I’ve thought a lot about the spectre of vast youth unemployment all around the world, at a time when low/no economic growth means that they are unlikely to be absorbed into any economy soon. I wrote about the phenomenon here, and have been meaning to follow up with a look at wider implications for our political landscape.

The past week’s riots in the UK are a consequence of disaffection, much of it – admittedly – on the part of unemployed youths. However, the picture is not quite so clear, because many looters would more likely be found in shops as legitimate shoppers.

The political concept that was on my mind was this: social media and the internet in general have changed historical tribal boundaries or definitions. In the beginning, tribes would have had a largely geographical basis. Now, it is possible for people in every imaginable niche to connect, in real time, regardless of any other affiliations.

People can easily congregate around issues or interests, even if they live thousands of miles apart. They may even support sports teams from different countries, as we can see with Capetonians who support New Zealand rugby sides, or people all around the world having their favoured British football side. If not the end of nationalism what implications does this have for political participation?

Umair Haque has written an excellent piece (here) about a phenomenon he calls The Great Splintering. I’m not even going to attempt to paraphrase his views about “broken institutions and splintered social contracts”, but having read it I was wondering if the extraordinarily vast wealth of a surprisingly large – and certainly visible – elite does not perhaps suggest that the 2011 version of capitalism has reached a point of disequilibrium. Let’s say we are in agreement that the basic capitalist intent is better for society than the alternatives that have been tried. What happens when the rich – as they are now – are rich to a degree this unimaginable to ordinary folk, and at the same time there are swathes of the world’s population that are have-nots to the most miserable degree?

The past week has seen spectacular stock market gyrations as ‘the market’ attempts to make sense of truly imponderable government debt. Default stalks several European governments. The US would take 100 years of paying $16.5 million every hour to redeem its sovereign debt. But it still borrows 40% of what its government spends. Those 100 years could easily become 150.

One has to wonder what the UK riots portend. What lies in wait for us?

It is irresistible not to quote Yeats’ Second Coming:
Things fall apart; the centre cannot hold;
Mere anarchy is loosed upon the world,
The blood-dimmed tide is loosed, and everywhere
The ceremony of innocence is drowned;
The best lack all conviction, while the worst
Are full of passionate intensity.

My view is less dark than his, but we certainly live in interesting times. We have no idea how this is all going to play out, other than the likelihood that the socio-political and economic landscapes could become very different.

VIX, daily chart as at 10 August 2011

In these uncertain times, you may be tempted to think that the only certainty is elevated feelings of fear, which will have you thinking VIX quicker than the Dow can lose 100 points.

So, buying VIX options or futures must be a ‘sure thing’, that can’t-miss road to instant riches?

Not so fast.

You first need to understand a few basic facts about the VIX, which may be the most ethereal of all tradable instruments.

There is nothing tangible behind the number. It’s not even like an option that confers the right to acquire (or sell) an asset. The VIX is nothing more than the numerical answer to a complicated equation that measures the option premium that traders are willing to pay for out-of-the-money options on the S&P 500. The more they are willing to pay for options, the higher the implied volatility.

So far, so good.

However, just because volatility is spiking right now doesn’t mean it’s expected to remain high. In times of high volatility it’s likely that the VIX goes into backwardation (as opposed to the usual contango). This phenomenon is occasionally seen in the oil market, when a supply interruption causes the spot price to exceed the futures price.

So, high current volatility is not expected to remain that way for months on end. Sure, there is an upward movement in the futures prices (also expressed in the price of options for future expiry), but the extent of the move will be a lot less than the spot VIX.

The only certain thing about VIX is that a dramatic spike will be temporary, which makes one think that possibly the only way of trading the VIX profitably is to trade it at its extremes, perhaps by using current month options.

However, the VIX remains a very, very dangerous instrument to trade, and is probably best left as an object of curiosity.

Warren Buffet famously described derivatives as “financial weapons of mass destruction”. At the top of the heap – so toxic one could refer to them as “Those Which Shall Not Be Named” – are trades structured around VIX options.

Let me give you an example. A ‘calendar’ involves options from two different months. So, with the VIX above 40 (yesterday’s close was 42.99), let’s say a trader sells August call options with a strike of 47.50 (six days to expiry) and buys the September expiry (41 days away) of the same call. Because of backwardation there may even be a small credit, let’s say 10c (that’s $10 per options contract).

Sweet, the trader thinks, I’m getting free money. Let’s really scale this, by buying 100 contracts. So the trader gets $1000 into his trading account.

The hope is that at expiry (six days hence), VIX is below 47.50, so the short call option expires worthless. Let’s say the trader can now sell the September calls for $1, which equates to $10,000 for the 100 contracts. Beautiful.

However, if the markets get really messy and VIX spikes to 70, the trader is on the hook for 22.50 (the difference between 70 and the strike price). The problem is that – due to backwardation – the September calls may be worth a lot less than that. So, the trader has a liability of $2,250 times 100 contracts; a cool $225 000. Let’s say that the September calls are trading at $15, so he’s only got $150,000 coming in. He casually entered a trade that gave him a $1000 credit (hoping to make $10,000), but he now owes his broker $75,000.

Now that is a weapon of pretty serious financial mass destruction.

You don’t have to be into horse racing to be blown away by Frankel. This super-star three-year-old colt is unbeaten from eight races. With the exception of his St James’s Palace Stakes victory, his average winning margin is six lengths. I get goose bumps watching him run.

Here are YouTube clips of his three most recent victories.

In the first he blitzes the best of his generation over Newmarket’s straight mile in the 2000 Guineas. He did it the hardest way possible by making the running (which is even harder than doing it around the bend) after he out-ran his pacemaker.

At Ascot everyone ignored his pacemaker, and he idled to victory in the St James’s Palace Stakes. Trainer Henry Cecil afterwards claimed that the race was “all wrong for him”.

Then he takes on another Champion, Canford Cliffs, in the Sussex Stakes and makes him look like an ordinary hack.

I’ve never been a believer in ‘hair of the dog’ solutions to hangovers. The reason you feel terrible is because your body has a toxic level of alcohol, on top of which you are sleep and nutrient deprived. And you’re also likely to be dehydrated. In my view, rest, vitamins and a toasted egg and bacon sandwich are going to do you a lot more good than downing another beer. Sure, the night was fun while it was all happening, but it’s not a sustainable way of spending your waking hours.

The credit crisis was caused by an oversupply of cheap money, lent completely indiscriminately to borrowers who would only be able to repay if the real estate bubble kept growing.

After the collapse of Lehman Brothers in 2008, the world’s economy was saved from total meltdown by governments taking private debt onto the public balance sheet. Various governments tossed obscene quantities of cheap money at the problem. So great was the torrent of cash rained down on the US that the chairman of the Federal Reserve was named Helicopter Ben. In fact, the vastness of the rounded-up billions seemed so unreal it may as well have been Thomas the Tank Engine handing out the money.

Sovereign debt is a nice way of describing the money owed by governments. However, just because it’s owed by governments, doesn’t mean that similar rules don’t apply as the ones for citizens. Greece is the latest country having difficulty in meeting its debt obligations. While in no way denying the gravity of the money problems on the Aegean, it’s one of several countries who owe far more than is healthy, or even sustainable.

Various players, anxious to stave off inevitable write downs for the reportedly 400 banks with exposure to Greek debt, along with the likely contagion that would then call into question the foundations of other countries’ debt, have been working on a bail-out plan. In accepting the ‘hair of the dog’, the Greeks have to submit to some pretty serious austerity.

Greece, of course, is the birthplace of democracy, about which Winston Churchill said in 1947: “No one pretends that democracy is perfect or all-wise. Indeed, it has been said that democracy is the worst form of government except all those other forms that have been tried from time to time.” At the time he said this, communism was still decades away from joining the forms of government that had also been tried.

One of the problems with democracy is that politicians need to keep their eyes on the next elections. To put it bluntly, if they piss off their constituencies they won’t get re-elected. One of the products of austerity is that some people lose their jobs, others may have to take salary cuts, and the government’s provision of services may be curtailed. So, all-in-all, imposing austerity isn’t a great way for politicians to get re-elected.

The system in ancient Athens, while democratic, was more like Survivor, in that public officials who displeased the people got voted out; not only out of office, but also out of the city. And, for good measure, their assets were stripped. The ballots were shards of pottery – ostrakon – on which votes were scratched. Remember, these were votes ‘out’, not votes ‘in’, and hence we have the word ostracise, which describes perfectly the position Greece finds itself in now.

There seems to be something quite Churchillian in the way that Brits have accepted their current dose of austerity. On second thoughts, perhaps tolerated is a better word. It’s almost like the Battle of Britain all over again, except this time a modern-day Churchill could be saying: “never before has so much [money] been owed, by so many.” People can say what they like about Britain losing its Britishness, but that famous ‘stiff upper lip’ is alive and well.

There is a case to be made, though, that the credit should belong to Westminster (as in the form of government) rather than to Churchill. You see, British politicians only really need to worry about elections every five years. In America, where over $14,000 billion in sovereign debt makes Greece’s look quite Mickey Mouse by comparison, presidential elections take place every four years, with Congressional elections mid-way through that. Basically, the Democrats and Republicans are always campaigning, so they cannot ever afford the voters to become displeased. Add to that a government budget that is perpetually in deficit. The combination of basic maths and voter-motivation suggests that US debt will continue to grow.

One wonders what Churchill would say about the versions of democracy in China and America. Using human rights as the standard, America is the winner. However, is it really The Land of the Free when its citizens are imprisoned by trillions of dollars in personal debt (most of it ultimately owed to China)? Don’t even get me on a bureaucracy so invasive that it became necessary for the US to pass the Reduction of Paperwork Act, in itself an impressive piece of paperwork that runs to something like 39 pages.

The credit crisis has brought the British economist John Maynard Keynes back into fashion. Personally, I’m with him on the positive effects of spending during recession, which causes money to circulate through the economy (he put it much more eloquently, but I’ve spent half an hour trying to find the exact reference without success), thereby driving demand.

The Nobel prize-winning economist Paul Krugman recently did a talk (click here to read the whole thing) on Keynes, in which he said: “I constantly encounter the argument that our crisis was brought on by too much debt – which is largely my view as well – followed by the insistence that the solution can’t possibly involve even more debt.

“Suppose that the government can borrow for a while, using the borrowed money to buy useful things like infrastructure. The true social cost of these things will be very low, because the spending will be putting resources that would otherwise be unemployed to work. And government spending will also make it easier for highly indebted players to pay down their debt. If the spending is sufficiently sustained, it can bring the debtors to the point where they’re no longer so severely balance-sheet constrained, and further deficit spending is no longer required to achieve full employment.”

That’s economist-speak for saying that – in theory – effective government expenditure can kickstart an ailing economy. The problem is that vote-chasing politicians run governments. They are going to allocate the money either to their favoured lobbies, or to their personal slush funds. And that’s without taking into account the possibility that the equivalents of Donald Rumsfeld are blundering away with the money.

I’m sorry, but I don’t have any confidence in government-managed disbursements. While I have a great deal of respect for Krugman and Keynes, it remains theoretical that government debt can fill the hole caused by bad private debt.

Despite its austerity measures, the British government still borrows an unsustainable 20% of what it spends, which looks provident when compared with America’s 40%. And no sign at all of reversing anytime soon.

We have many things for which to thank democracy; sadly, ballooning public debt is one of them. Something has to give. Could we be on the cusp of trying out another form of government?

This hangover is not going away.