgepodge response, full of half-measures and hopeful waiting.

In hindsight, perhaps we were lucky in the fall of 2008 that every leg of the crisis unfolded before Asian markets opened on Sunday night New York time. When shocks happen quickly, they’re perceived as being more severe. With unemployment and the euro, by contrast there has been plenty of time for policy makers to get comfortable with a status that would be utterly unacceptable if we got there overnight. A penchant for reacting to crises only if they’re sudden is something we can do without on any number of issues. Particularly in fiscal policy, because the CBO’s latest projections tell us that whether it’s a cliff or a slope, we’ll end up in recession either way. – Ben Walsh

On to today’s links:

Not That Reassuring
Citigroup will soon be issuing official identity cards to Pentagon contractors – WSJ

EU Mess
German officials float European bad bank as an alternative to euro bonds – NYT
Lagarde responds to Soros: Euro zone needs a master plan, not a deadline – Reuters
“The risk premium says Spain doesn’t have the market door open” – Reuters

Politicking
Ezra: Right or wrong, Romney may be best for the economy – WaPo

Primary Sources
ISM non-manufacturing index rises to 53.7 in May from 53.5 in April – Institute for Supply Manangement

Modest Proposals
The Uncollateralized BWDGTFBCWT Obligation, Series 17.01 – Michael Belkin

Old Normal
Pittsburgh fog: Photos of the Steel City before coal-burning regulations – Retronaut

Chinese Walls
Searches for Shanghai index blocked after 64-point drop on June 4, date of Tiananmen Square – Bloomberg

Good Thinking
Top Chesapeake shareholders take control of board – Reuters

Is 12,500 words on the demise of MF Global, courtesy of Fortune, not enough for you? How about 275 pages on the subject from James Giddens, the official trustee? They’re both tl;dnr as far as I’m concerned, so many thanks to Dealbook for picking up on one particularly salient theme of the trustee report: an MF Global subsidiary called MF Global Finance USA Inc, or FinCo.

The main thing you need to know about FinCo is that it was completely unregulated — it was basically an off-balance-sheet vehicle where Jon Corzine could park risk outside the purview of regulators. So when regulators started asking him to raise more capital against his risky European bond positions, he just moved a chunk of those positions out of MF Global proper and into FinCo:

While MF Global did move some cash around to protect against losses, the firm also transferred its roughly $3 billion in holdings of Italian bonds from the brokerage arm of the company to the “FinCo,” according to the report. By doing so, the firm met its requirements without having to raise money… The Italian bonds represented about half the firm’s risky European position.

Now I have to admit that I’ve been scouring the report this morning, searching on terms like FinCo and “net capital” and “Italian”, and I can’t work out what bit of the report Dealbook is talking about here: it would be great if they could use their DocumentCloud technology to show us rather than just tell us exactly what Giddens is saying. But assuming that the report says what Dealbook says it says, this seems incredibly damaging to Corzine.

The start of the financial crisis, remember, was in large part brought on when big banks like Citigroup started seeing enormous losses in their off-balance-sheet vehicles, and then were forced to recognize those losses by bringing them on balance sheet. Corzine, here, seems to have taken the decision that moving risk off his balance sheet was a great idea — even after having seen how dangerous it could be.

Meanwhile, that other rockstar banking CEO, Jamie Dimon, is testifying to Congress next week, and Andrew Ross Sorkin has a list of very good questions that he should be asked. To that list I would add one more: why was most of the Chief Investment Office’s activity based in London? The CIO’s investments were very much on JP Morgan’s balance sheet, of course, not off it. But they were pretty much out-of-sight, out-of-mind as far as regulators were concerned: the US regulators didn’t see them, and the UK regulators didn’t care about them.

The fact is that the CIO did most of its risk-taking in London for much the same reason that AIG Financial Products was based in London: regulatory arbitrage. Which is a problem regulators are always going to face, when dealing with big international banks. What MF Global did was far, far worse than what JP Morgan did. But the motivations were similar. And right now, regulators are simply not equipped to deal with such shenanigans.

Mitt Romney likes to think of himself as a businessman, but in reality he’s not a businessman, he’s a financier, and there’s a big difference between the vast majority of employers, on the one hand, and financiers like bankers and private-equity executives, on the other. It’s a difference which makes it all to easy to read a bit too much into things like Goldman Sachs headcount cuts:

Goldman Sachs last week laid off roughly 50 people, according to people briefed on the matter but not authorized to speak on the record. The cutbacks have rattled some people in the firm, in part because a number of the employees were managing directors and on the higher end of Goldman’s pay scale.

The thing to realize here is that when firms like Goldman (and Morgan Stanley, and Credit Suisse) fire people, we often think that they’ve made a really tough decision — because in our firms, when people get fired, that’s a big and fateful day.

But banks aren’t like our firms.

Here’s Tim Noah, in his new book, explaining how the real world works:

One of the ways that the real-world economy differs from theoretical models is that bosses tend not to think about employee salaries as they relate to the labor market. Or rather, the boss doesn’t typically compare an individual employee’s salary to the labor market after he hires him. Instead, the boss thinks about how good a job the employee is doing, how much cash the company has on hand this year (or doesn’t have) for raises and bonuses, what the company’s internal (perhaps union-negotiated) compensation policies are, and so on. The moment when the boss does compare an employee’s salary to the labor market typically occurs when he makes the hire. I need a guy to do X, the boss thinks. How much do guys like that get paid? After that, the employee ceases to be an economic abstraction and is judged based on his own performance.

The point here is that banks behave much more like theoretical models than most companies do. In some dystopian capitalist universe, employers would constantly be alive to the nuances of the labor market. Never mind that you were hired at $60,000 a year: if someone just as good as you can be found to do the job for $50,000 a year, then you’ll either have to accept a pay cut or get fired.

Employers don’t act that way, because they generally have better things to do than be concentrating on the nuances of the labor market all the time, and also because it’s really expensive and time-consuming and unpleasant to hire and fire people. And, because they’re not evil profit-maximizing automatons. But banks are different.

If you’re Goldman Sachs, it’s actually really easy to hire people. And the cost of firing people, relative to how much they get paid, is actually pretty low. Moreover, at Goldman, the value of any given employee is far more quantifiable than it is at most other firms. The employees know it, which is one reason they get paid so much. And the firm knows it, too. That’s why banks have variable compensation: if you were worth $2 million last year and $1 million this year, your pay will go down this year.

All businesses are cyclical, which makes it hard to hire effectively. Do you hire lots of people when times are booming, only to find yourself overstaffed when times are less great? Or do you underhire in the booms, depriving yourself of growth? Places like Goldman solve that problem the capitalist way: they simply staff to the cycle. When profits are going up, they hire; when profits are going down, they fire.

Private-equity companies generally behave that kind of way once, when they first come in to a company. They’ll fire a lot of people, or make them reapply for their jobs, or otherwise reset the firm to the labor market at the time. But even they don’t then continue to hire and fire people continually across cycles: it doesn’t make sense to do that, when the cost of keeping someone on, even if they’re earning a few thousand dollars more than the prevailing wage, is so much greater than the cost of firing them and then re-hiring for the job.

But at investment banks, it’s different. If you’re not pulling your weight, you’re out. And when dealflow dries up, jobs get lost. It’s brutal, but it has a lot of internal logic. Which means that the real surprise here, as the global recovery sputters, is not that investment banks are firing. Rather, it’s that such activity is newsworthy at all, or that Goldman employees ever thought that managing directors had any kind of job security in the first place.

Partners, on the other hand…

Carl Richards is worried about the cost of sending his daughter to Stanford:

One of our daughters decided a long time ago that she was going to Stanford. I’ve been careful not to crush her dream, but there’s a reason why they say reality bites.

Let’s say she manages to get accepted. (Stanford’s acceptance rate is 7 percent, so I know it’s a long shot for anyone.) According to Stanford, the costs for a typical undergraduate student adds up to $58,846 per year. That’s over $200,000 for an undergraduate degree, and that doesn’t even account for the next several years worth of inflation…

College students now say that being financially secure is their most important life goal.

See the issue here? On one side of the argument we’ve been taught that getting the best education money can buy is the best investment you can make. On the other side sits the fact that the skyrocketing cost of education can be a major hurdle to the thing that we say we value the most, financial security.

Richards is right that college-tuition inflation, and its cousin student-debt tuition, are real problems. But I think his example is ill chosen.

For one thing, the “typical undergraduate student” does not pay $58,846 per year. Not even close. That headline cost is covered by four parties: the student; the student’s parents; the government; and Stanford itself. Parents earning the median US income are expected to pay zero towards tuition. There is no parental contribution at all for parents earning $60,000 per year or less; parents earning $100,000 a year or less aren’t expected to cover any tuition. Federal and state grants, as well as needs-based scholarships, should cover all of that.

As for the student’s contribution, it’s generally around $5,000 — calibrated to be payable using income earned in the summer and during the academic year. “You may choose to cover part or all of your expected contributions with student loan funds”, says Stanford — but that’s not designed to be necessary.

According to its latest filing, Stanford extends financial aid to 3,560 of its 6,889 undergraduates — that’s more than half of them. The average financial aid package for each of those 3,560 undergrads? An impressive $41,919. And that’s far from everything: another 30% of students get other forms of assistance, like athletic scholarships. Add it all up, and just 20% of students get no aid at all; it’s reasonable to assume that a large chunk of that 20% are foreign students, bringing the percentage of domestic students paying full whack even lower.

All of which is to say that the chances of Richards’s daughter graduating with an undergraduate degree from Stanford in one hand and a massive student debt in the other are extremely slim. If you’re fortunate enough to get into Stanford’s undergrad program, you’re fine. It’s not your student debt that we’re worried about. Even if you do leave with a typical student loan balance of $23,000 or so, it’s still no great hardship to take that elementary-schoolteacher job and repay your loans at the same time.

The problematic student loans aren’t the ones going to Stanford undergrads, nearly all of whom have lovely white-collar careers ahead of them. Instead, the problematic loans fall into two other categories: perpetual students who rack up enormous debts by piling one graduate degree onto another; and poorer adults taking out loans to go to vocational colleges which are often run on a for-profit basis and which have enormous drop-out rates.

In general, even with massive rack-rate inflation, if you take out a loan to get an undergraduate degree and you end up getting that degree, you made a good financial decision. The bad decision is if you take out a loan to get a degree and then you drop out: college dropouts are, statistically speaking, no more employable than if they’d never gone to college at all, and yet they often have massive student-loan debts all the same. Or, you take out massive loans to get things like law degrees, only to find that the demand for lawyers is not nearly as big as you’d been given to believe.

The cost of going to Stanford is high, but it’s not really a problem for Richards’s daughter. Richards himself will be expected to pay a substantial sum, since he probably earns north of $100,000, but it’s unlikely to be significantly more than he’d pay to send his daughter to a much less prestigious private school. And in general the plight of Stanford undergrads is pretty much at the very bottom of things that America needs to worry about. Yes, there’s a student-loan problem in America. But you’ll find it much more at the University of Phoenix than you will at Stanford.

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Economic projections matter, because they are used to make real-world policy. Which is the second piece of bad news surrounding last week’s dismal jobs report – not just the horrible jobs numbers themselves, but also the fact that no economists expected them. Indeed, the economic consensus was for more than double the number of jobs actually created in May. Are the world’s policymakers buying into that all-too-cheery view of the economy?

Underestimating how bad things are, it turns out, has been something of a trend of late. Economists expected US factory orders to rise by 0.2%; in fact, they fell by 0.6%. More broadly, 18 of the 21 economic indicators released last week came in weaker than expected, per the folks at Bespoke Investment Group.

Does this matter? Calculated Risk points out – rightly – that economists’ missed projections don’t necessarily tell us anything other than how wrong economists tend to be. And John Mauldin notes that “the Blue Chip economics consensus has never forecast a recession. And they largely miss recoveries.” Here’s Mauldin’s chart:

Meanwhile, the missed projections in the US are being echoed in a flood of bad global economic data. As Edward Hugh notes, purchasing indexes for Germany, France, Italy, Spain, the Netherlands and Greece are all suggesting contraction. With growth in the BRICs slowing considerably, Hugh says that “the world’s industrial base is now, even in the best of cases, barely ekeing out growth.”

Certainly the markets don’t believe that policymakers are going to do anything about the slowdown. Europe, in Greg Ip’s estimation, is in the last phase of the Feldman CRIC cycle: crisis, response, improvement and, finally, complacency. Ryan Avent, echoing Brad DeLong’s words from last week, reads the latest data downturn and asks if  ”a broad institutional crisis appears to be brewing” where the markets increasingly distrust policymakers’ ability to do anything helpful. When we’re hearing whispers of a “broad-based global economic slowdown,” the world’s politicians and central bankers can’t afford more wrong projections.

Wonks
Taleb: It’s time to start rationing the amount of information you take in – Farnam Street

TBTF
Ken Lewis basically admits to withholding information from shareholders before the Merrill deal – NYT

Indicators
Global lending is now contracting at the fastest pace since ’08 – Telegraph

Must Read
George Soros’s compelling new speech on the “Euro bubble” – George Soros (PDF)

EU Mess
Germany suddenly willing to compromise to save the euro zone – WSJ
Portugal may actually be able to stick to its austerity goals – Reuters

Oxpeckers
The Viral Internet Commandments – Gawker

Green Acres
How urban trees reveal income inequality – Per Square Mile

New Normal
The majority of Americans who are unemployed have some college education – WSJ

Modest Proposals
Securitize the Queen – Bright Green Scotland

Old Normal
AIG CEO suggests raising the retirement age to 80 – Bloomberg

Cheer Up
Pop music is getting slower and sadder – Pacific Standard

Greg Ip is getting in on the probabilities game, this time looking at the three big risks facing the global macroeconomy.

Ip puts the chance of a Chinese hard landing at 20%; of the euro falling apart at 40%; and of the US fiscal cliff actually happening at 30%. Individually, each of these risks is bearable. But make the reasonable assumption that they’re independent variables, and it turns out that if you put them all together, the chances of none of them happening are just one in three.

But let’s go a bit further. Let’s say that if none of these things happen, that’s Good. If one of these things happen, that’s Bad. If two of these things happen, that’s Dreadful. And if all three of these things happen, that’s Apocalypse.

Then this is the result that you get. The chances of a good outcome are 33.6%, a bad outcome is 45.2%, a dreadful outcome is 18.8%, and the chances of apocalypse are a small but still scary 2.4%.

You can also look at each possible outcome individually, like this:

Europe	US	China	Probability
			33.6%
			22.4%
			14.4%
			9.6%
			8.4%
			5.6%
			3.6%
			2.4%

The most likely single outcome is the Good one, where everything goes well in all three regions. The next most likely outcome is the bad one where Europe falls apart but the US and China keep things together — that’s 22%. Then comes the bad outcome with a US fiscal cliff while Europe and China muddle through: that’s 14%. And in fourth place is the dreadful outcome where you get the US fiscal cliff and the euro falling apart: that has a substantial 10% probability.

This is what Ip calls the “big hairball of risk”, and it basically explains the flight to quality that we’re seeing globally, with long-term yields below 2% in every major currency in the world. How do you invest in such a world? It’s really hard, but most sensible strategies involve a pretty large degree of downside protection in the form of risk-free assets. “And that sort of disengagement,” says Ip, “can make economic pessimism self-fulfilling.”

Unless, of course, governments take advantage of their ultra-cheap funding to step in with massive economic stimulus.

There’s a good reason why the likes of Paul Krugman, Joe Weisenthal (twice), Cullen Roche, Ezra Klein, and everybody else are raving about George Soros’s analysis of what went wrong in the Eurozone: it’s really good. The big theme is that the European-unity project is a bubble, which could burst at any minute. But it’s the granular analysis in this 4,400-word speech which really makes it worth reading.

Essentially, Soros characterizes the European project as being a bit like a runner, moving at a steady clip in the direction of greater unity. Running is a weird thing: it’s basically the art of falling over continuously in a particular direction. So long as you keep on moving forwards, you can maintain a dynamic equilibrium. But stopping is really hard, because whenever you try to do that, you’re out of balance:

The process of integration was spearheaded by a small group of far sighted statesmen who practiced what Karl Popper called piecemeal social engineering. They recognized that perfection is unattainable; so they set limited objectives and firm timelines and then mobilized the political will for a small step forward, knowing full well that when they achieved it, its inadequacy would become apparent and require a further step. The process fed on its own success, very much like a financial bubble.

The problem here is that the statesmen didn’t understand that they were running: they thought they were walking. They thought that while forward momentum was a good thing and maybe even necessary, ever-greater union was in and of itself a good thing, which would bring the continent closer together and make it stronger. With hindsight, by contrast, we can see that it was a way of turbo-charging the European bubble, and setting it up for a catastrophic pop if and when the process of integration didn’t continue far beyond what was politically feasible circa Maastricht.

The bubble was a consequence of the convergence trade, which in turn, says Soros, was a function of BIS risk weightings:

When the euro was introduced the regulators allowed banks to buy unlimited amounts of government bonds without setting aside any equity capital; and the central bank accepted all government bonds at its discount window on equal terms. Commercial banks found it advantageous to accumulate the bonds of the weaker euro members in order to earn a few extra basis points. That is what caused interest rates to converge which in turn caused competitiveness to diverge. Germany, struggling with the burdens of reunification, undertook structural reforms and became more competitive. Other countries enjoyed housing and consumption booms on the back of cheap credit, making them less competitive. Then came the crash.

The problem here is that the convergence trade could probably have been better described as a divergence trade: it created a two-tier Europe, with a strong creditor-filled center funding a weak debtor-filled periphery. And as a result the political union — which had always been the necessary other shoe to drop — became impossible, rather than inevitable.

At this point, says Soros, optimistically, Europe still has three months to pull together a comprehensive package to save the union — a package which is just as economically necessary for Germany as it is for Spain. But politically, getting this done is going to be incredibly hard: “the disintegration of the European Union,” says Soros, is “just as self-reinforcing as its creation”.

The economic necessity for Germany, here, is a product of Target 2, the mechanism by which the Bundesbank’s balance sheet now holds €660 billion in peripheral-country claims. Germany needs to throw money, more or less continuously, at the European periphery at this point, because if it doesn’t, its central bank will suddenly find itself insolvent to the tune of roughly €1 trillion. That wouldn’t be the end of the world: if Germany got its Deutschmark back, then the Bundesbank could simply print €1 trillion worth of Deutschmarks to fill that hole. But a world where the Bundesbank is willing to print €1 trillion worth of Deutschmarks is simply not the world we’re living in, and the Germans will do pretty much anything to avoid that outcome.

Which leaves us with the only alternative:

Germany is likely to do what is necessary to preserve the euro – but nothing more. That would result in a eurozone dominated by Germany in which the divergence between the creditor and debtor countries would continue to widen and the periphery would turn into permanently depressed areas in need of constant transfer of payments. That would turn the European Union into something very different from what it was when it was a “fantastic object” that fired peoples imagination. It would be a German empire with the periphery as the hinterland.

This is, in a nutshell, the bet I have with Joe Weisenthal. He, like Soros, says that Europe — including Greece — will become a German empire, where the Germans reluctantly dole out a stream of transfer payments to a resentful periphery. I’m taking the other side of that bet, because I think it’s politically impossible, in a union of democratic nations. And also because I think that even if perpetual transfer payments to Spain are justifiable, perpetual transfer payments to Greece are not. Either way, here’s the video.

Back in August, the NYT’s public editor, Arthur Brisbane, penned an idiotic column about DealBook, saying that the NYT’s focus on Wall Street was in some way preventing it from big longform analyses of the European crisis. Today, he returns to his DealBook-bashing ways, complaining — I swear this is true — that by serving the kind of people who are interested in Wall Street, the NYT is ignoring the needs of individual investors who want to be told whether the latest hot IPO is going to go up or down.

Brisbane does that annoying thing of outsourcing his opinions to others (Ryan Chittum, Larry Kramer, Chris Roush), but he clearly endorses Roush’s criticism that the NYT didn’t do a good job, in the run-up to the Facebook IPO of explaining “whether this would be a good stock for an individual investor to own”.

Or, to put it another way, the NYT didn’t warn individual investors that Facebook stock was going to go down rather than up.

This of course is completely bonkers. There is no possible away that the NYT could have known that Facebook stock was going down — it’s not smarter than the markets as a whole. And in any case, it’s not the NYT”s job to rate IPO stocks on the basis of whether they’re likely to go up. You want that, buy a stock-picking newsletter, or Barron’s.

The most annoying thing, for me, about Brisbane’s column is right there in the headline: “Wall Street and the Average Reader”. Brisbane talks about “the general reader who relies on The Times to explain the risks of the stock market”, and says that “the paper could have done more to help the average investor understand the risks of the offering”. He continues:

The Times should have provided more focus for general-interest readers, who needed help cutting through the clutter. More coverage aimed at small investors may well have led to more scrutiny of the risks.

But with its specialized finance blog, DealBook, plus its general-news mission over all, the paper is committed to two audiences, and that is a challenge.

It took me a while to understand what Brisbane was saying here, so let me spell it out: Brisbane is making no distinction whatsoever between a general-news average reader of the NYT, on the one hand, and a small investor interested in buying Facebook stock in its IPO, on the other, looking to the NYT for guidance.

This is just utterly bizarre. The Facebook IPO was a big news story, which deserved a significant amount of coverage. Lots of people were interested in the story — and the overwhelming majority of them had no interest whatsoever in buying Facebook stock on day one. Many NYT readers, of course, don’t have anywhere near the amount of money or risk appetite needed to be investing in the stock market at all. Those who do, generally invest in funds, be they of the mutual or index variety. There’s a small minority of NYT readers who buy individual stocks for their own account, but even most of those generally stay away from the highly-specialized world of IPO investing. And of the tiny majority of NYT readers who actually buy stock in IPOs, only a fraction of them will make their decisions based at all on what the NYT says.

So it’s baffling to me why Brisbane is talking about the “average reader” here. The NYT served the average reader perfectly well.

And it’s frankly stupid for Brisbane, armed with 20-20 hindsight, to declare that Nick Bilton’s very good article about Facebook’s final prospectus revision wasn’t enough, and that “the Times could have delved much more deeply” into the issue. Surely he knows that the only reason he’s saying that is news that came out after the IPO, about the way in which the revision was accompanied by whispers from Facebook to various Wall Street analysts, causing them to downgrade their estimates of Facebook’s second-quarter revenues. There’s no way that the NYT should have known about those whispers pre-IPO, even if it did deep delving.

More generally, Brisbane is still stuck in a mindset which says that the NYT has to be all things to all people. It is possible that some tiny number of NYT readers thinks that the newspaper is the best place to go for fundamentals-based analysis of the Facebook IPO price, and that they should read the NYT, first and foremost, before deciding whether or not to participate in the IPO. But even if those people do exist, it is not incumbent upon the NYT to write articles for them.

Brisbane does at one point cite with admiration the work of Eileen Brown, a blogger at ZDNet. I’m not sure, but I think that he thinks that the NYT should have basically written the articles that she was writing. (Or, for that matter, that any number of other bloggers were writing all over the internet, at sites like SeekingAlpha or Business Insider or many others.) That’s just silly. Brisbane could — but didn’t — say that the NYT was missing links to the work of bloggers like Brown or Henry Blodget: that because the NYT sensibly does not consider itself a source of advice on whether or not to buy into a certain IPO, then it should point readers interested in such things to the best analysis available online.

But in order to say something like that, Brisbane would have to be a very different kind of public editor. He’s leaving, in September; I very much hope that when the NYT appoints his replacement, it won’t plump for yet another curmudgeonly dinosaur. So far, we’ve had a series of 60-something white men with long experience of, and nostalgia for, the glory days of print journalism. It’s time for a change: it’s time for someone younger, who appreciates that the overwhelming majority of the NYT’s readers no longer read it in print, who appreciates the power of hyperlinks and social media, who will use the public editor’s blog and Twitter accounts in new and powerful ways, aggregating the vibrant conversation which is always raging about the NYT, rather than treating those tools like a regrettable and newfangled source of extra problems and extra work.

My suggestion: Anna Holmes. I’m quite sure that she, unlike Brisbane, would engage effectively with, say, Xeni Jardin’s fantastic critique of today’s NYT declaration that men invented the internet. She might even — horrors! — engage in the comments on Xeni’s site, rather than remaining aloof in the NYT’s ivory tower. The NYT is a hugely important digital news organization with a fantastic social-media footprint. Here’s hoping that it manages to find a public editor worthy of engaging with the organization the NYT must be, rather than the one it was in decades past.

Update: Failing Anna Holmes, it seems to me the least they can do is appoint Pat Kiernan.

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Remember when all we had to worry about was an oversaturation of Facebook IPO coverage?

Today’s jobs report was decidedly bad: The US added just 69,000 jobs in May, leaving unemployment unchanged at 8.2% and employment gains in both March and April revised down. The ranks of the long-term unemployed, those without a job for 27 weeks or more, swelled by 300,000.

Justin Wolfers is convinced that economic conditions demand fiscal stimulus. And although Treasury yields are once again a fear gauge, Felix thinks they also show us the way out: vast government borrowing at cheap rates and spending to invest in infrastructure, public-sector employment and the social safety net.

But congressional intransigience and the president’s seeming discomfort with stimulus makes that an unlikely path. Betsey Stevenson calls on Congress to “stop acting like children and do something about the fiscal cliff and debt ceiling” rather than engage in seven months of brinkmanship. But Jared Bernstein, Joe Biden’s former economic adviser, doesn’t think that a Congress committed to acting on narrow, partisan terms ”regardless of the degree of hardship in the current economy” can mature on a whim. After all, the benefits of the president’s jobs bill are looking awfully attractive right now, and it was pronounced DOA.

Binyamin Appelbaum thinks the most likely source of economic juice will come from the Fed. Ryan Avent agrees that the Fed will be forced to consider action, but thinks it’s unlikely to be decisive enough:

The Fed bears the greatest responsibility for America’s pathetic recovery…The Fed’s interventions have been limited and seemingly designed to ignore the powerful expectations channel; at no point have breakevens shown inflation expectations steady at even pre-crisis levels when expectations above pre-crisis levels are what the current situation demands…It repeatedly stops pushing the economy forward as soon as it seems likely that the economic trajectory will carry inflation toward 2%.

Tim Duy feels like he’s already seen this movie in the summer of 2011. If that’s true, it will be deeply unfortunate, because after a month when the economy added too few jobs for at least one economic-recovery model to even compute, waiting to act is increasingly counterproductive. – Ben Walsh

On to today’s links:

EU Mess
Man with power to do something about the euro crisis urges others to do something about the euro crisis – NYT
What do you do when half of your country’s youth is unemployed? – TNR
Investors are paying Germany to watch their money for a couple of years – WSJ

New Normal
Americans are cutting back on debt – except, that is, for student loans – WSJ

Hackers
Obama ordered a wave of cyber attacks against Iran – NYT
Stuxnet, the worm that targeted Iran’s nuclear facilities, was created by the US and Israel – Boing Boing

Wonks
Everyone stop being so “dangerously facile” about deficits and growth – Ken Rogoff
Are we seeing a capital flight from China? – Tim Duy
A detailed case for “monetary regime change – National Review

Good Points
“You are no different from some teen in Indiana with a LiveJournal about cutting” – Choire Sicha

Facebook
That link to a 55-gallon bottle of personal lubricant you joked about on Facebook? It’s an ad now – NYT

Walmexgate
With bribery investigations looming, Wal-Mart chairman says integrity “is our business” – Reuters

Charts
The collapse and hollow return of private-sector employment – Mother Jones

Contrarian
This is the least important jobs report of all time – Josh Brown

Appropriately Surly
Raymond Chandler to a copy editor: “when I split an infinitive, God damn it, I split it so it will stay split” – Letters of Note

Politicking
Teamsters criticize Romney’s private equity background, but are happy to invest their pensions in it – CNBC

Chrystia Freeland has found a classic example of Silicon Valley hubris in TJ Rodgers, the CEO of Cypress Semiconductor. Rodgers reckons his taxes shouldn’t go up; his reasons are pretty simple. If that happened, he explains, he’d have less money to invest in Silicon Valley. And since “taking money from the investments, my investments, out of Silicon Valley, where they have been very, very good for the economy” is self-evidently a really bad idea, then raising his taxes can’t possibly make any sense.

The first problem with this is that Silicon Valley is not a place where TJ Rodgers’s money is magically transmogrified into growth and jobs. Yes, Silicon Valley is a very innovative place. But it would be a very innovative place even if it had significantly less money than it has right now. I actually lived in Palo Alto in the mid-80s, when Silicon Valley had long since matured as a vibrant technology center, and as I recall it cost about $500 a month to rent a nice family home. Since then, the amount of money in Silicon Valley has increased enormously, along with the price of Palo Alto real estate. But it’s far from clear that all that new money has made the Valley any more innovative.

In fact, we know exactly what would happen if a lot of the wealth in Silicon Valley suddenly got taken away: we know because it happened, when the dot-com bubble burst in 2000-01. The researchers kept on researching, the innovators kept on innovating, and the main effect of the dot-com bust was that bits of San Francisco looked, briefly, as though they might actually become affordable. That didn’t last for long.

But Chrystia herself provides the much stronger rebuttal to Rodgers, when she quotes Nandan Nilekani, the co-founder of Infosys, pointing out that huge amounts of Silicon Valley wealth are built on US government spending.

“It’s the role of governments to create public goods which are platforms for innovation. If you look at the U.S., the Internet was a government defense program on which today you have this huge innovation ecosystem. GPS is another example.” That system “was designed for military applications. But today it’s used for maps or car navigating systems or whatever. So the ideal is to create these global public goods or these national public goods that are platforms. And then make them open so that people can innovate.”

The big money in Silicon Valley these days is very much around anything that can credibly call itself a “platform”. Facebook might be worth a lot less than it was worth a couple of weeks ago, but it’s still worth vastly more than it would be if it were merely a media company making $1 billion a year selling ads. The bulk of Facebook’s value is embedded in the fact that it’s a platform: it’s the tool we use, all over the internet, to be ourselves and to have connections to our friends.

Innovation is in large part about building things on other things: build an iPad location tool on the GPS architecture, for instance, or build a social network using existing internet architecture. And underneath it all is a system of base-level infrastructure which needs to be carefully tended lest it all fall apart. One difference between Rodgers and Nilekani is that Rodgers has been living in Silicon Valley long enough that he takes a huge amount for granted: he has everything he needs to run a great business right on his doorstep. Nilekani, by contrast, needs to deal with obstructive Indian bureaucracy all the time: he knows that India, as a platform, is vastly inferior to the Bay Area.

Once you build a platform, you never know how you might be able to extract value from it. I was talking to the SecondMarket guys yesterday, for instance, and they talked a bit about what they’re calling their new marketing platform. They spent a lot of time building up a huge database of accredited investors interested in putting money into private companies — and now they’re looking to monetize that database by essentially renting it out to other shops looking for that kind of investor.

Art funds, diamond funds, wine funds, distressed-mortgage funds, tax-lien funds, you name it — somewhere in that SecondMarket database there’s a group of people who are likely to be very interested. And SecondMarket itself needs to do very little work, since they’re basically just acting as a high-tech dating agency, matching investors with fund managers. The investors came for the pre-IPO equity; they’ll stay for all the other goodies that SecondMarket can introduce them to.

And the USA is, in many ways, the ultimate platform — a massive market and currency zone, which can provide enormous demand for great products while also providing peace, prosperity, strong and stable institutions, and everything else that someone like Rodgers needs to be successful. It makes sense to invest in that platform — and it makes sense, too, that the people who get the most out of it should be asked to reinvest the most back into it.

You can call that reinvestment “stimulus” if you like, although that word seems to have gone out of favor these days. But what’s sure is that unless the USA keeps its infrastructure up to date, it’s going to lose a lot of competitiveness over the long term. We need a smart energy grid, we need a much better transportation network, we need to improve our educational system, and ultimately we need to have a much more constructive legislature than we have right now. If we fail in that, the whole country will decline, and it will take the likes of Rodgers down with it.

Nick Hanauer, another Silicon Valley multi-millionaire, uses the gardening metaphor: we need to maintain our garden if we’re going to reap abundant crops. So long as people like Rodgers think that the government is good for nothing but misguided cash-for-clunkers schemes, and that the best thing it can do is just get out of their way, they’re going to be the worst kind of free-rider: the kind who doesn’t even know they’re free-riding. Maybe we should tell him to try to build a great technology company in, I dunno, Greece, and see how that works. Only then might he appreciate just how much of his net worth he owes to his country.

This is about as bad as the jobs report could possibly be: just 69,000 jobs created, split between 95,000 new jobs for women and 26,000 fewer jobs for men. The market reaction has been swift and merciless, with stocks and bond yields plunging: the 10-year Treasury bond now yields less than 1.45%. When stock prices fall, of course, the earnings yield on the S&P 500 goes up, even as bond yields go down. Which means that the numbers on this chart are now even more extreme than at the close yesterday:

The green line, here, should not be able to simply go up and to the right indefinitely. While market failures clearly happen all the time, things are really bad when they persist for this long. And what you’re looking at, here, is a market failure, as Brad DeLong explains: what we’re seeing, he says, is nothing less than “a massive failure of our economic institutions”.

The first reason betrays a lack of trust that governments can and will do the job that they learned how to do in the Great Depression: keep the flow of spending stable so that big depressions with long-lasting, double-digit unemployment do not recur. The second reveals the financial industry’s failure adequately to mobilize society’s risk-bearing capacity for the service of enterprise.

Basically, we have low bond yields because the Fed has failed to do its job, and persuade the markets that it is capable of engineering a healthy economy over the long run. And we have high stock yields because the market has failed to do its job, which is to treat high corporate earnings as a fantastic opportunity to invest in the economy and build something even greater in the future. Just look at the amount of money which is flowing straight to corporations’ bottom lines, and not being put to good, productive work. Corporate profits now account for significantly more than 10% of GDP: that’s never happened before.

To spell this out: high corporate profits and low levels of job growth are two sides of the same coin. If things were working properly right now, companies would take their excess revenues and use them to hire more people. Instead, they’re basically just letting those excess revenues sit on their balance sheets as cash because they’re scared to invest in themselves. It’s frankly pathetic.

The solution to this problem is nothing complex — the arbitrage is sitting there in the first chart, plain for all to see. The government can borrow at 1.45%: it should do so, in vast quantities, and invest that money back into the economy itself. Take a few hundred billion dollars and use it to fix our broken infrastructure, to re-hire all those laid-off teachers and firefighters, to provide some kind of safety net for the millions of Americans who have been out of work for more than a year. Even if the real long-term return on any stimulus package was zero, the nominal long-term return would be well over 1.45%, making the investment worthwhile.

To put it another way, not all crises look the same. Back in 2008-9, the fact that we were in a crisis was obvious, and it resulted in unprecedented levels of enormous coordinated actions between Treasury and the Fed. Now, however, when we look at the crisis-level spreads in the first chart, we don’t think “crisis” any more — and the sense of urgency that everybody felt in 2008-9 is long gone. How many more dreadful jobs reports do we need before it returns?

The 2012 election should be a referendum between two visions of America. On the left, Obama should say that we’re in a jobs crisis, and that he’s going to do everything in his power to get people back to work — by employing them directly, if need be. On the right, Romney can say that job creation should be left to US companies, despite the fact that those companies are signally failing to increase their payrolls despite their record-high profits. And then the public can choose which side they want to vote for.

Sadly, the lines won’t be drawn nearly that cleanly: Obama is bizarrely reluctant to talk about anything which rhymes with “stimulus”. As a result, the current dysfunction — and horribly weak jobs market — is likely to persist for far too long.