Endowment Effect II

So I had a nice discussion about probability distributions concerning ideas. Unfortunately I failed to make a sufficient connection to answer the question.

How would a method of more accurately accounting for the truth of our beliefs counteract the endowment effect?

Normally when considering the probability of alternatives there are two keys parameters: 1.) probability of outcome's occurrence 2.) magnitude of gain or loss given the outcome's occurrence. In this way widely different "projects" become tradeable. For example, I have $100,000. I am proposed an investment opportunity in the stock market with a 5% chance of earning a 100% and a 95% percent chance of earning 0%. The expected payoff for this investment is simply calculated [.05*($100,000*1.0) + .95($100,000*0.0) = $5,000]. One could compare this opportunity with say an investment in alpaca farms. Let's say this opportunity is expected to yield $20,000 during the same time horizon. Although these are wildly different projects, they are tradeable in the sense that they are alternatives.

In the market of ideas, the value of ideas don't appear to be tradeable. Ideas are limited to the topic, within the topic they are tradeable, cross-topic tradeability doesn't hold. So we have millions of topics (could be policy issues, philosophical questions, scientific inquires, etc) and within each topic are alternatives. Each alternative could theoretically have a truth probability. Hence the only value ideas hold are their truth probability. We could conceivably multiply this probability by some measure of the value of the topic in general, which would enable cross topic idea rankings. But that is not the subject of our inquiry. We are concerned with the appropriate level of confidence in our idea's truth concerning a specific topic.

Back to the endowment effect. What the endowment effect means in this context is that ideas that are "owned" are given too great of value. Hence, their truth probability is ratcheted up too high. My argument is for a method that more accurately understands truth probabilities. I do not attempt to counterbalance the bias but instead hope to improve the mechanism causing the error.

Often I find myself falling into the trap of discrete thinking towards ideas. Either and ideas is "right" or "wrong." 0% or 100% probability. When in reality nothing is so cut and dry, especially on complex issues. This flaw seems a natural shortcut for the mind and may be behind the endowment effect in ideas. (Although we certainly haven't proven there is such an endowment effect, and given its different features it may deserve a different title.) If we can learn to think probabilistically, instead of in all-or-nothing terms, we may realize greater rationality in the domain of ideas.

Endowment Effect

The endowment effect is one of many cognitive biases recognized by the behavioral camp of economics. I like the name "ownership bias" better (I think its clearer). In short, the ownership bias results in the placement of greater value in goods that are owed as opposed to ones not owned, but rather out in the marketplace somewhere.

My question is: can this bias be applied to ideas?

Well, first of all, how can we "own" ideas? I'll define the ownership of an idea as the state where an individual moves beyond a stage of fact gathering and has reached a conclusion on the relevant issue.

The consequences of such a bias would be that the individual no longer views all ideas fairly, but disproportionately values the ideas in which he has determined to be "correct" in the past. Such as state would pose a dilemma regarding the individual's hopes for rationality in the consideration of alternative ideas.

Obviously, I haven't tested this. Nor have I checked for similar concepts throughout prior literature. On merely intuitive grounds it seems to make some sense. Observationally, it seems that people exert resistance to changing their minds (of course the variance in resistance must be massive concerning different types of issues). Also when a mind is confronted with unfalsifiable evidence of a mistaken belief, severe cognitive dissonance is the usual symptom. Such a reaction would coincide with the destruction of a large value (the owner's idea) and the gain of a small value (the new idea), resulting in a net pain or loss, even though this new idea must be superior based on the evidence.

With this in mind, how can we restore some semblance of rationality? The first logical answer is to not be hasty towards conclusions. This is good advice, but quite well known and, therefore, boring. At some point for some issues we will inevitably be forced to reach a conclusion. No matter how well thought-through the process of acceptance, according to the ownership bias theory, the end result will be a disproportionate assignment of value to the idea's merit, validity, truth, etc. However, it does stand to reason that on issues where one is relatively uninformed the best policy may be not to reach a conclusion.

Upon reaching a conclusion, a good technique may be to take inventory of the likely truth of your ideas. Assign some sort of probability toward their correctness. It seems that when most utilize this advice they come up with a distribution where a 99% probability is reserved for those ideas of the utmost certainty and a 51% percent probability reserved for issues of a tenuous nature. However, this would only apply to simpler true false questions, where there are only two options. It is important to note that for real world issues there will be infinitely many possible solutions. It is only through the correct framing (e.g. will the human race become extinct in the next 100 years?) that the problem can be circumvented. But this framing often removes much of the importance of the initial inquiry.

The point is that when you consider the probability that your view is correct think of all the possible alternatives. It may be very realistic to hold a 5% chance that your view is correct. This may be a view you have thought very long and hard about. You may be relatively more confident in your correctness on this issue than most of the conclusions you indulge. However, given the complexity of the problem, it is very likely that you are wrong (95% chance). Yet the view you have chosen remains the most likely winner of all possible candidates.

Without resisting the urge to wildly speculate, 5% seems a much more realistic probability than 51% on many social science questions (and the 5% may not even be a relatively tenuous position as the 51% was).

Whether this type of "realistic" probability distribution assignment has the power to overcome the endowment effect or ownership bias, is a question I will not answer.

You Can Never Have "Just One" Regulation

Arnold Kling at Econ Log,

Why worry about the clog in the first place? Because banks have some of these securities, they are marking these securities to market value, which means marking them way down. As a result, their balance sheets show a shortage of capital. To come back into compliance with regulations, they either have to sell new shares of stock (good luck with that) or curb lending. As they curb lending, the economy suffers.

So in order to comply with one regulation (mark to market, an accounting regulation), banks begin to violate another regulation (capital reserve requirements, a banking regulation). See once you regulate in one area, the incentive distortions lead to problems in others. Therefore, a regulation is needed to correct the distortion. Of course this inevitably leads to further incentive distortions. The process never ends.

In some modes of business people seem unfazed by unregulated activity. In others the thought is horrifying. I'll put banking in the horrifying category (along with education, health care, etc.). If you look at contagion effects due to psychology, you can make a case.

In unregulated activity it often may be difficult to perfectly align incentives. Markets don't always work perfectly. Two points though. First, we don't really know how a market in many areas would work since it have never enjoyed a true laissez-fair state. Second, simply because incentives are misaligned in an unregulated state doesn't justify regulation. The analysis is one of degree: to what degree are incentives aligned without the regulation vs. with the regulation. Just because a market can create unfavorable outcomes doesn't mean that there is automatically a top down regulatory solution to create more favorable outcomes.

American Revolution

Many Americans fiercely believe that the American revolution was justified. But a strong case can be made that it wasn't. Regardless of the moral justification of a revolution, revolution in general is pretty messy business. Revolution often results in a bloody mess ending with similar system of governance as before. The winning faction gains power and proceeds to abuse it.

A practical man in 1776 probably would have placed only a slight probably of success for the American revolution. Consider the odds against military victory alone. Next consider the odds of the formation of a stable, democratic government. Cost of defeat? Thousands of lives and a likely loss in degree of civil liberties. The benefit of victory? A gain in degree of civil liberties, but with a high variance in outcomes minus the cost of thousands of lives.

With this perspective maybe our founding fathers took some pretty large risks to secure a relatively small degree of liberties.

How did a stable government form? A big question in history for sure. I'll blurt out that it might have something to do with numerous competing factions instead of a single overthrowing party. The revolution succeeded militarily through the consolidation of the states. The same may be true for the success of government, but for opposite reasons. In order to remain a viable government they needed to consolidate to ward off future invaders. The initial pressure to form united states may have provided the pressure needed to keep diverse groups practical, enabling compromise. Although some states were clearly more powerful than others, the disparity of power seems thin. Equal yet competing agents may have been a critical ingredient towards the acceptance of disagreement and establishment of a tradition of compromise. The emergence of these cultural norms may have contributed to the production of both governmental stability and liberty.

Financial Crises and Regulation

Following a financial crisis the topic of regulation in inescapable. The default response by an overwhelming majority seems to be "we need more." Isn't there logically another response though? Couldn't it just as well be that we need less?

My Model of the Body's Energy System

Based on two simple observations, I have produced a model of the body’s system of rest and energy. I have no training in biology, but I have noticed two strange facts of personal disposition.

1. A good night’s sleep does not assure me to feel good the next day
2. Exercise feels good and increasingly so with frequency

Many might assume the more sleep enjoyed the night before the better one will feel the next day. Through my experience this simpler observation does not hold. Or at least not so directly. Often it takes many days of consistently good sleep to produce an energetic state of body and mind.

It may not seem strange that exercise feels good (and by feel good I mean after it is done.) But in one sense, exercise is the very activity we should wish to avoid and minimize. Exercise requires more calories relative to the resting state. As a result pleasure in the activity signals a human to find more food than would otherwise be required. This is inefficient. Donning the evolutionary lens, food is scarce. A human that utilizes less calories to survive will outcompete one that requires more. So why would the body reward us for this wasteful behavior?

In summary, humans are constantly preparing for the unforeseeable stressful event. The world usually follows a mundane routine. However, occasionally (I won’t define a time period for “occasionally”) an unforeseeable crisis arises. This crisis requires great energy. If this energy threshold cannot be met death follows. You can never lose (at least not until you have fathered or birthed some children).

In order to prepare for the stressful event, the body maintains an energy reserve (adrenaline?). The energy reserve is a fixed cost that the body pays nearly every day. The energy reserve maintains the annoying property that it doesn’t store well. It needs to be continually replenished. It doesn’t go down to zero every day but continually needs a topping off.

Once the energy reserve has been satisfied the body feels free to release extra energy to the regular workings of the day. Now obviously this is a tricky relationship. The body doesn’t strictly release energy after the reserve has been satisfied, since this would mean regular operations couldn’t take place until the reserve is met. It’s more like the body delegates energy between regular activity and the reserve until the reserve is met. It is only when the reserve is met that the body releases extra energy. This release can be noticed through a positive attitude or natural exuberance.

The key here is consistency. In order to consistently feel “good” the reserve must be met every day and enough energy produced to consistently exceed the reserve. A good night’s rest for several nights will slowly improve a person’s natural mood. The fact that the improvement is slow implies that the energy reserve is a significant cost. Consistency is also good in that it allows the body to plan. Erratic rest may signal erratic times.

Where does exercise come in? Exercise can be thought of as an investment. During the process it feels terrible—the unavoidable cost. Shortly after, the body often releases a short term pleasure emotion. Usually if someone rarely or never exercises this short term benefit is largely outweighed by the short term cost. (The nature of these costs and benefits are not static.) But exercise also has a long term benefit. This is what an investment is: the exchange of a current cost for a long term benefit. Exercise challenges the body and in the processes improves the efficiency of energy production. Exercise is practice. It not only prepares the body for the future unforeseeable stressful event but also improves the body’s ability to produce the energy reserve along with the daily energy requirement for regular tasks. The short term pleasure signal, which seems strange, signals the mind to invest in the body.

The key here is also consistency. For simplicity sake let’s say that exercise costs net $1 today (to the body) and benefits $3 three days from now. If invested in every day the effective yield is a $2 benefit every day. The consistent benefit improves the incentive to continue exercising. In this way it can be thought of as a positive feedback cycle. This positive feedback serves as a subtler signal. "When I exercised in the beginning it hurt a lot, but felt good at the end. As I continue, it doesn't quite hurt as much and I am able to enjoy the benefit" (a stronger net benefit through time. If inconsistent the signal is much less clear. There is a net cost on the initial day of exercise rather than the net benefit experienced for the consistent exerciser.

This concludes my simple model. A fixed toll must be paid each day to the energy reserve. Exercise is an investment with a positive feedback cycle. This simple model has one simple policy prescription: if interested in feeling good, sleep and exercise consistenly. (Prescription might be good, but the model may be just pandering to it.)

Hot Broads, Sweet Dudes

It’s a common phrase among us dudes, “the chicks at that bar are super-hot.” The claim is that some bars night in and night out host better looking women than others. Now I can think of a lot of reasons why this statement may be deluded, most of them having a lot to do with alcohol consumption, but I’ll let it be true. I have no real way of measuring, and I have experienced similar feelings (which means slightly more than nothing). Let’s grant it’s true and fool around with the implications.

Since we live in a relatively free society, I’ll knock out the possibility that male bouncers filter through the female applicants and systematically turn down the less ocularly pleasant.

OK, so the hot women must collectively choose a bar to patronize for this to work. Let’s take a normal population with a normal distribution of lookers compared to not-so-lookers. Given this population of female nightlife-seekers, more good looking girls choose a particular bar over another. Therefore, by implication a pretty woman must share similar preferences with other pretty women but these preferences must be distinct to the preferences of the ugly, at least on average. We need these different and distinct preferences to get this result.

So how do you as a bar owner go about attracting pretty women? Easy, you say. Make the place look really nice. Offer drink specials on martinis. Make it swanky, sexy, and trendy. Make it clean. Make it give off an aura of luxury. OK, sounds good. But wait, won’t this attract all women? what makes these things attract only good looking women?

Ah hah, I’ve got it. These are all nice things, but what hot women really want is men. Not just any man but a rich man, and maybe he’ll look ok and talk alright too. But in order to attract men, what do you signal or advertise? I would assume men don’t much care what the place looks like as long as the hot women are present. So the bar can go right ahead and mainly signal towards women’s desire with minimal consideration of men’s preferences (except the one preference).

Back to the rich part though. I’m not going to get into debate about what women value on average the most in men. I’ll just say it’s tough to screen men for anything other than wealth. And although wealth may not be the most important quality of a man, I’d make the safe bet that women on average would prefer a man with wealth over a man without it if all of their other qualities were exactly the same. So a bar can screen for rich men. How? Why charge high prices of course. Seems like a strange business model and certainly one with offsetting incentives at some point, but it certainly may help in weeding out the poor. After you charge high prices, put luxury items all over the place so the wealthy look more wealthy, and there you’ve got it—a room full of rich men. And what good is a room full of rich men with a normal distribution of looks, wit, charm? Well, it’s better than a room full of poor men with a normal distribution of wit, looks, and charm.

But wait a second; won’t the less than hot women prefer the room full of rich men better as well? Men don’t necessarily want rich women (not a bad thing), they want HOT women, especially when alcohol is involved. And since we can't restrict the supply, we’re back to square one.

Unless we delve into psychology and its games. Consider an ugly woman’s perspective. Let’s say that an ugly woman knows she’s ugly. She says to herself: “Men like hot women, women like rich men, therefore, many women will want to go the rich man’s bar. Men know that women like rich men. A rich man knows he’s rich, therefore, he will demand a better looking woman than had he not been rich. With these higher expectations, I [an ugly woman] will have less of chance of finding a mate at the rich man’s bar.” Or at least she’ll have to work a lot harder to showcase her other talents. You see it’s though this pyschologic process of circular expectations that an ugly woman may view her chances less favorably at the rich man’s bar.

[Tangent: If there weren't these cirular pychological expectations the first, say, 100 would get in the rich man's bar. The ability to show up early doesn't screen the population so a normal distribution exists. The ugly woman would have the same chances as she does in a normal population plus richer men to choose from so wouldn't be particularly disuaded from entering (they have no expectation that rich men have higher standards). So if these circular expectations are untrue or don't influence behavior much, this model breaks down quickly]

She also knows that poor men like hot women as well, but they have less to choose from (hot women know they’re hot so more go to the rich man’s bar due to higher expectations of success) so her relative status will be higher at the poor man’s bar. So if the ugly woman has a 10% chance of hooking it at the rich man’s bar and a 50% chance at the poor man’s bar, she’ll make her decision based on how much she values that differential between the two types of men. So within this framework, we could conceivably get a result where some bars have better looking women, on average, than others.

So do the swankier, more expensive bars have hotter women? I don’t know, all I can say is “maybe, probably” based on experience. This simple analysis opens up a wild world of signals and countersignals.

Example, ok I’m a rich man. I know that these swanky bars are going to have hotter women. But these women are going to expect me to be rich. I may be rich, but I don’t like that expectation. I want them to like me for my charm, wit and looks, not my money. And I especially don’t want them to expect me to buy them something expensive every other minute. So even though I’m rich I’ll go to the poor man’s bar and seek out the few good looking women there.

Or another. Ok I’m poor. I know the hot women like the rich guys, but I like hot women. I’m going to the rich man’s bar and living over my means for a night to score with a hot woman (and go back to her place of course, cause I live out in the suburbs). But women have heard about these “fakers.” So in the end if you play this game you are caught in and endless dance of signals and countersignals.

Fuck it, I quit. I’m not playing this stupid game [some crowd will say]. I’m above these petty signals. And here’s where you get your freaks in varying degrees. People seeking to send signals that they don’t send signals. They go to weird bars (and there’s a whole continuum of weirdness). Or maybe just dirty bars, dives. We of the dive bars don’t play games. Except we all play the game to see who can play the least games.

So are there hot-chick-bars? Maybe, but if you go, don’t look at your credit card statement in the morning.

A late in coming conclusion

Tonight I was reminded of a time in school when I gave a presentation on US health care regulation. I tried to lay out its forms, vehicles, and operations. It was such a complex topic that I struggled greatly to adhere to the time limit. In the end it was a pretty pitiful performance. Not one of my better efforts, but in truth I didn’t feel anyone would appreciate it even if it was. At the end of the presentation I was asked if I had a conclusion. “No not really.” I stammered. “It’s an important issue and it is important to be informed”—was all I could muster.

Although I did have a conclusion. However, I was reluctant to give it since its presentation would reveal my bias which could question the integrity of my research. (I think I have learned now that we all have a bias and not to reveal it is the real signal of questionable integrity). So if I had the question again the following would be my answer.

My research was presented with the intention of drawing a focus to the myriad of regulatory complexities that our health care/health insurance industry is riddled with. The chief effect of this regulation is a loosening of the association of cause with effect. It is through clear feedback mechanisms that intelligent beings are able to change a course of behavior in hopes of creating improved outcomes. Just as punishment of a dog an hour after it has overstretched its bounds is futile, paying for health benefits through tax revenues and insurance programs also confuses the costs of prior behavior. The regulatory complexity removes health decisions from the universe of practical everyday decisions. These sorts of decisions are feasibly within human abilities. Granted errors are made constantly, but on average people are able to decide which products work best for them; and in the process reward those goods and services that hold value. This simple, but essential mechanism is constantly under attack in the realm of health care.

But you say: “Health care is different from other goods. We NEED it. Without it we would die.” Would you die without food? shelter? clothing? And if so are you able to reliably find those goods with high quality and at low costs? And what sort health care would you really die without? There are rare incidences when people suffer from a critical circumstance, but every trivial health benefit is covered in these third party plans; and the benefits are growing all the time. And what does “need” mean anyways? Does need mean if it was cheaper you would consume no more of it? Does need mean that you would sacrifice literally everything you own to obtain it? With any procedure there are costs and benefits, but we seem to be unable to consider the alternative that for any procedure the cost could exceed the benefit. Yes, these procedures still have the same costs no matter who pays for them. It’s a scary thought to think of someone empowered with the ability to consume without any regard for the costs. But a scarier thought is that this disincentivizing trend will continue and we will fail to reward innovation that leads toward health care advances.

Hidden Gem

I confess a bit of a music obsession. I have consumed a good proportion of my life randomly following my melodic interests. Typically the search isn't completely random but confined to my usual time period (around 1966 to around 1972). I'm pretty biased towards this time period. Really enjoy blues music and its initial fusion with rock to make the greatest of all genres: blues rock. Big fan. Of course within this genre there a tons of styles.

One of the better bands that I have become familiar with recently is called Free. I'm sure this name isn't news to anyone with much interest in the period. This was Paul Rodger's band before he started Bad Company. "All Right Now" is the familiar hit. So the band isn't so much of a hidden gem, but I'm going to make the case that their first album is.

The album is called "Tons of Sobs" released in 1968. In many ways it is a typical bluesy release that many bands were putting out around this time. In fact it may have been a bit behind the curve. Not exactly original or highly creative. But what I am praising here is just plain blues rock excellence. I guess it all starts with Paul Rogders. He has a nice soothing voice if you'll remember from Bad Company. Sounds nice, maybe a little plain, and even though he is British sounds pretty American (that is the description that comes to mind when I think of Bad Company). But if you take Paul Rodgers for granted you might miss something. When he lets it loose he's amazing. I will say that I actually know nothing about music. However, his voice seems capable of great range while maintaining depth, and it just sounds really nice everywhere. But more than that he sings blues how (I think) its supposed to be sung. You really understand while listening to this album how blues grew into hard rock. Its loud, emotional, and perhaps honest. See blues music has more of an honest feel to me than other music from the era in contrast to psychedelic influences. Don't get me wrong I love psychadelic music and am all for mixing it up and creating new sounds, but I will always be drawn to the honest simplicity of blues music, its pureness of expression.

Other highlights of the group include the guitarist, Paul Kossoff, and the bassists Andy Fraser. Simoun Kirke is the drummer who also stayed with Rodgers through Bad Company. Kossoff is real good. His guitar is high flying. He was your typical drug and alcohol shitshow, and sadly his life ended early because of it. Andy Fraser was 16 when he joined the band and released this album. Before joining the prodigy was the bassist for (the great) John Mayall and the Bluesbreakers. What's even more impressive about him though was that he was the group's chief song-writer at such a young age. Although he contributed on only three songs on this album he quickly established himself as the main lyrical force in the outfit. Another impressive fact about this album (especially for blues music) is that all the material is original except for two covers "Goin' Down Slow" and "The Hunter" (which are both great).

If you listen to one song on this album listen to "Walk in My Shadow" and for Godsakes play it loud.

Put the Onus on the Company

I’ve recently been getting real cool and studying for the CFA (Chartered Financial Analyst) test. Going through the accounting sections can be mind numbing. But I have gotten a better idea of some hairy details of accounting for financial statements and reporting to the SEC. This by day and hearing about financial troubles by night has got me thinking about transparency and reporting. I’m going to provoke a bit of a thought experiment in financial reporting from a stance that no one else seems to be willing to take (especially at these times). However, I am at liberty to take such a stance mainly due to ignorance, inexperience, and maybe a hint of stupidity.

Ever since the SEC was formed, shortly after the crash of 1929, there has been push toward the mandating increasing transparency on public companies. Seems like a great idea. The more information people have the better investment decisions they should be able to make. I am going to hit the issue from another perspective, however, and argue it may not be such a good idea, especially as the economy becomes increasingly dynamic. The main thrust being; what if we put the onus on companies to supply us information and not on regulators? Instead of regulators trying to devise ways for every public company in every industry to conform to some universal standards what if companies decided to choose a way that fit their company and industry best? Well, I’ll admit, so far this sounds like idealistic horse-manure, but there are some hidden incentives here.

Investors will demand information of companies. If they don’t provide information, they will receive no capital. And in this way, this approach may unleash a competition for the most accurate and transparent disclosure. Companies may be more directly compensated for excellent standards than in today’s environment where essentially everyone is given either the stamp of approval or are under investigation. With the SEC model there are only two options, yes or no, good or bad. A company may have an incentive to cheat as much as possible while staying approved. Once approved all companies are basically on the same playing field. Information quality is viewed by most (but not the savvy) as uniform in quality. Do we really want uniformity in quality? What is the incentive for providing superior quality?

Cheating as much as one can while staying within the guidelines can be found in off-balance sheet accounting. It is perfectly legal, although it may be perfectly deceptive. There are loopholes to be exploited as there always will be. Especially as the nature of business changes more rapidly—the only thing we can be sure of in the future.

So let’s put the onus on the corporation. “No, I’m not going to give you rules. You give me the information. If I don’t like it I won’t invest. Furthermore, I’m going to see what your competitor does. If it does it better, well fat chance you’ll get anything.”

You may say this is too much of a burden for an ordinary investor. And it may well be. But there is already an industry for this, and this industry (one that I am quite fond of, to include my bias) is independent research. If there is no SEC, then independent research would become all the more important. This private industry is capable a moving at the speed of its focus industries. Specialization, superior flexibility (in comparison to a legislative timescale), new entrants, quick adoption of technology, etc. are all reasons why this industry could perform quite well. Will there be conflicts of interests? Sure, there always are (even at the SEC). But just as there is pressure to exploit conflicts of interest, there is always pressure to decouple conflicts of interest in order to enhance reputation.

That Damn Fed

Here's a good quote from Steve Forbes:

"One reason the Fed is feeding inflation is that it thinks it's grappling with a conundrum: Inflation is rising, and the economy is weakening. How can our central bank stimulate the economy without risking even more inflation? Rotten ideas never seem to die. The Fed's notion that it must choose between economic growth and inflation is absolutely false. Experience has repeatedly shown that there is no tradeoff between inflation and a vigorous economy. We can have both excellent growth and a stable currency"

Stevie Ray Vaughan

This is awesome to see him just play like this

"From the very first instance, automation replaced human work"

Here's a passage from Out of Control by Kevin Kelly:

Ktesibios was a barber who lived in Alexandria in the first half of the third century B.C. He was obsessed with mechanical devices, for which he had a natural genius. He eventually became a proper mechanician--a builder of artifactual creations--under King Ptolemy II. He is credited with having invented the pump, the water organ, several kinds of catapults, and a legendary water clock. At the time, Ktesibios's fame as an inventor rivaled that of the legendary engineer Archimedes. Today Ktesibious is credited with inventing the first honest-to-goodness automatic device.

Ktesbios's clock kept extraordinarily good time (for them) by self-regulating its water supply. The weakness of most water clocks until that moment was that as the reservoir of water propelling the drive mechanism emptied, the speed of emptying would gradually decrease (because a shallow level of water provides less pressure than a high level), slowing down the clock's movements. Ktesibios got around this perennial problem by inventing a regulating valve (regula) comprised of a float in the shape of a cone which fit its nose into a mating inverted funnel. Within the regula, water flowed from the funnel stem, over the cone, and into the bowl the cone swam in. The cone would then float up into the concave funnel and constrict the water passage, thus throttling its flow. As the water diminished, the float would sink, opening the passage again and allowing more water in. The regula would immediately seek a compromise position where it would let "just enough" water for a constant flow through the metering valve vessel.

Ktesibios's regula was the first nonliving object to self-regulate, self-govern, and self-control. Thus, it became the first "self" to be born outside of biology. It was a true "auto" thing--directed from within. We now consider it to be the primordial automatic device because it held the first breath of life-likeness in a machine.

It truly was a "self" because of what it displaced. A constant autoregulated flow of water translated into a constant autoregulated clock and relieved a king of the need for servants to tend the water clock's water vessels. In this way, "auto-self" shouldered out the human self. From the very first instance, automation replaced human work.

Some may call me evil, but I find great beauty in getting humans out of the picture.

Each time a new device is created, human toil is replaced with non-human toil. And in this way human capital is released. Released to take on a new task that inconveniences lives. Ad infinitum.

Have You Ever Loved A Woman

Obviously, one a my favourite blues artists of all time.

Thoughts on Income

How does one make money in this world? Who is best at it? Are the wealthiest the most intelligent? The hardest workers? The most determined?

I will argue that the wealthiest people are those that serve the greatest number to the greatest extent. Intelligence, work ethic, and determination certainly contribute to this ability, but these are traits rather than an essence. In fact, in my experience many highly intelligent people choose not to make a great deal of money since this service requires a sacrifice of their time towards nurturing their intellect, which may be a greater motivational force, marginally, than increased income. Although, most, if not all, would choose greater income than less, tradeoffs exist in the allocation of time towards intellectually stimulating endeavors and thrifty endeavors.

Take the case of an individual sitting on the sidelines and observing the economy. He then decides that he too would like to enter the game and create personal income. How would he create income, or make a profit?

In the most general terms, he has to provide a product that is “better” than some current product. Better is a relative term of course. There are two general characteristics of goodness in the economic sense: cost and quality. The “better” product is that product (or service) which provides the higher quality to cost ratio. This ratio, however, is unique for each individual. For both components may be different for each individual. It may cost more to provide a product for individuals in different geographic locations. But even if we assume the cost of providing the good are equal for all individuals, each ratio will still be unique.
Measures of quality differ based on unique personal preferences. Furthermore, the distributions of subjective quality for certain goods vary.

[As an aside I have to talk about willingness to pay. Willingness to pay is equal to an assessment of quality of items. An individual’s differences in willingness to pay represent his/her preferences in goods. However, it is not correct to compare willingness to pay across individuals for purposes of comparison of subjective value. Since some possess greater wealth, their absolute willingness to pay in nominal terms may be much greater than a poorer person’s nominal willingness to pay who may in fact value the item more. Therefore, a correct representation of willingness to pay will be willingness to pay as a percentage of wealth (wtp%w). This distinction is necessary only for my discussion of different “desires” for similar goods.]

For example, take a washing machine vs. a piece of modern art. If you were able to plot a population of individuals’ assessments of the quality (wtp%w) of these two items I suspect you would find the distribution to be much tighter for a washing machine than a piece of modern art. (In fact I suspect the range for the modern art piece would be a one extreme highly positive and at the other highly negative, essentially trash.) Therefore, the value in a good varies with subjective assessment.

Ok, once we know what to make, who shall we target? Two general groups look promising: masses and niches.

Masses are the dominant force to getting rich. If a profit margin is fixed, the only way to earn more wealth is to provide your product to more people. The masses approach is the one observed in TV commercials, mass marketing schemes, and generally anything to do with mass media. In being an approach that sells to a huge number and variety of people, mass campaigns try to appeal to common characteristics. These common characteristics often appeal to generally superficial qualities. Beauty is constant theme of mass marketing. It is easy to grow frustrated with the shallowness of advertisements based purely on sex appeal. But, sex appeal is a trait common to all human beings and, therefore, it shouldn’t be surprising that marketers are relentless plug sexual themes.

In general campaigns to the masses tend to ignores individualism and focus on collectively human themes. The larger the audience the more a company can be expected to engage in this type of activity.

But there is another driver of profit: individual interests. Rather than increasing the customer base, servicers to niche groups try to increase profit margin. Certainly there exists a tradeoff between advertising to unique interests and to large numbers. There is value in providing goods for unique interests taking advantage of higher willingness’s to pay due to increased desirability. As transactions costs decrease, an increasing number of niche groups will be provided to on profitable terms. The internet is a great facilitator towards desires of niches. Therefore, the niche influence (profit margin influence) places greater emphasis on individuality and customization. Future improvements in technology can only be expected to increase the amount of unique interests provided for.
The reason I have gone through discussion is that I think many people, especially thoughtful people, are disgusted with mass commercialism and its inherent superficiality. And what’s more, if you’re an intelligent, curious person seeking to pursue your intellectual desires often you’re left with few alternatives to both satisfy your curiosities and provide income. When this marriage happens it is a beautiful thing. I often think of engineers and scientists pursuing new creations. But even a great engineering achievement does not promise commercial success without mass-desirability. The value of the creation is in many ways unique to the creator and his peers.

As a strong advocate of individualism, I am also frustrated with difficulty in monetarizing my unique desires and ideas. Career paths can seem limited since creating income can reduce or eliminate time spent on personal interests. The internet and similar technologies provide hope, however, by connecting those with weird, wacky, and unique interests. Business in the future will increasingly segregate consumers. As transactions costs fall, entrepreneurs will seek to further differentiate their product.

Go To The Mirror!

Here's a goodnight post. A bit shitty on the quality.



Check on the heels on Daltrey

My Defense of Investing

As a student of both economics and finance, I generally hang out in the econ world (in the blogworld) more that the finance world. However, I try to keep abreast of financial matters. I hold, generally, a long-term view towards investment themes. Economists often harshly criticize the investors (often investors in mutual funds). They use the “efficient market hypothesis” to accuse those that dabble in managed investments to be cavemen. These are men that are so foolish as to shed any notion of reason and science and spend a career trying to beat the market. And those, that are lucky enough to succeed (for given a large sample size, there are bound to be a select few who come out wildly on top) have the shameless ignorance and arrogance to proclaim their methods to be of skill rather than luck. Many studies, which show mutual funds are about as likely to beat the market as throwing darts at the WSJ, showcase this disdain.

My comments will express my great displeasure with any notion of a “super” efficient market hypothesis as well as give a general defense of the investing profession (no matter how barbaric these men might seem). There are many areas of finance, but I will concentrate on investing, specifically active management (versus say indexing). I will conclude that active investing is indeed a viable industry just like any other and that it holds great value for society, which is shown in the vast profits that some claim.

The efficient market hypothesis in its most extreme goes a bit like this. “All information is instantly factored into the markets through the great knowledge of the masses. Stock prices reflect current expectations of future profitability based on aggregate information across the entire world up to this second. Picking stocks, therefore, is a fool’s game because no one can know any more than anyone else. Game over—INDEX.” Now, I will come right out and say it. This is about the stupidest thing that I have ever been taught. I don’t think anyone who teaches it takes it that seriously, but I’m sure some do. I guess it’s more or less taught to make a point—to understand the underlying logic to much of portfolio theory (or underlying rationalizations).
But why the hell do we choose the stock market and assume it is perfectly efficient? Why not everything else? Where are the efficiency theories for making cars, or planting corn, or teaching at universities, or writing books, or any other activity that creates economic value? For example, we could reason, all the information for the market for making cars is known by all instantly. Therefore, no one has an advantage. No one has a better idea of what will make a better car in the future. The market just works by random guess, some happen to work, some don’t.

Well why the fuck does anyone get out of bed in the morning then? If no one can ever find advantage over anyone else, let’s just shut it down. Why should I waste the effort, when the effort doesn’t matter, and I will be just as likely to make a billion as to lose everything (actually much more likely to lose everything, since I don’t have near a billion to start with).

Oh but the stock market is the exception. Because SOOO many people are interested in it, and SOOO many people have their retirement futures involved it in, and SOOO many people make SOOO much money in it (never mind that this last statement is self-defeating). Therefore, this is the one place where we play God and know everything. The worst part of the theory isn’t the absurd proposition that everyone knows everything instantly. I think that I can reason around this a bit. The people that matter the most know a lot, and with the acceleration in the speed of communications know more and more every day. And these people have enough money that they can put the odds back in shape, by placing huge bets. And there are enough of them around the world to do it very quickly. So in the end, this thing sort of works out as if everyone has all the information instantly. I can follow this and see some sense in it. The real stupidity comes in when you take this to the next step. One reasons, if everyone has exactly the same information (all current information), then everyone will share identical expectations.

Expectations are what stocks are priced on. Sure everyone has the information, but everyone uses the information differently. Thus each individual may represent unique expectations given equal information. Resulting stock prices are the aggregation of these millions of unique expectations. And these aggregations hold great wisdom. Some look to this type of emergent intelligence to be much greater than the sum of its parts. No single human could compete with such a depth of information. And quite frankly, this is true. So once again, what are we doing? Are we simply slaves to the master of market, fueled by the ignorant bliss than an individual’s opinion matters?

It depends on what you are talking about. No lone soul could match the depth of the worldwide market’s knowledge, but individuals or groups of individuals can specialize. An investor can focus her knowledge on a relevant niche of expertise. And maybe this is why markets are so smart in the first place. In every little niche available there are experts that analyze their niche every day. They know it inside and out. The true experts are a small group of individuals. These people, it would stand to reason, have varying opinions, but with their equal depth of knowledge may have less variance of opinion than a larger group of, say, investors as a whole. When these experts see the scales tipping out of control they mobilize their capital and try to take advantage of it. But even within these expert groups some might be very good and smart and others not so good and stupid. The stupid ones could match the smart ones bets and keep the value distorted for long periods of time, until the stupid ones are knocked out. But you’ll notice that this cycle favors the smart ones and keeps increasing their pies, which leads to more accurately valued stocks. But smart ones don’t always stay smart, you must remember.

The greater point is this. Investing is fundamentally just like any other business. A new investor is analogous to the entrepreneur. The entrepreneur looks at a market and sees an investment that is under or over-valued and tries to correct it. People often call entrepreneurs crazy, saying: “There are already huge corporations with really smart people that have been studying this for years. They know way more than you. They know everything to know about this business. How could you do better than them?” Well like anything there are always tradeoffs. Sometimes when you are too close to a business or market you can exhibit tunnel vision. Giants are often blindsided by wild entrepreneurs with a new approach to tickling the customer. And how does this relate to investing?

The investor can specialize. Focus his efforts. Create new ways to invest. Look for different things to invest in. Or do the same thing that is already done but just better. The information barriers to entry diminish with the increasing speed and quality of communication. The real barrier to entry in investing is capital. But some investors are able to turn a little into a lot. Especially since when you have just a little you can focus it on a portfolio of your best ideas.
So this has been a broad, perhaps unscientific, defense of the investing profession. Investing is by no means easy. There is fierce competition. But with specialization, intelligence, and a logical approach some will achieve success—and not just for luck. The freedom a hedge fund manager often enjoys allows for the best structure to compete in investing. (But you need serious capital to start up one of these, not to mention reputation).

The real question is: are active managers successful enough to reward the extra fees versus indexing? How costly is it to choose the correct active manager? I think for the typical average Joe is indexing a good bet. But for with more expertise and wealth, you'd be a fool not to put a bit of your portfolio in a hedge fund or funds. That being said everyone has different circumstances and goals that may require different investments.

Brown Sugar

Got another good one. The youtube archives of the rolling stones is fantastic.

Stones

Since I couldn't find my favorite Keith song, here is another sweet Stones performance for your pleasure:



I think this is 1966

Time Constraints

I recently read an article by Kevin Kelly that seems to have relevance to my previous post "Perpetual Welfare and the Value of a Life". Here is the link:

http://www.kk.org/thetechnium/archives/2008/02/the_bottom_is_n.php

I really respect Kevin Kelly and am currently sifting through one of his books Out of Control.

The point Kelly raises is that humans are bound by time. We don't have enough time to let evolutionary, bottom-up processes run their course. These evolutionary algorimths have a remarkable ability to find workable solutions to problems (maybe optimal but I don't want to go there). However, this process works over biological time. A human life is much too short to bear the fruits of the evolutionary process, therefore, some shortcuts and editing need take place.

The connection to welfare programs is the following. Sure, if we let the economy run with little or no regulation, no redistribution programs, and well-defined rights (such as property) the proper incentives should be in place. And eventually would expect a beautifully adaptive outcome to the incentives. But maybe we are working on different time scales here. Waiting for the "long run" does little good to current human populations.

So maybe a redistribution is necessary on some levels. For the poorest people may die without such distributions. Although, I really don't know. In the US it may be less dramatic. But nevertheless, those who are the result of poor luck in the lottery of birth will be subject to severe risks in comparison to those born wealthy. A system of no redistributions would provide the correct incentives and allow consequences for negative economic behavior to be fully felt. Also with no expectations of future redistributions individuals would be required to plan for the future. The economic pie would grow more quickly and diversely; wealth creating choices would be fully rewarded, wealth destroying choices fully punished. But to reach these optimal future conditions, significant current pain may be felt. Indeed, the current generation may be dead before we can fully grasp the benefits of such pure incentives.

I value the current generation more than future generations. Our lives seem to be more important than those that will come after us, perhaps due in part to the uncertainty of their eventual existence. And why should our society suffer for future society's benefit? Or more properly stated, why should some individuals' lives suffer in order to bring happiness to unknown and uncertain future individuals' lives? Its not just that the people are unknown, but on some level it is unknown and uncertain whether they will ever be born.

Usually, current and future generation's interests coincide. Pursuing wealth creation helps us now and creates a better world for future generations to be born into. But in this hypothetical case, current generation's interests suffer for greater future wealth creation.

However, the term "current generation's interests" is very misleading. It is really millions of individuals with unique interests. All these individuals are of different ages. None are really in the same "generation", where generation means that they share common interests. Therefore, it seems I am agruing out of a sense of justice more than anything. Just as I don't deserve to be born into luxury, other's don't deserve to be born into poverty.

Therefore, some level of redistribution seems valuable. Our human society would be better in the long-run if no redistribution exists, but an individual's life should not be sacrificed for future lives. In some ways there may need to be some accounting for the distributions in the lottery of birth.

That being said, intentions are different from effects. One may have the good intention to correct this unfair distribution, but the effects of trying to solve the problem may only worsen it. The specific methods should be subject to empirical testing. Specifically, public vs. private methods of redistribution remain debatable. Private alternatives may hold greater utility.

New Tax Scheme

As a sequel to my discussion of differential tax rates previously, I have devised a new taxing scheme. This taxing model has the advantages of simplicity and the removal of distortionary taxation effects. In other words, individuals’ decisions will not be influenced by tax rates (save the effect of choosing more leisure relative to work which all taxation will ensure).

In order to participate in society an individual must have money. In order to have money he must have income. Let’s assume all individuals work and, therefore, provide their income. Once the individual has provided himself with income, he has two options: spend or save—consume or invest. The function of these two options is exactly the same. In one case, he buys a coke and expects some utility (return) from the asset (in this case immediately). In the next case, he buys a stock and expects some utility (return) from the asset (greater quantities of the money in the future). But notice those are his only two real choices. Although, he can put it in a drawer, in which case the government has no claim to it.

The choices are essentially the same. Therefore, the taxation measures should be the same and the tax rates should be the same. There is no need to tax income (unless you are worried about money being spent in other countries, but that is trivial). Let’s just tax the only two things income can be used for: consumption or investment. And let’s tax them at the same rates at the same time. You want to buy a coke, pay 20% tax. You want to buy a stock—20% tax. The bank wants to buy your money (by your opening up a checking account)—20% tax (on the bank). Buy a boat—20% tax. Buy money (take out a loan)—20% tax. Up front, right in front of you. Wow, would this put the tax accountants in a tiffy. You wouldn’t be taxed when you received your investment income, because well, it is income remember.

Many will argue that this tax is not progressive—the poor have to pay the same percentage as the rich. It’s true. But the relevant question is: would the poor pay more or less tax than with the current system? Their income tax would be removed. The sales tax on goods may be set higher. The effect is uncertain, but the poor could be accommodated. Food stamps and no taxation on investments if you can prove your income is below a certain level. (This would be a hassle though, but don’t worry, there’s another route.)

I have never really been convinced that a progressive tax level is particularly valuable. Rich folks will still pay a huge percentage of the tax return. Also, they will be incentivized to spend more (on stocks or cokes). The government can do their re-distributions just as before (which of course are distortionary as well). If you want to retain the effects of a progressive tax structure, just give more benefits to the poor. It’s not how much money you make, but what you can afford with how much money you make. Collect evenly and distribute unevenly, the effects are exactly the same.

I’m not going to get into the cheating issue, which many cite as a criticism of greater sales tax levels. “There will become a black market to evade the sales tax. We will need a force to suppress it.” I think the IRS handles this already, and their job will probably be a bit easier with no income statements to mull over.

Perpetual Welfare and the Value of a Life

What if the implementation of welfare programs perpetuates more welfare programs? In other words, do welfare programs have some positive feedback effect inducing further creation?

The reasoning is pretty simple. Let’s assume that welfare programs help the poor very slightly in the short term, but hurt the poor to a greater extent in the long term. Poor are made a little better off, but they don’t have as strong an incentive to work, to learn, to innovate, to create, to problem solve, etc. These stronger incentives will lead the poor to a more prosperous future in the long run than the handout program.

To simplify this model, I’ll make another assumption: the short run will be defined as the current adult’s life who receives the handout. The long term will be defined as the poor adult’s children and all the future children’s children.

Ok, the current generation is made a bit better off with the handout. The children are made relatively worse off with the weak incentives. They also get a handout (later), but are left in much the same place as their parents. The political party that generally favors these sorts of handouts will keep receiving votes from the poor group. It is only human nature to want more and the benefits are to the current generation (the self interest). Therefore, the poor keep voting for welfare programs that damn their children to future poverty.

The parents of the poor may care for their children and want them to become wealthy. But since they lack education (have imperfect information), they remain unaware that their voting is perpetuating the problem. Once again the government handout creates less of an incentive to learn (and poor people are relatively less educated than non-poor form the start).

You are left with the current generation perpetually depressing wealth of future generations.

This argument is so clean and simple it bothers me. The assumptions are too basic and need some more sophistication. Maybe there is a kernel of truth to it though.

An area where such a discussion will invariably lead is the value of life. How can we choose between a life today and a life tomorrow? There seems to be some justification for welfare programs along these lines. By an unlucky draw in the lottery of birth one man was made so poor that he received no education or money and will surely die before the age of 20. Let him die and he won’t bear another son into the same situation to perpetuate the problem. But how can I justify letting him die when the cause is almost surely pure chance. Are all human lives counted the same? Should we discount future human life?

These are questions I must ponder.

Consumption vs. Investment: A Real Difference?

Here’s a topic that has bothered me ever since it has been introduced in macroeconomics—consumption and investment. See macro slides these things in there without really ever explaining them and then doing fancy math to bust your balls. So you think, “geez, this guy is smart, he must be right.”

A version of the argument usually goes like this. Consumption just spends money on things without concern for the future. Consumption is wasteful by nature. Investment on the other hand builds future wealth through innovation. Investment employs a lot of really smart people that invent the next great thing. And finally, this results in more future growth. Consumption today sacrifices growth tomorrow. Macroeconomists love this kind of talk because it gives them a job in policy making. “People will naturally be irrational and spend too much, therefore, we need to rationalize them and create more incentives to invest.” And these top-down government economists eat this shit up. (Not to mention Wall Street firms love these sentiments).

But I have to say I have never found much sense in defining consumption and investment differently. Let’s think about it from the micro view for a second. Consumption decisions are personal optimization decisions just as investment decisions are. The individual says, “well, hell, I want to enjoy my time on earth right now so I’m going to spend some of my income right now.”And there is no more important time than the present due to future uncertainty.

Then he also saves money. He saves money because he is making tradeoffs between the present and the future. He needs an investment portfolio than saves and grows value in order to protect against future uncertainty (fluctuation in income streams, fluctuations in costs). Basically, the individual has decided that his present profitable spending opportunities have diminished relative to profitable investment opportunities (which are future profitable spending opportunities). [Profitable used in the sense of utility]

Although, it’s not important why he spends or saves. The decision is based on a hypothetically infinite number of preference issues. The bottom line is some spend more than save, some save more than spend (corporations included). Those that have high levels of consumption can be thought of to have less profitable opportunities to invest. They prefer more present spending to future spending. The money doesn’t vanish but eventually finds its way to someone who has different opportunities and preferences. This person has a comparative advantage in investments over consumption. Therefore, the consumption and investing decisions on the individual level lead to an outcome once again where those with the greatest comparative advantage find the money to use it most productively.

And where is this digression leading? To capital gains taxes of course. To preface, I think that lower taxes are always better than higher taxes. But that being said I am also worried about tax distortions. Different levels of taxes for different things incentivize people to engage in behavior not solely based on personal choice metrics. The deciding factor of a consumption vs. investment decision could very plausibly be a tax difference. The result would have been different if tax levels were equal. The government has distorted choice.

It hurts me to ever propose a tax hike (on capital gains here specifically), so I’ll just argue for the other tax levels (without getting into the difference between income tax and other taxes) to be lowered to the capital gains rate 15%. Hah, in a perfect world, right?

This will be a common theme for me. Taxing reduces incentives to work in all the traditional ways. But differential levels also have distortionary effects. Future examples: health care, debt, and others.

The Credit Crisis Explained (or at least a weak attempt); Part I: What happened?

**Disclaimer** The following is an analysis of the recent credit crisis throughout the last approx six months. It is really inappropriate to pick an arbitrary point and just start explaining. Everything at one point would need to be understood from the previous events, ad infinitum. Also, this story is overwhelmingly complex and I will inevitably leave out many relevant factors. I seek to create a framework for understanding the problems; past, current, and future. And finally, I realize that understanding the past holds no predictive power for future timing of investments. It is important to understand general themes, however, that show up time and time again. We can get a framework for how individuals will respond to certain incentives, and, indeed, predict these responses based on estimated future incentives.

So everybody wants to know what the hell is going on with a supposed credit crisis. What happened? What’s happening now? And, of course, what’s going to happen? Well the world will finally be able to rest easy because the answers are upon us. I present the first part in my three part series: What happened?

First off, let’s get the perspective of the homeowner throughout the past few years. As we all know home prices have been rising dramatically (and rising since about 1996, but I don’t know if this is in real or nominal terms as of yet). Low interest rates set by the Greenspan Fed put some fuel on the home price fire. This heroic rise in prices led to pretty easy borrowing terms for homeowners. No down payments, low rates, and the like.

These easy terms were partly responsible for the high prices. To illustrate, if borrowing costs are lower, individuals have greater purchasing power. Let’s say a home cost $100,000. But lower relative borrowing costs yield the individual an additional $5,000 of wealth. Well, someone who is able to purchase a $95,000 home (considering all relevant costs) can now afford this $100,000 home. The home will get bid up to the extra relative amount of purchasing power since everyone shares these lower borrowing cost conditions. The value of the home really doesn’t change, but easier money makes for greater purchasing power. At the margin, this effect may pull renters into the homeowners market, further increasing demand (which would presumably throw some of the new homeowners back into the renters’ market, and we’re faced with a circularity problem, but let’s not get bogged down in the details. We know in the real economy a million factors are changing at once. I don’t think anyone can say that equilibrium is reached at any given moment.)

Ok, let’s talk about one more issue with the homeowner before we continue. No down payments. Not requiring a borrower to make a down payment is a dangerous thing. It essentially assumes there is no downside risk on home prices (“home prices have been rising for a while and will do so forever”). What this does create is a loan for the full price of the home. If the home declines in price, the homeowner owes more on the loan than the house is worth. He has negative equity in the home. This creates a substantial incentive to walk away from the home (and would be the rational choice expect for it affects your credit record). With no down payment, even the slightest depreciation of home price in the short term will lead to this result.

Next, let’s move onto the banks. Banking has two general areas commercial and investment banking. Both these operations may occur within one organization (per the repeal of the Glass-Steagall Act in 1999). In house or out of house, both areas definitely feed upon each other in a myriad of ways.

Commercial lending may be deemed to be the root of all this recklessness. Once again we’ll look back to home prices. With ever rising home prices, banks provided ever easing credit terms. Why do home prices correlate to lending terms? Well, the loans are mortgages, which means they have a lien on some asset. In the housing world this is the house. A mortgage is an asset-backed loan—collateralized. If the price of the house keeps rising, then the collateral is safe. Even if the borrower defaults, the bank can reposes the home and probably get its money back (maybe make some money, I’m not sure of the particulars, I think the homeowner keeps any equity in the home). So if prices are always going to rise, what the hell? Who needs a down payment? As this is what often happened.

But the funny part of it is that these no-down-payment mortgages were not made to borrowers of strong credit records, but rather to the least credit worthy—the subprime. Reason being is that the subprime became the competitive battle ground. Banks were flooded with capital and had no interest in building up reserves (and arcane notion in banking due to Federal Deposit Insurance). They had money and needed a place to use it profitably. It looked like these subprime borrowers were sure things because even if they defaulted, the collateral would be rock solid. Banks were competing for prime borrowers as well. Prime terms eased accordingly. But, it is in your interest to put up a down payment, despite the cash flow pain. A down payment lets you whether a storm (recession) and deceases your debt obligations. The reason many subprime borrowers provided no down payment is because they couldn’t afford one. A whole new market segment was opened up! But then again maybe you really can’t afford to buy a house if you can’t afford a down payment (which many of these borrowers found out through the foreclosure process). To top it off bankers provided adjustable rate mortgages and teasers (which have the similar effects—especially when the Fed is raising interest rates. A teaser is a common practice that has been over-publicized.), which gave less margin for downside risk of a homeowner’s income stream.

Ok, then lets package these babies up and splice them out into tranches and sell them to investors—creating CDO’s (collateralized debt obligations). The tranches all have different risk levels for different investors. Let’s go one set further and create complex securities using options on these things (SIV’s) that are so complex to value only the bank can do it. The credit agencies certainly don’t have a prayer. Furthermore, options are off balance sheet assets—therefore, under less scrutiny. This is the investment banking world. Really, these are great ideas, but when they are applied to heavily risky commercial loaning practices they too become very risky. The SIV’s even more so because of the valuation difficulties. They these become popular for a variety of reasons, but mainly because investors wanted to partake in this great housing bull market. So money flowed in and spreads shrank. Spreads between the Fed Funds rate and 30-year mortgages were reduced dramatically. This type of spread, generally speaking, is the key to profitability of a commercial bank. Banks borrow short and lend long to make a profit on the difference. The Fed Funds rate is the most short term rate there is (overnight holding rate for banks), whereas the 30-year mortgage is about the longest that a loan will go for. So as the Fed raises rates steadily, the commercial lending business is becoming less and less profitable.

Furthermore, for a period between the end of 2006 and the beginning of 2007, there was almost no spread between AAA rated corporate debt and the Fed Funds Rates. But the competition between banks surged on. This may be the root of the exuberance problem in commercial banking leading to credit cycles.

Let’s talk about investors for a second. China is a heavy investor. They have a huge trade surplus to the US, but also an equally huge capital deficit--which means they are investing big time in the US. This acts to pull interest rates down, allowing investment that once might not have been profitable to become profitable. Also, it’s a bull market in the US so people are looking to grab some of this return. Investors see the profit being made in subprime and want in. Naturally, risk premiums get bid down (probably below the actual level or risk, which always spells trouble). It is the bidding down of the risk premium that will fuel another industry—private equity. That the AAA corporate debt almost had no premium to the fed funds for a time is particularly telling of this story.

Onto private equity. These are presumably a bunch of smart MBA’s that look for undervalued or mismanaged companies and clean them up. They like leverage; maybe because they are real confident in their abilities (this is like the hot chick that knows she’s hot, smart people that know they’re smart). The bidding down of risk premiums opens up a lot of new doors for them. They will have a larger set of potentially profitable takeover opportunities. This story is fundamentally the same as the housing market. Easier borrowing terms led to company’s valuations being bid up. Acquisitions were all over the place. A heavy season of acquisitions is shown no place more dramatically than stock price indices. The indices steadily climbed upward. But maybe it got to a point where private equity overdid itself and took on opportunities that will be profitable only if market conditions experience no downside (much like mortgage lending). We’ll see how smart they are, or were.

Now we’ve done it—connected the debt story to equity. This is just a glimpse of the story of the bull market. Now for the interesting part—what can we learn from this situation? And where did it go wrong?

First of all, this is a credit cycle like any other. Credit cycles have been happening since time has been recorded and certainly since the US was founded. Lots of regulation or a little, they still happened. I would argue that more regulation usually leads to more distortion and larger swings. At the end of a long period of success, people seem to push the boundaries of profitability and, inevitably, fall off the edge. A realization must be made that individuals act according to incentives and constrains. Therefore, we need to structure a system which creates as accurate of feedback mechanisms as possible.

The basic problem was that lenders lent money that couldn’t be paid back. Investors then threw their money after these loans too. (Hindsight helps us judge these decisions.) Let’s take the mortgage industry for example. Somewhere in the bull market borrowing conditions eased to a point of unprofitability. Lenders seemed to stop asking questions like: What are the drivers of wealth and price appreciation for this geographical area? What are the risks in this borrower’s future income stream? What unexpected events might occur? What kind of leeway should we leave to deal with unexpected events? How much down payment should we require? How extensively should we check the borrower’s credit history? There is a time lag between this decision and the consequences of that poor decision, which enables poor decisions to persist. Pressure to make these decisions come from competition. Market share is a big driver of profitability in commercial lending since the banks products are very similar. The irony of these short term competitive pressure is that long term competitive pressures favor an opposite approach. If a bank would hold off for a period of time when things got excessively bullish they would lose profits/market share to their competitors in the short term. But they would pull dramatically ahead when the crash comes. Compensation bonus incentives on a one year timeline may partially explain this problem, since credit cycles certainly have a longer timeline than one year. But also it’s really hard to know exactly at what time things start to get hairy and then just pull out—especially with loan officers working for commissions. In a sense they are being rewarded for quantity not quality—but of course only in the short term. Many of the mortgage brokers probably lost their jobs.

My final thought will be a suggestion to remove the Federal Deposit Insurance. This insurance (or more properly insulation) has a large effect to increase bank lending. Therefore, leading bankers into every more risky areas. First of all, when your deposits are insured by the Federal government you don’t need nearly the reserves that you would otherwise carry without this distortion. The Federal Reserve is then charged with putting regulation on top of regulation (trying to fix their own problem) by requiring a certain amount of reserves. Who knows if this level is accurate or not. One thing that is for certain is that bankers will never worry about a bank run (this raises a myriad of incentive distortions). Therefore, they will use the least amount of reserves possible because there will be competition from other banks to do so. Banks use capital that otherwise wouldn’t have been lent and find the next best opportunity, which is certainly riskier than the previous best opportunity. Federal Deposit Insurance makes banks riskier institutions (but it’s “all right because taxpayers will just bail them out”).
Also, tax deductibility of interest makes no real sense. I will come back to this in further posts, but it distorts business into issuing more debt than they would otherwise issue.

Next issues:

Part II: “What’s going on now?” Uncertainty in the market

Part III: “What’s the future?” How does this lead to a recession? Do bad loans jeopardize good loans?

Goldman wins this time...the next?

Here is an interesting Michael Lewis article from Bloomberg:

http://www.bloomberg.com/apps/news?pid=20601039&sid=a5hq2xXdftEo&refer=columnist_lewis

You could expect firms to have variable exposure to sub-prime mortgages (and their eventual collapse). Goldman, however, (as far as we can tell right now) seems to be a bit of an outlier. Some banks did better than others but I don't know of any that actually made a pile out of this whole thing. Lewis presents evidence that two individuals were given large power to offset the rest of the firm's positions (basically as Lewis says, calling everyone else in the firm an idiot). It turns out this time they were right. The position must have been massive, and probably massively risky if they were able to overwhelm losses in other parts of the bank and produce substantial profits. This reminds me a bit of Long Term Capital. Really smart, maybe arrogant guys, given a ton of freedom to take on hugely risky positions. Will Goldman have an even bigger blowup in the future?

Who knows, maybe its a stupid question since its based on speculative evidence and they surely will have a big loss sometime in the future given their business of relatively high risk (lots of proprietary investments), but the loss may not be caused by risk management structure.

One final thought. I don't think arguing that this could be interpreted as a hedging strategy works, unless they wildly miscalculated the hedge. You could argue that from a risk management standpoint, it might be a good idea to go market neutral when an area looks especially uncertain or irrational. But this position seems to have made a bunch of money. Not a hedge at all but an outright call. (Although it was probably a sophisticated set of trades in order to isolate the specific risk they were looking for.)

Good Guys vs. Bad Guys

Tonight I watched a bit of a democratic debate featuring Clinton, O'bama, and Edwards. Needless to say I was disgusted very quickly. The fundamental problem I have with their answers (to a question about stimulus in the economy) is their perspective that given the right people in office, he or she will be able to guide the nation to prosperity (certain angels exists which don't respond to incentives). Thats not a realistic expectation in my view. What we must aim for is to set up the most appropriate incentive structure between individuals. This is summed up in a quote from a book I am currently reading "Knowledge and Decisions" by Thomas Sowell.

"Much discussion of the pros and cons of various 'issues' overlooks the crucial fact that the most basic decision is who makes the decision, under what constraints, and subject to what feedback mechanisms. This is fundamentally different from the approach which seeks better decisions by replacing 'the bad guys' with 'the good guys'--that is, by relying on differential rectitude and differential ingenuity rather than on a structure of incentives geared to the normal range of human propensities."

Favorite Albums Exemplying the Quality of "Albumness"

A new feature has been added to the blog: “Favorite Albums Exemplifiing the Quality of Albumness.” Listening to music through albums presents differences from an alternative of lets say a mix of your favorite songs. I believe music should be listened to in albums rather than randomly. Its purely an opinion, but I think a perspective that can lead to a greater understand and appreciation of the artist or the work. One view of an album is that it should have something different to say from the rest of the work. Each artist’s album should come at you from a different angle whether it be musically, lyrically, or some different message. And within this album there should be some unifying themes that tie it all together (once again either musically or lyrically). A great album should be as The Who say an “amazing journey”—an experience from front to end which creates greater musical experience somehow from just listening to songs in isolation. It also shows great thought and intention behind the work—a sort of orchestration or mastermind behind the work. A sign of a great album is that if you took a song by the same artist from a different album B and put it in album A it wouldn’t make sense—and indeed might ruin the album. In other words the album stands out from the rest of the artist’s work. Well in homage to the idea of “the album” I have arranged a list of albums which I considered to epitomize “albumness.”

(*As a disclaimer some of my favorite artists won’t make the album list even though some of their albums are my personal favorites, yet they don’t necessarily display “albumness”)

This list is subject to change of course. There will certainly be additions. One album in particular that stands out to me is “Quadrophenia” by The Who. The Who tried in both “Tommy” and “Quadrophenia” to create a sort of “rock opera.” These albums are narrations two adolescents, Tommy and Jimmy. “Quadrophenia” may be considered superior through its complexity of themes (four themes interwoven throughout the album representing the four bands members as well personality traits in Jimmy) as well as musical complexity. It tells the story of a movement in England in the 60s between Mods and Rockers. Whether or not the story interests you or not, its uses artistic expression to tell something real, which I highly value. “Quadrophenia” has a bit of a niche following and if you’re interested you will find much information about its story throughout Wikipedia and its links. But anyways, enjoy the list of albums and, hopefully, have some musical experiences a cut above the norm.

Fiscal Policy Implies Monetary Policy

Today the president announced an initiative to launch a stimulus package for which I condemned yesterday. The good news is it’s a tax cut plan rather than a spending plan. Needless to say though we can be assured that no equal reduction in government spending with accompany these cuts. The question was never raised to either the president or Hank Paulson (I guess it’s unheard of). So how are these cuts going to be financed? Well, by selling government bonds of course. If this were the end of the story, the government would have supplied individuals with more income (money) while at the same time removing money from the system through the sale of its bonds. Net effect is more of a reallocation then some “injection” of money to the system. But maybe this is not the end of the story.

The sale of these bonds will result in the previously stated contraction of money supply relative to the target level that the Fed had previously set. Well assuming that this action doesn’t change the Fed’s target money supply or interest rate target, they will engage to counter this contraction. Their exact methods may be through different instruments than the same specific government bonds sold to finance the tax cuts, but the effect is the same (as I understand it the Fed primarily works with about 22 banks, or primary dealers, to distort overnight rates of bank “repo” agreements). The Fed has thus engaged in an inflationary measure which has devalued all outstanding money prior to their actions by the exact amount of the tax cut. In conclusion, there is a lot of hoopla about nothing. Unless there is an equal cut in spending this fiscal stimulus isn’t going to do shit.

Stimulus Package

The idea of stimulus in recessionary times inevitably ties into the popular manta of the consumer found in popular economic reporting (and in fact used by successful investing and asset management firms). Usually it goes something like this “Will the US consumer ever stop?” or “US consumers are 2/3 of the economy” or “We will whether the storm because of the resilient US consumer” or “Economic predictions are subject to variability due to the possibility consumers will significantly change their spending habits.” We have all heard it, but what really annoys me is the assumption that consumers spend exogenously (in a vacuum) or that if consumers decided to spend less this would be irrational.

What follows from this belief is policy makers decide that since these consumers are so irrational about their spending preferences let’s take away some of their income through increased taxation and spend it for them on areas throughout the economy. These areas are in my view random but “experts” have determined them to be areas of optimal growth for the economy as a whole. Sweeping assumptions like this have many weak points but I will elaborate on one. Economic phenomena like efficiency, innovation, low prices, and increased standard of living are all attributable not to experts with a top down view over the economy, but to individuals making self-interested decision about their everyday lives. It is truly nobler economic work displayed by the poor single mother of two than the government bureaucrat invoking massive governmental funds to employ stimulus to the most relevant sectors based on the latest research.

But back to the consumer. There is no reason to think that consumers’ preferences in the broad economy have recently gone from rational to irrational due to expectations of recessionary times. Certainly consumers can display irrational behaviors and crowd mentalities, which may account for natural business cycles. It seems the only cure for such irrational exuberance or gloom is to let these irrationalities bear their consequences, which all irrationalities will, given time. But the greater point here is who knows if consumers are being irrational? Maybe circumstances in their daily lives are signaling to them that a change of behavior is in order for which only their avoidance would be irrational. Taking this prospective a stimulus package of spending declares “the consumers must be irrational,” therefore, let’s correct them. When in actuality the government has then forced an irrational policy that will certainly have equal, and more likely, greater negative effects then the reduced spending would have in the first place. For where daily livelihood is concerned, especially among the poor, people can be expected to behave much more rationally than say the investing community. Why? You might ask. For “the investing community if filled with some of the best and brightest with outstanding educations.” Yes, indeed but they have a greater leeway to be wrong. They can shoot for risky actions that may turn out to be irrational in hindsight and still have an insurance policy to fall back on (their education for one, ever if they are reaped of their money). However, the poor person is forced to become rational and less risky. The poor and middle class have real decisions to make. The poor quite frankly might not be around if they display repeated actions of irrationality. Their likely destination will be jail, death, or homelessness. The middle class have important consequences too all though maybe not so grave, “Will I be able to send my kids to college?”, “Will I have money for retirement?”, and many other issues that may lead the consumer to say: “maybe I will need to save now in order to be able to ensure goals in the future.” In conclusion, I find it hard to believe that there is great evidence to suppose that consumers are heavily irrational in times of recession. Why take money from the ground level where consequences are concrete and measureable in order to reallocate it into the sky where it will drop down to more specific beneficiaries with consequences vague enough to establish an industry of academics trying to discern the benefits. Aren’t concrete and measureable consumer choices the key to our efficiency, flexibility, innovation, and wealth creation?

Granted this is one kind of fiscal stimulus option—the other being cutting taxes. Cutting taxes would have a rather opposite allocative effect. More consumer choice with concrete and measurable consequences would ensue. However, in the interim this is a fool’s goal since this effect will only produce this result with an equal CUT in spending—which seems increasingly difficult for our federal government to accomplish in general not to mention in a short enough time period to ease a recession. But who says this would ease the recession anyways? If given more of their own money the consumers may choose to save it all. Unlikely, but possible if imminent recessionary times are forecasted. Even if this measure didn’t ease the recession it would in fact be a more appropriate response since individuals would make a more accurate allocation of their income based on their subjective expectations of future economic prospects.