Recent Reviews of 2009

It is always good to think critically about that which our minds ingest.

4 May 2009

Often when writing polemic one can get sucked into a worldview that sees all in terms of a particular thesis. DiLorenzo has fallen headlong into this trap with his latest book, Hamilton's Curse. Yes, Hamilton advocated the time-tested European model of imperial government practiced quite effectively by the English in opposition to the limited and checked government of the American Articles of Confederation and later Constitution, however, many of his ideas in this regard were neither novel nor enacted within his lifetime. DiLorenzo seems to see all of American history through a Hamiltonian/Jeffersonian lens, vilifying the former while nearly deifying the latter. Jefferson may have written in a high-minded manner, but when president he surely exceeded his constitutional authority with both the Louisiana Purchase and the Embargo. DiLorenzo mentions neither. And while Lincoln may have been political heir to Clay who was in turn heir to Hamilton, Lincoln surely looked back further in history than Hamilton for the precedents to establish his dictatorial power.

Hamilton and Jefferson both advocated abolition in their writings but both owned slaves and neither took political steps to end slavery. Hamilton understood the financial system of debts and bonds which European governments used to solidify support among the economically powerful and maintain liquidity. Yes, these systems were part of the tyranny Americans had fought against, but they were also successful. Whereas Jefferson saw the blood of patriots and tyrants as a natural manure, Hamilton knew that continuing revolutions in America could lead to a worse tyranny than the financial one he was imposing. One need only look to revolutionary France to see the greater violence and tyranny which could sprout from revolutions in quick succession. To this danger Jeffersonians of the day seemed almost blind. Hamilton's enforced stability meant America never had a Bonaparte or a Santa Anna.

Hamilton is not blameless for choosing the lesser of two evils, however, for he certainly didn't see his program as evil. His three pillars of government debt, a government bank and federal supremacy over the states have had many damaging effects throughout our history and continue to burden us. These pillars existed long before Hamilton in the bag of government's tools to protect itself. And one must not forget Hamilton was shot down in his prime. Jefferson eventually saw the later stages of the French Revolution for the tyranny that it was, but Hamilton was never given the chance to let old age soften and wisen his views. While DiLorenzo's book is an instructive journey following a meme through American history, his contention that Hamilton is not a mere carrier, but instead the originator of said meme is quite a bit overblown.

29 April 2009

Roger Lowenstein is a newspaperman. Nevertheless, it's obvious that he's been chafing under an editorial board for years from some of the grammatical flourishes in The Rise and Fall of Long Term Capital Management: When Genius Failed. Never heard of LTCM? Not familiar with the Black-Scholes formula for pricing options or the guys who won Nobel prizes for inventing it? Reading the book one almost wonders if the headlines were taken from last years newspapers: liquidity crisis, credit crunch, and the first major bailout orchestrated by the Fed. The old adage that those who don't learn from history are condemned to repeat it is only underscored by the fact that the main characters in the story were still running Merrill Lynch, Bear Stearns, Lehmen Brothers, etc. when the repeat, caused again by the speculative use of Black-Scholes, hit last year.

Lowenstein is easily able to dig to the heart of the matter when he presents Fama's critique of Black-Scholes assumption that prices swings are normally distributed. Unfortunately, having studied the formula in grad school, I can tell you that this critique is regularly ignored by or completely unknown to practitioners today. The "bible" of the industry, John C. Hull's Options, Futures, and other Derivatives, includes no mention of it. Being a fan of Mandelbrot since high school I fortunately came upon Fama's work with the Cauchy distribution during my own studies of Black-Scholes. As a particle physicist we call it the Breit-Wigner, and it is the distribution used for observing particles so I was quite familiar with it. However, it has some nasty properties: both the mean and standard deviation are undefined. In physics we improvise and use the middle of the distribution and the full width at half maximum as proxies for these more common statistics rather successfully, but mathematicians have more scruples and traders want something simpler. The normal distribution is a good approximation as long as you're within a few standard deviation of the mean, i.e. good on most days, but it leads to a gross underestimation of events beyond that as the partners of LTCM found out.

The tale of LTCM weaves it's through all the major players on Wall Street as well as the academic world of economics. Two of the company's partners won Nobel Prizes in that subject during the LTCM's run. Lowenstein provides excellent details while retaining the pace of a gripping narrative - story-telling at it's best. Apart from a few moralizing interludes the book is difficult to put down and should, perhaps, be required reading for prospective options traders to caution them against that gross underestimation of extreme events.

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Last Modified: 6 May 2009 by Brad Wogsland.