Monday, November 30, 2009

Romer's Growth Theory


It is generally presumed that Paul Romer will win a Nobel prize for his 'endogenous growth theory', so I was intrigued when Kling and Schultz interviewed him in their new book From Poverty to Prosperity. As mentioned yesterday, the book hits on a lot of issues I find interesting, not so much as providing a novel big idea, but noting a lot of outstanding puzzles and how the non-Left Establishment thinks about them.

Growth Theory is about long term economic growth, abstracting from business cycles. Given the power of compounding, and the ephemeral and intractible nature of business cycles, it is rather a shame for most economists to focus on recessions because over they don't matter too much over time. Sure, the East Germany had fewer recessions than West Germany, but over a couple generations, West Germany had 3 times the living standard. Wisdom is primarily prioritizing tasks according to importance and solubility.

Robert Solow started growith theory in the 1950s, and it basically broke the macroeconomy into three drivers: capital, labor, and productivity. It did not explain productivity, but did highlight that this factor seemed to be what really mattered, so no longer could one say, Tanzania needed more 'capital', because after you apply the model econometrically the problem is not capital or labor, but their productivity. Solow's growth model does not tell us how things work, but it did dismiss a popular incorrect idea, no small feat.

Romer highlights the fact that great economists, according to economists, are those that create great models. These models usually merely formalize existing intuition, as the Welfare Theorems of Arrow and Debreu really just proved the 'Invisible Hand' using set theory (ie, that a competitive equilibrium is Pareto Optimal, and that a Pareto Optimal Equilibrium is a competitive equilibrium). Or consider the Lucas Islands model, which modelled economic fluctuations as the result of unpredictable monetary growth an inflation. In the 1970's, this was a leading explanation of business cycles, but no longer. Nonetheless, the model remains in the canon because it is self-contained, has a lot of intuition, and inspires economists as to what they are trying to create. The hope is that one creates a mathematical model, like the Black-Scholes equation, that sheds light on new truths. Good models fit to existing phenomena should generalize in unexpected ways. Alas, this is rarely the case in economics, as the model usually remain parochial explanations of the economic fact that inspired it(eg, the Phillips Curve).

Romer's model is instigated by the fact that while there is convergence within various economies, such as Developed economies, there is not convergence among all of the economies. So, Japan, France, and the US all vary around a single value, but Africa remains mired in poverty, seemingly unaffected by worldwide economic growth. The existing Solow Growth Model could not explain this, except to trivially note the African economies had lower productivity, a parameter in the Solow Growth Model. The Romer model has the form

Y=F(x(i),k(i),K)

and x(i) is the labor of an individual, k(i) a firm's capital (assume people are also firms). K=sum(k(i)), reflecting the idea that bigger economies have more knowledge, and thus, greater productivity. F is increasing in all its arguments. The key technical point he makes is to assume Y is a concave function of k(i) and x(i), which is necessary for an equilibrium to exist, yet because F is increasing in K, you have increasing returns to scale in aggregate. Thus, a competitive equilibrium exists even with increasing returns to scale, because their individual effect on total output K is insignificant (otherwise, with increasing returns to scale, everyone soon chooses infinity to maximize their production/utility).

Most interestingly you get multiple equilibria, in that if you can coordinate everyone to invest a lot, growth is higher than otherwise. This highlights the potential for good institutions to incent greater growth, say by offering more secure property rights, or intellectual property laws. Prosperity becomes a coordination problem, seemingly soluble by abstruse mathematics.

This is the cause of great joy among economists because it allows for lots of modelling: you can prove an equilibrium exists in the infinite horizon case using Hamiltonians, which have proved very useful in physics (the gold standard for science). The end result of this is Bob Lucas's Recursive Methods in Economic Dynamics, a book with a lot of math but not much insight (ever since John Nash successfully used a fixed point theorem to prove his eponymous equilibrium, economists have been eager to apply fixed point theorems to other problems, without much success).

The new growth theory tries to explain productivity 'endogenously', as opposed to Solow's exogenous treatment. Yet what is Romer's take away, when translated into words? First, he repeats again and again that higher productivity leads to higher productivity. But that can't be right, in the sense that growth rates of developed countries are not increasing over the past 100 years. I think what he means is that developed countries keep growing, while undeveloped ones don't, do to their 'bad equilibrium'. So we are back to, why does the US have the good one and not Haiti?

Then Romer seems really happy about noticing that productivity is not merely more stuff, but stuff differently arranged. He notes there's a machine that using carbon, oxygen, hydrogen and a few other atoms that is smaller than a car, renews itself, fixes itself, and creates valuable output. What is it? A cow! See, all we have to do is arrange atoms into cow-like things, and the future of robot maids, jetpacks, and holodecks will finally arrive. I don't see this kind of insight rising above the fantasies of your average comic book reader.

In Romer's Fora.tv talk, he talks about theses issues, and highlights that a growing economy has 4 major pieces:

1) competition
2) entry
3) emulation
4) exit (loser firms are reallocated to winner firms)

He gets excited by the idea that many countries could be like Hong Kong in the pre-Chinese era, taking Britain's superior laws, customs, and technology. Yet, even in the US, things like competition, entry, and exit are heavily legislated against by entrenched interests. Sure, Haiti or Paraguay could allow in foreigners to set up franchises, but they don't, because that seems to many as exploitation, and has the stench of racism. So we are back to the old ideas about international trade, the distribution of wealth, and especially the distribution of wealth among various ethnicities. A ruling clique would keep their people poor rather than turn over, say, Petrobras to Exxon.

Japan in 1854 seems the best model for an economy that emulated existing technology, where the Japanese noted their technical deficiency after being defeated by the US Navy and then adopted Western technology without having the Westerners actually own anything. So the question is why did Japan do this, but not the hundred or so other undeveloped countries? Romer's big idea seems best addressed by much less mathematical analysis; his model is sterile when applied to the real world.

Romer's asking the right questions, but as Michele Boldrin noted in Against Intellectual Monopoly, the question about the value of various forms of patents is an empirical one, not deducible from theory. Clearly Romer's work motivated Kling and Schultz's chapter 2, which highlights the nature of our industrial revolution, which is truly remarkable. But to think that Romer's 'economic growth theory' has anything really to add, I haven't seen it.

Sunday, November 29, 2009

Kling and Schultz on Financial Intermediation

I read an interesting book this weekend by Nick Schultz and Arnold Kling: From Poverty to Prosperity. It's a nice exposition of how life has changed over the past 100 years (mainly for the good), interviews with top economists, and provides food for thought on many issues.

In the last section of the book, however, I found their general description of finance to have a misleading emphasis. There was an exposition where assets have risk characteristics that are obscured as they are passed up a food chain, until finally there is greater liquidity, but less information available. Risk is transferred, but because of the lack of transparency, it actually increases.

Clearly, there is transferral of risk in finance, but I think this is not the essence of finance. Finance is intermediation, taking money from savers and giving to people who want to use that money. They, in turn, promise to pay it back. The process generates prices that act as signals to inform those borrowers and savers how best to borrow or save.

Yet, fundamentally, much finance can be considered one of five forms: marketmaking, clearing, originating, servicing, and warehousing. These specializations make for different focus by various firms, so that things important to one set of financial institutions are often irrelevant for another, and 'risk' means different things to different parties, because the risk they retain have different characteristics.

Investment banks, NYSE members, and venture capitalists, often make markets for those wishing to buy or sell. If they merely help connect two parties, like Match.com, they are brokers. If they have an inventory, like Nevada's Bunny Ranch, they are dealers. This activity is primarily about pricing. Risks are mainly about not having a correct hedge.

Clearing transactions such as checks or sales of stocks, is a valuable service, because one needs to know funds actually get from one party to another. For example, it an escrow account, both parties are sure to get their interests prior to losing control of what they are exchanging. Risks are operational, due to fraud or incorrect documentation.

Lenders originate loans or investments via their connections or brand name. This gives money to those who want to buy houses, set up a company, or finance their receivables. It involves marketing, designing products with attractive features, and doing the initial credit evaluation of the borrower and collateral check (underwriting).Risks here involve making 'innovations' to the product that are material, while assuming they are not. As it takes several months for a bad loan to reveal itself, this is why banking is very different than market making, one should have seen several lending cycles to appreciate the importance of various traditions.

Lenders also service these loans, monitoring the ongoing health of the borrower, the collateral, whether he is paying interest, etc. Risk here is operational, in that one must be able to monitor payments, and actually repossess the collateral.

These investments are then finally warehoused as 'assets'. Presumably, idiosyncratic risks are no longer relevant, and so one is left with various exposures to systematic risks: credit cards, housing, banking in general, etc. The ultimate risks due to broad covariance with 'the market', of course, do not disappear, which is the basis of portfolio theory, that only these risks are 'priced' in the sense that one expects a premium for their discomfort. Alas, that theory fails empirically, in that no one has been able to find a general covariance that explains the relative returns of assets (see my book, Finding Alpha).

These 5 attributes of finance are complements, and so many firms have overlapping functions. Yet, some specialize, and so investment companies often are merely in the process of warehousing, buying equities or debt and bundling them into portfolios. As the ultimate owners, these warehousers hold most of the value of the investment, yet, some of the value must be apportioned to each, necessary part of the financial process, and so servicers, clearing firms, market makers, and originators receive some of the money, often a fixed transaction cost. It is wise to keep originators honest, and servicers diligent, by having them retain some of the residual risk of any investment.

This does not contradict the idea of financial intermediation as risk transfer, yet it highlights the fact that the basic risks that are kept away from the warehousing are generally those that are presumed to disappear. A good originator, or servicer, monitors and manages his task so that an investor can assume his asset has a certain expected return and variance and covariance.

In the housing crisis, the complexity of the CDOs and derivatives was incidental to the assumption that housing prices across the country, would suffer only negligible year-over-year declines. Everyone made this mistake: greedy bankers, clueless academics, regulators, even Robert Shiller in 2005 could only muster up the observation that the increase in housing prices was probably not going to continue, and further, some cities might experience declines. Add to that the power of diversification, and complexity grows. Unfortunately, when the AAA-rated Mortgage backed securities defaulted, the question arose as to what was the essence of the 'mistake': housing? AAA ratings? Rating agencies? Securitization? Bankers? The Fed? All AAA rated debt became suspect, and raising this rate across the board made many projects unsustainable.

So, I don't think it was 'too much opacity' that was the essence of our recent problem. Rather, it was a bad assumption, one that very few people mentioned prior to 2007 (see Stan Liebowitz). That was not a risk hidden via the other participants in the intermediation process, rather, the many people who witnessed the degradation in lending standards for homebuying thought they were doing something morally right and empirically innocuous, not worth highlighting.

testequation



Wednesday, November 25, 2009

Krugman's Deficit Rationalization


An alcoholic is someone you don't like who drinks more than you do; a 'fun guy' is someone you like who drinks more than you do. The relativity is important to the degree 'other things' are different.

So, when Krugman notes that, in three years, our debt/GDP ratio will be comparable with other decent economies (Belgium and Italy), we have no worries! It is true that Debt/GDP does not have a strong correlation with GDP/capita, or something. Yet, like drinking too much, it's still not good to be adding 10% of your GDP to debt every year.

Tuesday, November 24, 2009

Gammon's Black Holes

In 1968, the poverty rate in the US was 12.8%. Since then, we have introduced or vastly expanded the following:

food stamps
job training courses
community development block grants
urban redevelopment schemes
medicaid
aid to families with dependent children (AFDC)
social security disability income
section 8 housing grants
emergency assistance to needy families with children
college scholarship aid
free and reduced price lunches
child care
housing projects
head start

Currently, the poverty rate is around 12.3%. More importantly, most of our cities have become unlivable, so that most college-educated families simply do not live within the city borders of Cleveland, Detroit, Philadelphia, Newark, etc. More programs, worse results.

Dr. Max Gammon was a British physician who noticed that although government spent significantly more on health care than it had previously in the 1960s, the National Health Service didn't seem any better for it. After an extensive study of the British system of socialized medicine, Gammon formulated his law: "In a bureaucratic system, increase in expenditure will be matched by fall in production...such systems will act rather like 'black holes,' in the economic universe, simultaneously sucking in resources, and shrinking in terms of emitted production."

Monday, November 23, 2009

Modern Poverty

From Steve Sailer:
This weekend saw the national rollout of two crowd-pleaser movies about impoverished 350-pound black teens: Precious and The Blind Side. (What an amazing country we have, where a pair of poor children can tip the scales at 700 pounds!)

Sunday, November 22, 2009

90% of Politics is Context and Pretext

Political arguments, like much litigation, are rarely about what they are explicitly about.

Consider the blatant $100MM give away to Louisiana, to get Democratic Senator Mary Landrieu to vote for the health care bill (alas, we aren't done with the payoffs). How does one say 'Louisiana' without saying it?

Here is the portion of the bill that targets Louisiana:
the term ‘disaster-recovery FMAP adjustment State’ means a State that is one of
the 50 States or the District of Columbia, for which, at any time during the preceding 7 fiscal years, the President has declared a major disaster under section 401 of the Robert T. Stafford Disaster Relief and Emergency Assistance Act and determined as a result of such disaster that every county or parish in the State warrant individual and public assistance or public assistance from the Federal Government under such Act and for which— ‘‘(A) in the case of the first fiscal year (or part of a fiscal year) for which this subsection applies to the State, the Federal medical assistance percentage determined for the State for the fiscal year without regard to this subsection and subsection (y), is less than the Federal medical assistance percentage determined for the State for the preceding fiscal year after the application of only subsection (a) of section 5001 of Public Law 111–5 (if applicable to the preceding fiscal year) and without regard to this subsection, subsection (y), and subsections (b) and (c) of section 5001 of Public Law 111–5, by at least 3 percentage points; and ‘‘(B) in the case of the second or any succeeding fiscal year for which this subsection applies to the State, the Federal medical assistance percentage determined for the State for the fiscal year without regard to this subsection and subsection (y), is less than the Federal medical assistance percentage determined for the State for the preceding fiscal year under this subsection by at least 3 percentage points.

Thursday, November 19, 2009

My Politicals Enemies are Idiots!

I watched the BloggingHeads video about Sarah Palin's new book, and loved hearing Michelle Goldberg compare Obama's 'Dreams of My Father' to Tolstoy, whereas Palin's book is like the teen lit hit 'Twighlight'.

Liberals hate IQ but love to assert that conservatives are stupid. In any case, all this hullabaloo about Sarah Palin I find rather amusing. She, like most politicians, is not that bright. I would estimate an IQ about 115, your average college kid. But most high power pundits are 125, and hate it when successful politicians are less intelligent than they are out of envy. Thus, the kid who asked Dan Quayle how to spell potato was asked to lead the Pledge of Allegiance at the 1992 Democratic National Convention, as if to highlight how knowing how to spell potato proves one smart enough to run the country (but then, what about literacy tests for voters?).

Of course, they hate people with really high IQs too, because these smarter people are often too socially obtuse to pretend the David Brooks and Thom Friedmans have anything interesting to contribute (e.g., Donald Rumsfeld). Thus, the most famous people at any time are the Katie Courics, Oprahs, and Matt Lauers, people who are slightly above average but most of all, agreeable and deferential to self-appointed intellectuals. The criticism that Sarah Palin is stupid I find absurd because 1) she's merely slightly above average, as are most popular people and 2) almost all politicians are as smart/dumb as she is. Consider Harry Reid, Maxine Waters, Dennis Kucinich, none of whom is smart, they blurt out unthinking trope like trained monkeys, and none more intelligent than Charles Barkley.

It reminds me of when Hyman Minsky would go off on John F. Kennedy, noting that he was often presented as genius because he went to Harvard. Kennedy was a below average student at a time when Harvard had a lot of dopey legacies, and Minsky the Liberal was too independent to pretend he was some sort of genius.

I consider politicians mostly narcissistic, smarmy, and unthinking. Those accidentally glommed onto my general disposition towards Friedmanism, I'm for. Ronald Reagan was often called an idiot while in office, but was a good politician because he changed the trend through his steadfast defense of smaller government. He wasn't a Richard Feynman, but he was consistent, and a good communicator.

My old boss Jerry Jordan (a member of the Council of Economic Advisors and Cleveland Fed President) told me about a cabinet meeting the Gipper was in where someone said we should raise quotas against country I because they have quotas against us. Reagan responded, "so if they shoot a hole in their life raft, we should too?" That dismissed some marginal trade retaliation. Having this kind of common sense in the top position, whatever the origination, is something to be thankful for.

Most pundits, professional and amateur, consider a genius as someone who can articulate one's platform more effectively than themself. An idiot is someone who effectively articulates the other side.

Wednesday, November 18, 2009

Is it a bonus if everyone gets one?

In my children's athletic endeavors, they often get trophies or awards for 'participation'. The emphasis is on making everyone feel good for making an effort. For a child, this is not a bad thing. But when we become adults, we must put childish ways behind us. At least that's the classical view. A new incentive plan would pay Advanced Placement teachers $100 bonuses for each student who passes the test, and up to $3,000 a year for meeting other goals. Students also can also receive $100 for passing. But, it doesn't look like it will happen:
The Boston Teachers Union staunchly opposes a performance bonus plan for top teachers - launched at the John D. O’Bryant School in 2008 and funded by the Bill and Melinda Gates and Exxon Mobil foundations - insisting the dough be divvied up among all of a school’s teachers, good and bad.
...
Union head Richard Stutman bristled at criticism he doesn’t have his members’ interest at heart. “We’re not taking money away from teachers,” Stutman claimed.

He also objected to the suggestions his union is a foe of school reform, insisting he backs the incentive program - so long as the bonus goes to all teachers, not just AP instructors.

Unfortunately, unions think Woody Allen's line that "80% of life is just showing up" to be a creed, not a cynical remark.

Crisis and Leviathon

Crises tend to expand the role of government, which then never subsides. The theme of Robert Higgs' Crisis and Leviathon was that wars and great depressions create a ratchet-like movement toward ever bigger government. The process involves government taking on new functions more than expanding traditional ones. In the end a distant set of bureaucrats regulates everything, but nothing well. Most functional units have specialized argot, data, processes, and contacts, and new employees takes months to know enough to be productive. A regulator has a few weeks at best, probably a few days, to review an organization. How is he to find problems, let alone fix them?

In practice, regulators ask for a select set of reports, usually highlighting statistics that would have been useful in the last crisis, and make bland statements about the desirability of 'clear lines of authority' or a 'prioritization of risk management' (see the Fed's new Senior Supervisors Group Issues Report on Risk Management Practices).

I've talked to many risk managers at large financial firms lately, and there appears an increased focus on regulators: what do they want? This is in contrast to asking, what do we need? The latter question draws on the parochial expertise of people who have to create products and services worth more than they cost to produce, the former draws on the results of endless committee meetings by people who are far removed from the front line.

The subprime crisis has discredited internal financial risk management, so now, instead of thinking about how to manage risk better, large firms have taken the understandable course of action in our Brave New World, of deferring such judgments to the regulators. Appeasing regulators determines whether one can, say, hire immigrants under H1B visa program, or pay a dividend, or worst of all, be labeled 'undercapitalized', creating a self-fullfilling death spiral necessitating an acquisition.

Firms, and the individuals therein, are in the best position to better their practices. With this recent crisis, they have strong top-down directives to placate the government, and cease all innovation because that was the kind of thinking that led to CDOs! Talk about a bad take-away. I expect banks to respond to their lack of productivity by increasing lobbying efforts to squelch competition, because that is really the only way for non-innovative organizations to make profits.

There's an East German joke that goes "What would happen if the desert became communist? Nothing for a while, and then there would be a sand shortage." An important part of this joke is the 'nothing for a while'. Bad policies don't usually produce an immediate catastrophe, rather, they weaken the trend, barely observable when initially implemented. Only after a long while do people notice that the new system is a morass of dysfunctional duties that are done mostly out of precedent, no efficiency. For example, the socialist countries started to great enthusiasm by western intellectuals; so too with busing in schools, large scale public housing, the Department of Education. At best these are wasted resources, more often they create unintended consequences at the root of the next crisis.

A friend of mine lost his job in the financial sector. He got a new job with the FDIC. As a country we have decided to allocate more resources to government, more power to government, at all levels. I fail to see how moving more people out of private firms, that create wealth and pay taxes, to regulators, that impose costs and cost taxes, will make our financial system more robust. From the Great Depression, to the Carter Credit Controls of 1980:3Q, to the S&L crisis, to the Subprime Crisis, Government was not standing athwart history saying 'stop', rather, it was encouraging the very behavior that turned out, with hindsight, to be the root of the problem.

Monday, November 16, 2009

China Doesn't Like Carry Trade

A carry trade is when you borrow from a currency with a low interest rate, and then invest in a currency with a higher interest rate. Say the US interest rate is 3%, and the Chinese interest rate is 5%. Borrow at 3%, invest at 5%, make 2%, because the Chinese yuan is pegged to the dollar at a fixed rate. Easy! Unfortunately, there's a Peso Problem in this trade, because at any time the Chinese currency could be devalued relative to the dollar, and you can lose years of money in one day.

This trade is really just taking advantage of 'uncovered interest rate parity', where theoretically the differential in currency interest rates should be offset by the expected change in currency rate, plus some risk premium. On average, however, high interest rate countries tend to have currencies that also increase in value. The carry trade blew up in the latter half of 2008, but nicely rebounded, and if you look at over the past 30 years, it remains an 'anomaly' to standard risk models.

The chairman of the China Banking Regulatory Commission complained to Obama that the carry trade was destabilizing the Chinese economy, but this really means the capital inflows are making it hard to keep the currency peg at its low current level. China has a higher interest rate than the US, and though the US dollar is falling worldwide, the yuan remains at its old peg against the greenback. China could float it, and let the market decide, but like most politicians, he does not trust the market. More importantly, there are worried it will hurt exports because a stronger yuan would increase the price of their exports to the rest of the world.

If you meddle with major market prices, like a currency, you invariably make it too high or too low. Finding the 'right' price, is like finding the 'just' price, a subject of endless, fruitless debate. But if the Chinese want to sell us goods at below-market prices all I can say is: thanks for the subsidy!

Sunday, November 15, 2009

Gladwell's Igon Values

It has been said that a little inaccuracy can sometimes save a lot of explanation. Lies—what can't they do? It should also be noted that if you aren't bound by truth, you can tell a much better story, especially because when presented as truth, an untruth is usually 'unconventional'. A premeditated application of this approach is not merely a half-truth, however, but rather a whole lie. It plays on people's dreams about how the world should be, and so is rather a sophisticated version of organized religion's promise of heaven and hell.

In this weekend's New York Times book review, Steve Pinker reviews a set of essays by Malcolm Gladwell, and notes he mentions an “igon value” at one point, referring to an eigenvalue, which seems like an obvious error for the New Yorker's famous fact checkers to catch. Clearly, Gladwell talks to experts about a lot of things he does not really understand, and is able to create stories people find interesting, me included. But at the end of the day, it is important to be correct, and there, Gladwell is often comes up short.
The banalities come from a gimmick that can be called the Straw We. First Gladwell disarmingly includes himself and the reader in a dubious consensus — for example, that “we” believe that jailing an executive will end corporate malfeasance, or that geniuses are invariably self-made prodigies or that eliminating a risk can make a system 100 percent safe. He then knocks it down with an ambiguous observation, such as that “risks are not easily manageable, accidents are not easily preventable.” As a generic statement, this is true but trite: of course many things can go wrong in a complex system, and of course people sometimes trade off safety for cost and convenience (we don’t drive to work wearing crash helmets in Mack trucks at 10 miles per hour). But as a more substantive claim that accident investigations are meaningless “rituals of reassurance” with no effect on safety, or that people have a “fundamental tendency to compensate for lower risks in one area by taking greater risks in another,” it is demonstrably false.
...
The common thread in Gladwell’s writing is a kind of populism, which seeks to undermine the ideals of talent, intelligence and analytical prowess in favor of luck, opportunity, experience and intuition.
...
Readers have much to learn from Gladwell the journalist and essayist. But when it comes to Gladwell the social scientist, they should watch out for those igon values.
The straw man argument is popular because it is effective, and I would say is the dominant rhetorical ploy.

Friday, November 13, 2009

Our Government's No Money Down Efforts

Who knew the FHA was growing so rapidly:
But the New Deal-era agency has seen its market share swell, to around one-quarter of the mortgage market today, up from 2% in 2006, according to Inside Mortgage Finance.

During the second quarter, the FHA backed nearly half of all mortgages made to first-time home buyers, and today it accounts for around half of all new home loans in some of the nation's hardest-hit housing markets.

The agency expects defaults on 20% of those backed in 2008, when it should have known better. Considering they are politically afraid of foreclosure, they seem intent on learning the hard way that a pushover lender can lose a lot of money when the word gets out. But, heh, it's not their money, it comes from Obama's magic stash!

From the WSJ, we see that Rep. Scott Garrett (R., N.J.) introduced a bill last month that would raise minimum down payments to 5%, up from the current 3.5% minimum. He might also address the fact that the $8k tax credit can be transmogrified into the down payment, making no-money down quite common for first time homebuyers, but already he has substantial opposition.

Thursday, November 12, 2009

Tyler Cowen at TED

Tyler Cowen is an avid reader of many things, including fiction. He notes he dislikes games, such as Trivial Pursuit, in comparison to reading. Anyway, I found his talk at TEDxMidAtlantic rather fascinating, because he basically argues that fiction is, ultimately, fiction. He argues against trying to fit everything into a 'story'. That is, there is a small set of story lines: journey, rags to riches, quest, voyage and return, comedy, tragedy, rebirth, facing mortality, etc. So, we have the story of Moses, and helps us understand George Washington, Abraham Lincoln, and Martin Luther King, emancipating a people. Stories are the way most people make sense about everyday happenings. They are theory that we apply to events, the why that explains the what.

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.

I pass the baton to others--my kids, colleagues--and hope there's some benefit. I want to be better than my parents, my old bosses. I get satisfaction when I do things well in this regard. If it all disintegrates because I was a fool, or the sun blows up and disintegrates the Earth in 1 billion years, I don't care.

Wednesday, November 11, 2009

Mutual Funds Know Investors Like Stories

Most mutual funds don't earn their fees, but the great unwashed keep investing in them, the same way the vote for politicians who perennially suggest they can solve problems that the last 10 guys did not solve. Yet ultimately, they sell what the public demands: style funds, index funds, sector funds, analytic All Star funds. They suggest, as always, that talking to an investment analyst to 'meet one's future needs' magically will provide for kid's college, or retirement, as if stating 'I really want $1MM in 10 years' can make it happen. These are part of an inconsistent global view of alpha, or how risk relates to return, empirically, but never mind, the public believes in these stories.

The Wall Street Journal outlines that some funds are adding market timing to their strategy, clearly with hindsight a good idea for 2008:
The Quaker Small-Cap Growth Tactical Allocation Fund, launched late last year, now has about half its assets in cash, down from as much as 95% last year. The new John Hancock Technical Opportunities Fund had about 12% cash at the end of October and is managed using a strategy that devoted roughly 90% to cash early this year

Unfortunately, there is less evidence that market timing is feasible than stock picking. Indeed, in 1960s the first tests of mutual funds took seriously the idea the funds added value timing the market, but it was quickly discovered there was nothing there. Considering that predicting the aggregate stock market has major data limitations (there just aren't enough stock market cycles in one's working life), this skill tends to be mainly marketing bluster.
Anders Ekholm, adjunct professor at Hanken School of Economics in Helsinki, recently analyzed more than 4,000 U.S. stock funds' returns between 2000 and 2007. Managers helped their performance through stock-picking, he found, but hurt their returns by market-timing.

Tuesday, November 10, 2009

Developing an Investment Strategy

I know many people who trade stocks frequently but shouldn't. If you look at the most active stocks, they include many ProShares stocks that give you two, even three times the leverage of the regular stock market. Thus, the risk minimization from diversification implicit in indices is removed via leverage. Unfortunately, this does not amplify the 'equity risk premium' because the high amount of trading in these vehicles generates significantly drag longer term: being long the UltraPro S&P500 (UPRO) gives you three times the leverage against the S&P500 daily, but over the long run, a worse performance!

If you are going to invest this way, the best thing you can do is work out a system. Develop rules, test them, write them down, and at the end of the year, evaluate your results. If you fail, perhaps give it another year. But after a few years, if you underperform standard benchmarks (eg, the SPY ETF), then either get out of the market, or stop trading, an simply invest in the SPY.


A book like Larry Connor's High Probability ETF Trading is a good place to start. The author presents a straightforward technical trading strategies, mainly based on momentum over longer periods (eg, 200 days), and mean reversion over shorter horizons (eg, 3 days). There's a lot of empirical research that suggests these trends generally exist, in that momentum is one of the famous equity risk factors (from Jegadeesh and Titman), while mean reversion underlies a lot of 'stat arb' strategies. The issue is, can you use these facts to add alpha to a naive strategy of going long and forgetting about it.

In trying to be clever, there are two things going against you at all times. First, there are many nuances to any actual implementation, and if you play around enough something will work if only by chance. Thus, you have to be disciplined when testing these strategies because it is easy to find something if you try hard enough--torture the data enough and it will confess. Second, there are transaction costs. For a retail investor, I would assume a one-way cost of 2 cents a share. Make sure this cost is included in your performance results.

So, Connors' book walks through several such rules (buy if these 5 conditions are true, exit if this one condition holds). You can learn how to test strategies downloading daily Open-High-Low-Close from Yahoo!, and set up a spreadsheet to apply it to the past 5 or even 50 years of daily data. You may not like his specific rules, but it clues one in on what kinds of things people find useful, and if you can test his strategies, you are then in position to create your own, similar strategies.

Most importantly, if you plan on trading more than once a year, you should have a testable system. Maybe it's based on fundamentals, but at least you should have a written record of what you were thinking, and when. The main thing to avoid is investing ad hoc every year,and not learning that you are wasting money and time. Most people are wasting their time at anything innovative: your average poet, screenwriter, trader. The key is to discover if you are in the 'talented tenth' ASAP, because sampling alpha is costly.

So, if you must actively invest, evaluate not just a particular tactic (buy after 2 up days when price is above the 200 day moving average), but the strategy: should you even be actively trading at all? Remember, odds are you will fail as demonstrated by the fact that most retail investors do not outperform the market, and neither do professional money managers. Do not assume that simply trying hard, or wanting it, are sufficient, because every money manager really wants to outperform, and most work quite hard. Don't take it poorly, no one is good at everything, and very few are very good at more than a few things. The key is to find what you are good at so you can do it again and again, and this takes some courageous sampling, a good effort, and then a Hardheaded evaluation.

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. They just want to s be invited to the boardroom during large corporate events, like some clueless executive eager to seem relevant by being at all the key meetings. They do have a veto power, enough so that people won't laugh at them, but they so fear screwing up, they won't apply it (except with hindsight, where they will be laser-focused on investments that went down).

How could 'more' of this kind of oversight be helpful?

Sunday, November 08, 2009

PC Bias on Fort Hood Shooter Extends to Mortgages

The Fort Hood shootings are an example of how an event can be considered a anomaly, or a broad pattern, depending on the preconception. 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 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. As banks and regulators addressed the mortgage disparity, it was seen as simple justice. Fed Governor Edward Gramlich noted in 2004:
Given the generally low level of serious delinquencies, a purely numerical analysis seems to suggest that significant net social benefits have resulted from the rise in credit extensions and homeownership
At the end of the article he notes
Rising to these challenges will ensure that continued subprime mortgage lending growth will generate even more social benefits than it seems to have already generated.
The endgame to this was inevitable because no one was going to stop the trend towards easier lending criteria, let alone reverse it. 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.

Thursday, November 05, 2009

Innovation is Not Rewarded

That is, for the innovator. We all benefit from the Pasteurs, the Fords, even the Bill Gates. They create things with spillovers. Yet, you average innovator is simply wrong, hearing dog whistles others don't, and like Van Gogh getting his appreciation after dying, most innovators do their bidding for those they do not know. Deviating from the consensus produces all the things that has elevated us from hunter-gatherers, yet, the record for the individual innovators themselves, is decidedly negative.

Look at any nonfiction bookshelf, and there you will find lots of new ideas, most irrelevant, the rest just wrong. Important new ideas are extremely rare, which makes sense because their marginal cost, after being discovered, is trivial, so they spread. We don't have to independently discover the wheel, crop rotation, or why a Republic dominates a monarchy. If good ideas were discovered all the time, our heads would explode; alas, most weeks, even months, we learn nothing new, and not for lack of trying.

There's an interesting article on whether Liberals or conservatives are smarter in The American. I liked this snippet related to how IQ relates to religiousity:

there would still be a positive correlation between IQ and atheism. The correlation exists not because smart people have necessarily rejected religion, but because religion is the "default" position for most of our society.

This same principle works in places where the default and iconoclastic beliefs are reversed. Japan, for example, has no tradition of monotheistic religion, but the few Japanese Christians tend to be much more educated than non-Christians in Japan. By the logic of someone who wants to read a lot into the Stankov study, Christianity must be the wave of the future, perhaps even the one true faith! But, of course, the vast majority of educated Japanese are not Christians. Just as with atheism in the West, the correctness of Christianity cannot be inferred from the traits of the minority who subscribe to it in Japan.


So, the fact that most atheists in America, who are the minority, are smarter, does not imply that Atheism is necessarily a smarter choice, but rather, that in general elites tend to deviate from the default choice. Eventually, the masses emulate in the elites in subsequent generations, as Christianity or civil rights starts out as the belief of a small vanguard, and then becomes the modal choice of the great unwashed.

In my book Finding Alpha, I define risk as a deviation from the consensus. This is what is implied by a status oriented utility function, because you can always remain in the same spot by doing what everyone else is doing. Taking risk can mean either having zero exposure to the stock market, or double the average exposure; standard exposure is 'no risk'. This is why risk, and return, are not correlated empirically (see videos here, read book here).

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.

So, if you attempt to innovate, take pride that you are doing it with blatant disregard for your narrow self interest. Objectively, you will fail with a high probability. Like thinking about the lottery, there are happy delusions of grandeur considering your improbable future success. You can counter those who say, you should be feeding orphans in an African village, in that your efforts have large positive externalities. Most importantly, it's fun.

Tuesday, November 03, 2009

RiskMetrics Goes Corporate

I always have admired RiskMetrics, because they offer straightforward advice about how to measure risk. My career as a risk manager started as an attempt to implement the then-new (1994) RiskMetrics Value-at-Risk methodology to the KeyCorp trading operations. Sure, for any nuanced strategy, they are 'academic', in that they do not understand a lot of parochial issues related to, say, risk arb, but for setting a benchmark, understanding certain tools are useful, and being clear, I give them an A+.

Thus, I was saddened to see their acquisition of the KLD Research & Analytics, "a leader in environmental, social and governance (ESG) research and indexes for institutional investors", because it highlights the essence of Risk Management as a corporate enterprise. KLD's politically correct indices are lame, allowing companies to justify holdings to investors via moral preening. Having the imprimatur of some socially conscious busybody just says you are trying to get by on good intentions as defined by conventional wisdom.

Who's to say if investing in, say, Al Gore's latest initiative is morally superior, better for the world's people, than giving more money to Exxon? After all, Gore's senate tie breaking vote back in 1994 started this corn-based ethanol boondoggle, which is now an entitlement that will take decades to undo. Meanwhile, farming for ethanol takes more energy than it produces when you add up all the indirect cost (as any good economist should). Further, it raises the price of corn, and hurts natural aquifers. In contrast, Exxon produces oil that can then be used by centralized power plants or machines, instead of burning biomass, which is much less efficient.

That RiskMetrics thinks moral posturing complements their activities highlights how senior risk management as a profession is mainly about appearances and going through the motions. To be specific, official risk management, which is what RiskMetrics now advises upon, is mainly staffed by prigs and props. A prig is someone wedded to a theory that explains everything, and can be highly mathematical and conventional, like Phillipe Jorion, or highly obtuse, like Nassim Taleb's insight that 'risk is what you don't expect' [which I find not profound, but irrelevant]. The key is they are true believers, have credibility as experts, and are true idiot-savants: they have a lot of knowledge, and a lot of ignorance.

Then there are the props, the suits who actually run senior risk management posts, and they basically have a full time PR job, catching flak from outsiders about decisions not made in their presence. Official Risk Management futility comes from the fact they are graded on their ability to generate reports read by people three levels removed from a business, so that why the props need the prigs, for references. The prigs need the props to add credibility to what they do, though I think it would be most accurate to say there's some truth in what prigs do, but only if you know where to find it. Nuance, the things that really matter for a businesses survival, don't travel up the chain well, so everything is fit into cookie cutters based on the most recent conspicuous financial failures.

I wonder if the RiskMetrics management has convinced themselves this really addresses risk, or they realize it's simply the way the game is played, and they have to make a living. I'm too cynical to pull it off convincingly. I'm saddened by the whole thing because I understand a lot about actual risk management, but realize how irrelevant that knowledge is to risk management as practiced by large, regulated firms.

Macro, Risk Management. These are two fields I know enough about to avoid.

Geanakoplos' Theory is No Paradigm Shift


The WSJ has a Malcom Gladwellesque article on John Geanakoplos as an iconoclastic genius who topples staid conventional wisdom. These are popular because we like the idea, but alas, what makes for a good read is often not true, not that most readers really care (who goes back to check which alarmist Time Magazine cover stories turn out accurate?).

A good way to assess someone's philosophy is to see what it implies. If you read John Geanakoplos's "Solving the Present Crisis" paper, we see the following insights and proposals:

First, he notes financial crises are typified by periods of easy lending, followed by periods of hard lending. The boom is manifested by easier terms (less collateral required for the lender as a percentage of the loan amount) and lower rates. This is hardly revolutionary. There would have to be some greater specificity on that mechanism to be really useful.

The fact that banks offer greater leniency via two factors--the loan rate, and the amount of collateral required--is not really that radical. Many goods and services are multidimensional, such as when coffee is served in a nice cup or with free half&half. If you then say, if you give more leverage to 'natural buyers', they will push equilibrium prices above their 'true value', you need some metric of identifying this deviation ex ante. Everyone knows all things housing pre 2007 was overpriced. I don't remember Geanakoplos ringing the bell that some metric of overpricing was happening in real time. I don't see any metric here one can use to identify these situations, which makes sense because it implies an absence of arbitrage that implies people are leaving $20 bills on the ground.

But consider his solution to our crisis last year, his paper had three prongs.

1) Put a floor under housing prices.

His mechanism is unimportant, but highlights he is a true macroeconomist: he looks at aggregate prices, not relative prices. The problem, he notes, is that too much lending for housing occurred, so I don't see how keeping prices out of line fixes anything but the symptom, and delays the inevitable adjustment.

2) Provide easier lending for mortgage backed securities.

I don't have a problem with this. As I argued in the April PPIP Treasury plan that Stiglitz said was a massive give-away, but was eventually shelved for a total lack of interest: if you allow modest financing, the 'put option' you write is not so valuable, and so it is not a give away. But, given all the extra obligations that come with having Uncle Sam as your investing partner, it probably is not worth it. The plan won't help, but it won't hurt.

3) Put equity into financial organizations, and have the government get involved in management decisions, and getting banks to lend more.

This is a disaster. Look at which financial institutions are pegged to have the largest losses: Fannie and Freddie. They have the dual objective of doing good, as defined by politicians, and making money. Those objectives don't work well together. Note how once they took over IndyMac they immediately stopped foreclosure, a classic populist approach to banking that is not viable long term.

For what is presented as a new paradigm, it sounds a lot like a standard Democratic talking points on the crisis. Not that this is necessarily bad, just that there's nothing really interesting there that's new or clever.

No Money Down Mortgages Continue


It seems many people are taking advantage of two major programs at the low end of the housing bubble: the FHA is aggressively promoting lending with only 3.5% down, and the $8k tax credit for buying a house less than $200k. A good realtor can apply the tax credit to last years taxes, making sure that the buyer actually gets the money right away, and the HUD is actually OK with using the $8k to cover the down payment. Remember horror stories of sellers who would pay the slim down payment or closing costs, and leave the stupid investors with losses? Well, today that game is over, except for the government, which proves that stupidity in the private sector actually loses people money, causing them to change their ways. For the government, it's just more incentive to double down.

A person who can't afford a down payment should not be in a home. One needs capital to pay for routine maintenance, and most importantly, if something major happens, like if a heater breaks. A renter is someone who does not have the wherewithall to handle these large, unanticipated expenses. It is better for everyone if these people are renters, because otherwise a bad break leaves the property in poor shape, leading to a 'broken windows' problem.

No private bank would lend in such a manner, but FHA wants to take the risk, because unlike the greedy bank, it sees the 'bigger picture', presumably.

The government's program reminds me of the technique children independently discover to make it look like they've eaten up hated peas or carrots: spread them around the plate. Thus, the recent economic debacle is primarily centered on housing, especially lower-end housing financed by overeager lenders. The unavoidable endgame to this problem is fewer houses, and lower prices for those houses; demand was artificially high. But, we wouldn't want people to adjust, because every good Keynesian knows that all misallocations of resources in a complex economy can be solved via top down injections o fiat money, or "G"--they have the multipliers to prove it!

To the government every hangover needs a little more hair of the dog. A friend of mine says his rental real estate business is slow at the top end, because those renters are attracted to the FHA loan/$8k tax credit. Those kind of effects are basically unmeasurable, and what can't be measured is not counted. What about the complex dynamics implicated by the finite nature of the $8k tax credit? Preventing the pain with a temporary subsidy merely prolongs the amount of time spent in the doldrums (eg, 1933-39 was a period of very high unemployment).

Bad governments prioritize the seen over the unseen, the direct over the indirect. The sad fact is popular policies usually have highly concentrated benefits and highly distributed costs, and the politicians act like little children, hoping those watching do not notice stuff that's spread around.

Sunday, November 01, 2009

The Theory of Relativity, Updated

Watch this video on YouTube...the woman has this funny theory. She starts out asking, you do know what H2O is? You have heard of Einstein. Basically she notes

1) E=mc^2
2) As the diameter of protons, neutrons is about 1E-15 m, while the diameter of the atom is 1E-11. Thus, all the mass in the galaxy would fit into a small ball.
3) Thus, the mass being small, we can ignore it, and so E=c^2.

This plays into her theory that we are all mere energy, which somehow means homeopathy works.

Only using mere words can one can make this mistake.

Adult Kill Joys in Action


From the New York Times:
And in keeping with the theme of healthy eating inside the White House that Mrs. Obama has promoted, the children were also given a dried fruit mix of cherries, apricots, pears, apples and papayas.

I bet the kids were thrilled to get dried papayas.