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The Real Reason that Black-Scholes Failed

Victor Aguilar

posted on 08 December 2013

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In 1994 the Policy Statement on Discrimination in Lending set severe penalties for banks that refused to steer loans to people based on their ethnicity.  From 1994 until the housing market collapsed a decade later, banks were not allowed to operate as businesses but rather were required to implement an experiment in social engineering.

 

Clearly, the Community Reinvestment Act and the Policy Statement on Discrimination in Lending flies in the face of Black and Scholes’ first axiom by systematically discriminating against segments of the population in the distribution of credit.  Contra Black and Scholes, it is NOT possible to borrow and lend cash at a known constant risk-free interest rate.  Instead, loans are made on the basis of ethnicity and other non-economic factors, in spite of their known risks.

 

In reality, the distribution of credit has nothing to do with risk and everything to do with the government steering money to favored races and favored activities.  For instance, a sedan with a trunk ornament that looks like it was stolen off the Red Baron’s Fokker tri-plane costs about as much as a Bridgeport milling machine.   But banks will loan money to buy the former, not the latter.  Some activities, like putting minorities in McMansions, are favored and others, like starting small businesses, are just not.

 

For example, in spite of the fact that one can hardly walk three blocks in Los Angeles without encountering a Korean-owned grocery store, Korean banks have in the past and continue to loan just about any of their citizens $10,000 to start a grocery store in America.  Vietnamese banks will loan just about any of their citizens $10,000 to start a nail salon in America.  How many American grocers, beauticians or machinists are being given a similar start in business here?  None.   But, if you have worked the checkout counter in a Korean-owned grocery for six months, you will have no difficulty finding a bank that will help you drive back and forth to your job in a four-wheel-drive pickup with 36” rims and a little ladder up to the cab.

 

Observe that Congress passed the Cash for Clunkers law, which gives people $3500 for trading in a vehicle that gets less than 18 mpg.  This law has no direct impact on interest rates but only affects credit limits. People who own gas-guzzlers worth less than $3500 previously had a credit limit of zero; they could not buy a new car.  Now they can.

 

These examples support my claim that the government's influence on the market is primarily one of arbitrarily changing the credit limits of certain people, not one of changing interest rates. I said in 1999 and continue to insist that credit limits have more effect on the business cycle than interest rates.

Discussion

Mark Buchanan writes:

 

“Flashing orange alerts on the screen show that a cluster of U.S.-based hedge funds have unknowingly taken large ownership positions in similar assets… the computers warn… Many of the funds could be bankrupt within 30 minutes, creating a threat to the entire financial system. Armed with this information, financial authorities step in to orchestrate a controlled elimination of the dangerous tangle.”

 

What goes unmentioned is that this is private property; “controlled elimination” is just a euphemism for confiscation. Hence the inclusion of the phrase “U.S.-based,” because seizing a foreign hedge fund would be an act of war. But how did these U.S.-based hedge funds become so big that it seems credible that they could threaten the entire financial system? Answer: The U.S. government gave them almost unlimited credit, allowing them to borrow orders of magnitude more than they have collateral for, unlike us mere mortals whose loans must be fully collateralized.

 

As discussed in the OP, it is changes in credit limits – NOT changes in interest rates – that cause boom and bust cycles. Mark Buchanan is leading us down the classic path towards communism:

 

Step 1) Give a favored type of people – it does not really matter who because power will corrupt anyone – almost unlimited credit. Deny or severely restrict credit to everyone else. Here, “favored type” may be based on race, though it is more often based on activity – sometimes both.

 

Step 2) Sit back while the Keynesians and the Austrians bicker about whether interest rates go up during booms and down during busts (Keynesian) or down during booms and up during busts (Austrian) because, of course, interest rates do not matter.

 

Step 3) While the Keynesians and the Austrians are arguing so noisily, the favored type of people amass enormous wealth. Their ostentatious display of this wealth offends leftists and makes rightists look foolish trying to defend such obnoxious behavior in the name of capitalism. More noisy argument.

 

Step 4) “Alert!  Alert!  Alert!” shouts Mark Buchanan over the noise, quickly appending the magical phrase, “the computer warns.” This phrase is important both for the sake of credibility (who can argue with a supercomputer?) but also for the purpose of attributing the coming confiscation to faceless technocrats.

 

Step 5) Once the government has seized all the wealth and everybody is happy with this – after all, those obnoxious people in their nouveau riche mansions had brought us to within 30 minutes of financial ruin – the government can use General Equilibrium Theory to compose their five-year plans.

 

And that was the goals all along. In spite of the fact that Mark Buchanan hates, hates, hates on Gerard Debreu and his General Equilibrium Theory, the quotation above makes it clear that he is leading us towards a Soviet-style command economy controlled by faceless technocrats with their supercomputers programmed to find a general equilibrium. What else could “controlled elimination” mean?

 

And why will we not fail like the Soviets did? Because we have better computers. Even as I write this, the blue glow from the screen of my 64-bit, dual-core laptop is making me all warm and fuzzy inside. I feel safer already!