Tuesday, April 15, 2014

Book Review: Flash Boys

OK, I promised a review of Michael Lewis' Flash Boys, and here it is.

Flash Boys is an excellent book. It's fun and readable. It gives readers a window into how the stock market really works, and the kind of people who work there. It explains a lot about a very important issue that finance is facing.

For example, Lewis explains how a lot of the things that high-frequency traders are doing are just ways to game an SEC regulation, "Reg NMS", that came into effect in 2007. If this regulation were changed, a lot of the things HFT is doing would no longer make money. (Since gaming regulations is probably not a very socially valuable activity, a lot of financial economists have been calling for this regulation to be changed to create "batch auctions" every second or so; sadly, Lewis does not discuss this proposed solution.)

Also, Lewis gives a great explanation of how large banks use "dark pools", which were created to be a sort of refuge from HFTs, to rip off clients by selling them out to HFTs. Because the clients don't know the rules of the pools, and because they trust the big banks (yes, even after 2008), the clients lose money. In fact, I wish Lewis had shone more light on the dark pool issue in the first half of the book.

Finally, Lewis does a great job of exposing the injustice committed by Goldman Sachs against programmer Sergey Aleynikov. This actually had little to do with HFT, but was a classic tale of the evil that is callously committed by large bureaucracies where everyone is looking out for their own interests instead of trying to do the right thing.

So you should definitely read Flash Boys. But when you do, keep in mind two things that I think Lewis leaves out.

The first thing Lewis leaves out actually strengthens his case against HFT. Lewis, who tells a tale of bad guys ripping off good guys, glosses over the massive waste represented by the bad guys' own effort! At some point, it's clear that more speed is unnecessary for the efficient functioning of financial markets. There's no reason why prices need to adjust in a millisecond instead of a second. All the effort that HFTs spend on making this happen - all the math geniuses, and the supercomputers, and the hundreds of miles of fiber-optic cable - are valuable resources that could probably be put to much more productive use elsewhere in the economy. This has been pointed out by bloggers like David Glasner and Paul Krugman, and is based on a famous paper by Jack Hirshleifer, which you should read. A tale of social waste is not as exciting as a tale of plucky good guys rebelling against nefarious evil geniuses, but from an economist's perspective it's a big problem. The Death Star, if you think about it, was a massive waste of engineering talent.

The second thing Lewis leaves out is the other side of the story. All throughout Flash Boys, the victims of the HFTs - "investors" - are portrayed as good guys, just doing their jobs. The investors just want to trade, we're told, and the HFTs are unwanted middlemen who stand between the investors and stop them from trading. But who are these "investors"? Why are they doing all this "trading" in the first place?

Lewis' answer is that the investors are investing money on behalf of you and me - pension fund managers, for example, or mutual fund managers. But why should that require a lot of trading? Your pension manager is not Warren Buffett - he is not going to beat the market year after year. What he should do is to put your retirement money into a nice diversified basket of assets - ETFs, index funds, and the like - and just let it sit there for decades, maybe rebalancing it once a year or so. If he does that, the tiny amount that he gets front-run by HFTs at the beginning and end of those decades is going to make precisely zilch of a difference to your retirement account. But if instead, he trades and trades and trades enough to get substantially ripped off by HFTs, chances were that he was just playing the old sucker-and-be-suckered game that Michael Lewis wrote about in Liar's Poker.

In which case, he should be fired and replaced by a cat.

I'm actually not kidding. In 2012, the UK Observer held a stock-picking contest between professional investment managers - the good guys of Flash Boys - and a house cat named Orlando. The cat won. This result is, of course, supported by a long line of academic research into the unimpressive returns of professional money managers. As much as a quarter of your retirement account is being sucked away by the massive fees of money managers who, on average, are worse randomness. And this has been true since long before HFT existed.

In other words, HFT acts as a tax on trading, but much of that trading is hurting your mom and dad's retirement accounts in the first place - the "investors" who are the unambiguous good guys in Flash Boys are not so unambiguous in real life. In fact, if HFTs prompt pension funds to shift to passive management (or to "patient capital" investing that improves corporate governance), that could A) improve the efficiency of the financial sector, and B) boost returns for you and your mom and dad. In fact, there are signs that this is already happening! Led by California's massive CALPERS, big pension funds are shifting more and more money into ETFs, index funds, and the like.

Might we have HFT to thank for this sensible, rational shift? That's hard to say, but I think Michael Lewis should have at least mentioned the possibility in Flash Boys. Instead, I think he gives the "investors" and their "trading" a free pass.

So anyway, keep these omissions in mind when you read the book. But do read it. It's one of the most important popular books on modern finance, and - along with Scott Patterson's The Quants - is one of the first to introduce people to the brave, weird new world of electronic trading.

Monday, April 14, 2014

R vs. g

In his new book, Thomas Piketty argues that R, the rate of return on capital (which is different than the safe interest rate "r") is greater than g, the rate of economic growth, and that this fact can be expected to continue into the indefinite future, resulting in an ever-rising capital share of income and an ever-falling labor share. The big question is whether R really will be greater than g into the foreseeable future.

It occurs to me that this is just the "robots vs. globalization" argument all over again. 

The "robots" argument basically says: "Labor" is just the flow income from renting out one specific type of capital, i.e. human capital. If technology continues to make more and more obsolete, then the value of human capital will fall as a percentage of total capital, and thus labor's share of income will continue to fall toward zero. That's the scenario I considered in this Atlantic article a while back. This thesis is supported by the research of Loukas Karabarbounis and Brent Neiman, and is often labeled the "rise of the robots" in econ blog discussions.

The "globalization" argument basically says: In 1973, when the world finally began re-globalizing after the period of restricted trade brought about by the world wars, there was a lot of labor with very little capital, in China and India and Southeast Asia and Latin America and Africa and the communist bloc. Capital was scarce, and was highly concentrated in rich countries. After trade barriers started falling, all that labor was dumped on global markets, resulting in a global labor glut and capital shortage, raising the return to capital and decreasing the return to labor. That imbalance will eventually right itself, but only after enough time has passed. This thesis is supported by the research of Michael Elsby et al.

These explanations aren't mutually exclusive, of course. But in terms of policy, if the "rise of the robots" is the biggest factor, we need to think about all kinds of difficult policy decisions and welfare arguments. But if globalization is the main reason for R>g over the last 4 decades, then all we can do - and all we should do - is wait for the big wave to end.

Which is why strikes me as a little weird that conservative-leaning economists seem to want to embrace the "robots" argument, while liberal-leaning economists seem to want to embrace the "globalization" argument. If globalization is at fault, then even trade barriers will avail us little, since we trade in a global marketplace; all we can do is wait until the poor countries fill up with capital, and labor's share bounces back. That is an outcome that conservatives would favor. But if robots are to blame, then Piketty is right, and labor's share will never bounce back...leaving some kind of radical redistribution as the only option for preventing mass human misery. That is not an outcome that conservatives would favor.

Friday, April 11, 2014

Japanese toilets are something you should consider buying

I have a new article out in The Week about how America should be importing more of Japan's latest and greatest inventions:
The question of adoption of foreign technology is key to the Big Question of development economics — namely, why some societies grow fabulously rich while others remain desperately poor... 
I've lived in Japan for a total of about three years, and in the summer I usually go back. So I've had a lot of contact with Japanese technology. And let me tell you — they have some things we would really like, if we would only bring them to our shores. 
The biggest example is the amazing Japanese toilet. These so-called "washlets" are famous for washing your butt with a jet of warm water. But that's not their only important feature. For another thing, the seats are heated. Have you ever sat on a heated toilet seat? It is an experience not to be missed. Imagine a heated car seat on a cold day, and then imagine that without pants. Also, the toilet flushes at the touch of a button, and the button is on a control panel near your hand — no more having to reach behind you to pull a lever! 
But Americans do not have Japanese toilets... 
We've grown used to the idea that everything good is invented in America. If it wasn't invented here, it must not be worth having, we tell ourselves... 
There are other examples, besides just Japanese toilets. Japanese saran wrap, for example, makes American saran wrap look like the bad joke that it is. The Japanese version tears cleanly, doesn't stick to itself unless you want it to (how do they do that?!), and is strong and durable.
The article is obviously a little tongue-in-cheek, since toilets are not that big a deal in the grand scheme, and since America is in general relatively good about importing foreign technology (arguably better than Japan). But relatively good does not mean good enough, and it's important for us to keep our edge. Also, Japanese toilets are really great, and you should try one.

Wednesday, April 09, 2014

Some more ways that racism is hurting black Americans

Jonathan Chait has a long essay about race and the Obama presidency. I think he goes way too easy on conservatives, who seem to believe that the 1964 Civil Rights Act represented the end of American racism, and that the personal dislike and distrust of black people that is still fairly common in America somehow doesn't count as "racism". To me, it seems clear that this widespread "personal racism" has serious negative effects on the well-being of American black people.

How, you ask? Well of course there are the obvious and much-repeated examples of hiring discrimination, housing discrimination, and legal discrimination. People go back and forth on how much of these exist. I think that they're probably substantial, but I won't rehash those old arguments here. Instead, I want to suggest some additional ways that racism may be hurting black people.

1. Business networking. In the world of jobs and work and business, human networks are incredibly important. There's a huge amount of research on this, so much that it's almost too much effort to decide which links to post - see here, or here, or here or here, or anywhere. It's a well-known fact: friends and acquaintances are hugely important for getting a job, getting a promotion, getting a raise, and starting a successful business. The value of these connections is called "network capital" or "social capital".

And racism, of course, inhibits black people from forming human networks. When white (or Asian, or Hispanic) people don't see black people as worthy of friendship, trust, and frequent socialization, it makes it much harder for black people to succeed in the business world, legal discrimination or no.

This is different from the problem of workplace discrimination. That problem could, in theory, be solved if whites made a big effort to treat blacks fairly in hiring, salary, and promotion decisions. But the network capital problem will not be solved merely by fairness. It can only be solved by actual friendships between individual black and white people.

2. Neighborhood isolation. In an excellent article in Slate, Jamelle Bouie recently explained how many American black people, even after escaping poor neighborhoods, are pulled back to these neighborhoods, causing all kinds of negative outcomes. Why does this happen? Well, housing discrimination is one reason, but it's obviously more than that - the NFL player that Bouie describes could hardly have found it impossible to get a house in a rich white neighborhood. There must be other forces that make black people reluctant to leave poor, violent neighborhoods behind.

One obvious force is personal racism on the part of white people (and Asians, Hispancs, etc. - I'm going to stop writing this caveat now, and just say "white people"). If I were a black person who grew up poor or lower-middle-class, and I were contemplating becoming an upper-middle-class person, I would probably think twice. Why? Because I'd worry that an undercurrent of subtle, tacit, and unstated disdain, distrust, and dislike would permeate my new social set. I wouldn't want to give up my family and friends to hang out with a bunch of people who looked down on me because of my race. I'd choose to live around people who accepted me at a basic level, even if that entailed big risks and costs.

Look, in real life I'm Jewish, and if I lived in a country where half the upper middle class people were anti-Semitic, I'd think twice before hanging out with the upper middle class. I just would.

3. Personal violence. It's a fact that black communities in America are exceptionally violent, even after accounting for the effects of poverty. Why? One reason that strikes me as extremely likely to be a piece of the puzzle is police discrimination. Racist police - or even just the specter of racist police! - can be a powerful disincentive to use the police for protection, and motivate black people to rely on personal violence for their own defense.

It's pretty simple. If a guy in my neighborhood were threatening me, the first thing I'd do would be to pick up the phone and call the cops. I believe the cops would help me. But if I were black, I think I'd be very worried that the cops would just arrest me, or would simply fail to do anything about the problem because they just don't care about keeping black people safe. So I would not call the police. I would instead try to scare away the people who were threatening me. I'd get a gun. I'd get a gang of friends to watch my back. Maybe I'd even spray a few bullets into the guy's house, to teach him I meant business and was not a person to be f***ed with.

Yes, I really would do this, especially if I was poor and could not simply move away. It's not a "culture of violence", it's just plain old rationality. When I lived in Japan, many college-educated white people - who would call the cops in a second if threatened in Canada or Australia or the UK or wherever they came from - would just laugh if someone suggested calling the cops. They assumed that Japanese cops would discriminate against them, or would simply throw them in jail, if called.

(Note that violence in black communities declined a lot in the 1990s. If my theory is right, then "community policing" strategies, and the increasing racial diversity of the police in black neighborhoods, might have had a lot to do with that.)

What all of these problems add up to is this: To really help black Americans (and other minorities that are hurt by racism), it is not enough to make them nominally equal under the law. And it is not even enough for white people to act in a fair and unbiased manner toward black people. Respect is important, but mere distant, cold respect is not going to be enough. What needs to happen is for white and black people to actually be friends and hang out with each other on a regular basis. "Black America" can no longer continue to exist as a separate, foreign mini-nation within the American nation, because separate is inherently unequal. Real integration is the only real answer. Fortunately, I think attitudes are changing among the younger generation of Americans, but powerful people - political leaders, the media, churches, etc. - need to do their part.

Monday, April 07, 2014

The foxy Fed

A few days ago, the Fed released its workhorse model of the macroeconomy - the FRB/US model - to the public. The model had been only semi-private before, since the Fed would send it to interested researchers, and revealed some information about it to the general public. But now the model is fully public. How should we interpret that action?

Why didn't the Fed fully reveal FRB/US model before now? It always seemed to me that it was basically because of - for lack of a better word - embarrassment. Academic macroeconomists haven't used or studied this type of model in decades (having abandoned everything else in favor of DSGE). In 2010, Chris Sims appeared to call models like FRB/US "something close to a spreadsheet". Since most Fed employees are drawn from the same pool of people as academic macro (and interact with academic macroeconomists quite frequently), the fact that they use something like FRB/US must have seemed a bit awkward. In fact, I've heard academic macroeconomists make fun of FRB/US a number of times.

So if my guess is right, the Fed's publication of FRB/US indicates that whatever embarrassment existed is now essentially gone. That is kind of interesting.

After all, FRB/US flies in the face of two key developments in academic macro. Since FRB/US has a huge number of parameters, all of which are assumed to be structural, it is a lot harder for this model to pass the intuitive test known as the "Lucas Critique". Basically, more "structural" parameters = more assumptions = more chance to get some of the assumptions wrong = easier for any given economist to wrinkle his nose at the model.

Second, FRB/US does not force its users to use Rational Expectations (which the Fed more aptly calls "Model Consistent Expectations" or "MCE"). The model has an option that allows you to use it with MCE. But it also has an option to allow you to use it with non-model-consistent expectations. That flies in the face of what Robert Lucas told economists to do, and what most academic macroeconomists do in fact do.

(Also, FRB/US uses more heterogeneity than most academic DSGE-type models use.)

Lucas and his followers (and "his followers" include almost 100% of academic macroeconomists working after 1980, to a greater or lesser degree) hoped and expected that DSGE models, which have a relatively small number of parameters and generally only consider the MCE case, would fully replace models like FRB/US at central banks. But that has not happened, despite decades of arguments by academics. The Fed and other central banks do indeed use DSGE models, but they continue to use things like FRB/US as well. Where academic macro is hedgehoggy, central banks are stubbornly foxy.

And I say "stubbornly" because instead of becoming more and more shy about their continued deviation from academia, the Fed now seems to be getting more bold about it. In their notes on the public release of FRB/US, they very explicitly show how the model is used not just for unconditional forecasting, but for policy analysis - exactly the thing that Robert Lucas told us that we shouldn't do with this kind of model.

That's my (non-insider) takeaway from the public release of FRB/US - the Fed seems less embarrassed about its continued split with academic macro.

(Note: I'm definitely not calling the Fed cowards for not releasing FRB/US before now; in fact, the opposite. It takes lots of guts to keep using a diverse array of models when some of the world's smartest hedgehogs are yelling at you to use only one kind! Instead, I think it's the academics who might want to pause and think about why even central banks, their main audience, aren't totally sold on their approach even after more than three decades...)

Saturday, April 05, 2014

No one really knows if HFT is good or bad

Like every other human in the known Universe, I'm currently reading Michael Lewis' Flash Boys. But I've been thinking about HFT for quite a while, because Stony Brook has a lot of people who study it for a living (including some people who have done it for a living at Renaissance and other top firms). So even though I'm only halfway through the book - and I'll write a review when I finish it - I have some thoughts on the topic.

Basically, no one knows if HFT is good or bad. There are two reasons for this. The first is that no one really knows what HFT does to markets. The second is that no one really knows what is good or bad for markets.

Why don't we know what HFT does? Well, one reason is that there are a lot of different HFT strategies. Some HFTs could be pure market-makers, just gobbling up bid-ask spreads. Some could be "front-runners", looking for signals of large institutional trades and trading in between the chunks of these trades (this is the strategy Lewis spends a lot of time discussing). There are other common ones (like latency arbitrage, Twitter mining, high-frequency statistical arbitrage etc.). No one has the data to know how much of each of these is being done at any given time.

But a lot of HFTs simply don't know what their strategy really is. They hunt for patterns in prices or orders, find a pattern that seems to work, and trade on it until it stops making money. They don't have any idea why the pattern exists. Sometimes it only exists for a few seconds. In fact, if they stop to gather enough information about the pattern to figure out why it's there, it often disappears! Actually, there are deep mathematical (information-theoretical) reasons to suspect that lots of HFT opportunities can only be exploited by those who are willing to remain forever ignorant about the reason those opportunities exist. It's mind-bending (and incredibly interesting).

Needless to say, we have no idea what this latter type of HFT does to the market, because even its users don't know what it is! But even for the simpler strategies - market-making, front-running, etc. - we don't really know how they impact markets. This is because all of these strategies involve the phenomenon of asymmetric information. Most of our finance theories - the kind where you get nice clean results, like factor models or CAPM-type models - don't involve asymmetric information. Once you add it in, stuff gets complex and weird, fast. If you ever think you understand how financial markets work, go read Asset Pricing Under Asymmetric Information by Markus Brunnermeier, and you will be convinced otherwise.

Do market-makers increase or decrease liquidity? Do front-runners increase or decrease it? What about informational efficiency of prices? What about volatility and other forms of risk, at various time scales? What about total trading costs? Good luck answering any of these questions. Actually, Stony Brook people are working on some of these, as are researchers at a number of other universities, but they are huge questions, and our data sets are incredibly limited (data is expensive, and a lot of stuff, like identities of traders, just isn't recorded). And keep in mind, even if we did know how each of these strategies affected various market outcomes, that wouldn't necessarily tell us how the whole ecosystem of those strategies affects markets - after all, they interact with each other, and these interactions may change as the strategies themselves evolve, or as the number and wealth of the people using each strategy changes. 

Confused yet? OK, it gets worse. Because even if we did know how HFT affects markets, we don't really know if it's good or bad on balance. For example, HFT defenders often say HFT provides "liquidity". Is liquidity good for markets? How much is liquidity worth, are there different kinds of liquidity, and does it matter when the liquidity comes? If I have a bunch of totally random trading, that certainly makes markets liquid, but is that a good thing? Actually, maybe yes! In lots of models of markets, you need random, money-losing "liquidity traders" in order to overcome the adverse selection problem, thus inducing informed traders to trade, and getting them to reveal their information. But HFTs don't lose money, they make money - is their liquidity provision worth the cost?

To know that, even if we knew the impact of HFTs on informational quality of prices, we'd have to know the economic value of informational efficiency. Suppose the true worth of GE stock. according to the best information humanity has available, is $100. Suppose the price is $100.20. How bad is that? How much is it worth, in economic terms, to push the price from $100.20 to $100.00? Is it worth $0.20 per share? It depends on how GE's stock price affects the company's investment decisions. To know that, we need an economic model of corporate decision-making. We have many of these, but we don't have one over-arching one that we know works in all circumstances. Corporations are way more complicated than what you read in your intro corporate finance textbook!

(And this is all without thinking about weird things like behavioral effects of the humans who interact with HFTs...)

To sum up: There is very, very little that we know abouthttp://streetwiseprofessor.com/?p=8340 HFTs. We have incomplete data, incomplete understanding of the nature of HFT strategies, incomplete understanding about the interactions between ecosystems of strategies, incomplete theories of markets under asymmetric information, and incomplete understanding of the economic value of liquidity and informational efficiency.

So what the heck do we do?? Obviously we need a lot more research, but in the meantime, why not enlist the market itself to help give us some more info? If we legalize and facilitate a number of kinds of alternate kinds of stock exchanges where HFT has a much harder time - e.g. dark pools, batch-auction exchanges, etc. - we can learn a lot (though not nearly all we need to learn) about the overall impact of HFT (and other algorithmic trading!).

Like I said, I haven't finished Flash Boys (and I'll write a review when I do), but my early impression is that Lewis presents a very oversimplified picture of how HFT works - but in plumping for alternate types of exchanges, he gets the solution broadly right.

Here's a similar post by Craig Pirrong, who shares my uncertainty about the costs and benefits of liquidity and informational efficiency, but who is slightly more confident about the net effects of HFT on informational efficiency.

David Glasner has a great post on the topic as well. The biggest cost of HFT is probably the resources that are wasted on "information tournaments". I'm setting up a lab experiment about this very topic, in fact. This problem was pointed out in a famous 1971 paper by Jack Hirshleifer.

Thursday, April 03, 2014

How should Charles Koch use his power?

"It's a very dangerous thing to do exactly what you want"
- The Flaming Lips

One of the most startling moments of my life came at a conference earlier this year, when a tenured macroeconomics prof at a good school, whom I had never met, walked up to me and said: "Hey, I agree with a lot of the things you write about macroeconomics. What do you think we macroeconomists ought to be doing?" More than ever before, it sank in that people might care about, listen to, and be influenced by things I say. I know this sounds a little silly, but I had never really believed that before. Blogging felt like a way to have a fun discussion with smart, nerdy people like Brad DeLong and Tyler Cowen. But when enough people start reading you, you become a "thought leader", whether you meant to or not. At that point you basically have three choices: 1) shut up, 2) confidently push on, or 3) try to moderate what you say.

It's not an easy decision. If you think the Marketplace of Ideas is more or less efficient, then it doesn't matter how loud you shout or how many readers you have, society is going to weigh your arguments on the merits, so you might as well say whatever you feel like saying. Or if you think you're facing an implacable, dishonest opposition, then maybe you should make your message stronger to balance out their power - a sort of "dialectical" approach. Or maybe you think you've found the One True Way, and so it makes sense to fight tooth and nail. I don't really think any of these things, so I've decided to moderate my tone on macroeconomics-related issues ever since I talked to that professor at the conference. Not to say things I don't believe, but to tone it down, insert more caveats, and give a more accurate picture of what I really think instead of just blogging my most controversial (i.e. fun) ideas.

Now, I'm a guy with only a tiny amount of power, so I'm not too worried. A more famous writer like Paul Krugman or Michael Lewis has more. But some people have much, much, much more. For example, Charles and David Koch, the famous Koch brothers.

Together, Charles and David Koch have about 80 billion dollars of wealth. Compare that to Bill Gates, with $77B, and you see that if they were one person, the Kochs would be the richest person in the world...and they act as one for political purposes. If John D. Rockefeller were a comic-book superhero who got split into two people, he'd be the Koch Brothers.

This huge amount of wealth gives the Kochs enormous power to affect politics, if they choose to do so. And they do choose to do so - a lot. "Political activities of the Koch Brothers" has its own Wikipedia page. For the last two years, Koch money has been very important for the Republican party. In some political races, the Kochs outspend all other Republican donors combined. In addition, the Kochs have been extremely active in funding academic departments whose political tenor agrees with their own beliefs. And they have spent lots of money to set up think tanks - including the Mercatus Center, which provides supplemental employment to several of my favorite econ bloggers (for which I suppose I should thank them) - and to influence other think tanks.

Why do the Kochs do this? Why do they think their perspective is so much more important and valid than the perspectives of all the people who have less money and power than they do?

Well, they might believe that all their spending doesn't really influence the political process that much - that money doesn't translate into power. And they might have so much money that they don't feel the need to save it. So it all might just be for fun. But I highly doubt this.

Alternatively, they might believe that there are powerful negative forces in American society, and that these negative forces are unscrupulous and unrestrained in their tactics, and that in order to balance out the "bad guys", the Kochs must pull no punches. Finally, the Kochs might just believe that they understand the One True Way, and that the masses of people who disagree with them are simply misguided.

Reading Charles Koch's recent op-ed in the Wall Street Journal, I'd guess it's a combination of those latter two. Koch is very confident in his view of what is right and good, and he thinks that the people opposing him are unscrupulous and unrestrained:
[T]he fundamental concepts of dignity, respect, equality before the law and personal freedom are under attack...That's why, if we want to restore a free society and create greater well-being and opportunity for all Americans, we have no choice but to fight for those principles... 
Instead of encouraging free and open debate, collectivists strive to discredit and intimidate opponents. They engage in character assassination...Such tactics are the antithesis of what is required for a free society—and a telltale sign that the collectivists do not have good answers... 
Instead of fostering a system that enables people to help themselves, America is now saddled with a system that destroys value, raises costs, hinders innovation and relegates millions of citizens to a life of poverty, dependency and hopelessness... 
If more businesses (and elected officials) were to embrace a vision of creating real value for people in a principled way, our nation would be far better off—not just today, but for generations to come. I'm dedicated to fighting for that vision. I'm convinced most Americans believe it's worth fighting for, too.
Obviously, if America has elected "collectivist" politicians, it means that many, many Americans support "collectivism". Charles Koch thinks it's worth using his own tremendous personal power to singlehandedly balance out the power of a huge number of the people who disagree with him. He thinks this is OK because he believes so strongly in his cause, and because he thinks his rhetorical opponents use dirty tactics.

But if I were Charles Koch, I wouldn't be so sure of these things.

First of all, why do so many people disagree with Koch's ideas? There are certainly times in history when the mass of people was gravely, horribly wrong. But those times are rare. So if the majority is wrong, they're probably only moderately wrong. This is not a reason for Koch to moderate his views. But it is a reason for him to reconsider his policy of outspending the multitudes of his opponents.

Second of all, Koch should consider that his perception of the unscrupulous ways of the "collectivists" might be mistaken. There seems to be a bit of a tendency for certain rich old men to see themselves as being in more danger than they really are - for another example, witness Tom Perkins. Charles Koch should consider whether part of his perception of vicious tactics by the "collectivists" is just a persecution complex.

A big part of the reason that the Kochs are so reviled is that they have lots of power. Power magnifies the degree to which we don't like people who disagree with us. Charles Koch, with his $40 billion, can exercise a voice in politics that is far louder than the voice of any of the people who disagree with him. And with David Koch totally on his side with another $40 billion, there's basically two of him. That scares many people, and it strikes many others as unfair - why should another guy's voice be thousands of times more powerful than my own?

The Kochs have freedom of speech, so the only check on their use of money for political purposes is their own conscience and sense of responsibility. But those can be powerful checks. Notice that most of the super-rich don't shell out hundreds of millions of dollars on politics. Bill Gates doesn't. Warren Buffett doesn't, despite the fact that he obviously cares about issues. Larry Ellison doesn't. The Waltons do a little bit, but not nearly so much as the Kochs. Sheldon Adelson does, but his reasons are...more cynical. George Soros is the only real rival to the Kochs in terms of individual political spending, though he has only about a quarter of their wealth.

So it seems to me that most super-rich people are more skeptical than the Kochs about the correctness of their views, the badness of those who disagree, and/or the fairness of outspending hundreds of thousands of normal, non-rich individuals. If I were super-rich, I think I'd be more like Buffett or Gates or Rockefeller, and less like the Kochs.

(I do hope they keep supporting econ bloggers, however.)

Tuesday, April 01, 2014

A Marshall Plan for the Culture War

I have an article in the Atlantic, basically saying that now that we liberals have won the Culture War, it's time to reach out to conservatives to repair American families and promote work ethic. Excerpts:
Any time you win a great victory after years or decades of bitter struggle, there is the temptation to pillage the lands of the conquered enemy. This is always a mistake... 
The reason we need to reach out to conservatives is simple—there are a lot of them, and they are our countrymen. America is not going to be healthy unless conservative America is healthy. And America is not going to be a fully effective nation-state until conservative America feels completely included in the new liberal America that is now emerging... 
It’s time to reach out to conservatives on the issue of family stability. It’s becoming clear that traditional family gender roles—the idea that the man should be able to be the sole breadwinner—are not sustainable in the modern economic environment...The better way is what Richard Reeves, in a landmark article in The Atlantic, calls “High Investment Parenting.” When families focus on the kids, instead of on maintaining traditional gender roles, it turns out to be a lot easier to keep the family together...But how can we liberals help spread high-investment, gender-equal parenting to working-class, conservative America?...We need to make common cause with conservatives like W. Bradford Wilcox... 
We also need to reach out to conservatives on the issue of work. Many conservatives—like Kevin Williamson, Michael Strain, James Pethokoukis, and Ron Unz—have woken up to the fact that in a purely laissez-faire economy, lots of people get left behind in ways that are ultimately unhealthy to the nation.

Saturday, March 29, 2014

"Land of the brave" no more?

I really like this Megan McArdle piece about risk-taking:
If you can’t try something new in 10th grade, when can you? If you can’t afford to risk anything less than perfection at the age of 15, then for heaven’s sake, when is going to be the right time?... 
Now is when this kid should be learning to dream big dreams and dare greatly. Now is when she should be making mistakes and figuring out how to recover from them. Instead, we’re telling one of our best and brightest to focus all her talent on coloring within the lines... 
Now, more than ever, we view a college degree as an absolute prerequisite for a minimally decent life. And if we’re in the upper middle class, it has to be a degree from an elite school...To keep their kids from falling off the side, [parents are] pushing them harder than ever.
Is American risk-taking really decreasing? Well, it's hard to say. Despite the popularity of Silicon Valley startups in the news, the rate of new business formation has fallen steadily since the 80s. Americans are less likely to try to switch jobs than before. Discount rates implied by stock prices haven't fallen much, but I'm not sure that tells us a lot.

But anyway, let's assume it's true, and that America has on the whole become a more timid nation. Why might this be happening?

1. No social safety net. America has less of a social safety net than most rich European and Anglophone countries. Especially since welfare reform in 1996, economic failure has dire consequences. If your business or risky career path falls through, you'll have no health insurance (well, at least til Obamacare kicks in), and you could even find yourself on the street. Jacob Hacker calls this the Great Risk Shift.

2. Income inequality + income stagnation + social preferences. The big runup in inequality since 2000 has mostly been about the top 0.1%. But in the 1980s - when the rate of new business formation started to fall - there was a much broader increase in inequality. The middle class spread out, and that raises the penalty of failure. If you don't break into that $100k-and-up income bracket, you'll be stuck in $30k service-sector-land. Add to that the fact that incomes for the lower part of the distribution have flatlined since 1980, while incomes for the top brackets have soared; a career failure means, more than ever, that you'll be much poorer than your peers.

3. Labor market segmentation. In America, if you're unemployed for longer than six months, you have a much worse chance of getting a job Also, the college wage premium has increased - if you don't go to a decent school, good luck getting a decent job. This is a weaker version of what has happened in Japan. It seems like both college and the duration of unemployment have become important signaling devices. Fall off the "success" wagon, and good luck getting back on.

These three explanations don't involve any increase in Americans' risk aversion; they simply mean that risks have increased. But what if risk aversion is increasing too? I can think of a couple reasons for this:

4. High-Investment Parenting. America's upper-middle-class has largely adopted a parenting strategy that Richard Reeves calls "High-Investment Parenting". With relatively low fertility rates among the upper middle class, this kind of parenting strategy makes sense. But it could mean that parents are going out of their way to discourage their precious kids to take risks.

5. The Internet. I noticed something odd recently. Japanese people are traveling to America less, and when you ask them why, they often cite violence as the reason, even though violence in America has declined dramatically in the last two decades. But thanks to the internet, there's a lot more information available about the violence that does exist, and by the availability heuristic, this will tend to make people more worried about it. In the same way, Americans may be more acutely aware of the real consequences of failure, thanks to the internet, and this may be scaring them.

So the question is, what do we do to encourage Americans to take more risks? Well, the internet is here to stay, and High-Investment Parenting seems like a very good thing overall. So the best way to boost risk-taking seems to be to decrease the downside risks of failure - by establishing a social safety net (including universal health care), and by doing whatever we can to fight labor market segmentation (I'll admit I'm not sure how to do that, but there must be ways). It's a lot easier to be the "land of the brave" when you've got a whole army behind you.

Thursday, March 27, 2014

Coming into econ from physics (and other fields)

Chris House makes a very good point over at his blog: A physics background will not help you in econ as much as one might imagine. Actually, this is true not just of physics, but of all subjects, math and computer science included. But physicists are notorious for adventuring into other fields (especially given the lack of things to do in theoretical physics these days), so its understandable that House singles them out.

As a physics-undergrad-turned-econ-PhD student myself, I think I'm qualified to comment on the degree to which undergrad physics will help you in graduate econ. And the answer is: a little, but it will also hurt you a little.

A physics background will make you better prepared for the math of econ than someone who was a pure econ major in undergrad (though not better than the econ/math majors that you often see nowadays). You will be able to sleep through most of "math camp", and probably pass out of the first-year math class requirement, though you might want to take it anyway just as a refresher course (or, you know, because the prof has a funny accent). You will know what a Hamiltonian is, and a Lagrange multiplier. You will not be afraid of real analysis. But by the time you're done with your first year, everyone else in your class will be caught up in terms of math.

Then there are the downsides. Physics intuition is very different than econ intuition. Physics intuition is all about symmetry, and about finding elegant (i.e. easy) ways to solve tough-seeming systems. In econ, that rarely matters at all; the intuition is all about imagining human behavior. Having been trained on the former type of intuition in your formative years can actually make you less receptive to the latter, because it's hard to change the basic way you think and reason. And if you haven't taken a stats class, take one, because stats is not math, and the intuition is not the same. Basically, when you come to econ you're going to have to learn a whole new way of looking at the world, and your econ-undergrad classmates will be way ahead of you in this regard.

Also, physics doesn't prepare you to deal with empirical data. Physicists have lab experiments; economists rarely do. But the wonderful bounty of exogeneity that physicists enjoy can become a sort of handicap in econ - like growing up in California and suddenly having to survive in the Arctic.

Of course, like I said, all of this is true for mathematicians and computer scientists. Don't expect to be able to prove your way to good results with math badassery unless you are a hardcore game or decision theorist (in which case you never really left the math field at all). And while programming skill is just as useful in econ as anywhere, deciding what to program will be the most important thing in the end.

(Note: As people have been pointing out in the comments, a lot of computational and applied physics, applied math, and CS people are less about the "pure" theory elements of the disciplines, and more about modeling complex systems tractably. I think that skill will come in very handy in econ. But you're still going to need to build that intuition about human behavior, and that's pretty unique to economics.)

But should all this discourage you from switching to econ? No way! First of all, the list of former physics nerds who made it big in econ is long and illustrious, including such names as Joe Stiglitz, Dan McFadden, Mike Woodford, John Cochrane, and Robert Barro. People who switch disciplines may find it tough to adjust, but if they can manage it, they often bring fresh perspectives that can push research in new directions.

So don't be afraid, physicists and mathematicians and other lost nerd-souls of the world. Econ is different than what you've done before, but it's a great life path. That goes for biologists and chemists and other overworked, under-appreciated lab scientists too. Don't let Chris scare you off - he's gruff on the outside, but underneath he's a big softie.

Postscript: Chris also makes one other point - about professional physicists trying to horn in on econ's turf, or show up and "save the day". It's true that physics theory usually can't be applied in a cut-and-paste way to economic problems (option pricing theory being the famous exception). And Chris' intuition is right that group theory is unlikely to be very useful in econ (group theory is just about symmetry, and symmetries in econ tend to be few and far between, and also highly unrealistic, as Miles Kimball could tell you).

But I do appreciate the kind of external criticism that physicists (like Mark Buchanan) have applied to economics. If you allow an academic discipline to be judged only by insiders, you run into the problem of groupthink and vested interest. Smart outsiders are needed to look in from time to time and check on what other kinds of researchers are doing. Of course, it works both ways - outsiders have been instrumental in forcing the theoretical physics community to realize that string theory hasn't really gotten anywhere.

(Note: Also, I should have said, and forgot to say, that advanced math techniques often migrate into econ from other fields, and end up proving useful in the eyes of many economists. Economists did not invent functional analysis, for example, or stochastic calculus, but lots of economists use these now, so economists shouldn't be too quick to write off esoteric-sounding math techniques.)

Tuesday, March 25, 2014

"Data" the buzzword vs. data the actual thing

I'm a big Nate Silver fan, but let me join the chorus of people looking at his new "data-driven" blog site and saying "WTF?". As far as I can tell, it's barely data-driven at all!

For example, take this post about how climate change is not increasing the cost of natural disasters. The blogger, Roger Pielke, notes that natural disaster losses have slightly decreased since 1989 as a percentage of world GDP, and concludes that climate change is not causing (and will never cause!) increased losses. The post has been much maligned by professional climate scientists for having crappy and misleading data, but put that aside for now. Let's focus on the idea that this post represents "data-driven" journalism at all. It doesn't. 

The "data" in the post consists of one annual time series with a sample size of 23. That's too small to do any sort of statistical analysis on, but then again, the post doesn't do any statistical analysis. It shows a trendline, and from that trendline it draws broad, sweeping conclusions about the effects of climate change. How is that any more "data-driven" than what any blog does? Every newbie blogger and his dog draws a trendline and extrapolates it - and if the blogger is worth his salt, he'll at least have the common decency to qualify his extrapolation with "if this trend continues", which Pielke does not.

Furthermore, Pielke's analysis is just sloppy. What happens if you strip out earthquakes, tsunamis, volcanoes, etc. from the data? What if you extend the trend back 40 years instead of just 23? How does the recent trend compare with the trend from before climate change started significantly affecting global temperatures? And so on.

And the economic theory behind the conclusion is even sloppier. What about the costs of mitigation - levees, reinforced buildings, relocation of crops, and the like? That won't show up in loss measurements, but it represents a real cost to the economy. And what about variance? Aren't people risk-averse ? As Paul Krugman pointed out the other day, if you try to pretend you're just looking at data without any theory, you've just ignored your hidden theoretical assumptions.

OK, the Pielke post sucks, but that's just one post. Let's look at a few others. 

How about this post by Ben Casselman? This one has barely more data in it than the Pielke post! It shows a single monthly aggregate time series (of voluntary job quits), observes that quits are lower now than in 2008, and concludes that A) the economy may be becoming less dynamic, and B) wage gains may be suppressed going forward. This is less sophisticated than the average econ blog post. Well, at least Casselman used the word "may".

And how does this post extract any information from the data? Where is the data analysis connecting quits to dynamism, or to wages? There is none. Instead, Casselman links to a bunch of Wall Street Journal articles, and one speech about "dynamism" by Dennis Lockhart of the Atlanta Fed. The linked articles are all taken to support Casselman's central thesis. This is pure hedgehoggery, not foxiness

Or take this Casselman post on long-term unemployment. Compare the amount and detail of the data, the sophistication of the analysis, or careful thought about the data's implications to any of the following Matt O'Brien posts on the same topic: Post 1, Post 2, Post 3, Post 4. Casselman and O'Brien reach the same conclusion, but in terms of "data-driven journalism", Casselman's post is nowhere near O'Brien's league. 

Or take this post by Andrew Flowers on whether the labor market is slack or tight. Compare this to the average econ blog post on the topic, in terms of data quantity, data quality, data analysis, and data interpretation. Again, no contest.

Looking at a bunch of other posts, you can see that this is par for the course. And not one of the posts attempts a single quantitative prediction, which is what Silver has famously thrilled the world by doing in the past.

In sum, this so-called "data-driven" website is significantly less data-driven (and less sophisticated) than Business Insider or Bloomberg View or The Atlantic. It consists nearly entirely of hedgehoggy posts supporting simplistic theories with sparse data and zero statistical analysis, making no quantitative predictions whatsoever. It has no relationship whatsoever to the sophisticated analysis of rich data sets for which Nate Silver himself has become famous.

The problem with the new FiveThirtyEight is not one of data vs. theory. It is one of "data" the buzzword vs. data the actual thing. Nate Silver is a hero of mine, but this site is not living up to its billing at all.

Update: Just to be clear, I remain a Nate Silver fan, and I don't mean to get involved in (or start) any feuds. In fact, if I didn't have so much respect for Nate Silver, I'd never have written this post at all. In fact, I think all the criticisms of the new 538 site are based on the idea that Nate Silver is exceptional and can do better than the middle of the pack. It's the curse of high expectations.

Saturday, March 22, 2014

A grand unified theory of behavioral economics?

Tim Harford has a great article about the backlash against behavioral economics. You should read it.

There are two main knocks against behavioral econ. These are:

1. There is no "grand unified theory" of behavioral econ; instead it's a bunch of specific little theories for different situations. What we want is a widely applicable, unified theory of economic behavior.

2. The behaviors produced in a psychology lab are extreme effects produced by extreme, coordinated manipulations; in the real world, lots of stuff is going on, and what we care about is the average.

I never really understood Critique #1, because maybe there just isn't a grand unified theory of economic behavior; maybe it really is just a bunch of little situational things. But #2 does indeed seem like a big problem, because if you don't have external validity, you're spinning your wheels.

Now a thought occurs to me. What if Critique #2 contains the secret to answering Critique #1?

Suppose that there are a whole ton of different behavioral biases, and that these vary across time, across people, and across situations so much that even with a billion lab experiments we couldn't find them all. Only once in a while will the forces be aligned to make one behavioral bias dominate; most of the time, the net effect of all the biases will be unpredictable by the outside observer. When you have an unpredictable mishmash like that, you have to model it as a stochastic process. In other words, if it's too complicated to explain deterministically, then you treat it as randomness.

So what if psychology usually just ends up injecting randomness into our decisions? What would that theory look like? I think it would look like a Random Utility Model.

For those who don't know, Random Utility discrete-choice models are one of economic theory's great success stories. They've been around for over forty years, they're widely used in the private sector, and they've already won a Nobel Prize for their creator, Dan McFadden (currently of UC Berkeley). In a legendary example of theoretical badassery, McFadden used the model to predict the number of people who would ride the new BART train in the San Francisco Bay Area. The government predicted that 15% of Bay Area commuters would use BART; McFadden's model predicted 6.3%. The actual number? 6.2%.

(Next time someone tells you that "economic theory can't predict anything", tell them about McFadden and the BART.)

A Random Utility model treats human decision-making as if it has two components - a predictable, deterministic component, and a random component. But if there are a huge jumble of behavioral effects going on, it seems to me that outside of the lab, that's usually just going to be observationally equivalent to randomness in the objective function. Which is exactly a Random Utility model.

So what if Random Utility models are the grand unified theory of behavioral economics? What if the upshot of all of these psychological effects is simply that the random component of utility is partially irreducible - that there must be a random component of utility in almost any theory if that theory is going to have a chance of predicting human behavior accurately? Maybe sometimes the randomness is so negligible that people act like homo economicus, and sometimes the random part dominated so much that their decisions are completely unpredictable with science?

In other words, maybe the Grand Unified Theory of Behavioral Economics was invented and validated more than 40 years ago, and we just didn't recognize it for what it was?

Anyway, I'm sure someone has thought of this idea long before me, and I'm sure it won't be long before a commenter provides me with a link. But old or new, it's still a really interesting idea, which I think has the potential to answer both of the main criticisms of behavioral economics.

White supremacy does not reign supreme

Like pretty much everyone else, I love Ta-Nehisi Coates, but in recent years his writing has taken a turn for the pessimistic. During a recent argument with Jonathan Chait, he wrote:
Obama-era progressives view white supremacy as something awful that happened in the past whose historical vestiges still afflict black people today. They believe we need policies--though not race-specific policies--which address the affliction. I view white supremacy as one of the central organizing forces in American life whose vestiges and practices afflicted black people in the past, continue to afflict black people today, and will likely afflict black people until this country passes into the dust. (emphasis mine)
This kind of "nothing ever changes" viewpoint is seductive, especially to people who spend a lot of time reading history (as Coates does). Read war history, and you'll think that war will plague humanity forever; but if you look at the data, you see a very different picture.

Similarly, it is by no means certain that white supremacy will always define American society. Sure, white supremacy is still around, and is still powerful (see here, here, etc....there's no shortage of evidence). Sure, there will always be white supremacists out there - a chunk of white people who view the white "race" as their own "team", and who want that team to "win". But it seems quite possible that white supremacy will recede and recede until someday it's just one more toothless endemic disease lounging around in the gut bacteria of our national culture.

In fact, history and current events seem to favor that outcome. To say that white supremacy is as powerful today as in America's past is to deny rationality. The clearest piece of evidence of this is the election of Barack Obama. As Coates writes:
Barack Obama isn't the coach of "Team Negro," he is the commissioner of the league..."I’m not the president of black America," Barack Obama has said. "I’m the president of the United States of America."
The election of a black president obviously doesn't mean that white supremacy is gone from America. But would it have been possible in 1868? In 1968? Even in 1998? I don't think so. Obama's two elections don't show victory, but how can you deny that they show progress? They mean that a majority of Americans (who are increasingly less white) has twice been willing to make a black person their chief executive, their representative to the world, and the commander-in-chief of their armed forces. When enemies attack the United States, it is to a black man that Americans must turn - have chosen to turn - to defend them.

Of course, presidential elections are mainly symbolic choices. But if you look at the history of American policy, you see a steady march of very big, very real policy shifts  that have coincided with (and perhaps caused) dramatic improvements in the lives of African Americans.

The first of these, obviously, was the Civil War, in which the people of the Union fought (and took 646,000 casualties!) not just to assert Northern power over the South, but to smash the idea of America as a slave empire. The forcible end of de jure segregation was another blow to white supremacy.

Even after the end of official segregation, black people remained mostly poor. But in the 1960s, the black poverty rate plunged from almost 56 percent to around 33 percent. Some of that probably reflects America's rapid economic growth. But some of it probably reflects the War on Poverty, which included a welfare system, government efforts to end private racial discrimination in hiring, and various Affirmative Action initiatives.

In other words, in the 60s, while white supremacy was still strong in America, it was not strong enough to prevent massive collective attempts to improve the welfare of African Americans - efforts that, in retrospect, look mostly successful.

In the 1970s and 1980s, black Americans' lives improved in another important way: education. Over those decades, the so-called "achievement gap" between black and white test scores shrank by about a third. Again, there are a lot of factors that might have caused this, but it's undeniable that during this period, the American government was actively trying to improve black people's economic situation through Affirmative Action, welfare, and busing programs. White supremacy was not strong enough to prevent these initiatives, even though it tried.

In the 1990s and 2000s, there was another massive improvement in black Americans' lives: security. Between 1990 and 2008, the black homicide victimization rate fell by half. This was accompanied by a similar or even greater decrease in all forms of violent crime. The upshot of this is that black people, though still not safe enough, are a lot safer in America today than they were back in the 1980s.

Was this increase in safety caused by a weakening of white supremacy? Maybe. Many attribute the fall in crime to America's policy of increased incarceration, which has disproportionately fallen on blacks. But an improved relationship between black communities and the police may also be responsible. Research shows that black police are less likely to disproportionately arrest black people, and that mixed black-white police forces tend to have better relationships with mostly-black communities. And the percentage of police who are black has exploded since the 1970s.

The increase in the number of black police itself represents a weakening of white supremacy. Police are the people who are entrusted with a democratic society's official monopoly on the use of force - hence, when the police are black, it means that black people are the guarantors of all Americans' safety. It means that white people too are depending on black people to defend them. As for the reason why the percent of black police has increased, whether it was due to government policy or to decreased racism in hiring, it represents a failure of white supremacy to prevent more and more official, legitimate power from being placed in the hands of black people.

So over America's history, we see a steady march of improvement in African Americans' lives. At the same time, we see a steady series of collective attempts by American society - by black Americans, and also by other Americans who simply don't want our society to be a racist one - to improve life for black America. Whether the latter caused the former is almost beside the point. The point is that white supremacy has been desperately fighting battle after political battle - and losing many more battles than it wins. Again and again, America has been faced with a choice of more white supremacy or less, and most of the time, it has chosen less.

White supremacy will never die. But no movement ever dies. There are probably still people out there who think that Europe should be ruled by a Holy Roman Empire. There are probably still people out there who think Stalin's economic policies were the best. But to deny that progress has been made against these movements is to deny rationality.

So don't be discouraged by the pessimism of Ta-Nehisi Coates' post. White supremacy is not dead, and it is not yet dying. But it continues to lose more battles than it wins. America is not an inherently white supremacist nation; white supremacy is not in our national DNA. To me the evidence says that the willingness to combat white supremacy is in our national DNA.

Acknowledging the progress that has been made against white supremacism does not weaken the case for further action against it. In fact, it strengthens the case.

Wednesday, March 19, 2014

Which is better, data or theory?

One of the most annoying arguments that I see popping up again and again is the question of "Which is better, theory or data?" (A related bore-fest is "Which is better, induction or deduction?") Actually, you can't have one without the other. In a recent blog post, Paul Krugman points out that you can't have data without theory:
But you can’t be an effective fox just by letting the data speak for itself — because it never does. You use data to inform your analysis, you let it tell you that your pet hypothesis is wrong, but data are never a substitute for hard thinking. If you think the data are speaking for themselves, what you’re really doing is implicit theorizing, which is a really bad idea (because you can’t test your assumptions if you don’t even know what you’re assuming.)
True. Suppose you find a correlation between having an unfulfilling sex life and liking Charlie Kaufman movies. Does that mean that people watch Charlie Kaufman movies to ease the pain of their lame sex lives? Or did the fact that they watch Charlie Kaufman movies actually ruin their sex lives? Or are both the result of some third factor, such as being an insufferable hipster? If you don't pick one, you'll never be able to understand what's really going on. Even if all you care about is predictive power - you want to be able to catch someone watching a Charlie Kaufman movie and say "I bet girls won't touch that guy with a 10 foot pole" - you still need to assume that the correlation is stable over time, and your assumption is a theory. 

It's equally true that you can't actually have theory without data. A theory is always about something that you think is going on in the world, so you can't have something to theorize about without first seeing something happen in the world (i.e. data). For example, suppose my theory - which I deduced from some sort of a priori assumptions - is that watching Charlie Kaufman movies ruins one's sex life. I couldn't have made that theory without observing the existence of Charlie Kaufman movies.

So just as "data with no theory" is really just an implicit vague theory, "theory with no data" is really just sparse, unsystematic data. You can't have one without the other. 

But what you can do is be lazy with theory or be lazy with data. You can be an armchair philosopher, dreaming up ideas about how the world works without ever bothering to find out if your ideas are right. Then you get something like this:

Or you can be a "regression monkey", sitting there sifting for correlations without having any idea what you're looking at. Then you get something like this:

Obviously, if you're going to get good results, you shouldn't do either of these.

But which is a bigger menace to society, laziness about data or laziness about theory? Theory-laziness is seductive because it's easy - mining for correlations isn't very mentally taxing. But data-laziness is seductive because it's hard - the more complicated and intricate a theory you make, the smarter it makes you feel, even if the theory sucks.

In the past, data-laziness was probably more of a threat to humanity. Since systematic data was scarce, people had a tendency to sit around and daydream about how stuff might work. But now that Big Data is getting bigger and computing power is cheap, theory-laziness seems to be becoming more of a menace. The lure of Big Data is that we can get all our ideas from mining for patterns, but A) we get a lot of false patterns that way, and B) the patterns insidiously and subtly suggest interpretations for themselves, and those interpretations are often wrong.

So anyway, I hope this post destroys all of those "data vs. theory" arguments forever and ever. 

Monday, March 17, 2014

Do economists control our ideas?

John Maynard Keynes famously said: "The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood...Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist." And Nicholas Kristof recently wrote: "[E]conomists (including my colleague in columny (sic), Paul Krugman) shape debates on issues from health care to education."

Maybe our ideas are shaped by dead economists - Milton Friedman's libertarian vision, for example. But do living economists really hold such sway over the public discourse in this day and age? I'm not so sure.

With regard to the general public, only a few economists command real wide-ranging respect. Paul Krugman is the most prominent of these. But Krugman is an opinion columnist. When he writes about stuff outside his academic specialty - for example, race and politics - does he really carry more weight than his colleagues David Brooks, Nick Kristof, or Thomas Friedman? Maybe a bit more, but not a huge amount more. And there are not many Paul Krugmans out there. In lists of "top public intellectuals" and "most influential thinkers", few economists make an appearance.

Even in purely economic matters, economists don't seem to command the public respect one might expect. Sure, Robert Barro and Martin Feldstein pop up periodically in the Wall Street Journal to say that deficits or QE are bad, and Greg Mankiw rails against taxation of the rich in the pages of the New York Times. But there are a bunch of people saying the same thing (and the opposite thing), and it's not really clear to me that the stellar research careers of Barro, Feldstein, and Mankiw give these guys a greater power to move public opinion than the average WSJ staff writer or magazine pundit.

In fact, the general public seems to mistrust the verdict of economists on some key economic issues. Most Americans still seem to believe, for example, that free trade is not always a good thing, in defiance of economists' concerted (possibly too concerted) attempts to convince them otherwise.

There are some economists who successfully advance "big think" ideas - Richard Florida, Erik Brynjolfsson, and Tyler Cowen come to mind. But are these academics really more effective at this than, say, writers like Malcolm Gladwell? And among academics, aren't there psychologists and physicists and biologists whose popular books are just as powerful as those of economists? Steve Pinker is a good example.

Then there's Freakonomics, but I don't think anyone is the slave of Freakonomics. Though the phrase "slave of Freakonomics" is pretty fun to say.

How about elite opinion? People like Larry Summers and Christina Romer certainly seem to have some sway over the Obama administration, but overall their Keynesian advice was unable to overcome Obama's own instinct toward austerity and low deficits and structural reform. Art Laffer certainly seemed to have an outsized influence over Reagan and the GOP, but he's "the exception that proves the rule" (meaning, of course, that he's by far the biggest exception I can think of off the top of my head). In terms of broader elites - business leaders, opinion writers, Congressional staffers - it's more difficult to say.

How about effects on other fields? In the legal profession, there is the "law and economics" movement, which seems to have had a big effect. Economics made a push into the sociology realm with Gary Becker's "imperialist" econ, but that is no bigger than, say, psychology's intrusion into econ, or postmodern critical theory's intrusion into anthropology (Ha! See that? Random unprovoked anthropology diss!). And though you occasionally see an article about "the economics of sex", I don't think most people have yet bought into the idea that we can explain our daily lives with utility functions and Nash equilibria.

Actually, there has been somewhat of a pushback by other academics against the notion that economists are all-purpose sages. Physicist Mark Buchanan, for example, has been very vocal in challenging macroeconomics in public.

So if economists have outsized control over society's ideas, well, it's not that outsized. When it comes to the ability to exert undeserved influence over the minds of humankind, there's one group that blows economists, and everyone else, away:


Saturday, March 15, 2014

The Finance Macro Canon

Stop me if you've heard this one before:

1. Inflation is caused by increases in the money supply. If the Fed expands the monetary base ("prints money"), the new money may sit for a while in the bank, but will eventually make its way into the broader economy, at which point it will cause inflation.

2. QE represents money-printing, so it will eventually cause inflation. In fact, it probably already is causing inflation - have you been to the store lately and seen the price of a gallon of milk? And don't you know that they changed the way they measure inflation, meaning it's much higher than the official numbers suggest?

3. Alternatively, money-printing might itself be defined as inflation.

4. Additionally, QE is a stealth bailout of big banks. This will increase their risk-taking via moral hazard and precipitate another financial crisis.

5. QE depresses interest rates, encouraging investors to "reach for yield" by investing in risky assets, increasing the likelihood of another financial crisis.

6. Government borrowing requires the Fed to buy bonds to hold down interest rates and keep the government from defaulting; this will cause/is causing/is defined as inflation.

7. Every bad effect of QE will also result from a long period of zero interest rates.

I have heard this basic story from many employees in the financial industry. I have heard it from a large number of finance writers, including some people I like and respect (but also including some who are shameless hucksters). I have heard it from undergrads at Stony Brook and Michigan. I see it on Twitter and on the blogs and on TV, and I hear it in Wall Street bars. I call it the Finance Macro Canon - the basic framework through which a big chunk of Wall Street sees the macroeconomy.

What I think about each of these belief items is not important (Just for the record, I think #4, 5, 6, and 7 very well might be true, #3 is goofy, #2 is utterly wrong, and #1 is one of the biggest mysteries of macroeconomics). The really interesting question is why the finance industry has become such a hive mind with regards to this worldview.

First of all, part of this canon defies the data - Japan's eternal zero interest rate policy didn't end deflation, nor did a dramatic expansion of its monetary base in the 2000s. And America's "money-printing" and ZIRP haven't done much to budge inflation. Second of all, the canon goes against the bets of the finance industry itself - inflation expectations, as measured by TIPS breakevens, are around 2%, even in the long term.

This, I think, is why the Shadowstats BS - or its cousin, the "have you seen the price of a gallon of milk lately" BS - is so crucial to the Finance Macro Canon (FMC). Humans have cognitive dissonance - it's difficult for us to take actions that don't jive with our beliefs. So subscribers to the FMC have to tell themselves that CPI isn't actually real inflation - that's the only way to reconcile their bet on low CPI with their belief in the theory that QE and ZIRP cause inflation.

But why patch up the FMC with obvious BS like Shadowstats? Why not just alter it to include the possibility that QE and ZIRP don't always cause inflation, even in the long term? In other words, why is the Finance Macro Canon such a canon in the first place?

Here are a few candidate hypotheses, arranged from (in my opinion) the most rational to the least:

1. History. Throughout history, currency debasements have often resulted in inflation. In the 70s, easy monetary policy (money printing) did indeed seem to result in high inflation in the U.S. And when Volcker tightened policy, inflation fell. Why should this time be different?

2. The lingering influence of Milton Friedman and the monetarists. Friedman told us that easy monetary policy causes inflation. His insights form the core of the New Keynesian research program that has come to more-or-less dominate central bank thinking.

3. The lingering influence of the Austrians. Austrians traditionally are suspicious of big banks, and suspicious of government meddling in the economy. Peter Schiff calls himself an Austrian, and he's out there spouting this canon daily, and lots of people listen to him.

4. Motivated reasoning. Most of the retail clients of the finance industry - and the customers of financial media - are older high net worth individuals who stand to benefit both from higher interest rates and from lower inflation. It might be in the interests of financial industry employees and financial media people to express a worldview where the policy conclusion is exactly what their clients and customers would like, while simultaneously placing bets against this worldview.

5. Need for the Illusion of Knowledge. A world in which printing money doesn't have any clear link to inflation is a weird world indeed. Instead of casting themselves adrift on the sea of existential uncertainty, finance industry and media people might subconsciously choose to cling to the shores of certitude.

So how does one extract an individual human mind from this hive mind? That is always a tricky undertaking. But I've found two things that seem to have an effect:

Method 1: Introduce them to MMT. MMT is a great halfway house for recovering Austrians.

Method 2: Introduce them to the research of Steve Williamson. Williamson is an example of a guy who changed his mind about the most likely effect of QE, after observing its real effects.

So far, these are the only things I've found that work. If you have any other ideas, please share. Every mind we reclaim from the hive is another blow struck for rationalism, individuality, and optimal monetary policy (whatever that is).

Tuesday, March 11, 2014

The Robot Lords and the end of People Power

I have a new article in Quartz, about how cheap drone warfare might alter human political institutions for the worse. Excerpts:
The human race is on the brink of momentous and dire change. It is a change that potentially smashes our institutions and warps our society beyond recognition. It is also a change to which almost no one is paying attention. I’m talking about the coming obsolescence of the gun-wielding human infantryman as a weapon of war. Or to put it another way: the end of the Age of the Gun... 
[S]omeday soon, autonomous drone militaries become cheaper than infantry at any scale... 
The day that robot armies become more cost-effective than human infantry is the day when People Power becomes obsolete...The rabble may think whatever they please, but the Robot Lords will have the guns. 
Where this scenario really gets scary is when it combines with economic inequality. Although few people have been focusing on robot armies, many people have been asking what happens if robots put most of us out of a job. The final, last-ditch response to that contingency is income redistribution – if our future is to get paid to sit on a beach, so be it.
But with robot armies, that’s just not going to work. To pay the poor, you have to tax the rich, and the Robot Lords are unlikely to stand for that. Just imagine Tom Perkins with an army of cheap autonomous drones. Or  Greg Gopman. We’re all worried about the day that the 1% no longer need the 99%–but what’s really scary is when they don’t fear the 99% either... 
It’s the Robot Lords we should be afraid of, not Skynet... 
We can carry this dystopian thought exercise through to its ultimate conclusion. Imagine a world where gated communities have become self-contained cantonments, inside of which live the beautiful, rich, Robot Lords, served by cheap robot employees, guarded by cheap robot armies. Outside the gates, a teeming, ragged mass of lumpen humanity teeters on the edge of starvation. They can’t farm the land or mine for minerals, because the invincible robot swarms guard all the farms and mines. Their only hope is to catch the attention of the Robot Lords inside the cantonments, either by having enough rare talent to be admitted as a Robot Lord, or by becoming a novelty slave for a little while... 
[W]hen the Age of the Gun ends, the age of freedom and dignity and equality that much of humanity now enjoys may turn out to have been a bizarre, temporary aberration.
Read the whole thing here!