An economy is a system for generating and trading solutions to problems

Sunday, April 10th, 2022

Robin Hanson once wrote about how intelligent people tend to overestimate how smart everyone else is, and Anatoly Karlin elaborates on this, with support from PISA test scores:

Fortunately, the PISA website has sample math questions from the 2012 assessment, corresponding to each of the six different levels of difficulty, as well as statistics on the percentage of 15-16 year old students from each of the participating countries that is capable of correctly answering it.

Here is the sample question from Level 6, the hardest level:

Helen rode her bike from home to the river, which is 4 km away. It took her 9 minutes. She rode home using a shorter route of 3 km. This only took her 6 minutes.

What was Helen’s average speed, in km/h, for the trip to the river and back?

Karlin notes how few people get this right:

This problem requires a multi-step approach, an understanding of rates, and the intelligence to complete it in the correct order.

Though not especially hard, even at this level. I suspect that many of you can do it in your heads within a minute.

But a majority of all the tested teens begged to differ.

OECD average: 3% (!!). Korea: 12%, Japan: 8%, Germany: 5%. The US, Italy, Sweden, and Russia were all at 2%; the Mediterranean was at 1%.

Some countries where a big fat 100% (rounded up) were unable to do this problem: Argentina, Brazil, Chile, Colombia, Indonesia, Jordan, Kazakhstan, Malaysia, Mexico, Peru, Qatar, Tunisia, Uruguay.

The number of people at this level, the highest measured by PISA, is dwindling away into insignificance in Latin America and the Middle East.

And yet this only translates to an IQ of 120-125. We’re nowhere even near genius level yet.

This matters:

The classical definition of an economy is a system for the production and exchange of goods and services. However, I will argue that you can view it even more fundamentally as a system for generating and trading solutions to problems.


Some of these problems, such as subsistence farming and trucking, are pretty simple and can be accomplished with reasonable efficiency even by relatively dull workers. This is because problems in this “Foolproof sector” (as Garett Jones calls it) require few steps and have only a minimal threshold difficulty, so production in this sector is governed by the standard Cobb-Douglas equation. More highly skilled workers are only modestly more productive, and are thus awarded with modestly higher salaries. Labor differs by productivity, but is substitutable — one experienced waiter is worth two novice ones.

Other problems are very complex and require teams of competent workers to perform multiple complicated steps to create a successful solution. The best are paired with the best for maximum productivity. Moreover, many O-Ring problems might have a threshold limit for IQ, below which no productive work can be done on them in principle (as per the Ushakov-Kulivets model). To be commercially viable, the risk of failure on any one link of a long production chain needs to be kept low. Examples of these “O-Ring” tasks may include: Aircraft manufacturing; corporate merger planning; computer chip design; machine building; open-heart surgeries.

Is financial innovation a good thing?

Wednesday, April 6th, 2022

Is financial innovation a good thing?

In the context of a free market, innovation is a positive-sum game. The innovations that survive — most don’t — are the ones that conserve resources and improve quality. In the case of financial innovation, improving quality could mean better risk management.

But financial innovation does not take place in the context of a free market. Our financial system is permeated with government guarantees. Some guarantees, like deposit insurance or pension guarantees, are explicit. Other guarantees, like “too big to fail,” are implicit.

These guarantees can be exploited by firms that take on excessive risk. If a gamble pays off, the gains go to owners and managers of the firm. If the gamble turns out badly, some of the losses go to taxpayers. Even though managers might not consciously be searching for ways to game the system, the competition for returns will push them in the direction of doing so.

Innovative financial instruments and practices can facilitate gaming the system, without regulators realizing it. Clever innovations can enable a bank to comply with the letter of a regulation while violating its spirit. Sometimes, even the executives of the bank are fooled. They do not realize that their profits are coming from this “regulatory arbitrage,” rather than from real business skill.

This insurance was supposed to pay off in case those bonds lost value

Tuesday, March 22nd, 2022

Many money managers who had bought Russian bonds in the past had purchased credit insurance from other companies:

This insurance was supposed to pay off in case those bonds lost value, which they clearly have as a result of sanctions.

Under terms of some of these contracts, some money managers have been able to collect insurance claims. But other insurance contracts stated that in order to be paid, the money manager had to transfer the bonds to the insurer. But the sanctions will not allow the bonds to be transferred! Once again, innovative financial instruments proved to be fragile in ways that were not anticipated.

They want to solve poverty with sacrifice and without math

Wednesday, March 16th, 2022

Why is Bryan Caplan’s perspective on poverty so unpopular?

The obvious answer is that Effective Altruism is usually unpopular. Soft hearts and soft heads go together. Most people are instinctive Ineffective Altruists. They want to solve poverty with sacrifice and without math.

People perceive government bonds as wealth

Tuesday, March 15th, 2022

Arnold Kling thinks that people perceive government bonds as if they were wealth:

The government borrows $1 from me and spends it on you. You have a new dollar. And I think I still have a dollar, because the government owes me a dollar. Neither of us thinks that we will have our taxes raised next year, when the government has to pay me the dollar.


I assume that people are myopic and just look around and say “I got paid $x by the government” or “I lent $y to the government and got a $y bond in return” without thinking about what comes next.

Scary countries are deeply vulnerable to paid desertion

Thursday, March 3rd, 2022

Ukraine is offering amnesty plus five million rubles (about $48,000) to anyone who deserts from the Russian army and agrees to go to a Ukrainian prison, and Bryan Caplan suggests some improvements to this deal:

On the surface, this sounds like a sweet deal, but on reflection, it’s anything but. Put yourself in the shoes of a Russian soldier. First, you have to elude the Red Army, knowing you could be shot for desertion. Then, you have to surrender without getting killed by Ukrainians. After that, you’re stuck in prison; maybe they’ll deposit you in a regular POW camp, complete with Russian loyalists ready to kill you when the guard’s not looking. Wherever you languish, you know your fate hinges on the outcome of the war.


But let me propose a Version 2.0 to better fulfill the intent of the original offer.

Version 2.0: The EU, in cooperation with Ukraine, offers $100,000 plus EU citizenship to any Russian deserter. Russians can either go directly to the EU, or surrender to Ukrainian forces for speedy transport to the EU border.

The key gain: Deserters no longer have to gamble on Ukrainian success. As long as they escape from the Red Army’s zone of control, they survive. A much better gamble.

Extra benefits: Instead of going to a Ukrainian prison or POW camp, you get to enjoy freedom in the EU. And the EU is far more likely to swiftly hand over the promised monetary bounty.

How much of a burden is this on the EU? Chump change, really. Even in a magical scenario where all of the roughly 200,000 Russian troops in the vicinity take the deal, $100,000 per soldier is a mere $20 billion. That’s less than one-fifth of what Germany now plans to spend on defense in 2022 alone. It wouldn’t be crazy to go up to $1,000,000 per deserter. You could even do a classic multi-tier offer, where the first 10,000 deserters get a million bucks each to compensate for the high initial risk, followed by lower payments for late-leavers who get to desert in comparative safety.


Scary countries are deeply vulnerable to paid desertion, while the nicest countries are almost immune. How much would Russia have to offer Germans to desert to Russia? Nein, danke!

Working in business is the activity most likely to achieve positive social change

Monday, February 28th, 2022

It is tempting to think that working at a think tank is a way to encourage possible social change, but Arnold Kling found that working in business is the activity most likely to achieve positive social change:

In 1980, I completed my Ph.D dissertation. My goal was to solve a theoretical problem in Keynesian economics, hoping to steer the profession away from the “rational expectations neoclassical” macroeconomics that was all the rage within top economics departments. The idea was to explain price stickiness as based on information problems.

Trying to solve an important theoretical problem is a terrible strategy for a dissertation. Instead, you should figure out what the departments that are hiring are looking for. What they were looking for at the time were dissertations that were based on the rational expectations approach.

For me, the result was particularly bad. A professor who interviewed me on the job market stole my idea and published it before I did, without acknowledgment. The idea had no impact on the profession. In fact, it has been periodically rediscovered since (with no credit either to me or to the man who stole it), but again with no impact. This experience has left me less than excited about the academic research process in economics as a way to generate social change through ideas.

My first job out of grad school was at the Fed. I do not recall coming up with any significant ideas when I was there.

In 1986, I started working at Freddie Mac, the mortgage giant. At the time, I thought of it as a profit-seeking enterprise, albeit with some peculiar features. One feature was that it was supposed to “serve” upward mobility in the housing market.

Another feature was that with its government guarantee, its debt costs were low, and this gave it an advantage in undertaking certain forms of financial arbitrage. I was appalled when an economist told me excitedly about an anomaly in the Eurodollar market that he thought that Freddie could and should exploit. To me, that seemed like an abuse of Freddie’s Congressional charter.

In the 2000s, long after I had left, Freddie and Fannie took on riskier borrowers in a (misguided) attempt to serve upward mobility in the housing market. They also engaged in more of what I thought of as abuses of their low-cost debt status. I ended up happy to see them shut down during the financial crisis of 2008. I think that profit-seeking and a tight relationship with the government were ultimately a bad combination.

But working at Freddie gave me the best opportunity I have ever had to produce social change. My most significant idea there was to change the underwriting process to reduce judgment and rely more on data. Instead of trying to use AI to imitate human underwriters, I pushed for using credit scores. I also promoted using the Case-Shiller method for estimating home prices in an attempt to reduce the reliance on appraisals. The goal was to reduce the cost of obtaining a mortgage loan, to reject fewer good loans, and to accept fewer bad loans.

Freddie Mac adopted the credit scoring approach in 1994. For me personally, this was more bitter than sweet. Just as the idea I was pushing for was adopted, I was treated to a humiliating demotion, and I soon left the company.

As far as social change is concerned, the move toward credit scoring dramatically changed the mortgage industry. Yes, underwriting costs fell, and decisions became more accurate, with fewer good borrowers turned down and fewer bad borrowers accepted. But it also allowed new players to enter the mortgage lending market. Some of these players developed the so-called subprime mortgage market, with mortgage securities provided by Wall Street. These new players were central actors in the financial crisis of 2008.

I am not saying that I personally brought down mortgage lending costs, or that I personally caused the financial crisis. My guess is that the move toward credit scoring was going to happen at some point, anyway, and so that my efforts accelerated the process by at most a few years. And the financial crisis had many causal elements, mostly involving the political economy of mortgage lending in the U.S. I still think that introducing credit scoring into mortgage lending was socially beneficial, at least directly. But in a complicated world, the indirect effects of actions are difficult to assess.

When I left Freddie Mac in April of 1994, I created The Homebuyer’s Fair, one of the first commercial sites on the World Wide Web. The goal was to use the Internet to disintermediate in real estate and mortgage lending. For me personally, it worked out well. But apart from any role that the site played in stimulating interest in the Web (we got tons of press in 1994-1997), I would not say that it came anywhere close to achieving any major social goals. As any number of people who have tried to get rid of the excessive costs in real estate can tell you, institutional resistance to change is strong. In principle, the Internet could have eliminated real estate commissions 25 years ago. In practice, not so much. In principle, a digital property database could eliminate the title insurance industry. In practice, the title industry’s grip on Congress is too strong.

After our web site was sold in 1999 (to a subsidiary of the National Association of Realtors(tm), ironically enough), I “retired” to a career of teaching and writing. I taught on a volunteer basis for 15 years at a local high school. I mostly taught AP economics and AP statistics. I hated the AP econ curriculum, because my experience in business had led me to believe that a lot of mainstream economics is poorly conceived. I really liked the statistics curriculum, although one of my students, an autodidact who was a follower of the rationalist community, chided me for teaching a “frequentist” rather than a Bayesian approach.

My goal was to have some long-run influence with at least a few students. I think I was somewhat successful, although by 2015 or so I was struggling with what appeared to me to be the reduced maturity of the students.

I also taught for a few years at George Mason University, at the ridiculous adjunct salary of about $1500 for a class of 100 students. And, as my wife is fond of pointing out, GMU even made me pay for parking. Again, I would have been happy to reach a small number of students with a long-term impact, but I don’t think that I did.

Overall the book is an anti-checklist for Westminster

Saturday, February 26th, 2022

If you want to examine in detail an organisational culture that is much healthier and higher performance than Whitehall, an organisation that actually lives the culture it advocates, then you will find Working Backwards, about the management of Amazon by two people who worked with Bezos in senior roles, interesting, Dominic Cummings suggests:

Discussion in Westminster suffers from false dichotomies. People on ‘the right’ who don’t know about great management talk as if ‘bureaucracy is a public sector problem’ that can be cured by ‘making government more like business’. People on the left including many defenders of the status quo say ‘government is not the same as business … it’s simplistic to say cutting bureaucracy is the answer … lessons from great teams aren’t relevant to most of government … we need more money…’

They’re both a bit right and a lot wrong. Whitehall can and should learn from great businesses and great managers, though generally not in the ways ‘free market’ Tory MPs say. And Whitehall is different in critical ways that limit the application of some lessons from business in some narrow ways. But at a more general level, the lessons from great private sector management and the lessons from great public sector case studies are the same. Great businesses can and do learn from projects like Apollo. Governments can and should learn from great businesses. The breakthroughs of ‘systems management’ came in the public sector between the 1940s and 1960s then spread to business then were largely forgotten by western governments (though are much studied in China).

One of many useful things about this book is the way it shows how many problems of ‘bureaucracy’ we see in government are the same or similar to those experienced in Amazon — and Amazon is, by common consent of the great judges of these things (e.g Charlie Munger), one of the very best managed organisations in the world.

Overall the book is an anti-checklist for Westminster in the sense that if you look at all the things they do really well and really value, and you’ve worked around No10/Cabinet office, you’ll say to yourelf ‘tick, tick, tick, government does the opposite, opposite, opposite’. It’s similar to my paper on the ICBM and Apollo projects which also illustrated a set of ideas about brilliant management that are an anti-checklist for Westminster.


A more fundamental problem than the failures of the civil service is that politicians do not care and are not incentivised to care about performance and unless this changes we can only expect the same sort of failures over and over.

When I said this years ago nobody wanted to hear it. But in 2021 we saw that even after a global pandemic costing 150k lives and hundreds of billions, Westminster collectively turned away from facing the reasons for the implosion of core institutions in 2020, No10 embarked on an attempt to rewrite history, most MPs tried to ‘move on’ rather than force honesty about what happened, while the media mainly overwhelmed serious debate with noise. Errors of spring 2020 were repeated more than once killing thousands more. Things that worked well but challenged traditional ways of doing things, such as the Vaccine Taskforce, were dismantled rather than learned from and built on. Rather than have a very fast lessons learned process, the PM and other senior figures have repeated the historical pattern — punt an extremely lengthy inquiry led by lawyers far into the future where it will have little practical effect on how critical decisions are made, just as the Iraq inquiry did not fix the problems of the MOD and Cabinet Office.

Organisational structure and dynamics can bring lollapalooza results

Friday, February 25th, 2022

A theme of Dominic Cummings’s blog since before the referendum campaign has been that thinking about organisational structure and dynamics can bring what Warren Buffett calls “lollapalooza” results:

What seems to be very esoteric and disconnected from ‘practical politics’ (studying things like the management of the Manhattan Project and Apollo) turns out to be extraordinarily practical (gives you models for creating super-productive processes).

Part of the reason lollapalooza results are possible is that almost nobody near the apex of power believes the paragraph above is true and they actively fight to stop people learning from extreme successes so there is gold lying on the ground waiting to be picked up for trivial costs. Nudging reality down an alternative branch of history in summer 2016 only cost ~£106 so the ‘return on investment’ if you think about altered GDP, technology, hundreds of millions of lives over decades and so on was truly lollapalooza. Politics is not like the stock market where you need to be an extreme outlier like Buffett/Munger to find such inefficiencies and results consistently. The stock market is an exploitable market where being right means you get rich and you help the overall system error-correct which makes it harder to be right (the mechanism pushes prices close to random, they’re not quite random but few can exploit the non-randomness). Politics/government is not like this. Billionaires who want to influence politics could get better ‘returns on investment’ than from early stage Amazon.

After accounting for indirect taxes and in-kind transfers, the US redistributes a greater share of national income to low-income groups than any European country

Thursday, February 24th, 2022

After accounting for indirect taxes and in-kind transfers, the US redistributes a greater share of national income to low-income groups than any European country.

The relationship between wealth and power is essentially the relationship between potential and actual

Tuesday, February 8th, 2022

The relationship between wealth and power, Carroll Quigley argues in Weapons Systems and Political Stability, is essentially the relationship between potential and actual:

Wealth is not power, although, given time enough, it may be possible to turn it into power. Economic power can determine the relationships between states only by operating within a framework of military power itself. That is, potential power has to become actual power in order to determine the factual relationship between power units such as states. Thus the relationship is not determined by manpower, but by trained men; it is not established by steel output, but by weapons; it is not settled by energy production, but by explosives; not by scientists, but by technicians.

When economics was called “political economy” up to about 1840, it was recognized that the rules of economic life had to operate within a framework of a power structure. This was indicated at the time by the emphasis on the need for “domestic tranquility” and for international security as essentials of economic life. But when these political conditions became established and came to be taken for granted, political economy changed its name to “economics,” and everyone, in areas where these things were established, became confused about the true relationships. Only now, when disorder in our cities and threats from external foes are once again making life precarious, as it was before the 1830s, do we once again recognize national security and domestic tranquility as essential factors in economic life.

In the past century we have tended to assume that the richest states would be the most powerful ones, but it would be nearer the truth to say that the most secure and most powerful states will become the rich ones. We assumed, as late as 1941, that a rich state would win a war. This has never been true. Wealth as potential power becomes effective in power relationships, such as war, only to the degree that it becomes actual power, that is, military force. Merely as economic power it helps to win a war only potentially and actually hampers progress toward victory. We could almost say that wealth makes on less able to fight and more likely to be attacked. Throughout history poor nations have beaten rich ones again and again. Poor Assyria beat rich Babylonia; poor Rome beat rich Carthage; poor Macedonia beat rich Greece, after poor Sparta had beaten rich Athens; poor Prussia beat richer Austria and then beat richer France several times. Rich states throughout history have been able to defend their positions only if they saw the relationship between wealth and power and kept prepared or, if they were able when attacked to drag out the war so that they had time to turn their wealth into actual military power. That is wheat happened in the two World Wars. In each case the victims of German aggression were able to win in the long run only because there was a long run. If the Germans had been able to overcome the English Channel, their victims would not have had time to build up their military power.

Thus we see that wealth in itself is not of great importance in international affairs. It must be turned into military power to be effective, but then it ceases to be wealth. Wealth turned into guns no longer is wealth. But guns can protect wealth.

It is important only when we do not have it

Friday, January 28th, 2022

The need for security is a constant need, Carroll Quigley notes in Weapons Systems and Political Stability, but it is important only when we do not have it:

That is why the United States, in the 1920s and 1930s, could have such mistaken ideas about the relative significance of security and prosperity. Because we had the former, with little or no effort or expense to ourselves, from about 1817 to at least 1917, we continued to regard this almost essential feature of human life as of less significance than prosperity and rising standards of living from 1920 till late in the 1930s or even to 1941. Accordingly, we ignored the problem of security and concentrated on the pursuit of wealth and other things we did not have. This was a perfectly legitimate attitude toward life, for ourselves, but it did not entitle us to insist that other countries, so much closer to the dangers of normal human life than we were, must accept our erroneous belief that economics was more fundamental than politics and security.

Many years ago, when I talked of this matter to my students, all in uniform and preparing to go off to fight Hitler, one of them, who already had a doctorate degree in economics, challenged my view that politics is more fundamental than economics. The problem arose from a discussion of the Nazi slogan “Guns or butter?”

I asked him, “If you and I were together in a locked room with a sub-machine gun on one side and a million dollars on the other side, and you were given first choice, which of these objects would you choose?”

He answered, “I would take the million dollars.”

When I asked, “Why?,” he replied, “Because anyone would sell the gun for a lot less than a million dollars.”

“You don’t know me,” I retorted, “because if I got the gun, I’d leave the room with the money as well!”

There was little point in discussing the Third World when they knew so little about how their own society worked

Sunday, January 23rd, 2022

In his final weeks at Georgetown, Carroll Quigly told the students in his “The World Since 1914″ class that there was little point in discussing the Third World when they knew so little about how their own society worked:

So I told them about the USA — really very hair-raising when it is all laid out in sequence:

  1. cosmic hierarchy;
  2. energy;
  3. agriculture;
  4. food;
  5. health and medical services;
  6. education;
  7. income flows and the worship of growth;
  8. inflation;

showing how we are violating every aspect of life by turning everything into a ripoff, because we…have adopted the view that insatiable individualistic greed must run the world.

The traditional yeomanry is losing out

Tuesday, January 18th, 2022

The working class may have suffered the most in the past decades, but the angriest class in America may be the small business and property-owning class, Joel Kotkin says:

National chains and online services are replacing many traditional Main Street businesses — the insurance and travel agencies, the local banks, the High Street retailers and restauranteurs. To make matters worse, local smallholders increasingly find themselves dependent on what analyst Mike Lind calls “toll booth” companies like Facebook, Google, and Amazon, tech megaliths which are able to coerce small businesses to give up their data. Amidst the supply chain crisis, firms like Amazon and the big box stores use their bargaining power to minimize delays in deliveries in ways not available to smaller businesses.

The traditional yeomanry — like the “kulaks” or wealthy peasants in Stalin’s day — is losing out. As executive compensation reached the stratosphere at the big tech and finance firms, small businesses faced what Harvard Business Review described as “an existential threat.” Experts are warning that one-third of small businesses, which comprise the majority of U.S. companies and employ nearly 50 percent of all workers, could ultimately shut down for good.

Perhaps, Arnold Kling suggests, we are now living in the New Servants economy:

Tyler Cowen has a series called “those new service-sector jobs.” My favorites include Coffin Whisperer and Wedding Hashtag Composer. The demand for such services can only come from people with excess wealth, and the supply comes from people who realize that their best source of income is to cater to those with excess wealth. This is very different from the age of mass consumption, when Henry Ford tried to manufacture cars that his workers could afford.

Actually, I think that the biggest engine of the trickle-down economy is the nonprofit sector. I don’t have data on this, but I suspect that if you ask the next 10 young professionals you meet where they work, at least 3 of them will reply that they work for nonprofits.


I would much rather see billionaires invest in businesses in minority communities than fund nonprofits that donate to BLM.

What we needed instead was scientific socialism

Thursday, January 13th, 2022

The “Utopian” socialists were wrong, Bryan Caplan notes, but Marx was worse, as this excerpt from a piece by Joshua Muravchik explains:

He [“Utopian socialist” Robert Owen] was no obscure crank. When he arrived in the United States in 1824, he was received by a joint session of Congress that met over two separate days with outgoing President Monroe and incoming President John Quincy Adams, among the many luminaries who came to hear him out.

Owen then bought an already developed settlement on the banks of the Wabash River from a religious sect. The members of this group had developed it, and it included not only homes but vast fertile farmlands and more than twenty highly productive workshops that produced goods sold all across the country. Yet within a year after taking it over, Owen and his thousand followers had turned this little Switzerland into an Albania. All the other collective settlements, except for some that were first and foremost religious communities, had similar histories of failure.

But along came Marx and Engels, who wiped this record of failure away with one of the great intellectual conjuring tricks of all time. Owen and his ilk, said Marx and Engels, were utopians. What we needed instead was scientific socialism, which they then outfitted with great pseudo-scholarly paraphernalia: means and modes of production, historical forces, class struggle, and all the rest.

What I mean by conjuring trick is this: Owen and the other so-called utopians had an idea. What did they do? Owen and the other communitarians actually created experiments to test their ideas. Experimentation is the very essence of science. They were the real scientific socialists. Marx and Engels dismissed all experimental evidence, replaced it with an idea that was sheer prophecy, and claimed thereby to have progressed from utopia to science.