Dairy Beats Meat

An interesting fact in Cochran and Hapending's 10,000 Year Explosion, is that raising cattle for milk, as opposed to meat, generates 5 times the calories for a set amount of land. Thus, the milk raising people were able to outbreed, and eventually overwhelm, those whose cultures did not raise cattle for milk. The interesting point is that this is a strange form of genocide, because a lactose intolerant group could not simply adopt dairy farming, because without the lactose tolerant gene, it would be useless (and uncomfortable). Eventually, groups battle, and the numbers of the lactose tolerant simply overwhelms the lactose intolerant. Culture and genes are linked, because with the lactose tolerant genes you can't have a dairy culture, and without a dairy culture, you can't select for lactose tolerance.

I love a tall glass of milk, any time of the day. I still remember that on steak day my most mostly Jewish frat brothers would look in disgust as I drank milk with my steak. It wasn't the Talmudic restrictions that bothered them, rather, they found the combination repulsive, like eating chocolate covered potato chips.

Inconsistent Blurbers

As a separate issue, I noted Bhide's book has a blurb by uber-blurber Lawrence Summers:

Bhidé provides a fresh and reassuring perspective on America’s technological position in an increasingly global economy. Anyone interested in our economic future and especially our technology policies should read this book.
~Larry Summers

In Prophet of Innovation: Joseph Schumpeter and Creative Destruction, Thomas K. McCraw quotes Larry Summers saying that 'if Keynes was the most important economist of the 20th century, then Schumpeter may well be the most important of the 21st.' I don't see how both views can be considered so important. Emphasis is everything, and they point in very different directions.

You can admire works that are directly in contrast because they make good cases for their contradictory points. You might appreciate Barro and Krugman's take on the stimulus package because they are clear expositions of conflicting arguments. Yet that interpretation is probably too generous for your average conflicting blurb (as when Peter Bernstein, author of hagiographies of the founders of the Modern Portfolio Theory, writes a blurb for Taleb's Black Swan, which argues such ideas are worse than useless). A lot of public praise seems to reflect Oscar Wilde's observation that 'One can always be kind to people about whom one cares nothing'.

Bhide's Entrepreneurs

A neat book by Amar Bhide called The Venturesome Economy is about innovation quite different than that of the classic view given by Joseph Schumpeter. It's an important argument, well worth reading, because if he's right, we need fewer engineers, and more B-Schoolers.

Bhide emphasizes not the courage or genius of the entrepreneur, but rather the unintended effects of all the various forms of knowledge generated by the massively multiplayer innovation game that sustains economic growth. These mid level innovations do not show up in patent counts, and individually they are small steps, but they add up, especially because there is so much unsung innovation across the American economy. Bhide emphasizes the mundane innovations from many people making prosaic modifications to the status quo. Think of Wal-Mart's innovations in logistics, Apple's in design, or Proctor & Gamble in marketing. Hardly something to get excited about, but these are the engine for prosperity. He also highlights the importance of consumers taking risks when they buy, say, a new computer or software, as these risks have similar return characteristics as investments, and are essential for generating feedback to the producers. Innovation guru Joseph Schumpeter, in contrast, emphasized the entrepreneur (think Henry Ford), making it seem that we need to incent Unternehmergeist (entrepreneur-spirit) for specific technologies or companies.

Innovation is not so much from trade secrets that are regionally clustered, or deep ideas like the transistors, but rather from the willingness and ability of people to develop these ideas and technologies into products. Apple's successful iPod mainly came from technology outside the US as opposed to anything local in Silicon Valley, and was based on their great marketing and design expertise. Thus, maybe all those arrogant MBA's, who couldn't take the derivative of x² if they had access to their college math texts, and got B's for showing up, are really the key to our economy? Clearly, if true, the first implication is there is no God.

Emphasis is everything and if the Bhide interpretation is correct, Schumpeter's books seem much less important. Schumpter emphasizes brilliance, great men and great companies, whereas Bhide emphasizes the effect of a system where outliers are not so important.

Unfortunately, Bhide does not highlight exactly what kinds of policies, laws, morals, etc., are necessary or sufficient to generate a robust amount of mid level and consumer entrepreneurship. Thus, he does a nice job of convincing us that this is where the key to productivity lies, but is rather vague of why it occurs more in some places than others. For example, he suggests emphasizing the service sector more, in contrast to technologies, noting that Wal-Mart type productivity is one of the US's true strengths. But when he discusses this application to US health care, he seems without a clue as to why the innovative and productive US service sector fails so massively in that one area. It's a bit like a great book on psychology where at the end, the author suggests we watch more sunsets or look into our heart, advice that is boring or useless. True wisdom should lead to better practices, not merely a good read.

Geithner's Stress Test Revealed

The crack team at the Treasury, headed by veteran enterprise-wide capital allocations specialist Tim Geithner, revealed their stress test. The following scenarios are modeled:

The stress test assumes an unemployment rate averaging 8.9% in 2009 and 10.3% in 2010, a 3.3% contraction in gross domestic product in 2009 and home-price declines of another 22% in 2009 and 7% in 2010.

They then merely see how the various bank exposures are affected by these assumptions, including their ability to raise new capital, and 'other risks that are not fully captured in regulatory capital calculations.'

Well, that sounds reasonable if I didn't know anything about banks, but alas, you only fully realize The Experts are usually talking out of their backsides when you hear one talk about something near and dear to you, and note they have not a clue what they are talking about. Then, an epiphany: perhaps it's the same when experts discuss the Gaza strip, health care, everything? In my twenties I felt I didn't understand anything. Now I realize the experts don't know much about their expertise, so it's nothing to get too worked up about. Geithner is an expert in the Robert Rubin sense, who wasn't concerned with things like Citi's asset composition, but knows about getting access to the big politicos that affect essential regulation (isn't that what managing a bank is all about?).

Banks do not have an asset labeled GDP, Unemployment, or Homes. They merely have assets with various uncertain correlations to these factors. Some correlations are truly causations, as in mortgages and home prices, but even there, the connection between one and the other is very complicated, depending a multitude of characteristics in addition to these assumptions (vintage of the loan, its Loan-to-value, the credit score, income and wealth of the borrower). In other cases, such as looking at loans to shipbuilders, the connection is far removed.

If you think finding correlations between asset prices and basic assumptions is easy, consider that Peter Schiff, someone pounding the table that home prices were overvalued because of reckless underwriting standards. His portfolios actually performed horribly last year, because he assumed that this assumption implied a weaker dollar and the US equity market would underperform. You can be totally right on assumptions, but the complexity of the economy renders that insight irrelevant.

Or consider that business cycle forecasting is so fruitless because the particular drivers of each recession are different. The Stock-Watson leading economic indicators model failed to predict the 1990–1991 recession, and an updated version of the model (one that would have caught the 1990 recession) then failed to predict the 2001 recession.

Stock and Watson discuss this failure and argue that it is hard to predict recessions because each is caused by a unique set of factors. For instance, housing and durable goods consumption was strong preceding and throughout the 2001 recession, because the decline was focused on high technology manufacturing. By contrast, in the 1990–1991 recessions, housing and durable goods spending slowed considerably. As Stock and Watson say, “Without knowing these shocks in advance, it is unclear how a forecaster would have decided in 1999 which of the many promising leading indicators would perform well over the next few years and which would not.” Thus, note the stress test primarily involves housing, because that has fallen the most in the past couple of years. Three years ago, it probably would have included a big decline in internet stocks, whereas in 1980 an inflation or oil shock. One wonders what kind of trouble such thinking can lead to, this extreme reliance on the past couple years in forecasting the next couple years...

So, assuming you know where a few pieces of a complex economy are going is a very thin basis for any meaningful stress test. What are the implications for things like one's small business credit lines, credit cards, or airline leases? If you are using real data, you will probably have only 3 recessions at most in your historical analysis, and chances are, the coefficients on many asset classes will be insignificant, but all will be highly uncertain. Just yesterday, I was remarking on an article that blamed the subprime crisis in large part on people assigning too much credence in uncertain correlations. The correlations in a copula are infinitely more precise than any correlation with GDP, Housing prices, and Unemployment. Thus, the results of this exercise is so imprecise it can hardly be the basis for any action. Hopefully, the Treasury shrewdly recognizes this and are actually targeting a placebo effect.

People have to realize that banks are not portfolios of market traded bonds, with lots of data that make for some sort of fat-tail adjusted Value-at-Risk, or beta, meaningful at the bank holding company level. Further, most banks are not investment banks. A standard bank has most of its book not marked to market, its loans highly illiquid, and the best data one has is limited, multidimensional, noisy, has selection biases, and refers to a market with changing parameters (see mortgage underwriting innovations in the 1990's).

Geithner noted he will wrap this up by April. Given the absurdity of this exercise, they should shoot for Friday and save everyone a lot of time. It won't be any more accurate by taking two months.

Increasing Unemployment Insurance is also a Bad Idea

In various debates, the FreeMarketer eventually faces the question "If you don't like Obama's plan, what are you going to do?" The cowed quasi-libertarian then notes her affinity for increases to unemployment insurance, because it seems rather non controversial.

Unfortunately, it is not obvious unemployment insurance is a good thing, and the question reflects two flawed assumptions. First, that attempting to help generally helps. Second, that the situation will not improve without top down policies from Washington. Even Marx stated we should not judge policies based on their intentions, and the batting average for government relief programs is well below the Mendoza line. As per the situation not improving, since the Industrial Revolution began that has been the case. Japan's lost decade, meanwhile, was rife with Keynesian stimulus packages, and they now have trains going everywhere to prove it.

In 2008, unemployment insurance duration was increased 50%, from 26 weeks to 39 weeks. Now, Obama wants to expand state unemployment benefits to part-time workers and others who where previously ineligible to receive the funding, increase the benefits, and increase their duration further.

One iron-clad rule of economics is that whenever you subsidize something you get more of it, so increasing unemployment benefits increases the amount of unemployment. There really is not another side to this, as in the more well-known minimum wage debate.

For example, Bruce Meyer ("Unemployment insurance and Unemployment Spells") found that higher benefits reduce the probability that insured unemployed workers will leave unemployment. He did this by measuring the probability is measured as a ratio of newly employed workers at the end of the week to those unemployed at the beginning of the week. He finds a 10% increase in the benefits decreases this probability by 5.3%. A paper by Stephen Nickell found that looking at US and Europe from 1983-96, those 8 out of 15 countries with an unemployment rate 120% of the US had relatively generous unemployment benefits. He notes that generous unemployment benefits decreases the willingness of the unemployed to find employment, and increasing the duration of the entitlement increases long-term unemployment. In sum, raise unemployment benefits, expect a higher unemployment rate.

Everything has costs and benefits. The benefits of increasing unemployment insurance is the increased income of those getting more benefits, and--though this is highly cynical--that those supporting such transfers win status or votes by signaling their compassion through their willingness to support redistribution (it is easy to win votes when a disproportionate amount of the wealth comes from a minority). The costs are delaying the millions of individual transitions needed in the economy, because recessions basically inform us that we need fewer people in some fields and companies and more in others. What should the unemployed do next? I don't know, and people in Washington don't know either, because it depends on the specific skills of those diverse unemployed individuals and what the market is paying for those skills, data that is not available to our politburo. Only individuals are in the best position to solve this problem, and giving them cash may actually not be in their best interest because it just delays inevitable hard choices.

Don't Blame The Quants, Felix

It would be nice to think that this crisis was a huge math error. Some geek in a cubicle hit the wrong button on his HP12-C. Doh! Alas, it is not the case. Any error this pervasive is not from some obscure assumption, but an assumption that everyone was comfortable with. If an obscure technical assumption drove investors into various bonds, there should be a large group of investors who would have quants who disagreed, and they would have not been exposed. That is, quants may have no common sense, but on obscure technical results, they are smart and often disagree. Yet not one of the major investment banks worldwide escaped this craze. It's as if all the geeks thought the 5th digit of Pi was 6.

The only reason everyone made the mistake was that it was from an assumption that everyone seemed to think was reasonable, something quants did not have the authority to affect: that housing prices would not fall significantly. Look at Shiller's update Irrational Exuberance from 2005, and there's a chapter on the Housing Bubble, where he notes that recent housing price increases 'probably won't continue', hardly a clarion call to avoid housing. When everyone is doing something, and think it's right, the quants will perforce generate supporting documentation. Scientists in that way are like lawyers, advocates, not for a paid client, but rather, the ephemeral verities of the current zeitgeist. With $4B for global warming research, and much less for anti-global warming research, it is no surprise many scientists are documenting various evidence of global warming: people like the results, they aren't as skeptical, more likely to get published, get a grant, get on a government project, etc.

UBS used a 10-day Value-at-Risk on its residential mortgage backed portfolio to assess its risk, using data from the benign 2000-2005 period. This was an error. But UBS was going to invest in mortgages anyway, because presumably this collateral does not decline much if ever, so this was all standard rationalization of preconceived objectives.

Felix Salmon wrote a piece in Wired, where he fingers the copula function as the primary culprit.

And (David) Li's Gaussian copula formula will go down in history as instrumental in causing the unfathomable losses that brought the world financial system to its knees.

He then quotes some quants, like Darrell Duffie, who states that "corporate CDO world relied almost exclusively on this copula-based correlation model". Well, derivatives textbook authors might like to believe that their formulas underlie most financial activity, but I suspect the number of people using copulas in their sales pitch was low, no more than 5%, because most investors, big shots who actually make portfolio decisions, do not like pretentious mathematics. Perfunctory metrics may be ubiquitous, but they are still perfunctory. The decision makers are rich, powerful, kind of smart, do not feel embarrassed by their lack of knowledge in obscure technical trivia, and surely are not intimidated by it. Of that limited set, the copula itself, irrespective of the broader knowledge about mortgages and housing price trends, was probably the driver of 10% of those purchases, because even for investors who like formulas, most require a bigger picture. Thus, I generously estimate about 0.5% of all mortgages were bought because of David Li's Frankenstein formula.

Copulas, value at risk, correlations, credit scores, one might add standard deviations, means, and Microsoft Excel's 'solver'. These concepts can get tricky, but the basic assumption in the mortgage crisis, that housing prices would not fall significantly, was not tricky, and people with the authority to make decisions were not swayed by these technical issues, rather, they used them to validate their earlier beliefs.

Statistical Errors Play into Popular Demand

From A case for Due Diligence in Policy Formation:

In 1993, a team of researchers led by D.W. Dockery and C.A. Pope published a study in he New England Journal of Medicine supposedly showing a statistically significant correlation between atmospheric fine particulate levels and premature mortality in six US cities.

The audit of the HSC data reported no material problems in replicating the original results, though there were a few coding errors. However, their sensitivity analysis showed the risk originally attributed to articles became insignificant when sulphur dioxide was included in the model, and the estimated health effects differed by educational attainment and region, weakening the plausibility of the original findings. The HEI also found that there were simultaneous effects of different pollutants that needed to be included in the analysis to obtain more accurate results.

This is always the case, as empirical errors are mainly parochial issues involved the data, as opposed to whether one used 2 or 3-stage least squares. The authors go over several high-impact studies that were initially well-received and now seen as impossibly flawed: The Boston Fed discrimination study, the Global Warming Hockey stick graph, the Freakonomics Abortion and Crime study, the Bellesiles documentation that early Americans rarely owned guns, and others.

Doing complex problem sets with nuances that are really abstract helps you know the basics, yet at the end of it all the useful tools of analysis are all covered in undergraduate statistics. It takes years of study to really understand it, as I remember not really understanding basic probability and statistics until I TA'd the course three times in graduate school. They key is controlling for relevant omitted variables, knowing whether the relevant variability is over time or within a time period, how the errors are distributed, and other prosaic issues.

Academics are really good at proofs, refinements of cutting edge applications, but these are generally pretty irrelevant to any practical issue. The important insights in data come from understanding the data. In every case, the problem studies had one key commonality: they were results people wanted to believe. When people publish results consistent with intuition, especially when it is done in an academic way by making abstruse second order adjustments to coefficients and standard errors, this gives any piece sufficient superficial rigor so that you can then say to your critics: "if you do not understand instrumental variables (say), then you cannot criticize this study!" People love using these kinds of papers to buttress their pet policies, and thus they become popular.

Consider the study put out by four economists led by Paola Sapienza and Luigi Zingales in economics that supposedly proved the sex gap in mathematical abilities disappears when everyone embraces women's emancipation. In other words, The Man is at fault, as usual, for observed human biodiversity, a prized academic result (the Dean may show up at your seminar!). An anonymous blogger, La Grifffe du Lion, demolishes this and related studies by adjusting for the following facts:

1. the math gap mainly occurs only after the onset of puberty


2. simple proficiency tests do not measure ability relevant to explaining the proportion of engineers and top scientists, who are all highly proficient at mathematics


3. the means are not as important as the relative variances of the distributions when comparing the proportion of groups in extremums


4. higher IQ countries implies the level of 'proficiency' is less of an extreme tail cutoff, which lower group differences.

These corrections are not purely statistical, rather, they come from understanding the issue (eg, that gender differences appear only after hormones start diverging). It comes from understanding the phenomenon in question, as opposed to some abstract second-order statistical tweak.

The best way to succeed in academics is to assess what the zeitgeist currently wants documented, and give it to them in a long article with lots of abstruse mathematics. By the time someone says, "you assumed unobserved credit scores of the applications is uncorrelated with race", well, by then you have tenure and can call such criticisms hair splitting (though, conspicuously, you never publish on that subject again). Indeed, Liebowitz's rebuttal of Munnell's Boston Fed study is not great econometrics, and so Munnell was published in the AER, Liebowitz in the Journal of Obscure Economics, yet Liebowitz was right and Munnel wrong. But the result of Munnell was something many people, including academics, wanted to be true, so they read the conclusion (we can costlessly help poor people!), focused on second-order statistical adjustments but ignored bigger issues like omitted variables, noisy data, and the fact that default rates were, if anything, higher on the group than supposedly is held to a higher credit standard. While some might have noticed the increase in housing prices post 2000, no one was on the warpath saying we need to make current lending criteria more stringent prior to 2007. The cause of this mortgage bubble was something very few people wanted to tackle.

Thus, the problem in the mortgage debacle is not some specific statistical test, an obscure Value-at-Risk assumption buried in a footnote of Jorion's text, but merely an assumption anyone could understand (housing prices do go down, no money down is a very dangerous 'innovation'), yet no one cared about. Investment banks, academics, and regulators considered this scenario irrelevant for a variety of reasons, but most importantly because it was intellectually defensible (mortgage loss rates had not increased since underwriting standards started deteriorating in the early 1990's due to regulatory pressure), and it was something they wanted to believe (if true, it was generated a lot of money and votes for everyone involved). We can now go back and find all the technical errors by Moody's or the Boston Fed study, but anyone who thinks that moving from a 10-day VaR to an annual horizon is missing the deeper point, that the assumptions most dangerous are the one's that are changing due to some new big trend--tax shelter REIT's in the 1980's, new economy companies in the late 1990's--and people applying the old standard find themselves marginalized in the boom, and they become powerless if not jobless at the peak.

Stress Testing Now is a Really Bad Idea

Last week the market stumbled, especially financials. I think a lot of that was because people are afraid of Geithner's potential stress test. Today, I read two eminent people calling for stress testing. First, Andrew G Haldane, Executive Director of Financial Stability at the Bank of England. As Haldane notes:

First, setting the stress scenario. The key elements here are devising a multi-factor risk scenario that is sufficiently extreme to constitute a tail event. Arguably, designing such a scenario is better delegated to the authorities than to individual firms, in part because they ought to be more immune to disaster myopia. In its Financial Stability Report (FSR), the Bank describes such stress scenarios.

What is this stress test in the FSR, I wonder? I check it out online, and see that it seems to merely extrapolate losses on mortgages and corporate bonds. Now, with mortgages one can estimate based on the recent past, but with all of the mortgage proposals out there, this is all a huge guess, because they have the potential to make the current situation much worse via giving mortgage holders the incentive to default and then apply for federal aid. After all, a $1000 bounty is being proposed for such restructurings, in which case a new wave of mortgage defaults will occur as people rush to fit into the Feds new guidelines for restructuring. As to the corporate default rate extrapolations, there aren't any good aggregate corporate default rate models. I was at Moody's, and the model is pretty bad, merely because you really do not have a lot of data, and its basically like business cycle forecasting, which has thus far failed to anticipate every major economic event since Moses (not that they are stupid, it's a hard problem). Speculative default rates peaked in 1970, 1990, and 2002 at around 9%, so I would simply stick with that (it was 15% in 1933, however), though this is not mentioned in the report so I don't know what they are using. As per the investment grade default rate, those peak around 0.4% since the Great Depression. But is not clear the potential stress test would differentiate between speculative and investment grade loans. A distinction with a difference, one of many in this issue.

But this is a small part of many bank's portfolios. At KeyCorp, where I was head of capital allocations, most of our exposure was to consumer credit, and non-rated corporate debt, and the fluctuations there were milder, historically. What stress will you apply there? If they apply the speculative or mortgage default stress to these books, I imagine most banks are insolvent, but what does that prove? If a sector of the financial system is experiencing the one in 100 year flood, do you then assume every sector has the same 1 in 100 year flood simultaneously? Haldane does not specify this important issue. And many thought the invasion of Iraq was poorly planned.

Nouriel Roubini and Mathew Richardson are for instant stress tests to determine which banks live:

First -- and this is by far the toughest step -- determine which banks are insolvent. Geithner's stress test would be helpful here. The government should start with the big banks that have outside debt, and it should determine which are solvent and which aren't in one fell swoop, to avoid panic.

No details on the stress test are given. I presume he figures a 'stress test' is pretty straightforward. It is not. Any quick, nationwide stress test will be arbitrary. Regulators do not have a lot of experiencing assessing economic risk capital to 'good' assets. Historically, they merely check leverage ratios (tier 1, tier 2, total), and then make sure various level of bad loans are in their proper buckets (OAEM, Substandard, Doubtful, Loss).

So, a test might be something like, assume all assets can lose 10% of their value. This necessarily penalizes banks with lots of high quality assets, because it treats BB rated bonds like AAA rated bonds, and even with the recent surprises, one should not assume every liability has the same probability of going into default. A stress test should apply the stress based on their historical loss rates, looking at the institution and industry-wide data, but that would generate a large amount of differentiation and complexity, and this would generate a lot of haggling over important, real, differences of opinion, and sheer politics as some use legitimate issues as cover for naked opportunism. It is inherently complicated, and even though we would like a solution quickly, it is counterproductive to attempt a quick solution in this situation.

Now, doing this quickly would stop the contagion issue, but only by being arbitrary. I would take my chances with contagion vs. randomly culling the herd via some poorly thought-out stress test.


And who are these guys? Dr. Doom, Nouriel Roubini, is a man who always sees disaster looming (that picture is from his own homepage, I guess it's his cheeriest photo). He forecasts disaster perpetually from an infinite number of sources, and his mechanism hardly relied on the mortgage sector ex ante, so I think it's safe to say he is just a broken permabear clock who now has the correct time. Andrew Haldane, in his speech, critiques the financial community for missing the crisis, but since 2005, he headed the Bank of England's Systemic Risk Assessment work, responsible for the Bank’s new quantitative risk assessment framework and its six-monthly Financial Stability Report. I do not see why he exempts himself from this failure, or why he feels confident that an instant bank decimation scheme based on his trenchant understanding of the financial sector is better than simply leaving the patient alone.

There's a lot of talk about hubris driving this crisis. I think the hubris of these schemes is at least on that level. Just remember, no matter how bad things are, they can always get worse, and when dealing the the collapse of complex systems no one fully understands, attempting a quick fix is almost certainly going to make things worse.

Vaclav Klaus Rules!

At a meeting with European Parliament, Czech president Vaclav Klaus made the following observation:

Klaus said that the economic downturns are like a flu: if you don't cure it, it takes 7 days. If you do, it takes a week. He was also surprised that Bastiat's famous fictitious petition from the 19th century - a request by candle producers who wanted to be protected by the government against an unfairly advantaged competitor, the Sun - became real in the EU's decision from November 2008 to add 60% tariffs on Chinese candles.

That is, in contrast to Americans, he understands that doing something is not necessarily better than doing nothing.

How to Boil a Frog

Phil Gramm, on the mortgage crisis, in today's WSJ:

Countrywide Financial Corp. cloaked itself in righteousness and silenced any troubled regulator by being the first mortgage lender to sign a HUD "Declaration of Fair Lending Principles and Practices." Given privileged status by Fannie Mae as a reward for "the most flexible underwriting criteria," it became the world's largest mortgage lender -- until it became the first major casualty of the financial crisis.

The 1992 Housing Bill set quotas or "targets" that Fannie and Freddie were to achieve in meeting the housing needs of low- and moderate-income Americans. In 1995 HUD raised the primary quota for low- and moderate-income housing loans from the 30% set by Congress in 1992 to 40% in 1996 and to 42% in 1997.

By the time the housing market collapsed, Fannie and Freddie faced three quotas. The first was for mortgages to individuals with below-average income, set at 56% of their overall mortgage holdings. The second targeted families with incomes at or below 60% of area median income, set at 27% of their holdings. The third targeted geographic areas deemed to be underserved, set at 35%.

The results? In 1994, 4.5% of the mortgage market was subprime and 31% of those subprime loans were securitized. By 2006, 20.1% of the entire mortgage market was subprime and 81% of those loans were securitized. The Congressional Budget Office now estimates that GSE losses will cost $240 billion in fiscal year 2009. If this crisis proves nothing else, it proves you cannot help people by lending them more money than they can pay back.

Blinded by the experience of the postwar period, where aggregate housing prices had never declined on an annual basis, and using the last 20 years as a measure of the norm, rating agencies and regulators viewed securitized mortgages, even subprime and undocumented Alt-A mortgages, as embodying little risk. It was not that regulators were not empowered; it was that they were not alarmed.

The boiling frog story states that a frog can be boiled alive if the water is heated slowly enough — it is said that if a frog is placed in boiling water, it will jump out, but if it is placed in cold water that is slowly heated, it will never jump out. Alas, this observation is based on some tests done around 1898, and modern attempts to replicate it find the frog actually jumps out of the water before it dies. But the point still stands. Anyway, the decline in underwriting standards was a combination of greed and do-goodism, and without the overarching pretext of helping the disadvantaged, these standards would never have passed the common sense test.

Many say, but these had been going on for a while. True enough, it took 17 years, but I think any speculative bubble has non-monotonic dynamics, as in the classic Minsky cycle where standard investment, changes to finance predicated on asset price increases as opposed to cashflow, to a greater fool objective and then the bust. Similarly, initially the rising collateral inured people to the effects of these changes, and the effects of increasing demand led to the bubble, and eventually the crash. See Stan Liebowitz's video here.

Don't Panic, Inflation will Save Us

It is strange how many people I have heard say: "we should inflate as much as possible, worry about it later". Remember the poor Ukrainian peasants in 1918, saying 'what could be worse than the Czar?' Things can always get worse. As if the problems caused by an inflationary spiral are not bad. Clearly, it would solve the indebtedness issue. Yet, the inflationary decades are hardly ones of great economic times, and end with a nasty recessions.

M1 Growth 13 months after onset of last 8 recessions:

Recession Start	M1 Growth
Apr-60	2.4%
Dec-69	6.6%
Nov-73	4.9%
Jan-80	8.6%
Jul-81	7.0%
Jul-90	7.4%
Mar-01	7.1%
Dec-07	15.4%

So, Bernanke is trying. Unfortunately, its not working yet. But, when I was a freshman and we would drink grain alcohol until we felt it, that never ended well.

It's not all bad

Shark attacks at 5 year lows!

They say the weak economy is partially to 'blame'.

The Problem of Make-Work

Many eminent economists and most legislators think that a dollar spent creates jobs, creates wealth. But, 'creating jobs' is easy, entropy does that. The problem is creating jobs where the outputs are worth more than the inputs. If we create federal projects, and through Davis-Bacon and other contrivances (the endless auto bailouts), create a new bunch of unionized sectors and government employees dependent on the Federal Government, pretty soon people lose the ability to 'economize', to make more with less, to evaluate projects on a 'cost-benefit' basis, and productivity growth stalls.

Consider the Angler Fish. The smaller male is born with a huge olfactory system, and once he has developed some gonads, smells around for a gigantic female. When he finds her, he bites into her skin and releases an enzyme that digests the skin of his mouth and her body, fusing the pair down to the blood-vessel level. He is then fed by, and has his waste removed by, the female's blood supply, as the male is basically turned into a parasite. However, he is a welcomed parasite, because the female needs his sperm. What happens to a welcomed parasite? Other than his gonads, his organs simply disappear, because all that remains is all that is needed. No eyes, no jaw, no BRAIN. What you don't need, you don't use, and eventually you lose what you don't use.

So in our Brave New World bureaucrats create jobs where workers get paid by seniority, can't get fired, and have a million rights. People are guaranteed jobs, for life, merely by passing some simple criteria (eg, teachers unions, flag wavers on highways ($25/hour)). What is needed by their willing host? A vote, that is all.

It seems nice, but no responsible parent would do this to their kids. That is, no one would give their children unconditional privileges regardless of their schoolwork, how late they stay out, etc. Giving your kid unconditional support is a great way to create a lousy adult. Give people privileges for 'showing up' and not distinguish between levels of performance (as is customary in unions and government, paying by seniority only), and you squeeze the benefits of a capitalist economy out of the system, creating the lax work effort many West Germans discovered in their East German countrymen in the early 1990's.

How Helping 'Homeowners' Makes Things Worse

Obama announced a new plan to help renters (oops, 'homeowners') who cannot afford their mortgages.

There are two types of people who aren't paying their mortgage bills, and it is not simple to separate them. There are those whose incomes are insufficient to make the monthly payment. Then there are current homeowners who are merely underwater, and do not want to pay (mortgages are limited liability, so they can walk away and not owe anything). So the government has some rule, and 30% of people with such mortgages get to basically write down their old mortgages to a new level that make them able and/or willing to pay. There are two problems with this.

First, it directly lowers the value of the bank's assets. We are simultaneously trying to shore up banks. That the government is legislating this implies that banks will have to write down their assets more than they would have otherwise. So, it is directly inconsistent with the Treasury's other objective, to strengthen banks.

Secondly, it generates huge moral hazard. Say 4 million mortgage owners take advantage of this as targeted. Those who where not targeted, will look at what their neighbor did, on a house bought at the same time, and try to figure out how they too can write down their mortgage obligation. A good number will successfully navigate the lame top-down criteria applied, because any cookie-cutter criteria in Washington creates a very simple target to game. This process will put more pressure on housing, because it creates zombie properties as owners figure out if they can get this done, and it creates a new wave of defaults. Thus, previously people who, while underwater on the property or in trouble because of standard vagaries of chance, might have otherwise paid their mortgage. But to do so in this environment is to be a sucker. Many will find this unethical, but many won't. This creates the second wave of mortgage defaults, the opportunists. I imagine there will be incentives on the demand and supply side to play this game.

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

Geithner's Plan

Geithner unveiled a vague plan to address the crisis, and it's a what they call in Washington, a crap sandwich.

"First, we're going to require banking institutions to go through a carefully designed comprehensive stress test," he announced. "This borrows the medical term."

Sounds reasonable at 30,000 feet, but what kind of stress test do you imagine this group will generate? Anything with enough granularity to be really fair, taking into account the risk of obligors and facilities as banks evaluate them, is beyond the ken of any regulatory body. That they are going to rush it through, just means it will be 100 times worse than what they might have come up with.

Risk management in a large, complex financial institution implies a lot of detail. There is no easy way for banks to demonstrate their viability with a top down, easily verifiable number, for the main reason that such information is difficult to produce. If it was easy produce, one of them (certainly there is one) would have generated such information to ease their liquidity strain.

The only people who know less about portfolio risk than the senior executives at a bank, are the regulators. They will generate numbers that must ignore nuance because they can only apply cookie cutter solutions. They will feel obligated to fail some banks, merely because otherwise this will look toothless. Thus, you have an arbitrary axe hanging over the top 100 financial institutions, and we will only know who it will strike when we see how the stress tests are biased--towards community banks, consumer banks, investment banks, etc. This has weighed heavily on the markets, and I don't see it subsiding until we hear something comforting from the Treasury, like 'Heh. Just kidding! We aren't going to apply stress tests.'

Asking for specifics, a Treasury official made this ponderous statement:

"this stress test is . . . designed to be more forward-looking and to make sure we're taking into account a quite broad range of economic scenarios."

"What could be worse than the current situation?" the reporter asked.

The official smiled. "I'm not going to answer that," he said.

He should have said, "I can't answer that", because that's the truth. He has no clue. The bottom line is, no regulator with any power in Washington understands the specifics needed to assess credit risk. They merely measure asset performance, looking at late payments and the like. Their assessment of credit risk is merely various gradations of overdue accounts (30 days past due, 90 days past due, OAEM). All current assets are not the same, and if they apply the same stress test to all such assets, it is merely a leverage test, which is a very, very crude way to assess solvency. The good stuff, loans that are not past due, they have no experience grouping and classifying. Will they apply there stress test to consumer loans? How will they adjust by vintage? FICO score? Collateral type? Auto vs. home equity loan? Do the stress test multiples based on historic volatility, if so, is it using market value stress or cash flows? Does it apply 2, or 3 times these losses? These are essential question, and to assume they will figure it out on the fly, is like a surgeon just opening up the patient and hoping something obvious asks to be removed.

Further, the idea of making sure banks have capital for an unforeseen event, after the unforeseen event happens, is like asking banks have capital for 2 unforeseen events. It is the regulatory equivalent of mark-to-market, amplifying a bad event.

Too bad so many feel that if Washington is the solution, rather than the problem right now. I would merely demand that banks present all their credit information by product type: home loans, auto loans, indirect and direct lending, leases/lines/outstandings, and then, via their internal grading, the losses experienced by banks in these various buckets. Those firms with greater granularity, better data, will be able to show they are of lower risk. We need more information, and because banks are fearful of revealing secrets, they are making everyone too scared. I personally understand that you should never reveal information as a general rule, because there are enough people out there with bad faith that it is not a good general idea. But this is a crisis, and the public needs it. Then let the market punish the losers, as they will have to be taken over by the winners. The Fed or Treasury should merely help banks that have liquidity problems, by just trying to value their current assets and liabilities, so that you only do this to solvent banks (where solvency is based on current values, not value cum stress test).

Banks Insolvency is not about Stress Tests

Over at Marginal Revolutions, Alex Tabarrok notes that " Many of the major banks are insolvent", and links to NYTimes article here.

Actually, the article notes that if a 'stress test' is applied to banks, using 2 years of future losses, then these banks are near insolvent. They pulled in a credit firm, CreditSights, to generate the stress test. They produced some really large losses, like which generates some really large numbers, like $119B for Wells Fargo, which isn't inconceivable given they have about $1.3 Terabucks on their balance sheet.

But invsolvency is not "insolvency under a stress test", any more than you can say someone is "dead" if they are dead assuming they were run over by a bus. Further, without any details on the stress test, you might as well say "I pulled this number out of a monkey's butt--but I can still give you three significant digits!"

What where the default and recovery rate assumptions? What assets had mark-to-market losses in the stress tests. Break them out by product type to sufficient level of granularity (eg, a subprime loan where the owner has no equity is different than a conforming mortgage where the owner has a 50% equity stake). Without such additional information, their numbers are meaningless.

Crisis and Legislation

Rahm Emannuel recently stated that "You never want a serious crisis to go to waste." See here. This is not merely a left wing tactic, as even Milton Friedman noted that "Only a crisis actual or perceived produces real change." (the theme of Naomi Klein's Shock Doctrine). Thus, it's a political reality, and in this crisis, Democrats control the Presidency and Congress.

Clinton's welfare reforms are now effectively repealed, and we have $30MM to help protect the Salt Marsh Harvest Mouse. But who cares, we need to do something now, and every dollar spent in Washington, through the multiplier, pays for itself!

Industry Growth not Necessarily Industry Profits

In a Farewell to Alms, Gregory Clark's fascinating new account of the Industrial Revolution in England, he notes that profitability does not necessarily follow productivity.

Productivity growth in cotton textiles in England from 1770 to 1870, for example, far exceeded that in any other industry. But the competitive nature of the industry, and the inability of the patent system to protect most technological advances, kept profits low....New entrants abounded. By 1900 Britain had about two thousand firms in the industry. Firms learned improved techniques from innovative competitors by hiring away their skilled workers.
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The greatest of the Industrial Revolution cotton magnates, Richard Arkwright, is estimated to have left 0.5 million pounds when he died in 1792...This is less wealth than Josiah Wedgwood, who left 0.6 million pounds in 1795, even though Wedgewood operated in a sector, pottery, which had seen far less technological progress and was still largely dependent on manual labor even in the late nineteenth century

That the most productive industry, in the most productive country, could not reap the profits to the owners, highlights the merely predicting the success of an industry is different than predicting the stock returns in that sector.

While the book is truly fascinating and profound, it is kind of depressing. He argues that England became superproductive because the rich were outbreeding the poor and so after several centuries, the downward mobility of the rich pushed their genes and/or ethics across the country, and so productivity grew out of the masses of bourgeois virtues endemic to the British 'middle class', which is not a description of someone with a job (today's definition), but rather a description of a person's actions and morals. "Thrift, prudence, negotiation and hard work [became] values for communities that... [had been] spendthrift, impulsive, violent and leisure loving." (p.166) In contrast, today, the poor out breed the rich, music glorifies thugs, and popular culture does not exactly encourage thrift, prudence, and hard work. In a couple of centuries, Americans might be looking at our skyscrapers the way Egyptians looked at the pyramids in classical times.

Trader Book Gets Taken by Fraud

Millionaire Traders is a book in the tradition of Jack Schwager's Market Wizards, except instead of using famous traders, it uses 'regular guys'. Alas, how do you find these people? Why, go to internet sites where people promote their millionaire methods. Any auditing of results? No. Thus, it should come as no surprise they were taken. One of their subjects, Charles Hays, turned out to be running a Ponzi scheme.

The book paints a radically different picture of Hays than the one that has come out in federal court this month, where federal prosecutors now say he was the operator of a Ponzi scheme and a trader who lost money 20 out of 24 months. The expanding investigation has found 75 people who lost at least $25 million entrusting their money to Hays, prosecutors say.

The world Hays built held the trappings of a market wizard: his house, set in a wooded section of Rosemount; his reputation among day traders, built in part by the 33-page "Millionaire Traders" profile, and his $3 million, 64-foot Viking cabin cruiser.

He would trade the S&P500 (minis) for an hour a day in the morning, and supposedly generate a 3% monthly return to investors. Uh huh.

Taleb and Kahneman in Germany

see video here.

A couple quick comments. Taleb noted that he would not speak to the US based Chartered Financial Analyst meeting unless they stopped teaching Modern Portfolio Theory. They did not, so he withheld his eminence. Now, first, this is an absurd request, and I'm no fan of the CAPM. Second, Taleb argues MPT, including the CAPM, is worse than useless. Yet Peter Bernstein wrote a nice blurb on his book! Bernstein wrote a couple hagiographies of the founders of the Modern Portfolio Theory (Against the Gods, and Capital Ideas). I guess most people think inconsistency--MPT is the greatest intellectual achievement of the past 60 years, and worse that worthless--is no big deal.

As you get older, it is interesting to find people you really know are totally clueless as eminent authorities. Like when you are 24 or so, and see talking heads on TV, and think they know a lot, until they start talking about something you really know, like ethanol or health care, and then realize they don't know much about that. Perhaps they don't know anything about Somalian relief efforts, or fiscal policy, as well?

Taleb notes the Kahneman is the only Nobelist to be able to predict, via his 'prospect theory'. This theory was developed to explain why people gamble and buy insurance. It 'predicts' only what it was designed to explain. One could call this a successful prediction (people will buy insurance and lottery tickets next year too) only in the way that one considers superstring's prediction of gravity amazing. I find his prospect theory useless, because Markowitz, and Friedman and Savage introduced doubly inflected utility curves back in the 1950's, but the profession abandoned this approach because it explained too muc. A theory that people can be risk averse or risk loving, depending on the situation, is not useful. It's like George Soros's book, where in The Alchemy of Finance, he notes that stock prices are usually biased--either too high or too low. Well, that's one interpretation. A better one is that the expected return is unbiased, and stock prices will fluctuate. Behavioral finance supposes that economists have never tried to understand humans, which is simply false.

Unlike what Taleb's colleague and friend Paul Wilmott states, my criticisms of Taleb are not driven by envy, any more than I might envy Suze Orman or Naomi Klien, both highly popular in economics (I think Suze is generally correct if banal, Naomi strident and plain wrong). To the extent Taleb makes a consistent, novel point--which is rare--he is wrong, pure and simple. Further, he is truly crazy.

I agree with Taleb on some things, including the limitations of Value at Risk. But his inference than VaR is worse than useless, or the cause of the recent crisis, is simply stupid, and highlights that he does not understand how strategic decisions are made in large organizations. VaR had nothing to do with the subprime crisis, it has a very limited area of application, and strategic decisions are not one of them. Just as 'risk managers' do not okay acquisitions, risk managers do not okay strategy, they merely make sure the rules are being followed, in part by using a Value at Risk. That VaR might have been used to validate investing in mortgages (UBS had some poor Value-at-Risk numbers underlying their mortgage exposures), does not mean it was a critical driver. The decision, really the assumption, was widely held that default risk on mortgages was a trivial risk because the US had not had an aggregate decline in housing since WW2. Everything after that is incidental.

Further, the idea that 'shit happens' should be a center to one's thinking is totally perverse. It does not explain, it does not instruct, but rather just gives people an excuse to be lazy, overpay for insurance, and go on wild goose chases. They can always blame a 'Black Swan' for their failure to anticipate, or their lack of results.

Being Correct and Being Clear

Louisa Gilder, daughter of George Gilder, recently wrote a book on quantum spookiness. This is fun stuff. Anyway, in her diavlogue with George Johnson on Blogginheads, she makes a neat observation about Bohr's rhetoric. He would speak with such care about not being wrong, qualifying various statements, that it was difficult to know exactly what he meant.

Over on Overcoming Bias, Robin Hansen stresses that people should care primarily about the truth. One problem, as Bohr demonstrates, if you emphasize the truth too much, and are very careful to note exceptions, qualifications, and everything else, it isn't clear what you say.

Great Insight on Talking about the Future

From the NYT on how an official can avoid looking stupid:

Walter Heller, who went from the campus of the University of Minnesota to become chairman of the president’s Council of Economic Advisers, had briefed reporters on the administration’s plans to deal with an ongoing recession, and gave them actual numeric goals that began appearing in newspapers around the country. “Never do that again,” Kennedy told Heller in an angry telephone call. “Forget those numbers. Numbers can come back to haunt you. Words can always be explained away.”

Clearly this is true, but it really depends on one's audience and objective.

Barro on Krugman

in today's WSJ:

Atlantic: Oh, well he wrote a series of posts saying he thought the World War II spending evidence was not good, for a variety of reasons, but I guess . . .

Barro: He said elsewhere that it was good and that it was what got us out of the depression. He just says whatever is convenient for his political argument. He doesn't behave like an economist. And the guy has never done any work in Keynesian macroeconomics, which I actually did. He has never even done any work on that. His work is in trade stuff. He did excellent work, but it has nothing to do with what he's writing about.

Expert innovators in parochial models are smart. They aren't necessarily wise, even about things in their putative field.

Federal Stimulus

Gary Becker and Casey Mulligan have a good post on the 'stimulus' package in today's WSJ:

The evidence of past expansions of government programs is just the opposite. Once created they tend to survive and grow over time, even when the increases initially were said to be temporary. The underlying reason for this is that interest groups develop around new and expanded programs, and they lobby to keep and expand those programs.
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Whatever the merits of other government spending, the spending in this package is likely to have less value. A very large amount of money will be spent quickly over a two-year period: $500 billion amounts to about one-quarter of the total federal government annual spending of $2 trillion. It is extremely difficult for any group, private as well as public, to spend such a large sum wisely in a short period of time.

I can't agree more, and so find this all so depressing. But I don't blame Obama or Democrats per se, as they are giving the US what it wants. I just think what most people want is not in their best interest, like voting for rent controls.

Darwin's Birthday and Evolution's Quagmire

It's Darwin's 200th birthday February 12, in the sesquicentenial of the publication of his Origin of Species: By Means of Natural Selection or the Preservation of Favoured Races in the Struggle for Life. I think his seminal theory, that of evolution as the mechanism for creation of all life from some unspecified simple beginning (virus?), is in a very strange way. Go to PZ Meyer's website, noted by Science magazine as the best science education site, and over half his posts are on why critics of evolution are not only wrong, but moronic. Similarly, there are many books arguing that evolution is true, even though only a trace of practicing professors are arguing the other side.

No one gets mad when you say 2+2=5, so methinks they doth protest too much. One does not see, say, physicists spending much (any?) of their time defending the second law of thermodynamics and slamming those who critique it. Thus, for a theory that almost all scientists believe is 100% true, many scientists spend a lot of time, and get very upset, defending this assertion. I would think a confident, productive scientist, would merely discuss applications of evolution.

However, these same appliers of Modern Evolutionary Theory (aka, Darwinists, which I use merely for clarity, and do not consider it pejorative) are hesitant to apply Darwinian logic to the entire human species (that whole 'preservation of favoured races' thing in the subtitle). Explanations about how our environment shaped differences in male/female brains, or how different environments may have shaped different regional group's brains, is about as taboo a topic as there is (see Arthur Jensen, Larry Summers). So, even though evolution affects our height, skin color, lactose tolerance, and other biological processes, supposedly it stopped at our brains, penis size, speed, and most things we esteem. Thus, Guns, Germs and Steel gets rave reviews and is a best seller, whereas 10,000 Year Explosion or A Farewell to Alms will never see much acclaim or popularity because we just can't tolerate the inegalitarian implications of human biodiversity.

My appreciation and criticism of evolutionary theory covers both ends of its unpopularity: applying it to explaining all life via the first prokaryote (no) and applying it to humans (yes). The more we learn about intracellular molecular biology, the more complex it becomes. Cellular machines have dozens of proteins, with logistic systems for building and supplying it, so that the functioning parts involve a complex system of necessary components. The response to this 'irreducable complexity' argument is that the prior forms of any complex working tissue or organelle could have been very different, and we can't know exactly what it function was, but they are theoretically possible, such as the assertion that lungs were probably first air bladders in marine animals. Different function, same proto-organ. But its one thing to say proteins A through F appear in other cells, quite another to explain how they transmogrified, step by step, to a totally new function. If they existed in a particular useful constellation, moving them to a totally new cellular function is like the Towers of Hanoi puzzle, where every plate must be moved following the logic that plates can only lie on top of larger plates. The constraint that all discs must be on a larger disc is like the contraint that every move must not decrease the organism's fitness, and turns a simple problem into one that becomes insanely complex as the number of plates increase. That is, evolution is blind, and each change in genes via reshuffling and mutation can't kill the host, which is a strong constraint because most mutations with effect are harmful. The number of moves needed to move the Towers of Hanoi is on the order of 2^k, where k is the number of discs. Assuming the survivability constraint is analogous, moving a complex cellular machine from say a set of 8 proteins that performs cellular secretion of toxins (Ken Miller's Type III secretory system), to a set of 20 proteins which act in concert with all sorts of supply chains (Behe's bacteria flagellum), takes an insanely large number of steps because each step needs to not kill the genetic vehicle. As proteins conservatively have about 100 amino acids each, this means 2000 amino acids. Each amino acid needs three different base codes, so that's 6000 DNA letters. If the mutations occurred only at this level of the DNA, it would involve on the order of 2^6000 moves to get from function A to function B, a number greater than 1E500. A modern evolutionary theorist would say, this number is big, but so is the number of organisms and things they could change into, and planets in the universe. True enough, but all these numbers are so large, I think its at least just as likely that evolution's probability of success is effectively zero, as opposed to one. As one can't really quantify these things (what is the state space of potential organelles that a Type III secretory system could be?), I think arguing too hard about one side being certainly true is difficult. I have never seen quantitative estimates by Darwinists, just hard waving about possible ways things could have arisen, as opposed to actual numbers and probabilities.

On the other hand, I often find evolutionary explanations very compelling and productive. Why are people who live towards the equator darker skinned that those at the pole (melanomas and vitamin D)? Why do some groups develop greater ability to digest milk (raising cattle for milk is more efficient than merely eating them)? It is absurd to think all these biological differences among humans are confined to unimportant things, and so we just have different culture to explain substantive differences between races. As if black Africans have a culture that appears to really value sprinting, and so it follows in the African diaspora. Kids everywhere race on their little legs all the time, the most obvious, cheapest, contest ever. Out of thousands of known mutations that cause disease in humans, only three are known to cause increased connections between neurons, and all three have surprisingly high frequencies among Ashkenazi Jews, even though those mutations have bad, even lethal effects in people with two copies. What are the odds this gene was not 'selected for', resulting in both highly lethal diseases and 112 average IQs for this group? Every Darwinian biologist agrees with the story that Africans have a greater propensity to get sickle cell anemia because of the evolutionary explanation: good if you have 1 copy, bad if you have 2. The only way such genes could flourish is because of the beneficial evolutionary effects of one copy of this gene. Yet, this same logic, applied to Ashkenazi Jews and their diseases and propensity towards higher than average IQ is supposedly a 'just-so story', because we know that some groups can't be genetically smarter than other people (on average).

Jerry Coyne is a professor of evolutionary genetics at the University of Chicago, and wrote Why Evolution is True. He spends 350 pages defending evolution. When it comes to humans, he allocates a couple pages to the concept of human races (they are real), lactose tolerance and sickel cell anemia, and notes that "My guess--and this is just informed speculation--is that human races are too young to have evolved important differences in intnellect and behavior. [p. 216]", and moves on. Wouldn't evolutionary theory be most interesting applied to current humans, as opposed to molluscs in the Tertiary period? Why is the origin of horseshoe crabs so much more interesting to these people, than the origin of the differences in behavior between expressive Italians and taciturn Amerindians?

I don't believe in God, and don't have an alternative explanation for how we got here from the Big Bang, but I look at the problem thusly: what is the chance that a nematode could, through mutation, selection, and reproduction, change into a horse? What is the total state space of mutations? What proportion of dead ends in the state space of changes that take us from a nematode to a human? Mutations can be point by point along the DNA, insertions, deletions, amplifications, or changes to the morphology of the the DNA (its folds affect its effects). The vast majority of these changes are deadly or irrelevant. The probability that such changes end in a dead end is very high. How high, exactly? Evolutionists agree, they just highlight that the number of organisms, the time, the number of planets in the universe, all outweigh this. I'm not so sure. We are dealing with numbers beyond our intuition, but just because one is really big, does not mean it offsets the one that is really small. One number might be 1E134 and the other 1E-163, both of which I have no intuition for, but the product is zero.

If the critics of evolution weren't so often biblical creationists, I think this criticism might be taken seriously. Yet even though it is important to understand the motivations and pretexts of your adversaries, it is not true that just because a view is sometimes, or even often, a pretext, that it has no credence. Further, my interest in biology and the history of life is actually increased thinking about the mystery, because it seems like a big unsolved mystery. For example, the DNA folds in a particular way so that certain regions of the DNA are physically close even though very far away in the sequence. How is this folding pattern regulated in the DNA? The idea that evolution is necessary as a motivation for scientific inquiry is simply absurd, because regardless of how life got here, it is interesting to know how it works.

I'm not religious, I just sense the probability that new phyla are create by incremental blind mutation, compounded with natural selection, to be so small it is implausibly the mechanism. I would like to see estimates of the state space of mutations that take a nematode to a lizard via molecular mutations. That is, within a factor of E20, how many mutations were needed to get from prokaryotes to dogs? How many times has this been tried? But like Global Warming advocates who insist the debate is over, for the Darwinists merely engaging this kind of question cedes too much credibility to their critics, so all they do is sneer, note homologies between species, discuss micro evolution (finch beaks, genetic drift in bacteria), and that this has been tried so many times in the universe it does not matter how improbable it is because Infinity times any positive probability generates a certainty. But surely some alien designer surely would have homologies in his toolkit and allow microevolution, and the size and existence of the universe is finite, so there are limits to how improbable something can be before we should expect it to happen (famously, the monkeys typing randomly would not generate Shakespeare's Hamlet given the 14B year age of the universe and a million monkeys--it is too improbable).

It has always been that people take the limits of their own field of vision for the limits of the world, but I figure that humans trying to completely explain their provenance given our brains is like a worm trying to understand where rain comes from. It's fun to think about, but I don't insist that our best theory must be true simply because its our best theory. Quantum physics highlights many bizarre facts (eg, the Einstein-Podolsky-Rosen paradox), and I'm perfectly content thinking I have no clue what is going on there and no one has a good explanation. I don't have answers, but I'm pretty sure that the current state of knowledge is just hand waving when trying to explain all life on earth. And I don't think it really matters much, that is, whether we were created via natural selection, panspermia, or are avatars in some giant computer game, I really don't think it matters. Evolution is real and important, I just don't think it has to answer everything to be so. After all, there are no theories in chemistry or physics or economics that explain everything. Saying a theory is incomplete is not a radical critique, just modest realism.

Meanwhile, human biodiversity has political implications that make it simply impossible to acknowledge in public arenas (eg, major academic journals, the New York Times, best sellers, at NBER conferences), and so evolution's most useful application is considered taboo by the very people who consider themselves morally superior to those who reject evolution on a priori grounds. Most people assume a slippery slope from acknowledging human differences, to subjugation, slavery and genocide (after all, Hitler believed in human biodiversity). Smart people like to point out they understand nuance, and here's a case where nuance is not being applied out of a belief in a 'greater good', or really, a 'greater evil'. The result is that evolution is a mess, as its main proponents apply it selectively and defensively, to the least interesting cases.

Keynesianism in Practice

Keynesian vs. Supply Siders can be a purely technical debate about substitution effects from issuing government debt, or multiplier estimates. But fundamentally, someone who want the government to spend more is a Keynesian.

The recenty Fiscal Stimulus bills is a pork-laden spending bill, designed to build and perpetuate a patronage system. Listen to Obama's response to such a criticism:

Speaking to a House Democratic retreat on Thursday night, Mr. Obama took on those critics. "So then you get the argument, well, this is not a stimulus bill, this is a spending bill. What do you think a stimulus is? (Laughter and applause.) That's the whole point. No, seriously. (Laughter.) That's the point. (Applause.)"

Well, that's the Democratic president, speaking in front of Democrats. I think it is not a caricature to say that for Democrats, all government spending is stimulus.

Edits on Book

I got back edits on my book, and some of the comments are pretty interesting. Clearly, my usage of "that" and "which" is almost as bad as guessing. Did you know that it is correct to say "435 BC", but then, "AD 800"? Or that there were two Rochefoucaulds? Further, somehow he/she was able to find my quotes of others, and though I thought I generally cut and pasted them directly from online texts, I made an unusual number of errors, perhaps as I re-wrote some parts from memory. Anyway, I'm spending a lot of time on it because I get only two weeks, and this is my last chance to make changes. I do find that having not had my manuscript for a while and looking at it anew, there are some plain errors, some really poor explanations.

It's funny because while I basically had the book done last spring and was very eager to get it out asap, the time since I got Wiley to publish it has really allowed me to make it much better, with often major substantive changes in my arguments. The process of a book, the time, the scope, the depth, make them a unique way to present an argument in a way that articles or blog posts simply can't match, because its a sustained, consistent argument. My hope is that the argument is consistent and concise as possible, because rarely do I read a 300 plus page book without thinking it could have been a 200 page book, where some chapters seem unnecessary.

Nudge in Practice

Cass Sunstein and Richard Thaler wrote Nudge, which argues a seemingly reasonable amount of paternalism can make the world a better place. The main example is changing default options, because most people choose the default option, and so if the default option is to invest 6% in the retirement account, in an index fund, that will probably be the modal choice. As saving for retirement, and index funds, are good iddeas, why not make that the default? Who could be against that?

Well, while that particular default option is not a problem, if you give large institutions power to nudge in various ways they have the power to do a lot of damage. Take housing. In John Campbell's 2006 American Finance Association Presidential Address, he examines household financial choices, and notes that many households do not refinance when rates go down, which is bad for them. Thus he makes the seemingly innocuous policy proposition:

In mortgage markets, the U.S. government plays a major role through GNMA and its sponsorship of FNMA and FHLMC. The ability of these agencies to issue low-cost debt has likely reduced the cost of the mortgages they hold. The agencies have traditionally favored nominal fixed- rate mortgages, and it is plausible that they could encourage the use of mortgages with inflation adjustment or automatic refinancing feature.
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Finally, recent research in behavioral finance finds that default options–standard choices that households believe to be recommended by authoritative bodies–have a powerful effect on household behavior. The mortgage policies of GNMA, FNMA, and FHLMC may influence house-hold mortgage decisions through this channel as well as by driving down the cost of standard mortgage contracts.

In the context of his talk, he is clearly arguing a nudge policy by the influential, government-backed housing agencies. They are there, setting precedents for this market, so why not add the good ones Campbell sees are obvious?

Well, many other people thought of this first, and so GNMA and the rest were leading the charge in our subprime debacle using this same logic. Under the pretext of increasing home ownership--especially traditionally under served minorities--they got several large institutions, including but not limited to GNMA, FNMA and FHLMC, to nudge policy towards no income check, low or zero down payments. This was done in innumerable ways (the Fed and OCC approving mergers), as one would expect when billions of dollars are at issue. It's good policy, so why not? The historical default rates on residential mortgages was near zero for so long, mortgage risk was synonymous with 'prepayment risk' until 2006, as default rates were never large so off the radar scope.

If you give government-enmeshed institutions the power--indeed the obligation--to nudge people in view of some greater good (eg, more savings, owning a home), it will have a tendency to become co-opted by people using some principle as a pretext for less salutary objectives. I think the Nudge crowd needs to better appreciate that not everyone is as objective as an academic writing about a handful of good ideas that have been vetted for decades among his colleagues of diverse political affiliations (eg, the default choice on employee investment plans). There are lots of 'root causes' that can be addressed by a large institution, so the list of potential disastrous conflations of the public good with self-interested hucksters is impossible to enumerate.

If you give some institution great power to nudge, it has great power, and power is always corrupted.

High Risk, Low Return, Perfectly Consistent

Andrew Ang, Robert Hodrick et al wrote this piece on the Cross-Section of Volatility and Expected Returns. I'm about to get my edits back on my book, and so I'm rereading some of the works I reference. I had to spend a lot of money to be able to use or talk about the fact discussed (never mind it was in the public domain or my direct examination of this in my dissertation), so its a subject close to my heart. It's a pretty funny bit of post-modern finance.

They spend the first part of the paper presenting a formal conditional multifactor model. They then immediately note that "however, the true model in equation (1) is infeasible to examine because the true set of factors is unknown and the true conditional factor loadings are unobservable." Well, it was fun to go over anyway I guess.

Then they develop a factor mimicking portfolio by finding stocks that mimic the changes in the VIX index, and then sorting stocks by the prior correlations with the VIX changes and creating a portfolio of stocks correlated with future VIX changes. They then show, in true Fama-French fashion, that cross-tabbing portfolios formed on sensitivities to the changes in the VIX, are sensitive to the changes in the VIX! But the effect is small, as they estimate the price of volatility risk as -0.08% per month, factor loadings on the pre-sorted portfolios fall by a factor of 100, and adding or removing one August 1998 or October 1987 reverses the sign of the result. So, statistically significant, but not economically significant.

And totally unnecessary because it was motivated by the following, which basically insured the above '25-portfolio-Fama-French' test would work statistically. When they group stocks by low to high total volatility the stocks with the highest volatility had the lowest returns, so the 'price' of volatility is negative. They check robustness by presorting the stocks first by size (market cap), and the effect still shows, They do this for 8 or 9 other things. That's all we needed to know. The early part was less convincing, less intuitive, than the latter part. Good statistics is mainly about knowing what to control for, and these tests make it pretty clear that the obvious alternative hypotheses are not going to explain this. If you know X is correlated with returns in the presence of other variables, the Fama-French test is redundant, and suggests a spurious rigor that is not there.

Then, they get to the explanation, which is solid gold. Remember, higher volatility is correlated, cross sectionally, with lower returns empirically. What rational story might explain this?

our estimate of a negative price of risk of aggregate volatility is consistent with a [unspecified] multifactor model or Intertemproral CAPM. In these settings, aggregate volatility risk is priced with a negative sign because risk-averse agents reduce current consumption to increase precautionary savings in the presence of higher uncertainty about future market returns.

You see, in the Stone Ages we were taught higher risk implies higher return. Modern asset pricing just adds the nuance that higher volatility assets have lower returns, because of the offsetting demand for more savings (huh?). The specific model that generates that is an exercise for the reader, but I guess it could work, especially if we factor in the many worlds interpretation of reality, because I'm told there are universes where the Statue of Liberty waves at tourists when they sail by. But even there, the fanciful interpretation only works if you emphasize the factor loading stuff that was not economically significant, and not very compelling (note, it was not duplicated in their follow-up paper that documented this internationally). It's kind of like how Global Warming causes Global Cooling when you read the above rationalization. The bottom line is that stocks with higher volatility, that perform worst when times are really bad, have lower relative returns.

You can only get away with this kind of enlightened blather if you appear appear 100% serious and rigorous, even though the rigor only occluded the real result of this paper. If you just said, the standard model can't explain this, well, I know what happens to those papers.

Righteous Bonuses

Obama is rightly upset about the size of bonuses handed out when banks are getting a federal bailout, but not every bonus is undeserved, so it is not as easy as saying there should be zero bonuses until things are fixed. They key is how close they were to the decision making process. If someone in charge of a complex portfolio has his bonus cut back to zero, implying his future bonuses are also in peril, he has good reason to bolt and start at a new place. Worse, he has an incentive to screw up his portfolio by giving away securities to friends of his on the Street (brokers, other traders he deals with), building up a set of favors for his next position. Once there, the buddies he sold securities to at 72 when they were trading at 78 will remember him.

The reason we pay people a lot is because we think they are worth it. Many times they are not, but not always. A fund I know shut down one of its funds and people there basically gave away their positions before they left, making payments to the favor bank, for when they went to their new jobs. Why? They were told there would be no bonus, just exit your positions, and get your 1 month severance. A zero bonus is a horrible incentive structure for someone in charge of a portfolio, and it is not feasible to think your back office or audit group can monitor this. The portfolio managers know the best price, outsiders don't, that's why they get paid a lot. In the context of a moving market, and illiquid securities (such as mortgages), you don't really know how much money you are leaving on the table, but look at the incentives at the individual level, and expect people to act in their self interest.

Many times, bonuses are layered: the PM gets 10%, his boss gets 10% or the CEO gets another 10%. Infamous trader Joseph Jett made $9MM in his 1993 bonus (off fraudulent profits), and had to pay it back. His boss, Ed Cerullo, got $20MM in bonus that year in large part because of those same fraudulent profits. Cerullo was worse that Jett in that he not only had no idea what Jett was doing, but got paid more than Jett based on his activities, then was not held accountable (Cerullo paid a $50k fine and did not pay back any of his bonus)! This is why we mock 'management'. These higher ups can and should be squeezed.

Fundamentally, there is a continuum of rents earned from capital to labor. Those with special knowledge, or whose effort is difficult to monitor (even ex post), has alpha, because you can't necessarily replace him with a wage slave. Those with alpha negotiate with those with capital to share the proceeds of their venture, and they should be thought of as movie stars, those with talent, that get paid a bunch, but they aren't management, they aren't making strategic decisions. Management is sort of in the middle between capital and alpha, so there needs to be a judgment call as to how much these guys should make, but they generally aren't alpha producers. They tend to be overpaid, because they used to be on the front lines, and now manage those people, and using logic similar to a union (more senior people get paid more), think that anyone managing others should get paid more than them, via a cut of all their books. This is generally overdone, only because those setting their pay usually need the support of these managers, making it difficult to cut their pay. In these times, it would be a very good place to start docking all those Executive Vice President and Head of Global Market Derivatives, because there are lots of replacements on the street.

John Thain, doesn't need a bonus, nor any of his direct reports. But leave the lower level guys alone, regardless of their take. It may not be fair (isn't a schoolteacher worth more?), but they are in a position to do a lot of damage if you zero them out. These are the Atlases you don't want shrugging.