Capital isn’t a thing

Sunday, August 3rd, 2014

Capital isn’t a thing, Eric Falkenstein says — it’s a ledger, a way of determining who gets the make decisions about various things, and who gets the fruits of those things:

The fact that a minority has most of the power to decide and access the fruits is a consequence of a past where individuals anticipated a future where such a ledger would continue to be valid. It’s always been popular to think, maybe we should have a jubilee, get rid of those ledgers and start again as equals! Given the power law distribution of wealth at all times such a proposal is perennially popular to those ignorant of history. Yet, if you do this every period, capital isn’t owned by any individual, and so would be completely mismanaged as happens in societies without stable property rights. If you do this at all you can expect an immediately higher default premium which would make an economy undercapitalized. Luckily, our Founding Fathers specifically anticipated these problems and so emphasized the republican nature of our government, not making everything a democratic process.

All Men Seek to Rule

Saturday, August 2nd, 2014

Status-seeking is a human universal, Eric Falkenstein reminds us:

The anthropologist Harold Schneider studied hunter gatherers and noted they had an almost absence of hierarchy, which he saw as the resulting from the maxim that ‘all men seek to rule, but if they cannot, they seek to be equal.’ It’s a reasonable solution for a society without division of labor.  Unfortunately many progressives see the world the same way, and thus like the Rawlsian solution that everyone has the same outcome regardless of one’s talents or wealth. Now, that’s fine for a camping trip, but in modern society unnecessarily.

Reality shows like Top Chef, Project Ink, Project Runway, or Deadliest Catch show people passionate about activities I do not care about in the least, all private sector jobs. With thousands of different remunerative specialties that complement each other, this allows us to focus and then trade with others to get the benefits of other’s specialization focus. In modernity status isn’t limited to one dimension, and so you can be an important part of something bigger than yourself without joining a religion: you are part of a complex network of specialists in a market economy of individuals maximizing their status in their own individual way.

Everyone wants to live on in the future in some way, as part of heaven or something worldly that needed or at least appreciated you. If you obey the laws and social norms, including The Golden Rule, and generate more revenue than you cost, you are making your tribe better off. The egalitarian solution where we have a single-payer state for everything has no risk, but like Hegel’s farmer, promises little potential for self-actualization or what the Greeks called arête (‘excellence’), which in the modern world is consistent with specialization, trade, and productivity growth (arête incents one to do things better than before).  We shouldn’t base our norms on hunter gatherers, which is why most people don’t.

Not More, Better

Friday, August 1st, 2014

The government spends about 35% of GDP in the US today, Eric Falkenstein notes, and heavily regulates the rest:

It would be far better if, instead of thinking about new tricky ways to squeeze the rich, we instead set government spending to some fraction (say 35%) of the past 5 years of GDP and no more. The endless arguments about the level would stop, and it’s interesting to note that over the past 30 years in the US federal revenues as a percent of GDP has been remarkably consistent across various administrations. By using a moving average of historical GDP this would make spending countercyclical, most importantly instead of politicians being elected for their ability to promise ‘more’ they would instead focus on ‘better.’ That is, it would be nice if the politicians argued about better ways to allocate spending rather than about more or less in aggregate; the net result of the ‘more’ approach has been those who are good at articulating why we need more find they have no idea how to spend it, as when the government had $800B to spend in stimulus, most of it simply went to shoring up state budgets, meaning, state pension deficits, which is just an income transfer to state employees from future taxpayers.

Power to the People’s Proxies

Thursday, July 31st, 2014

Democracy does not decentralize power to the people, Eric Falkenstein finds — it does the opposite:

As the Occupy movement showed, unorganized mass movements get nothing done, so successful parties are those that channel public legitimacy into a small set of essential rights too important to be outside state dominion. Go to a school board meeting and watch how insiders anticipate idiotic comments from the rabble, and so control the outcome to make such meetings basically Potemkin village town halls. Eventually the organization-committed people take over the organization and the mission-committed people become frustrated and leave (see a description of the recently created regulator CFPB’s quick descent into solipsism). They set up national plans for health care, education, energy, etc., and slander choice and variety as a ‘race to the bottom.’ Thus, teachers unions and Medicare/Medicaid focus on preventing choices that might take away from centralized power, competition from other providers and exit by consumers is outlawed.

Democracy in Moderation

Wednesday, July 30th, 2014

Democracy, like all things, is good only in moderation, Eric Falkenstein says — it is a means and not an end:

Taken to an extreme it is highly dysfunctional, as decisions are not helped by making them mass plebiscites or town hall meetings.  Go to a school board meeting and watch how quickly thoughtful discussions get sidetracked. Philip Howard’s Rule of Nobody outlines an interesting consequence to increasing public participation in big decisions. As the number of stakeholders grows each interest group seeks its own group’s ends without moderation, they are single-issue advocates nobly advancing their righteous cause (e.g., Native Americans, aquifers, unions), and so veto action unless they are basically paid-off. The result is that usually nothing happens, and so the days when we could build the interstate highway system, the Hoover Dam, or the Empire State Building in only a year, are over.  Small ‘d’ democratic control of property leads to stasis, why government spending today is mainly on transfer payments and studies, not roads and bridges.

Intellectuals should run everything as the vanguard of the people

Tuesday, July 29th, 2014

Liberals consider Piketty’s book a must-read, but only, Eric Falkenstein says, because, like Marx’s Capital, it’s a great safety blanket for Liberal prejudices:

The end-game is exactly what progressive conventional wisdom (e.g., the common New York Times or Harvard professor view) has been preaching for over 50 years: enlarge the state. The key point is a highly credentialed academic wrote a long book proving that some abstruse mathematical inequality (r>g) implies we need to raise taxes on the rich and regulate wealth more democratically. It’s really the debating tactic called ‘spreading’, which is top put forth so many arguments, none sufficient or necessary, that you can always claim victory. For example I could question his many empirical assertions, such as how could German inflation have averaged only 14% from 1913-1950 (p. 545) given inflation was 10^10 in 1923, or how depreciation affects his r/g=C/I steady state equilibrium, but that would leave another 20 assertions unstained, and so those who want to euthanize renteirs can retain faith in their big picture.

Piketty is a modern progressive, best defined as someone who thinks intellectuals should run everything as the vanguard of the people, which is why academics, journalists, and writers are predominantly progressive. Hayek noted that scribes have always been egalitarian, probably always lamenting the fact that the idiots in power don’t write nearly as well as them, and thus, are objectively less qualified but via some tragic flaw in the universe, end up in power. It forms the common reverse dominance hierarchy so common today, where obsequious, hypocritical yet articulate and confident leaders pander to the masses and rule via democracy, focusing their envious eyes on those who aren’t interested in that game, such as those concerned with business, religion, or their own family. As Piketty notes, “if we are to regain control of capitalism we must bet everything on democracy” (p. 573), he says from his inegalitarian and very undemocratic position at the Paris School of Economics.

It never occurs to them that the main problem with subjecting markets to democratic control is that those who end up wielding power will be incompetent or tyrannical, and that ‘the people’ have never ruled directly, only their various proxies. Every totalitarian government of the 20th century has rested on at least the perception of massive popular support, which is why they have all ruled in the name of The People. An unchecked democracy becomes mob rule, which becomes tyrannical and highly illiberal, why the Founding Fathers, so familiar with Greek history, were careful to put checks and balances in the US constitution and emphasize the republican nature of government.

What have the Victorians done for us?

Monday, July 28th, 2014

Certainly the eras that gave us our scientific and intellectual heritage were very unequal, Eric Falkenstein notes, with not just an aristocracy but often slavery:

If some inequality is inevitable, how much is too much or too little?  When the West was beginning its industrial revolution and creating an unprecedented growth in productivity and social welfare, giving us the railroad, electricity, indoor plumbing, the internal combustion engine, etc., Piketty notes wages were ‘objectively miserable’ in the 19th century as if they could have been higher but for elite cupidity, and the Belle Époque evokes the specter of exploitation. The fact that the average height was rising and infant and maternal mortality rates were falling at an unprecedented rate after stagnating for centuries if not a millenium, supposedly means little. So too the great increase in technology that economist Robert Gordon notes was not only unprecedented, but singular, never to be achieved again.  In Piketty’s mind it’s an unbearably time, reminding me of the scene in Monte Python’s Life of Brian where John Cleese says, apart from the aqueduct, sanitation, peace, roads, etc., “what have the Romans done for us?”

A Theory of Growth

Thursday, January 13th, 2011

Eric Falkenstein reiterates his theory of growth, which does not focus on preventing recessions:

That decentralized, self-interested, people can collectively make such large errors seems irrational or corrupt to many, but they should remember that growing economies require people to be making things better, which means, new ways of doing things. New ideas are often wrong. Economics has gone onto intellectual cul-de-sacs many times (socialism, Keynesian macro models, input-output models, Hilbert spaces in finance, Arbitrage Pricing Theory, Kalman-filter macroeconomic models, etc.). Other scientific disciplines have their own mistakes, and political mistakes — stupid wars — are also common. These are rarely conspiracies, but rather, smart people making mistakes because the ideas that are true, important, and new, are really hard to discern, and tempting ones are alluring when lots of other seemingly successful people are doing them.

My Batesian Mimicry Theory posits that recessions happen because certain activities become full of mimics, entrepreneurs without any real alpha who got money from investors looking in their rear-view window of what worked and focusing on correlated but insufficient statistics. For example, people assumed a nationally diversified housing prices would not fall significantly in nominal terms, because they had not for generations; people assumed anything related to the internet would make them rich in the internet bubble, conglomerates would be robust to recession in 1970, that the ‘nifty fifty’ top US companies had Galbraithian power to withstand recessions in 1973, that cotton prices would not fall in 1837, etc.

As in ecological niches, there is no stable equilibrium when mimics arise to gain the advantages of those with a real, unique and costly, comparative advantage. Every so often there are too many mimic Viceroy butterflies, not enough real poisonous Monarch ones, and a massive cataclysm occurs as predators ignore the unpleasant after-effects and start chomping on all of them. The Viceroy population grows until this devastating event occurs, a species recession. Next time, it won’t happen in butterflies, but rather, among frogs or snakes. They key is, some ecological niche is always heading towards its own Mayan collapse (distinct from the 2012 Mayan apocolypse).

The key to wealth creation is doing more with less — destroying jobs at the micro level and creating jobs at the macro level by reallocating capital and labor to more valuable pursuits. The computer got rid of things from typesetters, secretaries, to engineers working with slide-rules, but these people didn’t stay unemployed, they did something else, making the economic pie bigger. This is antithetical to government and unions who think creating a permanent ‘job’ creates productivity — stability at the micro level and stagnation at the macro level. Wealth is created by having decentralized decision-makers focused on simple goal of making money, which means, they oversee transactions where revenues collected are greater than expenses paid. If externalities are properly priced (I know, most liberal think this never happens), this implies value is created. The continual improvements in method (ie, productivity, wealth creation) merely maintain profits in a competitive environment; to do nothing would see their profits eaten away by competitors would could easily copy what they did and just undercut their prices.

This passage reminds me of our recent discussion on authority and education:

The key to this is having managers who keep their workers focused. A good example is a story I heard second-hand about a football player for Minnesota Vikings in the 1970s. Coach Bud Grant called this marginal player into a meeting, and said, ‘Here’s what I need you to do…’. The player, an articulate fellow quite confident in himself, interrupted with an explanation of why he wasn’t doing better and suggestions about how to correct it, mainly focused what others were doing wrong. Grant cut him off: ‘You don’t understand. This isn’t a negotiation. Do what I’m telling you, and you have a role here. Otherwise, you don’t.’ Hierarchies only work well when people have clearly defined goals, and managers who manage their direct reports singlemindedly.

Private firms can do this much more quickly and often than government, and are rewarded with investment and retained earnings to the degree they do it well. When the government wants to do something, like build a light-rail system, it instead satisfies all its stakeholders who have no financial downside, only veto power, and so the cost/benefit calculus is almost irrelevant. The probability that benefits will outweigh costs when not prioritized is negligible, as highlighted by the fact that companies have to work very hard to make this positive when all those other considerations are ignored.

Courage and Power

Thursday, December 16th, 2010

Eric Falkenstein has long said that the risk premium doesn’t make sense — and not just in investment markets:

I was reading a book The Decline and Fall of the British Aristocracy, by David Cannadine, which covers 1870 through 1930. They highlight that this was the strongest aristrocracy in Europe due to primogeniture and Britain exceptional wealth, and so the combination of power, status and wealth was unequaled. in 1880 only 10,000 people owned 66% of the land. Yet land prices fell after 1880 due to a collapse in agricultural prices, the rising industrial sectors marginalized the rural areas that historically gave the nobility so much of their wealth, and new laws turned power irrevocably from nobles to number (the Third Reform Act of 1884).

Classical liberal Richard Cobden wrote that ‘the battle-plain is the harvest-field of the aristocracy, watered by the blood of the people’, meaning, the aristocracy prior to 1900 generated their legitimacy via their willingness to lead groups into battle (often needlessly). As the British aristocracy declined from 1880 to 1910 they thought that World War 1 would re-establish them as the top of their country. Many were eager to fight, mainly afraid the fighting would be over before they could prove themselves in battle. Yet, while they proportionately lost more of their sons than those of other classes in WW1, the decline of the aristocracy continued unabated after the Great War. Indeed, the loss of life sharply curtailed the supply of domestic servants, and inheritance taxes went from nothing to 60% by 1939. The lower classes felt no sense of gratitude towards the aristocracy, having lost enough themselves. Battlefield courage is admirable, but it is not sufficiently rare to generate privileged status; the lower classes were not party to such an exchange.

In retrospect, the aristocracy arrogated power via myth, tradition, and brute force, rationalized via their exception valor. The problem with their self-serving story is that many would accept a probability of death for such success, so this ‘courage preference’ was not a real equilibrium result, as WW1 showed. Courage was a necessary, not sufficient, condition for acquiring power.

When Quality Doesn’t Matter

Friday, September 3rd, 2010

Back when the Web was young, Paul Graham demonstrated a new algorithm to Yahoo’s Jerry Yang, one that ranked search results by user behavior and differentiated between clicks and clicks leading to purchases.  Yang didn’t seem to care, and this confused Graham:

I was showing him technology that extracted the maximum value from search traffic, and he didn’t care? I couldn’t tell whether I was explaining it badly, or he was just very poker faced.

I didn’t realize the answer till later, after I went to work at Yahoo. It was neither of my guesses. The reason Yahoo didn’t care about a technique that extracted the full value of traffic was that advertisers were already overpaying for it. If they merely extracted the actual value, they’d have made less.

This, Eric Falkenstain notes, is just one example of when quality doesn’t matter:

There are many stories about real-estate brokers setting up shop in the early aughts, not caring about whether homebuyers would actually pay their mortgage because it did not matter. This was a signal that rot was rampant. Basically, if quality doesn’t matter, and there’s free entry, there’s a bubble.

When people have positions that don’t do what they say they do, and make a lot of money, there are myriad bad effects. Once when I was a risk manager, I remember showing a swaps book trader a more efficient way for him to hedge his portfolio. As I had to calculate his value-at-risk I had all the data to demonstrate conclusively my superior algorithm. He found this annoying. As a market maker, his Sharpe was already well above 10, so decreasing his value-at-risk by 20% did not really matter. Like Graham’s encounter, I discovered it was all marketing.

The problem with this situation is that when you really understand the game, you have to never talk about it, which is easiest to do if you really don’t understand it. So, the best brokers or brokers-who-call-themselves-traders are blithely ignorant, because they don’t generate ‘tells’ that make everyone engaging in the game uncomfortable. When they talk about trade ideas that are totally unfounded, they can’t be convincing if aware of its lack of statistical evidence, or how their qualifications make everything said meaningless (this could lead to a retracement). Once you swallow the red pill, you can’t go back to enjoying the Matrix.

Similarly in the corporate borg, especially in places like the new Office of Minority and Women Inclusion that is now mandated to be part of each of our 30(!) financial regulatory bodies. As true discrimination is about as rare as a Klan rally, this is all just a sop to the Indian-like ethnic group spoils system the US is becoming (are there really any bankers who hate minorities enough to forgo extra profits?). So, the Chief Diversity officer’s real role is not to rid financial discrimination, but rather to spout cliches about diversity, and put a pretext on the patronage daisy-chain that led to the 2008 housing crisis. However, if you really understood this, you would go crazy, so earnest dolts plague the aristocracy because the dupes actually believe their job is about what it says it’s about.

A Batesian Mimicry Explanation of Business Cycles

Tuesday, July 27th, 2010

Erik Falkenstein went to grad school to become a macroeconomist and understand business cycles, but he quickly realized that no one understood business cycles.  Now he presents his own Batesian mimicry explanation of business cycles:

My argument is that business cycles are best understood though the framework of Batesian mimicry, an endogenous mechanism for booms and busts thru a misallocation in the horizontal structure of production. In ecosystems, Batesian mimicry is typified by a situation where a harmless species (the mimic) evolves to imitate the warning signals of a harmful species (the model) directed at a common predator (the dupe). For example, venomous coral snakes have red, yellow, and black bands, while the non-venomous scarlet king snake has the same colors in a different order. Animals afraid of venomous snakes would do well to avoid 4 foot long snakes with red, yellow and black stripes, in the process avoiding the scarlet king snake (alternatively, one could remember the rule “Red on yellow, kill a fellow; red on black, friend of Jack”).

The process has been observed in insects, reptiles, mammals, and plants, and sometimes occurs between species. By parasitizing the true warning signal of the protected species, the Batesian mimic gains the same advantage without having to go to the biological expense of maintaining a poison. The species being mimicked, on the other hand, is disadvantaged, along with the dupe who misses out on tasty mimic meals. If imposters appear in high numbers, positive experiences by the predator with the mimic may result in the model species losing the benefits of signaling its poison.

Atsushi Yamauchi has shown that when there are density effects on the model species, there is no stable equilibrium. Nonlinear dynamics make the system’s aggregate features unpredictable in specifics, but most importantly, it is not a stable equilibrium to have no mimics over long periods of time: the gains are large to the mimic because predators obey the model’s high-quality signal.

While it’s conceivable one could generate a formal economic model with these qualitative results, note that the ecological literature mainly looks at comparative statics for one species, noting what assumptions generate stable equilibria, and which do not. There is no attempt to generate a dynamic model of the mimic or models success over time, presumably because the highly nonlinear, recursive system is so sensitive to results would merely be qualitative, like the comparative statics.

In an expansion investors are constantly looking for better places to invest their capital, while entrepreneurs are always overconfident, hoping to get capital to fund their restless ambition. Sometimes, the investors (dupes) think a certain set of key characteristics are sufficient statistics of a quality investment because historically they were. Mimic investors seize upon these key characteristics that will allow them to garner funds from the duped investors. The mimic entrepreneurs then have a classic option value, which however low in expected value to the investor, has positive value to the entrepreneur. The mimicry itself may involve conscious fraud, or it may be more benign, such as naïve hope that they will learn what works once they get their funding, or sincere delusion that the characteristics are the essence of the seemingly promising activity. The mimicking entrepreneurs are a consequence of investing based on insufficient information that is thought sufficient, but they make things worse because they misallocate resources that eventually, painfully, must be reallocated.

Once the number of mimics is sufficiently high, their valueless enterprises become too conspicuous and they no longer pass off as legitimate investments. Failures caused by insufficient cash create a tipping point, notify investors that certain assumptions were incorrect. Areas that for decades were very productive, are found to often contain exceptional levels of fraud, or operate with no conceivable expectation of a profit. Everyone outside the industry with excessive mimics marvels at how such people—investors, entrepreneurs, and their middlemen–could be so short-sighted, but the key is that the mimics and duped investors chose those business models that seemed most solid based on objective, identifiable characteristics that were, historically, correlated with success. An econometric analysis would have found these ventures a good bet, which is why investors did not thoroughly vet their business models (banks, up through 2007, were one of the best performing industries since industry data has been available in the US, and performed well in the 2001 recession).

In the 1990’s tech firms in general and internet firms in specific were doing very well. The internet bubble was filled with a naïve lack of skepticism that allowed otherwise absurd business ventures to get funding. Using hindsight there were so many businesses with doomed business models, you wondered how they could have been taken seriously, but investors were looking primarily at a few key criteria—net presence, branding—and these did work well for several years until the March 2000 crash, especially using the criteria of their stock price. Consider that Enron was able to engage in negative cash flow activities for at least 5 years while their stock price kept climbing, highlighting that if you hit the key signals investors are naively prioritizing, they can be fooled, just not forever.

Risk and Return

Tuesday, July 13th, 2010

Eric Falkenstein summarizes what he has found when looking at the relationship between risk and return:

Here’s the bottom line, which apparently is more difficult to understand than the theory, but ultimately much more convincing once you see it.

The negative risk-return relation holds for volatility (cross-sectionally and over time, total and idiosyncratic), beta, options, private investments, leverage, currencies, country returns,yield curves, financial distress, sportsbooks, lotteries, IPOs, junk bonds, and analyst uncertainty.

It’s pretty absent in country returns, commodities, movies, and private investments.

It does work nicely in the the AAA-BBB spread or the short end of the yield curve.

Now, if you were an alien, what’s your generalization, that in general risk is related to return, not related, or the opposite? The Academy teaches that there’s a linear relation, positively sloped!

A Cognitively Demanding Sport

Monday, July 12th, 2010

I wasn’t expecting to get hit with a UFC spoiler while checking Eric Falkenstein’s finance-oriented Falkenblog last week, but he gave a good rundown of the Lesnar-Carwin fight — and he made a larger point that I often make when discussing MMA:

I know many consider MMA to be rather base because it seems so savage, but its strategy space is large, necessitating skills in boxing, wrestling, and jiu-jitsu. This makes it fun to watch. Several champions have undergraduate degrees in real subjects (Shane Carwin, Rich Franklin, Chuck Liddell), unlike boxing. Recently, the seemingly invincible Fedor Emelianenko was submitted by a jiu-jitsu specialist, highlighting that in a sport with such range, everyone can get beat because no one is best at all three (wrestling, striking, jiu-jitsu), and any one of these skills can be decisive if you don’t defend it intelligently. It’s a relatively cognitively demanding sport.

Two of the younger, less famous Gracies — Ryron and Rener — analyze the grappling end-game and what Shane Carwin should have done against Brock Lesnar:

Creativity is not rewarded

Thursday, April 8th, 2010

Everyone says they want creativity, but creativity is not rewarded:

There have been countless studies, too many to cite here, on teacher opinions of creative behavior in classrooms. In one example, a study by Westby and Dawson looked at characteristics of creative and non-creative students, then asked teachers to rate their favorite and least favorite students based on those traits.

First, teachers were asked if they valued creativity and enjoyed working with creative students, and they overwhelmingly answered “yes”. Next, they were asked to look at their own students and rate them on a variety of traits, ranging from highly creative traits, such as being determined, independent, individualistic, impulsive, and likely to take risks, to traits that are associated with low levels of creativity, such as peaceable, reliable, tolerant, steady, and practical. After they rated their students on these traits, they were asked to rate them from their least favorite to most favorite students.

Interestingly, there was a significant negative correlation between the degree of creativity of the student and his favorable rating by the teachers. This means that the most creative students were the least favorite of the teachers, across the entire sample surveyed. Additionally, the students that were rated as favorites of the teachers possessed traits that would seem counter-productive to creative behavior, such as conformity and unquestioning acceptance of authority. On the other hand, these are behaviors that fit well in a classroom setting. Even back in 1975, Feldhusen and Treffinger reported that 96% of teachers felt that creativity should be promoted in the classroom. However, when asked which students they actually liked to teach, they chose the students that were more compliant. Why the inconsistency?

Teachers say they want creativity, but that is not the behavior that is rewarded. In this study (as well as in many others), they found that there is a discrepancy between what teachers, and schools in general, say they value and desire, and what behaviors they actually reward and encourage. Teachers don’t want the student who is always raising their hand and questioning the assignment; they want the student who unquestioningly follows the outline given to them and turns the assignment in on time. After all, what a hassle it would be to allow a student to creatively revise an assignment, even if the new method still met the project objectives. Any type of questioning of the pre-set format is viewed as challenging and defiant behavior. Bad.

Unfortunately, once you leave school, society does not get much more supportive of really creative behavior. The most highly valued employees are the ones who blindly accept the ideology of the company, don’t challenge authority, and do the work that is required of them, no questions asked.

People don’t say what they think, Eric Falkenstein says:

Professors love creative students, as demonstrated by those who extend their work in predictable yet difficult dimensions. The ‘creativity’ is evidenced merely by embracing their-own paradigm shifting work. A truly creative person, like a true risk taker, is seen as a crank in real-time, and indeed on average they are. But sometimes they are right.

Like risk-taking, what these creativity lovers mean is, they like positive surprises. Risk-taking of a regular sort that leads to failure is considered just dumb, or worse, full of hubris. Creativity is great if it generates an obviously valuable thing, otherwise, it’s annoying, and just inappropriate.

I once read an article that accompanied an exposition on the Capital Asset Pricing Model, and its implication that expected return was positively related to risk (via the ‘beta’, now an anachronism). They asked a bunch of well-known portfolio managers about their greatest risks, and each one was an unqualified success. This gives one the feeling that risk is related to return, because in these biased samples they are. Kids, and adults, should know that risk-taking usually fails, and so the only key is to know when to stop, and to keep trying, learning along the way.

Gary Gorton vs. Michael Lewis

Thursday, March 25th, 2010

Gary Gorton’s Slapped in the Face by the Invisible Hand is insightful but not nearly as lively as its title, Eric Falkenstein says:

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, the impressions of a kid right out of college has after 2 years in a business, no matter how smart and eloquent the sojourner, are invariably quite mistaken. 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 or too low. 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.