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Goldman the Volcker Rule and Principal Investing

A report by BofA banking analyst Guy Moszkowski got a lot of attention yesterday, because Moszkowski claimed in the report that Goldman had a more aggressive interpretation of the Volcker Rule with regard to principal investing than the rest of the market. Specifically, Moszkowski said that:

“the market interpretation of Volcker rules is that [non-fund principal investing] will be off-limits ahead, but GS believes that many such investments will remain permissible, and will be closing on a ‘meaningful’ one in China shortly.”

I have no idea what Moszkowski is talking about. It’s absolutely not the “market interpretation” that the Volcker Rule will prohibit non-fund principal investing. Exactly the opposite. The Volcker Rule does not prohibit non-fund principal investing; it’s not even a close call. Nor, by the way, was it intended to. This was well understood during the financial reform debate.

So for all the analysts out there, I’ll walk you through it. The Volcker Rule, which is located in Section 619 of Dodd-Frank (pdf), contains the following prohibition:

(1) PROHIBITION.—Unless otherwise provided in this section, a banking entity shall not—

(A) engage in proprietary trading; or
(B) acquire or retain any equity, partnership, or other ownership interest in or sponsor a hedge fund or a private equity fund.

Since Goldman was specifically talking about non-fund principal investing, (B) doesn’t apply. The only way that non-fund principal investing could be prohibited by the Volcker Rule, then, is if it’s considered “proprietary trading” under (A).

So now we have to go look at the definition of “proprietary trading,” which is located in § 619(h)(4):

(4) PROPRIETARY TRADING.—The term ‘proprietary trading’, when used with respect to a banking entity . . . , means engaging as a principal for the trading account of the banking entity . . . in any transaction to purchase or sell, or otherwise acquire or dispose of, any security, any derivative, any contract of sale of a commodity for future delivery, any option on any such security, derivative, or contract, or any other security or financial instrument that the appropriate Federal banking agencies, the Securities and Exchange Commission, and the Commodity Futures Trading Commission may, by rule as provided in subsection (b)(2), determine. [emphasis mine]

OK, so only transactions for the “trading account” are considered proprietary trading. Would non-fund principal investments be transactions for the trading account? Well, let’s look at the definition of “trading account,” which is found in § 619(h)(6):

(6) TRADING ACCOUNT.—The term ‘trading account’ means any account used for acquiring or taking positions in the securities and instruments described in paragraph (4) principally for the purpose of selling in the near term (or otherwise with the intent to resell in order to profit from short-term price movements), and any such other accounts as the appropriate Federal banking agencies, the Securities and Exchange Commission, and the Commodity Futures Trading Commission may, by rule as provided in subsection (b)(2), determine. [emphasis mine]

Principal investing is, by definition, medium- to long-term, which means that principal investments would NOT be transactions for the trading account. In fact, the trading account definition is virtually identical to the “trading book” definition in the accounting rules (which was intentional). And, not surprisingly, principal investments are not typically part of the trading book. (That’s why Goldman distinguishes between “trading” and “principal investments.”)

So in sum, non-fund principal investments are not prohibited by the Volcker Rule because they are by definition medium- to long-term, which means they are not transactions for the “trading account,” and thus not considered “proprietary trading” under the Volcker Rule.

Is that simple enough for Mr. Moszkowski?

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Goldman and Olssons Conditional Probability Solution to the Swamping Problem

Goldman and Olsson (forthcoming) in “Reliabilism and the Value of Knowledge” offer several insightful responses to the ‘swamping problem.’ I think that the ‘conditional probability’ solution that they offer is the most interesting; evaluating this solution requires attention to some important, and sometimes unnoticed, aspects of the problem.

The swamping problem has been articulated a variety of ways, and unfortunately, different versions of the problem have been referred to under the same label.

Here’s a general and (hopefully) uncontroversial formulation of the problem, as presented by Goldman and Olsson:

Template Swamping Argument

(S1) Knowledge equals reliably produced true belief (simple reliabilism)
(S2) If a given belief is true, its value will not be raised by the fact that it was reliably produced.
(S3) Hence: knowledge is no more valuable than unreliably produced true belief. (reductio)

(S2) of the argument expresses what has been called the ‘swamping premise.’ Of course, (S3) is counterintuitive, and so the idea is to either reject the swamping premise, or to reject simple reliabilism (S1).

The swamping premise expresses a conditional claim. Those who want to save reliabilism are burdened, as it were, to show how a reliably produced true belief is more valuable than an unreliably produced true belief.

Kvanvig (2003) throws down the gauntlet at this point and suggests that we can, in principle, rule out a rejection of (S2).

His suggestion is that reliability is a valuable property for a belief to have insofar as it is valuable for a belief to be ‘objectively likely to be true.’ He argues that for a reliabilist to suppose that reliability is a valuable property for a belief to have for reasons other than its being likely to be true (i.e. say, because the “normative dimension that accompanies the right kind of objective likelihood of truth introduces a new valuational element distinct from the value of objective likelihood” (Kvanvig 2003b, p. 51) would seem magical, he says, “like pulling a rabbit from a hat” (51).

He argues further that being ‘objectively likely to be true’ isn’t a property that, when added to a true belief, increases its value, and thus, (S2) is true.

Goldman and Olsson take issue with Kvanvig’s reasoning here for a couple of reasons. First is what I’ll call the ‘entailment’ objection. Goldman and Olsson think that Kvanvig overlooks the fact that although being reliabily formed entails being likely to be true, being likely to be true doesn’t entail being reliably formed. They say:

John may have acquired his belief that he will contract lung cancer from reading tea leaves, an unrealiable process, and yet if John is a heavy smoker, his belief may well be likely to be true” (Goldman and Olsson, p. 8)

Goldman and Olsson overstate what they take to be the crime here. This example would damage Kvanvig’s view only if Kvanvig actually defended that the entailment goes both ways, that is, that (as Goldman and Olsson attribute to him) “Being produced by a process that normally produces true belief just means being likely to be true” (Goldman and Olsson 8). Kvanvig says nothing to pin him to such a biconditional. His view is, rather, that the extent to which being produced by a reliable process is a valuable property for a belief to have is exhausted by the extent to which being likely to be true is a valuable property for a belief to have. And so, an objection to Kvanvig’s claim here should take the form, rather, of pointing out some feature of being produced by a reliable belief forming process that is valuable for a belief to have in a way that is not reducible to the value that a belief would have qua being objectively likely to be true.
This is, indeed, the route they go in their ‘conditional probability’ repsonse. They argue that being produced by a reliable belief forming process can be valuable for a belief in a way that merely being objectively likely to be true isn’t valuable, and further, that its value is such that when combined with a true belief, yields a collectively more valuable whole. They write:

“Knowing that p is more valuable than truly believing that p. What is this extra valuable property that distinguishes knowledge from true belief? It is the property of making it likely that one’s future beliefs of a similar kind will also be true. More precisely, under reliabilism, the probability of having more true belief (of a similar kind) in the future is greater conditional on S’s knowing that p than conditional on S’s merely truly believing that p. (p. 16)

This claim, if correct, would amount to a counterexample to the swamping premise, which recall, says:

(S2) If a given belief is true, its value will not be raised by the fact that it was reliably produced.

Goldman and Olsson, thus, think that a true belief will be more valuable if produced by a reliable process because, as such, it contributes to the diachronic goal of having more true beliefs (of a similar kind) in the future. I want to turn to an example that helps illustrate their idea; it is the espresso example Zagzebski uses to support the swamping premise. Goldman and Olsson write:

If a good cup of espresso is produced by a reliable espresso machine, and this machine remains at one’s disposal, then the probability that one’s next cup of espresso will be good is greater than the probability that the next cup of espresso will be good given that the first good cup was just luckily produced by an unrealiable machine. If a reliable coffee machine produces good espresso for you today, and it remains at your disposal, it can normally produce a good espresso for you tomorrow. The reliable production of one good cup of espresso may or may not stand in the singular-causation relation to any subsequent good cup of espresso. But the reliable production of a good cup of espresso does raise or enhance the probability of a subsequent good cup of espresso. This probability enhancement is a valuable property to have (p. 16)

This attempted assault on the espresso analogy scores a victory at the expense of betraying a deeper, and perhaps untractable, defect in the ‘conditional probability’ response. The victory, in short, is that it gives an explanation for why two equally good cups of espresso might be such that one is more valuable than the other; this explanation rejects an assumption that Zagzebski seemed to make in the analogy, which is that ‘taste is all that matters’ for espresso (as she thought, ‘being true’ is what matters for a belief).
This sword cuts two ways, though. Consider that True Temp is a reliable belief former, and so the conditional probability of his future beliefs (of a similar kind) being true is greater given that they are formed from a reliable process (i.e. a reliable thermometer, perhaps purchased at the same store as you’d find a reliable espresso maker), than it would be had his beliefs been merely true, but unreliably produced. But, we should object, True Temp is not a knower, and so whatever makes his state valuable should not be as valuable as it would be if he were a knower. However, the conditional probability view has no way to explain this. In sum, the conditional probability response to the swamping argument works only if True Temp knows. But he doesn’t. So it doesn’t work. (Or so my objection goes…)

Here’s a second objection:

Suppose I have cancer and am in the hospital, and my 12 year old boy (I don’t really have one) is playing baseball in the little league world series. He has been practicing every day from sun up till sun down in hopes of making it to the world series and hitting a homerun. It is the ninth inning of the game, and my son (little Johnny) is up to bat. I am watching the television screen with intensity as he shouts (this one is for you, Dad!). The pitch is on the way, and then……

(Option A): The television suddenly blacks out. Knowing I might die any minute, I decide that Johnny has practiced hard and probably hit a home run, and so I believe that he did, although sadly, I realize I will never know. (And then I die, my last thoughts being ones of curiosity).

(Option B): The television does not black out, and I get to see Johnny hit the home run on TV. In fact, (for even more evidence) my hospital is close to the baseball field, and the ball comes through the window and lands on my bed. I know that Johnny hit the home run, and then I die (in peace).

On the conditional probability view, my true belief in Option B (in which I form my belief from reliable processes, i.e. watching a previously non-deceptive TV broadcast, which doesn’t display phantom images) is more valuable state than my true belief in Option A in so far as the true belief in B was produced by a reliable process, and as such, raises the probability that future beliefs (of a similar kind) will be true. However, as I know I am dying, I have no interest in future beliefs, as I am aware I am in my last throes. (And, in fact, I don’t form any more future beliefs of a similar kind). The conditional probability approach, then, seems committed to claiming that my true belief in B is no more valuable than my true belief in A. But surely that’s not true!

Okay, those are my worries. I’d love to hear any thoughts!

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