Can Europe Save the World?

Attended a debate by the legendary George Soros and Guy Verhofstabt, the former Prime Minister of Belgium. (I like how Soros, a currency trader, needs no introduction, but the former PM of Belgium does)

The topic of the day was “The Financial Crisis: How Europe Can Save the World” – based off Verhofstabt’s new book. I don’t pretend to know much about Europe (actually, I don’t think I know anything about this continent I’ve spent the last 3 months in), but I was there to see the world’s greatest currency trader in person, and I didn’t really care what the topic was.

(Actually, that’s a lie. I attended a video conference talk by Soros a few weeks ago about his theory of “reflexivity”, which was immensely esoteric and hard to follow. So maybe I was hoping that this would be a little more interesting than the last.)

I wasn’t disappointed. While they didn’t say anything new, there were some interesting perspectives from both sides. From what I understood, Verhofstabt was advocating very strongly for a singular European strategy on how to deal with the effects of the crisis. He bemoaned the fact that right now, there are “27 different recovery plans among the European nations”. Furthermore, these 27 plans seemed to be ineffective: according to the IMF, Western Europe would be the only region in the world to remain in stagnation in a few years.

In contrast, Soros called for the implementation of even more regulation on a global scale. He noted that the market fundamentalist approach was evidently unsuccessful: capital flows freely in the current system and cannot be taxed or regulated effectively – it flows to where it is treated best. He looked to the Financial Standards Board (FSB) as a possible solution, perhaps to establish a set of standardized rules which would be accepted and implemented across all nations. This would, according to Soros, prevent “regulatory arbitrage”. Autonomy in terms of enforcing these rules could be left to the individual states.
One interesting point he brought up was that these new rules should apply not only to banks but also to pension funds and insurance funds, since they were all competing for the same capital. This could be one measure of mitigating the contagion effect of a crisis. (I wonder he felt if these rules should apply to hedge funds as well? )

Soros also stated his strong opinions on Credit Default Swaps (CDS). He strongly feels that they should be banned altogether. According to him, a CDS is the equivalent of “selling insurance to people on someone’s life, and then giving them a gun” I thought this was hilarious.

This was honestly one of the most interesting lectures I’ve had at LSE. If only my lectures could be about macroeconomic and regulatory trends, financial crises and their impact, instead of how to price a freakin exotic option.

What I Learnt From Superfreakonomics

Recently went for a lecture by Steven Levitt and Stephen Dubner, authors of Freakonomics and Superfreakonomics, the latter of which I’ve just finished reading.

Firstly, a little bit of context: Freakonomics was the one book that convinced me that I should be an Economics major. (Sad, I know.) In his first book, Levitt investigated weird and taboo issues using economic tools: data, models, regression analysis, correlation and causality, etc. Using economic lenses to look at difficult issues such as abortion, prostitution, etc strips away the morals of the situation and focuses on the sometimes surprising underlying causes. In Levitt’s words, “being moral isn’t bad, but it gets in the way of answering questions.”

Sadly though, I was a little disappointed by his lecture. Aside from getting my copy of Superfreakonomics signed by the authors (whoohoo!), I didn’t take away as much as I did when Levitt came to speak at Penn. (I think it was, in part, because of the inane boring questions asked by the LSE audience, which had as much quirkiness as my Financial Econometrics textbook)

Some points raised by Levitt:

Macroeconomics, often the public persona of the Economics discipline, is way too demanding and complex to be useful. Economists specializing in it often get caught up in the mathematics of the discipline to be able to provide any useful information. (Sounds a LOT like my Financial Economics class). Thankfully though, there seems to me a movement away from this in academic circles to something more descriptive.

Microeconomics, however, is much easier to understand. We intuitively understand our own individual behavior, and hence it’s easier to come up with models that would generally describe how a rational individual would behave. (However, this doesn’t mean that everyone would behave rationally) With an idea of individual behavior, it’s a natural step to aggregate behaviors in order to get an idea of how an economy might run.

I disagree slightly with that last point. In the words of Tommy Lee Jones in the first Men in Black movie: “A person is smart. People are dumb, panicky, (and) stupid.” Or conversely, James Surowieki would claim in The Wisdom of Crowds that a crowd is a lot more intelligent than the sum of its parts.

Sorry, I digress – let’s talk about the book.
Superfreakonomics, while raising some interesting perspectives on prostitutes, politicians, drunk driving vs drunk walking, and climate change, didn’t blow me away as much as the first book did. A few gems within it are worth mentioning:

1) Levitt describes a counterterrorist agent who built an algorithm to identify potential terrorists by finding patterns in their banking behavior – withdrawals, deposits, and yes – purchases of life insurance. It proved to be really effective too. Out of the millions of accounts the bank had, the algorithm zeroed in on less than 50 suspicious accounts. That’s helluva accurate for that huge a scale. And I thought algorithmic trading was hard.

2) Before germ theory was discovered, there was a suspicious pattern of high mortality rates among women in labor who were treated by doctors. The cause? Doctors weren’t washing their hands.

3) A pimp adds more value for her clients than a Realtor does.

4) The real story behind the Kitty Genovese case and the bystander effect. I always thought that was a straightforward case of how people lack altruism and our world is full of selfish, coldblooded, indifferent people. Levitt provides a different explanation of the events surrounding Genovese’s murder.

4) The best solutions to our hardest problems – car safety, global warming, mortality rates in hospitals – are usually cheap and so blindingly simple that no one would think of implementing them – until they are actually executed.

Am currently trying to come up with a trading strategy along those lines – we’ll see where that gets me.

Dear Undercover Economist…

Attended a talk by Tim Hartford, author of the Undercover Economist, as well as an FT column at LSE last week. (I know, I know, I’m way behind on my blogging, but you won’t believe the amount of work they throw at us graduate students. That, and all those parties on weekday nights…)

Anyways, Hartford specializes in using economics to solve everyday problems, or in his own words, “to make people happy”. Sort of like an economist’s version of that Aunt Agony page in one of those trashy teen magazines. Here are just a few of the topics he covered:

On how to be happy
Hartford mentioned that there have been many studies by psychologists on happiness. He cites a typical psychologist’s “happiness equation”, which would go something like: Autonomy + Purpose + Leisure = Happiness. Now this is absolutely ludicrous from an economist’s point of view. This equation has no intercept, no coefficient, no error term, etcetc – it violates the very principles of econometrics.

Of course, we economists are very proud of econometrics. It’s what makes economics a “science”. (Perhaps I don’t entirely agree, plus I know Nassim Nicholas Taleb would have something to say about this, but we’ll leave that for now) Now the basic idea behind econometrics is to take a bunch of data, run a regression (which is just fancy stat-speak for drawing a straight line), and try to figure out the relationships between different sets of data.

Perhaps it’s because economics has been deemed the “dismal science”, but economists, like psychologists, have been very interested in what makes people happy. So they collected a wealth of data on people’s backgrounds and how happy they were, and ran regressions. In a nutshell, they found that the happiest people were:
1) Female.
2) In school. The next happiest people were self-employed.
3) Wealthy and educated. (Surprisingly, money does make you happy)
4) In terms of relationships, from the happiest: Married, single, divorced, separated. Which is interesting because in order to benefit from being happily married, you also have to run the risk of getting divorced and being miserable. Also interestingly, if you’re unhappy with your marriage, you’re better off getting a divorce than merely separating.
5) In terms of number of children, from the happiest: 0, 2, 1, 3. (Hah! I knew kids were bad news. However, if you really MUST procreate, it seems that 2 kids is the optimal solution)

Economists also found that sex was the activity that generated the most fun (big surprise here), yet it was also the activity that people spend the least amount of time on. (tell me about it…) In general, people like being around other people – the one person that people did NOT like spending time with was their boss. But Hartford also wondered how people felt about sex with their boss, which I thought was hilarious.

Of course, as a budding economist and critical thinker (yay liberal arts education!), I need to point out that we can’t accept the results of this study at face value. Firstly, we can’t mistake correlation for causation, ie just because females tend to be happier doesn’t mean that being female causes happiness. Along those lines, it could be quite possible that these supposed factors could be autocorrelated (econ techie jargon that would take too long to explain here). But hey, if being a wealthy and married female PhD student having lots of sex and no boss/children is what it takes to boost the odds of being happy, I guess it can’t hurt to try it out (except maybe the female part).

On dating
Hartford mentioned the practice of speed dating, which provided excellent data on men and women’s romantic preferences because there was every incentive to tell the truth when they wrote down who they wanted to see again. (Men and women would only get each other’s contact information if there was a match. If they liked someone and said that they didn’t want to see them again, they wouldn’t get to see them again. If however they didn’t like someone and lied that they did, they ran the risk of having some stalker calling them every day.)

The one conclusion from the speed dating data was that people adjust their standards depending on the alternatives available. We’d like to think that we have strict standards: if we meet someone who surpasses those standards, we date them, and if they don’t, we don’t date them. However, data from the speed dating experiment showed that regardless of how good-looking the men were, women would always indicate one or two men that they’d like to see again, out of a group of perhaps 20. When there was a high proportion of good-looking men, women adjusted their standards upwards. If the group wasn’t as attractive, women adjusted their standards downwards and still chose one or two men they’d like to see again. Surprisingly, men behave the same way. (No, we aren’t all the sex-crazy bastards you’d like to believe we are – we have standards too)

On food and wine
Apparently you can get away with serving cheap wine at parties, but not with cheap food. Studies showed that bottles with fancy labels significantly increased drinkers’ perceptions of wine. Even the supposed wine “experts” could be fooled. During wine-tasting contests, a typical expert would give different scores to the same wine when it was served in the first, third and fifth glasses that she drank from.

Food, however, is not as easy to get away with. People could tell the difference between duck liver pate and dog food. However, they couldn’t tell the difference between cheap food (like chicken liver) and dog food.

… Trust economists to come up with the idea of giving dog food to people. Perhaps we really do need people like Hartford to prevent the rest of the world from burning us at the stake.

We Don’t Trust Ourselves

My Maths for Micro professor said this during my (incredibly intense) MSc pre-sessional math and statistics course today:

“Quadratic forms are the simplest functions that are used after linear ones. They are used because they allow economists to have a handle over what is going on. However, this still doesn’t mean that economists actually HAVE a handle over what is going on.”

How true, how true.

Random Econ Humor

Since it’s the weekend, and no one’s in the mood for depressing griping about the economy/politics anyway, (and because I’m in the midst of the most boring vacation ever and I need some entertainment), I decided to give you some Economics humor that I’m so fond of (yes, I’m nerdy like that), courtesy of economistsdoitwithmodels.com

… I guess all economists need some way of keeping ourselves sane.

Bubbles and Beauty Contests

Finally got down to reading James Surowiecki’s The Wisdom of Crowds, which I was supposed to have finished a year ago for my Public Finance class. Its thesis, in a nutshell, is that when you aggregate a diverse set of perspectives, the collective decision is often far superior to even the smartest individual in the group. While the entire book is amazing, chapter 11 is by far my favorite because it talks about financial markets.

Markets seem to be Surowiecki’s favorite vehicle for collective decision-making. And rightly so: they’re an excellent medium for aggregating the vast opinions of diverse individuals, and a market’s collective decision –the price – is almost always an accurate predictor of the true value of the asset.

However, as Surowiecki points out, financial markets are curiously inefficient. There’re so many great things to talk about in this chapter but I’ll try to zero in on his main points:

1) The nature of financial markets. Financial markets thrive on dependent, (as opposed to independent) decision-making. Keynes compared financial markets to a beauty contest where everyone had to pick out the six prettiest faces from a hundred photographs, and the winner was the one whose choice corresponds closest to the average preferences of everyone else. In short, an investor is concerned not just with what the average investor thinks but with what the average investor thinks the average investor thinks, and so on. When everyone makes their decisions based on the decisions of everyone else, this makes the market “stupid”, leading to inefficiencies such as bubbles and crashes.

2) How bubbles form. Bubbles and crashes happen because of the dependent nature of markets. Bubbles, in particular, are unique to financial markets because most people are buying a stock hoping to resell it to the “greater fool” (or the more optimistic one). Surowiecki points to a Caltech experiment that shows that a bubble forms even though everyone knows that they are in the midst of one. Everyone is convinced that the greater fool was out there. Also, would any sensible money manager be able to resist sitting out of the Nasdaq boom of the late 90s when everyone was making returns of 40 – 85%? As a result, everyone piggybacks and mirrors each other.

It is here that Surowiecki points out that for all the antipathy directed against short sellers (investors betting that the market would go down) for causing the current financial crisis, the truth is that the presence of short sellers would have prevented (or at least dampened) the bubble from forming in the first place. Short sellers help to cancel out the effects of overoptimistic investors, thus helping the market to reach its true price. However, for a number of reasons, short sellers account only for a tiny fraction of all investors, so the market is allowed to drift upward and become ever more inefficient. Which leads me to question the Obama administration’s policies on imposing all these limits on short selling – do they really know what they’re doing?

3) The role of (too much) information. Surowiecki also talks about the role that information plays in financial markets. In particular, he feels that financial news media like CNBC actually magnify the dependent nature of the stock market because “it bombarded investors with news about what other investors were thinking”. We see the effects clearly: If a CNBC analyst likes a particular stock, its price jumps mere seconds after the report is broadcast. This is hardly enough time for any investor to make an informed decision of whether the stock is a good buy. Instead, investors are jumping on the bandwagon because they know that other people are jumping on as well.

A potentially harmful effect of being bombarded with information: studies have shown that people perform poorer than if they were not given the additional information at all. More information skews the collective wisdom of the crowd, upsetting the balance between public and private information that helps crowds come to a good decision.

I highly recommend anyone studying or trading the markets to take a good read of this chapter – it’s fascinating to see how markets are not so much driven by clinical, hard facts as opposed to irrational, uncontrollable emotions.

(all the ideas in this post are the ideas of James Surowiecki and I take no credit for summarizing and rephrasing them)

The Real Story Behind Airline Ops

Two interesting articles from the NYT Freakonomics site: one about pilots, and the other answering your airline questions.

The first one in particular is pretty much a slap in the face. How safe are these so-called “budget carriers” anyway? It’s true that the incentives for a qualified, safe pilot don’t seem to exist in the current system. Then again, I might be wrong – maybe they are getting incentives from sources other than pure revenue, but I highly doubt it.

And from the second article: “The airline business has never really been able or allowed to operate under a truly free market environment. The government continues to meddle in the business. It doesn’t let airlines go out of business as a rule, though several of the current airlines should have been allowed to die. Trust the market.”

I Actually Find This Hilarious

Taken from the Facebook fan page of my favorite economics blog:

Q: How many Chicago School economists does it take to change a lightbulb?

A: None. If the lightbulb needed changing the market would have done it already.

It’s Nice to Know You’re Being Read

Jodi Beggs (or “econgirl”), the author of Economists Do It With Models, commented in my About Me section!

I’m very flattered.

Inflation? Pfft..

New York Times article on why some academics think that inflation may not be as big of a threat as we fear.

Dad has been bullish on gold for some time because of the inflation threat, believing that gold will reach post $1000 levels again. (When inflation rises, the prices of commodities such as gold and oil rise because they are traditionally seen as inflation safeguards) The rationale: The Fed is pumping an extraordinary amount of reserves into the economy and keeping interest rates low, and all things remaining constant, that will lead to a rise in economic activity and inflation. (I’m not sure, but was there runaway inflation in the post-Great Depression era?)

However, it’s true that banks are now too frightened to do anything with the reserves they’ve received but to hoard them. This certainly wouldn’t boost economic activity, so perhaps our inflation fears are overstated. I’m not one to take investment ideas from articles, but perhaps I shouldn’t be so blindly bullish on gold as I was.