Wednesday, June 30, 2010

Economist Notes Economic Advice Not for Amateurs

Kartik Athreya writes that the masses should only trust PhD economists for their economic advice. As mathematics is the language of economics, and economists use a specific set of mathematical tools such as real analysis, method of moment estimators, and dynamic programming, these essential tools are clearly not understood by your average commentator, justifying this belief. Why listen to someone's opinion on the TARP if they don't know how to apply Blackwell's contraction mapping theorem? Insanity!

I agree these tools are essential, but I would add that they are not sufficient. So, readers should only trust PhD economists who understand these tools, and also the context in which they are applied. Having a couple business cycles worth of experience actually presenting micro and macro forecasts to CEOs and other key decision-makers, or running a portfolio that is marked to market, as also essential. As economists are primarily experts in models, applied to cherry-picked datasets that present cute results that showcase some novel cleverness, they are ignorant of the their ignorance. Their models are like the electric car, always just around the corner to viability. With hindsight, predicting business cycles--anything really--is very simple. You need someone who has been doing it in real time, with real feedback, giving you advice.

I therefore feel obligated to suggest that Obama internet monitor Cass Sunstein appoint me--and Falkenblog readers--gatekeeper of all economic opinion. Arguments my Star Chamber find invalid will be degoogled via an innovative JavaScript that will be mandated on all websites. Any page containing the keyword "cost" must have they keyword "benefit" on the same page, and vice versa. Any mention of effects must have heteroskedasticity consistent standard errors, even if the said effect is qualitative (further, one must spell that with a "k", not a "c"). Presuming market oriented solutions assume perfect competition or perfect foresight, is no longer cromulent.

But that just targets the non-PhDs. As to mere PhD economists, mentions of multiplier effects, increasing returns to scale, or default choices on IRA withholdings are also uncromulent. They must also remind people that "chief economist" is a PR position with no influence within their own organization, and their mothers admit they are doctors but "not the kind that will do you any good". Macro economists must use the term TNSTAAFL at least once but never IMCO.

Tuesday, June 29, 2010

Why Go to College?

The more I think about college, the less important it seems. I did take a lot of various intro classes, and engaged in standard late-night discussions that are supposedly the essence of a modern liberal education, but really most of my learning happened outside my college experience. That is, I learned most of my math, statistics, history and computer knowledge before or after college, and interpersonal skills outside of the structured social functions of my fraternity (AEPi--Sigma Chapter). Sure, I picked up some things in college, but think about it--it was probably the time in my life when I had the most leisure time, because I wasn't learning as much as other periods in my life.

Now that college can easily cost $40k/year, it's reasonable to really look at the benefits more skeptically, as no one presumes that merely being a college grad entitles one to success.

I suggest you go to Academic Earth and see some of their courses. I think what can be taught--physics, math, etc--is taught well, but hardly worth $40k/year. These subjects are straitforward enough to allow a cheaper option that gives you the same result. And for the things that really can't be taught--who knows the right answer?--such as history, political science, and philosophy, it seems like top shelf professors are caricatures of leftist-PC propoganda.

Listening to Yale historians talk about the Civil War and Reconstruction or European History or UCLA professor talk about African American studies, you would get the impression that human civilization has been a sequence of disasters, one horrible injustice following another.

The Kling and Schultz book From Poverty to Prosperity, is much needed here. If a Martian looked at the change in society from 1500 to 2000, I think the growth in wealth, liberty, and art, would be the singular effect. For a young person at a top school today, you will have to learn that on your own time, or in an economic history course (many colleges don't have these, unfortunately). Rather, like the Marxist critique of capitalism, you will learn about all the injustice and inefficiency, and then naively assume that some utopian alternative is eminently feasible if we could only get the cabal of oppressors to stop manipulating the system.

Is Peer Review Sufficient or Necessary?

George Monbiot, the British climate-change alarmist, once wrote of a skeptic: ‘I accepted and floored him with a simple question: Has he published his analysis in a peer-reviewed journal?’, as if this were a truth-seeking silver bullet.

Is peer review necessary for one to have an opinion on something important like tax cuts, climate change, the war in Iraq, etc? The book The Hockey Stick Illusion highlighted that Einstein's paper on special relativity, and Watson and Crick's paper on DNA, were not 'peer reviewed', but somehow managed to be apex of scientific insight. So, peer review is not a necessary condition to presenting a new, true, and important idea.

The peer-reviewed journal process is a good thing, but it's still merely a means to an end: highlighting the good ideas, argument, and data. There's no royal road to this end. I review a couple papers a year for second-tier journals, and often I get to read the other referees comments in the second round, and usually find the other reviewer to be an distracted person who meticulously checks some things (grammar, math, the data, the big picture), but then ignores other dimensions. This is only natural, because often the papers are complicated, and he (or she) is counting on the other reviewer. But, what if I didn't check his empirical results with data I have unique access to (say, on corporate defaults)? Would anyone know? If you know what buttons to push, especially by anticipating the kinds of people who will referee your paper, you can game the system to a large degree.

Peer reviewed articles have been found with fraud (Hwang Woo-Suk and stem cells), errors, but most often, irrelevance. The latter point is especially important, because like grade inflation, as professors need X peer reviewed papers for tenure, there are ever more journals being created to satisfy this criteria. Alas, Sturgeon's law ('90% of everything is crap') holds, and so it becomes harder and harder to find the truth in a sea of irrelevant papers.

In Karl Popper's the Open Society and Its Enemies he wrote that 'Institutions are like fortresses. They must be well designed and manned.' Unfortunately, there are always too few good people to go around. The peer review process is a good thing, but it is still a flawed process, rewarding ritual over substance by the way certain things are treated non-skeptically if you use the rhetoric popular amongst the journal gatekeepers (eg, applying GMM to an equation, or Sokal's hilarious post-modern bunkum).

As Alexander Cockburn notes, 'many cite peer-reviewed science because they're afraid to have the intellectual argument.' Just about any hypothesis has some esteemed person and publication supporting it. If you then go to the 'majority of experts' route, you need a strange faith in the majority opinion (remember, before 2007, most regulators, bankers, investors, and academics believed that lower underwriting standards such as no income verification for home ownership were innocuous if not morally righteous).

Sunday, June 27, 2010

Hockey Stick Science

A.W. Mortford has a book out titled The Hockey Stick Illusion. It highlights how modern science is done (I read its 400+ pages in two days because it was fascinating). The main issues are not abstruse statistics, but rather detailed, parochial empirical issues.

Recent warming only seems alarming if recent temperatures are outside of normal historical fluctuations. As the medieval warming period when Vikings settled Greenland was obviously very warm, at least in Greenland, one might think that current temps are not that alarming. Thus, in 1998, when Michael E. Mann, Bradley and Hughes published a paper documenting that current temperatures are many standard deviations of their average since at least 1000 AD, it became the signature graph for the Global Warming Community.

Tree rings, or isotopic composition of ice cores (the ratio of 18O to 16O) and other things are related to temperature, and these are the types of things used to estimate temperature prior to 1880. As the 20th century temperature increase that has everyone worried is only 0.6 degree centigrade, one needs some serious precision to claim that temperatures in the past 1000 years did not vary above this level. There's no fundamental law that related tree rings or oxygen isotopes to temperature, these things just have an imprecise theory and some empirical support, but it's not calibrated like some calorimeter. To think you can know the temperature in 1100 with the kind of accuracy that Mann et al present is really absurd.

The problem is there are many temperature proxies, various tree rings, ice cores, all with different results (over 400 of them). Mann et al eventually used 112 (or 159) of them for their paper, which allows for a lot of cherry picking. Further, some series are truncated, some extrapolated, using seemingly innocuous phrases like "if records terminate slightly before the 1980 training interval, they are extended by persistence". That's one bizarre way to treat missing data. They also extrapolated certain time series that did not start or end at convenient times, all with a bias towards their end ('We have to get rid of the Medieval Warm Period' said one infamous email).

There's lots of fun data issues and rhetorical strategy presented in this book that highlights how real science is done. You have two sides with pretty strong end-views--global warming is unprecedented, or not--and while both claim to simply be interested in the objective truth, after 10+ years invested in one conclusion it defies credulity to think a researcher can address this question objectively any more. Basically, we have two sets of partisan scientists presenting their case, like paid lawyers.

As David Goodstein notes in his recent book On Fact and Fraud: Cautionary Tales from the Front Lines of Science, a great quote from the great Richard Feynman:
The first principle is that you must not fool yourself—and you are the easiest person to fool.... After you’ve not fooled yourself, it’s easy not to fool other scientists. You just have to be honest in a conventional way after that.”

The winner of this debate will be those who fooled themselves the least. Like a financial economist rigging his backtest, this may generate a publication but in the long run the data are what they are, and its best to have the facts on your side because eventually the facts win. Very few are committing conscious fraud, but rather, fraud of the more common sort, that of where a seemingly innocuous inaccuracy saves tons of explanation in their mind.

As Oscar Wilde noted, education is an admirable thing, but it is well to remember from time to time that nothing that is worth knowing can be taught. Big debates are usually not centered on not singular facts or theories, but their many observations, knowing which are relevant, which are not. Knowing how to weight correctly is mainly an exercise in meticulous research and wisdom, and it especially helps to have correct or at least popular a priori prejudices.

Saturday, June 26, 2010

A Non-Hansonian View of Ulterior Motives

Robin Hanson blogs over at OvercomingBias, and his big idea is that a lot of behavior is explained by signaling. Everything from purchases (BMWs), rhetorical styles (aping the coalitions rather arbitrary protocols), to charity (giving to causes that project well upon you). I'm very sympathetic to this view, in that we like a particular wine not merely because it tastes good, but because of what it represents, and what our appreciation of it represents.

So, I like the signalling story because it seems we are status-hungry, and always be trying to climb the social hierarchy via such signals. Now comes Yale psychologist Paul Bloom with a new book How Pleasure Works, and he argues that much of our behavior and preferences come from an essentialism, as when we prefer art by Vermeer over a replica that otherwise looks exactly like a Vermeer.

Hanson emphasizes the signaling, whereas in this book, Bloom argues our pleasure is affected by what the person thinks is the true essence of the thing in question, and why prefer certain essential things. We like things that connect to our past, and to things that we think have some attractive, transcendent, property.

Bloom gives the example of faces, where people like objective things like symmetry and skin smoothness, but mainly whose face it is. People we know or like, have more attractive faces than other objectively similar faces.

It's an interesting argument. I think there's something to the idea that we choose things because we want to connect ourselves--our being, which includes what we have been--with things bigger than ourselves that are beautiful, true, or powerful. Thus, someone paid $750k for John F Kennedy's golf clubs, because it gets him closer to this famous great man. Or, kids prefer their teddy bear, not an identical substitute, because of a shared history. The implication is that context matters a lot, so things--ideas, objects--are never evaluated on a stand-alone basis. If true, it highlights that nothing is objective, because the context for everyone will be slightly different.

Wednesday, June 23, 2010

Sometimes the Paranoids are Right

Victor Niederhoffer interviewed about 'being wrong' in Slate:
They all knew that if I was hurting in one market, I'd have to liquidate in the other markets. ... I still think that the crash of Oct. 27, 1997, was basically due to brokers running my position against me, knowing that I was on the ropes. The market had its greatest drop in the previous 10 years that day. And then the next day, once they were able to force me out, it went up more than it dropped.

I knew a guy affiliated with a major player in the the CME at that time, and he told me about how at one point the executor of Niederhoffer's position was conspicuous in the pit, and it was clear he was going to execute a large trade to get out. As Niederhoffer's losses mandated a margin call, the person who liquidated this position had no skin in the game, and did not put any thought into doing it with minimal impact. He asked for a bid, and all the floor traders held their breath and looked at each other. Finally, one trader made an absurdly low bid, at which point they all piled on at that same price. It was, as my acquaintance said, his large company's single best day ever in the pits, suggesting that they not only made Niederhoffer pay extra, but many smaller fish trying to time this--and ignoring the game theory--also got shellacked.

Anyway, Niederhoffer is a fascinating guy. I especially liked this bit:
...regrettably, duplicity is very, very important in life. The direct approach always creates tremendous obstruction and friction from the adversary, so often the indirect approach is necessary.

Orszag the Deficit Hawk

From today's WSJ:
Peter Orszag brought to the White House sterling credentials as a deficit foe. But he will leave next month with the U.S. debt stuck above $1 trillion.

Debt, deficit, whatever!

The funny thing is that deficits are always secondary concern to spending more for all Democrats and most Republicans. As the economy has always been below its potential in real time (not hindsight), this implies that spending money now via the magic of the multiplier generates huge payoffs (if deficit financed they pay for themselves via the multiplier, if tax-financed through righteous redistribution of ill-gotten gains). While this is a common priority, it is telling that no politician would state this belief so flatly.

Orszag also co-authored (with Joe Stiglitz) the famous 2002 article asserting Fannie and Freddie's expected losses were 'effectively zero'.

But, he's got all the credentials and connections. So what if he's wrong about the big things, what's important is that he's articulate and has the singular confabulatory powers of current cutting edge economics. I'm sure he'll be a prize for any large bureaucracy.

Sunday, June 20, 2010

Wednesday, June 16, 2010

The Great Risk Snipe Hunt

Juan Maldacena is an accomplished young string theorist, currently at the famous Institute for Advanced Study in Princeton, NJ. In an interview in Big Ideas, he was asked,

Interviewer: "Have you ever thought your ideas may by wrong?"

Maldacena: "Yeah, this is possible; however the mathematical structure is probably going to be useful for whatever theory is the correct theory. And, what we do … at least is generate good interesting mathematics that is useful for other things in physics, and I think if it’s not string theory, it will be probably something similar to it."

And so it is with modern finance, which fully expects the yet unknown risk solution to be built out of the mathematical edifice already created, because the elegance and power of what has been created seems not just capable, but necessary to be any reasonable solution. The stochastic discount factor approach encapsulating CAPM is surely not a coincidence to these researchers. As Mark Rubinstein states about the Capital Asset Pricing Model (aka CAPM Betas):

More empirical effort may have been put into testing the CAPM equation than any other result in finance. The results are quite mixed and in many ways discouraging…At bottom…the central message of the CAPM is this: the prices of securities should be higher (or lower) to the extent their payoffs are slanted towards states in which aggregate wealth is low (or high)…The true pricing equation may not take the exact form of the CAPM, but the enduring belief of many financial economists is that, whatever form it takes, it will at least embody this principle.

The problem is, as the data have become clearer, the theory has become less clear. This is not a sign of a successful theory. Risk started out as merely nondiversifiable volatility, and now assets with really high nondiversifiable volatility presumably have low risk via some spooky risk factor, and behavioral biases are applied piecemeal to various anomalies (anchoring, preferring positive skew, or negative skew).

Sunday, June 13, 2010

Stimulus is Perennial Bad Advice

Nobel prize winner Paul Krugman may say it's econ 101 to have the federal government spend more in recessions, and I agree, but it's also wrong. The highly rigorous yet ultimately naively simplistic macro models have not been useful in rectifying this incorrect intuition, which remains dominant. Gone are the days like in 1920, when during a nasty recession, the federal government cut expenditure by half from 1920 to 1922, and the economy rebounded nicely. Historically, whenever we are in a recession, economists generally call for more fiscal spending, all the better if it is deficit financed. Yet as Milton Friedman noted, "The fascinating thing to me is that the widespread faith in the potency of fiscal policy … rests on no evidence whatsoever." Evidence no, theory, yes (currently, unemployment is 9.7%)

You can create neat models where you have consumers maximizing their utility over time, and producers maximizing profits, and if you made some very heroic assumptions, you can anthropomorphize this situation as one single individual, supposedly represents millions of people acting this way. Add some assumptions about time series shocks to productivity and tastes, and you can then calibrate the interesting variables(output, investment), and say "I have a viable model of the macro-economy".

This always seemed a bit strained, but it highlights a lot of models I see, where one evaluates a model based on it being able to generate output with similar 'moments': means, variances, covariances. Correlation does not imply causation, but it's dirty little secret that probably 90+% of actual science in practice involves mere correlations with ex post theorizing. I remember most of my fellow grad-school classmates thought these models were rather naive, as if anthropomorphizing the economy as a single person explains growth rates and business cycles, but over time those who stayed with the program got sucked in like the way individuals are absorbed into the Borg collective, and the rest of us, most of us, decided to chuck macro entirely.

Many scientists spend their life on these models, where an intuitive story motivates an algorithm--ideally one with maximizing behavior by decision makers and a supply=demand condition--that is then jerry-rigged to fit the output. It's very easy given the many degrees of freedom, to generate models that seem to work really well because it can create time series that when you eyeball them, looks like a desired time series (this seems to encourage a lot of econophysics efforts). This is a really bad way to evaluate theories, because it's too hard to falsify, and too easy to convince yourself the model works.

Note how totally irrelevant the representative agent model was to the latest recession. No one thinks some mechanism, highlighted by the representative agent framework, was really important. To some extent, the low interest rates of 2002-5 were relevant, and this effect falls within the representative agent models, but I don't think this was really essential part of the crisis, and the representative agent models don't make this connection clearer or more measurable.

There have been several Nobel prizes in this modeling dimension (Lucas, Kydland, Prescott), and I think they were valiant efforts, but it's important to recognize failures and move on, because wasting time on a dead end only helps aging researchers who are incapable of developing a new toolset maintain their citation counts. I'm rather unimpressed by the common tactic of using citations to validate research: suggestive, but hardly definitive. Unfortunately, bad ideas are rarely rejected but rather orphaned, ignored by young researchers. After all, proving something is wrong is hard, especially if that something is not so much a theory (the representative agent model), but rather a framework. It's best to look at the gestalt and say, I'm just not going there, and leave it at that. So, the models of risk and expected return persist because they are intuitive on some level, and can generate results that seem to match broad patterns. They merely can't predict, nor do they underly actually useful fiscal policy.

The worst thing is the focus upon mathematics can allow a researcher to avoid these problems, because there's always the hope that even if one's model dies, the mathematical techniques used in creating it will live on. It allows one to revel in rigor, and dismiss any particular model's empirical failures. Many economists I think dream of being like string theorist Ed Witten: Fields Medal winner and creator of understanding an applied subject (not coincidentally, an untestable theory).

The insiders will say, you're just a player-hater and don't understand let alone appreciate the math. It's true critics will not understand the tools as well as the true believers, because if you think it's a waste of time, you aren't going to get really good at these tools. So the bottom line is, do they generate useful predictions? Do large banks hire top-level macroeconomists? No and no. Hard core macroeconomic theory has been pretty irrelevant to the latest recession, as it always has been.

For example, the stimulus bill was debated by famous economists Paul Krugman (trade theorist), who argued for government spending money on anything, and Robert Barro (macro theorist) saying the government should cut taxes. Robert Barro may be a full-time macroeconomist who imposes more of the representative agent logic on his theories, but his advice is considered as relevant as the musings of Paul Krugman, who has never done actual macroeconomics at the peer-reviewed level (in the words of Barro, 'His work is in trade stuff. He did excellent work, but it has nothing to do with what he's writing about.') But that's the result of having a framework that explains everything and nothing, not even economists feel constrained by it. They know, that even though it's not their full time gig, it's no constraint on their opinions, it's not like some macroeconomist will embarrass them by pointing out a flaw in their logic. Such theory can justify any standard Keynesian, Monetarist, or Laissez-fair prejudice, making it irrelevant.

Saturday, June 12, 2010

SCO Lawsuit Done

After the latest defeat for SCO in their attempt to game US intellectual property law, perhaps it is over. The SCO-Linux litigation was absurd, predicated on 80 lines of insubstantial code on previously released software that was no longer used, but it was a hook for probable cause and thus the litigation commenced. Presumably, Microsoft told one hedge fund this was potentially viable, giving more reason to hate Bill Gates (as if Vista and Clippy weren't enough).

The mercenary lawyers who present these cases give $5 whores a bad name, because at least in those cases there's some utilitarian benefit. I remember in my litigation, after one hearing the opposing lawyer smiled and offered to shake my hand, like, this was just business. It was to her, but to me. Not being able to use anything related to "volatility", or "mean-variance optimization" because it would all be fruit from the poisoned tree, would make me forsake all my human capital, as well as a subject I really liked. I didn't shake her hand, I thought she was scum. Later at some meeting during the standard small talk, she was mentioning her charity work with orphans in South America or something, and I thought, you're still scum. I'm sure she thinks it balances out, engaging in vindictive lawsuits for insecure paranoids by day, helping heal cleft lips by night, but if there is a God, He won't allow dreck like that to pay for sins with charity.

There isn't a word for the people who use the law this way (anti-mensch?). Unfortunately, after RIM paid $650MM to a patent troll, lots of people think they can buy up property rights and extort companies. These people are parasites, pure and simple, all the worse because they probably live in nice communities among virtuous people unlike standard parasites that no regular being would recognize as equal, and are educated enough to know the context of what they are doing, but the law allows people to quote scripture for venal ends.

The worst thing, if you are on the end of these, is finding out that reason no longer matters, rather, every absurd claim such as "you can't use mean-variance optimization" or "profitability" as a factor in assessing stocks, is considered a viable property right assertion. If 'profits', 'volatility', and 'mean-variance optimization' are things I had to prove were not obviously part of the public domain, consider if you were a using something less obvious like pairs trading. Of course, you would 'win' in the end, but by then you haven't worked in a couple years and spent millions of dollars. Anyone working for a hedge fund in the US is open to the whims of rich men and their pit-bulls, you have to choose your business partners very carefully. Obviously, this case brings up bad memories.

SCO and their brethren give pond-scum a bad name. It's a shame they don't have to pay for wasting Linus Torvald's time.

Friday, June 11, 2010

Strange Bedfellows Indeed

From an interview with Sebastian Junger wrote A Perfect Storm, and was embedded in Afghanistan for a year. Here he is talking about his new book War:
Putting someone else's welfare above your own, its at the heart of combat, but ironically it's also at the heart of much of religious thought.

Wednesday, June 09, 2010

Jeremy Grantham on Risk and Return

One of the heads of GMO, a large institutional money manager based in Boston, Jeremy Grantham, believes like I do that risk is clearly not related to returns, expected or actual. Cam Harvey, a pretty good representative of the financial academic establishment, noted on this blog that the problem was conflated by the fact that we do not see expected returns, nor expected risk, only actual returns. He was even stronger, saying "Finance theory says nothing about [risk and returns]. Our theory relates risk to "expected returns" not ex-post returns."

Now, he caught me being imprecise, so let me be clear: risk is not related to expected returns either. If, with data going back to 1927 in the US, and corporate bonds, currencies, dozens of countries, and with all that data, somehow 'expected' returns are so different than actual returns that they seem orthogonal, it's a rather strange thing. It's like saying one's investments will probably, in their lifetime, not be correlated with one's expectations. So, why waste time studying finance? If the world is that random, that diabolically unpredictable, apply the Serenity Prayer and focus on things were we can make a difference.

The notes that the absence of a robust, intuitive measure of risk that is supposedly omnipresent and important, reminds me of attempts to explain the mysterious absence of the aether in the 19th century, because this was the medium through which light and gravity traveled, it was supposedly everywhere. Like 'risk', no one could measure it, so ever more clever reasons were adduced as to why nature hides what is all around us. See this little piece on Fresnel's coefficient of aether drag, which all seems so reasonable, and uses differential equations (ie, it's science!). Fresnel was able to come up with an equation very much like special relativity, and thus matching reality, but using wrong assumptions, because a good mathematically oriented modeler can always get from assumptions to data if you give him enough time (the degrees of freedom are hidden within the functional form or algorithm). We have a glut of Fresnellian finance going on right now

Anyway, here's Grantham on risk and returns (expected&actual):

In fact, Quality stocks have outperformed the market since 1965 (when our quality data begins) ... On noticing this outperformance, embarrassingly late in my opinion, Fama and French adopted a circular argument rather typical of ﬁnance academics in the 1970 to 2000 era: the market is efﬁcient; P/B and small cap outperform, ergo they must be risk factors. That the result in this case happens to get to the right result is luck. The real behavioral market is perfectly happy not rewarding “risk” when it feels like it, as is shown by the 70-year underperformance of high beta stocks. But this time it worked. Price-to-book, despite its low beta, is a risk factor because of its low fundamental quality and its vulnerability to failure in a depression. This is true with small cap as well. But what about “Quality?” This factor has outperformed forever. (The S&P had a High Grade Index that started in 1925 and handsomely outperformed the S&P 500 to the end of 1965 when our data starts.) Since the market is efﬁcient, to Fama and French quality must be a risk factor! So, by protecting you in the 1929 Crash and in 2008, and by having a low beta for that matter, Quality as represented by Coca-Cola and Johnson & Johnson must be a hidden risk factor. Oh, I know: “The real world is merely an inconvenient special case!”

Monday, June 07, 2010

Dishonest Forecasters

"Econophysicist Accurately Forecasts Gold Price Collapse" says the MIT Technology review. Didier Sornette seems to generate a lot of buzz, because the whole idea that something called 'complex-systems theory' can predict prices seems like a neat trick. His website notes a lot of press coverage, including Nature and the Wall Street Journal. Wikipedia states that 'complex systems theory' is "used as a broad term encompassing a research approach to problems in many diverse disciplines including anthropology, artificial intelligence, artificial life, chemistry, computer science, economics, evolutionary computation, earthquake prediction, meteorology, molecular biology, neuroscience, physics, psychology and sociology." A theory of everything indeed.

I find these models generally look like the multiplier-accelerator model that Paul A. Samuelson introduced back in 1939 because it seemed possible of mimicking the boom and bust nature of economic time series. That thread died because it was barren, but it was born of the same intuition: it looked like it could explain the future, because you could fit it to the past.

Econophysicists have always been on the cusp of some fantastic breakthrough, but these researchers seem to have a very selective memories. Sornette's December 2002 call for a stock market crash in 2003-4, could not have been more wrong, and it seems to have been put down the memory hole, nowhere on his website. Anyone who's even a little dishonest is not to be taken seriously, because once you start selectively picking from your prior forecasts, you generally don't stop.

A professor forwarded me some econophysics paper he co-authored that he thought was a paradigm shifter. It was basically some model that generated chaos, with some positive feedback loops, and I asked about some technical portion of it, he replied he didn't know about that, but his physics co-author did. This suggested to me the mechanism itself was not important, but rather, it generated the right big-picture pattern. How naive. If I want to generate a model of the stock market, I could rationalize a model of geometric brownian motion, with some Poisson jump process, perhaps some auto-regressive volatility, and say that looks like the S&P500, but that's hardly a model, just a description. It doesn't predict anymore than the rand() function predicts lottery numbers (they look like lottery numbers--very random!).

I remember the Stock-Watson model that was to replace the old Leading Economic Indicators in predicting recessions. Prior to the 1990 recession, it was generating a lot of buzz, because it used a Kalman filter, just like real rocket scientists, and seemed obviously better than the simple sum of ten correlates with business cycles. Yet the model failed to predict the 1990-1991 recession, and an updated version of the model then failed to predict the 2001 recession. Each time, however, Stock and Watson were very honest and clear about the degree it failed and why (see here). It's rather straightforward what they did, but remarkably rare for such prominent forecasters. Further, reading this research, I feel I learned something, which I never have done from the econophysicists (other than they don't realize that perfect competition, or Gaussian distributions are not necessary assumptions to most economic theories, see here).

Sunday, June 06, 2010

Arthur Brooks on Happiness

Arthur Brooks, president of the AEI, has a new book out, The Battle, and he makes an interesting claim. He states that the key factor in one's happiness--not experiential happiness, but 'remembered happiness' that is more correlated with 'life satisfaction', see Kahneman on the difference--is 'perceived earned success'. This is the willingness and ability to create value in your life or the life of others. He states that if you ask someone if they feel like they are creating such value, they are happy, regardless of how much they make. Giving people money, via welfare or inheritance, does not make people happy, because this if anything discourages the effort needed to find and develop such a niche.

In Finding Alpha, I noted that alpha isn't in an asset, but an individual's edge. Like Minnesota hedge fund manager Andy Redleaf's thesis in Panic that above-average returns are a function of 'good ideas', not risk, and good ideas aren't just relevant to picking stocks, but all sorts of things that can make you more successful. Finding alpha is about finding your comparative advantage in your work. As David Ricardo noted about comparative advantage, it exists regardless of one's absolute advantage, it's what one is relatively best at, basically, one's most productive activity. When you find it, you are literally being all you can be.

Invariably, one finds one is good at what they like and vice versa, because you can only get good at something via a lot of effort, and if the task is perceived as onerous or boring you won't put in enough effort; if you are good at it, you'll find you like the appreciation you receive from others that is greater than in any other activity. Thus, finding your alpha is like Brook's 'perceived earned success'. If you find what you would do for nothing and get so good people pay you for it, you will probably be happy.

One important refinement of this idea is that there's a difference between current and permanent value: vs. Google, the works of John Kenneth Galbraith vs. Ludwig von Mises. They might, at one time, have generated the same appreciation, but one faded, the other proved highly prescient. One's sense of whether one is creating permanent value, irrespective of current rewards, is important as well, because its rather ghastly to think one's lifework will be seen like past experts in quack homeopathy, irrelevant if not a joke.

A recent study found that as children get older, they move from egalitarians to meritocrats. This makes sense because kids learn that people are differently skilled, and one wants the best person acting as quarterback, lead violin, or head writer, because that helps them be more successful in their goals as wide receiver, lead flute, or lead actor; to reward people the same is to be counterproductive and unjust. Free markets are fair in the sense that they most closely allocate rewards according to this ideal, and Brooks finds that those who think the market is generally fair believe in markets, and those who think the market is a rigged game, believe in greater government control. It comes down to the belief as to whether a market is fairer than feasible alternatives, better at rewarding value, implementing justice.

If you are dead weight in an organization, one whose absense causes not merely indifference, but greater productivity and joy, one senses it through all sorts of little cues. It is much better to be underpaid than overpaid (though not too much). I remember the film 'About Schmidt', where right after a retirement dinner with all the insincere goodbyes, Schmidt (Jack Nicholson) stops by his old office and notes his replacement is too busy to speak with him, and his old files are set out for garbage collectors. Clearly no on misses him a whit, and it causes great existential despair. One can whine, like Willy Loman in Death of a Salesman, about people not appreciating us and how unfair that is, but only we have the ability to make the changes in our lives that get us into niches where we are best appreciated.

Most likely your destiny is not to be famous or rich, but rather, a dependable, valued, programmer for a company that makes paper. Or perhaps your best talent will never be exploited because of a large opportunity cost. Further, the work sphere of your life complements but does replace the personal side, where friends and family appreciate very different skills. The key is doing the best with what you can, the self-awareness and motivation to develop one's strengths so that your hard work generates a maximum payoff going forward. As Muhammad Ali once said, "You can be the best garbage man or you can be the best model--it doesnt matter as long as you're the best." 'The best' is mathematically improbable, 'really good' generates the same result. If you are really good at your job your day is filled with sincere gratitude by colleagues and customers, and hopefully you can also have a family that appreciates you as well (but for vary different reasons).

In the end Marcus Aurelius notes that popularity counts for nothing, "we're all forgotten. The abyss of endless time that swallows it all. The emptiness of those applauding hands." So, live for creating value in the lives of those around you, value that is appreciated and will be missed because it is real. If you create real value, things that with the passage of time retain their admiration, as Brooks suggests, that will probably make you happy, which isn't nothing.

Friday, June 04, 2010

Science isn't Objective

It tries to be, that's the ideal, but scientists are humans like anyone else. Those who claim their side is scientific, are basically saying the other side is prejudiced and ignorant. It could be true, but both parties in the US have significant anti-(ideal) science wings.

Anyway, think about psychology, which in the first half-century was dominated by Fruedian analysis, an embarrassment (penis envy, Oedipus complex). Think about the fact that most economists thought socialism was more productive than capitalism until the the latter half of the twentieth century, or that large-scale macro models could predict business cycles. Lots of smart, well-intentioned people spent their lives studying and lecturing false ideas, all under the guise of 'science'.

Comedian Harald Eia (see picture), in Norway produced a set of TV segments exposing the politically correct banality of Norwegian sociologists. The videos are here. From
Bjørn Vassnes, Science Journalist, Norway:

In Norway, the social sciences have been more dominated by ideology and fear of biology than in perhaps any other country. This has a long history starting in the 60s. Social science became very much bound up with the ideology of the Social Democrats, who put pride in the fact that Norway was the most egalitarian country in the world....

And in Norway this became a big problem because there are few scientists, and most research is sponsored by one source, the Norwegian Research Council, which has strong links with the government...

But the main problem, which Eia has exposed so brilliantly, is that much of Norwegian social science, and gender science in particular, is built on very shaky ground. Most studies have been done without even considering factors like heredity: The reason why some people turned criminals, or did badly in school, was always explained by social and cultural factors. To even mention heredity as a possible factor, was met with condescending laughter or irritation...

I wish it were in English, my Norwegian is not so good.

Thursday, June 03, 2010

Options on Options on Options

Equity is an option on the asset of a company, with the strike price being its total liabilities. Most 'options' are thus really options on options, and indeed some people (Geske) have made such explicit models (they aren't used much as a practical matter)

The VIX is a weighted blend of prices for a range of options on the S&P 500 index. In 2006 the index itself became directly tradeable via futures. Now we have the VXX and VXV, new ETFs that allow equity investors access to the VIX volatility index. The VXX trades a shload, about 30MM shares per day. This means, we now have options on the VIX. These aren't options on options, but options on implied vols of options on options (ack!). Looking at the implied volatilities by strike, and comparing them to the implieds on the SPY, we see they are quite different little beasts.

Note that for the SPY, volatilities increase as the strike goes down, because the market anticipates that downward movements in the index are correlated with higher volatility. The VXX, in contrast, has an upward sloping implied curve, because as the volatility increases, its volatility increases too.

The fact that volatility curve is not flat implies that the standard option models, such as Black-Scholes, are misspecified, as they assume a constant volatility. As Peter Carr has said, 'the implied volatility is the wrong volatility we use in the wrong model in order to get the right price'. Black-Scholes, and its American option counterparts, are still very useful, but this highlights that any model in practice is implemented within a kluge of ad hoc rules informed by reality. Having more price points to nail down how to adjust implied vols by strike/expiration is very useful, what Sandy Grossman called 'complete markets', allowing one to see more market derived probability estimates of various states of nature, where in this case the state is not just a price, but a volatility of a volatility of a price.

Tuesday, June 01, 2010

Moral Hazard Isn't The Answer

HL Mencken noted that 'for every human problem there is a neat simple solution and it is always wrong'. Such simple solutions includes the idea that 'moral hazard' by bank executives largely contributed to the 2008 financial crisis. The examples given are always INVESTMENT bankers, who make great bonuses when they do deals, and then leave large liabilities that are toxic. Also, one can point to rich guys like Bear Stearns CEO Jimmy Cayne, who lost over one billion dollars but still walked away rich, worth over $500MM. It was heads they win, tails taxpayers lose, a game maximized at infinite variance.

This narrative is pretty ubiquitous, so I'll give just two references: Russ Roberts in his paper "Gambling with Other People's Money: How Perverted Incentives Caused the Financial Crisis" (he podcasts on it here), or Barry Ritholtz's book Bailout Nation.

While anticipated financial bailouts do not increase lending prudence, I don't think they were very significant in the creation of the housing bubble. The 2008 crisis hit all banks, not just investment banks. Most non-investment bankers get much more modest salaries and bonuses, often largely in at-the-money options in their firm's stock, with 5 to 10 year horizons. So, looking at the accompanying chart, which shows the KBW Bank Index since 1994, we see that since 1998, bank stocks were pretty flat, with a slight 25% bump around 2006, but the index now is still below its 1997 level. When I left KeyCorp in 1999 I had a bunch of options priced around $25-30, and as I left I had to exercise them. Who knew that if I had stayed, those options would be worthless, as the stock now trades around $8, light-years away from being in-the-money. Most of my retirement savings would have been erased with the 2008 crisis had I remained there (and I'd be living in Cleveland--a twofer!).

This crash has been incredibly painful for your average bank decision maker. The Jimmy Caynes and Jamie Dimons may be rich, devious, and reckless, but it's naive to anthropomorphize banks via their titular leaders. As Bob Rubin, the erstwhile financial genius demonstrated when he said he knew nothing about Citibank's exposure to mortgages, these signature guys aren't too involved in the nuts and bolts of their ALCO meetings.

Your average bank decision-maker thought that lending to people with little income, to buy houses, was not that risky. Why this was so is interesting and complex, but I don't think it was as calculated as merely, 'well, I'll get rich lending the money, but won't lose much when it all goes downhill', because your average bank executive, at say Washington Mutual, Wachovia, or KeyCorp, just lost most of their retirement savings, and they won't be getting a do-over.

Update: Russ Roberts responds over at Cafe Hayek:
by 1998 [bank stocks] had nearly quadrupled, the time period when housing prices started to take off. Yes, it was flat for a while, but between 2003 and 2007, the heyday of subprime, [the KBW index] went from 70 to almost 120. I suspect those were some very good years for banking executives. Yes, they probably could not exercise their options immediately and some of them may have been stupid enough to hold on to them forever, but I would guess that they did just fine.

I'm sure the top executives over 10 years did just fine, as that select group tends to get out-sized compensation in all sorts of forms. But the decisions were made at all levels, especially the hundreds of mid-level executives who don't make millions, but it was they who really made the decision to originate and/or warehouse mortgages with 'innovative' underwriting standards (unlike Bob Rubin or Jimmy Cayne, who probably did not know, and never knew, what the distribution of loan-to-value ratios or other obligor metrics on mortgages were). If you assume these mid-level executives received 20-100% of their base salary in at-the-money options each year, they lost a lot of their wealth recently. They aren't poor, but if they thought this was a significant possibility back in 2005, they wouldn't have done it.