Book review: The Misbehavior of Markets: A Fractal View of Risk, Ruin & Reward by Benoit Mandelbrot.
Mandelbrot describes some problems with financial models that are designed to provide approximations of things that can’t be perfectly modeled. He pretends that pointing out the dangers of relying too much on imperfect approximations shows some brilliant insight. But mostly he’s just translating ideas that are understood by many experts into language that can be understood by laymen who are unlikely to get much value out of studying those ideas.
His list of “ten heresies” is arrogantly misnamed. Sure, there are some prestigious people whose overconfidence in financial models leads them to beliefs that are different from his “heresies”, but those “heresies” are closer to orthodoxies than they are to heresies.
His denial of the equity premium puzzle is fairly heretical, but his argument there is fairly cryptic, and relies on suspicious and poorly specified claims about risk.
He says market timing works, but the strategy he vaguely hints at requires faster reaction times than are likely to be achieved by the kind of investor this book seems aimed at.
His use of fractals doesn’t have any apparent value.
Mandelbrot is primarily a mathematician with limited interest in understanding how markets work. One clear example is his mention of a time when Magellan “was still a small fund, too small for any detractors to argue that its size alone gave it a competitive edge”. Any informed person should know that’s completely backward – larger funds have a clear disadvantage because they are limited to trading the most liquid investments.
Another example of a careless mistake is when he claims the evidence suggests basketball players have hot streaks, seemingly unaware that Tversky and others have largely debunked that idea.
Economics
The stock market reacted to today’s defeat of the bank bailout bill with an unusually big decline. Yet the news wasn’t much of a surprise to people watching Intrade, whose contract BAILOUT.APPROVE.SEP08 was trading around 20% all morning. Why did the stock market act as if it was a big surprise?
Did Intrade traders make a lucky guess not based on adequate evidence? Did they have evidence that the stock market ignored? Could the stock market have priced in an 80% chance of the bill being defeated (if so, that would seem to imply that passage would have caused the biggest one-day rise in history)? Could the stock market have been reacting to other news which just happened to coincide with the House vote? (It looks like the market had a short-lived jump coinciding with news that House leaders hoped to twist enough arms to reverse the vote, but I wasn’t able to watch the timing carefully because I was at the dentist).
It seems like one of these must be true, but each once seems improbable.
Arnold Kling, whose comments on the bailout have been better than most, was surprised that the bill failed.
I covered a few of my S&P 500 futures short positions at near the end of trading, but I’m still positioned quite cautiously (I made a small profit today).
Charlie Munger in the August 31, 2008 issue of Outstanding Investor Digest:
Let’s say you’re insuring against the outcome that people will lose money on a $100 million bond issue, and the credit default swaps, instead of amounting to $100 million, amount to $3 billion. Now you’ve got people with $3 billion worth of contracts that really have a big incentive in having somebody fail. And they may manipulate in some fraudulent or extreme way to cause a default in order to make the big collection.
There doesn’t seem to be enough transparency in financial systems to figure out whether this concern is relevant to this week’s panic.
To deter any suspicion that the comparisons I plan to make between Intrade’s predictions and polls are comparisons I selected to make Intrade look good, I’m announcing now that I intend to use FiveThirtyEight.com as the primary poll aggregator. I intend to pay attention to predictions that are more long-term than I focused in 2004, so the comparison I’ll attach the most importance to will be based on the first snapshot I took of FiveThirtyEight.com’s state by state projections, which was on July 24.
Also, as of last week, one of the Presidential Decision Markets that I’m subsidizing, DEM.PRES-OIL.FUTURES, has attracted enough trading (I suspect from one large trader) to make me reasonably confident that it’s showing the effects of trader opinion rather than the effects of my automated market maker (saying that oil futures will drop if the Democratic candidate wins, and rise if he loses).
News reports plus the pattern of crude oil fluctuations indicate that the large price increases around May and June were due mainly to Chinese desperation to guarantee a larger than normal margin of safety during the Olympics, not manipulation (although the results bear a good deal of resemblance to the results of manipulation).
Book Review: Let Their People Come: Breaking the Gridlock on Global Labor Mobility by Lant Pritchett.
This book is primarily written for economists and academics in related fields, but most of it can be understood by an average person.
I was a little hesitant to read this book because I suspected it would do little more than reinforce my existing beliefs. There were certainly parts of the book that I would have been better off skipping for that reason.
But one important effect of the book was to convince me that the effects on the poor of migration to wealthier countries is so large compared to things like “foreign aid” and free trade that anyone trying to help the poor by influencing government policies shouldn’t spend any time thinking about how to improve “foreign aid” or trade barriers.
I’ve long been wondering how to respond to remarks such as Jimmy Carter’s ‘We are the stingiest nation of all’ based the U.S.’s low “foreign aid” to GDP ratio. Pointing out that “foreign aid” is mostly wasted or even harmful requires too much analysis of lots of not-too-strong evidence. Pritchett shows that the wealth affects of allowing the poor to work in rich countries should dominate any measure of how those rich countries treat the poor. By that measure, adjusting for country size, the U.S. ranks better than countries in the EU, but is embarrassingly callous compared to the United Arab Emirates, Kuwait, and Jordan.
The book addresses both moral and selfish arguments for restricting immigration. It treats the selfish arguments (even those based on myths) as problems that can’t be overcome, but which can be reduced via compromises. These pragmatic parts of the book are too ordinary to be worth much.
The sections about moral arguments are more powerful. He clearly demonstrates a large blind spot in the moral vision of those who think they’re opposed to all discrimination but who aren’t offended by discrimination on the basis of the nationality a person was assigned at birth. But he exaggerates when he claims that nationality is the only exception to a widely agreed on outrage at discrimination based on “condition of birth”. Discrimination based on date of birth still gets wide support (e.g. the drinking age). And if you’re born as a conjoined twin, don’t expect much protection from surgery that looks about as moral as brain surgery designed to cure a child’s homosexuality should.
Perhaps this book is one small step toward creating a movement with a slogan such as “Tear down that kinder, gentler Berlin wall!”.
Book review: Infotopia: How Many Minds Produce Knowledge by Cass R. Sunstein.
There’s a lot of overlap between James Surowiecki’s The Wisdom of Crowds and Infotopia, but Infotopia is a good deal more balanced and careful to avoid exaggeration. This makes Infotopia less exciting but more likely to convince a thoughtful reader. It devotes a good deal of attention to conditions which make groups less wise than individuals as well as conditions where groups outperform the best individuals.
Infotopia is directed at people who know little about this subject. I found hardly any new insights in it, and few ideas that I disagreed with. Some of its comments will seem too obvious to be worth mentioning to anyone who uses the web much. It’s slightly better than Wisdom of Crowds, but if you’ve already read Wisdom of Crowds you’ll get little out of Infotopia.
Book review: Bad Samaritans: The Myth of Free Trade and the Secret History of Capitalism by Ha-Joon Chang.
This book attacks orthodoxies of the World Bank, IMF, WTO, neo-liberal economists, free-market economists, and pundits such as Thomas Friedman. Chang often implies that they all share a common orthodoxy, but the ideas he attacks are usually questioned by some of those groups.
His criticisms of the World Bank, IMF, and WTO are often correct, but it shouldn’t be surprising that they serve goals that don’t coincide with needs of developing countries.
His most important argument is a defense of mercantilist protection of infant industries. He shows that the evidence on the effects of tariffs is sufficiently mixed that his selective use of examples can give the impression that he has shown tariffs promote economic growth in developing countries. He makes claims of the form “X would have failed without protection”, but doesn’t say why his ability to predict failure is more reliable than other alleged experts (e.g. MITI’s belief that Honda would fail in the auto business). This provoked me into searching for more complete tests of the effects of tariffs. The evidence I found confirms that his confidence that tariffs work is foolish, but I was surprised to find that the evidence is too unclear to provide a guide to policy decision.
Chang has a good argument that the common orthodoxy about comparative advantage is a less conclusive reason for removing tariffs than it appears. But his attempts to describe a mechanism by which tariffs can be beneficial are naive. He talks about government protecting infant industries the way a parent protects a child, without any analysis of the political forces which cause governments to protect entrenched declining industries at the expense of less politically powerful startups.
He gives only vague hints about how to distinguish the tariffs he thinks are good from bad tariffs. I’ll offer a suggestion: any tariff that is designed to meet his notion of a good tariff should be set by statute to decrease to zero over a period of about a decade and never be reinstated for an industry to which they’ve been applied under this statute.
His complaints about privatizing state-owned enterprises contain some valid points. I wish people didn’t assume government and stockholder control are the only available choices. Having governments spin off enterprises as nonprofits would sometimes (often?) be a better option.
His comments about how patents and copyright affect developing countries are mostly correct. But he underestimates our dependence on drug patents when he implies that the 57% of drug research funding that comes from not-for-profit sources means we could get 57% of the results without commercial funding. A drug startup that will go broke if it doesn’t produce something valuable does different work than someone whose success comes from publishing papers.
Chang’s modest suggestions for patent reform would provide much less improvement than ideas I’ve found by reading free-market economists (e.g. prizes instead of patents, or Kremer’s patent buyout proposal).
His comments about inflation assume that it produces some benefits, but he shows no awareness of the economic literature which disputes that assumption.
He has plausible hypotheses that increasing market forces might cause an increase in corruption in some countries. I see no easy way to estimate the size of these effects.
His arguments that cultures change in response to economic change more than most people realize are strong enough to lower my opinion of Fukuyama’s book Trust (Fukuyama seems unaware that the German current high-trust culture is very different from a century ago when they had a reputation for dishonesty). But Chang exaggerates a lot when he says immigrants from poor countries working much harder in rich countries proves that work habits result from economic conditions rather than culture – those immigrants are unlikely to be typical of the culture they came from.
For more than 2 months, Treasury Inflation-Indexed Notes maturing within 2 years have been selling at prices that apparently mean their yields are negative (e.g. see here and here). This isn’t the first time people have apparently paid a government to hold their money, but I can’t think of a previous case where yields reached -1 percent.
What can cause such a perverse situation? An expectation that the CPI would overstate inflation by as much as 1 percent would mean appearances are misleading and investors do expect to make money on those notes. I could make a case for that by focusing on the way that the CPI’s reliance on rents to measure housing costs hides the effects of dropping home prices. But most evidence about people’s inflation expectations (e.g. the University of Michigan Inflation Expectation report) say they expect more inflation than what can be inferred from the Treasury Inflation-Indexed Notes about expected CPI change.
So I’m inclined to conclude that we’re seeing investors paying abnormally large amounts in order to get liquidity, and probably plan to redeploy those assets somewhere else within a few months. If we see a big financial crisis soon, that strategy may pay off. But having people prepare for financial crises tends to reduce their magnitude, so I’m skeptical and am short t-bond futures.
Yet another hypothesis for why the industrial revolution happened in Europe is that higher infectious disease levels elsewhere caused most cultures that might have produced technological development were more collectivist in order to reduce the spread of disease.
Collectivism may have inhibited scientific and technological innovation by discouraging trial-and-error learning and ideas which signal an absence of group loyalty.
collectivists make sharp distinctions between coalitional in-groups and out-groups, whereas among individualists the in-group/out-group distinction is typically weaker (Gelfand et al. 2004). A consequence is that collectivists are more wary of contact with foreigners
I suspect this effect is real but not strong enough to be the primary cause of the industrial revolution. It does, however, provide a good clue about why a relatively tropical region such as the Yangtze River Delta lagged behind more temperate England.