Tuesday, August 31, 2010

When Quality Doesn't Matter

Paul Graham, a successful programmer who now funds start-up tech firms, writes about his experience with Yahoo! in the late 1990's. He had a start-up with a search algorithm that ranked search results by user behavior, how many clicks actually created purchases as opposed to mere clicks. It was like the algorithm Google uses to sort ads today, but this was in back in 1998. It seems like a rather obvious, straightforward improvement than just treating all clicks the same.

He notes an impression from a meeting where he pitched his product to Jerry Yang:
Jerry didn't seem to care. I was confused. I was showing him technology that extracted the maximum value from search traffic, and he didn't care? I couldn't tell whether I was explaining it badly, or he was just very poker faced.

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

When an industry is rife with business where quality does not matter, it becomes ripe for mimics who come in and sow the seeds of a crash and possible recession. There are many stories about real-estate brokers setting up shop in the early aughts, not caring about whether homebuyers would actually pay their mortgage because it did not matter. This was a signal that rot was rampant. Basically, if quality doesn't matter, and there's free entry, there's a bubble.

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

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

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

Graham notes that Yahoo! was doomed by their dominant marketing, as opposed to programmer culture. I also think that when you get paid for something other than what you say you do, it doesn't give the same satisfaction. People who are overpaid may be rich, and such richness does buy you some friends, and I'm sure many think hey, I could live with that, no reason to be a prig about principle. I think that's a bit like thinking that if you had an infinite supply of sex, beer, or ice cream that would be awesome: only for a little while. Arthur Brook's perceived earned success I think highlights the importance of honest exchanges.

Science over Politics

The media tend to present scientists as super-rational beings, who stand outside the cognitive biases they note in others. For example, the paragon of rationality Carl Sagan famously wrote:
In science it often happens that scientists say, "You know that's a really good argument; my position is mistaken," and then they would actually change their minds and you never hear that old view from them again. They really do it. It doesn't happen as often as it should, because scientists are human and change is sometimes painful. But it happens every day. I cannot recall the last time something like that happened in politics or religion.

I think this is profoundly misleading, because I can't remember any occasion where some scientist, on the spot, changed his mind about something important. They might concede a minor plank, but never the big idea. Inconsistent data points are seen as fatal or noise depending on what side you are on. Almost all interesting economic phenomena do not have definitive proof, so basically most of what we argue about comes down to common sense, just as in political or moral debates. After all, we only have a handful of recessions, and the effects of deficits (say) on unemployment (say) depend on whether the economy was at full employment, and whether the spending was an automatic stabilizer or exogenous increase, etc. Basically, we are left with about 2 datapoints to extrapolate from, and these also had their own idiosyncracies (especially if one is old enough to remember them personally).

The objective standard errors on important policy disagreements basically allows one to have any belief they want on fiscal policy. That doesn't mean everyone is equally right/wrong, just that it's essential to have good prejudices, opinions on things that can't be proven from axioms. This is why the academics aren't much help, because IQ and education just allows one to distinguish what is true, false, or indeterminate, and not very good at establishing probabilities. That is, a good statistician like Joshua Angrist will have a chapter on nonlinear relationships, and how important they are, and then argue that a 2% wage increase from when kids started school has implications for spending more on college; or Paul Samuelson will continually beat the drum for more deficit spending, and when someone mentions he is encouraging a debasement of the currency he will mention that he acknowledged that governments could spend too much, so he has done no such thing.

Priorities, not truths, underlie common sense.

The main advantage of scientific as opposed to political debates is that you don't have to be democratic, the mob does not rule.

Monday, August 30, 2010

Unemployment Insurance

The idea that 'if you subsidize something you get more of it' seems as good a law in economics as you can find. Robert Barro argues today in the WSJ that since we moved unemployment insurance from 26 weeks of 'temporary' relief, to now 99 weeks, we have exacerbated unemployment problem, and now are approaching the European base rate. Isn't a more 'European style' economy what Obama wanted? Alas, when we create an American Europe, we don't get to choose what parts transfer.

Barro notes that increasing unemployment insurance lowers the probability a job seeker will accept a new job, and the economy is always creating and destroying a lot of jobs:
For example, the Bureau of Labor Statistics reports that, near the worst of the recession in March 2009, 3.9 million people were hired and 4.7 million were separated from jobs. This net loss of 800,000 jobs in one month indicates a very weak economy—but nevertheless one in which 3.9 million people were hired. A program that reduced incentives for people to search for and accept jobs could surely matter a lot here.

But, for the other side, the issue is rather simple. If we did not give people unemployment insurance, they would die. Here's American Prospect columnist Tim Fernholz explaining his utter disdain for Jim Bunning, the congressman who tried to block increasing unemployment insurance without funding it first.

Friday, August 27, 2010

A Funny Endogeneity Problem

One big question is whether variables like the deficit or Fed Funds rate causes GDP, or GDP causes the deficit, or both are caused by something else. Sometimes, these relationships change in various situations, as for example usually your temperature merely reflects an illness, but extreme exposure to cool water can lead to a low body temperature that directly causes death. It's a big problem in economics, where sadly we often don't have enough data.

However, common sense is very helpful in these environments. Over at Bloggingheads, this woman argues that obese, poor Americans are really hungry--a novel hunger problem--which is caused by their poverty.
"One of the biggest risk factors for somebody being both hungry and obese is living in poverty"

Thursday, August 26, 2010

Who's Weird?

Someone told me these two laws, which I find comforting:

1) You aren't as weird as you think
2) Other people are weirder than you think

Hedge Fund Disclosure Rules Favors Hedge Funds

The Securities and Exchange Commission nicely illustrates a big problem with regulation: capture. Under the pretext of justice or fairness, the SEC routinely hurts the unorganized plebians vs. the insiders. Consider that it's first commissioner was Joe Kennedy, who made his first fortune off then-legal bucket shop trading tactics. The SEC then sat on a monopoly on equity trading, and mandated commission rates for decades, as well as preventing all sorts of competition. You might remember the SEC in penalizing famous frauds like Madoff, Bayou, and Wood River--after they were exposed as frauds by their own investors. These are the police who show up after you've tackled and hog-tied your intruder, and then take credit for putting him in jail.

SEC rules prohibit hedge funds from mentioning their returns because the rubes who read newspapers and the interweb include 'nonqualified investors' (those making less that $200k per year and are not worth $1MM). This only helps the fraudsters and inhibits competition, and makes investing more complicated. If people knew about Madoff's record many would have highlighted its patent impossibility: you simply could not have generated that kind of return record doing what he said he was doing, and many an assistant professor would have loved demonstrating this.

What are the returns to hedge funds? Who knows, because currently discussing it is not merely discouraged, but illegal! This supposedly helps the widow who might be tempted by the siren song of hedge fund jingles, but any stripper knows that coy concealment titillates much more than brazen reality. Fund X made 100% in 2008? I must find out! The fund's insiders abet the misinformation as required by law by making no comment. The rules are designed to encourage rumor-driven investing. The hedge fund indices themselves have repeatedly been found to contain survivorship bias (see here and here), which makes total sense. Any hedge fund index is more beholden to hedge funds than potential clients, because the funds are not obligated to give them their returns. You don't become an expert in something, without being an advocate in some way, just as all those socialist economics professors pre-1989 generally preferred socialism. Is it surprising they neglect various subsidiary funds of an entity when it fails, because that really wasn't a 'fund', and it wasn't really part of X?

Consider instead if funds could mention their performance. Lying about returns would still be illegal, so, truth telling by those with good returns would be a dominant strategy, and silent firms would look bad because they probably aren't talking for a reason. This would give investors more information about the risks and opportunities available to them.

Current SEC chairman Mary Schapiro came from the NASD, the group that helped keep the exchanged in monopolistic control over order flow well into the internet age. She has always jumped on conspicuous peccadilloes to divert attention from what she should be doing: encouraging vigorous competition. For example, in 2005 she shined the light on Wall Street gift boxes, as if the occasional bottle of wine or golf bag is a big priority. The SEC is involved in the complex 'flash crash' on March 6 2010, when systems were failing, and arcane institutional restrictions on how market trades must be routed ended up in chaos. Her preferred solution: restrict what competitors can offer customers. Brilliant!

Tuesday, August 24, 2010

Complex Adaptive Systems

An ecosystem is in a complex equilibrium with diurnal and seasonal patterns, and also random trends in geology in species distributions. One thing most people understand is that trying to make an ecosystem better is really, really hard, because everything is connected in complex ways, and not obvious what 'better' means.

For example, before the middle of the 20th century most forest managers believed that fires should be suppressed at all times. By 1935, the U.S. Forest Service's fire management policy stipulated that all wildfires were to be suppressed by 10 A.M. the morning after they were first spotted. Early posters of Smokey Bear misled the public into believing that western wildfires were predominantly human-caused. In Yellowstone park human-caused fires average about 8 annually, while about 35 wildfires are ignited by lightning. Fire is a natural process, and helps clean out the understory and dead plant matter, allowing economically important tree species to grow with less competition for nutrients. Scientists knew a little about that, so starting in 1972 the National Park Service began allowing natural fires in Yellowstone to burn under controlled conditions, yet of a total of 235 prescribed natural fires burned under the directives of the new policy, only 15 spread to more than 100 acres. With all that kindling, in 1988, a total of 793,880 acres (3,213 km2), or 36 percent of Yellowstone park burned, an unprecedented disaster.

It should come as no surprise that trying to fix the economy--also a complex, endogenous, adaptive system--is also difficult. The cash for clunkers program that gave a $3,500 voucher to those who traded in old cars for more efficient ones (and then destroyed the old cars) seemed likea great deal, but it boosted used car prices by as much as 30% , basically giving a one-time boost to car sellers, as the subsidy mainly went into a rise in auto prices. By literally destroying over 500k cars, the price rationing system mercilessly punishes the poor slobs who did not have a car before the cash-for-clunkers started.


Alas, an esteemed economist was behind this boondoggle. Alan Blinder helped popularize the idea of a scrappage program, and the moniker "cash for clunkers", with his July 2008 op-ed piece in the New York Times. Blinder argued that a cash for clunkers program would have a tripartite purpose of helping the environment, stimulating the economy, and reducing economic inequality. Solving for these three objectives simultaneously is harder than the three-body problem of Newtonian mechanics, an impossibly difficult task. Simple carbon taxes, tax cuts, even straight out checks to the poor, would be more effective, but then the results would be too obvious. Apparently the impossibility of the objective isn't a bug in these programs, but rather, a feature, because if you can't say something worked, you can't say it didn't work.

Credit card interest rates have risen dramatically, as new federal rules intened to help credit consumers have backfired. The changes required under the Credit Card Accountability, Responsibility and Disclosure Act prohibits lenders from raising rates on outstanding card balances. Card issuers also won't be able to change the terms of a contract so long as the cardholder makes a minimum payment on time. In response, banks raised rates across the board for everyone. The average rate is now 11.45 percentage points higher than the prime rate, the benchmark against which card rates are set. That's the largest difference in at least 22 years. What did regulators think would happen?

Lastly, there's the US Treasury trying to figure out how it can still help new homeowners, but without implicitly paying as much as Fannie and Freddie appeared to have cost US taxpayers. Bill Gross writes that "nine in 10 new loans are currently backed by Fannie, Freddie or government agencies", and further that if the government got out of the business, mortgage rates would "rise 300 basis points to 400 basis points, crippling any hopes of a housing-led revival to the economy.” The Treasury will have a new plan announced in January, but they have a tiger by the tale. One thing the government does not do well is price for risk, and as Joe Stiglitz knows, this leads to pooling equilibria, where good and bad risks are priced the same. In such events, the good credits leave because they don't like subsidizing their free-riding brethren, so its a race to the bottom that eventually blows us (i.e., it's not an equilibrium). So, either we let the government-guarantees gestate to a much bigger problem at some later date, or we let housing prices fall dramatically soon.

As long as the Chinese keep giving us money and inflation remains low, I see nothing forcing US policy to change. This is not sustainable, however, and when the US turns into a Greece-like situation, it will be a very bad decade. When you try to micromanage a complex system, the most important virtue is humility.

Monday, August 23, 2010

Nassim's Selective Returns


Nassim 'the Dream' Taleb's Universa is supposedly advising China Investment Corporation on buying some insurance on all their US exposure. Here's a pro tip for the CIC: if you want to hedge your exposure to US Treasuries, don't buy US Treasuries plus insurance on US Treasuries & the US Dollar. That's churning. Instead, invest more in a different country, like Canada or Iceland. You don't get the insurance for free, you pay the expected loss plus fees--otherwise no one would sell insurance. It's almost as if the Chinese exist to give their money away to Americans.

Nassim is fond of highlighting that public prognosticators, especially financial analysts, do not keep an accurate, testable track record, and so are deceitful, uncalibrated, and most importantly wrong. So it's fun to see his record bandied about in a misleading, tendentious way. Today's Wall Street Journal states the Universa Fund he is affiliated with (but run by Mark Spitznagel), had "client portfolios [in 2009] down an average of about 4%, one person close to the matter said". "This year, Universa clients on average have lost about 2% of their notional account value", but in 2008 "extreme market losses helped many Universa clients profit more than 100%."

There are a lot of qualifiers in those off-the-record statements. As implied vols went from 40 to 20 in 2009, I'd be surprised if his average client only lost 4% that year. Further, as vols peaked around early November 2008 around 80, and then fell dramatically to 40 by December 31 2008, I'd be surprised if that 100% number is representative for 2008, because that was the number bandied about by the credulous press during the top tic in November when vols were 80. Of course, without audited returns, who knows.

Janet Tavakoli busted a GQ article that stated Taleb made $20B for his clients, and Taleb angrily responded that he never said that number, and Tavakoli was on a smear campaign. It's very manipulative when you let an interviewer quote unidentified sources for returns in your piece, and then act shocked, shocked, when people point out they are incorrect: 'I never said that'. Technically true, but knowingly misleading, pathetic for a man who makes a big deal out of the fact that financial professionals are miscalibrated and hide their track records. I know three people he threatened to sue for defamation; he's not forthright when it comes to his own record.

NNT's returns from 1999-2003 were probably only 4% annualized (I don't have audited returns, so I'm going on hear say), and as it closed a year later, probably lower than that for its lifetime, pretty lame, but his 60% return in 2000 is all he needed for marketing. It's called the 'representativeness heuristic', a conspicuous focal point one then irrationally generalizes. Or it could be the 'anchoring heuristic', a number that once set, biases the final estimate towards this number. In any case, he's selling lottery tickets, an unfalsifiable strategy that generates really large returns in big crashes like 2008. Great, but as volatility, especially at the tails, is priced if anything too high, I don't think this strategy has a positive expected value to anyone but the fund owners (and their advisers!).

Thursday, August 19, 2010

Macro Aggregation Fallacies

It would be very convenient if the macro economy could be steered like a big oil tanker using a few inputs. Sure, it's hard to steer an oil tanker, but it's feasible. You just need an objective (full employment!), inputs (a map and a clear view), and control variables (the rudder, engine speed). After all, Newton took all those epicycles, and merged them into simple F=G*m1mm2/r2, so that's what scientists do. I agree it's nice when it happens, but sometimes it's not possible, and it's obviously not true that historians know nothing merely because they don't know math or statistics.



Paul Krugman notes that there's a simple relation between the 'private sector surplus' and the interest rate. He uses graph above to show that the higher the interest rate, the more the private sector--consumers plus the businesses they own--will save.

Fine enough, that's all partial equilibrium analysis. That is, the capital goes outside this system, and the price of riskless capital (interest rate) is set exogenously. Supposedly:
in normal times the central bank can reduce interest rates enough to set this surplus at zero, or no larger than the public sector deficit, thus ensuring full employment

In stressed times after a bubble (eg, the 'after' line above), the private sector tries to run a big surplus as it pays down debt. This causes recessions, which can be mitigated if not eliminated via countercyclical budget deficits by the public sector.

This argument would be tenable if it were 1936 and people never tried it, but it has been tried over and over and if a government could spend itself to prosperity and stability, a couple such countries would demonstrate this. Instead, we have the examples of the contrary, where fiscal restraint and modest automatic stabilizers were consistent with the wealthier countries post WW-II.

But what I love is the way Krugman totally ignores the heterogeneity of investment and employment, and simply thinks that people and companies are saving 'too much', and so anti-savings by the government would offset this, leading to full-employment bliss. That kind of thinking is profoundly misleading.

Tuesday, August 17, 2010

Song Lyrics Aren't Poetry

An interesting article in the Wall Street Journal notes that lyricists are getting a lot interest, as a catchy chorus (eg, "If you like it then you should have put a ring on it") can greatly enhance a song's playability. Yet they note that while good lyrics are nice, they aren't as deep as people think:
"Lyrics just don't hold up without the music," says Billy Collins, professor and former poet laureate. When his students argue that the lines by their favorite rock stars should be assessed as literature, he demurs: "I assure them that Jim Morrison is not a poet in any sense of the word."

When I was young, I knew a lot of kids that thought lyrics were really deep. I think it only seems so when it accompanies good music, the mood swings of youth, depression, or drugs. That is, in combination with other emotional drivers, lyrics seem much deeper than they are. By themselves many tunes that sound emotionally powerful when sung, are almost parodies of themselves when read silently (MacArthur Park? Muskrat Love? Careless Whisper?). I watched a documentary of the making of Bohemian Rhapsody, a great road tune, and they went over the lyrics, and it was clear that many words and images were picked merely because they rhymed, or the words or phrases out of context matched the mood of the song in that measure. As a poem it fails.

Alas, something similar is true for economics, where silly ideas, when combined with rigorous mathematics, don't seem so silly. Take an argument like the idea of infant industries, where if you protect an industry from overseas competition, it may increase a country's growth because only after infancy it can thrive; in infancy it may die from competition. The idea is predicated on increasing returns to scale, such that there's an inflexion point at which firm rapidly move down a cost curve relative to smaller producers. 200 years of empirical evidence, not logic, demonstrate this infant industry argument is wrong, that infant industries invariably become coddled, spoiled infants that never grow up. As per increasing returns, it is hardly a rigorous point: Microsoft and Google have both benefits (via increasing returns to scale) and costs (via decreasing returns to scale) peculiar to their large size. Yet if you dress the argument up in mathematics, where the idea is derived given algebraic assumptions for utility, production, and market clearing conditions, you get Paul Krugman's Nobel Prize. The argument isn't any more compelling with mathematics when you try to explain it in words via Krugman's model, and that should tell you something.

Krugman might say in his defense that his argument was meant to explain the stylized fact that trade between two large nations can hardly be explained by mere natural resources, and so how does one explain persistent German excellence in cutlery, or why Sweden exports and imports autos, except via some Guthian-inflation that occurs in certain firms. Fine, I get that, but Krugman's algebraic model is not really useful in isolating some idea in that argument. Without the faux-rigorous math model, there's no there there. Economics as a 'science' might be poorer without math, but as an understanding of our world it would have been the same.

Math helps ideas when it isolates the relationships or implications with greater parsimony or precision. In practice, economic models are abstruse arguments with mere potential for great scope, but the history of economics suggests great skepticism for this potential. What irreducible-to-words model, other than derivatives models in finance or statistical models in econometrics, have generalized to create a greater consensus on anything of economic importance? My best guess would be Ricardo's theory of comparative advantage, but note 1) that was made over 150 years ago and 2) it hasn't really convinced anyone that free trade is a good idea (it's easy to add some assumption that invalidates it).

Paul A. Samuelson's Foundations of Economic Analysis, in 1947 argued that rigorous modeling based on optimizing behavior of agents and stability of equilibrium was the essence of scientific economics; that is, modeling. It was one of the greatest intellectual errors of the 20th century. After all, for all of Samuelson's noted brilliance, what economic idea remains, other that methodology? I would say the Law of Iterated Expectations, which basically says that rational expectations implies a martingale, which is like Brownian motion. Nice, but hardly proportionate to his outsized reputation while alive.

Having a sense of the rhythms and emotions of music helps poetry, and so to does the logic of mathematics help economics. But good economics, like good poetry, almost always stands by itself without the adjunct. Just as we should beware of poetry that only sounds good when there's music playing, we should distrust economic analysis that only seems profound within mathematical models. There's the hope that if we use some rigorous method of reasoning economics will avoid the stagnation of ideas we see in politics or journalism. Would that it were true.

First a Tragedy, Now a Farce

Today's WSJ has an interesting article by Edward Pinto on the current housing mess. Basically, politicians still think they can have their cake and eat it too, subsidizing new homebuyers at rates that guarantees too much housing. What is 'too much'? That which is unsustainable. The 3.5% down mortgage that dominates the under $250k market is almost solely a government creation. As it says in the article:
In 1990, one in 200 home purchase loans (all government insured) had a down payment of less than or equal to 3%... Columbia University's Charles Calomiris to increase minimum down payments by 1% per year over 15 years, bringing them back to 20%, where they had been for decades.

Charles Calomiris was a professor of mine at Northwestern, and he is an expert on economic history, as well as how finance relates to business cycles. This is only natural because you discover quite quickly that the history of economic busts is that of financial panics. His proposal is considered extreme, highlighting the current insanity.

Anyway, to see how we got here, note that many are trying to say that the housing crisis was created by one blade in the supply-demand scissor: greedy bankers. Now, this is really rich because bankers--paradoxically to some--have suffered most, much more than the poor family that put up almost nothing to live in a nice house for a couple years. The Fed and otherwise intelligent Ben Bernanke would like you to believe the Community Reinvestment Act (CRA) had absolutely nothing to do with the 2007 housing crisis. Barry Ritholz went so far as to offer a $100k prize to someone who can 'prove' it caused the crisis, and Paul Krugman argues it had nothing to do with the crisis.

These are often semantic debates. I don't think the CRA caused the crisis, as in if the CRA legislation had not existed the crisis would not have happened. Yet it was symptomatic of the mindset that led to the crisis. The zeitgeist suggested that lowering underwriting criteria for homeowners was costless, turn renters with their various social and economic deficiencies into homeowners with their various social and economic proficiencies, and be morally just. The mindset that underlay the CRA, not the CRA itself, caused the housing crisis. The CRA was joined by the Fair Housing Act and other explicit legislation. The regulators from the OFHEO, OCC, FDIC, SEC, and Federal Reserve were all on board with the tactics consistent with the strategy, meaning that bankers weren't criticized for lowering their standards in regards to home lending, but rather congratulated. The US Department of Housing and Urban Development, and Department of Justice had similar objectives and initiatives to those in the CRA. The CRA, in this context, was unnecessary.

Consider what was being argued before it became patently obvious that you can have too much of a house. In the National Housing Institute Journal, which contained a lot of economics and social justice (funny how these are conflated when convenient), Gregory Squires wrote in 2003:
And the Community Reinvestment Modernization Act would likely not have been produced if it were not for the advocacy efforts of the National Community Reinvestment Coalition, ACORN, the National Training and Information Center and community organizations around the country.

Saul Alinsky argued that there are no permanent friends or permanent enemies. And there are few, if any, permanent victories. Progress has been made in fair lending and community reinvestment, but that progress is threatened, as the rise of predatory lending in recent years demonstrates. Homeownership may be at record levels today, but low-income and minority neighborhoods remain underserved. Future goals for community reinvestment and fair lending seem reasonably clear, as do the tactics and strategies for achieving them. Sustaining the type of efforts responsible for past victories and required for future ones remains the challenge of the day.

A course on Community Development at the University of Buffalo lays out the housing strategy as part of what is true and good, and gives a grading scale with precision to the second decimal, as if the idea to redistribute via housing subsidies hidden within mortgages is so obviously true, we are just concerned about the decimals in any academic work in that subject.

In The Future of Community Reinvestment, Occidental College Poli Sci professor Peter Dreier lays out the conventional wisdom before anyone tried to lay blame for the insanity that peaked in 2006. Here are some of Dreier's Seven Key Ingredients to Community Reinvestment in 2003, which celebrated the housing bubble trends (he's being sincerely laudatory of all these trends):

Ingredient 2:
Activists pressured banks to invest more money in specific urban neighborhoods...Under pressure to channel credit into redlined neighborhoods--and to co-opt protects from community organizing groups and win favor with regulators and ploiticians--banks forged partnerships with community development corporations. for the most part, protest groups shook the money tree, and CDCs collected the rewards.

Ingredient 4:
Within a decade after the CRA was enacted, many banks created separate "community reinvestment" divisions. these divisions were often staffed by liberal individuals who sympathiszed with teh amis of the community reeinventment movement. Indeed, some of these individuals had themselves been cummunity activitists who were recruited by banks to serve as liaisons with community groups.

Ingredient 5:
The movement's organizing strategy gave residents a clear set of remedies at the national, state, and local levels that went beyond neighborhood organizing... through the National Commuinty Reinvestment Coalition, they worked with other groups to pressure Congress to strengthen the CRA and HMDA.

Ingredient 6:
By requiring banks to meet community needs as a prerequisite for obtaining various approvals from federal bank regulators and by giving consumer and community groups the right to challenge these approvals, the CRA provided these groups with leverage to bring banks to the negotiating table.

Ingredient 7:
Local groups working on the same issue were able to learn from one another. This learning occurred through several national organizing networks and training centers, particularly National Peoples Action, ACORN, the Center for Community Change, and the National Community Reinvestment Coalisiton.

The paper ends with a plea:
We Need a Progressive Agenda: the community reinvestment movement is part of struggle to make access to capital more democratic.

Dreier is unrepentant, arguing in the many posts online that ACORN has been unfairly demonized, and that the housing crisis had nothing to do with his earlier proposals for meeting loan quotas irrespective of standards. People at ground zero in this crisis who have been insulated from its direct effects--academics, wonks, politicians--have learned nothing from this conspicuous failure between theory and reality: the old 20% down payment was not arbitrary hatred of black people, it was merely prudent lending. Markets abetted the housing crisis as investors were co-conspirators with everyone else, but at least they learned a lesson. Clearly politicians have not learned and want to continue the madness at 3.5% downpayments forever. It's not sustainable.

Monday, August 16, 2010

Ethicist Less Ethical

Over on Bloggingheads.tv, two philosophers navel gaze to consider whether thinking about morality make you a more moral person? Or just someone more effective at using morality to justify whatever they want to do. Eric Schwitzgebel finds the latter, for example documenting that ethics books in philosophy are more often overdue than books in other fields. Ethical philosophers are not more ethical than other people, merely especially talented at finding justification for doing what they want to do. Such convenient confabulation is no stranger to economics and finance, in than an economist can justify his preference for any reasonably popular economic policy via some published economics. It is is not as if the big questions in economics have become less disputed over the past century via theory, merely the failure of the Soviet Union, and other datapoints make certain arguments less compelling.

Wednesday, August 11, 2010

The Unemployed Still Have Jobs

Tyler Cowen's suggestion that in times like now with high unemployment
If one wishes to consider state intervention, in light of recalculation one is pointed in the direction of direct [government] employment of the struggling workers

This is really bad advice, as it defers the inevitable. The most important job I have I don't get paid for: raising my kids. Just because you aren't getting paid does not mean something important isn't necessary, onerous, and time consuming, just like paid jobs. It is a mistake to think those without paying jobs are or should be sitting around waiting for a foreman to tell them where to shovel.

Everyone has many jobs to do right now. Entropy naturally creates disordered states that need reorganizing. We all could invest more in ourselves by learning Java, or fix things in our house. Unless you are an invalid you have jobs to do that increase your wealth and that of the community.

The number one job for someone fired or downsized is to find a new job. That kind of matching takes a lot of work, and you are always in the best position to know how your talents, interests, and costs fit with various opportunities. Finding an occupation where one feels appreciated is like finding your comparative advantage, something you do relatively well, something that relative to others in that niche, you do with less cost and higher output. The common macroeconomic mistake of treating the unemployed like some homogeneous mass leads to the fallacy that bureaucrats with the public purse are best suited for giving people jobs. A good job, like the meaning of life, is something someone can't give to you, you have to find it for yourself.

'Perceived earned success' is what Arthur Brooks calls the key to happiness, and this is obtained through a job that makes one feel like they earned their pay, their respect, and this matters more than the level of their pay: a respected bricklayer knows he's good and feels good about himself, much more than some executive vice president making millions doing a job that he knows is merely about exercising authority, something anyone merely decisive could do. Such jobs may have power, but as they don't take any really special skill, just fortunate standing in some organization, the worker is financially wealthy but he does not have the same satisfaction.

A make-work job, like charity that it is, does not generate happiness for the recipient because it is degrading. That's why if you want someone to like you, ask them a small favor, it shows you appreciate them; if you want them to hate you, do them a big favor. A good example is how France loved America for needing their help in our revolution, so much so they built us a Statue of Liberty 100 years later. After freeing them from the Germans twice in 30 years, however, the French find Americans annoying.

I know people who had very firm-specific capital that is now gone. They need to find something similar but different, and taking them off task for government make-work will not help them find their best fit as soon as possible, it will do the opposite. A bureaucrat, who's not financially interested in your employment status, and does not know you well, will certainly find you a worse employment match in whatever job is given to you. Life has a lot of randomness to it, but thoughtfulness and effort help tilt the probabilities in your favor. Effort and thoughtfulness pays off, if only statistically.

Tuesday, August 10, 2010

FHA Needs Brains

In the 1990's many Japanese banks were known as zombie banks because while technically insolvent, they continued to operate because their ability to repay their debts is shored up by implicit or explicit government credit support. The banks did not write down their loans, but neither did they lend much because they were in a holding period until the asset pricing fairy pulled prices back up to their pre-bubble peak. A decade of stagnation followed.

Luckily, Americans are too stupid to do that again. Instead, we have the FHA, a government agency staffed by many talented economists who I'm sure could prove to you their policy is optimal (under certain assumptions), highlighting the benefits of a rigorous education in the dismal science. Currently the FHA is dominating the lower-than-average house mortgage market. It offers lenient terms for home buyers than any profit-oriented banker, all in the name of stimulus, such as only a 3.5% vs. 10% down payment, and debt-payment/income ratios of 60% vs 36%.

Why FHA's contrary lending stance is a bad idea is because it takes a certain level of financial capital, and the correlated amount of prudence, to maintain a house, to make sense as the residual claimant on the property, to be the owner. There's a large probability a furnace will break, and then what? For a $150k house, if you could only afford the 3.5% down payment, there's a smaller chance you can maintain the house due to normal wear-and tear, as well as those big expenses like a blown furnace. Then, when the deteriorated house makes it clear the transaction is not easy money, the homeowner bolts and the property sits for 18 months attracting squatters, drug users, and vandals, which depresses neighborhood values (this is due to laws designed to protect the homeowner, who presumably is being bullied by the bank).

This FHA insanity highlights why, as mercurial and imperfect markets are, they are better than government directed markets. Markets make mistakes but they correct themselves much faster than government does.

The following pie charts show the growth in FHA as a percent of total mortgage loans in the Minneapolis-St.Paul metro area since 2005 (data from here). For houses under $400k, they really dominate according to people I know in the business, but I wasn't able to get it broken out that way. In fact, I couldn't get much data from the FHA in general, as if they know what they are doing is dumb. FHA is the red slice of the pie.






Monday, August 09, 2010

Director's Law Repealed

An interesting issue is why doesn't the bottom 51% of a democracy simply expropriate the rich every couple of years. The Constitution is subject to considerable tendentious interpretation (the 10th Amendment, the right to privacy). In this video, Friedman states that it is a common myth to think the government takes from the rich and gives to the poor. He mentions Director's law--really an empirical tendency in the US circa 1960--that the rich and poor pay for programs to the middle class.



A bottom 51% coalition isn't effective because they are not as skillful at political activity: someone has to write the speeches, write initial checks, and those people usually are above average in economic standing. The top 51% would be a good coalition, but as the top 10% make so much money they are ripe for expropriating. Thus the most logical coalition in Friedman's argument is from the lower middle class to the upper middle class, feeding off the the very rich and very poor.

As depressing as Friedman's argument may be, there are worse things than tyranny of the middle class: a coalition of the elites with the lowest classes. We have legislators bestowing all sorts of sinecures, pensions, and welfare on the masses, creating a coalition of the unproductive, and they grow in popularity and power by granting more entitlements. The end game is bankruptcy.

We have replaced Say's Law--that supply creates its own demand--with the Liberal's Law--that demand creates its own supply. Thus, Krugman contemptuously ridicules Paul Ryan's proposed budget because it freezes discretionary spending in the future, as if this modest fiscal restraint is insane. How is this sustainable? In a private company, if you are losing money you cut until revenues meet expenses, whereas in government that's illogical via the sophistry of macroeconomics. All good liberals presume any spending (a component of Aggregate Demand) is a good idea in times of higher than average unemployment. What or how it is spent is not of any importance. The fact that debt is created is presumably irrelevant, because if the markets lends us the money, it must mean it's prudent. The thought of having government get out of the way to promote growth is considered stupid and mean.

So, we can increase the size of the Transportation Safety Administration even though they spend all day looking out for signs of the repeat of a crime that will not happen again anyway, a lot like the way our financial regulators analyze financial practices. They will look closely at arrow-heads in the pockets of 11-year old boys, as the did to my son recently who was taken aside and given a serious work-over for this transgression (he was literally crying during the interrogation). These do-nothings are not adding to our nation's wealth or safety, but they are creating permanent liabilities and voting union members.

If you read Roman history, you see the constant struggles between the patricians, equestrians, and plebeians, questions about who is considered a citizen, and finally the apotheosis of the Emperor. There was a general trend from an aristocracy that built the Republic, to the end where a god-like emperor ruled with the support of the masses who were placated with free grain and big coliseum events. It was a barbell strategy, and was unstable, always extending.

A cardinal mistake in the last expansion was to presume that merely because lenders would give home buyers money it was a good idea. Even after the defaults you hear people excuse the home buyer who put nothing down as if he's the victim (current muni-bond and sovereign debt salesmen take note). Similarly, the US is currently borrowing at record peacetime level, and the solution to our problem seems to have the government spend more. As anyone with some fiscal discipline knows, you don't buy something merely because you can, bills must be paid.

So, perhaps every society has a different optimal coalition at various times, and currently I don't see what will keep it from bringing everything down to the coalition of a few elites, sincerely deluded as to their belief in the virtue of government spending, combined with a vast entitlement mob at the bottom, all literally feeding off the middle class. It sounds a lot like South America.

Sunday, August 08, 2010

Brown Bears and Grizzlies


I would often go to Yellowstone park as a child, and my dad always prepared our campsites for bears by putting our food in a bag strung between trees so a bear could not get it. I also remember listening to various park rangers tell us what to do in the case of a bear contact. For black and brown bears, you want to stand still, look the bear in the eye, and make yourself look large. For grizzlies and polar bears, you want to play dead in a little ball with your hands around your head.


Now, my fevered 11-year mind quickly focused on the scenario where, facing a large, brownish bear I should either raise up like the Karate Kid or shrink into a human McNugget, depending on what type of bear it was. My response function was not robust to reasonable estimation error as bear ethnicities are probably indistinguishable when I'm pooping my pants in fear (brown right, grizzly left). Many things are like this, as when doctors say that margarine or butter, is worse for you; too much, or too little, self esteem is bad for teen-agers; the early bird gets the worm, the second mouse gets the cheese. It seems all great advice can be boiled down to one essential truth: Always--or is it never?--do X.

Thus I'm rather amused by the skewness avenue for fixing our empirical asset pricing mess (ie, what's the risk that begets higher expected returns?), as suggested by Campbell Harvey. The idea that people really like right skewed assets, like lottery tickets, options, and really volatile stocks, nicely explains why these assets have low returns: they give us so much pleasure when they hit a ten-bagger, we are willing to forgive the fact that they are eating a hole in our net wealth. Could be true. But as assets with really high right skewness have high volatility, then the question would always be, is this one of those high skewness-high volatility assets that people like because of its skewness, or don't like because of its volatility? Skewness are volatility are positively correlated. I guess analysts should love it because it explains everything without obviously saying so.

I really doubt the skewness story because it isn't robust. If people got an extra premium for buying assets with the 'bad' skew, a leftward skew as in bonds, then bonds should have pretty good return premiums, and they don't. Risky currencies,which have a leftward skew, do not have a demonstrable premium above assets without this skew. Utility stocks have historically had leftward skew because their returns are capped via regulation, yet they have not outperformed the market since data has been kept.

Thursday, August 05, 2010

A Wise Kid


Kids are often very clever, as IQ tends to peak about the same time their testosterone does. They just haven't the time to digest history, or how tactics relate to strategy in human groupings (often contrary to stated principles). So I was really impressed by Erica Goldson's valedictory speech given for a high school somewhere in America (Coxsackie-Athens High):

… I have successfully shown that I was the best slave. I did what I was told to the extreme. While others sat in class and doodled to later become great artists, I sat in class to take notes and become a great test-taker. While others would come to class without their homework done because they were reading about an interest of theirs, I never missed an assignment. While others were creating music and writing lyrics, I decided to do extra credit, even though I never needed it. … I have no clue about what I want to do with my life; I have no interests because I saw every subject of study as work, and I excelled at every subject just for the purpose of excelling …


I had brothers and a sister, and saw 4 years of high school valedictory speeches in a row, and learned that the eggheads who got straight A's were the trite, parent-pleasing dorks we all thought they were. I was class president a couple years, and remember giving standard speeches on how our bake sale to end poverty was really successful that year. In short, young adults are banal when asked to say something big and important.

This speaker, however, is wrestling with what should be the primary issue in every young person's life: what gives my life meaning? Victor Frankl's book Man's Search for Meaning is one of my favorites. It's a question that many never address directly but always wonder. I'm sure that whatever she does with her life, she'll be a mensch.

In contrast, the New York Times reports about a young man from a gifted school in NYC who lambasted the disparate impact in standardized tests (at Elena Kagan's alma mater, no less). His valedictory speech got a standing ovation from the school's faculty, which should be no surprise because seniors submit graduation speeches and a faculty committee selects one to be read. The faculty was congratulating itself on the bold idea that that geometry and antonym tests are biased (but not against Asians for some reason). The speech is filled with bromides and sanctimony ("We are playing God, and we are losing", "I apologize if this is not the speech you wanted to hear"). The kid is a tool for academic establishment cliches, and unfortunately, is being told that he's precociously authentic and wise. The line, "this is not the speech you wanted to hear" was chosen among many as the speech they wanted to hear, and no one seems to have noticed.

Read the girl's whole speech. It's not really profound--her classmates probably won't be great artists or musicians, 'slave' is a bit of a stretch--but it's genuine, and brings me back to what I was thinking, or should have thought, when I was 17. She quotes Mencken, and notes her 10th grade English teacher. It would never make the New York Times. Her parents should be very proud.

Update. Commenter Lance notes:
agree that most commencement speeches are laudatory BS, but the girl's speech is pathetic.

"The majority of students are put through the same brainwashing techniques in order to create a complacent labor force working in the interests of large corporations and secretive government, and worst of all, they are completely unaware of it".

The girl's speech is the usual "against the establishment" type drivel that just because they are not mentioned in high school speeches very often does not mean her insights are particularly profound.

Ack! I skimmed, and clearly didn't see that. I think it's important to know that 'industry' has no big coordinated strategy in some kind of capital-labor Marxian battle, and profit maximizing firms really want to hire thoughtful, bright, energetic, creative, people.

A Clean Desk


It's easy to clean a desk. Just wipe everything off the top and shove it in a drawer. But a truly clean desk is not merely organized on top, but below, where we can not see. Unfortunately, people forget to look deeper when looking at other metrics like employment. Presumably, if the government hires people that counts just as much as if private company does in our employment data. Indeed, for decades economists thought that one big advantage of the socialist economies was they were always using all their workforce, whereas the capitalist economies often suffered from inadequate aggregate demand and so operated at less than full employment. Yet it makes a big difference what a government worker actually does, as while many add value most do not, and they get paid either way.

I know someone who works for a small bank of about 10 people, and he was telling me about once a year, about 6 people from the FDIC come in for a week and go over their books. He says they work always with an eye on the clock, and if you are talking to them at 11:30, you can expect them to leave mid-sentence because they take breaks, show up and leave like union regulars. Of course, they don't highlight anything useful to the bankers, or society, in their annual exercise (remember, pre 2007 regulators were mainly critical that banks lent too little to historically underserved homeowners).

I know people who have jumped from industry to regulators and I don't see this as sustainable. These regulators are truly a zero, if not negative. Do you remember CAMEL ratings on banks? That was a way, after the Savings & Loan crisis of the 1980's, that regulators would identify troubled banks. It has always been a complete waste of everyone's time.

Washington D.C. has one of he lowest unemployment rates in the country. It is hiring a lot of people, many quite talented, and paying them well. It is also turning them into part of the overhead of this country without getting anything in return other than 'Keynesian stimulus'. Further, these people know their jobs aren't about producing anything useful. As the joke about faculty politics implies, people become mean and petty when the stakes are low. That makes for a stressful environment, because nothing causes more stress than working day in and day out at a place where nothing you do matters.

Tuesday, August 03, 2010

Why I Don't Want to Live Forever

In last weekend's NYT book review, Abraham Verghese reviewed Jonathan Weiner's Long for This World, a book about the science of immortality, primarily focusing on the English gerontologist Aubrey de Grey. It seems the book is a bankhanded slap, noting that
If biologists could have done for the dictators of the 20th century what they can now do for roundworms and flies — double their life span — then Mao Zedong might still be alive

Most people, like Mao, give it their best and are better off dead after 90 years. After that, they merely say the same things, and keep others from saying new things via their cult of personality. Further, people who are powerful at 83 tend to be evil, so mortality is especially useful for battling tyranny.

I like life, can't imagine being dead, and especially will miss not being able to share experiences with my children, and help them as best I can. I have no reason to believe in an afterlife, which many find reason to fight for more life at any expense. Yet, the thought of immortality really pains me. I see so many people develop a personality that after a while converges on some big idea, some routine in thought and behavior, it becomes not merely unhelpful to the world, but boring for the person and every thinking person around him. I rather respect the view of William F. Buckley, who not long before dying, said he was tired and didn't care to live much more. As Richard P. Feynman noted, he didn't feel like dying would be the end of him, because he has created so many memes, he would still be alive. That's a good attitude. During his death, proximally caused by kidney failure, his last words were 'I'd hate to die twice. It's so boring'.

I was reminded of this last weekend reading a couple of Reagan era bigshots discussing their big ideas. First, David Stockman had a Sunday NYTimes op-ed decrying Republican hypocrisy for not enthusiastically raising tax rates on the wealthy. Stockman became famous after a December 1981 Atlantic Monthly article, "The Education of David Stockman", based on lengthy interviews with famous liberal financial reporter William Greider. In it he pronounced great skepticism of supply side economics (lower taxes--> higher revenues). Clearly, his big idea is unchanged.

On the other side, Arthur Laffer, the guy who promoted supply side economics by showing, on a cocktail napkin, that theoretically at some point a higher tax rate implies a lower tax revenues by virtue of their boundary conditions, also had a prominent WSJ op-ed. In it, he said raising taxes would hurt the economy and tax revenues, just as he said in 1980.

Since 1980 total tax revenue as a percent of the US economy, has risen and then fallen to its 1980 level, while marginal tax rates have fallen for both income and capital gains. Total spending, meanwhile, is at record peacetime levels as a percent of GDP. Given the various Democrats and Republicans in charge of the White House or Congress, and business cycles, the cause and effect is not obvious. But clearly 30 years later, we are spending more, and government is getting about the same total vig at lower marginal rates.

Now, I tend like simple proofs and so a demonstration on a cocktail napkin is impressive, but that's besides the point. They both have had their say and they've said it. Thirty years after the fact, it is still the their only big insight that gets them top billing in the New York Times and Wall Street Journal. I am sure it will be in the second paragraph of their obituaries. We don't need another 900 years of that. They themselves will become bored saying it. Best to move on, let others reformulate their argument, and say it better or not at all.

I guess my big idea--one I've been told is wrong, obvious, and for a time, illegal--is that risk, however defined, does not beget higher returns--on average or rationally expected. I know the academy doesn't want to hear it, but also I don't want to say it over and over. Maybe, I'll come back as a bug and experience some unexpected pleasure by hearing someone proved my assertion using the Taniyama-Shimura conjecture (proven by Andrew Wiles), giving the faux-rigor that economic assertions need to influence academics.

Sunday, August 01, 2010

Crisis and Leviathan p. MCXLLII

1970 had one of the largest financial debacles since the 1930s. The top 10 computer, technology, and conglomerates stocks lost about 85% in 1969-70. The Penn Central Railroad company was a prominent issuer of Commercial Paper, and when they went into default many worried that companies that lent to them might go default as well, leading to contagion of default.

John Kenneth Galbraith once quipped there were two types of economists: those who don't know, and those who don't know they don't know. Yet early in 1970, Galbraith wrote a New York Times article drawing a series of parallels between the then current situation and that of 1929: excessive speculation, too much leverage, inflated investment funds, funds that invested in other funds, etc. He seemed to have granted himself an exception, implicitly forecasting another Great Depression (however, like all good prognosticators, without actually saying so, so he's never wrong). In any case, his diagnosis highlights that every recession make public minded people think: we shouldn't let this happen again!

In response to the crisis, congress created Securities Investor Protection Corporation, or SIPC. They used funds provided by the securities industtry to protect customers against losses when their brokers went broke. I think it's fair to say that the SIPC has been ineffectual. For that matter, so were the FDIC, SEC, OCC, OFHEO, the Fed, and state insurance regulars, each of which was born around some crisis of confidence, the idea that a committee of far-seeing technocrats in Washington would surely prevent the current cataclysm. The new Consumers Financial Protection Agency hopes to be more relevant primarily by having a broader mandate, but it's rather naive to think that a program that does not work, would work if only it had more on its plate.

As per Penn Central, it happened right after the venerable Pullman Railroad Company failed, and led many to believe that rail transportation would be dealt a fatal blow. In response Congress passed and President Richard Nixon signed into law the Rail Passenger Service Act. This gave government funding to assure the continuation of passenger trains. It also create Amtrak, a hybrid public-private entity that would temporarily receive taxpayer funding and assume operation of intercity passenger trains. Amtrak has lost money perpetually, and its onerous work rules created a bloated, inefficient industry that did not reverse rail traffic decline.

The new government-owned GM, and the new Consumer Financial Protection Agency are just more permanent government agencies of irrelevance, similar to previous attempts to rectify identical problems in the past.