Friday, February 26, 2010

Krugman's Petulance Explained

A long New Yorker piece looks at Paul Krugman, and he clearly is one of those high functioning, socially obtuse nerds one meets all the time in quantitative fields. That is, he has some amount of Asperger's, which means he has trouble seeing things from other's perspectives. Thus, everyone who disagrees with him is 1) an idiot or 2) evil. He can't imagine it otherwise.

Tuesday, February 23, 2010

Sowell's Intellectuals and Society

I really loved Sowell's latest book Intellectuals and Society. As I'm a big fan of Friederich Hayek, the application of his seminal insight about how the market effectively decentralizes decision making was really enjoyable. That is, Sowell notes that intellectuals don't know the essential information of parochial time and place that is so essential. It is easy to dismiss this knowledge because it tends to be pedestrian, not elegant or sophisticated. Yet there are so many different essential facts, the sum of this simple knowledge adds up to 100 times whatever is known by intellectuals like Paul Krugman or Ezra Klein, who pontificate on their industrial policies as if such details don't matter. Intellectuals have a tendency to dismiss this because they have often been the smartest person in the room growing up, and naturally assume this greater knowledge is also present when considering health care or energy policy, but it's just one of those insights that isn't obvious because they have always gotten an A+ on their term papers, which never actually were implemented.

The stupidity of government do-gooder regulators was really highlighted for me last weekend. My wife doesn't work, staying home with our 2 year-old Izzie. She would often go to our health club after our boys are at school, around 9 AM, where there is a childcare facility and she can have a leisurely workout. She found they needed help, and she knows people there, so she works there part time, around 4-hour shifts, while Izzie is in childcare. She enjoys the break from the kids, the adult comaraderie, and Izzie has fun playing with other kids in a room just down the hall from my wife. Yet last weekend OSHA, the US agency that 'regulates workplace safety' determined that this could not stand, because the health club's child care center was not licensed for such service (greater than 2 hours). Supposedly, they would need some extra-special licensed childcare, which would then be too expensive to the club. So, because some bureaucrat decided they would save workers from the evils of firm childcare, the health club loses out on my wife's cheap labor, my wife loses out on some quality no-kid/adult time, and Izzie loses out on playing with her snot-nosed buddies. Lose-lose-lose.

The New Republic's Alan Wolfe harshly reviewed the book, but precisely because he is the type of intellectual Sowell is criticizing. Indeed, he criticizes a couple of New Republic founders, so it surely hit home. Surely, Sowell makes generalizations that aren't always true (as if any generalization is always true), and even the really obtuse intellectuals had some neat insights, stylish prose, and witty ripostes. Yet net-net, I think Sowell is spot on. The contractor that can build houses on time and on budget, is so much more useful to society than any intellectuals with their trenchant insights on society. Yet, allowing them to interact in the market without top down direction is rarely considered optimal, as if that is like building a bridge without blueprints. It rarely occurs to them we need the government to get out of the way, as opposed to apply another top-down fix. Further, many of our big benefactors--Henry Ford, Andrew Carnegie, John D. Rockefeller--are presented as Robber Barons by intellectuals, as if they were parasites and not wealth creators. Haiti and many other countries could use those kind of people.

He's one of those lucky writer who writes books basically full time, with paid assistants, and it shows, as the book reads well with appropriate examples (I wish I had a helper for my book!).

Placebo Effect in Drug Tests

It's common practice for FDA tests to prove their worth in 'double blind' tests: the dispenser and the recipient both don't know who gets the sugar pills, who gets the real thing. That way, one can account for the well documented placebo effect, which is that people respond positively to any putative action. But, it turns out this isn't really well captured. From the New Yorker:
But antidepressants have side effects, and sugar pills don’t. Commonly, side effects of antidepressants are tolerable things like nausea, restlessness, dry mouth, and so on. This means that a patient who experiences minor side effects can conclude that he is taking the drug, and start to feel better, and a patient who doesn’t experience side effects can conclude that she’s taking the placebo, and feel worse. On Kirsch’s calculation, the placebo effect—you believe that you are taking a pill that will make you feel better; therefore, you feel better—wipes out the statistical difference [in most psychiatric drugs].

Yikes! That seems like a major blunder. Given the FDA bureaucracy, I doubt it's going to be addressed anytime soon (ie, before I die).

Wednesday, February 17, 2010

Progressive Competition

The real magic of the invisible hand is based on two pillars: self interested action to motivate people, and competition. Without competition, self interest leads to monopolies and sloth, but workers compete with other workers, and companies compete with other companies, we get better workers and widgets.

So one would think that opening up states for real competition would be an obviously good idea. Yet it is highly instructive what progressives think about competition and markets, that they approve of only highly constrained competition that basically neuters it. In Minnesota, we have 3 health care providers, and they all have highly regulated choice offerings. We have 68 mandates, meaning, I am paying for things I would not otherwise pay for (osteopathy, chiropracter, port-wine stain elimination). Insurance means exchanging a certain small payment for an uncertain large payment; in this case, I'm paying for many things I'll certainly never use. If providers all have to provide identical service menus, entitling consumers all they can get from that list, this is not competition.

It's as if the state decided that food was too important for the mere market, and so gave us all food insurance. We paid a special food contribution (not a tax!), and we were all entitled to a buffet offered by 3 different private companies. The buffet has to include traditional American fare, as well as Chinese, Mexican, Italian, Korean (dog), etc.--68 mandates in all. Most people don't want all the choices they pay for, but as they don't pay when they eat most people do not notice they are paying for things they don't eat. Now, as the food budget as a percent of GDP in America grows, and Americans are not any healthier than other developed countries, people ask, hey, can I just buy what I want to eat? The government tells you 'no', that is just a race to the bottom, and your stupid, irrational inclinations will cause you to buy the medical equivalent of a pet rock.

So we have 3 buffets but the same menus, no out-of-pocket spending, and no real competition. This is what progressives think of as 'the market'. They convince themselves things will get better if they have even more top-down control (single payer) because then they could implement technological and logistic innovations (cutting out the darn middle man) that will lower costs, all the while keeping health care employment levels and compensation rates the same. One might be tempted to say, it can't get worse than the status quo, but that what the Russians said in 1917, and boy were they wrong.

Sunday, February 14, 2010

Valentine's Day Sexonomics

Steve Levitt's Freakonomics bestseller highlighted that many quirky phenomenon can be analyzed using economic reasoning, or really, assuming individuals are self interested, and applying statistics and logic to that. Many people find this application of 'economics' much more interesting than applying such logic to widgets or muni bonds, so why not just get all those cost and indifference curves in price/quantity space out of economics textbooks, and replace with sexy pictures and fun sex trivia? One could then see economic lessons on Spike TV, right after Manswers. After all, sex is an object of exchange just like any other commodity, but a lot more fun for college-aged students to contemplate.

For example, Charlotte Allen's article on the New Dating Game, and Lori Gottlieb's book on why women should settle rather than become spinsters, brought forth a lot of 'Freakonomic' issues around dating, sex and marriage, and generated considerable blog buzz (see Robin Hansen, Slate, Jezebel). Writing about these matters is always sure to get people excited, because these are issues people feel they understand pretty well, so people who disagree are way wrong! This got me thinking about the fun book, Mathematics and Sex, which is good nerd porn. Consider the application of economic models to the following issues:

Asset pricing: Choosing a young man for a long-term mate means evaluating his future value; you don't want a young hottie who won't age well. Hot Chippendale dancers with low intelligence aren't good buys. But then, if you want to get the next billionaire, should you try to find the next Bill Gates or Warren Buffet? These are true nerds, and at 18 they weren’t attractive to most women (Buffet writes candidly about his social ineptness as a young man). So, should women glom on to nerds? Well, it could be that nerds have a higher top return, but lower average return, so this isn't optimal even abstracting from their obviously lower current value. Fads based on conspicuous successes can alter the value of current young men. Perhaps your dad was a prior bubble (eg, he was good at 'the hustle').

Labor Economics: A lot of labor issues are about cartels: monopsonies, such as one-firm towns as when mining companies employed a plurality of people in a town, or monopolies as when unions prevent companies from negotiating with individual employees. Historically men have dominated women in the sense of having more political and monetary power, so, why not have all women form a cartel, as in Lysistrata, withholding sex to get men to be nicer? The problem is this is not robust to defection. One woman, presumably an opportunistic woman of lower quality (eg, a "2"), could offer sex to a high quality man and thus snag a top male. Once this happens, the coalition falls like a house of cards. Indeed, Milton Friedman predicted that the OPEC oil cartel would eventually fail because such cartels are inherently fragile.

Game Theory: Thomas Schelling highlighted the benefits of being irrational, because if you convince other countries you will blow the world up if they launch an atomic bomb at you, you actually deter their use of the bomb. Committing to an irrational response, is rational. In a similar way, prudish mores about sex can make everyone in society better off, because without stigma and shame of having sex outside a pair-bond, there's massive sexual inequality and lower parental investment. Consider that monogamy is good for beta or omega males, because that keeps alpha males with only one female. But if sexual morality becomes unpopular, serial monogamy (aka one-night stands) will be a dominant strategy for those with the highest value, because they can. Those with the most to gain from such activity will do it most, further eroding the quaint stigma attached to casual sex, encouraging more of it. Those with low value will try to have casual sex to signal they have higher value, leading to an equilibrium like when Charlton Heston comes down from the mountain with the 10 commandments and it's the best frat party ever (soon ruined by a vengeful God, and as always the people who didn't rush are very envious). Charlotte Adam's piece on the New Dating Game basically suggests this is what is happening, leading to alpha males having many partners, omega males left out, and women of all qualities tolerating philandering men who aren't there to raise the kids (aka, 'restoring primate-style hypergamy').

Supply/Demand curve elasticities: Men's demand for sex more inelastic, in that they need sex more than women. Just look at the sex frequency of gays vs. lesbians, and you see that men prefer more sex than women. One reason may be that a sex act implies a much higher probability of orgasm for men than women, so if the present value of sex is the expected orgasmic payoff, it’s strictly higher for men. In any case, women can extract compensation from men in return for sex, because the person with the higher elasticity has the market power. Ergo, men have to bring more to the transaction than their bodies, they have to pay for dates, open doors, put the toilet seat down, etc. Indeed, on a day-to-day basis, a woman's lower sexual desire negates a man’s physical or monetary advantage, which is why most women are at least co-equals in their relationships.

Public Choice Theory: median voter theory suggests that candidates merge to slightly different takes on the median position. However, when political issues are considered multidimensional rather than single dimensional, an agenda setter could start at any point in the issue space and, by strategically selecting issues end up at any other point in the issue space, so that there is no unique and stable outcome. Arrow's Impossibility Theorem highlights that there is no way a multidimensional person can be unambiguously ranked, in that there is always some arbitrariness how you weigh, say, personality vs. physical attractiveness, or within looks, face vs body, or within a face, skin tone vs symmetry (eg, there are many important dimensions). So one clear implication is to emphasize, like Maureen Dowd, your best attributes as best for everyone, and pooh-pooh the status quo preferences that highlight the Beyonce's and their male equivalents as vulgar, uneducated and short sighted.

Search Theory: Date 37 men. That is a sample of men who reveal a desire to match with you. You want to maximize your mate’s quality. This is the optimal stopping problem, or secretary problem, because you sequentially select from a sample of a population, and at some time have to settle down to enjoy the benefits of that person (eg, you eventually want to ‘use’ the secretary/mate), and you can’t go back (always pathetic, ‘hey, remember me? It turns out I was wrong and you are the best I can do. Want to go out again?’). A practical solution that is near optimal is to lock on to your next partner that is better than best of the original 37, which presumably increases the odds of finding your best match from 1% to 37%(that seems like a lot to me, but hey, he proved it). That's probably near your best match given your type.

Pooling vs. Separating Equilibria: in a pooling equilibrium, the good and bad apples are mixed together, so you price them as the average. This leads to breakdown in markets, because no one will sell good apples if they are assumed half-good. Quality signals will be costly, because otherwise they lead to pooling equilibrium. One thing men want is fertility, which is correlated with attributes like waist-to-hip ratios (optimally 0.69—heh—for women, 0.92 for men), clear skin, white sclera, and women’s magazines often highlight ways for middle aged women to enhance these attributes. One thing women want in men is money, so they find men with BMWs more attractive than men in Dodge Neons (indeed, women have a higher frequency of orgasm with higher wealth men).

Obviously, one could come up with enough examples and applications to replace Mankiw with something much more salacious and of interest to the mass of 18-21 year olds learning economics. It's not as if the application of economics to the study of GDP and employment has elevated the nature of political debates over the past 100 years.

Thursday, February 11, 2010

Math Hard, Society Easy?

From the Chronicle of Higher Education:
The social sciences are easier than the natural sciences, according to second graders.

Adults more or less agree. A study published in the Journal of Experimental Psychology took a look at which disciplines children and adults thought were the most difficult to learn. For the most part, people of all ages think psychology is easy and physics is hard. That bias begins early and changes some, but not much, the older we get.

One of the most interesting things we learned in Artificial Intelligence is that what we consider hard, like chess and multiplication, is easy for a computer. What we consider easy--like recognizing emotions on faces, or visually distinguishing between a dog and a cat--a computer finds quite difficult. What is hard for us, is only because we know the right answer, and know how difficult it is to do the logic in our head. Most thoughts we take for granted are really quite complex, yet because we can't even begin to write down how we do it, we do not realize it.

The social sciences are much harder than the physical sciences or math, in that our progress has been much slower here than in these areas. An educated man knows a lot more math or physics than a child or hunter-gatherer; he does not know much more about what causes business cycles. Figuring out why Haiti is so poor, or how interest rates affect investment, is really difficult. However, it is easy for someone to articulate an answer to hard social issues that is not obviously wrong, which makes it easy to think one knows the answer. A wrong math or physics answer, is clearly wrong, and if you have worked with people who knows something quantitative you learn quite quickly how ignorant you are in that area.

Don't confuse the inability to falsify with having figured something out. It generally means you just don't know what you don't know.

Tuesday, February 09, 2010

Naive Anthropomorphisms

Children's stories contain animals, even objects, that have human-like characteristics. They have not only intentions, but often faces. Further, they are either good or bad. Only later do we learn that most of the world is not so much malicious as indifferent. Hopefully, we learn that many most facets of society, such as income distribution, or the creation of cities, of technologies, is an emergent phenomenon, created but not designed by individuals, and singular individuals mainly help us apply a narrative.

So, smarmy Elizabeth Warren, writes an article today that suggests all bank policy is the result of bank CEO intentions. They " brought the economy to its knees", and now are "determined to stop any kind of watchdog" (the SEC, Fed, FDIC, OCC, and state insurance regulators don't seem to count). They are "bonus babies who were so short-sighted that they put the economy at risk and contributed to the destruction of their own companies". She shows not mere mistrust, but contempt for the the financial market she plans on controlling. As William F. Buckley put it, I would rather have Citibank be run by the first 100 names in the Boston phone directory than a bunch of Harvard professors.

I've worked with a CEO of a large financial organization. He was a nice guy, but he had very little to do with the pricing, product design, or other tactical strategic issues in the bank. He managed 'the process', personalities, did public relations, and perhaps championed a handful of corporate actions such as acquisitions. To personify the banking industry's actions as the will of their individual leaders, is like saying that America does what Obama wants it to do. They have more of a say than anyone, but it's still a small say.

If Jamie Dimon wanted to price, say, credit cards at a rate higher, lower, or less nuanced than other banks, more power to him, but if that tactic started losing money, it would be abandoned, and if it made money it would be copied. That's how the market works, profits tell banks what to do, losses what not to do. To the extent they are making short term profits, say by lending to windfarms due to a stimulus package windfall, investors are the only ones with real incentives to evaluate and punish firms for this behavior. After all, in Washington, they not only still encourage home loans with only 3.5% down, they shamelessly blame bankers for lending too much to home buyers while boasting about their affordable housing initiatives that made any regulatory concern about lower underwriting criteria impossible, and indeed sued firms, and blocked their mergers, if they did not meet lending targets to people who by definition had little income (historically underserved communities).

That someone with such a understanding of complex financial institutions highlights her naiveté, as if things are what they are, not because they are an equilibrium of borrower and saver preferences, but rather, the whims of The Captains of Industry in their top hats. To give her power, would merely reinforce what everyone in the industry knows, that Washington regulators are out-of-touch. For her, competition is simply a "race to the bottom to develop new ways to trick customers", and so we should expect her to create a 'stable' industry, like in our education and postal industries, where there is limited competition but lots of guarantees, and little or no productivity growth. She knows what banking customers want, and so doesn't trust a market to provide quality services and products because evil CEOs hypnotize their customers into thinking they want things they really don't. A better definition of a do-gooder cannot be found. I think she might be successful in her primary objective, in that socialists countries were immune from financial crises. I just think she doesn't realize this cripples GDP growth, as highlighted by the Cold War 'experiment'. After all, you can keep a pet from getting sick by killing it, if that's your sole objective.

Bad things aren't the result of evil intentions, so much as smart people overconfident in their ability to make the world a better place. They see people who disagree with their means as disagreeing with their ends, totally dismissing the possibility that they could be making things worse. She thinks her new fiefdom, the CFPA , will "consolidate seven separate bureaucracies, cut down on paperwork, and promote understandable consumer products. In the process, it will stabilize the industry, rebuild confidence in the securitization market, and leave more money in the pockets of families". ORLY? When has a new bureaucracy reduced bureaucracy? When has it 'cut down on paperwork'? The pages of fine print and endless places to initial are because of our laws and regulations, not in spite them. Will the bureaucracy make people wealthier? Well, government's the main place of employment growth, so I guess things are looking up.

Monday, February 08, 2010

Emotions Annoying but Necessary

When I was writing my dissertation in 1994, I had to avoid any 'behavioralist' explanation because these were considered ad hoc. This really stymied me because my main finding that low volatility stocks had higher than average returns didn't fit into any rational framework. Now the pendulum is on the other side, and behavioralist explanation need hardly any support more than an anecdote or introspection to motivate an empirical finding. We are obviously irrational, emotional, and use predictably irrational heuristics to make sense of the world. The question remains, are these explanations helpful, or simply ex post rationalizations? As Eugene Fama notes, half the behavioralist findings suggest overextrapolation (representativeness bias), half underextrapolation (anchoring bias), the average being 'rational'.

This subject was highlighted in a Bloggingheads TV post between Eliezer Yudkowsky and Razib Kahn. They ponder whether people are more problematically stupid or crazy. I'd go with crazy. Stupidity is a problem, but the really harmful ideas come from the smart people who believe in bad ideas, and the most imaginative people are the most credulous, because for them everything is possible if we just implement their master plan.

A lot of psychotherapy, if not philosophy, is based on letting go of emotions (the Serenity Prayer, Zen Buddhism), because anxiety makes us feel bad. As Hamlet said, 'There is nothing either good or bad, but thinking makes it so'. It's a nice thought, that we have nothing to fear but fear itself. Yet fear, and anxiety, do have a function. I find it interesting that children are learning at a much faster rate than adults, and one of the most distinguishing characteristics of children is the are much more emotional than adults, with more frequent and stronger mood swings; little kids cry a lot, adults almost never (curiously, I currently am only tempted to tear up during movies). I have met many very smart people, and they are often quite emotional. They are prone to paranoia, conspiracies, feeling either too proud or too ashamed of themselves at times. I don't think this correlation is an accident.

I think if you look closely at any thoughtful person, you will find attributes in their personality that border on some DSM disorder. The only people I know really well who seem totally normal are rather shallow, they have no great emotions that drive them to really interesting opinions. As Abraham Lincoln noted, 'It has been my experience that folks who have not vices have very few virtues.'

Neuroscientist Antonio Damasio studied people who had received brain injuries that had had one specific effect: to damage that part of the brain where emotions are generated (see David Brooks talking about it here). In all other respects they seemed normal - they just lost the ability to feel emotions. The interesting thing Damasio found was that their ability to make decisions was seriously impaired. Ask what restaurant they want to go to, they would dither, and consider an infinite number of considerations but never choose. They are lacking the emotion that allows them to mark things as good, bad, or indifferent, so without any emotional state they just see more data, often with conflicting implications. In particular, many decisions have pros and cons on both sides, and without emotions, the net result is ambiguous.

Shall I have the fish or the chicken? With no emotions, people are unable to make the decision.

I think this is related to the Ellsberg's paradox, which is the observation that people prefer to bet they will find a 'blue' ball if there are 50 blue and 50 red balls in an urn, as opposed to one where there's a 50% chance an urn contains 100 blue balls, and a 50% chance an urn contains 100 red balls. In the latter, the information is kind of incomplete, one can imagine others know whether the urn has blue or red balls, and is so arbitraging you. In the former, with a known 50% blue frequency, you are safe. Similarly, if your information set is incomplete, because you have not exhausted the state space of potentially informative data, you are potentially making a blatantly suboptimal choice. As shown in the paper 'Fact-Free Learning', looking for the set of inputs that maximizes an R2 is computationally hard. The problem is so pervasive that it has been canonized in literature: Sherlock Holmes regularly explains how the combination of a variety of clues leads inexorably to a particular conclusion, to which Watson exclaims, “Of course!” Once you know the answer, it's obvious, and it's scary to think an obvious explanation is out there, but you were merely too lazy to find it.

So, without a little built-in anxiety, a little homunculus who hates dithering, we would 'rationally' sift through all the data forever, because the state space we are searching for is not well defined, and it could provide an 'aha!' moment. But our whiney anxiety impulse pushes us to decide, which is a good thing, because we have finite lives, and many things to do.

Thursday, February 04, 2010

Heidegger is no Paradox

Martin Heidegger is one the twentieth century's most important philosophers. His Sein und Zeit gets one thinking about what does it mean to be? Yet, in the end such musings remind me of Bertrand Russell's observation that "If any philosopher had been asked for a definition of infinity, he might have produced some unintelligible rigmarole, but he would certainly not have been able to give a definition that had any meaning at all."

Anyway, there's a neat BBC video on Martin Heidegger, which spends a lot of time on Heidegger's life, but little on his ideas. Most interestingly, they spend about half the time discussing the 'paradox' that he was also a virulent Nazi. How could someone so wise is the ways of philosophy be so wrong on something so important?

Simple. It's no paradox that Hitler was nice to dogs and children, that Noam Chomsky is a great linguist and an apologist for every anti-American illiberal regime, that Isaac Newton believed in Biblically inspired numerology, or that someone who is really good at a parochial models of economic interaction would support socialism. My beliefs are not shaken by the fact that someone really smart thinks the opposite on some political issue--what crackpot idea does not have someone really smart who believes it? People have multiple selves, in some contexts, agreeable and insightful, in others closed and clueless.

Most importantly, politics is the arena of ideas that are not 'decidable' in the sense that one can logically prove any currently popular idea is 'wrong', and smart people are good at logic, not prioritizing uncertain hypotheses. Over time wrong ideas, like communism, have their wrongness exposed via empirical contradictions, as when the Eastern Bloc was neither more prosperous or free than the West even though it was putatively for 'the people'. In 1950, most of the best economists thought socialism would economically dominate the perceived anarchy and inefficiency of market oriented economies.

Brake Problems Old as Time

Toyota is doing damage control, primarily because the audio on this car crash is so horrifying, so vivid, they figure they will lose that case no matter what. But I remember a big brouhaha back in the 80's on 'sudden acceleration syndrome', and the more investigative reporters investigated, the more evidence they found it existed! But in the end, as many people swore on their bible that they were hitting the brake, it turned out that 'pedal misapplication' was the problem. The key is to put the brake on the other side of the car, as in Medicare-mobiles like Cadillac.

PJ O'Roarke discussed this way back in his really funny book, Parliament of the Whores:
Yes the dumb buggers stepped on the gas instead of the brakes. These 'sudden-accelleration incidents' or SAIs closely resemble those sudden-unintelligence incidents, or SUIs, that many of us have experienced with our automobiles, especially when we were in our teens or early twenties...."

Now, if we could just work on a problem particular to Lincoln Continentals: farmer's markets seem to jump right out in front of them.

Tuesday, February 02, 2010

Profits Are Good

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

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

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

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

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


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

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

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

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

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

Monday, February 01, 2010

Bob Solow Dismisses High Frequency Trading

At the end of his review on this week's latest book on the recent economic crisis, liberal economist Bob Solow brings in this observation:
I have read that a firm such as Goldman Sachs has made very large profits from having devised ways to spot and carry out favorable transactions minutes or even seconds before the next most clever competitor can make a move...

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

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

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

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

The only problem is with this insight is it isn't obvious how to spend money 'wisely', on say obvious public goods. For example, In the 1990's an activist Kansas City judge decided to mandate the state pay for a first class shool system. The results were typical:
Kansas City spent as much as $11,700 per pupil--more money per pupil, on a cost of living adjusted basis, than any other of the 280 largest districts in the country. The money bought higher teachers' salaries, 15 new schools, and such amenities as an Olympic-sized swimming pool with an underwater viewing room, television and animation studios, a robotics lab, a 25-acre wildlife sanctuary, a zoo, a model United Nations with simultaneous translation capability, and field trips to Mexico and Senegal. The student-teacher ratio was 12 or 13 to 1, the lowest of any major school district in the country.

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

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

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