'Inside Job' Tries to Define the Narrative

The award winning documentary Inside Job presents the 2008 financial crisis as basically a bunch of unethical, greedy bankers. There's an interview with a Madame who states 40% of her high-end clients are Wall Streeters, pictures of the Hampton homes highlighting how rich some people are, and a rockin' soundtrack. I'm sure there's an artist's reconstruction of banker baby-eating rituals that didn't make the cut. Comments on YouTube start at angry and get more emotional.

I did like the interviews with economists, such as when they interviewed Fred Mishkin, and he wrote a white paper just before the crisis giving the Icelandic financial system his expert Seal of Approval, titled "Financial Stability in Iceland," which after the crisis was listed on his CV as "Financial Instability in Iceland," something he called a 'typo' (see here). It's bad, and Mishkin should be ashamed for the rewrite, but such lame consulting projects by big names are omnipresent and orthogonal to the mortgage problem.

There's the focus on CDO's, which presumably were responsible for the mess. No mention, zero, of the Community Reinvestment Act, Fannie Mae, underwriting innovation driven by increased homeownership goals for minorities, the Boston Fed bank study and eventual $38MM payout to its sponsor Bill Styron, or Alicia Munnell's exceptional career based on a deeply flawed bit of hack advocacy masquerading as dry econometrics. One would never learn that government, journalists, community activists, and academics were fully behind the mortgage boom because it served their ends too, and they too ignored the warnings because asking for things like substantial down payments and income verification were just outdated, if not racist, homelending criteria.

Robert Gnaizda (see picture above), head of the Greenlining Institute, is given a lot of air time, arguing bankers were singularly responsible via their greedy, unregulated, predatory behavior. This shill for ninja loans is presented as a prescient advocate of sensible lending, when nothing could be further from the truth. The Greenlining Institute has been a lobbying and litigating group for 20 years. Greenlining’s principal aim is to push state and local politicians and the California business community to facilitate “community reinvestment” in low-income and minority neighborhoods.

Here's a description of one of their successes, written in August 2008:

But Greenlining can still play rough. Consider its dealings with Rabobank, an international Netherlands-based “megabank” (assets: $740 billion) that in early 2006 acquired Salinas-based Community Bank of Central California for $371 million.
…
Earlier, in November 2005, Rabobank had agreed to pay $851 million for another California bank, Mid-State Bancshares. At that time, Greenlining publicly demanded that Rabobank commit $7.5 billion for loan programs to help farmworkers buy their own farms. With only 40-some California branches, Rabobank balked.
…
Greenlining’s reply was a shot fired across the Dutch institution’s bow: “If Rabobank cannot reach an agreement to commit funding to CRA programs, the institute will oppose any further acquisitions it tries to make in California.” Greenlining then asked the Comptroller of the Currency to hold hearings into Rabobank’s acquisition of Mid-State and to require Rabobank to issue quarterly reports on its compliance with the CRA.

It also announced a protest demonstration. In February 2007, Latino and Southeast Asian farmers and farmworkers joined Greenlining organizers in a demonstration outside Rabobank’s Fresno, California offices. Backed by Mariachi and Hmong bands, the demonstrators waved placards and chanted slogans in English, Dutch, Spanish, and Hmong: “We’re Not a Dutch Colony!”, “Help de armen (Dutch for ‘Help the Poor’)” and “Geen immigranten schoppen (Dutch for ‘Don’t kick the immigrants’).” “Congratulations to everyone,” Greenlining’s Robert Gnaizda told demonstrators through a bullhorn, “Rabobank is totally afraid of you.” Apparently it is. This year, Greenlining proudly announced what it called a “unique agreement” with Rabobank “to turn San Joaquin farmworkers into farmowners.”

The net result of this was to prod mortgage lenders into lending to the easiest area where they could meet these goals: home mortgages. 'Predatory' lending, I suppose, is when a bank gives a loans to someone who can't afford it, and then has the gall to ask for their collateral after 500 days of non-payment. Gnaizda has spent his entire life arguing for lowering underwriting criteria (see here and here), and when he says 'increase regulation' he just means buyers should not have to pay supbrime rates, but rather prime rates, in other words, even easier terms.

It's fun to see history rewritten in real time. Everyone knows the diagnosis influences the cure, and if the zeitgeist is for more regulation the narrative has to be that the crisis was solely the cause of unregulated, greedy bankers, and presume that the selfless bureaucrats would have never let this happen. But bankers have always been greedy, what they didn't have was government not merely telling them that they should lower their underwriting standards, but that if they didn't they would be sued for disparate impact. Any CEO seeing this trend, and asking 'well, what have our losses been on these riskier home loans government wants us to make?', would have been told 'not much', because historically the collateral had always risen. That is, while default may have been high, recoveries were higher, and defaults were also masked by the higher collateral that made refinancing easier. In this environment, it is easy to see how banks slowly eliminated their previous lending criteria.

Government at Work

Here in Minneapolis, the geniuses in charge of their underfunded police and fireman's pensions came up with this brilliant idea to merge their pensions into a different entity.:

The deal would allow the city to slash its police and fire pension liability. That's partly because it would switch them to the actuarial assumptions of the state fund, which assume higher investment returns and lower pension increases. It's also because the deal would give the city 11 more years than it has under current law to fully fund the two plans' deficits...
However, the deal would come with several costs for taxpayers. First, the city agreed not to oppose a firefighter bid for a last-minute boost in their pensions to bring them to parity with police. That would cost the city $7 million in future pension costs, figured in today's dollars.

Moreover, the deal would substantially boost the checks for police and fire pensioners, all of whom were hired before mid-1980. The police pension would jump by 43 percent to $64,000 in 2015, for example.

So, they actually increase their liability, but increase their assets via more optimistic return assumptions. That a bunch of adults find this solution attractive is rather disturbing.

Powerful Scene

Here's one of the most heartrending videos I've scene in my life, a widow's recollection of her heroic husband's last moments protecting her in the latest tornado disaster. If you don't tear up your not human. RIP Don Lansaw.

High Frequency Trading Paper

I'm involved in high frequency trading so I don't comment much on it anymore; it's good when not telling people all your ideas on some subject is the optimal strategy. But there's been a rather popular piece on a new metric of volatility by Easley, de Prado, and O'Hara, Flow Toxicity and Volatility in a High Frequency World, so it's not insider information. O'Hara has been writing on this topic for decades it seems, and she's a pretty solid author in this field. Indeed, as de Prado is associated with the Tudor Hedge fund, and they are OK with him publishing this, that highlights this information is not valuable in and of itself. But, lots of useful tools are not obviously translatable into money, so this is not a big knock.

Their Volume-Synchronized Probability of Informed Trading, or the VPIN informed trading metric, is as follows:

It's hard to see in the gif, but the numeration has Vb is the volume of buys, which are assumed to when the price of a trade is greater than or equal to the last trade price, Vs, or Volume of Sells, otherwise. Thus, the greater the imbalance of buys vs sells in the past, say, 10000 shares traded, the greater this metric. These all occur within the past V shares traded in any bucket. n is the number of number of buckets in the sample. Thus, the estimation is in transaction space, not time space, which the authors assert is more stable and meaningful.

The graph below shows how this metric forecasts future trade volatility. Note that as the log of the VPIN goes up, the dispersion of price moves increases. It's not a perfect relationship, but nothing important is.

The point is that in fast moving markets, one needs something a little better than simple historical moving averages of daily closing prices. This is better, and extending the idea of 'volume time' vs. 'chronological time' is an intriguing direction. But one can also look at bid-ask spreads directly, or the VIX futures, or its etf, the VXX, and combinations, to gauge intraday volatility as well. Further, one can better estimate 'buy volume' using the transaction price relative to the then extant bid-ask spread, rather than if the price was weakly increasing, though this then involves syncing the trade information with quote information, and for academics such data are often hard to come by (further, quote information is often 10 times as large).

Congressmen Have the Buffet Touch

A new study out notes that:

Four university researchers examined 16,000 common stock transactions made by approximately 300 House representatives from 1985 to 2001, and found what they call "significant positive abnormal returns," with portfolios based on congressional trades beating the market by about 6 percent annually.
...
A study of senators by the same team of researchers five years ago found members of the higher chamber even better at beating the market -- outperforming it by about 10 percent, an amount the academics said was "both economically large and statistically significant."

I suppose they are good at stock investing for the same reason Hillary Clinton was a savvy commodities trader, and Obama was good at playing poker with Illinois lobbyists.

If the guys who set my property taxes want to bet on something, anything, I'm willing to post great odds. Just be sure to remember me, you know, later.

Update: Toronto PhD student Feng Chi has recently published an independent analysis with a similar results, see here.

27% Borrow Against 401ks

According to CNN:

In 2010, nearly 28% of those with 401(k)s had loans outstanding on them, a record high, according to a recent study by Aon Hewitt, a consulting firm owned by Aon Corp. The average loan was $7,860.

This is generally not a good idea, like the stats on credit card balances (average of $7k for families with credit cards). Just one more problem to be solved by our future inflation!

The main financial problems for average consumers are within themselves: they trade too much, have too much debt. If I believed in libertarian paternalism as in Cass Sunstein's Nudge, I would be for increasing various costs of trading and borrowing to alleviate this. Yet, the the costs would undoubtedly be stacked towards politically powerful but economically unwise investments (eg, ethanol, mortgages), and people would learn they are not responsible for themselves. One of the costs of freedom is the pain of learning by experience.

But some people don't learn, or only via trial-and-error, which is unfortunate. Our modern welfare state makes it harder for these people because many of them need powerful negative feedback to change behavior, and generally people who don't have life skills get encouragement to self-righteous self-pity.

Asians Learning 'The Neg'

In a fascinating essay in the New York Magazine, an Asian writer Wesley Yang talks about coming out of his timid shell:

I recall one of the strangest conversations I had in the city. A woman came up to me at a party and said she had been moved by a piece of writing I had published. She confessed that prior to reading it, she had never wanted to talk to me, and had always been sure, on the basis of what she could see from across the room, that I was nobody worth talking to, that I was in fact someone to avoid.

But she had been wrong about this, she told me: It was now plain to her that I was a person with great reserves of feeling and insight. She did not ask my forgiveness for this brutal misjudgment. Instead, what she wanted to know was—why had I kept that person she had glimpsed in my essay so well hidden? She confessed something of her own hidden sorrow: She had never been beautiful and had decided, early on, that it therefore fell to her to “love the world twice as hard.” Why hadn’t I done that?

The piece goes on to note Asians promoting a 'neg' strategy towards Americans, and giving paid advice on the tactic. The idea of a smart young man discovering he had needed to be more obstreperous I find rather interesting. Is it simply prudent to be less considerate of others? Is appearing aloof and disrespectful of others a smart tactic to make you more more powerful, more financially successful? This concept has been popularized in the neg, a tactic of sexual swindle by making the target think you think you are better than them, which makes them find you more attractive.

The neg seems most likely to work on insecure, below-excellent, targets, which might be sufficient for a young man looking for sex, but not necessarily a good life strategy. Then again, most people meet their spouses in inauspicious scenarios, and just this weekend I learned of a woman whose first date with her now husband involved him getting into an almost fight with another man--clearly this display was impressive.

But as for the woman taking her lack of beauty as a reason to love the world twice as much, I'm skeptical this is the optimal response. Rather, I think she should simply accept that unlike the Halle Barrys of the world, not everyone will appreciate her attractiveness, and not be discouraged by it. It seems a very Biblical assertion that the more you suffer the more you love the Creator who allows such suffering. Anyway, I like that the woman had a strategy that tried to compensate for her realistic constraints, but I think except in extreme circumstances, a person is never objectively ugly, but rather, merely not beautiful.

Most of us, including me, aren't beautiful like models and movie stars. We are a totality, usually sufficiently attractive to make our objective appearance irrelevant to whether a worthy evaluator considers us beautiful irrespective of our thoughts, behaviors, and manners. I think if my daughter becomes an 'unattractive' woman, I will still think of her as beautiful because I appreciate her essence. Her optimal strategy should not be to love more, but rather, be as attractive as possible--maximize her potential as a person--and find people who appreciate her.

Mark Zandi's Prognostication Prowess

I came across this at Ritholz, which noted that popular Keynesian economist pundit Mark Zandi has a horrible track record. The problem with pundits is that rarely do people care, and like Jim Cramer you just predict so often it's not obvious what your forecasts were.

Obama Meddles in Israel

A good starting point for the idea that our government shouldn't try to fix everything, is foreign policy, which is even harder than economic policy. It's important to know what is and isn't our Federal government's business.

Jimmy Carter and Noam Chomsky are perfectly consistent when they argue for UN Security Council Resolution 242 because they believe in redistribution of money and power based on inequalities they believe are the result of illegitimate expropriations. The rich, in general, are the beneficiaries of previous injustices.

Historically American Jews have voted Democratic, and exit polls showed 77% voted for Obama in 2008. It certainly is politically beneficial to present yourself as a persecuted minority if you can, and just like African-Americans Jews are a minority. In the long run, this won't stand because Jews are relatively successful, and so via inevitable liberal logic they are a hegemon who needs to share their wealth. Obama's call for a return to 1967 borders seems a consistent stand within the Democratic party, and especially the very progressive US State Department.

End of World Note

Considering the world will end at 6 pm local time today, you should remember the South Park episode 'Probably', where everyone goes to hell. At one point the newcomers to Hell are being informed they were damned. One guy says 'hey, wait a minute, I shouldn't be here, I was a totally strict and devout Protestant, I thought we went to heaven?' The tour guide says 'you picked the wrong religion.' The correct group ... Mormons! I'm hoping that's not how it goes down, but we'll see soon enough.

Man Finds $45k in Attic

There's a nice story about a man who found $45k hidden in a house he bought from the family of an old man who recently died. He did the good thing, and gave the money to his family. Back in the 1970's, my family moved into a rather unique new house in a suburb of Cleveland Ohio. It was reputedly constructed by a mafia man, and had a fun rec room we called 'the ballroom' because it had floors for dancing with speakers and a bar with mirrors at one end. We bought it for $80k, which was slightly above market in my neighborhood, but nothing one would consider rich (not a prime residential neighborhood).

In any case, a couple years after we bought it, my dad was trimming the house, and found a $10 bill coming out of the molding connected to the roof. He went into the attic, looked in the floorboard near this $5, and found $5k in cash that were all dated from the 1950s. We didn't give it back, because it literally had blood on it, implying that its exposure might be unappreciated by the former homeowners. I remember how fun it was freshening up the old bills with a laundry iron. My mom's second career after raising me and my siblings was as an IRS agent, and she made me report my summer lawn mowing income, so this was her one little transgression against The Man.

Twitter Hedge Fund

The World's First Twitter-Based Hedge Fund:

This week, Derwent Capital Markets, a London investment firm, launched a $40 million hedge fund that will use Twitter to guide its investments. The world's first social media-based hedge fund will monitor a selection of tweets in real-time to feel out market sentiment before placing its bets...
The professors harvested tweets for key words and plugged them into an algorithm to determine the mood of the broader market. Using this mood index, the professors predicted the Dow's daily fluctuations in 2008 with an astounding 87 percent accuracy.

I remember smart people looking at keyword algorithms to predict asset fluctuations in the 1990's, and these projects invariably foundered. Thus, it's not a new idea, just a new medium, in this case Twitter. I'm skeptical.

Hedge Fund Return Timing Bias

It's well-known that there's a backfill and survivorship bias to many Hedge Fund indices. As most indices promote their product, this is understandible. Yet just as with the equity risk premium, the hedge fund bias usually neglects the adverse timing bias: that market inflows and outflows make the raw time series returns overestimate the return to an average investor. Thus, many funds with $100MM in assets have great return their first year, of say 50%, and then get on the cover of a big magazine, get $1B, and lose %20. Is the return on such a fund the average--geometric or arithmetic--of the 50% and -20% return, or should it weight the 20% loss more, reflecting the performance of the average investor in that fund?

I remember in 2004 or so when convertible bonds got rocked, convertible bond indices simply disappeared, merged into other indices within broader Fixed Income categories. But then, after a strong rebound, they returned as if nothing happened.

Ilia Dichev has a new paper out (with Gwen Yu) in the JFE documenting this bias is around 3-7% for hedge funds, just as he found this bias was around 3% for equity indices:

We use dollar-weighted returns (a form of IRR) to assess the properties of actual investor returns on hedge funds and compare them to buy-and-hold fund returns. Our main finding is that annualized dollar-weighted returns are on the magnitude of 3 to 7 percent lower than corresponding buy-and-hold fund returns. Using factor models of risk and the estimated dollar-weighted performance gap, we find that the real alpha of hedge fund investors is close to zero. In absolute terms, dollar-weighted returns are reliably lower than the return on the S&P 500 index, and are only marginally higher than the risk-free rate as of the end of 2008. The combined impression from these results is that the return experience of hedge fund investors is much worse than previously thought.

Antti Ilmanen estimates a 3-5% survivorship bias, and a 1-3% backfill bias in Hedge Fund indices, so be sure to add to those. Here's something simple and valuable the new Consumer Financial Protection Bureau can do: monitor and disseminate accurate asset class performance data, eliminating the bias present in most indices that tend to inflate all of them.

Bank Stocks Still Stagnant

Above is the KBW bank index (extrapolated back to 1990 via another bank index). When I was working for a bank in the 1990, I remember we always had lots of unrecognized gains in our book of assets acquired from the S&L crisis. It seemed like a bottomless cookie jar that bailed us out whenever we needed it. As there were lots of banks, and bank assets, sold well below their value, it seeded the best decade of bank stock returns ever. But after the latest crisis, bank stocks have stagnated well below their prior peaks.

I think this time, we have a reverse cookie jar. Banks had a lot of mortgage assets, and not only have those prices fallen, but the rules have changed, so that the time to foreclosure has more than doubled. Thus, banks still have lots of unrecognized losses, and like Japan in the 1990s, hope to slowly write them off. I'm guessing. One thing I learned about banking is that unless you have some first hand knowledge that CFOs have, you don't really know.

New Econ Data Sites

I don't know why, but in the past week two new websites were introduced to me that consolidate economic data: Junar and Zanran. Junar is more into charts and exportable data, while Zanran has more pdfs with academic papers on the relevant topics.

So, for example, I pulled up this on Argentina, which is an interesting case study in Keynesian policies. From 1890 to 1939, the country's per capita income was similar to that of France, Germany and Canada, but then President Juan Perón took over and instituted a suite of progressive reforms: increased unionization, nationalization of major industries, more generous social welfare, increased public works investments, high tariffs and import restrictions. The big idea then was called developmentism, which is a national-socialist-fascist model that attempts to ameliorate the deficiencies of 'the market'. The result you can see below, as their income relative to other countries steadily declined from about 1946 onward (the center of the graph is 1946ish).

blog probs

so...blog was down for a day or so...came back missing last post...now back to normal...

I think it was someone in the Consumer Protection Financial Bureau...

The Perennial Hubris

Ariana Huffington makes the following lament:

"We do big things," President Obama said during his State of the Union speech in January. And, in fact, we do. Sometimes. Finding and dispatching Osama bin Laden certainly qualifies. "We are once again reminded," the president said after announcing the terrorist's death, "that America can do whatever we set our mind to." But if that's true, why are our leaders so accepting of a stagnant economy?

This kind of naive thinking is ubiquitious over time and space, the idea that collectives can do whatever they want because of examples like landing a man on the moon, winning World War 2, and now, killing Osama bin Laden (which given its cost, is hardly a great example of Federal success). The implication is that all we need is the will, and we can accomplish anything we set our minds to. Life teaches us that there’s only one corner of the universe you can be certain of improving, your own self, and even that does not imply you will be materially richer for it.

We have some affect on our family, less on friends, imperceptible on strangers. The idea that outsiders can materially improve an entire demographic--Gypsies, the unemployed, Haitians--via some federal job or income program involves a rather unempirical conceit about the ability of progressive policies to bend complex systems to our ends. To create real jobs in the public sector, jobs that provide benefits greater than their costs, is just as difficult as it is in the private economy without government. If it seems easy the result is merely consumption.

Stalin's five year plans, Nixon's War on Cancer, Johnson's War on Poverty, all shared a deep commitment from those up top. There are some things that can't be fixed merely by outsiders with good intentions, in part because they may be insoluble, in part because they may actually induces counterproductive incentives to lower level individual incentives. I remember when I worked with the CEO of KeyCorp, and can tell you he really really wanted our stock price and ROE to rise above its peers, but that didn't make it happen.

Hayek said it best in his Nobel speech:

If man is not to do more harm than good in his efforts to improve the social order, he will have to learn that in this, as in all other fields where essential complexity of an organized kind prevails, he cannot acquire the full knowledge which would make mastery of the events possible. He will therefore have to use what knowledge he can achieve, not to shape the results as the craftsman shapes his handiwork, but rather to cultivate a growth by providing the appropriate environment, in the manner in which the gardener does this for his plants.

Federal do-gooders have ignored this advice, increased spending and regulations immensely over the past 4 years in order to create jobs. It has failed, and the predictable reaction by progressives is to double down. Real Federal outlays have increased 25% from 2008 to 2011, including a 40% increase in 'Income security', and a 23% increase in 'Education, Training, Employment and Social Services,' yet Ariana quotes economist Mark Thoma, who spouts the standard Keynesian belief that

We can't help to stimulate job growth if we don't try, and so far we aren't trying anywhere near hard enough.

The idea that good things can and will happen is we merely 'work together' or the rich pay more taxes is a popular belief, but it's still namby-pamby nonsense. It's unfortunate that even though the data have never shown that countries could spend and inflate their way to prosperity, one can cherry pick history to think this true. The War on Poverty, India's 'third way', the foreign aid disaster in Africa, Keynesian failures of the 1970's throughout Western Europe, affirmative action, and the positive results of market-centered solutions such as China's market oriented reforms, Adenauer's West Germany, the entire 19th century in the West, I think it's clear the best thing we can do is reduce the size and scope of government.

While many have rejected the comforting thought that an all-knowing God will reward and punish the living for their Earthly deeds, wishful thinking is still as prominent as ever. Theories like the Invisible Hand are seen as defeatist if not cruel, but most proverbs seem self-serving platitudes until you have personally experienced the truth of them.

We need some government, but given the current size of government, worry about anarchy is a bugaboo. Getting out of the way won't guarantee anything--especially equality--but it will certainly maximize liberty, is something we can afford, and is our best bet to maximize prosperity.

As laziness and self-pity are common vices, our greatest incentives are not positive but negative: the need to pay for essential expenditures. Our government is in an all out effort to eliminate this incentive via extending unemployment insurance from 13 to 99 weeks, making time since last payment to foreclosure going from 244 to 500 days, and creating make-work jobs in trendy areas like light-rail and ethanol production. Macro stagnation is the direct result of government encouraged micro stagnation, of people continuing to do things that make no economic sense for fear they won't appreciate the necessary transition. Remember that the initial reaction to the Exxon Valdez oil spill was to steam clean the rocks to get rid of the oil, which later was seen as more harmful than doing nothing; putting out little forest fires in Yellowstone created a huge backlog of kindling that created a horrible set of fires in 1988; AFDC created generations of people dependent on government without any job skills; paying people to destroy working cars increased the cost for those who did not already have cars. Complex systems are invariably made worse by outsiders trying to directly make things better.

Allowing people to fail incents them to make optimal decisions, no less so for Joe Sixpack than for Bear Stearns. It is a shame that large corporations are so cravenly dependent upon government for favors, but given the size of government and the capriciousness with which it can apply the law and create valuable favors, a corporation is like a college football program: it can't be big and not somewhat corrupt. Government can't increase our aggregate income any more than it can increase our aggregate happiness, and the sooner everyone realizes this the better off we all will be. At the rate we are on the path of all failed states where every bug needs a patch which needs another fix, all the while the size of city, county, state, and federal government keeps rising. If you look at failed states throughout the Third World you see this game does not correct itself, it simply creates a patronage system, and hypocrisy becomes a necessary tactic as bureaucrats spout populist rhetoric about how their parochial powers are in the best interests of the people.

Regal Risk Premium

The average homicide rate in America is about 6 per 100,000 people per year. Among certain areas and demographics, this is substantially higher: 42 for African American males, 40 for Detroit, Michigan, 154 for Honduras.

According to a paper by Manual Eisner, kings had a rather extreme violent death rate:

This paper examines the frequency of violent death and regicide amongst 1,513 monarchs in 45 monarchies across Europe between AD 600 and 1800. The analyses reveal that all types of violence combined account for about 22 per cent of all deaths. Murder is by far the most important violent cause of death, accounting for about 15 per cent of all deaths and corresponding to a homicide rate of about 1,000 per 100,000 ruler-years.

Further, there is 'positive autocorrelation' in murder rates, in that if you murder a King to take his spot, your probability of being killed is above trend. Thus, to commit regicide puts you in the rarefied air 10 times that of the most murderous environs on the planet.

One can see why the primary virtue of the nobility has always been physical courage, demonstrated most recently when young Prince Harry eagerly signed up for dangerous missions in Afghanistan, and has the benefit of merely being a function of will. Modern warfare and information technology has made such bravery as irrelevant and absurd as it should be for determining our class structure.

Obliquity Coda

John Kay's book, Obliquity, raises some very important points, but ultimately, his solution seems to lead at least him to nothing approaching wisdom, which is the ability to distinguish the good. Phillip Tetlock, whom Kay references, has a similar result. An expert in experts and their predictions, Tetlock surveys experts and their predictions, and categorizes them as either foxes (detail experts) or hedgehogs (big picture experts). He finds that foxes are usually right, but hedgehogs are occasionally right on the farthest out and important predictions. When asked if he is a fox or a hedgehog, Tetlock said he's a fox with a little hedgehog in him--isn't everyone? He notes this is the general pattern: foxes qualify their statements a lot, but are more correct--when you ignore the qualifications. I was left thinking he articulates some nice points, but ultimately is one of the archetypes he criticizes.

Kay notes the Iraqi invasion of 2003, and assumes without arguement it has been a failure. I agree on that, though the reason I have is probably different than for most commenters, and I think the why matters. Anyway, he notes he didn't know beforehand it was a failure, but:

I believe the right way to have formed an opinion would have been to say "I do not trust the judgment of the people [Bush and Cheney] who are making this decision or their ability to handle the consequences." That would have led to the right conclusion, and for the right reason.

As a 'right reason' it seems pure hindsight, because he gives absolutely no reason to not trust Bush and Cheney. He has other such practical examples of obliquity, which come off a lot like the derided objective to 'maximize shareholder value', an objective without much use because its easy ex post, but impossibly unspecific ex ante. Asking the right questions doesn't mean you are going to get good answers, which I guess highlights his main point, that good solutions are indirect.

Obliquity

Browsing at my local bookstore I picked up a copy of Obliquity by British economist John Kay (right), and was quickly taken in. It takes on a very profound subject with admirable brevity (200 pages). He notes the story of seeing three stone masons working on a medieval cathedral, and one says 'I am cutting stones to shape', one says 'I am building a great cathedral', and one says 'I am working for the glory of God.' These highlight that actions are guided by a hierarchy of objectives some short term, some long term, and some prove better guides than others.

Putting these various tactical and strategic objectives in harmony is tough work. Enjoying the journey and knowing you are on the right path removes the pressure and angst associated with an excessive focus on the end-goal, making that same goal more achievable. I think the key point he makes is to have all levels working for you, by adjusting all of them in light of feedback. An example is golf, a sport which for many is a 'game worth playing', making it worthy, and which benefits from practice and coaching, yet ultimately you can only swing well if you don't think when you are doing it.

Obliquity is his term for what someone called 'muddling through', and involves experiment and discovery in uncertain environments. Higher-level objectives, intermediate goals, and basic actions are constantly reassessed. The problem is that the big goals--a fulfilling life, maximizing shareholder value--are too imprecise to have any clear idea how to do them. As GE CEO Jack Welch noted, maximizing shareholder value is not a useful guide because it doesn't help you know what to do when you come to work.

It's a great book, though ultimately there is no clear answer, just another version of Feyerabend's 'Against Method': whatever works. Plans should be tentative and adjusted based on feedback from intermediate objectives, acknowledging our imperfect understanding of the solution, or even, the adequacy of our goal.

The problem is basically how to know when you should think outside the box, how to use common sense. To always think outside the box is to ignore the great toolkit of algorithms and methods smart people have given us so we do not have to reinvent, say, ordinary least squares or t-statistics. Common sense may be a straight jacket, but letting every wacky idea into your mind leads to insufficient focus. Quantification is imperfect, and can lead to useless reification as with macroeconomics, but its still the ultimate benchmark, and indeed, allows us to know that macroeconomics does not work. I know success, happiness, justice, are impossible to objectively and uniquely quantify, but I think modest attempts to provide proxies are helpful.

I wish it were easier to know how to solve important problems, and more importantly, know what problem are important and soluble. I do know there isn't a simple cookbook, and Jacques Barzun's observation serves a cautionary warning:

Again and again, the bright thought has occurred, "if we can only define our terms, if we can only find the basic unit, if we can spot the right 'indicators', we can then measure and reason flawlessly, we shall have created one more science."

This has usually been a failure in the social sciences, including business, in part because of Goodhart's law: targeting a variable changes its meaning and significance. Yet, as a full-time quant that's what I do--measure, model--and often I find that simple rules dominate the vague, obfuscatory, self-serving, and disingenuous descriptions many workers apply to their tasks. It's a paradox that makes my life interesting.

Macro Aggregate Vacuousness

Brad DeLong had a post on Hayek, and at one point he buttresses his argument with this observation:

We start with our quantity theory of money, which tells us what nominal income PY is:

PY = MV(i)

Normally one would stabilize nominal income by boosting M. The problem is that the normal way the central bank boosts M is via open-market operations by which it buys safe savings vehicles for cash. Reduce the supply of safe savings vehicles and you raise their price--and thus lower the safe nominal interest rate i some more. Lowering i further reduces the opportunity cost of holding money and further reduces V. The net effect on PY is:

d(PY) = [V(i) + M(dV/di)(di/dM)]dM

Now, this all seems pretty scientific. Its logic is best exemplified by Don Patinkin’s Money, Interest and Prices (1957), which had page after page of such equations, and has been called the 'height of the IS/LM' theory. It appeared to be a very compelling theory, because it was consistent and logical at every step. All the partial derivatives made sense, but one had to hope that such simple models were sufficient to overcome all the variables and interactions not explicitly addressed, because in a complex economy there's an almost infinite number of relationships and omitted factors.

But what are theses variables and relationships that have such mathematical precision? Consider V, velocity. Velocity is the residual of the measurables nominal income and money. Thus, the derivative of V with respect to i (the interest rate) is really from the derivatives, and their correlations, of nominal income and money. Are either of these stable in any sense (d(PY)/di, dM/di)? No. They have no stable values and suggest they are no better than asserting a mathematical relationship between your body temperature and how much coffee you drank based on thermodynamics: there's a simple effect from the initial impact, but very shortly feedback effects that make the initial physical model worthless.

And so it goes with all these relationships. The economy is a complex, nonlinear, adaptive system where short run effects are often opposite of long run effects. Ultimately, people need to be involved in activities that generate more benefit than they they cost for they to be sustainable, and they must appear attractive to individuals given their other opportunities as they see them. A higher growth rate simply involves having more people near their unknown optimal--unknown because only rudimentary laborers know what the truly best use of their time is at any moment--and stagnation is caused when too many individuals lose their ability or willingness to actively search and make these choices. The more government puts in rules saying we can't drill in the Arctic because of potential effects of exhaust on a nearby village of 100 Eskimos, or that we can't cut hair without a state license, the lower our productivity. Economic freedom results in long term growth and so the key to macro policy is not from some chain rule but rather the wisdom of Smith, Bastiat, von Mises, Hayek, Friedman, Stigler, and the rest who found aggregate prosperity and economic freedom synonymous.

Increasing the money supply to fool employees into thinking they have more money than they do, hoping on a multiplier effect via such derivative compounding logic, is simply absurd. Currently, we are changing M to affect i, so the relationship should be di/dM, not dM/di, highlighting why the empirical relationship between i and M is so spastic. If countries could simply print and spend to increase GDP, the 1970's would have been an era of great growth, instead of the disaster it was, which is why the 1970s--increasing inflation, increased government spending--is such a profound empirical contradiction to the Keynesian model.

Thinking about aggregates this way is pure blather, like the way Marxist intellectuals talked about the laws of motion a century ago when their Oracle bloviated in Das Kapital that just 'as the heavenly bodies, once thrown into a certain definite motion, always repeat this, so it is with social production.' Yeah, just like celestial mechanics. I generally just ignore any argument based on or alluding to such pretentious, hopeful, willfully naive twaddle, but if for some reason someone accosted me at a Town Hall meeting and said such an equation implied we should do X, I would simply ask that they show me the regression results for it on a handful of developed countries in the modern era. The parameters would not be consistent over times or between countries.

Salt May Not be Unhealthy

Gary Taubes wrote What if It's All Been a Big Fat Lie? back in 2002 for the New York Times Magazine, which reinvigorated the Atkins/Southbeach/Paleo diets. He argues carbohydrates put us on an insulin treadmill, whereas proteins and fats satiate us. It seems the key effect is on your appetite via insulin regulation and the stability of going into fat burning mode, as opposed to some calories having different effects on your weight.

But he's a pretty interesting guy in general. His Blogginheads interview on last weekend's Science Saturday was pretty neat. He also wrote back in 1998 that the conventional wisdom on salt could be wrong too, with correlation not equaling causation. Indeed, there are a lot of bad correlations purported to be causations in medicine and biology, and it makes me skeptical of statins. Anyway, here's good news for salt lovers from a New York Times article on a study that included 3,681 middle-aged Europeans who did not have high blood pressure or cardiovascular disease and followed them for an average of 7.9 years.

A new study found that low-salt diets increase the risk of death from heart attacks and strokes and do not prevent high blood pressure, but the research’s limitations mean the debate over the effects of salt in the diet is far from over. In fact, officials at the Centers for Disease Control and Prevention felt so strongly that the study was flawed that they criticized it in an interview, something they normally do not do.

The investigators found that the less salt people ate, the more likely they were to die of heart disease – 50 people in the lowest third of salt consumption (2.5 grams of sodium per day) died during the study as compared with 24 in the medium group (3.9 grams of sodium per day) and 10 in the highest salt consumption group (6.0 grams of sodium per day). And while those eating the most salt had, on average, a slight increase in systolic blood pressure — a 1.71-millimeter increase in pressure for each 2.5-gram increase in sodium per day — they were no more likely to develop hypertension.

Limits to Growth

Martin Feldstein writes an op-ed in the WSJ where he asserts a 5.5% real equity growth rate. This is a common assumption, implying an expected 7.5% nominal equity growth rate going forward, just as CalPers and many other large funds assume.

Consider that profits are a pretty constant portion of GDP, around 10%:



Now, as Jeremy Siegal notes, you can have higher-than-GDP earnings per share growth in stocks if companies continually repurchase shares, but here's a graph from Barry Ritholz on the valuation of the market relative to our GDP over time: it's gone up, but it can't go up forever.


If valuations stay about the same portion of GDP, the average return to a dollar invested is capped by the growth rate of earnings. Remember that these profits are then used for dividends and buybacks.

Fama and French argued that the US 1950-2000 period that is so prominent in academic minds was truly anomalous:

the dividend-price and earnings-price ratios fall from 1950 to 2000: the cumulative percent capital gain for the period is more than three times the percent growth in divdends or earnings. All valuation models agree that the two price ratios are driven by expectations about future returns (discount rates) and expectations about dividend and earnings growth.

This means, the second half of the 20th century was abnormal, even with hindsight looking at dividends and earnings. Expecting greater than 3% real returns out of stocks relies on a lot of hope.

Then again, you can take the view of Jay Ritter, who notes very little correlation between equity returns and GDP growth cross-sectionally, looking at data from 16 countries over 100 years:



As an empirical matter, knowing a country's GDP growth is a pretty lame indicator of even its long run stock market return. Valuation (P/E fluctuations), the fraction of corporate profits paid out to shareholders, and the probability of catastrophic loss due to hyperinflation, revolution, war, are all very important in these 100 year samples.

But ultimately, a 3% top-line return seems the most reasonable equity premium estimate, and the return to shareholders will probably be below that due to transaction costs and adverse timing. The 5.5% return bandied about is a bias from a very biased sample--the US post WW2--not representative of general experience.

Macroeconomists Lament Sterile Methods

Brad DeLong argues that macro needs an overhaul:

We need more Eichengreens, Shillers, Akerlofs, Reinharts, and Rogoffs – not to mention a Kindleberger, Minsky, or Bagehot...perhaps economics will remain a discipline that forgets most of what it once knew and allows itself to be continually distracted, confused, and in denial.

Now, Rogoff has created some conventional macro models, but presumably is mentioned here because of his recent economic history book 'This Time It's Different' with Carmen Reinhart. Shiller's on the list presumably because he doesn't believe in the caricature of efficient markets, though no one believes in that caricature so I'm not sure what the alternative is. Akerloff's theory also highlights limits of efficient markets because of asymmetric information, though it should be mentioned that without the efficient markets benchmark, his result would be ambiguous, highlighting the usefulness of the benchmark.

It's easy to criticize straw men, but even one who tries to make money must realize the value of assuming that markets efficient is useful because otherwise it would be too easy to generate alpha, and any thoughtful person should recognize this is difficult, or at least, rare.

As to Kindleberger, Minsky, Bagehot, and Eichengreen, they tell stories. While these are very interesting, they aren't concise stories, and the older ones were especially vague and inconsistent. What is the essence of Bagehot's worldview? If these are the key writers, macro would have to admit it's best viewed like the field of history as opposed to physics.

Noahpinion makes a common complaint of macroeconomics:

When we learned [Real Business Cycle theory], we were told that the measure of its success in explaining the data was - get this - that if you tweaked the parameters just right, you could get the theory to produce economic fluctuations of about the same size as the ones we see in real life... The editors of Econometrica, the American Economic Review, the Quarterly Journal of Economics, and the other top journals are the ones who publish paper after paper on these subjects, who accept "moment matching" as a standard of empirical verification, who approve of pages upon pages of math that tells "stories" instead of making quantitative predictions

It would be interesting if macro moved away from its emphasis on Dynamic Stochastic General Equilibrium modeling. This toolset takes a major intellectual investment which makes one loathe to dismiss it, just as few who have read the Bible really carefully would admit it is insignificant, but clearly macro hasn't proved useful in explaining the big problems such as why Haiti is poor or what causes business cycles. After a couple decades I think it's fair to say this has been a dead end.

Robert Merton once wrote about finance that

As recently as a generation ago, finance theory was still little more than a collection of anecdotes, rules of thumb, and manipulation of accounting data...The subsequent evolution from this conceptual potpourri to a rigorous economic theory subjected to scientific empirical examination was, of course, the work of many, but most observers would agree that Arrow, Debreu, Lintner, Markowitz, Miller, Modigliani, Samuelson, Sharpe and Tobin were the early pioneers in this transformation.'

And this is the way the history of any field is written, principally by esteemed academics as a form of ancestor-worship, no doubt in the hope that they, too, will become ancestors worthy of worship. In this version, the history of finance, or macro, is that of the smooth and triumphant ascent of knowledge and technique, to our current state of unprecedented enlightenment. Yet it is clear that the big issues of macro and finance, which are closely related, have generated little knowledge or skill that could have helped practitioners about expected returns and economic growth relative to that acquired by economic historians.

The essence of Macro was to leave the methodological individualism that is the essence of economics, and look instead at macro aggregates following laws of motion loosely motivated to look like supply and demand curves. One of the best decisions I ever made was to leave this field, because like being a learned Marxist or sociologist (same thing?), this may get you tenure, but you still don't understand anything.

It's important to know when a paradigm is not working, and clearly macro is just as unhelpful today as it was in the Great Depression in terms of focusing the debate, eliminating irrelevant distractions. The same arguments are being made for more or less government. I don't have the answers, but I do know that full-time macroeconomists are like active mutual fund managers: articulate, hard working, and basically worthless.

Front Kick Wins Again

For the second time in two months, a front kick to the face ended a major UFC fight. This time, it was Lyoto Machida delivering to Randy Couture, whereas previously it was Anderson Silva delivering on Vito Belfort. Machida and Silva are good friends, and both gave credit to action film star Steven Seagal, so I guess he truly deserves credit. It's pretty devastating because the defender is watching his opponents hands, and the kick comes straight up between one's hands. A good shot to the chin is like hitting the power switch on your computer.