Hold the Gloom. The Economy is Changing, not Dying

I've been working on some other projects recently, but I wanted to respond to some of the increasing darkness and pessimism about the future that is seeping into public discussion. Take this article in Commentary Magazine, "Our Miserable 21st Century," which attracted much attention this week.

It turns out that the year 2000 marks a grim historical milestone of sorts for our nation. For whatever reasons, the Great American Escalator, which had lifted successive generations of Americans to ever higher standards of living and levels of social well-being, broke down around then—and broke down very badly.

The warning lights have been flashing, and the klaxons sounding, for more than a decade and a half. But our pundits and prognosticators and professors and policymakers, ensconced as they generally are deep within the bubble, were for the most part too distant from the distress of the general population to see or hear it. (So much for the vaunted “information era” and “big-data revolution.”)

David Brooks reinforces the message in the NYT here.

 Of course, it's a good thing to highlight problems. Opioid addiction and people dropping out of the labor force to live on disability and daytime TV are serious issues.  

But the despair is not justified. Society and technology and customs and institutions are always changing. That means we have to be resourceful and creative in making the changes work for us. It means we have to change how we think and realize some major 20th century social institutions need to adapt as well. 

We might have said much much worse about the economy in 1820 or 1830, just before the world got an order of magnitude wealthier than ever before in the following decades.  Malthus told us the mass of the population would be immiserated and kept at starvation levels, forever. Engels noticed working life in Manchester was horrific. Marx argued this was inevitable and would lead to such pain and rage the whole social system would be overthrown. 

None of this came true. The economy didn't collapse. It went through a boom of  stupendous magnitude and duration.

Now the problem is too little dark satanic mills and too much uninspiring lower class leisure like daytime tv? 

The world got hit with two massive shocks in the last twenty years. 

1. Global labor supply effectively doubled in the 1990s, both because of the entry of China and India into the world economy and because logistics and communication made it much easier to use remote labor.  The impact of that hit the American working class. A shock of that magnitude takes time to absorb.
2. Most new innovations are free at the point of delivery (Github, Facebook, Dropbox ) or not excludable goods, like cleaner air. 

A Shift in the Boundaries of the Market

That means we are seeing a shift in the boundaries of the market economy. Relatively fewer things will be exchanged for money, because the marginal cost of many goods  will be zero and distribution costs will be near-zero. Automation and artificial intelligence will only accelerate that trend. 

The shift in the boundaries of exchange is also because most of the new needs people have as society gets wealthier - status, affiliation, stimulation, meaning - aren't as easily bought and sold as grain or port wine or mousetraps .  

That doesn't necessarily mean disaster, though.  Most human societies historically have always had a smaller market sector. The "commons" was larger. Gift exchange, feudal or hierarchical obligation, family ties or subsistence agriculture have been far more important than the labor market for most of human history.  Women  mostly didn't work in the moneyed sector at all until forty years ago.  Indeed, even England only became a fully market economy in the early 1800s when the old medieval commons were enclosed and labor forced off the land to the cities or colonies. And it was only the requirement to pay government taxes in currency that forced many groups around the world into the market economy at all. The current  bundle of rules that make up a "job" or "corporation" and legal framework and expectations that go with them are mostly only 150 years old at most, not eternal  facts of nature.

In 1800 over 95% of populations worked the land. Now in the US it's about 3%. We have more agricultural productivity than ever, by a massive margin. But it's less important to the whole economy and population. The same thing will happen to the monetized exchange sector of the economy. The goods and labor market will be more productive than ever,  but a smaller proportion of the whole. 

We have a motivational and moral problem, not an economic problem

But it takes a lot of time for culture and human institutions and values to catch up. (See Douglas North, for example, or Avner Offer's brilliant The Challenge of Affluence.)  The main issue now  for humanity isn't starvation. It's motivation and what makes for human flourishing and the good life.  (Probably not daytime tv and OxyContin.)  It's  very much as Keynes foresaw in his famous essay Economic Possibilities for our Grandchildren. 

We've now actually solved the original economic problem of raw economic scarcity, starvation and disease. The problem isn't 30% child mortality or famine, as for most of human history.  Survival is rarely the problem any more. Instead, it's purpose. It's value and reward and how people get respect. That's an institutional, social or moral problem more than an economic one, which is why many economists can't handle it.

That's an epochal shift. We just have to figure out what to do with it. 

Underperforming hedge funds (again)

More bad news for hedge fund returns, according to this NYT piece. A standard 60% equity/40% bond portfolio returned 90% over the last decade, compared with 17% after fees for a common hedge fund index.

The author finds some people just seem to want to pay higher fees for lack of transparency and hints about secret rocket science under the hood. People - and also pension funds. Two-thirds of the industry is now institutional money. But how long can that go on, if performance is so bad on average?

 

Double Entry and the Modern World

I read Double Entry: How the Merchants of Venice Created Modern Financeby Jane Gleeson-White last week, largely motivated by wanting to know some of the deeper reasons behind the surface apparatus of Quickbooks, which for various reasons I have to figure out soon.

It sounds like a dry subject. But the book is historically colorful, thought-provoking and well-written. Accounting numbers rule much of our lives and way of seeing the world. But they have a history and limits and flaws.

Measurement and capitalism

She tells the story of how Italian monk and mathematician Luca Pacioli in 1494 first wrote down the methods Venetian merchants had used to keep accounts, possibly for several centuries before that. The invention of double-entry clarified notions of cost and profit. According to some historians perhaps it led to capitalism itself.

In six pages Sombart set out his belief that the emergence of capitalism and the appearance of double-entry bookkeeping in the thirteenth century are causally related. He wrote: ‘It is simply impossible to imagine capitalism without double-entry bookkeeping; they are like form and content.’

Weber’s definition of a ‘capitalistic enterprise’ is derived from the concepts of double-entry bookkeeping: ‘a rational capitalistic establishment is one with capital accounting’. Like Sombart, Weber argues that double entry is significant because it makes possible an abstract measure of income and expenses—and therefore enables the calculation of profit, the key component of capitalistic business practice. Weber also believed that the formal rationality of double entry made the world a cold and disenchanted place—and, ominously, predicted that double entry would continue its rule ‘perhaps until the last ton of fossilized coal is burnt’.

The new double-entry methods caused a deeper change in perception:

He calls Pacioli’s treatise on double-entry bookkeeping ‘a major innovation in economic history’. First, because double entry provided the means of discarding all information extraneous to decision-making, leaving behind only numbers. And second, because it translated these numbers into a common measuring tool called ‘profit’, which allowed a relatively precise evaluation of actions. Double entry thus transformed business books from mere memory aids into records which allow the calculation of profit—and which can therefore be used to measure the success of each individual transaction and of a business generally.

But this did not come without a price.

We are now so familiar with this once innovative (and largely arbitrary) cost-benefit way of thinking that we take it for granted and cannot imagine it otherwise. And yet, as we shall see, this profit-driven way of thinking encouraged by double entry is not only driving managers to drink, academics to pull their hair out, politicians to short-term opportunism and most human beings to suffer in some way, but it is also destroying the world beneath our feet.

She argues that accounting is poorly suited to count environmental damage, for example. This is a problem when accounting has become central to the practice of policy and government.

National statistics

One of the main extensions of accounting is modern national income accounting. It is so familiar (at least if you have studied economics) that we forget how relatively recent it is. Keynes and Kuznets largely invented it, and both were skeptical about its use.

As a thinker of great depth and complexity who saw economics above all as a moral practice, Keynes was suspicious of statistics and considered these quantitative measures of the national economy as exceptional, emergency measures demanded by the times. In the budget speech which presented these accounts for the first time, the British Chancellor expressed the same view, stressing that the publication of official estimates of national income and expenditure should not be regarded as setting a precedent.

That did not stop a massive increase in the use of techniques which had proved useful during the war.

In 1952, very few statisticians were familiar with the theory and practice of national accounting. This would soon change irrevocably. The work done by Stone, Kuznets and others became the foundation of international accounting, and their national income statistics used to measure economic growth would soon become the key indicator of national success and government performance.

But even the main originator of much national income accounting was skeptical of its application.

But the accuracy and usefulness of national income measures have been questioned from the beginning, by Keynes and others, including Simon Kuznets himself. For example, Kuznets believed the national accounts should include the value of unpaid housework, despite the fact that including this vast contribution to the national economy would present statisticians with the difficult task of making monetary estimates of this valuable work. The US Commerce Department refused to calculate these estimates—and as a result Kuznets broke his association with the department in the late 1940s. Kuznets was also concerned about the effects on people’s lives of the modern economic growth that these statistics encourage as an end in itself.

GNP continues to be questioned as an adequate measure, most significantly recently in the Stiglitz-Sen-Fitoussi study.

Perpetual scandal

The numbers can often conceal as much as they convey, and we can mistake a false impression of precision for truth. The numbers sometimes are outright lies, for one thing. Accounting is also inseparable from scandals, she says, and always has been. People have not lost confidence in accounting despite failure to detect fraud or indications of problems on a litany of cases from Enron to Worldcom to RBS.

However, not only has no such fall ensued but it turns out that these accounting scandals are a regular feature in the landscape of accounting. They are as old as the profession itself, dating back to the earliest days of the formalised use of collective capital: the corporation. Corporations and accounting scandals go together like Gordon Gekko and greed. The nineteenth and early twentieth centuries are rife with corporate collapses of the magnitude of Enron’s and comparable in their elements. And they all stem from significant accounting misstatements orchestrated by influential senior managers. Equally, the responses of lawmakers and watchdogs have been the same over the past one hundred years: tinker around the edges of the law, found new watchdogs, proclaim a new era of greater scrutiny and let accountants and auditors out to play with the managers of vast sums of other people’s money.

We'll look at more tomorrow.

 

"Sure, Big Data Is Great. But So Is Intuition"

An NYT article is skeptical of inflated claims for Big Data:

The quest to draw useful insights from business measurements is nothing new. Big Data is a descendant of Frederick Winslow Taylor’s “scientific management” of more than a century ago. Taylor’s instrument of measurement was the stopwatch, timing and monitoring a worker’s every movement. Taylor and his acolytes used these time-and-motion studies to redesign work for maximum efficiency. The excesses of this approach would become satirical grist for Charlie Chaplin’s “Modern Times.” The enthusiasm for quantitative methods has waxed and waned ever since.

Big Data proponents point to the Internet for examples of triumphant data businesses, notably Google. But many of the Big Data techniques of math modeling, predictive algorithms and artificial intelligence software were first widely applied on Wall Street.

At the M.I.T. conference, a panel was asked to cite examples of big failures in Big Data. No one could really think of any. Soon after, though, Roberto Rigobon could barely contain himself as he took to the stage. Mr. Rigobon, a professor at M.I.T.’s Sloan School of Management, said that the financial crisis certainly humbled the data hounds. “Hedge funds failed all over the world,” he said.

The problem is that a math model, like a metaphor, is a simplification. This type of modeling came out of the sciences, where the behavior of particles in a fluid, for example, is predictable according to the laws of physics.

In so many Big Data applications, a math model attaches a crisp number to human behavior, interests and preferences. The peril of that approach, as in finance, was the subject of a recent book by Emanuel Derman, a former quant at Goldman Sachs and now a professor at Columbia University. Its title is “Models. Behaving. Badly.”

It really is a matter of proper scope, and consciousness of limits. Big Data is wonderful for finding the Higgs Boson among billions of particle paths, or tracking potential credit card fraud. It is not so good at many other tasks where the data is absent or incomplete or misleading. In those cases, it is little different from ancient farmers looking at the sky and seeing mythical animal patterns.

"More Heat than Light": the failure of modern economics

I'm going to turn now to Philip Mirowski's More Heat than Light: Economics as Social Physics, Physics as Nature's Economics, which is a quite devastating critique of mainstream neoclassical economics.

The heart of modern economics, he argues persuasively, was lifted wholesale from physics in the late nineteenth century. The trouble was that the main figures of the marginalist revolution, such as Walras, Jevons and Marshall, didn't quite understand all the math they imported into political economy.

The neoclassical founders almost all came from an engineering or natural science background. But they had a limited grasp of the state of the art of physics even at the time. Above all, says Mirowski, they failed to understand the importance of conservation principles in the math. To accurately measure change, something must stay the same. That means most of the edifice of neoclassical economics is based on stale physics contaminated by basic errors.

 

Substance and fields

What happened was basically this. Natural scientists struggled in the early nineteenth century with ideas of heat and motion, imagining fluids or ethers or substances. By the 1870s, that had given way to a unified view centered on energy, and the conservation of energy as it was transformed from one kind to another. Instead of fluids or other kinds of substance, physicists now thought of fields and forces, and worked out the vector math of kinetic and potential energy.

The heart of neoclassical economics, says Mirowski, is that economists replaced energy with utility in the same equations, and lifted the framework wholesale. The marginalist revoluton paralled the revolution in physics in preceding decades. Classical economists saw Value as a substance, such as the equivalent of wheat for the physiocrats or the labor theory of value for Ricardo and Marx. But for neoclassicals, Value was a field, like electromagnetism in physics. Kinetic energy was essentially spending and income; potential energy was utility.

He quotes several of the major marginalists who explicitly acknowledged that this is how they thought. But later economists mostly forgot these origins. The discipline has never been that historically self-conscious.

There were two main problems with all this, however. First, without a conservation principle, the math didn't work. Conserving energy implied income and utility were a constant - so essentially the same thing. That would mean utility would be superfluous as a separate measure to money, which was not at all desirable. The point was often lost in a technical debate about "integrability". Leading physicists tried to explain the point to economists, who appeared to have been mostly baffled and nonplussed at the argument.

Secondly, physics moved on from its 1870-vintage "proto-energetics" state, as Mirowski termed it. The second law of thermodynamics implied entropy was always increasing, so interactions were not easily reversible. Special relativity, general relativity and quantum theory all upset the mechanical "Laplacian dream" of 1870s physics, bringing frames of reference, probability, indeterminacy and the role of the observer into the picture. Symmetries and conservation principles could be broken. Matter could decay. Particles could pop in and out of existence. In contrast to notions of inherent "scarcity", the whole universe might be a "free lunch", something which came from a temporary variation in nothing.

None of these could easily be incorporated into the neoclassical framework. However, economists insisted all the more stridently that they were pursuing disciplined science, in contrast to sociologists or anthropologists, while actual scientists were increasingly doing something quite different.

As long as the Laplacian Dream was their dream, they clutched neurotically at their portrait of persons as irrotational mental fields suffusing an independent commodity space, as science ebbed ever further away toward a world subject to change, diversity and indeterminacy, and at one with the observer. P275

And the outcome?

In brief, the practical dissolution of the energy concept in advanced twentieth-century physics has painted neoclassical economics into a corner. p388

Mirowski wrote the book in 1989. Of course, the metaphor of utility as (potential) energy looks even more strained today. We now know that the visible universe of 1870s physics is only 4% of the universe. The rest is dark matter and dark energy that we cannot as yet observe and don't understand.

So what? Some mainstream economists concede to his argument about the origin of the neoclassical model, notes Mirowski, but they claim it is not relevant to the subsequent evolution of the discipline.

But it is. They still want the appearance of science, while being stuck with a model which is increasingly divergent from science in reality, he claims. To talk about analogies to entropy, said Samuelson, for example, is always the mark of a crank. But Mirowski points out that Samuelson frequently published articles with tenuous links to physics himself. Indeed, the key to Samuelson's career was maintaining the appearance of scientism.

Economists have produced various ad-hoc conservation principles in the twentieth century, according to Mirowski, "but in the final analysis this is all one big shell game, with the offending conservation principles passed from one assumption to another." p274

 

Production

The metaphor of utility as an energy field is too embedded to be given up by neoclassical economics, he says The trouble is it is also a metaphor of instantaneous exchange, and as such it has proved consistently difficult to reconcile with production, which had been the focus of classical economics. Classical economics thought that value was created in production, circulated in trade, and consumed in consumption. Neoclassical economics was focused on exchange, and found it hard to explain production at all.

That inconsistency explains a proliferation of production functions in postwar economics, and difficulties with temporarily and the existence of firms through time.

Economists have effectively tried to reinvent a substance theory when it comes to production, says Mirowksi. But this is bound to be inconsistent with utility as a potential energy field. So the profession has not been able to settle on a satisfactory answer.

The situation was embarrassing, but no neoclassical was willing to come right out and say that production was superfluous or irrelevant in their scheme of things. (Lionel Robbins came the closest). p272

Scarcity

There are also implications for scarcity. The idea of scarcity as the heart of the economic (and human) condition was largely an artifact of the neoclassical approach, he says.

Prior to that time, scarcity as some sort of primordial state of mankind did not play any signficant role in the value theory of classical political economy. Only with the dominant impression that Nature enforced a general state of dearth, say, rather than the physiocratic notion of Nature's bounty, could it become possible to even think of economic equilbrium as a state of psychological counterpoise, hemmed in by the urgent necessity to clear markets in a state of stringent limitations. p240

This caused obvious problems.

The metaphor of utility as potential energy was predicated upon a Weltanschauung of a closed, bounded system that exemplified the natural state of mankind as enduring ineluctable scarcity. If and when production was to be introduced into this morality play, it had to be done in such a way as to prevent the contravention of the scarcity principle, all the while maintaining the field theory of value. p293

Of course, I think this is fascinating given I think one of our main challenges now is thinking through the implications of abundance.

Keynes, he says. succeeded in introducing a kind of value substance in the guise of "national income". That allowed the idea of an economic process to be reintroduced. There has been an immense effort in recent decades to link macro with rational choice "microfoundations." But this is doomed to failure, says Mirowski.

Keynes generated a theory of an unstable economic process by the instrumentality of his reversion to a substance theory of value, a tactic that allowed the joint conceptualization of production, growth and the passage of time in (relatively) internally consistent manner. In contrast, it is the avowed intention of the microfoundations school to renounce all value substances and to recast all macroeconomic analysis in the format of production and utility fields. It is precisely this choice that prohibits the logical modeling of process in priduction, in growth, and in exchange, as explained earlier in this chapter. The field metaphor cannot represent a circular economy where outputs become inputs and so on, ad infinitum. It cannot specify precisely what it is that grows in an economy. p346

Fields are just not suitable when time is involved.

.. the formalism of the field is useful only in cases where one can safely abstract away all considerations of process and the passage of time. p346

Utility

Mid-twentieth century neoclassical economics would have found an alternative to utility if it could, he says. The mainstream forgot how widespread concern about utility had become in the profession before the second world war. Mirowski quoted Viner as saying economists' understanding of utility was comparable to "the knowledge of heat prior to the discovery of the thermometer." It could not be satisfactorily measured. There had always been concern at how locating value in a purely mental framework came close to idealism or solipsism.

The development of the indifference curve approach and Samuelson's theory of revealed preference were not durable responses, either, and only served to obscure the origin of the utility metaphor. Revealed preference was not empirically tractable, for one thing, and confused preferences and behavior.

In the absence of the metaphor of utility as nineteenth-century potential energy, there is no alternative theory of value, no heuristic guide to research, no principle on which to base mathematical formalism, no causal invariant in the Meyersonian sense, and most threatneing, no basis for the claim that economics has finally become scientific. p368

So what does this lead to? There is, Mirowski says, no scientific method that can guarantee economics' scientific status.

This lesson is the legacy of the decline of positivist philosophies of science in the late twentieth century. Juxtapose this fact with the hypothesis that economic research has always met with the greatest difficulties in establishing the credibiliy of its results and fending off charges of charlatanism and quackery. p357

It is hard to revise the neoclassical framework without undermining it. New approaches do not have that problem. This means, he says, neoclassical economics will be vulnerable to new contenders for the role of social physics.

Theories of Value

And is there an alternative theory of value? Mirowski says there are two main alternatives. One is to deny any separate value, rarely advocated, but as represented by someone called Samuel Bailey (who I have never heard of).

This position argues that no economic phenomenon is conserved through time, and therefore scientific analysis is impossible. Whatever one might think of the truth of this option, it should be clear than the nihilism inherent in the program assures that in this instance there can be no legitimate research program called economics. p400

The other alternative is a "social theory of value", he says, based not on scientific or social metaphors , but in social institutions such as accounting conventions or property rights.

I doubt myself whether this is true. I imagine evolution is the main contender for an alternative scientifc framework, together with the notion of adaptability and "fitness" of some kind or another.

Conclusions

Overall, it is a very bracing read. It seems, at least to me, highly persuasive - but I would want to read some reviews and responses to make sure I am not overlooking flaws in Mirowski's own analysis. .

What it underlines is that utility and scarcity were chosen not so much because of their psychological or social accuracy, but because the math "worked". And if the math worked there was more scientific respectability. I have always had the firm impression that this was the driving force of major parts of the discipline, which is likely the main reason I did not become an academic economist. It did not ring true. It was about the aesthetics of models rather than genuine insight. It was about a particular quasi-religious view of rationality rather than solving problems.

The book is also highly illuminating , not to say shocking, about the origins of utility in modern economics. I've often talked before about how ethical theory went off the rails in the eighteenth and nineteenth centuries, dropping the older tradition of the virtues and the good life for a more utilitarian, neutral and welfarist approach. Mirowski excavates a much deeper layer of intellectual history underlying current economics. It was not a matter of an import from Bentham. It was an import from physics, and just more or less happened to be called utility.

The metaphor of potential energy as a utility field locked economics into an increasingly less productive path for a century - and to a large extent still does. I knew most of the arguments about indifference curves, production functions and revealed preference, of course, but I was much less familiar with the intellectual history of the arguments. It is fascinating. And disturbing.


Perhaps most of all, it shows how value theory is the great unsolved problem at the heart of economics. That is what I have been grasping toward in my own terms on this blog. To understand the future of the economy , we have to be back up into ethics and the question of the good life and human flourishing. That, after all, is the only place a valid notion of value can come from.

 

Shaking the British Establishment

It's interesting that Canadian Mark Carney has been appointed Governor of the Bank of England. Carney is very able. But it is a huge blow to BoE insiders like Paul Tucker, who had spent twenty-five years specifically working very are to get the top job someday.

Interestingly, it is a sign of much deeper disarray and loss of confidence in the British economic establishment. From the Guardian:

Rachel Lomax is practically the definition of establishment: Cheltenham Ladies' College followed by Cambridge and the LSE; principal private secretary to then-chancellor Nigel Lawson; deputy governor of the Bank of England for five years until 2008. Which makes what she said on Friday evening all the more startling.

This being a debate on the future of capitalism in the People's Republic of Bristol, the audience were satisfyingly radical – but Lomax was just as bluntly and disarmingly political. The former Treasury mandarin made no bones about admitting that she had been part of a project of "dismantling a version of capitalism" and replacing it with "Anglo-American neo-liberalism". You'd struggle to get scholars of Thatcherism to speak with such straightforwardness, but here it was coming from one of the era's key backroom players.

And now this co-architect of Britain's economic model as good as admitted that the system she had helped create was broken. But Lomax had one question: "Where is the revolutionary thinking?"

You surely couldn't ask for a better measure of the economic mess we're in, that even members of the establishment are now calling for revolution.

Striking as it is, such despair isn't exceptional. Indeed, it now appears endemic among the policy-making elite. Whether you look at Westminster or Threadneedle Street, Britain's economic officials reek of policy fatigue – of having riffled through all the pages in their textbooks without getting a good answer.

That also exists here in the US.

 

Futility and stock-picking

Active managers have had another bad year, says CNBC. Traditional stock-picking and bottom-up analysis doesn't work any more.

 

Just as in 2011, only about 1 in 5 active managers are beating their benchmarks in a year marked by the same type of headline volatility caused by events in Europe and fiscal concerns closer to home.

While the advantage of passive over active is nothing new, the near-record level of futility is, and the cracks are beginning to show.

[...]

"The market is being driven by macro factors," Flam said. "So most professional advisors have a background in evaluating companies, industries, economies. It's not in politics, and politics is what dominating the markets over the last couple of years."

Political factors are about decisions and perception, not ratios.

Overfitting models

We're looking at Nate Silver's The Signal and the Noise: Why So Many Predictions Fail-but Some Don't, starting here. Silver discusses some of the inherent problems and mistakes people make with statistical models.

One of the most important is overfitting.

The name overfitting comes from the way that statistical models are “fit” to match past observations. The fit can be too loose—this is called underfitting—in which case you will not be capturing as much of the signal as you could. Or it can be too tight—an overfit model—which means that you’re fitting the noise in the data rather than discovering its underlying structure. The latter error is much more common in practice.

It can lead to serious problems.

 

As obvious as this might seem when explained in this way, many forecasters completely ignore this problem. The wide array of statistical methods available to researchers enables them to be no less fanciful—and no more scientific—than a child finding animal patterns in clouds.* “With four parameters I can fit an elephant,” the mathematician John von Neumann once said of this problem. “And with five I can make him wiggle his trunk.” Overfitting represents a double whammy: it makes our model look better on paper but perform worse in the real world. Because of the latter trait, an overfit model eventually will get its comeuppance if and when it is used to make real predictions.

This is one of the great stories of financial markets. People are forever trying to come up with the equivalent of quantitative alchemy to transform historical data into gold. It is quite easy to tune a model so it performs very well on past data, and marches undulations with surprising precision. And it is amazingly easy to lose your shirt when the model goes awry when used to predict where the market will go next.

 

Signal, Noise and Prediction

I'm now going to turn to Nate Silver's new book, The Signal and the Noise: Why So Many Predictions Fail-but Some Don't. Silver is the well-known political forecaster who parlayed his blog FiveThirtyEight into a prominent spot in the New York Times.

I didn't expect much when I bought it. I thought it would be one of those "my quantitative model explains the universe" books (and investment funds) which are so tiresome and common. The world, and especially the markets, are filled with quants who think all you need is Mathematica and some back issues of Econometrica to explain everything. They are usually overconfident, expert on code rather than decisions,and tend to blow up spectacularly like LTCM given time.

Nothing could be further from the truth in this case. The book massively exceeded expectations and turns out to be a thoughtful, mature and reflective. It is consistent with much of my experience and thinking, but I still learned a lot of things I didn't know. It's also fluent and well-written. I'd recommend it without hesitation, and I'll look at it in some detail.

The crux of the book, from someone known for his number-crunching models, is that there is no such thing as objective data-driven models, at least in human affairs.

The numbers have no way of speaking for themselves. We speak for them. We imbue them with meaning. Like Caesar, we may construe them in self-serving ways that are detached from their objective reality. Data-driven predictions can succeed—and they can fail. It is when we deny our role in the process that the odds of failure rise. Before we demand more of our data, we need to demand more of ourselves.

The more information we have, the more we tend to screen out that which does not match our preconceptions. More information most often makes us narrower rather than wiser.

Alvin Toffler, writing in the book Future Shock in 1970, predicted some of the consequences of what he called “information overload.” He thought our defense mechanism would be to simplify the world in ways that confirmed our biases, even as the world itself was growing more diverse and more complex.

Information is no longer scarce, but much of it is not very useful.

Our biological instincts are not always very well adapted to the information-rich modern world. Unless we work actively to become aware of the biases we introduce, the returns to additional information may be minimal—or diminishing.

This does not mean we should just give up, or adopt lazy relativism. Instead, everything is approximate.

Some of you may be uncomfortable with a premise that I have been hinting at and will now state explicitly: we can never make perfectly objective predictions. They will always be tainted by our subjective point of view. But this book is emphatically against the nihilistic viewpoint that there is no objective truth. It asserts, rather, that a belief in the objective truth—and a commitment to pursuing it—is the first prerequisite of making better predictions. The forecaster’s next commitment is to realize that she perceives it imperfectly.

So what are the causes of failure to predict outcomes?

The most calamitous failures of prediction usually have a lot in common. We focus on those signals that tell a story about the world as we would like it to be, not how it really is. We ignore the risks that are hardest to measure, even when they pose the greatest threats to our well-being. We make approximations and assumptions about the world that are much cruder than we realize. We abhor uncertainty, even when it is an irreducible part of the problem we are trying to solve.

Indeed, experts have a particular tendency to ignore threats to their expertise. The rating agencies, for example, did not think through the possibility that default risk of various CDOs and CDO tranches might not be independent and uncorrelated.

The possibility of a housing bubble, and that it might burst, thus represented a threat to the ratings agencies’ gravy train. Human beings have an extraordinary capacity to ignore risks that threaten their livelihood, as though this will make them go away.

Our expectations about the future are riddled with blind spots, as anyone who has ever really thought about the policy process or had to predict events for a living - and been held accountable for it - knows.

We'll look at some other aspects of the book in more detail.

 

Radical Monetary Reform

This is an interesting development - highly radical monetary reform proposals from two staff economists at the IMF. The often excitable Ambrose Evans-Pritchard writes about it in the Telegraph.

The IMF paper, which apparently came out in August, argues for a renewed look at a "Chicago Plan" which Irving Fisher put forward in 1936. It required 100% reserve backing for bank loans, thus eliminating the ability of banks to create credit. And that, IMF authors Benes and Kumhof argue, would eliminate much of the volatility of the business cycle, eliminate the possibility of bank runs, and dramatically reduce both public and private debts. It would not be inflationary, and it would boost output by 10%. They claim they can demonstrate this with a DGSE model in a way which Fisher never could.

This shows just how disillusioned the wider world has become with the banking and financial system. The IMF staff has always had some variety of viewpoints - and of course this is very strictly speaking the view of the authors, not the institution - but it is still hard to see the folks on 19th St NW producing something like this ten years ago.

Would it work? It essentially replaces a largely private money system with a 100% government money system. Fractional reserve banking means that right now a bank only has typically 5-10% of "money" - mostly central bank reserves - underpinning the rest of the asset side of the balance sheet, which is bank-created credit.

In our current system, a bank creates money by issuing a loan, and crediting the borrower with an offsetting deposit at the same time. ( eg if Citibank lends you $10,000, it has a $10,000 loan as its asset, and you have an additional $10,000 in your deposit account to spend). The proposal would stop banks creating money, because they could only re-loan reserves from the central bank.

The problem, of course, is that money systems can be too inflexible, too rigid as well as too volatile. This most often shows up in exchange rate policy. The gold standard had fixed exchange rates (but freer credit). However, it still forced international adjustment by inflation and deflation of the price level, because gold was the fundamental reserve asset, not central bank fiat money. "Ye shall not crucify mankind on a cross of gold", William Jennings Bryan famously said.The euro is a prime contemporary example of the problems monetary inflexibility can cause.

The "Chicago Plan" would require policymakers to carefully calibrate the supply of reserves, and if they did not there would be serious problems. Of course, many economists think rules rather than discretion is better for policy in any case, as the track record for discretionary monetary policy is mixed at best. So making policymakers stick to a rue or money growth might be a good thing.

The plan would not necessarily imply government would allocate loans , or choose specific winners and losers. Banks could still lend to whoever they wanted, but they could not create money at the same time. the lack of leverage would cripple bank profits, however.

There might be more role for equity based venture investors in such a system, offsetting some of the credit supply. And the reduction of government debt looks very attractive in current circumstances.

Patience with banks is wearing thin. Policymakers are clearly very frustrated that they are launching massive balance sheet expansions like QE3, but the transmission mechanism to convey that liquidity to the real economy seems to be blocked in the banking system. The banks generally claim that it is because there is less demand for loans, not their reluctance to lend. But whatever the cause, the Fed, BoE and others are not getting much traction. Cutting out the middleman becomes more attractive, at least in theory.

Clearly the financial system would fight this to the death, as it would remove most of the profits in the industry. But radical as it is, perhaps it deserves serious scrutiny as a plan - if only as a device to hold over the banks. Our system does seem to have an inherent bias and drift towards debt, both private and governmental.

Perhaps we need a better system of money creation calibrated to create flourishing in society rather than simply credit. The legitimacy of the current system has been shaken by the crisis, and much of the intellectual confidence of mainstream economics has been eclipsed. I'll read further reactions to the plan and examination of potential flaws with interest.

 

 

More pain at hedge funds

A major trader at Moore Capital decides to get out.

Moore Capital Management LLC’s Greg Coffey is calling it quits amid markets that have proved difficult for even the most nimble hedge-fund investors.

Coffey, who has lost money for clients in the past two years, follows other high-profile hedge-fund managers to step away from trading as Europe’s sovereign-debt crisis and concerns over global economic growth roils markets. Chris Rokos, 42, a co-founder of Brevan Howard Asset Management LLP, retired to “pursue his personal interests,” the London-based firm said in August. Billionaire energy trader John Arnold, 38, former Morgan Stanley co-president Zoe Cruz, 57, and oil trader Pierre Andurand, 35, shuttered their hedge funds this year.

The industry has matured and the easy money is largely gone. It's now more a game of the management fees - the '2' in the '2 and 20' standard deal of 2% of assets and 20% of gains.

The coming Japanese crash?

Here's a very gloomy take on the economic outlook. Simon Johnson, former chief economist at the IMF, and a colleague predict Japan is heading for a vast crash.

The euro zone is well down the path to severe crisis, but other industrialized democracies are hot on its heels. Do not let the euro zone’s troubles distract you from the bigger picture: we are all in a mess. Who could be next in line for a gut-wrenching loss of confidence in its growth prospects, its sovereign debt, and its banking system? Think about Japan.

Traders have lost their shirts for a decade shorting JGBs, ie predicting a crisis in Japan. It hasn't happened. But long delays do not mean the problem could come with a major bang.

The problem is systemic. Easy debt facilitates bad behavior.

Bankers and politicians seem to enable the worst characteristics and behaviors of the other. The past few years have led us to focus on half of that phenomenon: the degree to which government guarantees have facilitated irresponsible risk-taking on Wall Street. And this is, of course, an issue that demands continued attention.

But Japan illustrates the other half of the phenomenon—the extent to which finance has allowed and encouraged politicians to make attractive short-term decisions that are eventually damaging. This may ultimately yield worse crises than the one we faced in 2008 or the one now unfolding in Europe. Greece, Ireland, Portugal, Spain, and Italy found their own ways to economic devastation, but each road was paved with easy credit. Those whom the gods would destroy, they first encourage to borrow cheaply.

China is looking wobbly too. It is always hard to tell the next step in a crisis, however. Often the loudest voices of panic come at the trough.

What is clear and a sure thing, however, is we are not finished with turbulence yet.

(H/t Via Meadia)

 

 

Faster than Common Sense

Here's a very good article from Wired on high-frequency trading.

Trading increasingly is an end in itself, operating at a remove from the goods-and-services-producing part of the economy and taking a growing share of GDP—twice what it did a century ago, when Wall Street was financing the enormous industrial expansion of the economy. “This is counterintuitive, to say the least,” wrote New York University economist Thomas Philippon in an article for the Russell Sage Foundation. “How is it possible for today’s finance industry not to be significantly more efficient than the finance industry of John Pierpont Morgan?”

I just don't believe that more than a few algos can really make consistent money out of exploiting market mispricing and anomalies. It's more flaws in the structure of the market itself. This is all making the case for a Tobin Tax look stronger.

The Cult of Equity?

Bill Gross, not coincidentally the world's largest bond manager, at the worst time in the cycle to hold bonds, thinks future equity returns will be terrible (although long-term bonds will also be terrible.)

Together then, a presumed 2% return for bonds and an historically low percentage nominal return for stocks – call it 4%, when combined in a diversified portfolio produce a nominal return of 3% and an expected inflation adjusted return near zero. The Siegel constant of 6.6% real appreciation, therefore, is an historical freak, a mutation likely never to be seen again as far as we mortals are concerned. The simple point though whether approached in real or nominal space is that U.S. and global economies will undergo substantial change if they mistakenly expect asset price appreciation to do the heavy lifting over the next few decades. Private pension funds, government budgets and household savings balances have in many cases been predicated and justified on the basis of 7–8% minimum asset appreciation annually. One of the country’s largest state pension funds for instance recently assumed that its diversified portfolio would appreciate at a real rate of 4.75%. Assuming a goodly portion of that is in bonds yielding at 1–2% real, then stocks must do some very heavy lifting at 7–8% after adjusting for inflation. That is unlikely. If/when that does not happen, then the economy’s wheels start spinning like a two-wheel-drive sedan on a sandy beach. Instead of thrusting forward, spending patterns flatline or reverse; instead of thriving, a growing number of households and corporations experience a haircut of wealth and/or default; instead of returning to old norms, economies begin to resemble the lost decades of Japan

I don't quite get his argument. The long run return from stocks is a combination of profit income - the share of corporate profits in the economy, including dividends - plus capital appreciation. It is not just the economy's growth rate in isolation.

In any case, pronouncements of the death of equities usually tend to be a buy signal for stocks. In the longer run, I think we could see more legal and institutional change in the nature of the economy that affects stocks, but that is likely decades off.

Hedge fund pain

This is a sign of the times in the macro world. Louis Bacon is nonplussed and returning some cash to investors.

 

LONDON -- A hedge fund titan has decided to return a large sum of money to investors, a revealing illustration of how dried-up markets, vicious volatility and a paralysis of ideas all borne of the crisis in Europe have been particularly hard on the traders who swing for the fences on currencies, stocks and bonds all over the world.

Louis M. Bacon, who together with Paul Tudor Jones and George Soros has come to define this style of high-stakes macro investing for more than 20 years, said in a letter to his investors on Wednesday that he would be giving back $2 billion, about one quarter of the size his benchmark Moore Global Investment fund.

He cited 18 months of what he called "disappointing" investment returns -- and a particularly tough second quarter this year when his main fund was down 3.18 percent.

 

Lie-BOR!

Ha! It's now the Lie-BORgate scandal. Clever.

 

The LIBOR scandal grows

Barclays boss Bob Diamond has been forced out this morning, as the LIBOR scandal continues to pick up momentum (at least in the UK).

Every CEO of a major bank is going to be having a queasy feeling this morning. It's probable many other major institutions were doing the same thing. Charles Schwab filed a lawsuit last year accusing JPMorganChase, Citi and Bank of America of doing the same thing, not to mention Credit Suisse, Deutsche, RBS, HSBC, WestLB and UBS.

Expect a blizzard of other lawsuits, including from consumers, US states, and shareholders alleging negligence. The question is whether there will be criminal as well as civil prosecutions in some jurisdictions.

There could also be difficult questions about the role of Paul Tucker of the Bank of England in Parliament today. It just does not seem believable that the Bank would encourage any distortions, however.

 

Macro dominates

This CNBC story says risk appetite and macro trends are so dominating markets there may be no future in covering individual stocks.

With markets continuing to move in lockstep to every headline out of Europe, China or the Fed, the days of individual stock analysts may finally be numbered. ..

To be sure, many investors said that markets can't move forever on the whims of central banks. At some point in the future, individual stock picking and research is bound to matter again.The question is, how long will that take? Investment banks and boutique firms can't keep low-margin research businesses going forever, especially with the proliferation of free content on the Internet.

 

This has been a trend for a while, of course, since the Spitzer research settlement. What is still surprising is that the same thing is not happening more actively to quants. After all, most quant funds turned in horrific performance during 2008-10.

The field is effectively commoditized. There may be room for one or two players with superior quant techniques. But it's hard to see how most players have any sustainable advantage running algorithms and mining high frequency data or econometric series. If everyone has physics PhDs playing with Mathematica, then there's no extra edge, and no point to having thousands of people do it. The market becomes completely efficient in that respect.

 

 

Punish bankers like rioters, says the Guardian

The liberal Guardian actually finds a crime where the individuals are not just engaged in a desperate cry for help.

 

Even if he hasn't yet debased the coinage, Bob Diamond has certainly done his bit to debase further the language of British public life. Confronted with a clear ruling that Barclays traders had lied and cheated in seeking to rig a key interest rate used to determine everything from mortgages to credit card bills, Diamond put his hands up and conceded that the traders' action had been "wholly inappropriate".

Inappropriate? Inappropriate is wearing a tie to a barbecue. Wholly inappropriate is burping during the wedding vows. Distorting for personal gain a rate that underpins contracts worth $350 trillion worldwide is rather more than "inappropriate".

 

The Moral Roots of Crisis

The LIBOR scandal is getting plenty of attention in Britain, but most of the American media haven't figured out yet how much it means for average US borrowers. Floating rates tend to be linked to dollar LIBOR, which is a number as close to the heart of finance as you can get.

The British banks are also reeling from other new scandals about ripping small businesses off with inappropriate interest rate swaps, and a huge breakdown in RBS's payment mechanisms. The press is full of stories like couples having to cancel their honeymoon because the bank incompetently did not clear the money in time.

This is all also stirring some deep moral angst. Here's a former archbishop of Canterbury sensing that something much deeper has gone wrong morally. This is interesting.

You might think it ill-behoves a retired Archbishop to comment on economic matters about which I have no expertise, but the banking crisis is not merely a matter for the markets. The banking sector is an important part of the network of institutions which build a civil society.Thus evidence of corruption in our banks, and the resulting collapse of public trust in them, affects our very democracy.

It is not an exaggeration to say that the sort of widespread alienation we are now witnessing among the public towards these multi-billion-pound behemoths can lead to civil unrest.

And it is not just banks in which public confidence is at an all-time low. For over the past five years, we have witnessed an unprecedented public crisis in the great pillars of state: the banks, the police and Parliament.

Why? Because in more and more cases, naked greed seems to have been the driving force for many self-serving individuals in these institutions. That said, the real crisis we are facing is not a financial but a moral one. And it is a direct result of the something-for-nothing culture which is poisoning our society.

Western elites don't just look greedy and self-serving. They look like failures. The euro crisis is another example - largely self-inflicted by pro-integration elites.

In many ways the crisis genuinely isn't a matter of economics, but of ethics and behavior. The Archbishop is right.

That doesn't mean a populist response is justified. Property speculation and unsustainable pensions and welfare came from broad popular enthusiasm.

Is it just another cycle? Societies tend to go through periods of laxity and sternness. Or sometimes they lose their powers of self-renewal.