What is wrong with passive investing and index hugging?  One problem is that these strategies often use ETFs. I wrote about the potential for ETF meltdown last October, with a follow-up shortly thereafter, so I won't belabor that here.  Another problem is that most passive portfolios follow a cap-weighted index. Recently I also wrote about the risk from this. So I won't repeat that here, either. What I will do is add another risk that comes from the passive and index-hugging approach to portfolio management, the resulting lack of diversity in investment strategies and outlook.

The need for diversity is fresh on my mind because last week I was fortunate to share the stage with two academic luminaries, Andrew Lo, a finance professor at MIT , and Simon Levin, a professor of ecology and evolutionary biology at Princeton, at an event jointly sponsored by the BCG Henderson Institute and the Institute for New Economic Thinking. It took place at BCG's new office at Hudson Yards on New York's West Side, a place where shiny office buildings are popping up like sunflowers.

Andrew and Simon co-authored a paper arguing that financial regulation can learn from the regulation of biological systems. Andrew also has a recent book Adaptive Markets with arguments closely related to the same topic, that financial systems can be viewed as adapting to the changing, dynamic work in ways analogous to biological entities.

The essence of a biological system is that it is dynamic and complex, with the agents of that system facing unexpected changes in their environment. One way they meet the challenges of their dynamic world is to adapt through evolutionary changes. But in the biological realm evolution takes time, whereas the changes to their environment can be sudden. The more immediate survival mechanism in the biological realm is diversity, both across species and within any given species.

Diversity is the immediate result of sexual reproduction. There is a mixing of genetic traits, so each offspring is a little different. Which means many offspring are less than ideal for the current environment. In contrast, with asexual reproduction you get carbon copies of the parent, absent the occasional mutation. If the world keeps on going the same way and if the survivor in the assexual world is among the fittest for that world, then its offspring will be equally fit. The diversity in outcome from the sexual species will just add noise and inefficiencies in terms of survival.

The reason the world has largely moved to sexual reproduction is that things do not stay the same. Because the asexual species are all genetically identical, if things move the wrong way they all die off. But because there is diversity within any sexual species, there is a chance that some will have the characteristics to survive in the new system. Maybe those will not be the ones that are the best in the current system, and maybe they won't be the best in the new one, but they will be good enough in both.

Passive investing is the financial equivalent of an asexual ecology. That is, being asexual means it is not diverse. (And being asexual also means that passive investing, as many portfolio managers can attest, is not a lot of fun.)

The risk, then, is that with us all crowding into the same passive investments we will not have the diversity to adapt if something bad comes along.  But it is actually worse than that.  Being all the same might actually create the bad thing that comes along.  Because we don't just live in the ecology, we create it, and we create many of its shocks.  If things start going in the wrong direction, the effect of all of the passive investors moving in the same way, and the lack of deep-pocketed investors ready to take alternative tacks, will itself create the dynamic cascade.

By the way, this is a problem that is not restricted to passive investing, or even to finance.  I have written about the asexual capitalist, and how the same problem of a lack of diversity inflicts the capitalist system broadly.

The recent tumble in the market is being attributed to the wage report, a rise in interest rates, and concern about inflation. A reassessment of economic conditions does not lead to such a violent reaction. It might give a push, but then gravity does the rest. For the markets, gravity is the technicals -- how leveraged or overextended investors are, how concentrated, and how much liquidity there is in the face of a flood of selling.

This is just a quick recap of a couple of posts I have done over the past months that relate to technicals behind the current market downturn. In early November I wrote a post about how the low volatility regime we have enjoyed (if that is the right term) could blow up. We have seen the first leg of that with the decimation of the inverse volatility ETFs and ETNs. They have actually printed negative prices. What was worth $2 billion a day ago was worth $20 million in after-hours trading, and depending on how they terminate, could become zero.

The VIX went from the lowest level in history to near the highest. The next shoe that might drop will be the actual market volatility. If actual volatility rises, there will be a rash of funds that target a specified volatility that will have to sell positions -- mostly equities. If a fund is targeting, say, 12% volatility and market volatility goes from 12% to 24%, the fund will need to go from fully invested to 50% invested.

Looking at an extreme tail risk, the total failure of the inverse volatility ETF might cause ripples across ETFs more broadly. Some investors, I would think mostly retail investors, might simply hear that an ETF went to zero in one day, and think that is a concern for other ETFs. If they start to liquidate on that basis, it could lead to widespread contagion. I posit this in a post from October, though with high yield ETFs as the spark.

The cascade due to volatility and the contagion from ETFs might occur, or might not. If they do, it will be a slower process than what we have observed over the past few days. And things do not follow a straight line. There will be "bargain hunting" along the way. But depending on how that plays out, it might be piling more investors onto the thinning ice.

Investors tend to focus on the most likely outcome. As a risk manager, I spend time focusing on the unlikely, on the bad things that might possibly happen. Where T.S. Eliot writes, "This is the way the world ends, Not with a bang but a whimper" I would write, "This is one possible way the world might end...."

So, with that as the starting point, how might the world end for Facebook? And, by extension, for Apple and Google, because Google faces similar, but not so dire, business risk, and because much of Apple's raison d'être is to provide the hardware for Facebook and related applications.

Regulatory Backlash

As a start, there is a crescendo of regulatory backlash to the power that Facebook and Google wield. It is most manifest in recent action in Europe, and has been given some headline coverage from a speech a few days ago by George Soros at the World Economic Forum. If you want a sense of where he is coming from, the Washington Post headlined it as "Facebook and Google are doomed, George Soros says."

The current controversy on net neutrality applies to Google and Facebook. One concern is that without net neutrality there will be a stifling of the small start-ups, and increased power for the larger players. Point the rifle three clicks to the left from the net neutrality debate, and you have them in the line of fire.

A Self-destructive Business Model

Facebook and Google have a business model that is at war with itself. On the one hand they link like-minded people together, so they can share their views, interests, and product suggestions. On the other hand, they depend on advertisers for their revenue. But if their business model is perfected in the first case, there is no need for the second. People will know what they want without the advertisers that are outside their social circle chiming in.

Social Norms

Obviously a social network like Facebook or Instagram only works if people want to share on the social network. And the bulk of those who do so are acutely sensitive to the cool thing to do. If it becomes uncool, that is the end of that. Put another way, the fever pitch of social media is of the same flavor as any fad. It has no purpose other than being the thing of the moment. For social media, that moment might last another two years or another ten. But at some point there is the risk people will find it so last year, or so "what my parents used to do."

As a measure of it being a fad, what other $500 billion company could disappear from the face of the earth tomorrow and have no real impact -- except on advertisers?

And there are signs of change. When Cook states that he wouldn't want his nephew on social media, that is not a good sign. Closer to home, a month ago my fourteen year old daughter decided to get off of social media.

A recent meme is social media as cigarettes. Think of cigarettes in the Mad Men era. People were addicted, but also it was part of being social, and it was the way you kept yourself busy. If you weren't holding a cigarette, what were you going to do with your hands? Social media is addictive, social, and keeps you feeling like you are doing something with your hands.

How Does Apple Fit into the Mix?

The iPhone is the hardware that runs the fad. Take away the need for social media functionality, and there is no reason to move beyond the power of, say, the iPhone 6. Maybe you disagree with that, but by the time you get to the iPhone X I think you are at a bridge beyond. Once you deal with the battery issues and avoid dropping it, (or drop it and pay $100 to get the screen repaired), a smart phone lasts forever, and has the power you need if you are not lighting up social media. Put another way, think about how frequently you upgrade your iMac.

The Darkening of Silicon Valley

One thing that can help push social norms away from Facebook is a reframing of the Silicon Valley sphere away from the cool end of the dial and toward the menacing. The sea change that is putting Silicon Valley companies in the sights of regulators is also washing away the veneer. Soros wasn't the only one bashing the fruits of Silicon Valley. There was a litany of others along with Soros from the World Economic Forum. Undeniably, Silicon Valley is exciting, filled with great minds, and is the go-to destination for college kids. I know the feeling; that was the investment banks of the 1980's. And look where that ended up.

Case in point, there is the growing realization that Facebook is not simply a fun app, and the work of those brilliant Silicon Valley engineers is not just creating a global sand box where we can play. In the wrong hands it in can subvert a political system with more efficiency than a rioting mob. It already has. That has got to move the dial a bit in terms of perceptions.

Note: I did a post on Facebook back in 2011 that has similar sentiments, but with a more philosophical flair.

I'm not going to write anything here about the huge drop in bitcoin over the last few days, so what I am writing cannot be ignored should bitcoin get back up to the 20,000 range. And I'm not going to write about the stupid articles that espouse bitcoin. Though to get a sense of the level of thoughtfulness for the arguments for bitcoin, just to pull one recent one at random, check out this from Forbes.

I'm going to point out only one simple but devastating barrier to bitcoin becoming the standard, becoming even a second-tier means of payment:

If bitcoin doesn't find its way back into the shadows of the drug trade and underground economy on its own, it will be banished by the stroke of a pen, actually, of many pens. No sovereign will give up the power of issuing and controlling its currency. The central bank and monetary authority is one the most powerful economic tools of any government. If bitcoin or other extra-governmental currencies start to take hold, they can and will be made illegal to use for payment in one country after the other.

The cryptocurrencies will still find a market in the underground economy, where people want to avoid taxes or need to remain anonymous and untracable because their activity is illegal or subversive (It is true the ledger is public so all transactions can be seen. But the identity of the user behind the address can be kept anonymous.) But it will not be useable for the bulk of transactions, like your mortgage, credit card bill, tax payments. Or purchases on Amazon. It will be good for your recreational drugs, and your under-the-radar part-time t-shirt printing business.

A few other thoughts while I'm at it:

I can't take seriously a currency, crypto or otherwise, keeping in mind that currencies are supposed to be a store of value, when its exchange rate is determined by speculative activity, untethered to anything in the real world. Where the volatility is greater than for any asset in the real world. And where the assessment by bitcoin.org is that "it is truly difficult (and exciting) to imagine how it will play out."

To those who think there is credibility for bitcoin and other cryptocurrencies because Goldman now is considering a cryptocurrency trading operation, just remember this from Matt Taibbi:

The world's most powerful investment bank is a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money."

And right now, bitcoin smells like money.

Note: A fiat currency is the currency issued by a government that is declared its legal tender, accepted for payment of all debts, public and private. The word "fiat" means it is not backed by anything. No gold or silver; the government declares it as currency by fiat.

As I mentioned in an earlier post, working in a pension fund makes me think toward the long term. In that post I spoke about broader long-term risks; here I will give my view about long-term risks at the more specific level -- namely, industries to short if you are looking out a generation or more. That is, how various industries will decline over the next thirty or forty years. That is a long time, like the time since Whip Inflation Now of the mid-1970's, or the LBO craze of the late 1980s, but if you are under fifty there is a good chance you will live to see it, and your grandchildren will be in the thick of it.

General propositions
The key drivers of what to short are developments in the following areas:

• Increased reliability of products. Already, many of the things we consume are more reliable and last longer than any time in the past. Take computers and LED screens. And soon, it will be electric cars.
• Less consumption of goods. In the sense that most of our time is spent on fewer things – like those highly reliable computer items.
• More commodity items. Which means less demand for advertising. Compare advertisements today with those of a generation or two ago. Almost everything was driven by brands. Now we are not as focused on brands, and as far as brands go, there are so many brands that are hard to differentiate that they may as well be commodities. Meanwhile luxury goods are moving toward items that are inherently scarce, like art and real estate -- items that do not require production.
• More efficient production. And part of that efficiency is that what we produce requires less labor.
• Increased demand for personal space and privacy. We will circle the wagons around our personal space and privacy. We are going to draw the line when we find that companies know more about us than we know about ourselves.

Let's start with the easy ones, where there is a clear consensus, and work our way down from there:

Energy
Oil. We all know that fossil fuel is a goner. And the more obvious it becomes that oil remaining in the ground will be a stranded asset, the more oil will be pumped out in the shorter term. So between growing renewables, flowing oil, and more efficient technologies, energy will be abundant.

Will the oil jobs be replaced by renewables. Is it only a matter of retraining of those working in this sector to work with renewables? No, because even ignoring the higher economies in production, the capital plant of renewables lasts a lot longer and requires less maintenance per kilowatt-hour produced.

Saudi Arabia and the rest of the Middle East. There is a clear regional implication to this, of course. This is not good for the Middle East. And what is also bad for the Middle East is climate change. Some predictions are that the Arabian Peninsula will become so hot as to be uninhabitable. So much for the Saudi's Vision 2030. And, I really can’t understand what the thinking is with Aramco. It is a long-term bet under the clouds of oil demand dropping with increasing speed and the political vulnerability of Saudi Arabia.

Transportation
Trucking. Trucking will also clearly be altered from an employment standpoint by self-driving vehicles. We got a taste of this a few weeks ago when Tesla unveiled its semi truck. Whether you like Tesla's odds or not, self-driving trucks are coming, especially for runs along the interstate.

Things will also change at the local level, for example for package delivery. A new household appliance, already in the works, will be a lockbox that can be opened for securely delivering packages, as ubiquitous as mailboxes. In the limit there will be one run per day of an autonomous vehicle to each residence and business. (How the packages get from the vehicle to the lockbox is the weak link in taking humans out of the loop in this scenario.)

Autos. Another no-brainer is that the automobile-related industries will be far smaller. Gas stations will disappear. And most mechanics. Cars will last far longer and require less maintenance, garages, which are already on the downswing, will largely disappear as well. (New tires from Costco.) Once production is scaled up with a few rounds of efficiency gains, electric cars are not complex, and are cheap to build. The cost of cars will be a fraction of what they are today. With low maintenance, low fuels costs, low purchase price, and autonomous driving, transportation will be far safer and less expensive.

People will be traveling less; fewer trips to the mall. People will have less need for a dedicated car because they will summon an autonomous car that can be running people one place or another nearly 24/7. And most people won't care as much about style because they will be treating them as what they are, transportation services -- which gets to my point about more commodity-like products.

There will still be the vestigial car, just like there are still mechanical watches. Gas-powered cars will be admired and collected for their workmanship and intricacy, and not for their performance or function. Driving a car will be a hobby, like horseback riding. And maybe not in forty years, but at some point, people-driven cars will be seen on the street about as often as horses are. They will be enjoyed on closed tracks, just as horses are today.

Casualty Insurance
It is a mixed bag; some lines will dwindle, others will grow.
Auto. Autonomous vehicles are safer than people-driven vehicles, especially when all cars are autonomous. Fewer accidents means less need for casualty insurance.
Liability. Less high-risk labor.
Property. Things will be looking up here, due to the effects of climate change.

Real Estate
Commercial. Stores will become less prominent as the efficiencies of delivery improve. And as many items last longer. This leads to issues for commercial real estate. There will be construction for warehouses and "fulfillment centers." These are cheaper to build and maintain than commercial retail space. So less construction and maintenance. With the move toward renewables, there is a drop in construction of large-scale fossil fuel plants, and the plant for renewables will not require as much construction and maintenance demand.

Residential. Demographics and lifestyle will change the demand for housing. There will be less demand for large houses with living rooms and dining rooms that are not used, and for four and five bedrooms. This means a glut for some zip codes. And it also means fewer construction jobs. Houses will have solar cells and batteries to be increasingly self-sufficient, so less energy use.

So chalk up the construction industry -- one that is more immune to technology -- as another casualty.

Basic Materials and Mining
With less demand for new cars, less construction, and key goods that are replaced less often, there will be a drop in demand for many raw materials. Though others, like those that are needed for batteries and computers, will increase in demand. Or maybe not. Who knows what raw materials will be in demand, and how great that demand will be with the changes in technology that we might see over the course of the next generations. And because these products last longer, and finally meet the needs for various functions, they will not be the same engine of production.

Advertising (and Facebook and Google)
There is a feedback loop between advertising and the information and social network companies that depends on advertising. This feedback leads to a self-destructing business model, with the information companies and advertising going down together. The information companies depend on advertising, and yet they are information engines that reduce the need for advertising.

And advertising for non-luxury and non-status goods (luxury and status goods are not the fodder of Google or Facebook) will drop for the reasons I mentioned above: less advertising because we will demand fewer goods, and many of the goods will be commodity-like. Few of us care about which chargers we buy for our phones.

There are other pressures that might build for social networks such as Facebook. We will still need search engines, but Facebook is already tiresome to some of us, and we are getting the first whiffs of the toxicity at its root. With the world veering toward an impersonal dystopia, we will guard our privacy, we will circle around our real relationships. Here are recent articles from Wired that give a flavor of where things might be going, one a truly harrowing saga of overcoming malicious cyber attack, and another one of any number you can find, appearing with increasing frequency, on privatizing Facebook. From the perspective of forty years out, Facebook and social networking in general will have been a flash in the pan.

...An Actuary is someone who wanted to be an accountant but didn't have the personality for it....An introverted actuary stares at his own feet, and extroverted one stares at the other person's feet....What is the difference between God and an actuary? God doesn't think he is an actuary...."Look at the white horses over there." Actuary: "They're white on this side, anyway."

Unfortunately, when it comes to the mess our pensions are in, actuaries are no joke. Pension funds labor under actuarial assumption for expected returns that are mainly pulled out of thin air without any regard for financial economics. Does anyone really think pensions will be able to grow at seven percent or more per annum? When they are constrained by their various constituents to hold 50% to 60% in bonds and cash? (See Figure 3 of this OECD publication.)

Those unrealistic assumptions lead to unsupportable levels of contributions, and thus pensions are underfunded as a matter of course. You know the assumption are wrong when virtually every pension is on the negative side of the ledger. But the actuaries do not seem to have been trained in the concept of making course corrections. Nor do they educate themselves in financial economics to better evaluate the mess they are creating.

Why am I going into this? Over the weekend I attended an event honoring a former colleague of mine from my days at Morgan Stanley, Jeremy Gold. He is an actuary who has spent his career trying to move the pension actuaries toward a firmer foundation in financial economics -- to have them at least avail themselves of what financial economists can provide. In the mid-1980's, Jeremy and I worked together in the Fixed Income Research Group at Morgan Stanley. He and I went on various trips to push fixed income products, and to market the fledging new strategy of portfolio insurance (flying out once to have dinner with the head of the Port Authority of Los Angeles, who we discovered, part way through the first course, had -- surprise -- thought we were selling port insurance). We co-authored a paper in 1988, In Search of the Liability Asset, that is still on various reading lists, maybe not for actuaries, but at least for those in finance.

Jeremy left Morgan Stanley in the late 1980's to get a Ph.D. from Wharton, and spent the next twenty years as a thorn in the side of the actuarial profession, pushing them to add financial and economic structure to their methods. One of the best and most widely read of his works for this is the paper Reinventing Pension Actuarial Science.

At the base of it, finance is not actuarial science. It is not predicated on repeatable, or even known, probabilities. There is no appeal to the law of large numbers for the systematic risks of the financial system.The future does not look like the past. There are no mortality tables for asset returns.

...What do actuaries and Packer fans have in common? They both think that history will repeat itself...

So if you want to be the arbiter for over 20 trillion of U.S. pension assets, a good start is to do it based upon a foundation in finance.

I wrote a post a month or so ago on the risks from ETFs, in particular how ETFs on less liquid markets - with high yield bonds being my poster child - could cause problems for the market generally. Basically that there is a fundamental flaw when people think an instrument based on a illiquid market is capable of intraday liquidity. And that if the ETFs in such a market have a severe problem, ETFs generally might be considered tainted by a range of retail investors, leading to an outflow from even the more liquid ETFs.

Here is an article that points toward the potential for problems with high yield bond ETFs:

Investors Playing ETF Rout Pushed Junk Bonds to Brink of Chaos.

Excerpt:

Trading in exchange-traded funds got a little crazy last week when it became clear that junk bonds were in for more pain. But the market was fortunate the consequences weren’t more severe, strategists warn. Though spared the worst, investors came close to creating a scenario where ETF activity drove prices....a snowball effect where a dislocation develops between the fund price and the value of its underlying assets.

In case you haven't noticed -- and I haven't -- we apparently are in a world of exceptionally low risk. To see this you need look no further than the volatility of the major markets. The volatility of the U.S. equity market, for one, is at its lowest level in a generation. So, no worries here, right?

I wrote a blog post in 2011 titled The Volatility Paradox which explained that when volatility is low, risk is actually rising because people are more emboldened to take on higher leverage and to move to riskier assets. If volatility is half of what it used to be, why not lever twice as much? Thus the immediate question is what happens if there is a sudden surge in volatility from our current, low level. What is the dynamic through which a volatility shock might propagate across the financial system?

A conventional stress test will assess positions that have explicit volatility exposure, such as positions in options, in the VIX and other volatility-based instruments. There is plenty of dry powder here; over the course of 2017, as the U.S. equity market volatility as measured by the VIX index dropped to one of its lowest points in history, we have seen a growing concentration in short volatility exposure by leveraged ETFs, mutual funds, and hedge funds.

But a stress test that does the simple mathematical calculation of direct portfolio exposure to volatility will underestimate the effect of a rise in volatility, because there are dynamics triggered by other strategies that do not have explicit volatility exposure but that have a link to the volatility of assets and to the assets themselves. A rise in volatility will trigger actions for these strategies, leading to selling of the underlying assets, and this in turn will lead volatility to rise even more, creating a positive feedback between the volatility of the market and the assets in the market.

What are these strategies? Well, a good place to start are volatility targeting, risk parity, and other strategies that will rebalance their portfolios when volatility rises. Volatility targeting is a strategy that targets a level of volatility to manage risk that is typically set based on the manager’s mandate. For example, the manager might follow a strategy that will seek to keep the portfolio’s volatility near 12%. If the volatility of the market is 12%, the fund can be fully invested. However, if the volatility of the market rises to 24%, the fund will sell half of its holdings in order to stay in line with its 12% target. Risk parity allocates portfolio weights to have the same total dollar volatility in each asset class. These multi-asset class strategies often use leverage to adjust holdings of underlying assets, buying more of the lower volatility assets relative to the higher volatility ones. If the volatility of one of the asset classes rises, the fund will need to sell some of that asset class in order to maintain equal dollar volatility. In both of these cases, there is a clear mechanism going from the rise in volatility to a drop in the underlying asset.

Things won't all happen at once. The agents for these strategies differ significantly in their time horizon. Those who are directly linked to volatility, those that are in short-volatility ETFs and the like, will have an immediate P L effect from a surge in volatility, and will need to reduce their positions immediately. The volatility targeters will only reduce positions as the rise in volatility is seen as having a non-transient component, and their adjustments will be in a weekly to monthly time scale. And the risk parity agents will have an even longer time horizon, because they generally make asset adjustment with a monthly or quarterly time frame, and do readjustments based on a longer-term estimate of volatility.

Oh, a little more on the relationship between low volatility and risk: If you want to see really low volatility, look back at the swaps markets in the summer of 1998. But you might recall that in August of 1998 there was a rash of defaults in Russia, which was then followed by the blow up of LTCM, the (before that) famously successful quant fund whose principals a few months earlier had graced the cover of Business Week (never a good sign). In that case, low volatility didn't spell low perceptions of risk, it was an indication that no one wanted to go into those markets because things were so uncertain. I go through my first-hand experiences with this in one of the chapters of my 2007 book, A Demon of Our Own Design.

What is the magic that allows us to have intraday liquidity through an ETF on a market that itself trades more or less by appointment? Case in point: the high yield bond market. Or emerging markets. Or just about any bond market short of sovereigns and maybe agencies.

Suppose there is a sudden rush for the exits in the high yield bond market. Those in the cash bonds know the drill. They will put in orders with the bank/dealer market makers. For a while those high yield bond trading desks will buy the bonds and hold them in inventory. But it won't take long for the trading desks to reach their capacity. After that point, they won't be buyers. They will act as agent -- also knows as riskless principal -- and look for someone on the other side of the trade. In the meantime the seller has to bide its time. The point is that on the cash bond side, it is not an intraday sort of a transaction. It can take days to find the other side for the trade. And anyone who is active in the high yield bond market knows that, so they structure their leverage and liquidity accordingly.

However, those in the ETFs by and large have no inkling that this is the way the market for high yield bonds works. As far as they can tell, the ETFs trade like an S&P 500 stock. You put in an order to sell, and you are done in minutes.

The reason there is typically high liquidity in the ETFs is that there is typically good two-way flow. And beyond the buyers and sellers are what are called authorized participants. The authorized participants keep the ETFs linked to the underlying cash bonds. They can create ETFs by buying up and bundling the underlying bonds, and they can take in the ETFs and unbundle them and sell the underlying bonds. In a functioning, two-way market, this all works the way arbitrage does for equities indexes. If the ETFs are at too high a price relative to the cash bonds, they grab the cash bonds to create and sell ETFs. If the ETFs are at too low a price relative to the cash bonds, they buy the ETFs and take the bonds to sell in the bank/dealer market.

It sounds simple, but it can't really be foolproof. You know there must be something that can go wrong when you have an instrument -- the high yield bond ETF -- that is as liquid as water even though the bonds it contains are almost the definition of an illiquid security. There is something akin to trying to cheat the law of conservation of momentum. And we all know that anytime something depends on some notion of arbitrage, things can go off the rails. I was in the middle of the portfolio insurance problems that led to the market crash in October, 1987. I knew all about option theory, but when the market was in free fall and the bid-offer spread for the S&P 500 futures was over a dollar, no one was in the mood to try to keep prices in line by doing delta hedging. Options traded in their own world. Implied volatilities were 80% and higher. The option market went into rotation -- trading one stock at a time throughout the day.

For the ETFs, things can go off the rails if the authorized participants can't do their job. If there is not a two-way market, and if the authorized participants' inventory is filled up with ETFs, and if they see that it will take days to get the bonds off of their hands, at the very time that prices are going crazy, they will be stepping away. At that point there is nothing tethering the ETFs to the cash market. The ETF market and the high yield bond market will each trade as their own thing, based on who needs to sell and who is there to buy. At that point it might as well be one market for Martian gravel and another for Enceladian ice cones.

Sure, that is taking it a little too far. There will be some real money investors who will finally step in and keep things from moving into a totally imaginary world. But for the time being the ETF market will, for all practical purposes, shut down. And, getting to the next chapter in this story, it is the "for all practical purposes" that matters.

A clear-thinking, experienced investor in, say, an ETF on an equity market index or gold or currency will not be bothered much by the failure of the high yield bond ETFs. They will get the point that the high yield ETF was creating a fiction of liquidity when there wasn't any, whereas in these equity and currency and commodity markets the underlying markets trade with pretty much the same liquidity as the ETF. But for many investors, all they will hear is that ETFs are in trouble. In the face of the major market dislocation in which the high yield bond problems are likely to be embroiled, people are already going to be in risk-off mode, and if they smell some sort of structural risk with these "newfangled ETFs" they will sell them, period. And there will be plenty of sources out there ready to spread the view that something is amiss.

And, getting to Soros's theory of reflexivity, the changing expectations that come from people in the market buying into this view means that those clear-thinking experienced investors will get out of these more liquid ETFs themselves. And if the authorized participants are still up for doing their job in those markets, that selling will feed back to drop the underlying markets in equities, currencies, and commodities.

I break risk management into three levels, Versions 1.0, 2.0, and 3.0.

Risk Management 1.0 is the standard risk management of VaR and the like, where history is used as a guide, and thus where things work if the future is drawn from the same distribution as the past. Any approach that is looking at risks historically, whether using past prices or variance-covariance relationships or leverage numbers or credit ratings; whether using a normal distribution or a t distribution or a gamma distribution or a part of a distribution like semi-variance, is part of this. If the future looks like the past in some specific ways, it works; if the futures deviates from the past it might not work.

Risk Management 2.0 is a reaction to the fact that the 1.0 methods failed during the 2008 crisis. This failure is not surprising or unexpected by most of those working in risk management, because we understand the assumptions behind Version 1.0. But sometimes this was not articulated well when the numbers were passed up the chain. In any case, after 2008 risk management started to depend more visibly on stress testing. I say "more visibly" because anyone doing risk management over the past decades has done stress testing in one form or another. Certainly when there are non-linear risk-return tradeoffs, like with option exposures, it is a standard method. But after 2008 it became de rigor in the analysis of bank risk, for example using CCAR.

And there is Risk Management 3.0, which I won't get into here. It recognizes that a static stress will miss important dynamics that lead to feedback, contagion, and cascades. And it is not something that can be readily addressed with the standard economics. You can check out my book, The End of Theory, or some of my papers while I was at the Office of Financial Research to get more on this.

Here I am focused on what we need to do before we can get to these dynamics: We need to know what is triggering a market dislocation. And we are particularly interested in triggers that are large in either magnitude or in the number of agents that are affected. So even before worrying about the methods for dealing with crisis dynamics, the question to ask is: What can go wrong in a really big way.

I sometimes get at this by starting with something really extreme, and then dialing it back until it can be considered as a reasonable scenario. Reasonable does not mean it is likely to happen, but it also is not "what if an asteroid hits New York" either. Anyway, I want to run through some of the extreme scenarios that I have been thinking about. I'll put one out here and see if anyone responds, either with comments on it in particular, or with others that they are cooking up in a similar vein.

So, Out-there Scenario I: A large asset manager is rumored to be funding ISIS.

Suppose a rumor goes viral that a very large asset management firm is actually owned by, or at least is funding ISIS. This hits all the usual fake news outlets, and is then, of course, bounces into the real news if only as a "there is a rumor, unsubstantiated, making the rounds that...." The result will be large scale redemptions in that asset manager. This will start a downdraft in the markets. It will also lead to questions about other asset managers, and redemptions there as well. The resulting cascade could spread across the markets, erode confidence, and become a major market event.

Now, of course (at least I hope it is obvious) I am not saying specifically that this rumor is likely. But start with this and, as I suggested above, dial it down a bit. The point is, we can come up with scenarios where there can be massive redemptions in some particular major asset manager, and they can be exogenous to anything in the market, and on the face of it might be unreasonable.

One argument against this path to major redemptions hitting the market is that people can redeem by moving their holdings to another asset manager. If they do that there will be no actual selling of assets, and no market impact. This is the way investors will redeem if they continue to want to hold the assets and if they operate with professional aplomb. But the sort of people who would buy into a rumor like this are also likely to simply say, "give me my money", and then figure out what to do after that.

A little footnote: A few years ago the Office of Financial Research did a research study of the asset management community, with the key question being whether the largest asset should be SIFIs (systemically important financial institutions). The report was castigated, especially by the SEC, mostly, I think, because the SEC was honed for inter-agency rivalry. But in any case, no one threw the ISIS scenario into the report.

I work in a pension fund. And pension funds, as well as sovereign wealth funds -- which are like pension funds for an entire country -- need to take the long view. The liabilities can stretch out for twenty or thirty years. And a lot can happen in between. But some of this is not too hard to divine. In fact, ironically, the issues that extend to the long term are in some ways more predictable than those of the shorter term. Things like demographics, changes in demand due to the adoption of new technology, fixed income of retirement, and, unfortunately, climate change.

The thing about demographics is that you get plenty of warning. If the driving issue for risk is what twenty year-olds are up to, you get to know how many twenty year-olds you will be dealing with twenty years ahead of time. (Excluding immigration.) And, similarly, you have a pretty good head start in knowing what lies ahead as people retire, like, that they will live longer, and that there is a sizable group that does not have enough between savings (which is close to zero) and social security and pensions (which averages under $20K a year) to make a go of it.

Demographics is a slow motion tidal wave that washes over society. Look at how our institutions have changed as the baby boomers moved into school age (remember split sessions as elementary schools became overcrowded ) and then college age, and then became home buyers. And now they are moving into retirement, an age of dissaving, of heading off to Florida, and of consuming more and more health care resources. Will we soon see in reverse the housing boom that occurred when the baby boomers reached house-buying age. Will the cash strapped Millennials be able to pick up the inventory? In a time when dining rooms and living rooms are the housing equivalent of an appendix, will there be demand for what will be coming onto the market?

We don't know what lies ahead for technological innovation, but we do know the longer-term trend as the technology that we already have is improved and adopted. Jobs in transportation will shrink. Jobs generally will shrink. The oil, insurance, and auto industries will face huge disruption. The wonders of innovation will meet the realities of political will. The winner-takes-all business models, Amazon being the dominant case, will find increasing headwinds from the regulators and lawmakers.

What is true for the path of demographics is also true for climate change. We have a pretty good read on the direction, if not the magnitude, of climate change. There has been so much energy expended in fighting the pushback on whether climate change is real that we haven't had the energy to contemplate the full implications of its course. If you want to get a scary version of what can happen, read the New York Magazine article The Uninhabitable Earth. The author spoke to climate scientists about their views of the future, views that they generally do not share publicly because it is hard enough to put the simple, non-dire view out there without dodging tomatoes. The dire-view list includes, section by section in the article: heat death, the end of food, climate plagues, unbreathable air, perpetual war, permanent economic collapse, and poisoned oceans.

Where does all this lead? To something that is more concerning (well, not as concerning as heat death, the end of food, and the rest) than the trends themselves: social revolt. The ushering in of the industrial age had its Karl Marx and its hundred years of revolution rolling across the globe. What will we see rolling across the globe when the broadly predictable demographic, retirement, employment, and climate trends take their course during the next decades? (And I haven't even discussed the implications of all of this for rising inequality and marginalization.) When we have a younger generation trying to support an older one that outnumbers it by some multiple; when it is doing so without being able to find meaningful (or just about any) jobs; where the retirees do not have the wherewithal for self support; all with the backdrop of a climate that is making the earth uninhabitable in multiple ways?

As is obvious by looking at the time span between recent posts, I have not been active in blogging. I am planning to get back into things. As a start, to help catch up on what I have been doing, here are a couple of papers and a presentation I recently made on the area of my focus, using agent-based modeling to help assess financial vulnerabilities.

The model is presented here.

For a concise presentation on the model and its application you can look at a talk I did in August at the Newton Institute for Mathematical Sciences at Cambridge University. (Despite what is suggested by the venue, I did the presentation mathlessly).

Related to the model is work I have been doing to develop a map of sorts for the key agents in the financial system and the ways in which they link to one another. The fist step is what I call the funding map.

In the first paragraph of my book A Demon of Our Own Design (Wiley, 2007) I observe that “You don't deliberately obliterate hundreds of billions of dollars of investor money. And that is at the heart of this book – it is going to happen again. The financial markets that we have constructed are now so complex, and the speed of transactions so fast, that apparently isolated actions and even minor events can have catastrophic consequences.” I then spend a significant portion of the book explaining the mechanics that lead the financial markets to lurch from crisis to crisis; why is it that while engineering in other fields increases safety, financial engineering seems to make things get worse. I suggest that the problem stems from the complexity and tight coupling that we introduce into the markets; complexity through financial innovations, tight coupling through leverage.

A system that is both complex and tightly coupled will almost inevitably have occasional accidents, what engineers term “normal accidents.” Attempts to reduce these accidents by adding in safety measures might actually increase their frequency because the safety measures add further complexity. This is not merely a philosophical point; in my book I go into detail on how some notable accidents – Chernobyl, Three Mile Island and Value Jet – occurred because of the added complexity from safety measures.

We can delve more deeply into the question, because even if we accept the argument from normal accidents, it still seems that financial markets have more than their fair share. Crises seem integral in financial sphere in a way that they do not in other industries. So we can pose the question of what it is about financial markets and the financial industry that make them different. There is an obvious and at the same time deep answer, one that relates to the essence of social interaction.

Lender or Borrower Be
“To breed an animal with the right to make promises—is not this the paradoxical task that nature has set itself in the case of man?” – Nietzsche

In the Stanford “Marshmallow Test”, a child is placed in a room alone with a marshmallow and told that he may eat the marshmallow now, but if he waits ten minutes without eating it he will get two marshmallows. The punchline for the test is that there appears to be a relationship between the ability to wait and success later in life. (Not considered is how much the child actually likes marshmallows – I imagine an astute child who hates marshmallows eating the one immediately so as not to face eating two later. Neither is considered how much the subject ate for lunch before the test).

This is a test of an innately human trait: the willingness to sacrifice today for a later reward. For Toynbee, this trait is the mark of civilization, because it is only through building structures, clearing land, planting trees, all designed to find function beyond one's own life, that civilization can take root. When this trait occurs between two parties, we have created the relationship of the creditor and debtor. For Nietzsche, the promise enacted between creditor and debtor is the source of conscience and mercy. And, ultimately it is also the source of feudal classes and of what we now call capitalism.

The human trait of binding oneself now to gain a reward in the future leads to our ability to make promises. And the ability to make promises leads to three other traits: First, a conscience. And, because conscience only goes so far, the right to mete out punishment for non-performance. It also requires that people be similar, or at least predictable, because unlike a trade in the present, a promise is an abstraction that requires both parties share the same context.

It is through the creditor/debtor relationship that the rudimentary concepts of economic exchange – setting prices, determining values, agreeing on equivalences – evolved to introduce concepts of rights, contract, obligation, and means of settlement into society. With regard to the ability to enforce the terms and to punish those who fail, it also introduced the concepts of measuring one's power against another. And the promise required yet other characteristics we find essential to civilization: the ability to reach and record an abstract understanding, and to trust.

Nietzsche takes this beyond the corporeal to the extreme of the spiritual, where the realization of the promise is not in one's lifetime. The creditor becomes Christ, salvation to the debtor in the future for obedience and faith in the present. Nietzsche states, “we stand before the paradoxical and horrifying expedient that afforded temporary relief for tormented humanity, that stroke of genius on the part of Christianity: God himself sacrifices himself for the guilt of mankind, God himself makes payment to himself."

The Abstraction of Promises
It is the role of creditor and debtor that differentiates finance from economics. The most common and primitive economic act, that of trading goods, whether in kind or through a medium of exchange, does not have an temporal separation and does not invoke a promise. The promise and its traits come about once the roles of creditor and debtor become part of society, that is, once a financial exchange occurs.

In measured steps, finance has added layers of abstraction to the creditor/debtor relationship. In early society promises were made in kind. One good was delivered in exchange for the promise of another. Then collateral was attached to the loan – if the item being loaned formed the collateral, it was the equivalent of modern-day mortgage bonds. Collateral also could take the form of an agreement to be punished in the face of non-performance; the preverbal pound of flesh. With the advent of money came the promise made in terms of a payment that required a notion of equivalence, a general obligation bond. As with any promise there was the risk of default, but otherwise the payment made and received was fully defined in monetary terms. This made debts more easily transferable, creating what was essentially a bearer bond rather than an obligation to a specific creditor.

With the advent of mercantile trade in Medieval Europe came capital for financing the fleet and crew in exchange for the promise of a share of the bounty. This is the critical step in differentiating promises in finance from those in other areas, because the promise was defined in terms of unknown value. The final step in the chain of increasing abstraction and uncertainty came with forward contracts, where both the roles of the creditor and debtor were blurred. Both parties owed and were paid, but the exchange occurred in the future. One or the other part of the exchange was of uncertain value – indeed it did not yet exist – and funds could be more easily borrowed if the uncertain value was converted to a certain one.

Promises, Punishment and Mercy
In a primitive society, the punishment for reneging on a promise could be severe. This was because the “shadow of the future” was short, and because the debtor might not be brought to punishment. But as the structure of society progressed, punishment became more certain. People formed societies where reputation was critical, and as the societies became more stable, the failures of the debtor could be absorbed more easily. As people became more wealthy and their status secure – and those with wealth were the likely creditors – they could afford to reduce the severity of punishment. One path of this social evolution led to the feudal relationship of lord and vassal: the beneficent creditor and the loyal debtor. This process came to the point of contributing to a societal role for forgiveness and mercy. Nietzsche observes that:


So we can see the path from the trait of sacrificing for the future leading to the concept of creditor and debtor; the creditor and debtor bound by a promise; and the concept of a promise helping to establish the form of society and its moral structure. It is no wonder, given its genealogy, that many view capitalism as something more basic than a form of economic organization, indeed that it is viewed by some as having moral, even religious, overtones.

Note: This post draws heavily from Nietzsche: On The Genealogy of Morals, from which the quotes are taken.

Today there is a New York Times article on my work on agent-based models and related points. The paper the article refers to is linked to here. And there is related discussion, dealing with stress testing issues and agent-based modeling, in the Office of Financial Research 2012 Annual Report pages 46 to 58.

Last year I did a post on a mathematical error that has dictated the direction of important work in economics, and more especially finance. The discovery of this error, by U.K. mathematician Ole Peters, has slowly gained some recognition, though for some reason the journal where the original paper was published has not been willing to publish this correction.

At its root the error is obscure -- as would inevitably be the case for it to have persisted for so long and for its incorrect conclusion to be relied on by such luminaries as Paul Samuelson and Kenneth Arrow. But more has been published about it after my post which do a better job at explaining the problem and its implications. So for those who are interested -- and you will be interested if you think about how a portfolio grows over time, how the policy for a group relates to the results for individuals, or the implications (correct and mistaken) of the St. Petersburg paradox -- I am providing links to them here:

The first is an interview with Ole by Michael Mauboussin, and the second is a paper by a group at Tower Watson. It is significant that the bulk of the notice for this is coming from industry rather than academics, and that the core group that is providing notice is the affiliated with the interdisciplinary Santa Fe Institute.

Some of the dominant policy issues of today – immigration, energy, the emergence of China – have their analogues in the great Industrial Revolution. The key government policies that laid the foundation for the Industrial Revolution in England include supporting the immigration of skilled workers, allowing for private ownership of farm land, weakening the unions of the day (the guilds), and addressing the energy crisis (in charcoal). And contrary policies in Italy and Spain – countries that were far wealthier and advanced than was pre-Industrial Revolution England – derailed a similar revolution from occurring in continental Europe.

England would not have been anyone's first bet as the cradle of the Industrial Revolution. When compared to the developed countries of the time, such as Italy, the Netherlands, France, and Germany, sixteenth century England was an also-ran, and had fewer than 4 million inhabitants, compared to 15 million in France, 11 million in Italy, and 7 million in Spain. We all know the key innovations and developments that sparked the Industrial Revolution:

TextilesFor centuries preceding the Industrial Revolution England produced the best wool in Europe, and from the fourteenth century onward moved more and more into the production of woolen cloth. Wool and woolen cloth represented the bulk of English exports. Four inventions mechanized textile manufacturing and ushered in the Industrial Revolution: the spinning-jenny, patented by Hargreaves in 1770; the water frame, invented by Arkwright in 1769; Crompton's mule introduced in 1779; and the self-acting mule, which was brought into use until Roberts improved it in 1825. The most famous invention of all, patented by Cartwright in 1785, was the power-loom. And add to these a critical one from America: the cotton gin.

Coal and Iron. Meanwhile, the iron industry had been equally revolutionized by the invention of smelting by pit-coal brought into use between 1740 and 1750, and by the application in 1788 of the steam-engine to blast furnaces. In the eight years that followed, the amount of iron manufactured nearly doubled. Improvements were introduced in puddling, rolling, and other processes. The production of coal increased more than proportionately. The smelting of iron and the use of the steam-engine created fresh demand for coal, so capital and innovation extended to mining, leading to steam pumps, timber roof supports, and safety lamps.

The factory system. Prior to the Industrial Revolution, manufacturing was organized according to the "domestic system". Manufacturing was carried on in houses by a master working with a few journeymen and apprentices, usually in country villages. The implements of manufacture belonged to the master. The raw material—wool, linen, metal, or whatever —was the property of a town merchant or capitalist, who distributed it to the manufacturers in their houses in the villages, paying them for the product and then selling or exporting it. The power spinning machines were too large to be used in a house and required a large scale power plant. As a result, the Industrial Revolution led to an increase in the size of plants and a resulting concentration of labor and capital into centralized production centers. Shipbuilding, textile manufacture and the like required plants worth millions of pounds with hundreds of workers. Manufacturing thus moved from the traditional domestic or guild system to what became known as the factory system. The factory system brought with it capital-intensive production methods, power, and regimented laborer.

Less discussed are the government policies that provided the foundation and then nurtured these innovations:

Investing in infrastructure
The roads in England were in terrible condition at the start of the Industrial Revolution. It took a week or more for a coach to go from London to Edinburgh. Ruts were four feet deep, hardly a mile could be passed without seeing carts broken down.

Infrastructure projects, both by private turnpike companies and by public authorities, covered England with good roads. And even more important that the roads was the development of the infrastructure of the waterways. The first canal was completed in 1761, and within a few years a system of canals gave ready transportation for goods through all parts of the country. The investment in infrastructure, augmented by the introduction of steam engines for both rail and boats, was one of the most critical foundations for expansion of the Industrial Revolution, and indeed for the nineteenth century in general.

Opening immigration for skilled workers
Another policy that enhanced England’s position for industrialization was the influx of skilled immigrant. Persecution in France and Spain and economic difficulties in Spain and elsewhere drove people to more hospitable countries, with England at the top of the list. This immigration was not merely an infusion of labor, but of skilled labor that brought with it new methods of production: Flemish cloth; Walloon weavers, thread-makers and iron smiths; French Huguenots silk-weavers; clocks and metal goods from Normandy and Brittany; Spanish needles; Venetian glass; fine milled paper from Germany.

Not surprisingly, the immigrants were frequently harassed by English craftsmen, who saw in them as potentially dangerous competitors. But the Crown had policies to protect them, and ultimately the English craftsmen learned their techniques and often improved them.

Weakening the guilds
The influx of immigrants could only benefit England to the extent they were allowed to ply their trades. The English government put policies in place that assured this. In England the government – through the action of the Crown – did not permit restrictive practices of the crafts guilds In the cities, guilds also weakened because of the domination of the mercantile class, which controlled the market and the raw material of the craftsmen. Many immigrants did not stay in the cities, because once in the countryside the power of the guilds was dampened further.

In contrast to England, where manufacturing escaped from the controls of the city guilds, thereby allowing skilled immigrant, in Italy the guilds remained dominant, thwarting the few attempts to introduce innovations. Manufacturing remained stagnant in Italy, entrenched in the past. The result was a gradual replacement of Italian goods and services by foreign ones because the English – along with the Dutch and the French – could offer lower prices due to their innovations in production. Italian products were of a higher quality, but Italian manufacturers were constrained by guild regulations to use less efficient, traditional methods. The English and the Dutch swamped the textile market. Their products were inferior, lighter and less durable than the Italian products, but they cost a good deal less.

And not only did Italy lag in efficiencies of production. The guilds led to higher labor costs. Competition lowered wages outside Italy; while within Italy the guild organization kept wages up. At the beginning of the seventeenth century, Italian wages were out of step with wages in other countries. As a result there was a marked decline in Italian exports along with reduced investment in manufacturing and shipping.

Establishing private agricultural land
Traditionally the agricultural land in England was largely held in commons. Towards the late 1600's the government enacted laws that permitted enclosures, effectively privatizing land. Enclosing agricultural lands provided a scale of production and a level of control by the owners that led the to radically improved the efficiency of agricultural production. Rotation of crops, better fertilizers, drainage, breeding of better livestock (by one contemporary estimate, between the early and late 1700s black cattle increased from 370 pounds to 800 pounds, and sheep from 28 pounds to 80 pounds), were among the characteristics of the new farming, and these were practical only to those who had some capital, knowledge, and enterprise – all of which came more naturally to larger tracts of land under private ownership.

These improvements led to a cascade of further consolidation because those who continued to work the small farms could not compete and so sold them to neighboring landowners who had already created a production edge through earlier consolidation.

As with most of the other policies, enclosures came with its social costs. A popular piece of doggerel declared that:
The law locks up the man or woman;
Who steals the goose from off the common;
But leaves the greater villain loose;
Who steals the common from the goose."

Nonetheless, the resulting agricultural revolution played a large part in the industrial revolution. Not only in terms of the production of food to fuel the labor, but in the flow of farmers into the industrial sector.

Overcoming the energy crisis by forcing a move to new energy sources
The Industrial Revolution can be viewed as the control and redirection of energy toward production. But early on this was stymied because of deforestation and the resulting shortage of the primary fuel of the time: charcoal. To give an idea of the shortage, as early as the 1500's and into the 1600's the price of oak (primarily used in shipbuilding) rose twelve-fold, and the price of timber for charcoal increased five-fold.

In the sixteenth century England ordered a governmental inquiry into timber wastage and deforestation and then instituted a number of Acts of Parliament to suppress the cutting of timber for industrial purposes. As a result, foundries were forced to reduce their activities and England began to use coal for heating and in industrial processes. People were wary of the toxic fumes, but had no alternative. The transport of coal by sea from Newcastle to London increased from 35,000 is 1550 to 560,000 tons a century late. By 1738 a French traveler wrote that coal was "the soul of all English Industries."

As it turned out, this energy crisis, by forcing a move toward coal (and helped in that regard by the fact that England was relatively sparsely populated by forests in the first place but was abundant in coal), ended up helping to push England down the road towards industrialization.

Bringing in capital
Capital had not existed in any large amounts in medieval England, and even in the later centuries there was no group that focused on investing capital into industry. Agriculture and manufacturing were carried on with very small capital, usually the capital each farmer, artisan, or merchant might have of his own. There was no use of credit either from individuals or from banks for industrial development.

But capital was required to buy the new machinery at the heart of the industrial age. These machines were far too expensive for the old cottage weavers. Capital therefore had to be brought into manufacturing. This capital came from various directions.

Capital from Privateering
Privateering, also known as commerce-raiding, was basically government-sanctioned piracy. Strange as it may seem, with the development of England's seafaring capability and the flow of precious cargo from the Americas, privateering became an important source of capital accumulation in England. Indeed, in the three years following the defeat of the Spanish Armada in 1588, over two hundred English ships were involved in privateering, and over three hundred foreign ships were captured.

Capital from Spain
Meanwhile, Spain, which had an early lead on capital because of the influx of American treasure, enjoyed a period of splendor and economic superiority but lacked the human capital due to a cultural antipathy, even prejudice toward productive labor, to put that capital to good use.

So Spanish merchants turned to foreign producers and provided their capital to the foreign enterprises. A Venetian ambassador remarked, "Spain cannot exist unless relieved by others, nor can the rest of the world exist without the money of Spain."

The capital from the Americas thus provided Spain with purchasing power but ultimately stimulated the development of Holland, England, France, and other European countries.This prosperity, easily funded but inevitably of limited duration, led many to abandon farming and to regard craft and mercantile activities as menial occupations. Instead resources poured into the academies, whose product occupied the clergy and the increasingly bloated government bureaucracy rather than productive industry – and disguised structural unemployment as well.

In 1675 Alfonso Nuñez de Castro wrote:
Let London manufacture those fabrics of hers to her heart's content; Holland her chambrays; Florence her cloth; the Indies their beaver and vicuna; Milan her brocades; Italy and Flanders their linens, so long as our capital can enjoy them; the only thing it proves is that all nations train journeymen for Madrid and that Madrid is the queen of Parliaments, for all the world serves her and she serves nobody.

In short, seventeenth century Spain lacked entrepreneurs and artisans but had an overabundance of bureaucrats, lawyers. As England was building the foundation for the industrial revolution, easy-come-easy-go Spain provided capital even as it sank into decline.

Capital from rescinding primogeniture
The economic way of life in medieval England was framed by two economic realities: Virtually all wealth was in the form of land, and the land could not be sold. Wealth was held in land even up to the seventeenth century it was the universal outlet for savings in England-primarily because there were not many alternative investments. As late as the sixteenth century, more than 80 percent of production was based on agriculture. What limited industry there was bore little resemblance to the Industrial Age that would follow centuries later. Some towns had specialized industry-brewing, salt making, iron working, paper mills-but this was still not characteristic of the economy as a whole. And because land was the preponderant store of wealth, it was also the source of social stature and political power. A large landed estate gave its owner great local influence in controlling elections and sharing in patronage and opened the door for him to join the gentry.

As early as the time of the Norman Conquest in 1066, land could not be sold or even used as collateral for a loan because feudal lords exchanged it for a knight's military service. A knight could no more transfer his land than he could pass on his military obligation. This this limitation on the right to transfer land carried the weight of law because of another import into England: primogeniture. Landholders had a right to their land only for the course of their lives, after which the deed was transferred according to the rules of primogeniture, which meant it generally passed to the oldest son.

The cost of having capital be literally land-locked capital became increasingly apparent on a practical level as new avenues for wealth and investment opened up. The development of overseas commerce and the increasing involvement of leading merchants in the lucrative business of lending money to the government expanded investment opportunities. Finally, there were prospects for building fortunes apart from land ownership. The landed gentry had an incentive to extract the wealth from their land to pursue other opportunities, so various artifices were used to circumvent primogeniture.

The new-found liquidity in the land progressed during the Tudor and early Stuart reigns, resulting in the rapid growth and independence of the English gentry and their servants. Now that land could be used as collateral, it opened up new possibilities for borrowing and lending. An embryonic capital market developed in London, and by the seventeenth century in other cites as well. The end of primogeniture thus helped allow capital to find its way into financing the emerging opportunities of the Industrial Revolution.

Breaking down class barriers for artisans and engineers
In the Middle Ages, science and technology were separate and distinct. Science was philosophy; technology was craft. Science had no interest in technological affairs, and technological developments were the fruits of uneducated artisans. For example, physicians viewed themselves as scientists and philosophers, and so had nothing to do with the surgeons, who were considered technicians and simple artisans.

But developments in ocean navigation, in the watch and clock industry, and in experimental science required increasing numbers of precision instruments which in turn led to a new, superior sort of technician who could interact with the scientists, with both the technician and the scientist engaged in similar problems. It required an elevation in the status of the artisans, engineers and skilled workers, and a partnership between these occupations and the more elite and lettered of science and philosophy. This interaction between the philosopher-scientist and the artisan was promoted by so august a body as The Royal Society of London, which charged some of its members with compiling a history of artisan trades and techniques.

This new attitude, an attitude toward science that placed pragmatism before idealism, that applied mathematics to explaining the real world, and that introduced experimentation and empiricism (along with statistical methods – the experimenters of the seventeenth century endlessly recorded, cataloged, and counted) as an integral part of the scientific process, underlies the inventions of the Industrial Revolution. The willingness to have science deal with the practical rather than the philosophical, to solve the concrete problems of production, and to team up with the skilled artisans – a partnership across class lines that was unique to England -- was critical for the technological developments behind the Industrial Revolution.