Profits Are Good

A lot of people seem to find Goldman's profits rather disturbing--these guys are in it for themselves! That can't be good! Ah, but Economics was created as a separate discipline based on the insight that the unintended consequences of self interest are, often, quite good. As even today most people find this incredibly difficult to believe, I figure I would point to some seminal references on this. After all, profits are not bad, losses are, and it's good to remember that.

The magic of the free market is based fundamentally on the assumption that people are self interested, and so profits are sought after, and losses shunned. Given sufficient freedom of entry and property rights, firms will compete for those profits and in the process generate greater consumer surplus for your average schlub. Today's doofus lives a pretty good life relative to his counterpart in the middle ages, through neither his doofus antecedents or the conscious intentions of his actual benefactors

This is the invisible hand that magically transforms the greed of individuals into a social good totally orthogonal to their explicit intention. That it is a truly remarkable insight is reflected by how counterintuitive it is to this day. I think the underlying reason most intellectuals do not trust the free market is because they feel that left to itself, the market tends to monopoly, inefficient outcomes as highlighted in RollerBall, or It's a Wonderful Life. Global Warming and health care policy concerns are both, in a sense, driven by the intuition that without top-down guidance, we are like airplane passengers without a pilot, doomed to catastrophe.

But, markets do force profits to zero, as anyone in business can attest. Not immediately, but over only a few years. The best descriptions of the competitive process and how it is consistent with efficiency, for me starts with Risk, Uncertainty, and Profit, in which Frank Knight describes how people respond to profit opportunities, and how this both lowers profits and provides lower costs to consumers. Friederich Hayek's most important essay, The Use of Knowledge in Society, noted the way the price system aggregates information in a way a Politburo could not, and I quote it at length only because what he says here is what virtually every free-marketer tries to say all the time (to little avail):

... or the arbitrageur who gains from local differences of commodity prices, are all performing eminently useful functions based on special knowledge of circumstances of the fleeting moment not known to others.
...
To gain an advantage from better knowledge of facilities of communication or transport is sometimes regarded as almost dishonest, although it is quite as important that society make use of the best opportunities in this respect as in using the latest scientific discoveries. This prejudice has in a considerable measure affected the attitude toward commerce in general compared with that toward production. Even economists who regard themselves as definitely immune to the crude materialist fallacies of the past constantly commit the same mistake where activities directed toward the acquisition of such practical knowledge are concerned—apparently because in their scheme of things all such knowledge is supposed to be "given."
...
Of course, these adjustments are probably never "perfect" in the sense in which the economist conceives of them in his equilibrium analysis. But I fear that our theoretical habits of approaching the problem with the assumption of more or less perfect knowledge on the part of almost everyone has made us somewhat blind to the true function of the price mechanism and led us to apply rather misleading standards in judging its efficiency. The marvel is that in a case like that of a scarcity of one raw material, without an order being issued, without more than perhaps a handful of people knowing the cause, tens of thousands of people whose identity could not be ascertained by months of investigation, are made to use the material or its products more sparingly; i.e., they move in the right direction. This is enough of a marvel even if, in a constantly changing world, not all will hit it off so perfectly that their profit rates will always be maintained at the same constant or "normal" level.

...

those who clamor for "conscious direction"—and who cannot believe that anything which has evolved without design should solve problems which we should not be able to solve consciously—should remember this: The problem is precisely how to extend the span of out utilization of resources beyond the span of the control of any one mind; and therefore, how to dispense with the need of conscious control, and how to provide inducements which will make the individuals do the desirable things with

Sandy Grossman won the John Bates Clarke medal in 1988 based on more mathematical demonstrations of this view, how a profit seeking agent gets information into prices, and how this increases welfare.

This is one of those things that, if you believe it is important and generally true, is why you tend to favor market solutions; if you think it's for parochial cases of perfect competition, why you tend to favor top-down solutions. I obviously can't 'prove' why I think it is a better rule of thumb than any alternative, in that there are cases where it is untrue (monopoly, cartels, irrational businessmen). Futher, you can show that if certain increasing returns to scale (eg, Krugman's Nobel insight) are present, or informational asymmetries present (Stigltiz's Nobel insight), a modeler--who knows everything, isn't petty--can improve the equilibrium. I tend to find these exceptions as that, exceptions to a general rule.

More importantly, the solutions to imperfections are not a high-minded as modelers let on, in that while one can prove a situation is inefficient when you have a small set of assumptions, and then, God-like, note that you could make these imaginary people better. Yet one must consider that the bureaucrat in charge of fixing things is just as irrational and self-interested as any businessman or consumer. That is, if you think profits are a poor shepard, what about elections? With majority rule, there is a pressing desire to pass a law taking the money from the top (indirectly, usually). Given wealth and power always has a power-law distribution (fewer on the top than bottom), there will always be a desire by the masses to turn things upside-down. Thus, you have anarchy or coalitions waxing and waning like in the Roman Empire.

Our current climate seems to be that popular politicians are like union bosses or Marxist dictators, chiefs who state they are implementing the People's Will, all the while effecting more power than any CEO. This populist approach can only work within well-defined coalitions, because it necessarily involves Lenin's famous 'Who? Whom?' question (ie, who would prevail over whom?). You can't get power without taking someone down, you can't get patronage jobs without restrictions on entry. There really isn't a powerful coalition for maximizing GDP, because it doesn't exclude and include based on who signs up.

Bob Solow Dismisses High Frequency Trading

At the end of his review on this week's latest book on the recent economic crisis, liberal economist Bob Solow brings in this observation:

I have read that a firm such as Goldman Sachs has made very large profits from having devised ways to spot and carry out favorable transactions minutes or even seconds before the next most clever competitor can make a move...

Now ask yourself: can it make any serious difference to the real economy whether one of those profitable anomalies is discovered now or a half-minute from now? It can be enormously profitable to the financial services industry, but that may represent just a transfer of wealth from one person or group to another. It remains hard to believe that it all adds anything much to the efficiency with which the real economy generates and improves our standard of living.

This kind of reasoning has been going on for a long time, and while introspection is useful, it's really not good for figuring out what other people should do. Some guy thinks to himself, 'what's the use of that?', and decides the world would be a better place not only without that activity. The fact that an academic in Boston can't fathom how something helps the world seems rather unsurprising.

I'll say for the record that I think Puff Daddy is a waste of resources--I have no need for him, and can't understand his celebrity. There are many activities I not only don't do, I judgmentally think people waste time when they do them, but I'm not so arrogant to think that really means they must do something else. It took us decades to figure out that altruism could be based on enlightened self-interest (iterated prisoner's dilemma, reciprocal altruism), so it's a good idea not to throw something out merely because we haven't figured out its benefit in 'the big picture'.

A famous article in 1962 by Fisher, Griliches, and Kaysen (The Costs of Automobile Model Changes since 1949, JPE), argued that the improvements in cars from 1949 were all a waste! Using exacting logic, they noted one could have bought the same 1949 car for $700 less in 1961, and could have used that money to buy coats for the poor or some other 'obviously' better use (after all, 1949 car got from A to B just like the fancy 1962 ones). But, then, one could say the same thing about books: 99.99% of everything written today was said better previously by someone else. Better those people serve the poor or something more obvious than engage in frivolous or redundant work. One could go on and on, because most of the internet is frivolous (porn, games), much liesure activity pointless (football?), etc.

The only problem is with this insight is it isn't obvious how to spend money 'wisely', on say obvious public goods. For example, In the 1990's an activist Kansas City judge decided to mandate the state pay for a first class shool system. The results were typical:

Kansas City spent as much as $11,700 per pupil--more money per pupil, on a cost of living adjusted basis, than any other of the 280 largest districts in the country. The money bought higher teachers' salaries, 15 new schools, and such amenities as an Olympic-sized swimming pool with an underwater viewing room, television and animation studios, a robotics lab, a 25-acre wildlife sanctuary, a zoo, a model United Nations with simultaneous translation capability, and field trips to Mexico and Senegal. The student-teacher ratio was 12 or 13 to 1, the lowest of any major school district in the country.

The results were dismal. Test scores did not rise; the black-white gap did not diminish; and there was less, not greater, integration

William Easterly has discussed the issues of international aid, and how over $2 Trillion dollars have basically been flushed down the toilet. So, good intentions are neither necessary (the unintended benefits of self-interest) or sufficient (charity).

I think it's much better to let people spend their money the way they want (with a few exceptions), and equally importantly make money the way they want. It's a good thing that American car companies, in 1962, didn't think the 1949 model was 'good enough' and then spend it on something obviously of public good, like aid to Africa, or public housing. Such thinking leads to zero productivity growth, and without productivity, we can't pay for things like, public pensions, or actually create things we find really elevating (like the Large Hadron Collider, or Al Gore's Nobel prize winning power point presentation).

Ethics Expert on Global Warming...

Mike Treder, Managing Director at the Institute for Ethics and Emerging Technology, notes that ALL those who disagree with him that Global Warming is going to kill billions unless we invest more in wind farms are either stupid or evil. One would think such a manichean understanding of a complex system would only be found in rural bars were everyone has a chain attached to their wallet. I prefer to be called evil.

Gaffe Defined

Republican Lt. Gov. Andre Bauer of South Carolina on charity:

My grandmother was not a highly educated woman, but she told me as a small child to quit feeding stray animals. You know why? Because they breed. You’re facilitating the problem if you give an animal or a person ample food supply. They will reproduce, especially ones that don’t think too much further than that. And so what you’ve got to do is you’ve got to curtail that type of behavior. They don’t know any better,

Of course, the press responded by noting how ridiculously stupid and offensive that remark is. I'm not running for office, so I'll say I think that's about right. One could nuance that, by saying 'The most melancholy of human reflections, perhaps, is that on the whole, it is a question whether the benevolence of mankind does more good or harm (Walter Bagehot). Or that 'The poor don't need money or pity, they need temperance, diligence, thrift and other bourgeois virtues'. Or that 'The ultimate result of shielding men from the effects of folly is to fill the world with fools' (Herbert Spenser). Same idea.

I think what's considered so offensive about the remarks is it implies these people are poor, in large part, because they aren't very bright. That means it's not someone else's fault, and thus responsibility, and thus the rich might just eat them like Soylent green! For a post-Christian society, we sure hate to judge, just like our bible-thumping predecessors. Better to point out the exceptions to 'disprove' the generalization, and say 'there but for the grace of God go I'.

How to Listen to Stock Analysts

Prior to the reforms after the internet bubble, stock analysts were generally partisan shills trying to maximize the corporate banking activity from the firms they were supposedly giving objective advice. Case in point: Asset Asset Selection and Under-Diversification with Financial Constraints and Income: Implications for Household', by Roche, Tompaidis, and Yang. They note:

Studies continue to show that revisions are informative, causing mean announcement-returns of 1% to 2.5% for up revisions and -1% to -2.5% for down revisions. The total value of these announcement-returns points to the release of enormous information value by revisions, given their great frequency.

But they note that many of the revisions occur overnight, and they often accompany company information, such as a new product release or earnings guidance. So, focusing only on analyst revisions that occur intraday, and focusing on a 40 minute window around the forecast revision, generates a measly 0.05% price move.

So, ignore all those talking heads, and glossy binders by your broker? No! It turns out, there is information in analyst forecasts, specifically, shorting your broker. In Long-Term Earnings Growth Forecasts, Limited Attention, and Return Predictability by Da and Warachka, they find that if you take the long-run earnings growth and divide by the recent earnings growth, you get a straightforward metric of optimism: higher is more optimistic. It turns out, the highest decile has a 4% annualized lower risk-adjusted return than the lowest decile; more optimistic stocks have lower returns.

A simple explanation (see here) is that mutual funds "herd" (trade together) into stocks with consensus analyst upgrades and (especially) herd out of stocks with consensus downgrades. Stronger fund herding occurs when analyst recommendation revisions are more unanimous.

However, there is some information that analyst recommendations are more useful at the industry level. Portfolios long in industries about which analysts are optimistic and short in industries about which analysts are pessimistic generate significant abnormal returns (see here).

So, listen to your broker's advice on sectors and stocks, just remember to short the stock picks.

Diderot, Euler and Cochrane

John Cochrane dismisses polymath Richard Posner thusly:

I don’t want to comment on Posner. He’s a nice guy. But I spend my life trying to understand this stuff. My last two papers, which took me three years, were on determinacy conditions in New-Keynesian models. It took me a lot of time and a lot of math. If Posner can keep with that and with Law and Economics, good for him.

Note he avoids actually confronting anything specific in Posner's argument or providing any argument of his own, and merely points out he knows a lot of math and some parochial modeling expertise. Now, investigating 'determinacy conditions in New-Keynesian models' (see here) seems very high tech, and he does absolutely nothing to explain to the intelligent, but uneducated reader what this means. It is really bad form, using pretentious jargon to avoid argumentation.

In the context of what he investigated 'for the past two years', determinacy conditions just means whether one can say that Fed interest rate targets can moderate inflation by itself, independent of say, the monetary aggregates. We don't have enough data to determine if that is true. Now, given the way interest rates and inflation have behaved, with a long secular trend up from 1950 to 1980, then back down to today, that should be obvious. It's basically two datapoints. Ideally, we need hundreds of such periods. That we don't have enough data to define optimal monetary policy is only an abstruse concept if you are being disingenuous. Every technical debate in economics comes down to a pretty common sensical debate, and if you can't articulate it in such a way, you are either an idiot-savant who does not understand what the models really mean, or you are trying to brow-beat outsiders via intellectual intimidation. As Cochrane wrote a very nice piece on how to write a good economics thesis, he knows better.

There's a famous story about the great mathematician Leonard Euler, and the French philosopher Denis Diderot, who created te first encyclopedia. They were both visiting Russia on Catherine the Great's invitation. The Empress didn't like Diderot's arguments for atheism, and was concerned such arguments were influencing members of her court, and so Euler was asked to confront the Frenchman. Diderot was informed that a learned mathematician had produced a proof of the existence of God, so he agreed to view the proof as it was presented in court. Euler appeared, advanced toward Diderot, and in a tone of perfect conviction announced, "Sir, (a^b+n)/z=x, hence God exists—reply!". Supposedly Diderot stood dumbstruck as laughter erupted from the court. Of course, the 'proof' is total nonsense.

It's not clear how true that story is--surely it's embellished--but it reflects a common tactic by those with specialized skill: hide behind parochial terminology. Some economists like to say you can't have a defensible opinion on the economy unless you fully understand Turnpike theorems, value functions, or set theory. These are model paradigms, and the relation of a model to reality, in economics, has been more hope than reality. All model paradigms in macro have been irrelevant to reality, so the onus is on them to demonstrate they aren't part of parochial status game fancied by academics. Bohr's model of the hydrogen atom isn't 'correct', with an electron circling the nucleus in the way a planet circles the sun, but it gives one some useful intuition. That is really all any economic model can aspire to. The idea that an economic model will allow one to estimate parameters that predict something with the right digit, is the hope of all non-physical sciences, but they haven't been successful.

Interviews with Fama and Cochrane

The New Yorker had some thoughtful interviews with two leading financial economists. Fama is here, and John Cochrane is here.

From Fama:

There were some people out there saying this was an unsustainable bubble…
Right. For example, (Robert) Shiller was saying that since 1996.

I would add, Shiller didn't say there was a housing bubble in 2006. Specifically, he said some the recent increase in housing prices was unsustainable, and some markets might experience a decline in housing prices. That was entirely consistent with the disastrous assumption that nationwide housing prices will not fall, and has somehow turned into a clear call of an imminent market correction (and Shiller deserves some moral blame for not correcting this common statement because it distorts reality in his favor at the cost of rewriting the past).

Cochrane has a few interesting notes, I especially liked his general equilibrium take on macro, noting

Possibly, but it’s not obvious how “stimulus” is going to help this recession. Think about an unemployed accountant in New Jersey, fired from a big bank. How is going to build a road in Montana going to help him? Keynes thought of a world in the nineteen-thirties where labor was more amorphous labor. If you hired people to dig ditches, that would solve the unemployment line in the car industry. We have very specialized labor, and just hiring people doesn’t resolve the problem. Somebody who lost their job in a bank—building more roads is not going to help them.

Meanwhile, Joe Stiglitz has been praising the Venezuelan model of development:

Joseph Stiglitz, a Nobel economics laureate visiting Venezuela, said developing nations must strike a balance between public and private control of the economy.

After meeting in the presidential palace with Venezuelan leader Hugo Chavez, Stiglitz praised the South American country's success at distributing its oil income among citizens. He urged the government to ensure its economic policies are leading to sustainable growth

R2s and Sharpes

In strategy simulations the performance metric is sometimes presented as an R². These are difficult to interpret because clearly a 1% R² over 1 day is a better strategy than one with an R² of 1% over a month. A nice focal point is an annualized Sharpe ratio. Historically, the benchmark offered by the equity risk premium is a nice focal point, because it is common and feasible (around 0.4, as given a 6% equity premium, a 15% annualized vol (I wrote a book why I think this is probably more like 0.1, but that’s a minority view). Anything above 0.5 is quite good, and above 1.0 excellent. The annualized Sharpe ratio is define as


By using annualized Sharpes we can compare apples to apples. As returns are linear in time, standard deviation increases by the square root of time, so one needs to have a common time to make Sharpe ratio comparisons.

Now, for many strategies, one is predicting the profit on the combination of a specific tactical rule with a model that generates an expected return. For example, if I think the market is going up, one can take advantage of this several ways: buy futures, options, bull-call spreads, etc. This adds degrees of freedom to the result, because often certain criteria can generate different Sharpe ratios.

I will assume one implements a linear position rule, such that a position is linear in the expected return of the strategy. Thus, if one expects a return of 1%, one has half the long position as when one expects a return of 2%; if one expect a return of -1%, one has the opposite position as when the expected return is 1%. It is the proportionality between signals that affects the Sharpe ratio, not the absolute size, because whether I invest, on average, $1k or $1MM, it will have the same Sharpe ratio. As to whether linear is optimal, intuitively it is pretty close to optimal, basically saying that if conditional variance is constant, you put down twice as many chips as when you expect twice the return.

Thus, assume we are forecasting a return, which can be a portfolio, or a single stock, it does not matter. Some ‘thing’ has an expected return. This has a forecastable and nonforecastable component.


Here f is the forecastable component, ε the random component, of the strategy return. Given the linear position rule, the exected return is simply


It is useful to assume the unconditional expected return above the risk-free rate on the strategy and the forecast are both zero. To the extent they are not, that would be part of the predictable return that would not be ‘excess’, a cost of capital. Thus, with we have


Now, the variance of the product of two Gaussian random variables, applied to f and ret, is

Var(f⋅ret)=σ²_f,ret+2σ_f,retE(f)E(ret)+E(f)²σ²_ret+E(ret)²σ²_f+σ²_fσ²_ret

The proof for that is quite tedious (see Bohrnstedt and Goldberger, 1969), and crucially relies on the Gaussian distribution to avoid extra complexity from higher moments (that’s why we love the normal!).

Given the expected returns are both zero, we have


So, the Sharpe of the strategy is just


Now, given σ_x,y=ρ_x,yσ_xσ_y we have


The nice thing is that the numerator, ρ_x,y, is just the square root of an R²! That is, whatever your f, the R² of a regression of the return on f, is what you need to know to calculated a Sharpe ratio.

The last step is to annualize, to put this into consistent units. To do this we simply apply the adjustment. For strategies that are not necessarily done over calendar time in constant increments, we assume t=number of sequential trades per year. This generates the following adjustment. You multiply the Sharpe by the square root of the expected number of trades per year. So, in this equation, you meake sure you have the number of expected trades in there, t.


or

So, with an R², and trading frequency, we can generate a reasonable Sharpe. For example, in the graph below, we see how the R² of Sharpe 1.0 strategies vary by the number of trades made per year (eg, a horizon of 1 month trades 12 times a year).




So, an R² when forecasting annual data, is not nearly as valuable as the same R² over 1 week. That's obvious on some level, but I think it's nice to have a specific formula to make such comparisons. An important qualifications is that transaction costs are not addressed here. The higher the frequency of the strategy, the higher the importance of transaction costs.

IQ and Trading Profits

A paper by Mark Grinblatt and two Finnish guys whose names I can't pronounce (Linnainmaa & Keloharju), took data from Finnish military IQ tests, and combined them with transactional data on the Helsinki Stock Exchange. The paper is cleanly titled, "Do Smart Investors Outperform Dumb Investors?"

From the abstract:

This study analyzes whether high IQ investors exhibit superior investment performance. It combines equity return, trade, and limit order book data with two decades of scores from an intelligence test administered to nearly every Finnish male of draft age. Controlling for wealth, trading frequency, age, and determinants of the cross-section of stock returns on each day, we find that high IQ investors exhibit superior stock-picking skills, particularly for purchases, which earn up to 11% more per year than the purchases of below average IQ nvestors.

Wouldn't it be interesting if, instead of expected returns being a function of an asset's risk, it was a function of the investor's smarts? It seems plausible, indeed, I argued in my book that alpha is not really a function of an asset, but rather, of the investor. Gold, day-trading, futures, are not really attractive in themselves, but rather if they are consistent with your relative skills.

They group investors into a stanine distribution, where 1 is low, 9 is highest. The highest IQ group has a 4.4 basis point return advantage, looking at their picks on day t-2, and return on day t. This annualizes to 11% (252*.00044), but that isn't very realistic, because you can't trade that much. The advantage peters out, as after two months the return advantage is only 0.5 basis points.

The paper notes a distinct short run advantage to high IQ traders. This seems to make sense, but one should remember investing is not a sprint, but a marathon. Grinblatt and company show higher IQ investors are more diversified, and trade less, than their stupid counterparts, so it does seem like those who trade benefit from smarts.

I think this is a lot like noting that smarter gamblers are better gamblers, because everyone in this paper is trading all the time, for edges of basis points, when the transaction cost merely on the bid-ask is 100 basis points. The really really smart (wise?) people do not gamble at all, because they know the long-run house edge kills any edge they might have. In trading, trying to make money with trade horizons less than a year, the only way to make consistent money is to be an insider, why brokers have nice yachts ('where are the customer's yachts?'). The best stock strateg is something very passive, because a 4 basis point edge does not overcome transaction costs, whereas a simple strategy of buying, say, low volatility portfolios generate a superior Sharpe ratio and is very feasible.

Our New Power Elite

As we move into our new era of greater government, there are many signs of the new regime. One is the great deference by risk managers to regulators, turning what was once a promising intellectual field into a subservient rationalization for whatever the regulators appear to want, conventional wisdom on steroids (ie, rigorous and common yet often irrelevant). Another is that rents in DC are approaching those in New York.

But now, we have the new alpha male: übernerd Peter Orszag. This guy probably experienced his share of weggies in junior high, but
as Henry Kissinger noted, power is the ultimate aphrodisiac, so it seems Orszag left his earlier wife (all for 'change'), had an out-of-wedlock child with an attractive heiress, and has a future wedding to 31-year-old journalist Bianna Golodryga. I guess lines like 'Mind if I compute the rotation coefficients of that symmetric bilinear pairing?' work, as long as you are minding a $3.5T budget.

New Blogging Policy

Just fyi, I'm only going to do 1 post a week. I might have a brief one in between. I'm now pretty ensconced in an interesting full time job working on quantitative issues related to equities and their options, but I know enough not to discuss it directly. I can't write much about what I work on most of the day, and my opportunity cost of blogging has made daily posting impractical.

So, check in once a week, I appreciate any comments and read them all, even when I don't respond.

The Age of Envy

A good test of a theory is to ask the simple question: can it more parsimoniously explain the world better than the status quo?

I argue that people are primarily driven by envy as opposed to greed (see here), so they are mindful of their relative, as opposed to absolute, position, and this leads to doing what others are doing as a mechanism of minimizing risk. In contrast, a standard utility optimizer looks at how to generate a maximum return for a given level of portfolio volatility, broadly defined to include human capital. Now consider, investment advisers generate tables of risk and return, and ask their client where they want to be? They do nothing of the sort. Instead, they generate extensive commentary of hot issues, major market sectors that are growing or shrinking, because notify what sectors where investors should shun or increase. This creates the occasional bubble, though that is an unintended consequence.

Understanding the prominence of envy over greed has several other implications. For example, there is a known home bias, where people overinvest in their home country. From a strict mean-variance perspective this makes no sense, because adding Germany and Japan to an American's portfolio would be a first-order diversification tactic. But if you are mainly concerned with keeping up with your neighbors who primarily invest in the US, then the home bias makes perfect sense. Another key implication is that happiness is not a function of aggregate wealth, so even as wealth per capita has risen immensely over the past 100 years, we aren't all that much happier. This is known as the Easterlin Paradox, because it is a paradox to standard asset pricing theory.

Self interest was at first derided as amoral, Machiavellian, but first Adam Smith showed that it could generate socially desirable results through unintended consequences, though to this day many find this fanciful. Evolutionary biologists like David Hamilton and George C. Williams showed that self interest could lead to altruistic instincts towards are families. Game theorist showed that rational, far-sighted self interest produced 'win-win' outcomes, as in the iterated Prisoner's Dilemma. Given the conspicuous failure of socialism in 1989, wealth maximization is intellectually defensible on moral, societal, and libertarian grounds. There is no such bright side to envy, which does not generate any salubrious unintended consequences.

People rarely say what they mean when targeting a goal because the indirect route is usually more efficient in the context of working within a collective where others have competing goals, and so selectively emphasizing process or results to the act or the rule, allows a great deal of rationalization. Efforts at redistribution invariably are framed as win-win or part of a broader altruism, when in fact it is merely taking from the rich just as Stalin expropriated the Kulaks. Christina Romer, an economic advisor to President Obama, notes that we can reduce the cost of health care by basically taxing premium care out of existence, which only makes utility maximizing sense (ie, sense to an economist) if you think those who consume more than others directly hurts those who consume less, intuition given our common envy (see page six, top paragraph here). Paul Krugman baldly states that universal care is the progressive objective for health care, as if distribution were all that mattered. As Greg Mankiw noted, health care reform would lose its impetus if it were revenue neutral; the redistribution isn't a side benefit, its the main point.

We are an envious little species. This is why there is no general risk premium, but has many other footprints, such as the desire for redistribution, why we aren't twice as happy as our great-grandparents, or ten times as happy as those living in Guatamala, why people have a home bias, etc. (my book goes over these in more detail). It is also why the moral superiority of self-rule is self evident to most people, regardless of how incompetent and inefficient the local rulers are (no one is proposing Britain, US, or Italy take over Zimbabwe, Afghanistan, or Ethiopia, regardless of the anarchy in these countries). Envy is why, regardless of how well an immigrant group is doing relative to their home country, or even anywhere else in the entire world, if they are doing below average in America they are presented as dispirited victims--how can you be happy if you have all the creature comforts you can manage, but less than average in America itself?

Egalitarianism is the essence of diversity, which is the primary principle championed by modern universities. The idea that redistribution of money and power--progressive taxation, making wealthy individuals kowtow to elected officials--is suggested as win-win, but there's no data suggesting that affirmative action has ever raised a group out of its inferior socio-economic position, or generated anything but further friction. It remains popular, however, because its short run effects are directly attractive to most people, who have no problem rationalizing taking money and power from those at the top.

John Adams made sure the USA had many republican features because he worried that "There never was a democracy yet that did not commit suicide", an opinion first articulated by Thucydides in the fifth century BC. I think this is because mob rule unleashes the envy of the masses, which brings down the best, and in the process the talented tenth, the elites, that drive anything worth cumulating upon in the realm of ideas (and thus, art, science, and technology). Under the elevation of diversity as an end in itself, envy is almost shameless now.

In sum, envy is a better description of what motivates people in general, and underlies currently popular politics and progressive intellectuals. We can rationalize the desire to take from those with more under various pretexts--reducing health care costs, rectifying racism, improving the financial system--but only because the mind is very good at confabulating (eg, taking money from the top 5% is often presented as an altruistic disposition). People aren't utilitarians, and academics are usually only utilitarian when they presume it is consistent with egalitarianism (eg, Peter Singer arguing that giving everyone positive rights is utilitarian). I don't believe 'ought implies is' anymore than 'is implies ought', so I'm comfortable knowing my pragmatic utilitarianism that emphasizes the the virtue of liberty is not what most other people think is good policy. My only comfort is that I believe most educated egalitarians would admit their beliefs are untenable if they weren't also consistent with utilitarianism, that there is a trade-off between equality and efficiency, and that their instincts are more base than the dismal scientists every imagined.

Models aren't Theories

A theory is is an analytic structure designed to explain a set of empirical observations. It should be nontautological, tautologies are for theorems. A good theory identifies a relation so that one can simplify or predict better than without the theory, and 'better' might be because of a lower mean-squared error, or because the simpler model makes it easier to intuit a solution using one's own wet neural net. A good theory can often be modeled, though not all theories are helped by modeling (eg, the theory 'power corrupts', or 'the invisible hand').

Attempts to formalize the principles of the empirical sciences in the same way mathematicians axiomatize the principles of logic use an interpretation to model reality. As economic systems do not have the precision of physical systems (there are no fundamental constants analogous to the force of gravity on Earth, no equations as strict as PV=nrt), I think economic modeling has gone too far, in that most top economic journals stress the model, thinking that improving the generality of a model, especially if it involves sufficient rigor (eg, theorems using set theory or value functions). But models are means to an end, and as there are no models in econ with the same reality as in physics, we should recognize their intermediate status.

A lot of good theory, as in Hayek or Adam Smith is best presented as mere words. A lot of top theorists today have created models that have not generated really novel important results (eg, Mankiw, Cochrane, Campbell, Lucas, Romer, Krugman), instead, the models seem to offer hope that they will prove foundational, creating a method for introducing a theory that tersely explains, and offers the potential for refinements that create new important insights. That hope, alas, is not grounded in experience. Bellman equations, input-output matrices, second-order difference equations, set theory, are all areas of economic modeling that were once thought to provide essential methods for understanding economics, though they have been highly disappointing in what they have produced.

I wrote a book, Finding Alpha, which had a simple theme. My newly updated paper on this theory is here. Risk, however defined, is not empirically positively related to return. This is not an exception to the rule, it is the rule. This is explained by the fact that if most investors are benchmarking—against the S&P500, for example—then there is no risk premium. As people appear to be more driven by envy than greed, this makes sense.

I discovered previous theoretical work consistent with this idea. Models that contained my idea as a special, extreme, case. For example, Gali (1994) notes that if utility is a function of both one’s own consumption, c, and aggregate consumption, C, such that

U(c,C)=(1-A)^-1c^1-AC^γA

where γ <1 and A>0. So, if γ<0, there are consumption externalities, "keeping up with the Joneses” effects that cause people to herd into aggregate risky wealth investments. That is, emulating the average risky asset investment lowers the risk of falling too much behind the aggregate consumption, and this causes the required risk premium to be lower than it otherwise would be. However, Gali also notes that γ<0, there are public goods aspects to aggregate consumption, as when your neighbors spend their money on making your neighborhood more beautiful. This would increase the theoretical equity premium.

DeMarzo, Kaniel, and Kremer (2004) present a model where agent’s utility is a function of two types of consumption: standard goods, and positional goods. Positional goods are things like mates, beachfront properties, or table seatings at a restaurant, that are unaffected by aggregate wealth. They create a ‘complete’ model by having the positional goods proxied by service consumption in period 2 provided by a fixed amount of labor, so that regardless of the total wealth in the model, people will be competing for access to services in exactly the same way. Thus, the positional nature of the service goods is endogenous to the model. Their utility function is given by

U(c_g,c_s)=(1-a)^-1(c_g^1-A+c_s^1-A)

here A is the standard coefficient of risk aversion, and c_gthe consumption of goods, c_s the consumption of services. Total output for the economy is given by 1+θx, where x is the allocation of wealth in the risky asset, and θ is a random variable. The production of services, however, is fixed by the size of the labor pool and unaffected by the output from 'risky' investment. DeMarzo et al shows that under some parameterizations for θ a zero risk premium can occur.

These other findings highlight that my logic is correct; a relative status orientation can lower the risk premia to zero. My main innovation is merely to make this connection less subtle, less tentative, less convoluted. In those papers the main innovation was basically to show that one could generate overinvestment or underinvestment because of externalities of consumption: Gali assumed it, DeMarzo set up a 'services' portion of the utility that had clear, positional good characteristics. They did not emphasize that risk premiums are often, if not usually zero, only that it could happen.

The key is what utility function best explains the the world we see, and a relative status one works much better than a standard one based on decreasing marginal utility based on absolute consumption. To add parameter that captures the fact that some consumption is of positional goods, and assert this can create different risk premia, including under some parameters a zero risk premium, is not so much a theory, but rather a flexible model.

To have results such as positional goods arise ‘endogenously’ via having services provided by a fixed labor supply, but then to highlight highly arbitrary parameterizations that yield equilibria different than the standard models does not make the idea of a relative wealth orientation more compelling to me, but that appears a matter of taste. I was told by one referee my model was too simple, and the fact these papers (Gali and DeMarzo et al) were published in top journals highlights that economics demands a certain level of rigor to ideas regardless of whether it is needed. That is, I could have generated a general model that encompassed my main result and the standard model as special cases when a parameter is adjusted from 0 to 1, but I find that disingenuous, pretentious, and ambiguous. The main point is that if people are better defined as envious, not greedy, there is a lot of benchmarking, and this leads to zero risk premiums, which is generally what we observe. That's a simple idea, which makes it a better idea than saying something less definitive but more ornate. But, that's why I'm not an academic.

Merry Christmas

I'm in family mode, celebrating the holiday. Unfortunately, Anthropogenic Global Warming is responsible for a large amount of snow, and it's forecast to be really heavy over the next 24 hours here in Minneapolis. I'm telling my kids—who find this increasing less funny each time—that Santa might have to cancel Christmas. If only one of his reindeer had some sort of illuminating device so Santa could see where he is going...

Avatar Silly Fun

I took my boys to Avatar and found it visually dazzling, though the story totally cliche. It's the standard trope about the superior virtues of a primitive, indigeounous culture. The funny thing is that everyone knows primitive indigenous white cultures, such as those in Appalachia (rural America), are backward: illiterate, racist, sexist, and homophobic. The have high rates of crime, drug use, and incest. Their religiosity is not admirable, it merely highlights their devotion to dogma. However, given the current enlightened tribalism white trash has no analogue among brown, black, yellow and now blue hominids. I guess the marginal effect of education on rational self-interest is high only for Europeans; everyone else simply knows that 'playing nice' is an optimal strategy in dynamic interactions.

The most important fact to remember when species from different ecosystems meet is that one usually has 100x the brainpower of the other. When one comes light years to visit the other, and you can put your money on the visitors, and remember, they are not only smart, but hungry. This is why I'm not too excited by the thought of aliens coming back, because I don't think they are going to serve mankind in a way we would like.

Most importantly, I was wondering whether it counts as creepy if you lust for females of another species merely because they look and act kind of human. Sure, she's a pretty blue girl, but horses are pretty, and if they could talk, I still wouldn't fark one, even if "I" were a horse. I guess ever since Captain Kirk started making out with alien babes everyone figures a hot chick with a tail and racing stripes is just a hot chick. I'm all for being color blind, but if your neighbors are really blue, deep blue, don't tell me you'll treat them just like everyone else.

Interestingly, there's a fun theory out there (see Chariots of the Gods), that aliens with really big heads came around, bred with the locals and build megaliths, then left or where killed, suggesting that Ghengis Khan is not the greatest progenitor of the planet, but rather the Captain Kirk from Planet X. This also explains why all cultures assume the Gods come from the heavens. You can see evidence of their big heads in South American to Russia, and their buildings from Macchu Picchu to Giza.

Worst Stock Return Decade Ever?

From the WSJ:

With two weeks to go in 2009, the declines since the end of 1999 make the last 10 years the worst calendar decade for stocks going back to the 1820s, when reliable stock market records begin, according to data compiled by Yale University finance professor William Goetzmann. He estimates it would take a 3.6% rise between now and year end for the decade to come in better than the 0.2% decline suffered by stocks during the Depression years of the 1930s.
...

Since the end of 1999, the Standard & Poor's 500-stock index has lost an average of 3.3% a year on an inflation-adjusted basis, compared with a 1.8% average annual gain during the 1930s when deflation afflicted the economy, according to data compiled by Charles Jones, finance professor at North Carolina State University. His data use dividend estimates for 2009 and the consumer price index for the 12 months through November.

Just shows how fickle conventional wisdom is. The 1990's had its best return decade ever, averaging 17.6% returns, and the equity return premium was often estimated around 6%. Now, it's generally thought to be around 2-3%.

It's Not Science to Slant Data

In the latest Science Saturday at bloggingheads, George Johnson tries to diminish the relevance of the climategate emails by saying that "everyone does it". As if, that's just locker room science talk.



There is no excuse for trying to hide the medieval warming period statistically, or diminish the credibility of critics. It isn't simple talk, and more than a white guy can say they use the N-word casually but that means nothing: everyone knows that someone who talks that way isn't credible on racial issues.

Talking about coalitions, and hiding conspicuous trends, is pure slanting data to one's predisposition. If someone shaded beta-return data from the 1970s because they were not relevant to the CAPM ,that would be conscious fraud. Luckily in economics we are all looking at the same data, so no one would even try to do that, but if they did, it would be a big, black stain. There is no good excuse for what they said in those emails.

The Context of Magic vs. Tiger

So, one guy has tens of extramarital affairs and is considered a disgrace, someone who must come clean and ask forgiveness. Another guy has hundreds if not thousands of affairs, in the process acquiring HIV, thus exposing his poor wife.

Which guy is morally worse? Clearly, the guy who caught HIV by having 100x more affairs. Yet, when Magic Johnson announced he had become HIV positive due to innumerable extramarital affairs, all he got was sincere pity, poor Magic. In contrast, the venom inspired by Tiger's actions is rather severe.

To me this highlights that everything has a context. What is true, just, beautiful, or important, is rarely seen in isolation, but as a member of a larger class. Magic was announcing he had HIV when the politics of AIDS were especially large, and 'blaming the victim' was not politically correct so he got the appropriate pity, regardless of his reckless behavior. Tiger doesn't have any such angle.

The importance of context is why so many partisans think the other side are a bunch of hypocrites. Your average true believer rationalizes exceptions to their world view, sacrifices various smaller principles to larger ones. This is the right thing to do, just as murdering Hitler is morally good thing to do if you had a time machine, and saw him in 1938, or ignoring Pasteur's faulty argument's in favor of his 'germ theory' would have been prudent.

The key in all these exceptions is being on the right side, which is determined by current politics, posterity, and one's own conscience. Clearly, the easiest way to go through life is to see what is popular, and shade one's prejudices appropriately, so 150 years ago it would be proper to be a racist and think that the 'upper class' was a thoroughly different beast, whereas today smarmy college freshman at top colleges think every human grouping possible has equal genetic ability and interest in every meaningful human dimension. People never get rid of their prejudices, they just change them.

It is far better to acknowledge our most basic unproven assumptions than to claim they don't exist, and that it's all about truth now, or only 'my side' is using science (the other, driven by crass self interest). Of course it is about truth, but truth of what? No one lies like the indignant because they feel their big point is being obscured by unfair tactics, and so feel justified in fighting fire with fire to acheive their ultimate, good aim (which, because it is good, is also true).

Dan Ariely Wrong on Bandages?

in Dan Ariely's Predictably Irrational, he highlights a smorgasbord of incorrect intuitions. He was burned in an explosion as a young man, and had bandages removed regularly. He talks here about debates he had with nurses about how to trade-off the quick rip-off of bandages, versus slow rips. He talks about lab experiments that proved ripping off slowly was 'better', than when you rip them off quickly. This was in contrast to the nurse intuition, and highlights that our intuitions are often incorrect.

This is not really economics, just the standard Freakonomics empirical analysis of random stuff. It makes for fun reading, as trivia books often are, but as to whether the trivia is wrong, well, no one really cares.

So, I found this recent finding of interest, because I'm sure it won't affect Ariely's research one iota, because the truth about this is really not so interesting.

THE perennial debate in every playground has finally been solved - ripping a Band-Aid off quickly causes less pain than pulling it away from the skin in a slow two-second tug.
...
For the study, published today in the Medical Journal of Australia, each student had two plasters applied to their upper arm, hand and ankle. The plasters were then removed using both fast and slow methods, with a randomisation process used to decide which was used first on each student. Subjects were asked to rate the pain on a scale of 0 to 10, with 10 being the "worst pain imaginable".

Fast removal achieved an average pain score of 0.92, while slow removal was significantly more painful at 1.58

A Nobel Rant

A Nobel Prize means that you did something really well appreciated. With hindsight, some of these are found positively harmful (note Edgar Moniz's Nobel for the lobotomy), and many are just irrelevant (what great insights today do we use from, say, Myrdal, Leontief, or Lewis?). Unfortunately, it is the best brand name in academia, so Krugman speaks over at the NYTimes with absolute certainty about what low-minded idiots we are for not agreeing with him:

When I first began writing for The Times, I was naïve about many things. But my biggest misconception was this: I actually believed that influential people could be moved by evidence, that they would change their views if events completely refuted their beliefs.

It couldn't be that he is not correct, or insufficiently persuasive.

America emerged from the Great Depression with a tightly regulated banking system. The regulations worked: the nation was spared major financial crises for almost four decades after World War II.

Post Hoc ergo Propter Hoc is ok if you have a Nobel. A lot of things were unique to that period: Jim Crow laws, the Korean War, fear of nuclear death, Elvis...I suppose they all caused the prosperous 1950s. I'm not sure what, specifically, he thinks was a good policy: the separation of Investment Banking from commercial banking? That has been shown irrelevant looking at cross-country analysis, and even in this latest crisis, it was not investment/commercial bank hybrids that did much different. Perhaps he's talking about the various Securities acts of 1934 and 43, which basically made brokers sign statements with their addresses, and noting they understood parochial laws that forbid stealing and fraud (who knew?).

The first big wave of deregulation took place under Ronald Reagan — and quickly led to disaster, in the form of the savings-and-loan crisis of the 1980s.

The economy is a big, complex thing. To blame the S&L crisis on Reagan is like blaming WW2 on Franklin D. Roosevelt. Its long history, from the Depository Institutions Deregulation and Monetary Control Act of 1980, to the Garn–St. Germain Depository Institutions Act of 1982, to Tax Reform in 1986, created a problem that was not anticipated by either party very well. But they started in the Carter administration.

In a memorable 2003 incident, top bank regulators staged a photo-op in which they used garden shears and a chainsaw to cut up stacks of paper representing regulations.

And the bankers — liberated both by legislation that removed traditional restrictions and by the hands-off attitude of regulators who didn’t believe in regulation — responded by dramatically loosening lending standards.

He seems to forget that the regulators were actually punishing banks that did not lower their standards sufficiently. To meet Community Reinvestment Act goals, and goals set forth at the Justice Department, banks had to get more loans into minority groups, and the easiest way to do that was to lend with no money down based on the incorrect, but widely held assumption that housing prices, in aggregate, would not go down. Regulators were encouraging this, so to the degree there would have been 'more regulation', it would have only been worse.

In part, the prevalence of this narrative reflects the principle enunciated by Upton Sinclair: “It is difficult to get a man to understand something when his salary depends on his not understanding it.”

To Krugman, it's all about good guys and bad guys. He and his ilk are good guys, who are for helping humanity, seek what is true. Those who disagree with him are selfishly motivated (unlike, say, union members or bureaucrats), or plain stupid.

But he's really smart! He has a Nobel prize!

Samuelson RIP

Paul Samuelson died last weekend, and its a fitting time to assess his economic output. People I knew who knew him never failed to note his great intelligence, which was probably off the IQ charts. Given that cleverness is probably the most important quality of an economist-respected economist, his prominence is mainly a 'he's *SMART*' response everyone has when discussing his work.

Samuelson was an economist's economist, publishing almost a paper a month in his prime. His papers were rigorous, and often invoked obscure theorems as if everyone knew them. His Foundations of Economic Analysis laid down the rigorous methodology, showing how economics can be fruitfully studied as the solution to maximization problems explicitly employing differential and integral calculus: equilibrium based on the solution to maximizing agents. Little remembered was he also stressed a 'correspondence principle', so that equilibria needed a certain degree of robustness, stability, to be important. This property was later basically ignored. He gave us our first understanding of how randomness is consistent with ration expectations, overlapping generations model, revealed preference theory, and several other major tools in the economic modeling toolkit.

But the best way to evaluate Samuelson's thinking on economics is to look at the evolution of his Principles text, which dominated the field for 30 years. He built up what was to become orthodox Keynesianism: that Government spending was basically the same as Investment (in that old C+I+G), in that both added to the capital stock. Via the Multiplier, Government spending magically created 3 times its spending in output. This implied that expenditures were almost always a free lunch. He focused on the Paradox of Thrift, the idea that economies tend to save too much, retarding growth, and necessitating government deficit spending when below full employment (which is always the case in real time). He believed private enterprise is afflicted with periodic acute and chronic cycles in unemployment, output and prices, which government had a responsibility to alleviate. "The private economy is not unlike a machine without an effective steering wheel or governor," Samuelson wrote. "Compensatory fiscal policy tries to introduce such a governor or thermostatic control device" (Principles, 1948)

Samuelson generally thought taxes were innocuous at worst, but often morally just, and productive. Several editions displayed a chart showing that poor, underdeveloped countries had a tendency to tax less, relative to national product, suggesting causation (Principles, 1958). He thought the Laffer-curve was incorrect, and that greater progressivity to taxes would not only stimulate the economy directly (because the rich consumer less than the poor at the margin), but taxes might actually make some people "work harder in order to make their million."

He emphasized market failure as endemic to capitalist systems, including imperfect competition, externalities, inequities, monopoly power and public goods. Samuelson pointed out that the government could take of "an almost infinite variety of roles in response to the flaws in the market mechanism" Explanations of market failure deserve a counterbalancing discussion of government failures, which are not difficult to document, but this was not considered very important to Samuelson, relatively.

Just before the fall of communism in the thirteenth edition (1989), Samuelson and Nordhaus declared, "the Soviet economy is proof that, contrary to what many skeptics had earlier believed, a socialist command economy can function and even thrive." Six years later in the fifteenth edition (1995) they noted that Soviet Communism was a "failed model". He did not have much to say about the free market success stories, from West Germany's post war recovery, or the success of countries Korea, Singapore, Taiwan, Indonesia, Malaysia and Thailand. If it couldn't be traced to a government program, it wasn't that interesting.

He made market perfection the enemy of the good, ignoring the government failures Public housing, international aid, Africa, India, the lowered labor participation of African Americans, higher levels of debt, the destructive effects of unions on the US steel and auto industries, all irrelevant, relative to various market failures. His students include Krugman and Stiglitz, who clearly were influenced by Samuelson's natural skepticism of the market.

But, he had good faith, and was a disciplined, honest, and thoughtful person. He avoided engaging in the ad hominem and bad faith assumptions that are so common in Krugman and Stiglitz's op-eds (Samuelson wrote op-eds for Newsweek for a long time). Yet, he was wrong about the biggest issues in his main area of expertise. To me, this highlights that the really important truths in life aren't black and white truths you can discern through sufficient effort and intelligence. It's like giving a random person a big computer with a googleplex of RAM, CPU, and access to the internet: that person will not become productive with a high probability. Getting right answers seems based on some pre-deliberative assumptions, prejudices, and there I think his intuitions led him astray. Rest in peace.

Are Generalizations Useful?

William Blake noted that "To generalize is to be an idiot. To particularize alone is a distinction of merit." Journalism is primarily about anecdotes, witness the Malcom Gladwell phenomenon.

Robin Hanson recently posted an interesting blog post on women using sex as a bargaining chip in marriages. Midge Decter (wife of Norman Podhoretz) noted this in her autobiography, that a woman's main power over men was that they needed sex less than men did, and this actually countered their disadvantage in earnings and strength quite effectively.

Yet, there seemed many feminists unhappy with Hanson's cynical evaluation of male-female relationships. One commenter (a 'sex activist') noted that

it would be nice to see some recognition that women sometimes don’t get as much sex as (or the kind of sex that) they want out of long-term relationships. And that there are men who have considerably more complex experiences of sexuality than you seem to acknowledge here.

So, Robin noted a generalization (women have a propensity to do X more than men), and some women got hysterical (heh) about the insight. Let's be clear. A stereotype is that all A are A. These are generally untrue, because there are exceptions to most assertions (eg, 'men are taller than women'). But generalizations are true and useful. It is useful to know that walking in a dark alley containing a bunch of young men is dangerous for a young woman. Not that all such situations mean bad things will happen, but the odds imply it is not a good idea.

Most things come down to probabilities, and learning to slant them in your favor is part of an intelligent life. For those who think only deterministic relations are interesting, or known facts about individuals, I just can't empathize. I find it a childish view of life. Not that anecdotes and biographies aren't interesting, but they are primarily interesting as how they are relevant to everyone's story, or a metaphor for something larger.

Mainstream Media Mission Statement Highlights Bad Faith

An editorial was published Dec. 7 by 56 newspapers around the world in 20 languages. The text was drafted by a London Guardian team during more than a month of consultations with editors from more than 20 of the papers involved.

Unless we combine to take decisive action, climate change will ravage our planet, and with it our prosperity and security. The dangers have been becoming apparent for a generation. Now the facts have started to speak: Eleven of the past 14 years have been the warmest on record, the Arctic ice cap is melting and last year’s inflamed oil and food prices provide a foretaste of future havoc.

So, higher oil prices, and the havoc caused by that, is what we want to avoid?

Consider that a Pigovian Tax is a tax applied directly to fossil fuels, intended to cover the 'externalities' in the costs of producing carbon not born by, say, a mining company that extracts the coal. It would introduced by Keynes' mentor Pigou as a way to efficiently deal with externalities like pollution, and Greg Mankiw explains its motivation here). It is liked by economists because it puts the cost of the carbon right on the carbon, making its costs focused on the source, and not spread around. It is the least distortionary method of getting people to burn less carbon: raise its price, people will substitute alternatives (wind, nuclear, sweaters). Cap and Trade is less efficient than a Pigovian tax, and all sorts of targeted taxes and subsidies less so than that (even Paul 'I'm Mad as Hell' Krugman agrees). Raising oil prices is the least distortionary solution to any effort to lower carbon burning.

So, what they highlight as an undesirable effect of Global Warming is a lower bound cost as to what would go into any solution being considered. I have a feeling the Global Warming crowd knows what they want, and are just trying to present anything motivation to get us to agree to their proposals, regardless of how inconsistent their reasoning.

Government Spending to the Rescue

Congress passed a $700B bill to save our financial system last year. Alas, they can't seem to spend it, as banks would rather not have the funds than have the government as a partner. Of course, that just means the government will spend it elsewhere, because as economist Brad DeLong states, "At this point, anything that boosts the government's deficit over the next two years passes the benefit-cost test--anything at all." So Obama now Says TARP Funds Can Go Toward Cutting Deficit, Creating Jobs.

It's a shame so many think that government creates jobs. Sure, there is a level of overhead necessary in an economy, providing us with courts, roads, etc., but to think at our current levels of government, that deficit spending is a net positive is simply naive, and if it worked, Japan wouldn't have stagnated in the 1990's, and the ballooning government deficits of Western countries in the 1970's wouldn't have brought the great productivity slowdown that started around 1973.

Consider this boondoggle, spun charitably by my local public radio station:

A weatherization lab and entire energy efficient house at the school are used to teach a variety of weatherization techniques.

West said more than 130 people have been through Summit's new weatherization program. But just a couple dozen have landed jobs.

Abe Hassan, who runs a stimulus-funded weatherization training program targeting minorities in East St. Paul tells a similar story.

Hassan said 19 people graduated from his training program recently at Merrick Community Services but none of his students have found jobs using those skills.

$130 million over 2 years is geared towards green jobs, conflated with an extra minority objective. Very few real jobs--jobs that are from customers paying for services or products-- are created, but everyone can feel good about trying to help the environment, and persons of color. The boom field appears to be in green jobs minority training.

Peer Review All About Politics

With the Global Warming debate, 'peer review' is mentioned as the essence of objective science. Yet the Shannon Love makes an interesting point. Peer review is basically a mechanism to avoid a certain kind of politics, not to evaluate a paper's value.

It is not a journal’s responsibility to confirm or refute experimental conclusions, but it is their responsibility to check for basic errors in math or methodology, just as they would check for errors in grammar or spelling. Peer review offloads any responsibility for publishing bad papers onto anonymous members of the scientific community. It’s a perfect form of blame passing that everyone else wishes they could use.

This blame passing also keeps journals and editors from being accused of taking sides in personal and professional quarrels. It is also the reason that reviewers themselves prefer to remain anonymous. No scientist wants to suffer the professional and personal consequences from either refusing or accepting a paper they should not have refused or accepted. It is also why peer review is a superficial review. The reviewers do not wish to be dragged into the minutia of scientific debates and quarrels. Instead, they concentrate on the basics that everyone can agree on.

So, to avoid the politics in choosing which papers are worthy, the anonymous peer review allows an editor to reject papers without having everyone hate him. Peer reviewers correct obvious errors, and make recommendations about the usefulness of a paper. The former point is objective and straightforward, but note this does not involve checking the raw data for fraud, or replicating an algorithm. I've refereed many papers, and I never independently tried to replicate their results with their algorithm and data. If they faked their data subtly, only posterity would punish them, not a referee.

But a referee also crucially opines on a paper's usefulness, and this involves guessing what other people would like to reference. Most models do not have straightforward empirical implications, so this is often an assessment of which toolkit is considered cutting edge. Economics often builds huge Rube Goldberg machines that potentially are useful, which are never refuted, but rather, fade away as the professors who made their reputations on these models retire, and the new generation sees that they are quite useless.

Input-output models, large scale macroeconomic models, second order difference equations modeling the GDP. These were all considered the apex of 'good form', and so any results in these frameworks, if sufficiently rigorous, were published. If you submitted a paper today using these frameworks, you would get rejected out of hand because they are no longer considered useful. But that came through long experience, and not any definitive rejection. Even today, some results based on dynamic programming, and using vector autoregressions, are published merely for getting a result, not an interesting one, because the technique is difficult, rigorous, and takes economics a leap equivalent to the leap from astrology to astronomy. Who says economists don't work on faith?

This is an example how something can be peer reviewed, and not even wrong.

Two Cheers for Lower Mortality

n Arnold Kling and Nick Schultz's From Poverty to Prosperity, they highlight the many ways life has become much wealthier, easier, better, than 100 years ago. A signature fact is that life expectancy has increased 25 years in the US over the past 250 years, and these stats are significant in Robert Fogel's nifty book The Escape from Hunger and Premature Death, 1700-2100. Mortality stats are often given as prima facia evidence of a better life.

But, there is a downside. As mortality has gone down the preoccupation with death has gone up. Personally, I have experienced a small number of deaths, none of them of young people, as is typical. This leads to an unfamiliarity, and so it becomes scarier. The bestseller, Tuesday's with Morrie was supposedly all about how a learned man's dying was really about teaching a young Mich Albom how to live. I read it as a pathetic screed against dying, thinly masked against this hysterical objective. We have come a long way since Roman times, when defeated generals would regularly kill themselves in defeat, and a fallen gladiator would always present his throat to his adversary, accepting death (he was usually spared, however).

Death is so rare we think it unnatural, but it is necessarily as natural as being born. Given it is so uncommon and we generally don't believe in an afterlife, our fear of death is probably greater than it has ever been. Fear of death causes us to increase suffering to avoid death at all costs creating a further fear, the fear of the pre-death slide.

There's a neat scene in Marley and Me, where the old dog leaves the family because he knows he is going to die. The old dog knows how to die. One does one's best, and when the body gives, resign and accept this fact of life. Recently, an acquaintance noted his father was getting frail, and he and his siblings decided to force the widower into into a nursing home for his own good. After they informed him of their decision, and how it was in his best interest, he said, 'let me say goodbye to Billy', his pet goat. He then shot himself in his barn. This was seen by his pastor as a shameful end, but I think it rather stoic.

In our secular age, we think living is everything, and so doing everything to stop it is a good thing, but it's not. Regardless of motivation, facing death with equanimity is a sign of courage and wisdom, because it's hard to enjoy the present knowing you are going to be scared shitless with certainty in the future.

I don't want to die, but I also don't want to fear death, because via backward induction, it would imply I feel fear all the time. It's like competition: hating losing, but don't fear it; in this case, hate death but don't fear it. It is not the worst of all things.

Parasite or Predator, still Selfish

There's an interesting exchange over at Bloggingheads.tv, about group selection. You see, evolution happens at many levels, such as the gene level as when the sickle cell gene grows in malarial environments. The mere gene view is the 'selfish gene' process introduced in contrast to naive group selectionism, which in the 1960s was based on the idea that 'what is good for the group is good for the individual'. However, Richard Dawkins was far too dismissive of non gene-centered selection, as it is now recognized that organizations higher than the gene—the organism, the tribe, the species—sometimes compete evolutionarily, as when grey squirrels drive red squirrel populations to zero when they have overlapping boundaries.

Anyway, Razib Kahn asks David Sloan Wilson about scientific allegations that certain groups (notably, the Jews) are parasites, and Wilson notes that ecologically you can group people into two groups: predators and parasites. A predator takes advantage of the smaller population, a parasite takes advantage of a larger population, but, they do the same thing. Thus, it isn't any different to assert some group is acting parasitic any more than it is to assert some group is acting predatory. If all groups are selfish acting in their own interest just has a different name depending on its numbers.

I'm if anything a Semitophile, so if you're a visitor, don't infer I'm trying to justify anti-Semitism. However, I think it's reasonable to look at human groups historically and call various strategies as parasitic or predatory. Indeed, given the zeitgeist strongly discourages allegations of parasitism because this is considered piling on minority groups, discouraging diversity, etc., it is probable that parasitic behavior is more common, because it doesn't have to withstand criticisms of parasitism the way majority groups have to withstand the negative PR of predation. For example, note that Noam Chomsky basically defines evil as bad behavior combined with total power, thus making the US the monster of the twentieth century as a consequence of the size of its economy (and, in his mind, the relative virtue of the weak Palestinians vs. the stronger Israelis). It's reasonable to assume majority groups will have more problems exploiting minority groups (predation) than minority groups will have exploiting majority groups (parasitism).

Important, but Uninteresting

Over on Bloggingheads, they are talking about Elizabeth Whalen's 8000 word article on he rather ordinary, happy marriage, in the upcoming New York Times Magazine. Ann Althouse makes this interesting point:

Is writing about an ordinary marriage, an interesting writing project? It may be a wonderful experience to have, but so is sleeping all night, and there's nothing to write.

So true. Reading the news it's good to remember that item frequencies are not proportional to the importance in our everyday lives. As someone once said: 'Literature is mostly about sex and a little about having children. Life is the other way around.'

Science in Practice

A sad note that in every field, protocol is a prerequisite to substance. A paper not only needs to have a new point, but it must do so in a way that patronizes the methodology they all have uniquely mastered. A scientist is generally not someone who simply knows a lot about 'x', but also knows how his status tribe discuss such ideas. Whether its post modern philosophy or economic dynamics, the key is the methodology, because that is what defines who is relevant, because someone with good ideas, but who does not use your method, potentially trashes your human capital (eg, you mean my understanding of the difference between Brouwers' and Kakutani's fixed point theorems was wasted?).

Of course, scientists will deny this, say that while they know some others who act this way, they themselves just care about truth, the scientific method, prediction, etc. It's true to some degree these attributes define what persists, and in that sense, is operative. But to get published, you need to play the game.

From the Chronicle of Higher Education, David Hakes, an economics professor at Northern Iowa, shares this anecdote:

When we submitted the paper to risk, uncertainty, and insurance journals, the referees responded that the results were self-evident. After some degree of frustration, my coauthor suggested that the problem with the paper might be that we had made the argument too easy to follow, and thus referees and editors were not sufficiently impressed. He said that he could make the paper more impressive by generalizing the model. While making the same point as the original paper, the new paper would be more mathematically elegant, and it would become absolutely impenetrable to most readers. The resulting paper had fifteen equations, two propositions and proofs, dozens of additional mathematical expressions, and a mathematical appendix containing nineteen equations and even more mathematical expressions. I personally could no longer understand the paper and I could not possibly present the paper alone.

The paper was published in the first journal to which we submitted.

The Univ of Minnesota Loves Diversity

The University of Minnesota has a new booklet out articulating how much they love diversity. How much? They say "diversity" 230 times in 18 pages. As a local journalist noted about a different program at the U:

aspiring teachers there must repudiate the notion of "the American Dream" in order to obtain the recommendation for licensure required by the Minnesota Board of Teaching. Instead, teacher candidates must embrace -- and be prepared to teach our state's kids -- the task force's own vision of America as an oppressive hellhole: racist, sexist and homophobic.

It seems like the essence of a higher education is diversity, not of thought, but of human subgroups based on ethnicity, religion, race, and sex.

Tolerance of diversity is has morphed into celebration, and in the process took something salutary and turned into something destructive. Some think diversity encourages the active and complex kind of thinking because it puts students in uncomfortable situations, but diversity is usually the most scripted and routine parts of their education, because for decades now, the diversity agenda has taught them all the safe answers to their smarmy questions.

Equating group disparities with racism on the part of the more successful group guarantees mutual resentment. As overt discrimination fades, still large racial disparities in success leads African Americans to conclude that racism is not only pervasive but also insidious because it is so unobservable and unconscious. Whites resent that nonfalsifiable accusation and the demands to feel guilty, if not directly compensate, African Americans for harm they do not believe they caused.

Once we encountered the world’s diversity with prejudice, disgust, erotic excitement, pity-—but also curiosity. Now we look at it incoherently, as both vastly important (in explaining inequality) and utterly irrelevant (in explaining fundamental differences between races). Such nonsense quickly instills in one an incurious attitude towards diversity in order to avoid offense and nonsense. Ask a professor why black sprinters dominate the 100 meters, and you'll often here something silly and a quick change of the topic. Ask that same professor why blacks have lower socioeconomic status in the West, and you'll hear a confident exposition on institutional racism. Smart people learn to just avoid the subject.

The diversity mantra implies class membership trumps individual character in determining moral standing. It should be no surprise that this belief has failed to improve the lot of those regarded as oppressed. It inverts Martin Luther King's call to judge people by the content of their character, and in the process creates a greater divide.