Saturday, December 26, 2009

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


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


here A is the standard coefficient of risk aversion, and cgthe consumption of goods, cs 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.

Thursday, December 24, 2009

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...

Monday, December 21, 2009

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.

Sunday, December 20, 2009

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%.

Saturday, December 19, 2009

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.

Wednesday, December 16, 2009

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

Tuesday, December 15, 2009

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!

Sunday, December 13, 2009

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.

Thursday, December 10, 2009

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.

Tuesday, December 08, 2009

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.

Monday, December 07, 2009

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.

Sunday, December 06, 2009

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, 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).

Friday, December 04, 2009

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.'

Thursday, December 03, 2009

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.

Tuesday, December 01, 2009

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.

Monday, November 30, 2009

Romer's Growth Theory

It is generally presumed that Paul Romer will win a Nobel prize for his 'endogenous growth theory', so I was intrigued when Kling and Schultz interviewed him in their new book From Poverty to Prosperity. Their book hits on a lot of issues I find interesting, not so much as providing a novel big idea, but noting a lot of outstanding puzzles and how the non-Left Establishment thinks about them.

Growth Theory is about long-term economic growth, which means, abstracting from business cycles. Given the power of compounding, and the ephemeral and intractable nature of business cycles, it is rather a shame for most economists to focus on recessions because over they don't matter too much over time. Sure, East Germany had fewer recessions than West Germany, but over a couple generations, West Germany had 3 times the living standard. Wisdom is primarily prioritizing tasks according to importance and solubility.

Robert Solow started growth theory in the 1950s, and it basically broke the macroeconomy into three drivers: capital, labor, and productivity. It did not explain productivity but highlighted that this factor seemed to be what really mattered, so no longer could one say, Tanzania needed more 'capital,' because after you apply the model econometrically the problem is not capital or labor, but their productivity. Solow's growth model does not tell us how things work, but it did dismiss a popular incorrect idea, no small feat.

Romer highlights the fact that great economists, according to economists, are those that create great models. These models usually formalize existing intuition, as the Welfare Theorems of Arrow and Debreu really just proved the 'Invisible Hand' using set theory (ie, that a competitive equilibrium is Pareto Optimal, and that a Pareto Optimal Equilibrium is a competitive equilibrium). Or consider the Lucas Islands model, which modeled economic fluctuations as the result of unpredictable monetary growth an inflation. In the 1970's, this was a leading explanation of business cycles, but no longer. Nonetheless, the model remains in the canon because it is self-contained, has a lot of intuition, and inspires economists as to what they are trying to create. The hope is that one creates a mathematical model, like the Black-Scholes equation, that sheds light on new truths. Good models calibrated to existing phenomena should generalize in unexpected ways. Alas, this is rarely the case in economics, as the model usually remain parochial explanations of the economic fact that inspired it (eg, the Phillips Curve).

Romer's model is motivated by the fact that while there is convergence among various economies, such as developed economies, there is not convergence among all of the economies. So, Japan, France, and the US all vary around a similar GDP/capita, but Africa remains mired in poverty, seemingly unaffected by worldwide economic growth. The existing Solow Growth Model could not explain this, except to trivially note the African economies had lower productivity, a parameter in the Solow Growth Model.

The Romer model has the form


and x(i) is the labor of an individual, k(i) a firm's capital (assume people are also firms). K=sum(k(i)), reflecting the idea that bigger economies have more knowledge, and thus, greater productivity. F is increasing in all its arguments. The key technical point he makes is to assume Y is a concave function of k(i) and x(i), which is necessary for an equilibrium to exist, yet because F is increasing in K, you have increasing returns to scale in aggregate. Thus, a competitive equilibrium exists even with increasing returns to scale, because their individual effect on total output K is insignificant (otherwise, with increasing returns to scale, everyone soon chooses infinity to maximize their production/utility).

Most interestingly you get multiple equilibria, in that if you can coordinate everyone to invest a lot, growth is higher than otherwise. This highlights the potential for good institutions to incent greater growth, say by offering more secure property rights, or intellectual property laws. Prosperity becomes a coordination problem, seemingly soluble by abstruse mathematics.

This is the cause of great joy among economists because it allows for lots of modeling: you can prove an equilibrium exists in the infinite horizon case using Hamiltonians, which have proved very useful in physics (the gold standard for science). The end result of this is Bob Lucas's Recursive Methods in Economic Dynamics, a book with a lot of math but not much insight (ever since John Nash successfully used a fixed point theorem to prove his eponymous equilibrium, economists have been eager to apply fixed point theorems to other problems, without much success).

The new growth theory tries to explain productivity 'endogenously', as opposed to Solow's exogenous treatment. Yet what is Romer's take away, when translated into words? First, he repeats again and again that higher productivity leads to higher productivity. But that can't be right, in the sense that growth rates of developed countries are not increasing over the past 100 years. I think what he means is that developed countries keep growing, while undeveloped ones don't, due to their 'bad equilibrium'. So we are back to, why does the US have the good one and not Haiti?

Then Romer seems really happy about noticing that productivity is not merely more stuff, but stuff differently arranged. He notes there's a machine that using carbon, oxygen, hydrogen and a few other atoms that is smaller than a car, renews itself, fixes itself, and creates valuable output. What is it? A cow! See, all we have to do is arrange atoms into cow-like things, and the future of robot maids, jetpacks, and holodecks will finally arrive. I don't see this kind of insight rising above the fantasies of your average comic book reader.

In Romer's talk, he talks about these issues, and highlights that a growing economy has 4 major pieces:

1) competition
2) entry
3) emulation
4) exit (loser firms are reallocated to winner firms)

He gets excited by the idea that many countries could be like Hong Kong in the pre-Chinese era, taking Britain's superior laws, customs, and technology. Yet, even in the US, things like competition, entry, and exit are heavily legislated against by entrenched interests. Sure, Haiti or Paraguay could allow in foreigners to set up franchises, but they don't, because that seems to many as exploitation, and has the stench of racism. So we are back to the old ideas about international trade, the distribution of wealth, and especially the distribution of wealth among various ethnicities. A ruling clique would keep their people poor rather than turn over, say, Petrobras to Exxon.

Japan in 1854 seems the best model for an economy that emulated existing technology, where the Japanese noted their technical deficiency after being defeated by the US Navy and then adopted Western technology without having the Westerners actually own anything. So the question is why did Japan do this, but not the hundred or so other undeveloped countries? Romer's big idea seems best addressed by much less mathematical analysis; his model is sterile when applied to the real world.

Romer's asking the right questions, but as Michele Boldrin noted in Against Intellectual Monopoly, the question about the value of various forms of patents is an empirical one, not deducible from theory. If Romer's 'growth theory' has anything really to add, I haven't seen it.

Sunday, November 29, 2009

Kling and Schultz on Financial Intermediation

I read an interesting book this weekend by Nick Schultz and Arnold Kling: From Poverty to Prosperity. It's a nice exposition of how life has changed over the past 100 years (mainly for the good), interviews with top economists, and provides food for thought on many issues.

In the last section of the book, however, I found their general description of finance to have a misleading emphasis. There was an exposition where assets have risk characteristics that are obscured as they are passed up a food chain, until finally there is greater liquidity, but less information available. Risk is transferred, but because of the lack of transparency, it actually increases.

Clearly, there is transferral of risk in finance, but I think this is not the essence of finance. Finance is intermediation, taking money from savers and giving to people who want to use that money. They, in turn, promise to pay it back. The process generates prices that act as signals to inform those borrowers and savers how best to borrow or save.

Yet, fundamentally, much finance can be considered one of five forms: marketmaking, clearing, originating, servicing, and warehousing. These specializations make for different focus by various firms, so that things important to one set of financial institutions are often irrelevant for another, and 'risk' means different things to different parties, because the risk they retain have different characteristics.

Investment banks, NYSE members, and venture capitalists, often make markets for those wishing to buy or sell. If they merely help connect two parties, like, they are brokers. If they have an inventory, like Nevada's Bunny Ranch, they are dealers. This activity is primarily about pricing. Risks are mainly about not having a correct hedge.

Clearing transactions such as checks or sales of stocks, is a valuable service, because one needs to know funds actually get from one party to another. For example, it an escrow account, both parties are sure to get their interests prior to losing control of what they are exchanging. Risks are operational, due to fraud or incorrect documentation.

Lenders originate loans or investments via their connections or brand name. This gives money to those who want to buy houses, set up a company, or finance their receivables. It involves marketing, designing products with attractive features, and doing the initial credit evaluation of the borrower and collateral check (underwriting).Risks here involve making 'innovations' to the product that are material, while assuming they are not. As it takes several months for a bad loan to reveal itself, this is why banking is very different than market making, one should have seen several lending cycles to appreciate the importance of various traditions.

Lenders also service these loans, monitoring the ongoing health of the borrower, the collateral, whether he is paying interest, etc. Risk here is operational, in that one must be able to monitor payments, and actually repossess the collateral.

These investments are then finally warehoused as 'assets'. Presumably, idiosyncratic risks are no longer relevant, and so one is left with various exposures to systematic risks: credit cards, housing, banking in general, etc. The ultimate risks due to broad covariance with 'the market', of course, do not disappear, which is the basis of portfolio theory, that only these risks are 'priced' in the sense that one expects a premium for their discomfort. Alas, that theory fails empirically, in that no one has been able to find a general covariance that explains the relative returns of assets (see my book, Finding Alpha).

These 5 attributes of finance are complements, and so many firms have overlapping functions. Yet, some specialize, and so investment companies often are merely in the process of warehousing, buying equities or debt and bundling them into portfolios. As the ultimate owners, these warehousers hold most of the value of the investment, yet, some of the value must be apportioned to each, necessary part of the financial process, and so servicers, clearing firms, market makers, and originators receive some of the money, often a fixed transaction cost. It is wise to keep originators honest, and servicers diligent, by having them retain some of the residual risk of any investment.

This does not contradict the idea of financial intermediation as risk transfer, yet it highlights the fact that the basic risks that are kept away from the warehousing are generally those that are presumed to disappear. A good originator, or servicer, monitors and manages his task so that an investor can assume his asset has a certain expected return and variance and covariance.

In the housing crisis, the complexity of the CDOs and derivatives was incidental to the assumption that housing prices across the country, would suffer only negligible year-over-year declines. Everyone made this mistake: greedy bankers, clueless academics, regulators, even Robert Shiller in 2005 could only muster up the observation that the increase in housing prices was probably not going to continue, and further, some cities might experience declines. Add to that the power of diversification, and complexity grows. Unfortunately, when the AAA-rated Mortgage backed securities defaulted, the question arose as to what was the essence of the 'mistake': housing? AAA ratings? Rating agencies? Securitization? Bankers? The Fed? All AAA rated debt became suspect, and raising this rate across the board made many projects unsustainable.

So, I don't think it was 'too much opacity' that was the essence of our recent problem. Rather, it was a bad assumption, one that very few people mentioned prior to 2007 (see Stan Liebowitz). That was not a risk hidden via the other participants in the intermediation process, rather, the many people who witnessed the degradation in lending standards for homebuying thought they were doing something morally right and empirically innocuous, not worth highlighting.


Wednesday, November 25, 2009

Krugman's Deficit Rationalization

An alcoholic is someone you don't like who drinks more than you do; a 'fun guy' is someone you like who drinks more than you do. The relativity is important to the degree 'other things' are different.

So, when Krugman notes that, in three years, our debt/GDP ratio will be comparable with other decent economies (Belgium and Italy), we have no worries! It is true that Debt/GDP does not have a strong correlation with GDP/capita, or something. Yet, like drinking too much, it's still not good to be adding 10% of your GDP to debt every year.

Tuesday, November 24, 2009

Gammon's Black Holes

In 1968, the poverty rate in the US was 12.8%. Since then, we have introduced or vastly expanded the following:

food stamps
job training courses
community development block grants
urban redevelopment schemes
aid to families with dependent children (AFDC)
social security disability income
section 8 housing grants
emergency assistance to needy families with children
college scholarship aid
free and reduced price lunches
child care
housing projects
head start

Currently, the poverty rate is around 12.3%. More importantly, most of our cities have become unlivable, so that most college-educated families simply do not live within the city borders of Cleveland, Detroit, Philadelphia, Newark, etc. More programs, worse results.

Dr. Max Gammon was a British physician who noticed that although government spent significantly more on health care than it had previously in the 1960s, the National Health Service didn't seem any better for it. After an extensive study of the British system of socialized medicine, Gammon formulated his law: "In a bureaucratic system, increase in expenditure will be matched by fall in production...such systems will act rather like 'black holes,' in the economic universe, simultaneously sucking in resources, and shrinking in terms of emitted production."

Monday, November 23, 2009

Modern Poverty

From Steve Sailer:
This weekend saw the national rollout of two crowd-pleaser movies about impoverished 350-pound black teens: Precious and The Blind Side. (What an amazing country we have, where a pair of poor children can tip the scales at 700 pounds!)

Sunday, November 22, 2009

90% of Politics is Context and Pretext

Political arguments, like much litigation, are rarely about what they are explicitly about.

Consider the blatant $100MM give away to Louisiana, to get Democratic Senator Mary Landrieu to vote for the health care bill (alas, we aren't done with the payoffs). How does one say 'Louisiana' without saying it?

Here is the portion of the bill that targets Louisiana:
the term ‘disaster-recovery FMAP adjustment State’ means a State that is one of
the 50 States or the District of Columbia, for which, at any time during the preceding 7 fiscal years, the President has declared a major disaster under section 401 of the Robert T. Stafford Disaster Relief and Emergency Assistance Act and determined as a result of such disaster that every county or parish in the State warrant individual and public assistance or public assistance from the Federal Government under such Act and for which— ‘‘(A) in the case of the first fiscal year (or part of a fiscal year) for which this subsection applies to the State, the Federal medical assistance percentage determined for the State for the fiscal year without regard to this subsection and subsection (y), is less than the Federal medical assistance percentage determined for the State for the preceding fiscal year after the application of only subsection (a) of section 5001 of Public Law 111–5 (if applicable to the preceding fiscal year) and without regard to this subsection, subsection (y), and subsections (b) and (c) of section 5001 of Public Law 111–5, by at least 3 percentage points; and ‘‘(B) in the case of the second or any succeeding fiscal year for which this subsection applies to the State, the Federal medical assistance percentage determined for the State for the fiscal year without regard to this subsection and subsection (y), is less than the Federal medical assistance percentage determined for the State for the preceding fiscal year under this subsection by at least 3 percentage points.

Thursday, November 19, 2009

My Politicals Enemies are Idiots!

I watched the BloggingHeads video about Sarah Palin's new book, and loved hearing Michelle Goldberg compare Obama's 'Dreams of My Father' to Tolstoy, whereas Palin's book is like the teen lit hit 'Twighlight'.

Liberals hate IQ but love to assert that conservatives are stupid. In any case, all this hullabaloo about Sarah Palin I find rather amusing. She, like most politicians, is not that bright. I would estimate an IQ about 115, your average college kid. But most high power pundits are 125, and hate it when successful politicians are less intelligent than they are out of envy. Thus, the kid who asked Dan Quayle how to spell potato was asked to lead the Pledge of Allegiance at the 1992 Democratic National Convention, as if to highlight how knowing how to spell potato proves one smart enough to run the country (but then, what about literacy tests for voters?).

Of course, they hate people with really high IQs too, because these smarter people are often too socially obtuse to pretend the David Brooks and Thom Friedmans have anything interesting to contribute (e.g., Donald Rumsfeld). Thus, the most famous people at any time are the Katie Courics, Oprahs, and Matt Lauers, people who are slightly above average but most of all, agreeable and deferential to self-appointed intellectuals. The criticism that Sarah Palin is stupid I find absurd because 1) she's merely slightly above average, as are most popular people and 2) almost all politicians are as smart/dumb as she is. Consider Harry Reid, Maxine Waters, Dennis Kucinich, none of whom is smart, they blurt out unthinking trope like trained monkeys, and none more intelligent than Charles Barkley.

It reminds me of when Hyman Minsky would go off on John F. Kennedy, noting that he was often presented as genius because he went to Harvard. Kennedy was a below average student at a time when Harvard had a lot of dopey legacies, and Minsky the Liberal was too independent to pretend he was some sort of genius.

I consider politicians mostly narcissistic, smarmy, and unthinking. Those accidentally glommed onto my general disposition towards Friedmanism, I'm for. Ronald Reagan was often called an idiot while in office, but was a good politician because he changed the trend through his steadfast defense of smaller government. He wasn't a Richard Feynman, but he was consistent, and a good communicator.

My old boss Jerry Jordan (a member of the Council of Economic Advisors and Cleveland Fed President) told me about a cabinet meeting the Gipper was in where someone said we should raise quotas against country I because they have quotas against us. Reagan responded, "so if they shoot a hole in their life raft, we should too?" That dismissed some marginal trade retaliation. Having this kind of common sense in the top position, whatever the origination, is something to be thankful for.

Most pundits, professional and amateur, consider a genius as someone who can articulate one's platform more effectively than themself. An idiot is someone who effectively articulates the other side.

Wednesday, November 18, 2009

Is it a bonus if everyone gets one?

In my children's athletic endeavors, they often get trophies or awards for 'participation'. The emphasis is on making everyone feel good for making an effort. For a child, this is not a bad thing. But when we become adults, we must put childish ways behind us. At least that's the classical view. A new incentive plan would pay Advanced Placement teachers $100 bonuses for each student who passes the test, and up to $3,000 a year for meeting other goals. Students also can also receive $100 for passing. But, it doesn't look like it will happen:
The Boston Teachers Union staunchly opposes a performance bonus plan for top teachers - launched at the John D. O’Bryant School in 2008 and funded by the Bill and Melinda Gates and Exxon Mobil foundations - insisting the dough be divvied up among all of a school’s teachers, good and bad.
Union head Richard Stutman bristled at criticism he doesn’t have his members’ interest at heart. “We’re not taking money away from teachers,” Stutman claimed.

He also objected to the suggestions his union is a foe of school reform, insisting he backs the incentive program - so long as the bonus goes to all teachers, not just AP instructors.

Unfortunately, unions think Woody Allen's line that "80% of life is just showing up" to be a creed, not a cynical remark.

Crisis and Leviathon

Crises tend to expand the role of government, which then never subsides. The theme of Robert Higgs' Crisis and Leviathon was that wars and great depressions create a ratchet-like movement toward ever bigger government. The process involves government taking on new functions more than expanding traditional ones. In the end a distant set of bureaucrats regulates everything, but nothing well. Most functional units have specialized argot, data, processes, and contacts, and new employees takes months to know enough to be productive. A regulator has a few weeks at best, probably a few days, to review an organization. How is he to find problems, let alone fix them?

In practice, regulators ask for a select set of reports, usually highlighting statistics that would have been useful in the last crisis, and make bland statements about the desirability of 'clear lines of authority' or a 'prioritization of risk management' (see the Fed's new Senior Supervisors Group Issues Report on Risk Management Practices).

I've talked to many risk managers at large financial firms lately, and there appears an increased focus on regulators: what do they want? This is in contrast to asking, what do we need? The latter question draws on the parochial expertise of people who have to create products and services worth more than they cost to produce, the former draws on the results of endless committee meetings by people who are far removed from the front line.

The subprime crisis has discredited internal financial risk management, so now, instead of thinking about how to manage risk better, large firms have taken the understandable course of action in our Brave New World, of deferring such judgments to the regulators. Appeasing regulators determines whether one can, say, hire immigrants under H1B visa program, or pay a dividend, or worst of all, be labeled 'undercapitalized', creating a self-fullfilling death spiral necessitating an acquisition.

Firms, and the individuals therein, are in the best position to better their practices. With this recent crisis, they have strong top-down directives to placate the government, and cease all innovation because that was the kind of thinking that led to CDOs! Talk about a bad take-away. I expect banks to respond to their lack of productivity by increasing lobbying efforts to squelch competition, because that is really the only way for non-innovative organizations to make profits.

There's an East German joke that goes "What would happen if the desert became communist? Nothing for a while, and then there would be a sand shortage." An important part of this joke is the 'nothing for a while'. Bad policies don't usually produce an immediate catastrophe, rather, they weaken the trend, barely observable when initially implemented. Only after a long while do people notice that the new system is a morass of dysfunctional duties that are done mostly out of precedent, no efficiency. For example, the socialist countries started to great enthusiasm by western intellectuals; so too with busing in schools, large scale public housing, the Department of Education. At best these are wasted resources, more often they create unintended consequences at the root of the next crisis.

A friend of mine lost his job in the financial sector. He got a new job with the FDIC. As a country we have decided to allocate more resources to government, more power to government, at all levels. I fail to see how moving more people out of private firms, that create wealth and pay taxes, to regulators, that impose costs and cost taxes, will make our financial system more robust. From the Great Depression, to the Carter Credit Controls of 1980:3Q, to the S&L crisis, to the Subprime Crisis, Government was not standing athwart history saying 'stop', rather, it was encouraging the very behavior that turned out, with hindsight, to be the root of the problem.

Monday, November 16, 2009

China Doesn't Like Carry Trade

A carry trade is when you borrow from a currency with a low interest rate, and then invest in a currency with a higher interest rate. Say the US interest rate is 3%, and the Chinese interest rate is 5%. Borrow at 3%, invest at 5%, make 2%, because the Chinese yuan is pegged to the dollar at a fixed rate. Easy! Unfortunately, there's a Peso Problem in this trade, because at any time the Chinese currency could be devalued relative to the dollar, and you can lose years of money in one day.

This trade is really just taking advantage of 'uncovered interest rate parity', where theoretically the differential in currency interest rates should be offset by the expected change in currency rate, plus some risk premium. On average, however, high interest rate countries tend to have currencies that also increase in value. The carry trade blew up in the latter half of 2008, but nicely rebounded, and if you look at over the past 30 years, it remains an 'anomaly' to standard risk models.

The chairman of the China Banking Regulatory Commission complained to Obama that the carry trade was destabilizing the Chinese economy, but this really means the capital inflows are making it hard to keep the currency peg at its low current level. China has a higher interest rate than the US, and though the US dollar is falling worldwide, the yuan remains at its old peg against the greenback. China could float it, and let the market decide, but like most politicians, he does not trust the market. More importantly, there are worried it will hurt exports because a stronger yuan would increase the price of their exports to the rest of the world.

If you meddle with major market prices, like a currency, you invariably make it too high or too low. Finding the 'right' price, is like finding the 'just' price, a subject of endless, fruitless debate. But if the Chinese want to sell us goods at below-market prices all I can say is: thanks for the subsidy!

Sunday, November 15, 2009

Gladwell's Igon Values

It has been said that a little inaccuracy can sometimes save a lot of explanation. Lies—what can't they do? It should also be noted that if you aren't bound by truth, you can tell a much better story, especially because when presented as truth, an untruth is usually 'unconventional'. A premeditated application of this approach is not merely a half-truth, however, but rather a whole lie. It plays on people's dreams about how the world should be, and so is rather a sophisticated version of organized religion's promise of heaven and hell.

In this weekend's New York Times book review, Steve Pinker reviews a set of essays by Malcolm Gladwell, and notes he mentions an “igon value” at one point, referring to an eigenvalue, which seems like an obvious error for the New Yorker's famous fact checkers to catch. Clearly, Gladwell talks to experts about a lot of things he does not really understand, and is able to create stories people find interesting, me included. But at the end of the day, it is important to be correct, and there, Gladwell is often comes up short.
The banalities come from a gimmick that can be called the Straw We. First Gladwell disarmingly includes himself and the reader in a dubious consensus — for example, that “we” believe that jailing an executive will end corporate malfeasance, or that geniuses are invariably self-made prodigies or that eliminating a risk can make a system 100 percent safe. He then knocks it down with an ambiguous observation, such as that “risks are not easily manageable, accidents are not easily preventable.” As a generic statement, this is true but trite: of course many things can go wrong in a complex system, and of course people sometimes trade off safety for cost and convenience (we don’t drive to work wearing crash helmets in Mack trucks at 10 miles per hour). But as a more substantive claim that accident investigations are meaningless “rituals of reassurance” with no effect on safety, or that people have a “fundamental tendency to compensate for lower risks in one area by taking greater risks in another,” it is demonstrably false.
The common thread in Gladwell’s writing is a kind of populism, which seeks to undermine the ideals of talent, intelligence and analytical prowess in favor of luck, opportunity, experience and intuition.
Readers have much to learn from Gladwell the journalist and essayist. But when it comes to Gladwell the social scientist, they should watch out for those igon values.
The straw man argument is popular because it is effective, and I would say is the dominant rhetorical ploy.

Friday, November 13, 2009

Our Government's No Money Down Efforts

Who knew the FHA was growing so rapidly:
But the New Deal-era agency has seen its market share swell, to around one-quarter of the mortgage market today, up from 2% in 2006, according to Inside Mortgage Finance.

During the second quarter, the FHA backed nearly half of all mortgages made to first-time home buyers, and today it accounts for around half of all new home loans in some of the nation's hardest-hit housing markets.

The agency expects defaults on 20% of those backed in 2008, when it should have known better. Considering they are politically afraid of foreclosure, they seem intent on learning the hard way that a pushover lender can lose a lot of money when the word gets out. But, heh, it's not their money, it comes from Obama's magic stash!

From the WSJ, we see that Rep. Scott Garrett (R., N.J.) introduced a bill last month that would raise minimum down payments to 5%, up from the current 3.5% minimum. He might also address the fact that the $8k tax credit can be transmogrified into the down payment, making no-money down quite common for first time homebuyers, but already he has substantial opposition.

Thursday, November 12, 2009

Tyler Cowen at TED

Tyler Cowen is an avid reader of many things, including fiction. He notes he dislikes games, such as Trivial Pursuit, in comparison to reading. Anyway, I found his talk at TEDxMidAtlantic rather fascinating, because he basically argues that fiction is, ultimately, fiction. He argues against trying to fit everything into a 'story'. That is, there is a small set of story lines: journey, rags to riches, quest, voyage and return, comedy, tragedy, rebirth, facing mortality, etc. So, we have the story of Moses, and helps us understand George Washington, Abraham Lincoln, and Martin Luther King, emancipating a people. Stories are the way most people make sense about everyday happenings. They are theory that we apply to events, the why that explains the what.

We instinctively try to fit everything into such narratives: the health care debate, our career trajectory, our lives. Tyler notes that this may be too much. Life isn't a story. Often it just keeps going, is messy, and has no point.

I found this a very refreshing point. My 10 year old son had to write a story, and his first draft was basically a narrative with stuff happening but no arc, no Exposition/Rising Action/Climax/Falling Action/Denouement: he went there, and Clay said X and so we did this and Connor said Y and yada yada yda. I tried to get him to appreciate the essence of a story, but it was suprisingly (for me!) not obvious to him, and his intuition was based on his experience with life, which is, there is no story.

I suppose that my view, that stories should have an arc, is more educated, and his 10-year old intuition is unstructured, incomplete. Yet his innocence betrays some naive wisdom, that life is in some sense 'one damned thing after another'. It's good to know the strengths and limitations of both views: without facts, everything is bullshit; without theory, everything is trivia.

It's comforting to believe there's a bigger purpose, yet we flatter ourselves that unlike the Coelacanth or starfish our finite lives have some transcendence, which in our secular age means some small yet permanent benefit to justice and equality (synonymous for many). Instead, I think today's giants are all like great harpists of the past. They may have been fortunate to play an instrument well, but no matter how good, their skill is now an anachronism, and not valued in itself. Over time, it will be totally unappreciated, as future generations prefer different melodies and instruments. To think every drama in our lives is part of a story, written by fate, is alluring, but fanciful.

I pass the baton to others--my kids, colleagues--and hope there's some benefit. I want to be better than my parents, my old bosses. I get satisfaction when I do things well in this regard. If it all disintegrates because I was a fool, or the sun blows up and disintegrates the Earth in 1 billion years, I don't care.

Wednesday, November 11, 2009

Mutual Funds Know Investors Like Stories

Most mutual funds don't earn their fees, but the great unwashed keep investing in them, the same way the vote for politicians who perennially suggest they can solve problems that the last 10 guys did not solve. Yet ultimately, they sell what the public demands: style funds, index funds, sector funds, analytic All Star funds. They suggest, as always, that talking to an investment analyst to 'meet one's future needs' magically will provide for kid's college, or retirement, as if stating 'I really want $1MM in 10 years' can make it happen. These are part of an inconsistent global view of alpha, or how risk relates to return, empirically, but never mind, the public believes in these stories.

The Wall Street Journal outlines that some funds are adding market timing to their strategy, clearly with hindsight a good idea for 2008:
The Quaker Small-Cap Growth Tactical Allocation Fund, launched late last year, now has about half its assets in cash, down from as much as 95% last year. The new John Hancock Technical Opportunities Fund had about 12% cash at the end of October and is managed using a strategy that devoted roughly 90% to cash early this year

Unfortunately, there is less evidence that market timing is feasible than stock picking. Indeed, in 1960s the first tests of mutual funds took seriously the idea the funds added value timing the market, but it was quickly discovered there was nothing there. Considering that predicting the aggregate stock market has major data limitations (there just aren't enough stock market cycles in one's working life), this skill tends to be mainly marketing bluster.
Anders Ekholm, adjunct professor at Hanken School of Economics in Helsinki, recently analyzed more than 4,000 U.S. stock funds' returns between 2000 and 2007. Managers helped their performance through stock-picking, he found, but hurt their returns by market-timing.

Tuesday, November 10, 2009

Developing an Investment Strategy

I know many people who trade stocks frequently but shouldn't. If you look at the most active stocks, they include many ProShares stocks that give you two, even three times the leverage of the regular stock market. Thus, the risk minimization from diversification implicit in indices is removed via leverage. Unfortunately, this does not amplify the 'equity risk premium' because the high amount of trading in these vehicles generates significantly drag longer term: being long the UltraPro S&P500 (UPRO) gives you three times the leverage against the S&P500 daily, but over the long run, a worse performance!

If you are going to invest this way, the best thing you can do is work out a system. Develop rules, test them, write them down, and at the end of the year, evaluate your results. If you fail, perhaps give it another year. But after a few years, if you underperform standard benchmarks (eg, the SPY ETF), then either get out of the market, or stop trading, an simply invest in the SPY.

A book like Larry Connor's High Probability ETF Trading is a good place to start. The author presents a straightforward technical trading strategies, mainly based on momentum over longer periods (eg, 200 days), and mean reversion over shorter horizons (eg, 3 days). There's a lot of empirical research that suggests these trends generally exist, in that momentum is one of the famous equity risk factors (from Jegadeesh and Titman), while mean reversion underlies a lot of 'stat arb' strategies. The issue is, can you use these facts to add alpha to a naive strategy of going long and forgetting about it.

In trying to be clever, there are two things going against you at all times. First, there are many nuances to any actual implementation, and if you play around enough something will work if only by chance. Thus, you have to be disciplined when testing these strategies because it is easy to find something if you try hard enough--torture the data enough and it will confess. Second, there are transaction costs. For a retail investor, I would assume a one-way cost of 2 cents a share. Make sure this cost is included in your performance results.

So, Connors' book walks through several such rules (buy if these 5 conditions are true, exit if this one condition holds). You can learn how to test strategies downloading daily Open-High-Low-Close from Yahoo!, and set up a spreadsheet to apply it to the past 5 or even 50 years of daily data. You may not like his specific rules, but it clues one in on what kinds of things people find useful, and if you can test his strategies, you are then in position to create your own, similar strategies.

Most importantly, if you plan on trading more than once a year, you should have a testable system. Maybe it's based on fundamentals, but at least you should have a written record of what you were thinking, and when. The main thing to avoid is investing ad hoc every year,and not learning that you are wasting money and time. Most people are wasting their time at anything innovative: your average poet, screenwriter, trader. The key is to discover if you are in the 'talented tenth' ASAP, because sampling alpha is costly.

So, if you must actively invest, evaluate not just a particular tactic (buy after 2 up days when price is above the 200 day moving average), but the strategy: should you even be actively trading at all? Remember, odds are you will fail as demonstrated by the fact that most retail investors do not outperform the market, and neither do professional money managers. Do not assume that simply trying hard, or wanting it, are sufficient, because every money manager really wants to outperform, and most work quite hard. Don't take it poorly, no one is good at everything, and very few are very good at more than a few things. The key is to find what you are good at so you can do it again and again, and this takes some courageous sampling, a good effort, and then a Hardheaded evaluation.