Wednesday, March 31, 2010

My Finance Videos

My envy post generated some emails, and I should note I have easy to absorb videos on this subject. Many of the key insights into a series of videos I now keep on my personal website here. They are done in Camtasia, like Khan Academy, and last from 30 to 50 minutes. These videos complement my book, Finding Alpha: The Search for Alpha When Risk and Return Break Down. Then there's my SSRN paper on Risk and Return.

Each includes a downloadable PowerPoint for easy copying into your own work! Indeed, given my book is not exactly on the front table at Barnes and Noble, you probably could get away with presenting these as your own without much fear.

Ch1: Extended Intro--basically, the book in a nutshell

Ch2: Asset Pricing Theory--good replacement reading for MBAs

Ch3: History of Empirical Tests--overview of academic empirical asset pricing tests, rather unique

Ch4: Scope of Empirical Failure--highlights where the theory fails

Ch5: Where Risk Premiums Appear--notes areas where risk premiums exist

Ch6: The Flawed Assumption--outlines the flawed assumption in standard theory

Ch7: My New Theory--outlines my new theory

Ch8: Alpha Examples--examples of alpha in finance, mainly based on practical experience

Ch9: Tactical Recommendations--highlights various implications of my theory

Sunday, March 28, 2010

Why Envy Dominates Greed

Economists generally think of self-interest as maximizing the present value of one’s consumption, or wealth, independent of others. Wealth can be generalized to include not just their financial assets, but the present value of their labor income and even public goods. Adam Smith emphasized a self-interest that also recognized social position and regard for society as a whole, but this was well before anyone thought of writing down a utility function, which is a mathematically precise formulation of how people define their self-interest.

But what if economists have it all wrong, that self-interest is primarily about status, and only incidentally correlated with wealth? A lot, it turns out.

In a book titled Human Universals, professor of anthropology Donald Brown listed hundreds of human universals in an effort to emphasize the fundamental cognitive commonality between members of the human species. Some of these human universals include incest avoidance, child care, pretend play and many more. A concern for relative status is a human universal, and relative status is a nice way of saying people have envy and desire power [status seeking, benchmarking, all fall under this more sensational description, envy].

The idea that ‘incentives matter’, and that people generally act in their material self-interest, is a powerful assumption. Alternative conceptions of human action, such as that people care mainly about their community, country, or God, are considerably more convoluted in explaining, say, why stock prices are uncorrelated from one day to the next.

However, there are many anomalies to this assumption, and my big idea in this article is the standard conception of self-interest is not cynical enough: envy can explain most of what greed can, plus more. For example, a nonobvious implication of a standard formulation of self-interest--that our happiness increases in wealth, but at a decreasing rate--is a necessary and sufficient condition that a ‘risk premium’ must accompany risky assets. This was developed in the 1950s and 1960s into Modern Portfolio Theory and is a mainstay of business school curricula. Yet the data supporting this seemingly intuitive theory (‘higher risk--correctly defined--implies higher expected return’), is lacking for every asset class you can imagine (stocks, bonds, lotteries, currencies, futures), with only a few conspicuous consistent anecdotes (ie, short-term US Treasuries and AAA bonds have low risk and low returns).

Why might this be? I wrote a book arguing this is because if everyone is benchmarking against everyone else, not maximizing wealth but rather relative wealth, it turns out the mathematical implication is that the risk premium goes to zero (see The Missing Risk Premium for a terse update). It’s a rather straightforward implication, and it does involve a little math, but the bottom line is, different assumptions generate different realities.

In the 1950s, Harry Markowitz discovered that regardless of how much we diversify our portfolios, risk remains because assets tend to be correlated. That is, regardless of how many stocks you own, when the market is down, all the broadly diversified portfolios are down. So there's this thing, non-diversifiable risk, often proxied by the SP500, that is the risk society must bear. However, people do not like risk. This is a direct outcome of how we model self-interest. We assume that utility (aka 'welfare') is increasing in wealth, the increase occurs at a decreasing rate. That is, given the graph below of utility, we see the payout of A or C has a mean of D. However, the utility of the certain payoff of B is the same as the average utility of A and B. Thus, you need more than the expected value of a payoff, a risk premium, to accept risk (B less than D). Those accepting this risk receive higher returns than those that do not, as an inescapable consequence of the fundamental way economists model human behavior.

Standard Utility Function

While Modern Portfolio Theory, which developed the above into the Capital Asset Pricing Model, has become a staple for B-School students, one of its central empirical implications does not work: there is no premium for high-risk stocks as predicted, such as those with high covariance with the market. This standard model is still prominent because supposedly the 'true' model works just like it, if we only knew the subtle trick needed to estimate 'true' risk. The confounding results are everywhere: there is no intuitive measure of risk that predicts returns in currencies, movies, mutual funds, BBB to B rated corporate bonds, private investments. Returns when the market is volatile (eg, 2008) are not higher than when it is tranquil (eg, 2004). Idiosyncratic volatility, financial distress, analyst disagreement, equity options, IPOs, lotteries, and long odds in sportsbooks, all confound standard theory because what is intuitively risk—things with high volatility, or highly correlated with the business cycle—have similar or even lower returns than average.

Most work finance today involves teasing out the nuance of risk that explains this null result. Like a wine expert finding they can't discern a Chateau Lafite Rothschild from Two-Buck Chuck, experts are very good at rationalizing, especially using 'powerful econometric techniques' that hide the embarrassment in obscure metrics.

I wrote a book arguing a simpler solution. As shown in the table below, X is considered riskier, with a 30 point range in payoffs versus a 10 point range for Y. Yet on a relative basis, each asset generates identical risk. In State 2, X is a +5 outperformer; in State 1, X is a -5 underperformer, and vice versa for asset Y. In relative return space, the higher absolute volatility asset is not riskier; the reader can check this for any case in which the two assets have the same mean absolute payout over the states (i.e., the average for asset X and asset Y is the same). The risk in low volatility assets is its losing ground during good times. If X and Y are the only two assets in the economy, equivalent relative risk can be achieved by taking on an undiversified bet on X or Y, which is identical to taking a position on not-Y and not-X. The positions, from a relative standpoint, are mirror images. Buying the market, in this case, allocating half of each, meanwhile, generates zero risk.

Relative Payoffs Symmetric
total return
relative return
State 1
State 2

Everything related to risk premiums flows from this simple insight. Implicitly the utility and arbitrage equilibria derive from the fact that when relative wealth is the objective, the risk is symmetric, as the complement to any portfolio subset will necessarily have identical — though opposite signed — relative return. Thus arbitrage exits if there is a risk premium (in a relative status world). One should note that a relative wealth world is just like a world where everyone is benchmarking against others, and note that most investment managers are measured relative to a benchmark (this generates the same zero-risk premium implication if everyone is maximizing return dividing by 'residual benchmark error').

Of course, people are still risk-averse, in that they will pay to avoid having risk thrust upon them, and so buy insurance. Yet, systematic risk, the risk that presumably yields a risk premium, is distinct from that. Note that as 'risk-free' is buying whatever everyone else is buying, you have the potential for bubbles. As a sector like internet companies, or housing, becomes larger, one allocates more to it without much notice, because it isn't risky if everyone is doing it. My experience working in finance is that it is much easier to sell a new strategy if several of your competitors are already doing it, indeed, one should probably anticipate your superiors asking for good reasons why one is not doing what competitors are doing. An investment that starts off solid and gains conspicuous support can cross over into a bubble because at some point investment demand can create a positive feedback loop as more people try to emulate their peers, who then generate more benchmarks that generate more emulation.

Envy Explains a lot more than Asset Pricing

Now, you may consider this abstract or parochial, but it has other implications that make it anathema to economists. Consider Easterlin's Paradox, the finding that after a minimum level of income has been achieved, measured happiness does not appear to rise much. If people's happiness is a function of wealth, we are much wealthier than our ancestors but not much happier. This has been documented in many countries, such as Japan, where income rose five-fold from 1958-1987, yet people remained about as happy. This puzzle has been addressed in such books as Gregg Easterbrook's The Progress Paradox, David Myer's The American Paradox, Barry Schwart's The Paradox of Choice. It is a paradox because it is contrary to what we think should make people happy. If people are primarily envious, this is no paradox at all. Libertarians are fond of highlighting criticisms of Easterlin’s Paradox because they can’t stand the thought that people are primarily status-seeking. This is because the assumption of simple wealth maximization has the nice property that liberty maximizes people’s wealth and thus happiness; if people are primarily status seeking, letting people alone won’t necessarily increase aggregate welfare because there will always be an underclass that is relatively poor, and unhappy.

Status seeking is all about positioning oneself in a rank. Envy is simply another way to approach the status game, noting the focus on those above. Status seeking manifests itself in many ways in common behavior. Much signaling, as when one buys conspicuous goods like a fancy watch, is about signaling status. The pleasure they generate is not a means to an end, it is an end, the feeling of having a superior status, at least for an instant. Robin Hanson, who blogs at OvercomingBias, often investigates things that are more about signaling than what they are putatively about: art, charity, and humor, often aren’t at all about art, charity, or humor. For example, he notes that perhaps one reason for the marked decline in fertility among developed nations is that for women, being successful at work signals higher status than being a full-time mom. Thus, many women choose to have fewer children to signal their status. This is envy because seeking status is motivated by a desire to outperform peers, as opposed to anything related solely to mere wealth. Indeed, from an evolutionary standpoint, children are the ultimate form of wealth, but if we are hardwired to outdo our peers that objective is no longer primary, but rather incidental.

Or consider Steven Pinker noting that many aspects of speech involve protocols around dominance so that people say things like 'if you could pass the salt that would be awesome,' as a way to express a command without appearing domineering. Envy, the intrinsic hatred of being inferior, is always present and must be managed to be liked. Or consider that economist John List finds that our desire to share depends on how much the other person has and how they got to their position, greatly complicating the simple self-interest. Some have highlighted this suggests a 'sharing' instinct, in part because augmenting the standard model with a preference for equality seems so nice, 'is' would be consistent with 'ought'. Alas, a lot of generosity consists of signals and quid pro quos in the context of envy. Relatively, our desire for just 'more stuff', as the standard model assumes, has no such omnipresence.

Stress isn’t caused by the deprivation of stuff so much as feeling your talents are unappreciated by your colleagues, friends, or family. An envious person wants to feel appreciated by others. This is why if you want to make someone like you, ask them a small favor. This implies you value them, that you appreciate what they can do for you. In contrast, if you offer to do something for them, they generally find your attention meddlesome and implying they are relatively incompetent. In standard economic models of self-interest, this would make little sense.

Humans are inherently social creatures, and so our greatest rewards and problems come from other people, as opposed to 'stuff'. For economists to focus on wealth as consumption, independent of others, ignores all this.

Implications of Envy

In Helmut Schoeck's Envy, he discusses the dysfunctional cultures all have an excess of undisguised envy. An extreme example is the Navaho Indians who have no concept of luck or of personal achievement and believe that one person's success can only come at another's expense. This kind of attitude effectively discourages people in such a society from adopting a better way of growing crops, etc. This may explain why James Madison insisted that no democracy has not committed suicide, is that there is a constant push to greater redistribution because nothing hits as directly at envy as progressive tax increases--which affect a minority. Functional cultures are not so defensive, and so adopt better ways even if not invented there, allowing countries like Japan to move quickly into modernity with all the advantages that wealth brings, by emulating a superior western technology, thus acknowledging their backwardness. What is so remarkable is how rare the Japanese strategy has been.

One must remember that the selfish behavior initially described by Adam Smith was seen as antithetical to a good society, and many argued that we are not that Machiavellian, and prioritized God, Nation, or honor. The Invisible Hand argument of Adam Smith argues the competitive equilibria of individuals acting in their own self-interest are socially desirable. Later, game theorists and evolutionary biologists showed that altruism is consistent with rational self-interest in repeated interactions (the optimal rule tit-for-tat implies being nice, provocative, and forgiving). Self-interest is morally defensible in these contexts, which is why having shareholders simply maximize share value is a counterintuitive but optimal policy in most economic models.

Is there a similar, counterintuitive silver lining to envy? There are a few things. Consider envy to be like mental depression, a state of feeling we do not like, but in moderation, keeps us from staying in a dysfunctional rut. When you are screwing up and things are not going well, you feel depressed, and hopefully, learn to change your behavior. When you are envious, hopefully, you work to relieve that feeling. How? Find something where you are relatively good, something where you can increase the amount you are respected and appreciated. You might not be a good singer or poet, but you can write code, or speak Klingon. Mickey Kaus has argued that one wonderful thing about modernity is the great variety of status hierarchies available to us, some vocations, many also many avocations. This highlights the advice we often give our children: try many things, find something you like. Invariably, kids like doing things they are good at, and among a large number of sports, academics, and extracurricular activities, you have a very good chance of finding something that elevates your status to tolerable levels. 

This search for our comparative advantage is a good thing for us and our neighbors. The implication that you should search for your best status hierarchy because you will enjoy it more, in turn, because other people will appreciate you more, so it is a win-win.

Compassion is another attribute that benefits from envy. Considering how wealthy we are relative to the third world, it would make no sense to feel sorry for the poor in the US. Yet, no one in America thinks the poor are doing well, because we know the unambiguously bad nature of being at the bottom, regardless of how much food and shelter goes along with it. If we didn't have envy, we could not and should not, empathize with the poor in America who generally live like the wealthy in most other times and places.

Many of today's policy debates involve, at their base, redistribution. Greg Mankiw noted health care reform would lose its impetus if it were revenue-neutral; the redistribution isn't a side benefit, it is the main point. Tax relief, or fiscal stimulus, is usually targeted at some disadvantaged group. That implies, necessarily, a subsidy from the rich. Is that really just incidental? Many times people argue for the selflessness of voting for higher taxes as if taxing a superior minority more shows your generosity. Is it fair to say good faith progressive policies are a pretext for envious redistribution? I'm sure many do not consciously believe this motivates their behavior; however, the mind is very good at rationalizing what it wants, and everyone knows the first rule of envy is not to admit it as a rationale because others do not want to work with such people. The bottom line is that if we are more envious than greedy, the desire to bring the rich down may be primary, not incidental, and all that blather about equality making for more stable or higher growth all a confabulation.

While there are some salutary effects of envy, it presents a gloomier future relative to if we are merely greedy. After 200 plus years of the Industrial Revolution, it is easy to simply assume we are going to grow at 2% GDP/capita forever, neglecting the fall of great civilizations that built the pyramids, Cuzco, or the Pantheon. Perhaps civilizations implode because they are made of people driven by envy that inevitably pulls down the talented tenth that creates everything that great societies cumulate upon in art, science, and technology. Such a scenario was scarily recounted in Amy Chua's World On Fire, which noted that one commonality of genocide is the extermination of elites, who are always in the minority, and appeals to the envy, not the greed, of the masses (Jews in Germany, Kulaks by Stalin, Tutsi's in Rwanda, Armenians in Turkey, educated Cambodians by Pol Pot).

Risk Aversion’s Fragile Formulation

Economists strongly prefer the idea that people are merely wealth maximizing agents because this generates tractable models, and economists are primarily modelers. Envy would invalidate many models, if not entire subdisciplines because in that case, one cannot aggregate preferences into one person, as it makes no sense to talk about the aggregate happiness of people when their happiness depends mainly on their relative positions. Economists like to add these curiosities outside models, but clearly, the objective function to maximize GDP is misleading if envy is very important. As the old can opener joke goes, economists like the assumption because it generates nice answers.

So, over the years, economists have become good at defining exactly what kind of utility allows them to generate tractable models. While some assumptions, such as assuming everyone has the same beliefs and preferences, have been attacked, they generally haven't made much of a difference. But these are rather small compared to the idea that the utility function people are maximizing has 'constant relative risk aversion'. The idea here is that while we think it fundamental that people have utility increasing in wealth at a decreasing rate, the specific functional form is actually highly circumscribed.

The problem is, we know that the utility curve becomes come much flatter as wealth increases, implying rich people are almost indifferent to risk. It seems implausible that risk preferences for you average person have declined over the past millennium, or century, as this would be reflected in all sorts of prices like the 'risk-free rate, which has not changed considerably over the past 150 years. So, economists discovered we must have 'constant relative risk aversion' so that 'risk' is relatively the same regardless of how much wealth you have: a 10% gamble always much feels the same. If risk preferences were not of this sort, one can be presented with a series of risks where some other party—say, the casino management—can always make a profit, and essentially "pump" money out of players. While some people undoubtedly are like that, the population in the aggregate cannot be, or the economy would grind to a halt forever. The modern notion of risk aversion that does not lead to absurdity is that we value wealth via a function of the precise form x^(1-a)/(1-a) (where a is the risk aversion constant, usually 3.0 to 10.0), because only that function would imply the consistent interest rates we have seen over the past thousand years. How plausible is it that humans have this kind of mathematically precise instinct?

Economists like to argue about some parameters of this function, but as mentioned, one must be able to approximate a collective's preferences this way or we run into absurdities. Yet, even this highly restricted function has its own absurdities. Mathew Rabin won a MacArthur genius grant for showing that one can apply the fact that concave functions to show that if one has the above utility, and one chooses to turn down a 50-50 bet to lose $10 or gain $11, one would not accept a bet to lose $100 and win an infinite amount of money. This clearly makes no sense and holds for any conception of utility where the utility of wealth declines as one gets more wealth. Most economists have responded with a shrug as if this is just an absurd extrapolation. A fatal counterexample, or trivial anomaly, always depends on one's priors. I think it highlights how rotten the core is, that it can not even handle the broad case. The specific function is even more implausible and absurd.

Assume you were the designer of a species of conscious agents: God, the program developer of avatars in a game (actually considered possible by thoughtful philosophers!), or anthropomorphize natural selection. The objective you face is to give these agents a utility function such that they are motivated to create buildings, art, and of course children by themselves based on some instinct. So, as a designer, you can add a mechanism so that people feel hungry if famished, and lustful when in the presence of mating opportunities, so they survive over generations. Yet, each of these desires has a clear governor that has a 'high' and 'low' setting, when you feel full or empty: you don't want people eating or having sex so much they ignore everything else, such as getting ready for eating and having sex tomorrow. Now consider the governor that signals the will to want more 'stuff'. The person one creates must have a specific function if we have an 'absolute utility' function. That is, say people developed a utility function x^½, which satisfies our basic intuition that self-interest is both increasing in wealth, but at a decreasing rate. Back in 1800, it worked pretty well. But now we are 10 times wealthier, so we should have much lower risk aversion if our utility were not of that very specific formulation--something like -x^(-3)/3--such that risk means roughly the same thing then as it does now. If risk aversion today is correct, then back then you were afraid to look at your shadow if you people's utility was x^½, and interest rates would have been around 100%. Thus, our DNA needs a knife-edged utility function that seems patently absurd. One could, however, invoke the anthropic principle and leave it at that (i.e., if it were not so, we wouldn't have enough wealth to be discussing this on the internet).

In contrast, it seems more likely our little governor simply says: be above average. As humans always lived in societies with others, benchmarks are not lacking, so this is a very feasible goal. Then, things take care of themselves. People are constantly doing more each generation because even if you are on top you have to run fast just to stay in the same place. Desire, striving, want, has no abstruse functional knife-edge, but a more reasonable feedback mechanism that does not lead to, or starts with an absurdity.


Envy is a much more evolutionarily plausible self-interest mechanism than greed because it is more robust.

In the end, going from greed to envy would allow us to explain the absence of risk premium, the Easterlin effect, the preoccupation with respect. These are not trivial phenomena. It would render a large swath of economics irrelevant, such as welfare economics or public choice because 'optimal' is usually defined relative to a utility function based on the 'Pareto principle', that you can only judge a society to be better than another if everyone is better off. Given one assumes some mechanism for redistribution exists, this generally results in rationalizing that maximizing income becomes the goal. However, as much as economists have treasured these exercises, they remain irrelevant to perennial policy debates. It's not as if current finance built on the standard utility premise can identify, let alone explain, the risk premiums that should be its ubiquitous consequence.

Economists agree that no reasonable risk metric predicts returns within or between any asset class, but now assert that risk, like fine wine, is very subtle. This is because we know there is a risk premium because, given our conception of utility (increasing at a decreasing rate), there must be a risk premium. Like telling the Journal of Marxist Studies that 'class' is not the best lens to view behavior, telling economists that self-interest is primarily envy, not consumption, is simply too dismissive of the foundations they find so compelling to their calling; all that human capital is tied to mastery of work that may not work, but at least currently there's hope that another tweak might turn these highly rigorous models into seminal, important work.

While we should recognize envy as a driver behind so much human behavior, we should recognize that like most of our drives, it must be disciplined. We have many innate drives for sex, food, and warmth, but realize that a good life does not make these ultimate things, and at many times we have to override our natural instincts. Virtue is all about doing what does not come effortlessly.

We should not be so naïve to believe most government policy is about making institutions safer, efficient, or fairer, as these are incidental means to an end, and that end is an envy-based redistribution. In some cases, base motives can lead to good outcomes, as when our efforts to maximize our status lead a business owner to treat customers well. However, government policies enacted out of envy have no beneficial results because it merely rearranges status based on political power and not the productivity that leads to so much progress in science, leisure, art, and health. If our base assumption that self-interest is not simply maximizing wealth, but rather, status, the future is a far less rosy place. An economists' current view of human nature implies that societal and self-interest are in sync via the invisible hand (with varying amounts of regulation), and is the source of much libertarian optimism. Would that it were true. We will be much better off navigating the future with a more accurate concept of human nature.

More practically, for how long does a theory have to not work before it is abandoned (ie, the risk-return implications of Modern Portfolio Theory)?

Wednesday, March 24, 2010

Economists Becoming more Clueless

Tyler Cowen makes the following observation about publishing economists:
In essence the standards are now so high in terms of skills and data sets and thoroughness that it is mainly the young and ambitious who publish in tier one journals. Those people are found around the world. The 44-year-old tenured Princeton economist isn't so much in the AER as in times past.

[note: I'm not the 'Eric' he is referring to earlier in his post]

Economics is not like physics in the 1920's where foundational results are being generated by prodigies, so having the top forums dominated by kids who really like extending formal models is not a great signal. For fundamental constants, physicists argue about the 7-th digit, while economists argue about the sign. Indeed, for all the emphasis in top journals on mathematics, formal proofs, econometrics with the newest standard errors, most of the debate about the 2008 crisis was historical, using a little statistics, but mostly arguments that did not hinge on the existence of an equilibrium.

Top tier publications are now solely for those climbing the tenure ladder, a way to establish bona fides among their peers who are involved with the very important business of determining who belongs in their elite group. That's really a sad, because it means that those in the peak of their careers have moved on to something with greater significance, and the biggest signal a field isn't fruitful is people stop doing it when presented with other opportunities.

Back in 1947s, Paul A. Samuelson laid down his Foundations of Economics, and his model was to formalize a hypothesis based on mathematical assumptions and utility maximization, generate some empirical implications, and test using econometrics. As much as it would be nice if we could steamroll through interesting and important questions this way, it violates Niels Bohr's important rule: never express yourself more clearly than you are able to think.

One big problem with economists is they get into parochial technical issues that are not falsifiable, because its very easy for insiders to become obsessed with process and technique as opposed to some tangible result. Tools are important, so there's no intrinsic flaw there, but a tool's importance is reflected by its productivity, and Bellman's equations, 3-stage least squares, and Banach spaces, simply have not generated any new, true, and important findings in economics.

Most economic papers proving that if you assume X, you get Y, to which someone can say you need to assume X', which implies something quite different. Or that for a particular dataset, applying some technique generates p-values of 0.01 on some coefficient of interest, but then this totally ignores other data that imply contrary conclusions . Remember that Arrow and Debreu 'proved' a free market competitive equilibrium is in some sense societally optimal. Yet this didn't alter the debate about Free Markets vs. Government because those who like government just said the assumptions were unrealistic. And of course they were right, all assumptions are unrealistic. Theory really is just a heuristic in economics, such as when Arrow and Debreu's work gives us a deeper understanding of the basic argument made by Adam Smith centuries ago. Mathematical proofs are never definitive in their application, but they can be very useful in isolating the essence of an argument, especially among readers who understand math (eg, the Townsend Model and the usefulness of debt vs. equity, the Arbitrage Pricing Theory and the linearity of returns to 'risk factors, are best understood via math). These formalizations, however, have not settled any practical debates (after all, socialist economics in the US only became marginalized when the Soviet Union collapsed in 1989).

All this emphasis on pure logic in the most prestigious journals means economists will become less focused on useful research. If the main criteria for advancement is publishing work that is dominated by young researchers who admittedly know 10 times more math than history, self-referential threads grow unimpeded. Criticizing those also actively publishing is not a good idea because recently published work tends to be liked by editors and referees (after all, they published it!), who are evaluating your paper. Further, a great way to get invited to conferences, get grants from the NBER or the NSF allocated by those same referees and editors, is to extend 'popular' research, where popular means 'research done by those same referees and editors'. It's a path to irrelevance, because actually explaining reality uses softer techniques like analogies, history, surveys of very different data, institutional knowledge--all of which are anathema to the 'rigor' that defines a prestigious journal.

An expert is a person who has made all the mistakes that can be made in a very narrow field.
~Niels Bohr

Alas, I don't think top economists make mistakes any more, and that is not a good thing. Like mathematicians, everything they do is right as far as it goes, but it's usually irrelevant.

Tuesday, March 23, 2010

What if The Poor Aren't Just Like You and Me?

A perennial approach to poverty is to look at the poor as people just like regular people, who merely have a lack of resources. Sociologist and economists have taken this tact for years, because it seems condescending to do otherwise. In the early 20th century, Franz Boas started the standard meme that any child can become scientist, beggar, priest, or whatever. The corollary seems to be the Axiom of Equality: every group (race,income,religion,language,age,sex) has the same distribution of every phenotype given the same environment (except sex organs and melanin content). Thus ,the homeless are just people without homes, the poor simply people without money. Indeed, many homeless and poor are this way.

Yet, most poor in the US are not simply those just like us without money (note: 'most' does not mean 'all'). The poor in most developed countries have disproportionately lower self-control and IQs, and these traits are somewhat hard-wired; a higher teacher-student ratio probably won't turn Cletus Spuckler's spawn into yuppies. There actually isn't a Genius in All of Us. It is and has been conventional wisdom that traits like intelligence and self-control are themselves a function of wealth or some other environmental root cause. Here are two conventional, well-known economists (Glenn Loury and Sendhil Mullainathan) seemingly discovering this conventional wisdom as if they just created a paradigm shift.

It's as if no one ever tried modeling the poor as being resource constrained, but instead economists have always assumed they are stupid or lazy. Nothing could be further from the truth. Further, the idea of providing welfare to the poor to rectify the situation has been tried, and is still there, and you can see its results in most urban American cities. We don't expect responsibility and so we don't get it, as opposed to what Glenn states, which is that all we do is preach self-responsibility to these poor ciphers of social forces. I suppose, like international aid, he thinks a doubling of expenditures would surely do the trick.

I say, let's actually try the stupid and lazy approach. It hasn't been investigated by economists for the reasons Sendhil mentions (its depressing and seemingly mean-spirited). After several decades, isn't it worth a couple top-tier pubs? A handful of tenure posts? Isn't is possible this may have some relevance?

The purpose isn't to make us feel morally superior, but rather, to design more effective remedies, to help the poor be all they can be, which may not be equality. It would be nice to our egalitarian instincts if everyone latched onto some socioeconomic achievement as if they were shot out of a randomizer, but what if that's not possible? What does that imply for policy? Is does not imply ought, but it does constrain what is possible, and highlights what is futile. If we treat the poor like MIT undergrads without wealth, and they don't respond as such, this only helps those who selfishly or naively preen about their moral righteousness, and the journalists and policymakers who think this line of thinking is novel.

Sunday, March 21, 2010

Gary Gorton vs. Michael Lewis

I earlier blogged about Yale economist Gary Gorton's model of the financial crisis here. He put several papers into a new book, Slapped in the Face by the Invisible Hand, which is a quite helpful distillation of several of his papers. Unfortunately, while the book has hardly any math, it still reads pretty much like an academic paper, and there are no conspicuous villains, no gobsmackingly stupid errors. So, it will never be very satisfying to most people, who like to think it was all hubris, a bad formula, greed, meanness, or lack of sufficient regulation.

The basic idea is that the repo market had developed as an independent source of funds, and when some AAA rated mortgaged backed securities started to fall in price, this tainted all AAA securities, especially asset backed paper. AAA securities have a 0.01% default rate, so from a bayesian perspective, when you see a default here the probability is not that one was very unfortunate, but rather, the rating was wrong. Perhaps all ratings are wrong?! Everyone was scrambling to understand how much these previously innocuous securities were worth and found them insanely complicated, so people naturally assumed the root cause could be anything related to the housing-related securities: debt, derivatives, rated securities, complexity, etc. Everything was painted by the same brush, as when one cow tainted with e. coli causes a wholesale destruction of all beef products sold in the US, because one can't be sure. A run on the repo market was a classic bank run, causing the banking system to be insolvent, and lending to sharply contract.

His main evidence that this was a system-wide crisis was that securities backed by autos, credit cards, student loans, and financial companies of varied focus all declined, even though default rates in these other classes were not changing much. A financial crisis is when all finance becomes suspect, created a self-fulling prophesy because the system is always insolvent if there is no confidence in the system. This was best highlighted by Felix Salmon's article blaming the crisis on a specific mathematical formula, copulas, as if this could underlie any portfolio (portfolios invariably are designed with a focus on correlations, and copulas are a way to do this for debt securities).

It's very interesting to think of financial crises, and recessions they cause, this way, as overreactions caused by people not being able to suss out the essence of a crisis in real time. Gorton notes crises occurred regularly in the US (1819, 1837, 1860, 73, 84, 90, 93, 1907, 1914, 1931-33), and every time, people are befuddled. When a a drastic change occurs, such as the change from Free Banking era (1837-62) to the National Banking era, or the creation of the Federal Reserve, after about 10 years they think they have eliminated business cycles. They put in new institutions, but because they don't fully understand the old institution, they fail in totally unappreciated new ways. For example, the Fed contracted the money supply dramatically from 1931-33, something they were oblivious to (interest rates were low, so they thought monetary policy was 'easy'), which Friedman and Schwartz argue turned a recession into a depression.

Gorton notes that fixes are perhaps futile. Indeed, he has some recommendations, one that the government insure 'approved AAA' paper, to help reduce the risk of a panic, but given their role in the reduction of credit underwriting standards (documented on page 66), it is then likely they would have made the essential mistake worse, because one thing government does not do well is admit mistakes, because they don't have to (unfortunately, no government agency has gone bankrupt).

I would suggest that the US financial system was also insolvent in 1975,1981,1990, and that if you had to mark their books to market, (indeed we had new accounting, FAS 157 that tried to apply market prices to accounting during the crisis), this would basically cause massive dislocations. Why not increase bank capital rates from 4-8%, to 20+%? I don't see a consistent risk premium in financial markets, so the cost is rather low. That is, the market does not require a 6% return premium to bank equity, so one does not need that kind of leveraged return.

This book is not a definitive statement on the crisis, but it highlights a necessary and sufficient condition for a financial crisis. As to what caused the initial problem, Gorton highlights housing price declines, noting that the subprime Asset Backed securities assumed prices could only rise or stay flat. As a rule, any collateral should be assumed to have the same expected return, say a couple percent above the risk free rate. Further, its future volatility should assume that the historical moves up reveal potential moves downward (e.g., the 50% upturn suggests a 50% downturn is highly probable). The junk bonds at the center of the 1990 financial crisis, the high tech financing in the 2001 crisis, the lending to oil states in the 1980s, were all associated with excessive leverage based on the idea that collateral would either be stable or rise. It's a common mistake, made in different asset classes each time. As my old mentor Kevin Blakely has said, the problem of excessive leverage keeps showing up with different names: Highly Levered Transactions (HLTs), equity financing (loans backed by firm 'equity'), Alt-A mortgage-backed securities.

Alas, most people will find Gorton a bit too dry, too many references, too much math (there are a handful of algebraic equations). Michael Lewis, in contrast, takes the Gladwellian approach to big problems, which is always well received. Indeed, I have seen him an on TV with several different interviewers discussing his latest book, The Big Short [I expect Russ Roberts at econtalk to interview him and totally agree, notwithstanding the 5 other authors with orthogonal diagnoses he also totally agreed with]. Lewis is considered an expert because he worked on Wall street for 2 years and wrote Liar's Poker, an insider's view of the bluster of rich young men. As anyone who has worked in an industry for a couple decades knows, after only 2 years in the business, the impressions of a kid right out of college, no matter how smart and eloquent the sojourner, are invariably quite naive. Indeed, Lewis's main thesis in Liar's Poker remains a theme in his latest book, the Big Short: finance is mainly an irrelevant Rube's Goldberg device for paying greedy, selfish people too much money. He notes that banks actually were shorting some products they were promoting, as if there was a big conspiracy, ignoring the fact that a market requires sellers, and increasing liquidity is a good thing because if every asset must be held to maturity, costs of financing would be much higher, etc. Further, large financial institutions have many departments, and the fact they have different opinions is about as strange as the fact that America is full of people who disagree on whether tax rates are too high. Ultimately Lewis blames everyone, but especially greedy bankers, and so in a banal sense he is correct.

But Lewis will most assuredly sell more books than Gorton, part of the reason these crises are endogenous.

Friday, March 19, 2010

Crisis and Leviathan

A list of all the new boards, bureaucracies, commissions, and programs created in H.R. 3962, Speaker Pelosi's 1018 page health care bill.

I think that government is necessary for a well-ordered society. What really bothers me, is that when they create an policy or department, it never dies, so we have sugar quotas, agricultural subsidies, NASA doing global climate change research. It's estimated to be about 50k new employees, 111 new groups.

1. Retiree Reserve Trust Fund (Section 111(d), p. 61)
2. Grant program for wellness programs to small employers (Section 112, p. 62)
3. Grant program for State health access programs (Section 114, p. 72)
4. Program of administrative simplification (Section 115, p. 76)
5. Health Benefits Advisory Committee (Section 223, p. 111)
6. Health Choices Administration (Section 241, p. 131)
7. Qualified Health Benefits Plan Ombudsman (Section 244, p. 138)
8. Health Insurance Exchange (Section 201, p. 155)
9. Program for technical assistance to employees of small businesses buying Exchange coverage (Section 305(h), p. 191)
10. Mechanism for insurance risk pooling to be established by Health Choices Commissioner (Section 306(b), p. 194)
11. Health Insurance Exchange Trust Fund (Section 307, p. 195)
12. State-based Health Insurance Exchanges (Section 308, p. 197)
13. Grant program for health insurance cooperatives (Section 310, p. 206)
14. Public Health Insurance Option (Section 321, p. 211)
15. Ombudsman for Public Health Insurance Option (Section 321(d), p. 213)
16. Account for receipts and disbursements for Public Health Insurance Option(Section 322(b), p. 215)
17. Telehealth Advisory Committee (Section 1191 (b), p. 589)
18. Demonstration program providing reimbursement for culturally and linguistically appropriate services(Section 1222, p. 617)
19. Demonstration program for shared decision making using patient decision aids (Section 1236, p. 648)
20. Accountable Care Organization pilot program under Medicare (Section 1301, p. 653)
21. Independent patient-centered medical home pilot program under Medicare (Section 1302, p. 672)
22. Community-based medical home pilot program under Medicare (Section 1302(d), p. 681)
23. Independence at home demonstration program (Sect Health Insurance Option(Section 322(b), p. 215)
17. Telehealth Advisory Committee (Section 1191 (b), p. 589)
18. Demonstration program providing reimbursement for culturally and linguistically appropriate services (Section 1222, p. 617)
19. Demonstration program for shared decision making using patient decision aids (Section 1236, p. 648)
20. Accountable Care Organization pilot program under Medicare (Section 1301, p. 653)
21. Independent patient-centered medical home pilot program under Medicare (Section 1302, p. 672)
22. Community-based medical home pilot program under Medicare (Section 1302(d), p. 681)
23. Independence at home demonstration program (Section 1312, p. 718)
24. Center for Comparative Effectiveness Research (Section 1401(a), p. 734)
25. Comparative Effectiveness Research Commission (Section 1401(a), p. 738)
26. Patient ombudsman for comparative effectiveness research (Section 1401(a), p. 753)
27. Quality assurance and performance improvement program for skilled nursing facilities (Section 1412(b)(1), p. 784)
28. Quality assurance and performance improvement program for nursing facilities (Section 1412 (b)(2), p. 786)
29. Special focus facility program for skilled nursing facilities (Section 1413(a)(3), p. 796)
30. Special focus facility program for nursing facilities (Section 1413(b)(3), p. 804)
31. National independent monitor pilot program for skilled nursing facilities and nursing facilities (Section 1422, p. 859)
32. Demonstration program for approved teaching health centers with respect to Medicare GME (Section 1502(d), p. 933)
33. Pilot program to develop anti-fraud compliance systems for Medicare providers (Section 1635, p. 978)
34. Special Inspector General for the Health Insurance Exchange (Section 1647, p. 1000)
35. Medical home pilot program under Medicaid (Section 1722, p. 1058)
36. Accountable Care Organization pilot program under Medicaid (Section 1730A, p. 1073)
37. Nursing facility supplemental payment program (Section 1745, p. 1106)
38. Demo program for Medicaid coverage to stabilize emergency medical conditions in institutions for mental diseases (Section 1787, p. 1149)
39. Comparative Effectiveness Research Trust Fund (Section 1802, p. 1162)
40. Identifiable office or program within CMS to provide for improved coordination between Medicare and Medicaid in the case of dual eligibility (Section 1905, p. 1191)
41. Center for Medicare and Medicaid Innovation (Section 1907, p. 1198)
42. Public Health Investment Fund (Section 2002, p. 1214)
43. Scholarships for service in health professional needs areas (Section 2211, p. 1224)
44. Program for training medical residents in community-based settings (Section 2214, p. 1236)
45. Grant program for training in dentistry programs (Section 2215, p. 1240)
46. Public Health Workforce Corps (Section 2231, p. 1253)
47. Public health workforce scholarship program (Section 2231, p. 1254)
48. Public health workforce loan forgiveness program (Section 2231, p. 1258)
49. Grant program for innovations in interdisciplinary care (Section 2252, p. 1272)
50. Advisory Committee on Health Workforce Evaluation and Assessment (Section 2261, p. 1275)
51. Prevention and Wellness Trust (Section 2301, p. 1286)
52. Clinical Prevention Stakeholders Board (Section 2301, p. 1295)
53. Community Prevention Stakeholders Board (Section 2301, p. 1301)
54. Grant program for community prevention and wellness research (Section 2301, p. 1305)
55. Grant program for research and demonstration projects related to wellness incentives (Section 2301, p. 1305)
56. Grant program for community prevention and wellness services (Section 2301, p. 1308)
57. Grant program for public health infrastructure (Section 2301, p. 1313)
58. Center for Quality Improvement (Section 2401, p. 1322)
59. Assistant Secretary for Health Information (Section 2402, p. 1330)
60. Grant program to support the operation of school-based health clinics (Section 2511, p. 1352)
61. Grant program for nurse-managed health centers (Section 2512, p. 1361)
62. Grants for labor-management programs for nursing training (Section 2521, p. 1372)
63. Grant program for interdisciplinary mental and behavioral health training (Section 2522, p. 1382)
64. No Child Left Non-immunized Against Influenza demonstration grant program (Section 2524, p. 1391)
65. Healthy Teen Initiative grant program regarding teen pregnancy (Section 2526, p. 1398)
66. Grant program for interdisciplinary training, education, and services for individuals with autism (Section 2527(a), p. 1402)
67. University centers for excellence in developmental disabilities education (Section 2527(b), p. 1410)
68. Grant program to implement medication therapy management services (Section 2528, p. 1412)
69. Grant program to promote positive health behaviors in underserved communities (Section 2530, p. 1422)
70. Grant program for State alternative medical liability laws (Section 2531, p. 1431)
71. Grant program to develop infant mortality programs (Section 2532, p. 1433)
72. Grant program to prepare secondary school students for careers in health professions (Section 2533, p. 1437)
73. Grant program for community-based collaborative care (Section 2534, p. 1440)
74. Grant program for community-based overweight and obesity prevention (Section 2535, p. 1457)
75. Grant program for reducing the student-to-school nurse ratio in primary and secondary schools (Section 2536, p. 1462)
76. Demonstration project of grants to medical-legal partnerships (Section 2537, p. 1464)
77. Center for Emergency Care under the Assistant Secretary for Preparedness and Response (Section 2552, p. 1478)
78. Council for Emergency Care (Section 2552, p 1479)
79. Grant program to support demonstration programs that design and implement regionalized emergency care systems (Section 2553, p. 1480)
80. Grant program to assist veterans who wish to become emergency medical technicians upon discharge (Section 2554, p. 1487)
81. Interagency Pain Research Coordinating Committee (Section 2562, p. 1494)
82. National Medical Device Registry (Section 2571, p. 1501)
83. CLASS Independence Fund (Section 2581, p. 1597)
84. CLASS Independence Fund Board of Trustees (Section 2581, p. 1598)
85. CLASS Independence Advisory Council (Section 2581, p. 1602)
86. Health and Human Services Coordinating Committee on Women’s Health (Section 2588, p. 1610)
87. National Woman's Health Information Center (Section 2588, p. 1611)
88. Centers for Disease Control Office of Woman's Health (Section 2588, p. 1614)
89. Agency for Health Care Research and Quality Office of Woman's Health and Gender-Based Research (Section 2588, p. 1617)
90. Health Resources and Services Administration Office of Woman's Health (Section 2588, p. 1618)
91. Food and Drug Administration Office of Woman's Health (Section 2588, p. 1621)
92. Personal Care Attendant Workforce Advisory Panel (Section 2589(a)(2), p. 1624)
93. Grant program for national health workforce online training (Section 2591, p. 1629)
94. Grant program to disseminate best practices on implementing health workforce investment programs (Section 2591, p. 1632)
95. Demonstration program for chronic shortages of health professionals (Section 3101, p. 1717)
96. Demonstration program for substance abuse counselor educational curricula (Section 3101, p. 1719)
97. Program of Indian community education on mental illness (Section 3101, p. 1722)
98. Intergovernmental Task Force on Indian environmental and nuclear hazards (Section 3101, p. 1754)
99. Office of Indian Man's Health (Section 3101, p. 1765)
100. Indian Health facilities appropriation advisory board (Section 3101, p. 1774)
101. Indian Health facilities needs assessment workgroup (Section 3101, p. 1775)
102. Indian Health Service tribal facilities joint venture demonstration projects (Section 3101, p. 1809)
103. Urban youth treatment center demonstration project (Section 3101, p. 1873)
104. Grants to Urban Indian Organizations for diabetes prevention (Section 3101, p. 1874)
105. Grants to Urban Indian Organizations for health IT adoption (Section 3101, p. 1877)
106. Mental health technician training program (Section 3101, p. 1898)
107. Indian youth telemental health demonstration project (Section 3101, p. 1909)
108. Program for treatment of child sexual abuse victims and perpetrators (Section 3101, p. 1925)
109. Program for treatment of domestic violence and sexual abuse (Section 3101, p. 1927)
110. Native American Health and Wellness Foundation (Section 3103, p. 1966)
111. Committee for the Establishment of the Native American Health and Wellness Foundation (Section 3103, p. 1968)

Thursday, March 18, 2010

Odds of a Perfect Bracket

2-63. That's if you don't know anything, where the chance of winning is 50% each game. To put this into perspective, that's about 250 times worse than winning back-to-back Powerball lotteries. Let's say you predict games correctly about 74% of the time, then the odds go up to a single Powerball.

In other words, don't be tempted by the lead that you will win $1MM if you get a perfect bracket. The time value of entering is well below the minimum wage.

[for non-US readers, I'm referring to the annual college basketball, single elimination basketball tournament with 64 teams]

Wednesday, March 17, 2010


There's the famous story about a philosophy course where the midterm exam question is simply 'Why?' While many students write for the entire hour, one kid simply writes, 'why not?', and gets an A. If this story is true, it highlights that philosophers are very good at talking nonsense and making it seem profound.

Consider comedian Louis CK's riff on 'Why?', and compare that to Richard Feynman's riff on 'Why?'. Both good, but in different ways.

Louis CK:

Richard Feynman:

Tuesday, March 16, 2010

Renaissance's Medallion Fund

A front page WSJ article on James Simon's Medallion fund, which has averaged a 45% return since its inception in 1988. Truly amazing. No one really knows how they do it, but it is rumored to employ some sort of quasi-market making, 'pairs-like' algorithm. That is, they trade a lot electronically, seeding the book and provididing liquidity (eg, limit orders to buy at the best bid or lower), and looking for abnormal movements with sympathetic stocks (eg, when IBM goes up, but Dell does not, sell IBM). This would explain why they are not really scalable ($10B Medallion has been closed to new investors for a long time).

But who knows. I hear they don't hire many economists, and instead prefer PhDs in Math, computer science, etc. This could be a slam on economists, in that we aren't as bright as these guys, or it could be our framework has been poisened by modern econometrics. However, it could be economist's are savvy enough to see the essence of the alpha, and so would be a bigger threat via leaving and starting a competitor, whereas the math PhDs are too focused on the little issues to grasp the bigger picture.

I did hear once (third hand) that in their legal dispute two ex-employees, the intellectual property at issue was quite trivial, which would suggest their alpha is merely being the fastest electronic market makers in the world. Someone has to be fastest. Considering the new co-CEOs are both computer scientists, that would make sense.

It is interesting that they started two other funds with a larger scale, hoping to make money off longer term strategies in futures and equities. These have not even outperformed the benchmarks, let alone displayed the amazing Medallion-type dominance. This highlights another reason to hide one's alpha, among the many (read Finding Alpha for more!). If your firm is in industry X, and makes money doing something very parochial within X, don't be too specific. This way, when you extend your brand, no one thinks twice about the plausibility that their new venture is totally different, and so customers are willing to give it a shot. It's possible Renaissance's alpha is in subtle price change correlations, a skill that would translate to other

Friday, March 12, 2010

Khan Academy

I came across a great website for brushing up on little ideas, like the the Laplace Transform, Ideal Gas equation; everything from Algebra to Evolution to the Geithner plan. Short snippets are done Camtasia-style, with no face, just talking over Khan Academy was founded by Salman Khan (Sal) with the goal of using technology to educate the world. Everything is free. An NPR interview with Khan is here. He worked for a hedge fund, and has technical degrees from Harvard and MIT.

I think in the long run, these are going to replace technical teaching. Khan is a very good teacher, and he's teaching things that aren't smushy like history or economics, so I think the subject is more like a commodity.

Wednesday, March 10, 2010

Hollywood for CFPA

A bunch of legendary comedians got together to make a sketch, where the punchline is: "establish a Consumer Financial Protection Agency". It's kinda a funny, but mostly because of the Darrell Hammond's imitation of Clinton making sexual innuendos, and Fred Armisen's impersonation of Barak Obama. It seems director Ron Howard was trying to find something to 'do good', so he chatted with the earnest and overeducated Elizabeth Warren, and decided consumer financial regulation was the kind of smart idea that would obviously work. After all, who's against consumer protection?

I am! This is the same government that goaded banks to lower standard to lend more to historically damaged communities, and then when those borrowers defaulted, blamed such lending on the banks. Avoiding the poor is redlining, targeting the poor is predatory, which means, whatever goes wrong can be blamed on the banks. Government always wants to have its cake and eat it too: low taxes & high spending, high growth and union-type work rules, banks lending more today and raising their capital.

The CFPA tries to do what most regulators try to do: improve efficiency, eliminate waste, consolidate regulations,simplify regulations, protect consumers, and protect jobs! It seems banks are greedy and basically uregulated, leading directly to the 2008 housing crisis. There are seven government bodies already regulating banks, highlighting how incredibly naive this proposal is. If there's a magic bullet for improving efficiency, etc., share it with existing regulators...unless you think that all the regulators have been captured by some interest group, which if true just means we are bringing in one more interest group to advocate why they should get a better deal.

More importantly, if your concern is about the irrational poor people easily duped by huckster bankers, lower prices and penalties on the poor doesn't help them, it enables them. Life has carrots and sticks, and one definition of a vice is that which generates bad outcomes in the long run. If you are constantly overdrafting your account, don't have enough money to make a 20% down payment on a property, you need better financial discipline. Helping the poor from being trapped by debt should try to minimize they amount of debt they have, say by increasing rather than lowering prices on credit cards. That would still allow emergency spending, but make people do it much less, which is a good thing.

It's like alcohol. You want to tax it sufficiently that making beer in your basement is not better (because then it will lead to illegal activity and lower quality control), but not so cheap that being a career drunk is easy (note that Cuba and the Soviet Union have very cheap booze prices--they want the populace perpetually inebriated).

One key to the housing bubble was the credit underwriting standards fell: no verification of income, no money down, etc. Basically, people got loans they could not afford. So this agency is intent on doubling down, assuming the problems before weren't because too many people had loans, but rather, bankers were greedy. Bankers want to maximize profits, but politicians want to pander via expropriation and cross-subsidizing. Which is better in the long run to an economy?

Politics is all about pandering egalitarianism, treating everyone the same regardless of their risk or behavior. As Joe Stiglitz knows, this leads to inefficiencies, because when you don't price according to cost (as reflected by higher default rates), you get more adverse selection in that the highest cost customers find the product most attractive, leading the best credits to leave, and ultimately rationing of those best credits. As Stiglitz 'proved', this is an inefficient equilibrium. But if government is running the show, such inefficiencies are all ok, because government merely adds more regulations, and so on. When the businesses fail, they almost always go out of business (unless they are really big); when government fails, it just increases its mandate's scope.

Monday, March 08, 2010

Kahneman on Two Happinesses

Danny Kahneman is the father of behavioral economics, and writes many interesting things. I think the implications of this school are vastly overstated, but he's a thoughtful, interesting, person.

He gave a talk at recently on experience vs. memory. His main idea is that there are two kinds of 'happiness', that which is experienced in a particular moment, and that which is remembered. The experiencing self that lives in the present, and is relevant when a doctor asks ‘does it hurt when I do this’? The remembering self is present, as when we ask ‘how was your vacation’? Happiness can be the memorizing self over time, or happiness when someone thinks about their life.

He mentions that these two aspects are very different, and lead to different objectives. The correlation between people’s experiential vs. remembered happiness is 0.5, which is why you can ask someone ‘are you happy now?’ and get no correlation with income over $60k, and ‘are you happy with your life?’, and get a significant correlation with income over $60k. It’s the difference between being happy in your life, and being happy about your life.

The difference between the two has been documented by by many experiments. For example, during colonoscopies in the 1990’s, back when the procedure was unambiguously painful, subjects would record their pain every minute. If you think of the pain going over a bell curve over time (rising and falling symmetricall), an experience that stopped at the top of the curve would be better than one that road the curve over its entire path. Yet the remembered experience that stopped at the top would be remembered worse, because the diminution of pain at the lower ending point would make the longer experience with more total pain seem ‘better'.

People choose mainly between memories of experiences vs. just experiences, and generally prefer the memorizing self vs. the experiencing self.

You can predictably manipulate the remembered experiences by manipulating endings. In the colonoscopy case, just remember to draw the procedure out longer, making it slightly less painful every minute, even though the procedure is functionally over. Go on a 1 week vacation instead of 2, because you will remember the experience it the same, as the memory of going to Greece is basically allocated a unit regardless of length once you go over a couple of days. This explains why people generally like having children, and find them adding to their life’s satisfaction, yet generally don’t like playing or interacting with their children.

Anyway, listen to the talk, it’s very interesting (though I just told you the main points).

Tuesday, March 02, 2010

Stiglitz's Freefall

The subtitle should be "why free market types are like religious fundamentalists", because he loves using the cute phrase 'market fundamentalism' the way MSNBC uses the phrase 'tea baggers'.

A nice thing about being a Nobel prize winner in economics is when you write books with the same policy recommendations, but use inconsistent arguments in each book, you still get the front table at Barnes and Noble. FreeFall makes the standard talking points you hear on AirAmerica,, or Noam Chomsky:

1) every economy needs more regulation and higher taxes, especially on the rich
2) He, along with everyone who agrees with him that markets are irrational, predicted the 2008 financial crisis
3) the Community Reinvestment Act and similar government programs had absolutely nothing to do with the crisis.
4) the bubble was fueled by Greenspan's easy money from 2002-2007.

Why do we need more taxes and regulation? Well, according to Stiglitz, the rich are generally immune to incentives, probably parasitic, and generally monopolistic. Like Russian Kulaks, Jews in pre-War Germany, Indians in Uganda, the rich are impediments to growth & justice. Yet he also notes a large amount of financial innovation is to skirt taxes and regulations. I agree that many finacial innovations are focused on taxes and regulations, but that's only because these exogenous rules tend to create mutual gains from trade, and so are bad only if you think prices are wrong (ie, market participants are predictably wrong, or fail to capture externalities).

His proof that the CRA and other government housing initiative had nothing at all to do with the housing bubble, is proven thusly: AIG failed, and they didn't issue mortgages, just bought bonds and derivatives. QED. Further, subprime mortgages failed at rates similar to CRA related subprime mortgages. Yet, current law does not allow a bank to charge different prices based on race. To increase the amount of loans in historically underserved demographics--poor people--you have to lower the bar for all loans.

The old and seemingly irrational rules of thumb of having certain levels of wealth, credit score, validation of income, and downpayment, were diminished because of the fact that banks historically had low losses on mortgages, because there was little evidence of large year-over-year aggregate declines in real housing prices. Thus, for example, we went from requiring 20% down in the 1990's, to zero percent down in the bubble (now upped to 3.5% by the US's FHA). Indeed, Stiglitz himself wrote a white paper arguing that Fannie Mae's 2% capital requirement was more than adequate in 2002 (he estimated an expected loss on $1 Trillion by Fannie of only $2 Million--pre hindsight). Indeed, Fannie Mae was one of his examples of beneficial government policy in his 2002 book The Roaring Nineties. Fannie and Freddie have already cost the government $127B, and it's not done. That's 90 Nick Leesons and counting, but the nice thing about being an intellectual is you aren't accountable for for how policies that were aided and abbetted by your arguments actually worked, because if it fails, it wasn't implemented correctly (eg, Socialism didn't fail, rather, Soviet-style socialism failed).

His assertion that he called the subprime crisis is pretty weak. Look in vain for any strong statement by Stiglitz that underwriting for home lending was too easy prior to 2007, and you won't find it. He did reference an argument he made in 1992 that mortgage asset backed securities may be problematic, but this was a hedged statement, and not important enough to reassert over the subsequent 15 years.

In Stiglitz's Globalization and Its Discontents, written in 2002 just after the internet bubble, the big policy blunders where high interest rates, free markets, the 'fear of default' by lenders, and a lack of concern for the poor. He specifically mentions that Greenspan was excessively concerned with inflation during the 1990's, constraining the Clinton's ability to create economic growth. So, the easy money, lack of concern with default, and insufficient initiatives targeted to the poor, all arguments that he now asserts caused the 2008 crash, would seem to be right out of his playbook. Consistency is for non-experts, I guess.

In his 2006 book, Making Globalization Work, Stiglitz praises Japan, Korea, and China, for their high-minded government policies and trade restrictions as an impetus for growth. Now, modern economies all have government of at least 25% of the economy, and many regulations on businesses. Any success could be a result of some governmental interference, which are many. But to be convincing, one would have to do a true cross-country comparison, and like typical theorist his idea of data is anecdote. The Asian Tigers, West Germany's Adenauer, Chile, recent ascent of Ireland are all ignored. As is the fact that China and India moved considerably towards free markets at the same time their growth rate rose, or that Japan and Korea are less regulated than most nations.

Stiglitz's two most prominent papers are papers he coauthored: "Credit Rationing in Markets with Imperfect Information", The American Economic Review (1981), and his “On the Impossibility of Informationally Efficient. Markets”, American Economic Review (1980). He has always been a theorist, not an empiricist.

Grossman and Stiglitz's "On the Impossibility of Informationally Efficient Markets" flows naturally from Grossman's work on getting information into prices, and Stiglitz's obsession with market imperfection (which came from his fawning work on Samuelson's collected works, which tended to emphasize market imperfections). I have never seen an empirical application of this paper. It's often used as a profound proof that markets aren't efficient, for those who think the relevant standard is perfection. If all information is totally transparent, symmetric, and logical, nobody trades securities with anyone, like what Stokey and Milgrom proved in their No-Trade Theorem (1982, Information, Trade and Common Knowledge, Journal of Economic Theory).

What really bothers me about the paper is its pretentiousness, as if they proved something profound. They proved something obvious. Sure the proof is hard (you solve a differential equation and there's a chi-squared distribution), but the results aren't surprising to anyone. A really neat theory should be important (in this case: maybe), succinct proof (no), and slightly surprising(not!). G&S have all these results in the paper that are really obvious, like the greater the noise, the less informative the price system will be, or the lower the utility of the uninformed, etc. Stigler and Hayek basically argued the same idea, that all the theoretical papers that assume 'perfect competition' and perfect foresight basically assume no need for the market: the data sufficient for a central planner is assumed available. Yet, economies need entrepreneurs and businessmen seizing profits precisely because relevant information is parochial and flawed. Decentralized decision-making takes advantage of decentralized information, and profits are the incentive. So, his demonstration the market perfection is never, technically, true, isn't a critique of the market, it's why many free marketers believe what they do.

In their seminal paper on credit rationing, Stiglitz and Weiss (1981) posed the question: “Why is credit rationed?”. In a perfect capital market with all information available to everyone banks give risk adjusted credits to borrowers of different types. Banks choose in a perfect competition the interest rate such that they achieve zero profits in equilibrium. Stiglitz and Weiss by contrast consider an imperfect credit market in which banks cannot observe the types of the borrowers. With two borrower types, that means that a bank does not know whether a safe or a risky borrower is applying for credit. They assume that all borrower types have the same expected return, but riskier projects offer a higher return in case of success (because of the standard debt contract that has limited upside and 100% loss downside), at the cost of a lower probability of success compared to safe projects.

At any interest rate, the expected profit is thus higher for the risky borrowers than for the safe borrowers. Therefore, the risky borrowers are willing to pay a higher interest rate and still make non-negative profit. So it would be effective for a bank to charge lower interest rates from the safe borrowers and higher interest rates from the riskier investors, but because banks lack the knowledge of the risk types, they set a common interest rate for both borrower classes, which yields zero profit. An equilibrium with credit rationing is necessary for banks give credit to both risk types at a common interest rate. Safe borrowers effectively cross subsidize risky borrowers. This is an inefficient outcome because it rations safe borrowers.

Notice this is inefficient because lenders make safe borrowers subsidize risky borrowers, because of ‘imperfect information’. Yet, banks usually do not have zero information on borrowers as Stiglitz and Weiss assume, but rather, imperfect information. Risky borrowers, via FICO scores and down payment (ie, equity investment in the collateral), pay more on average. In contrast, the major government initiatives, such as Health Care programs, charge everyone the same, which is why people don't like these programs when they aren't cross-subsidized by the non-participants (eg, Medicaid). Thus, to the extent charging everyone the same is inefficient, it is much more prevalent in government initiatives than private ones. Yet, because he proved the market is imperfect relative to perfect information, Stiglitz then merely notes this proves markets are inefficient, and thus government is better, a highly dubious inference given the way government works even when lots of information is available (ie, without a pnl objective, or better information, or less irrationality or selfishness by individuals working for the government).

In sum, Stiglitz generates the same platitudes you hear from typical far left-wing types (eg, the market is inefficient therefore dominated by government, the market leads to a race to the bottom). His arguments supporting his policy preferences are inconsistent. His Nobel prize winnung research did not, does not, forcefully prove we should always be increasing government as he assumes (he notes government gave us the internet, biotech, and ‘research and developement’ --i.e., Tang).

Monday, March 01, 2010

Macroeconomist Phelps States Macroeconomics Progressing

In this EconTalk episode, Russ Roberts interviews Nobel prizewinner and macroeconomists Edmund Phelps about macro (his main contribution was to note the Phillips curve was wrong, there is a 'natural level' of unemployment and no long run trade off between unemployment and inflation). Phelps states that macro has been very productive over the last generation.

I disagree. The main issues in macro, what is the optimal size of the government in the economy? As the size of the government in the US have grown pretty constistently over the past 100 years, with episodic upswings and downswings during major wars, suggests policy makers and voters think it has always been too small. For all the shrill excorations about market fundamentalism, and the emphasis on markets, markets have been a shrinking part of the economy. So, what is 'the fact' that needs explanation, the rise of the intellectual basis for markets, or the rise in the attractiveness of government? It seems famous, credentialed economists disagree (eg, Friedman, North, vs. Stiglitz, Krugman).

Phelps thinks we know a lot more about the economy, and by this he means, I think, that several theoretical innovations--the Phillips curve, the steady growth of money ensuring steady growth--have been proven wrong. So, some ideas have been rejected, and in that sense we know more. But there have been many innovations--overlapping generations models, dynamic programming, Hansen's generalized method of moments--have shown themselves to not really focus our efforts, but rather allows everyone to add rigor showing that some things could be true. That's hardly helpful, in that theories that explain everything explain nothing, and bad ideas are a dime a dozen (ie, developing an enthusiasm for the Phillips curve, and proving it wrong, is hardly progress).

So, we currently have debates about the value of the multiplier, where values over 1 suggest government spending is good, less than 1 means counterproductive (assuming that government and private consumption and investment have the same value, ie, the cost is the value created). Robert J. Barro--a well respected economist--suggests a value of -1.1. Joseph Stiglitz--a well respected economist--argues that the multiplier is around 2.0 (1.5 in the short run). Monetary policy currently targets a nominal GDP via the Taylor rule, an ad hoc policy that is indifferent to how much of GDP is inflation or real growth, so it reflects nothing that macro theorists have figured out, but rather, a reasonable rule of thumb. There is no consensus on why poor countries are poor (Easterly: too much top-down control; Stiglitz: too much markets, too little government spending).

I think the only thing macroeconomists have learned, is that Soviet style socialism does not generate higher growth than non-Soviet style socialism, and this fact wasn't predicted by any economic consensus, but rather, the obvious failure of the Soviet Union, and the comparison of countries like East and West Germany, or North and South Korea.