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Daniel

Black Swans, Fat Tails, and me

by Daniel on November 7, 2012

Sooooooo, this is a thing that happened …

And the moral is that if you’re in a mood where you’re likely to insult your favourite authors on Twitter, don’t count on them not finding out about it in this modern and interconnected world. I was clearly in an unusually difficult mood that day, as I also managed to piss of Steve Randy Waldman by describing his latest thesis on macroresilience as “occasionally letting a city block burn down in order to clear out the undergrowth”. As with the Taleb quip, I kind of stand behind the underlying point, but almost certainly wouldn’t have said the same thing to the guy’s face, so sorry Steve. In any case, by way of penance I will now write a few things about resilience and unpredictability. Starting with the point that I found “incredibly insightful” in the Taleb extract most recently posted.

The point I really liked was on p454 of the technical appendix (p8 of the .pdf file), which is something I ought to have realised myself during a couple of debates a few years ago about exactly what went wrong with the CDO structure. Translating from the mathematical language, I would characterise Taleb’s point as being that the problem with “fat tails” is not that they’re fat; it’s that they’re tails. Even when you’re dealing with a perfectly Gaussian or normal distribution, it’s difficult to say anything with any real confidence about the tails of the distribution, because you have much less data about the shape of the tails (because they’re tails) than about the centre and the region around the mean. So you end up estimating the parameters of your favourite probability distribution based on the mean (central tendency) and variance (spread) of the data you have, and hoping that the tails are going to be roughly in the right place.

But any little errors you make in estimation of the central tendency are going to get blown up to a significant extent when you start trying to use your estimate to try to say something about the 99th percentile of the same distribution. Which is kind of a problem since we have a whole financial regulatory infrastructure built up on “value at risk”, which is a term effectively meaning “trying to say something about the 99th percentile of an empirically estimated distribution.”

The deep point I see here is that it’s not worth getting worked up about “fat tails” specifically, or holding out much hope of being able to model financial (and other risks) better by changing one’s distribution assumptions. A little bit of model uncertainty in a normal context will do all the same damage as a massively fat-tailed underlying distribution. And the thing about model uncertainty is that it’s even more toxic to the estimation of correlations and joint probability distributions than it is to the higher percentiles of a single distribution. Even at this late stage, it really isn’t obvious whether the large movements in CDO values in 2007-9 were caused by a sudden shift in default correlation[1], a correlation that had been misestimated in the first place, or by an episode of model failure that looked correlated because it was the same model failing in every case.

The basic problem here is that in a wide variety of important cases, you just don’t know what size or shape the space of possible outcomes might have. At the root of it, this is the basis of my disagreement with SRW too – because we have so little reason to be confident at all in our ability to anticipate the kind of shocks that might arrive, I always tend to regard the project of designing a “resilient” financial system that can shrug off the slings and arrows as being more or less a waste of time. So, should we give up on any sort of planning?
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What the hey, let’s keep this theme rolling …

One of the responses to Henry’s post, from Scott Lemieux’s has a passage which (though probably meant rhetorically rather than literally) really perfectly exemplifies what I see as one of the biggest problems with lesser-evilism.

But, the argument seems to run, at least Romney would generate more opposition from Democrats when he committed similar and worse abuses. I believe this is true. But to carry any weight that would justify the repeal of the ACA, the overruling of Roe v. Wade, the gutting of environmental and civil rights enforcement, massive upper-class tax cuts, etc. etc. etc. it’s not enough that there be more opposition; it must be the case that this opposition be effectual. And it’s overwhelmingly clear that, in fact, this increased opposition would be extremely ineffectual.

The “Ect, ect, ect” bit there could have been a much longer list, but even at that length it seems implausible on the face of it. Recall, Obama’s whole strategy was based around abandoning all other priorities such as carbon tax, an effective stimulus bill, half his nominations, most of the financial sector reforms and so forth, all to concentrate on passing health care. And he only got about half of that – the version passed was something he’d specifically camapigned against as not being anything like radical enough. So given that, how are we to suppose that President Romney would be able to push through an agenda five times as radical, including the ultimate third-rail issue of abortion? You would have to believe that under a Democratic administration Congress is a sclerotic, obstructionist institution which prevents all possibility of effective government, but as soon as the Republicans get in it becomes a streamlined ideological machine.

Which is in fact not far from what’s being argued here and it’s really quite frightening. Part of the case for persuading people to vote to keep the Democrats in government is that they’re so terrible at being in opposition. Specifically, their very weakness and incompetence in carrying out the business of politics is being used as an electoral asset. That’s not a cool rhetorical ju-jitsu move; it’s nightmarish. Similarly, the case has been advanced that the time for the liberal wing of the Democrats to express their opinions is at the primary stage, but there wasn’t a primary this time – the economy was so weak and the administration so unpopular that nobody wanted to risk weakening the candidate further.

This is the problem with lesser-evilism – it’s very vulnerable to strategic behaviour. If all you care about is the gap between parties, you can increase it either by making your own party more attractive to vote for, or by making the other side look even worse (either by strategically weakening your ability to resist them, or by being somewhat adventurous in your claims). This is really just a specific case of Henry’s general point that in the long term, one is unlikely to change the behaviour of any self-aware entity by constantly rewarding it for going on in the same way.

Predistribution – a bad idea whose time has come?

by Daniel on September 26, 2012

I foolishly promised a few people that I was going to write something about “Predistribution”, which would not normally have resulted in actually writing anything about it, except that Chris then wrote his piece and I felt I ought to enter into the lists on the somewhat more sceptical side. In as much as it isn’t just a bit of industrial policy combined with “all things bright and beautiful” (More education! More skills! But who will empty the bins in this hi-tech utopia[1] and how much will they be paid and why?), predistribution appears to be, as Chris says, an attempt to make all sorts of regulations and interventions in the economy do the work of a redistributive tax and benefit system. I don’t like this idea, basically for reasons to do with the fact that even after it all, I’m still an economist at heart. But the fact that I don’t like it doesn’t mean, in and of itself, that it might not be the best idea going in Britain today – after all, all the other politically live proposals might be worse. Read on, for a discussion of all these issues … [click to continue…]

New Ideas From Dead Political Systems

by Daniel on June 2, 2012

Back in the days before I had realised that a guy who takes five years to deliver a simple book review probably ought to rein in the ambition a bit when it comes to larger-scale projects, I occasionally pitched an idea to publishers of management books. It was going to be called “Great Ideas From Failed Companies”, the idea being that when you have the perspective of the entire history of a corporate story, you’re probably going to get a more honest appraisal of its strengths and weaknesses, and that although companies like Enron, Northern Rock and Atari clearly had major problems, they quite likely also had some good points too, or how did they ever get so big in the first place?
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Somewhat later than promised, I was motivated to write my follow-up post to the Greece choose-your-own adventure one. If you recall, the decisions in that post were motivated by advice from “Maynard”, your advisor working for “The One World Government”. In actual fact, there isn’t a One World Government, and the people who have jobs similar to Maynard’s all work for a variety of international organizations which are tasked with doing a job similar to what a global government would do, but without any power to make anyone do anything. Alan Beattie of the FT (full disclosure – a mate, we were at the Bank of England together) has spent the last fifteen or so years covering these international institutions and has now written a book called “Who’s In Charge Here?” (Americans), which in a typically punchy and exasperated style, sets out the complete mess which is the state of global financial institutions today. I will now review that book in the “London Review of Books style” – ie, by writing an essay on a tangential subject of interest to myself, and then tacking on a paragraph or so about the book at the end.
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Too Big To Fail: The First 5000 Years

by Daniel on February 25, 2012

One of the many fascinating pieces of information that David Graeber tosses off like shrapnel in Debt is that the first recorded appearance of the word “freedom” in a political document is in a Sumerian proclamation of a debt amnesty or jubilee.

What interested me, however, from the point of view of a professional banker, is that the document in question provided only for the discharge of personal debts of the Sumerians; commercial debts of merchants were not discharged. Clearly (and I suppose there is an interesting anthropological history to be written of the extent to which the appropriate level of cynicism about these things as changed from pre-Christian Mesopotamia to modern London), anyone who could have convinced the Babylonian legal system that his liabilities were all personal debts covered by the jubilee, while his assets were all mercantile trade credits, would have made out like a bandit. The point I am trying to make here is that as well as being the first mention of the word “freedom”, this proclamation marks the first recorded instance of a regulator-sanctioned selective default. Then a lot of things happened including the Fall of Rome and the Beatles, and then we had the FDIC’s decision in 2009 to transfer the assets and deposits of Washington Mutual to JP Morgan Chase over a weekend, leaving holding company creditors exposed to an extravagantly bankrupt shell. So from the start to the beginning of the story of debt, it has always mattered whether or not you were on the right side of what the relevant regulator wanted to accomplish.
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So, what would your plan for Greece be?

by Daniel on February 16, 2012

Reading the media and blogs, it seems to me that left and right are united in the view that the Greek default is being handled appallingly, that the current attempts at a solution are childishly obviously wrong and that everything is the fault of someone, probably the Germans. My own view – that it is not at all clear what the direction of policy is, and that although I don’t agree with the troika plan, it’s recognizable as a good-faith plan made by conscientious international civil servants working under unimaginably difficult political constraints in an economic context that was irreparably broken before they got there – is, as always, unpopular.

I don’t have a solution myself – the more I end up discussing this with people, the more I am reminded of the London Business School proverb taught on some of the gnarlier case studies, which is “Not All Business Problems Have Solutions”. So, CT hivemind, what do you think the best outcome is? Below the fold, I note some talking points, aimed at preventing our commentariat from falling into some of the pitfalls and mistakes which appear to be dominating debate at present. Because the whole issue is a twisty turny maze which at times seems to consist of nothing but false moves, I am presenting it in the form of a “Choose Your Own Adventure” book. I would note at this stage that I could probably have presented it in a funky HTML way rather than making you scroll up and down, but I have convinced myself that this is a feature rather than a bug – the medium matches the message here, because international debt negotiations are cumbersome, inconvenient and irritating too. Also, it is probably easier than it needs to be for readers to end up at the wrong paragraph and get a confusing jumbled narrative which bears little resemblance to the decisions they thought they’d made. Again, this is a crucial part of giving you the authentic international financial diplomacy experience.

I will have another post on this in a few days (more realistically: in a week). But for the meantime, I’d be very interested if CT readers would play the game below and let me know, in comments, where they ended up. And also, if having ended up there, they were left with a strong feeling of having been bamboozled into something they didn’t really want to do.

Update: It is no longer literally impossible to reach #50 (and therefore #15 and #21). I don’t think this was a popular path, but sorry. Thanks to “M” and “Vasi” for noticing.

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Meet Marion and Herb Sandler. They’re good people, you’ll like them. As two of the most prolific and committed philanthropists currently supporting progressive causes, they are currently major funders of ProPublica (investigative journalism), the Centre for American Progress (activism), the Centre for Responsible Lending (anti- payday loans, financial fairness) and the American Asthma Foundation. The contribution of US$1.3bn that they gave to the Sandler Foundation was the second largest charitable contribution of 2006, according to Wikipedia. They are a bit too keen on testing and measurement in education for my taste but you can’t have everything, and they are at least advocates of “multiple measures”.

Meet the Pick-A-Pay Option ARM. This was a lending product that, among other features, allowed for “negative amortization” – a feature under which the principal was not repaid but rather rolled up, meaning that the borrower was effectively dependent on future refinancing. It was not a subprime product, but it allowed people to take on huge amounts of mortgage debt, and contributed to the “payment shock” which sent so many of them into repossession and bankruptcy. As the link above shows, the Pick-A-Pay mortgage product was the subject of a number of compensation settlements with affected borrowers.

What’s the connection? Well, as founders of Golden West Financial, a mortgage lender which was sold to Wachovia Bank in 2006 (the proceeds of which financed that very large charitable contribution), Herb and Marion Sandler were responsible for introducing the Pick-A-Pay mortgage to the market.

Ah.

Read on, there’s two or three more twists before the end of this story …
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Joris Luyendijk’s new project up at the Guardian is aiming to apply the methods of social anthropology to the financial sector in the City of London. He’s carrying out interviews in pubs and coffee bars with people at all levels and in different roles in financial services industry, to get a proper picture of how the social roles all fit together. So far, he has made at least one major discovery:

I know, I was just as surprised. I’ve been doing my own amateur social anthropology exercise too. By which I mean that I’ve got a Twitter account and some spare time, and as a result, have been collecting[1] prime specimens of banker abuse. So far, I’ve gathered that I, personally, have stolen from every single benefits claimant in England, and that Sir Fred Goodwin (crime: got a big pension, managed a bank poorly) is clearly a bigger criminal than Sir Anthony Blunt (crime: betrayed dozens of serving agents to Stalinist Russia). And, of course, during the recent London riots, dozens of variations on “who is the real criminal – the man who smashes a shop window and steals an iPod, or the man who gets paid a bonus?”

Because, at the end of the day, Dr Harold Shipman murdered 52 infirm old women in order to steal money from their wills, but bankers, get bonuses. Who is the real criminal, eh??

It is without any anticipation of popularity or agreement (or even any real hope of not being called an asshole on my own blog, although I must say that would be jolly nice if you were in the mood) that I tell you that I think this is all rather a pack of bollocks.

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… is a question that might be asked of Professor AC Grayling, the media don and pundit who has launched the “New College Of The Humanities, and who is proposing to charge undergraduates £18,000 per year for three years (by way of comparison, an MBA from the London Business School will set you back £49,900 for the full two year course). Further thoughts on whether this represents simple value-for-money, let alone a brand new direction for the world, below the fold.
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Scoring the pundits

by Daniel on May 3, 2011

A working paper by students at Hamilton College out yesterday has the laudable aim of auditing the predictions made by political pundits in order to see whether they are any use or not. Unsurprisingly, it finds that Paul Krugman is the most useful columnist and that a bunch of hacks I’ve never heard of are the worst (it also, wonderfully, gives the success formula for prognostication as “avoid law school and adopt a liberal philosophy). Below the fold, a few points on a subject which many readers will know is dear to my heart.

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… It was pretty silly when Standard & Poor’s started wagging the finger at the UK and expecting to be taken seriously. Trying to do the same thing with respect to the USA is pretty much the definition of tugging on Superman’s cape.

At least one economist burst out laughing on hearing about the S&P announcement. “They did what?” exclaimed James Galbraith, a professor of economics at the University of Texas in Austin, who formerly served as executive director of the Congressional Joint Economic Committee. “This is remarkable! It certainly will confirm the suspicions of those who have questioned S&P’s competence after its performance on the mortgage debacle.”

I can confirm that although it was “at least one” economist that burst out laughing, it was not “at most one”.

The ECJ has ruled that it is illegal discrimination for the insurance industry to treat men and women differently.

This is currently mainly being covered as an excuse to do larf-o-larf items about “weren’t people funny about women drivers in the 1970s! But actually women are safer drivers! Imagine!”. In actual fact the car insurance thing is not that big of a deal since the no-claims bonus swamps any gender effect within a couple of years; all it really means is that nobody will insure teenagers at all, which I count as not necessarily an unmitigated cost. The real issue is pensions.

Women live longer than men. That’s one of the few actuarially reliable things you can say about life expectancy[1]. And so it requires more resources to provide a given level of life expectancy for women than it does for men. (NB: it is easy to get confused about this – remember that “risk” in context always means “financial risk to the insurer” rather than “health outcome or mortality risk to the insured”, and that living for a long time is bad news for the person who’s agreed to pay you an annuity).

Because it costs more to give women a retirement income, you can basically choose two options from the following three:

1) Equal retirement incomes for women and men
2) Equal commitment of society’s resources to providing retirement savings for women and men
3) A functioning pension annuity industry

There are a load of interesting questions about the nature of equality which might be considered relevant to the choice between 1) and 2) (although they might be considered a lot more practically relevant in a society where there was a greater degree of equality in lifetime earnings). I’m just interested to see that for the first time, a major society has decided that 3) is potentially the one to give up on. Edit: Just realised I probably ought to give my own favoured solution – I think it’s fairly obvious that 2) is the one to give up on and we just have to accept that the biological facts of the matter are that society needs to arrange things so that a given woman has a larger pool of retirement savings allocated to each other than an otherwise qualitatively identical man[2]. It’s rather like the number of social and economic consequences that we accept as flowing from the biological fact that women give birth and men don’t. Historically, capitalist economies have implicitly given up on 1), by allowing retirement incomes to be determined by savings out of lifetime labour income.

[1] by the way, don’t hold out too much hope for genetic testing as a silver bullet solution that will give us all individualised life expectancies and annuity rates. And even if it does, those rates will still be better for men as a group than women as a group, so the discrimination problem will still be there).

[2] the concept of “a woman and man who are identical in all properties except gender” perhaps not being terribly firmly anchored in reality, but as an actuarial construct I can probably save it.

JQ OK

by Daniel on January 11, 2011

Just a quick post for CT readers who don’t also subscribe to John’s blog: he’s on the road and many miles from Brisbane at the moment (and so not flooded) and his family are OK, but apparently there’s property damage and flood damage is in my experience a real bugger to sort out, so probably not much blogging for a while. In the interim and because he hasn’t apparently posted about here (I found out when we met up for a pint on the Zombie Economics book tour), I will boast on his behalf that John has been elected a Fellow of the Econometric Society. That is a big deal. If you are not impressed by this, take my word for it that if you knew more about the professional structure of the economics profession you would be. Best of luck John.

The Christmas sermon

by Daniel on December 22, 2010

Another year over, and what have we done? Once more, I muse philosophically on matters of risk and return, at annoying length (at least I cut out the footnotes this year). But first, perhaps, a little quasi-seasonal story:

The Great Homeopathic Cocktail Bar
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