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.

The Only Thing Macroeconomists Have Learned

Monday, March 1st, 2010

Russ Roberts interviews Nobel prize-winning macroeconomists Edmund Phelps in the latest EconTalk podcast, and Phelps states that macro has been very productive over the last generation. Eric Falkenstein disagrees:

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.

Progressive Competition

Thursday, February 18th, 2010

Eric Falkenstein considers progressive competition oxymoronic:

In Minnesota, we have 3 health care providers, and they all have highly regulated choice offerings. We have 68 mandates, meaning, I am paying for things I would not otherwise pay for (osteopathy, chiropracter, port-wine stain elimination). Insurance means exchanging a certain small payment for an uncertain large payment; in this case, I’m paying for many things I’ll certainly never use. If providers all have to provide identical service menus, entitling consumers all they can get from that list, this is not competition.

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

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

Scientific Peer-Review is a Lightweight Process

Thursday, December 10th, 2009

Shannon Love explains to non-scientists that scientific peer-review is a lightweight process:

It works like this. An experimenter in a particular field sends a paper to a journal that covers that field. The editor then secretly selects scientists in the same field whom the editor believes are competent to glance over the paper and check it for obvious errors or faults. In the vast majority of cases, peer reviewers do not examine the original data, do not examine experimental records, do not examine the experiment’s hardware/software and they most certainly do not confirm the results claimed in the paper by reproducing the experiment themselves.

Saying a paper is peer reviewed says nothing about the validity of its conclusions.

Peer-review is a political process:

Peer review protects a journal’s reputation by hiring experts in a field to check papers prior to publication. It is not a journal’s responsibility to confirm or refute experimental conclusions, but it is their responsibility to check for basic errors in math or methodology, just as they would check for errors in grammar or spelling. Peer review offloads any responsibility for publishing bad papers onto anonymous members of the scientific community. It’s a perfect form of blame passing that everyone else wishes they could use.

This blame passing also keeps journals and editors from being accused of taking sides in personal and professional quarrels. It is also the reason that reviewers themselves prefer to remain anonymous. No scientist wants to suffer the professional and personal consequences from either refusing or accepting a paper they should not have refused or accepted. It is also why peer review is a superficial review. The reviewers do not wish to be dragged into the minutia of scientific debates and quarrels. Instead, they concentrate on the basics that everyone can agree on.

Eric Falkenstein adds his thoughts:

I’ve refereed many papers, and I never independently tried to replicate their results with their algorithm and data. If they faked their data subtly, only posterity would punish them, not a referee.

But a referee also crucially opines on a paper’s usefulness, and this involves guessing what other people would like to reference. Most models do not have straightforward empirical implications, so this is often an assessment of which toolkit is considered cutting edge. Economics often builds huge Rube Goldberg machines that potentially are useful, which are never refuted, but rather, fade away as the professors who made their reputations on these models retire, and the new generation sees that they are quite useless.

Input-output models, large scale macroeconomic models, second order difference equations modeling the GDP. These were all considered the apex of ‘good form’, and so any results in these frameworks, if sufficiently rigorous, were published. If you submitted a paper today using these frameworks, you would get rejected out of hand because they are no longer considered useful. But that came through long experience, and not any definitive rejection. Even today, some results based on dynamic programming, and using vector autoregressions, are published merely for getting a result, not an interesting one, because the technique is difficult, rigorous, and takes economics a leap equivalent to the leap from astrology to astronomy. Who says economists don’t work on faith?

Science in Practice

Monday, December 7th, 2009

Eric Falkenstein laments that protocol is a prerequisite to substance:

A paper not only needs to have a new point, but it must do so in a way that patronizes the methodology they all have uniquely mastered. A scientist is generally not someone who simply knows a lot about ‘x’, but also knows how his status tribe discuss such ideas. Whether its post modern philosophy or economic dynamics, the key is the methodology, because that is what defines who is relevant, because someone with good ideas, but who does not use your method, potentially trashes your human capital (eg, you mean my understanding of the difference between Brouwers’ and Kakutani’s fixed point theorems was wasted?).

He shares an anecdote from David Hakes, an economics professor at Northern Iowa:

When we submitted the paper to risk, uncertainty, and insurance journals, the referees responded that the results were self-evident. After some degree of frustration, my coauthor suggested that the problem with the paper might be that we had made the argument too easy to follow, and thus referees and editors were not sufficiently impressed. He said that he could make the paper more impressive by generalizing the model. While making the same point as the original paper, the new paper would be more mathematically elegant, and it would become absolutely impenetrable to most readers. The resulting paper had fifteen equations, two propositions and proofs, dozens of additional mathematical expressions, and a mathematical appendix containing nineteen equations and even more mathematical expressions. I personally could no longer understand the paper and I could not possibly present the paper alone.

The paper was published in the first journal to which we submitted.

The University of Minnesota Loves Diversity

Thursday, December 3rd, 2009

The University of Minnesota loves diversity, Eric Falkenstein notes:

The University of Minnesota has a new booklet out articulating how much they love diversity. How much? They say “diversity” 230 times in 18 pages. As a local journalist noted about a different program at the U:
[A]spiring teachers there must repudiate the notion of “the American Dream” in order to obtain the recommendation for licensure required by the Minnesota Board of Teaching. Instead, teacher candidates must embrace — and be prepared to teach our state’s kids — the task force’s own vision of America as an oppressive hellhole: racist, sexist and homophobic.

It seems like the essence of a higher education is diversity, not of thought, but of human subgroups based on ethnicity, religion, race, and sex.

Fiction is Fiction

Saturday, November 14th, 2009

Eric Falkenstain watched Tyler Cowen’s recent TED talk, which argues that fiction is fiction:

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

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

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

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

Risk-Averse Regulators

Friday, November 13th, 2009

Eric Falkenstein tells a tale of risk-averse regulators:

A friend of mine runs a small bank. He said the regulators came in, and said that they had too much money invested in brokered deposits. Like any businessman he wanted a spotless review, because any negative marks could imply he could not do certain things, such as expand a new office, acquire or be acquired. Bad reviews give the government an undefined option to meddle, veto, who knows? So he asked, what level would be alright with you Fed guys? They said, ‘that’s a business decision”. My business friend noted they were very clear that they do not give advice or anything that could be construed as advice.

Translation. We are suspicious of your exposure, but do not want to defend our suspicions.

This is government in action, afraid to make any hard decisions.

Anomaly or Pattern?

Wednesday, November 11th, 2009

The Fort Hood shooting is an example of how an event can be considered an anomaly or a broad pattern, depending on preconceptions:

The major media and the White House have a strong belief that Muslim extremism is idiosyncratic and mainly irrelevant. As Chris Matthews stated, ‘we may never know if religion was a factor at Fort Hood’ (who’s this ‘we’ kemosabe?). Obama cautioned against ‘jumping to conclusions. The New York Times has the headline articles “Army Chief Concerned for Muslim Troops, and also Little Evidence of Terror Plot in Base Killings, and finally, Painful Stories Take a Toll on Military Therapists. The narrative they want to tell is that a poor psychologist was overwhelmed by the stress of listening to troops discuss their stress by going over to Iraq, and that the biggest problem created by this event is anti-Muslim bigotry.

Consider that when 4 college kids were killed at Kent State in 1970 it was quickly decided this was the signature event of how the government war machine was killing unarmed American kids, as opposed to an unintended accident caused by students bent on increasing anarchy until something happened. James Byrd was a black man murdered by some white supremacists in 1998. There are prime time documentaries, foundations, and major references by politicians and pundits on this event, as if it signified a broad issue. Actually it was highly unusual, most interracial violence involves black perpetrators and white victims, the disparity in crime propensity is on the order of the male/female difference.

Events are either anomalies or examples of a pattern based on a simple politically correct view of how the world works, still based on Marx’s class lens: the dominant class is responsible for everything bad done by everyone, either directly or indirectly. The Statistical Abstract of the United States has lots of tables on crime victimization by race, but not the perpetrator by race, because we don’t want to blame the victim.

How does this relate to Falkenstein’s area of expertise, finance?

The Fed keeps easy to read data on mortgage rejection rates by race, but hides default rates by race, which has led to innumerable simplistic newspaper stories that have ‘proved’ rampant discrimination by banks.
[...]
If the statistical disparity was simply due to bigoted discrimination, closing the gap would be costless. As they say, things always end badly, otherwise, they wouldn’t end. Once subprime blew up, sticking with the Marxist narrative right-thinking people were quick to blame banks for forcing ill-advised mortgages on minorities.

The same principle is involved in education, crime, and borrowing, that of seeing any behavior by socially disadvantaged groups as more evidence of their victimization by the dominant majority. Policies predicated on mistaken assumptions make things worse. By promoting the belief that bigotry accounts for most of every disadvantaged group disparity, the PC elites are doing more harm than good to everyone. Their bad solutions are then applied to everyone, creating a race to the bottom based on great intentions.

Innovation is Not Rewarded

Tuesday, November 10th, 2009

Innovation is not rewarded, Eric Falkenstein says, because thinking different generally isn’t a good idea:

I personally have known a lot of really smart people and have to say they are more unconventional in their ideas, yet most of their ideas are crazy. If you have ever been to a Mensa meeting (IQ but little formal education), you realize how things like homeopathy, or truthers, get their bearings. If you have ever hung out with PhDs, you know how limited their competence scope is (at research universities they have the same IQ as Mensans, but are more disciplined and less creative). It’s no wonder guys like stereotypical MBAs, who are not so analytical but rather personable and articulate, tend to dominate society. I suspect MBA rule is less catastrophic than PhD or Mensa rule, if only because they aren’t as certain of themselves. This all gets back to the idea there is an optimal IQ, and it’s not 180, but rather, say, 125 (probably the modal IQ for any large group leader, such as Presidents and CEOs).

Being smart is a good thing, and I’m happy when my kids do well on cognitive tests because of what this portends for their life (as Charles Murray noted, most people would prefer their kid had 15 more IQ points than get $1 million on their 21st birthday). Yet highly intelligent people tend to innovate more, and such innovation tends to be counterproductive for the innovator. So, the fact really smart people can answer a question faster or more accurately than others, is at some point offset by the fact that when they have to supply the question — as is the case once they leave formal schooling — they will be attracted towards less conventional, usually irrelevant or wrong, paths. For every Steve Jobs or Albert Einstein there were many who lived and died in obscurity; for every Black-Derman-Toy there are hundreds of insanely convoluted, in-house models, of no value.

Obama’s Alpha Delusion

Friday, October 30th, 2009

The current administration recently unveiled $3.4 billion in stimulus grants for advanced electricity-grid projects, and Eric Falkenstein calls this Obama’s Alpha Delusion:

This PR parade relies on the idea that this administration, if not Obama himself, gets into details, and chooses the right cutting edge technologies and methods. Look at Obama above, with his sleeves rolled up, giving pointers to an appreciative bunch of field managers (perhaps the NEA can get to work on some Soviet Realism in this context). In this case, Obama merely has to allocate some of our money to a select list of projects that are aligned with the buzzwords ‘clean energy’, and we get the increasing returns to scale that Paul Krugman won his Nobel Prize for (too bad Ann Krueger didn’t win a Nobel for showing the same ‘infant industry’ argument has been a pretext to protect inefficient industries for over 200 years).

It never occured to any of these guys that there aren’t any magic solutions to our energy problem. They act as if we only tried to develop batteries, we could have ten times the power. See this video from Zocalo, and at the end of the critical discussion about the oil industry an audience member earnestly asks: “can’t we develop energy out of water?” as if the only reason we use oil is because the Rich Uncle Pennybags character from the Monopoly Game is not letting us. The electric car predates the internal combustion engine. My laptop and cell phone routinely run out of energy, highlighting the high reward waiting for the next battery innovation. There has been and continues to be research, and incentives, to increase the efficiencies of batteries.

Obama hates being compared to socialists, so I’ll refrain and compare him to a communist. In the state published hagiography, Divine Stories About the Dear Leader, Kim Jong-Il is presented as someone excellent at golf, pistol shooting, technology, and battlefield courage. He’s basically better than everyone at everything. For a communist state that belief is necessary, otherwise their system is too centralized.

Obama and his experts are presumably more efficient than the market at allocating more resources to productive technologies. The idea that since the market won’t provide funds, perhaps the informed expected return on battery investment is truly low, seems absurd: how could selfish oafs who run business know better than an articulate, caring, public servant? It’s The Secret writ large: think it true, and it becomes so. No wonder it’s a popular idea: would that it were true.

Unfortunately, the bien pensants who adore Obama (or really, adore that they adore Obama), see his value add being multifaceted micromanagement. There are countless $3.4B special investment targets to do, each one with dreams of cold-fusion, high-speed trains, and the end to the achievement gap. Most people think that ‘good smart people’ are better in almost every way than your average businessman, and most people think they vote for such people, thus these politicians should be directing activities the way a coach directs a football team.

Alas, the value of extreme intelligence and knowledge of detail, does not scale at the managerial level. It runs out of benefit to a ruler, because they cannot and should not try to micromanage things. Thus, the best developer of a new technology is often a lousy director for a state or large corporation, and the best managers are often not the best developers. Indeed, a key advantage of those who are smart — but not too smart — is they know they don’t know more than everyone. The Barak Obamas and Paul Krugmans, having excelled at Harvard or MIT, can more easily think they actually know more than everyone else, leading to the classic Fatal Conceit of planners everywhere.

The idea that the only feasible alpha for a leader of a large collective, is to enforce rules and get out of the way, is simply preposterous for those who think the Invisible Hand is merely a theory used by conservatives to excuse their indifference. This reflects a failure to appreciate the complex, homeostatic mechanisms of self interested agents within a free market, and the infinite number of ways top-down rules are worked around when applied to the masses. As Hayek noted, the biggest flaw with the free market is that it wasn’t designed, it emerged spontaneously, which causes people to dismiss its value. Thus, they have 1000 page plans like our health care bill, or ideas about new committees that will assess issues intelligently and disinterestedly.

McAlpha Deception

Tuesday, October 27th, 2009

Alpha is like secret sauce, and Eric Falkenstein estimates that 90 percent of alpha is misrepresented:

Anyone in charge of a business line making money, is usually too embarrassed by the straightforward nature of their advantage to admit it, so they have to point out some nuance that makes absolutely no difference. Thus, every market maker, making money off order flow, will swear they are adding value ‘reading the tape’ or trading like a turtle, or some other such nonsense. Finance is probably the worst, because there’s so little alpha and so much branding and ‘sticky money’, that truth-telling is a strictly dominated strategy. If you ask your average financial executive to explain what he does, chances are he won’t tell you even if he knows. Further, many are actually clueless. They don’t know their job is to provide the appearance of a method to the whims of the main decision-maker, that they fit the right diversity box, or their husband is a senator. Admitting the truth would be too depressing, and the mind is very good at protecting its self image.

Falkenstein takes the secret-sauce metaphor one step further:

I like McDonald’s: it’s clean, I like the burgers and fries, my kids enjoy their play areas and have a fairly nutritious lunch (hamburger with apple slices and milk). But their burgers tend to lose adult taste tests against Burger King. Why? McDonald’s burgers are primarily loaded with ketchup, which appeals to kids, where BK has more mayo, which appeals to adults. The solution might seem easy, add an option to replace ketchup with mayo.

But that would make the burger choice seem much less alpha-like. A burger chain has a reputation, and they carefully project one of having super quality and care, or something outside the box like a square shape, or flame broiling. Heaven forbid they state, these are hamburgers, not steak. They are cooked by people who have trouble remembering to wash their hands after using the bathroom (thus the prominent signs), let alone the ordinal ranking of rare, medium, and well-done. A multinational corporation can’t produce a medium rare burger without generating a class action E. coli lawsuit, and a well-done piece of ground beef is about as nuanced (yet still enjoyable), as an ice-cold light beer.

But that’s like a finance professor saying all investment analysts can’t predict the market. A thriving industry goes on, acting as if they have alpha in every ‘buy’ recommendation, every burger. Thus, the newest McDonald’s creation are their new Angus burgers. They have… lots of mayonnaise. Too much in fact. So, even though they know this is the true ‘secret sauce’ in the adult burger battle, they emphasize the Angus dimension, and then overload the key ingredient. I prefer the more predictable double quarter pounder with no pickle.

Epictetus the Life Coach

Monday, October 19th, 2009

Marcus Aurelius, not EpictetusEric Falkenstein turns to Epictetus the Life Coach, because optimism has one glaring deficiency:

The problem with optimism is that it’s blatantly incorrect: we aren’t all above average in everything, things do not always get better, and we can’t always get what we want. The problem with realism is that by itself it is depressing, a demotivator that does not elevate.

He summarizes Marcus Aurelius’s stoic advice from his Meditations as don’t sweat mean people:

But this is actually quite important, because frustrations with people, not nature, causes most of our grief. Most of what causes people angst are not exogenous constraints of no one’s fault, but rather, when people do things that seemingly are intended to harm you: someone cuts you off in traffic, privately belittles your contributions to colleagues. Recognize there are things you can control, and those you can’t, and this include other people’s actions: learn the difference, and don’t worry about things you can’t control (aka the Serenity Prayer).

Big Man Basket Case

Wednesday, October 7th, 2009

Africa is a basket case, Eric Falkenstein notes. Then he shares the origin of the term:

The term basket case came from WWI, indicating a soldier missing both his arms and legs who needed to be literally carried around in a basket.

I did not know that. I think I was happier not knowing that.

Falkenstein’s real point is that the big man phenomenon is holding Africa back. He cites Theodore Dalrymple‘s explanation:

The young black doctors who earned the same salary as we whites could not achieve the same standard of living for a very simple reason: they had an immense number of social obligations to fulfill. They were expected to provide for an ever expanding circle of family members (some of whom may have invested in their education) and people from their village, tribe, and province. An income that allowed a white to live like a lord because of a lack of such obligations scarcely raised a black above the level of his family. Mere equality of salary, therefore, was quite insufficient to procure for them the standard of living that they saw the whites had and that it was only human nature for them to desire—and believe themselves entitled to, on account of the superior talent that had allowed them to raise themselves above their fellows. In fact, a salary a thousand times as great would hardly have been sufficient to procure it: for their social obligations increased pari passu with their incomes…

The thick network of social obligations explains why, while it would have been out of the question to bribe most Rhodesian bureaucrats, yet in only a few years it would have been out of the question not to try to bribe most Zimbabwean ones, whose relatives would have condemned them for failing to obtain on their behalf all the advantages their official opportunities might provide. Thus do the very same tasks in the very same offices carried out by people of different cultural and social backgrounds result in very different outcomes.

Eric Falkenstein’s Finding Alpha

Monday, September 21st, 2009

Tyler Cowen definitely liked Eric Falkenstein's Finding Alpha:

It’s the best readable summary I know of why CAPM fails (see my comments here). Market data do not, upon examination, show a close connection between risk and return, at least not once you start moving out on the risk spectrum beyond T-Bills and the like. It’s not just the famous Fama and French papers, it is worse than you think. I also like the author’s “relative status” theory for why many people enjoy risk; it reminds me of Reuven Brenner, a neglected economist to this day.