It's not regulation, it's the incentive system

The press, the pundits, and both presidential campaigns have been recently talking incessantly about regulating the financial industry. Here's a representative quote from today's NY Times:

"The swaps market has been unregulated. It has been just a lot of people making bets with one another. Some of them made incredibly fortunate payoff wagers against the mortgage bonds, using credit-default swaps as their wagering vehicle."

http://www.nytimes.com/2008/09/28/business/28every.html?em

Although it is not stated, the implicit assumption in this article is that if the credit swaps WERE regulated, the market collapse could have been avoided. Which makes me wonder - wouldn't people just trade in a different unregulated security then? Swapped collared credit swap swaps :-)? The moment the game is defined, people will always find a way around the rules...

I think that the real reason for the financial disaster (it is actually more of a monetary crisis, but that's a topic for a different post) is that there is a broad incentive for managers in the US to underprice or outright ignore the risk associated with their decision.

It is in the structure of the compensation system: the upside of an action that produces very positive short-term effect but is detrimental long-term is higher than that of an action that results in steady, predictable, but not exceptional output. Corporate manager, a rational being when it comes to money, starts exhibiting the behavior that is better correlated with a speculator rather than a long-term investor.

(More here: http://1-800-magic.blogspot.com/2007/12/risk-vs-reward.html)

How this can be solved? Not with regulation of financial assets, that's for sure. The problem isn't even financial - it is endemic to every US enterprise, Wall Street or otherwise, and is rooted to a simple fact that a huge cash infusion in the form of a bonus is better than a steady stream of "just decent" salary.

One way to address it would be to make executive salary based on very long-term performance of the enterprise, for example, to eliminate stock-based compensation entirely, and make cash compensation dependent on 5-year average growth of stock price.

Government of course cannot do this - it would be up to the boards of individual corporations. Boards unfortunately are not known for the sort of the leadership this would require: it might have something to do with the fact that they are recruited by the very same CEOs whose compensation they are supposed to regulate.

What government CAN do is eliminate the attractiveness of huge cash infusions - for example, by raising the taxes for people making more than 10M/year to 90%. Then 1M/year for 10 years becomes much more attractive than 10M in the first year and 0 afterwards. This could actually realign the incentives of executive class to be more inline with those of the shareholders.

To free the economy from its dependency on bubbles, we need to move the country to a pre-Reagan tax structure.

See how terrible British socialized medical care is?

http://news.bbc.co.uk/2/hi/uk_news/magazine/7633254.stm

:-)

Would you like fries with it?

"Maddow started her career with more interest in changing policy than in changing the media. After attending Stanford, she studied at Oxford, where as a Rhodes scholar...<snip>

In 1999, Maddow was supporting herself with odd jobs (she met her partner Susan Mikula after the artist hired Maddow to do yard work)..."

http://www.prospect.org/cs/articles?article=channel_changer_08

Reminded me of an old joke...

Science major asks, "why does it work?"
Engineering major asks, "how does it work?"
Business major asks, "how much will it cost?"
Humanities major asks, "would you like fries with it?"

:-)

Painting it with a broad brush

To continue the discussion of scientific merits of current approach to economics (see http://1-800-magic.blogspot.com/2008/09/economics-as-voodoo-science.html): here's what the Treasury spokeswoman had to say about current $700B bailout plan, according to Forbes:

"It's not based on any particular data point... We just wanted to choose a really large number."

http://www.forbes.com/home/2008/09/23/bailout-paulson-congress-biz-beltway-cx_jz_bw_0923bailout.html

For a moment I thought that the Forbes web site was hacked...

Economics as a voodoo science, written under the influence of a whole bottle of Lambrusco

I was reading two books at the same time this week.

One was "The Great Influenza" by John Barry (http://www.amazon.com/Great-Influenza-deadliest-pandemic-history/dp/0143036491) which among other things lays the history of medicine's transformation into science as it gradually happened throughout the 19th century, from a trade largely practiced by uneducated, unlicensed doctors some of whom could barely read (in the early 1800s there were no prerequisites for medical school, not even college education, no entrance exams, and no laboratory training) into the true scientific discipline which used statistics, biochemistry, and extensive experimentation.

The second was "Ahead of the Curve" by Philip Broughton (http://www.amazon.com/Ahead-Curve-Harvard-Business-School/dp/1594201757), documenting the author's experience at the Harvard Business School. This one nicely superimposed itself over the week of the economic turmoil, and brought back my own MBA memories.

Being reminded of what an actual scientific method looks like while listening to the solemn bullshit pronouncements about the economy that is overflowing the news, I could not help but compare these pronouncements to the writings of the medieval alchemists.

Compare, for example, the following quote from "The Revelations of Hermes"...

"But it is a skillful, perfect equation of all the Elements, a right commingling of natural forces, a most particular union of spiritual virtues, an indissoluble uniting of body and soul. It is the purest and noblest substance of an indestructible body, which cannot be destroyed nor harmed by the Elements, and is produced by Art. With this Aristotle prepared an apple prolonging life by its scent, when he, fifteen days before his death, could neither eat nor drink on account of old age." (http://www.sacred-texts.com/alc/arr/arr27.htm)

...with the following citation from Alan Greenspan...

"We cannot be certain that this benign environment will persist and that there are not more deep-seated forces emerging as a consequence of prolonged monetary accommodation."

Or this amazing pearl from Greenspan circa 2000:

"This does not necessarily imply a decline in asset values - although that can happen at any time for any number of reasons - but these values will increase no faster than household income."

Wikipedia defined science as "the effort to discover, and increase human understanding of how the physical world works. Through controlled methods, scientists use observable physical evidence of natural phenomena to collect data, and analyze this information to explain what and how things work. Such methods include experimentation that tries to simulate natural phenomena under controlled conditions and thought experiments. Knowledge in science is gained through research."

A typical science - such as physics - starts with observing the natural phenomena, proceeds with deducing the basic laws that govern the system under examination, then uses these laws to create mathematical formulas to describe the behavior of the system, then use these formulas to predict some aspects of the behavior of the Universe.

A representative scientific formula might look like this...



...and lead to results that look like this:



Most importantly, the results are REPRODUCIBLE, can be used to produce NON-TRIVIAL predictions of system's behavior, and are considered TRUE by the scientific community within the limits of their applicability.

By contrast, let's examine a representative economic construct, a Laffer Curve.

Wikipedia says, "In economics, the Laffer curve is used to illustrate the idea that increases in the rate of taxation may sometimes decrease tax revenue. Since a 100 percent income tax will generate no revenue (as citizens will have no incentive to work), the optimal tax rate that maximizes government revenue must lie below 100 percent."



If you look closely at the picture above, you can notice several things. First, it contains only two numbers - 0 and 1. The Y axis is not marked at all. Its shape is deceptive - it resembles a parabola, but there is no mathematical proof that it really is one. Furthermore, the t0 point on the curve is deceptive - it appears to be exactly at the 0.5 coordinate (which might suggest a 50% income taxation as maximizing the government revenue), but there is no data that suggest that this is true.

If I were to produce a picture like this in any of my undergraduate classes, every one of my physics or math teachers would have given me an F on the spot. Doing it twice would have most likely resulted in premature termination of my college education.

Examining the "idea" that the Laffer curve illustrates, it becomes immediately obvious that it contains NO NON-TRIVIAL RESULTS. The claims that it makes is that at 0% and at 100% taxation rates the government income is 0. So what? The theory would only be USEFUL if it were to predict what the maximum is (or at least that there is only one).

What if the curve actually looks like this?


Or this?



Finally, did anybody prove that it is even a function?



There is no way of saying, of course - the theory behind the Laffer curve did not result from any statistical analysis - or any scientific analysis for that matter. It was based on a mental model, "common sense", and an ideology - much like Aristotle's derivations of the laws of nature. Only instead of 300BC, in economics this approach is practiced today.

Laffer curve happens to be a representative economic concept - a model that while sounding important can actually give one no useful information. Or, to use Greenspan's quote again...

"The fact that our econometric models at the Fed, the best in the world, have been wrong for 14 straight quarters, does not mean thay will not be right in the 15th quarter."

"I'm voting for Sarah because she's a mom. She knows what it's like to be a mom."

http://www.newsweek.com/id/160080/page/1

US is about to elect a vice president who thinks that Earth is 7000 years old...

This wasn't the first time Sarah Palin expressed her support for creationism, According to Philip Munger, Palin was part of efforts to get an evangelical, creationist school board in Mat-Su Borough: "I pushed her on the earth's creation, whether it was really less than 7,000 years old and whether dinosaurs and humans walked the earth at the same time. And she said yes, she'd seen images somewhere of dinosaur fossils with human footprints in them."

http://atheism.about.com/od/sarahpalinreligion/a/PalinEvolution.htm

Wow... just wow...

Greed and Wall Street

The press (and the McCain campaign) are crying wolf about the "executive greed" to which they attribute the recent bank collapses. In view of last year's multimillion dollar giveaways on Wall Street, this story is easy to sell to an unsuspecting average Joe who has no idea how markets work.

The reality of course is not that people have somehow became greedier over the last 10 years. It is that with the transition to the public form of capitalism - where the financial markets are dominated by companies nominally owned by shareholders but ruled by the class of professional managers - the interests of the people who own the capital (AKA "public good") and the people who run the companies have considerably diverged.

Specifically, there exists a huge incentive for a manager to ignore the long term risk in favor of short-term reward. This is exactly what happened during the dot-com boom and more recently during the finance industry collapse.

I wrote about it last year: http://1-800-magic.blogspot.com/2007/12/risk-vs-reward.html, and it seems to become more relevant by the minute.

A story of a failed business...

"There was no doubt about it: I had discovered The Next Big Thing. Like Edison and the lightbulb, like Gates and the pc operating system, I would launch a revolution that would transform society while bringing me wealth and fame. I was about to become the first person in America to sell condom key chains."

http://www.stanfordalumni.org/news/magazine/1999/julaug/articles/condoms.html


...courtesy of Dzembu (http://pizzaovenproject.blogspot.com/)...

Poll shows support for torture among Southern evangelicals

"WASHINGTON — A new poll finds that nearly six in 10 white Southern evangelicals believe torture is justified, but their views can shift when they consider the Christian principle of the golden rule.

The poll released Thursday, commissioned by Faith in Public Life and Mercer University, found that 57% of respondents said torture can be often or sometimes justified to gain important information from suspected terrorists. Thirty-eight percent said it was never or rarely justified."

http://www.usatoday.com/news/religion/2008-09-16-torture-baptists_N.htm

WPO Poll on attitudes towards torture around the world is here: http://1-800-magic.blogspot.com/2008/06/religion-and-morality.html.

Incidentally, John McCain was against waterboarding before he was for it.

http://thinkprogress.org/2008/02/13/mccain-waterboarding-fail/

Obama on Constitution

If the plotters of the Sept. 11 attacks are in the government's sights, Obama went on, they should be targeted and killed.

"My position has always been clear: If you've got a terrorist, take him out," Obama said. "Anybody who was involved in 9/11, take 'em out."

But Obama, who taught constitutional law at the University of Chicago for more than a decade, said captured suspects deserve to file writs of habeus corpus.

Calling it "the foundation of Anglo-American law," he said the principle "says very simply: If the government grabs you, then you have the right to at least ask, 'Why was I grabbed?' And say, 'Maybe you've got the wrong person.'"

The safeguard is essential, Obama continued, "because we don't always have the right person."

http://voices.washingtonpost.com/the-trail/2008/09/08/obama_to_palin_dont_mock_the_c.html



So extrajudicial executions are fine, but once you captured them, then the rights are essential because "you might not have the right person". What if you kill someone who is not the right person?

Family values: Exclusively for RNC - 'till 6 AM!

I swear I did NOT inspire this job ad :-)

"A C/C++ developer with solid traditional Win32 programming skills but with no exposure to managed code is preferred."

http://members.microsoft.com/careers/search/details.aspx?JobID=6ADCA489-CFAE-406F-A758-3AA47DED2B53&start=1&interval=10&SortCol=DatePosted

Sarah Palin

Apparently, Sarah Palin, McCain's VP pick, is far worse than Dick Cheney. Mean, vindictive, racist, and just plain evil...

Just a piece of paper...

http://www.capitolhillblue.com/artman/publish/article_7779.shtml

...

GOP leaders told Bush that his hardcore push to renew the more onerous provisions of the act could further alienate conservatives still mad at the President from his botched attempt to nominate White House Counsel Harriet Miers to the Supreme Court.

"I don't give a goddamn," Bush retorted. "I'm the President and the Commander-in-Chief. Do it my way."

"Mr. President," one aide in the meeting said. "There is a valid case that the provisions in this law undermine the Constitution."

"Stop throwing the Constitution in my face," Bush screamed back. "It's just a goddamned piece of paper!"

...

This was in 2005, and the press has never reported it. Imagine this was said by any of the leading Democrats - the echo chamber would have lasted to this day, I am sure. But a Republican president says he doesn't care about the constitution - deafening silence.

The same thing happened with Sarah Palin whose pastor says that Jesus commands Christians to die. Silence. Contrast it to Obama pastor's behavior that was recirculated ad nauseum.

The list goes on and on. Palin's 17 year-old daughter's out of wedlock pregnancy, which is "off limits" - should have been were Palin not running on "family values" (i.e. sexual morality). McCain abandoning the injured wife for a younger, wealthier woman. Rush Limbaugh getting caught nursing his drug habit while calling for death to the drug addicts. Ted Haggard condemning homosexuality while visiting a male prostitute. Larry Craig...

It looks like in this country overt religiosity is an acceptable substitute for the actual decency... All it takes is "re-accepting Jesus" and one can go on preaching morality while continuing behaving in the same old bastardly ways - and the media just goes right along!

Christian Jihad

From the musings of Sarah Palin's (McCain's choice for VP) pastor:

"What you see in a terrorist -- that's called the invisible enemy. There has always been an invisible enemy. What you see in Iraq, basically, is a manifestation of what's going on in this unseen world called the spirit world. ... We need to think like Jesus thinks. We are in a time and a season of war, and we need to think like that. We need to develop that instinct. We need to develop as believers the instinct that we are at war, and that war is contending for your faith. ... Jesus called us to die. You're worried about getting hurt? He's called us to die. Listen, you know we can't even follow him unless you are willing to give up your life. ... I believe that Jesus himself operated from that position of war mode. Everyone say "war mode." Now you say, wait a minute Ed, he's like the good shepherd, he's loving all the time and he's kind all the time. Oh yes he is -- but I also believe that he had a part of his thoughts that knew that he was in a war."

"Religion of peace", huh?

http://www.huffingtonpost.com/2008/09/02/palins-church-may-have-sh_n_123205.html

I cannot believe my tax dollars are paying for this...

http://www.counterpunch.org/cook09022008.html

Palestinian Village Faces Army Reign of Terror

By JONATHAN COOK

The window through which Salam Amira, 16, filmed the moment when an Israeli soldier shot from close range a handcuffed and blindfolded Palestinian detainee has a large hole at its centre with cracks running in every direction.

“Since my video was shown, the soldiers shoot at our house all the time,” she said. The shattered and cracked windows at the front of the building confirm her story. “When we leave the windows open, they fire tear gas inside too.”

...