Economics

The Taylor Rule

Posted by Peter on November 7, 2011
Posted in: Book Reviews, Economics. Tagged: .

Book review: Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis, by John B. Taylor.

This book contains a few good ideas, expressed simply and clearly. It explains some of what caused the 2008 financial crisis. But he exaggerates a good deal when he claims he has “provided empirical proof that monetary policy was a key cause of the boom”.

He provides clear evidence that counterparty risk was a more important problem than lack of liquidity, and has some hints about how counterparty risk could have been handled better. But that doesn’t say much about whether policies to deal with liquidity problems were mistaken – I doubt that many of the people pushing those liquidity related policies were denying that counterparty risk was a problem.

I’ve been convinced since before the crisis that having the Fed follow the Taylor Rule would have been better than the monetary policy that we actually had. But the details of the rule seem somewhat arbitrary, and I’m disappointed that the book doesn’t provide much explanation of why the Taylor Rule is better than alternative rules.

I’ve found a link on Taylor’s blog to an article (The Taylor Rule and QE2 By David Papell) which compares it to some alternatives which seem motivated primarily by a desire to rationalize more monetary or fiscal stimulus. But what I want to know is whether it’s possible to create a rule that is more countercyclical without being more inflationary.

I have an intuition that it’s not too hard to improve on the inflation component of the rule. The CPI seems to have many drawbacks, such as being slow to reflect changes. I suspect Taylor’s inflation coefficient of 1.5 is larger than what an ideal rule would use in order to make up for the delays associated with using the CPI. When I’m estimating inflation for my investment decisions, I pay more attention to the ISM price index, the money supply (MZM), commodity prices, and stock prices. And the ISM Purchasing Managers Index should provide more up to date evidence of the “output gap” than GDP figures. A version of the Taylor Rule which emphasized those should react more quickly to changes in the economy.

Bitcoin

Posted by Peter on October 28, 2011
Posted in: Investing. Tagged: .

In the process of researching Bitcoin to help me decide whether to buy some as an investment, I’ve come across some confusion about money in some prominent articles.
This article says:

the demand for Bitcoins is driven by the volume of Bitcoin-denominated transactions.

…

the value of a currency is built on its reputation, and five months of bad news and depreciation have done serious damage.

Money serves several different functions. To be widely accepted, a currency typically needs to serve as a medium of exchange and as a store of value. But gold is a good example of a quasi-currency that functions as a fairly good store of value (at least for people with long time horizons). Bitcoin shows more promise of functioning as a store of value than as a medium of exchange.

If Bitcoin were only a medium of exchange, it might make sense to say the volume of Bitcoin transactions drives the demand for it. But if most people who are buying Bitcoins are hiding them under their mattresses on EMP-resistant media (cd-rom?), the price of Bitcoins can rise indefinitely without an increase in transactions.

It isn’t very useful to lump many beliefs about a currency into a single reputation. Bitcoin has different reputations for different traits.

A currency should have a reputation for being in limited supply and for not having that supply increase too rapidly. I’d say Bitcoin has developed a better reputation for this than the US dollar, and might exceed gold’s reputation.

A currency should be easy to store and transport safely. This is an area where Bitcoin’s reputation is the subject of much confusion. There’s currently an unpleasant tradeoff between secure ways to store Bitcoin and convenient ways to have them available to spend. It make take a major rewrite of operating systems (e.g. to use Capability-based security with a good UI) for it to be possible to have Bitcoins be conveniently accessible but hard to steal. Confusion over the risk of theft has probably driven a fair amount of the recent Bitcoin price volatility. My guess is that it’s better that theft has happened now than after people become more reliant on Bitcoin. It will either drive the creation of more secure software (with benefits much wider than Bitcoin use) or discourage people from relying on insecure ways of handling digital money.

Finally, it’s important that a currency have a reputation for being something that people will value in the future. This is a source of significant uncertainty, because it depends on people’s perceptions of the alternative stores of value, the alternative media of exchange, and the risk of Bitcoin theft. Bitcoin has the potential to be a better store of value than gold, because a transparent algorithm can better guarantee a limited supply than the difficulty of mining a metal. People who started watching Bitcoin prices a few months ago in response to a flurry of publicity attach a low reputation to its prospects as a store of value because the recent price crash is more vivid in their mind than the earlier boom, but that’s a temporary phenomenon that doesn’t deserve much attention.

For most uses as a medium of exchange, Bitcoin doesn’t offer much advantage now. For most transactions, the small cost savings aren’t enough to persuade consumers to give up the ability to dispute a payment, or for stores that accept Bitcoin with an option to dispute payment to offer a discount for Bitcoin purchases. And I expect governments and large financial institutions to create obstacles to its use as a medium of exchange. There are a few small uses where it works better than any existing alternative – e.g. Wikileaks, where the existing financial system refuses to support online payments. Bitcoin anonymity doesn’t appear strong enough to attract people engaged in illegal businesses. Online gambling companies might get some advantage from using Bitcoin if the obstacles to transferring money to gambling sites exceed the obstacles to buying Bitcoin, but I’m guessing the obstacles are and will be at least as large for buying Bitcoin. So I expect very slow adoption of Bitcoin as a medium of exchange.

I do think there’s a nontrivial chance that Bitcoin will become widely used as a store of value, and that might replace a significant amount of demand for gold a decade or two from now. A decline in demand for gold as a store of value might well snowball, as extrapolating that trend would imply that gold becomes a less reliable store of value. That doesn’t yet make me reluctant to buy gold, but a Bitcoin price over 0.1 ounces of gold might make me reconsider.

I will probably invest a small fraction of my net worth in Bitcoin, but I don’t feel any urgency about it.

Expected Returns

Posted by Peter on August 23, 2011
Posted in: Book Reviews, Investing. Tagged: , .

Book review: Expected Returns: An Investor’s Guide to Harvesting Market Rewards, by Antti Ilmanen.
This book is causing me to change my approach to investing much more than any other book has. It is essential reading for any professional investor.

The foreword starts by describing Ilmanen as insane, and that sounds like a good description of how much effort was needed to write it.

Amateur investors will have trouble understanding it – if you’re not familiar with Sharpe ratios, you should expect to spend a lot of time looking elsewhere for descriptions of many concepts that the book uses. I had a few problems understanding the book – he uses the term information ratio on page 188, but doesn’t explain it until page 491 (and it’s not indexed). I was also somewhat suspicious about how he handled data mining (overfitting) concerns in momentum strategies until I found a decent answer in a non-obvious place (page 404).

The most important benefit of this book is that he has put a lot of thought into identifying which questions investors should be trying to answer. Questions such as whether past performance is a good indicator of future returns, and what would cause a pattern of superior returns to persist or vanish.

Some other interesting topics:

  • why it’s important to distinguish between different types of undiversifiable risk, and how to diversify your strategies so that the timing of losses aren’t highly correlated across those strategies.
  • why earnings per share growth has been and probably will continue to be below GDP growth, contrary to what most forecasts suggest.
  • how to estimate the premium associated with illiquidity
  • why it’s useful to look at changes in correlations between equities

It’s really strange that I ordered this a few weeks after what Amazon lists as the publication date, but it took them nearly 7 weeks to find a copy of it.

Some quotes:

overfitting bias is so insidious that we cannot eliminate it (we cannot “become virgins again” and forget our knowledge)

the leverage of banks will soon be more tightly restricted by new regulations. The practical impact will be more pronounced risk premia for low-volatility assets, more sustained mispricings, and greater opportunities for those who can still apply leverage

European financial crisis

Posted by Peter on August 8, 2011
Posted in: Investing, Politics.

Arnold Kling has a concise summary of the current crisis:

Apparently, the resolution of the debt ceiling restored the dollar’s status as a safe haven in the eyes of the world’s investors. That accelerated the flight from European sovereign debt and European banks. That in turn raised fears in financial markets, driving down stocks, including in the United States.

The European monetary system appears to suffer from the same problems as Bretton Woods.

European voters seem unlikely to tolerate the measures needed to maintain the current system. Yet the breakup will cause enough problems for the banking system that politicians will postpone it as long as possible.

Avoid News

Posted by Peter on March 9, 2011
Posted in: Investing, Politics. Tagged: .

Avoid News is a good rant against paying attention to the storytellers that typically get labeled as news reporters:

Information is no longer a scarce commodity. But attention is. Why give it away so easily? You are not that irresponsible with your money, your reputation or your health. Why give away your mind?

I don’t know a single truly creative mind who is a news junkie – not a writer, not a composer, mathematician, physician, scientist, musician, designer, architect or painter. On the other hand, I know a whole bunch of viciously uncreative minds who consume news like drugs.

Bryan Caplan says:

P.S. When I read this passage, the counter-example of Tyler Cowen came immediately to mind.

I don’t consider that much of a counter-example. I found Tyler Cowen’s blog to be a dangerous addiction, and I’m glad I quit. I have a strong impression that he could be much more creative than he is, but has made a deliberate choice to pursue fame at the expense of creativity.

In order to maintain the pretense that news focuses on important information, storytellers focus on events that make us unhappy (avoiding or fixing mistakes are more important than understanding what routinely goes right, which makes it hard to focus on good news). [This also applies to other sources of political information, but that means I want the most concise source, which is not likely to be a rapidly published source.]

I’m not willing to completely follow the advice to kick my news addiction, since I’m somewhat dependent on social connections with people who imagine that news media provide valuable information. But I can mostly learn enough by watching The Daily Show, which often (but hardly consistently) is careful to indicate that they focus on frivolous, entertaining stories that give low priority to educational value. I’m definitely better off with that than I was when I was addicted to serious-sounding daily news sources.

I have a system for reading financial news that minimizes the problems with news. It involves mostly reading numbers that I find via stock symbols. Most of those numbers have been checked by accountants, who have strict rules to minimize biases. I’m fairly careful to select which symbols I follow by analyzing numbers, not stories.

For more evidence that news harms you, see an experiment done by Andreassen where subjects trading stocks did worse if they saw a constant stream of news than if they saw no news once they started trading.

Also, Robin Hanson’s analysis of how the press handled one story suggests a pretty clear positive correlation between the time a source takes to convey a story and the accuracy of that story.

[I’ve been neglecting this blog recently due to an obsession with finding waterfalls; that will change any week now when rainfall tapers off.]

Drive

Posted by Peter on August 31, 2010
Posted in: Economics, The Human Mind. Tagged: , , , .

Book review: Drive: The Surprising Truth About What Motivates Us, by Daniel H. Pink.

This book explores some of the complexities of what motivates humans. It attacks a stereotype that says only financial rewards matter, and exaggerates the extent to which people adopt that fallacy. His style is similar to Malcolm Gladwell’s, but with more substance than Gladwell.

The book’s advice is likely to cause some improvement in how businesses are run and in how people choose careers. But I wonder how many bosses will ignore it because their desire to exert control over people outweighs their desire to create successful companies.

I’m not satisfied with the way he and others classify motivations as intrinsic and extrinsic. While feelings of flow may be almost entirely internally generated, other motivations that he classifies as intrinsic seem to involve an important component of feeling that others are rewarding you with higher status/reputation.

Shirking may have been a been an important problem a century ago for which financial rewards were appropriate solutions, but the nature of work has changed so that it’s much less common for workers to want to put less effort into a job. The author implies that this means standard financial rewards have become fairly unimportant factors in determining productivity. I think he underestimates the importance they play in determining how goals are prioritized.

He believes the changes in work that reduced the importance of financial incentives was the replacement of rule-following routine work with work that requires creativity. I suggest that another factor was that in 1900, work often required muscle-power that consumed almost as much energy as a worker could afford to feed himself.

He states his claims vaguely enough that they could be interpreted as implying that broad categories of financial incentives (including stock options and equity) work poorly. I checked one of the references that sounded like it might address that (“When performance-related pay backfires”), and found it only dealt with payments for completing specific tasks.

His complaints about excessive focus on quarterly earnings probably have some value, but it’s important to remember that it’s easy to err in the other direction as well (the dot-com bubble seemed to coincide with an unusual amount of effort at focusing on earnings 5 to 10 years away).

I’m disappointed that he advises not to encourage workers to compete against each other without offering evidence about its effects.

One interesting story is the bonus system at Kimley-Horn and Associates, where any employee can award another employee $50 for doing something exceptional. I’d be interested in more tests of this – is there something special about Kimley-Horn that prevents abuse, or would it work in most companies?

Disadvantages of Stories

Posted by Peter on August 12, 2010
Posted in: Investing, The Human Mind.

Tyler Cowen has a good video describing why we shouldn’t be too influenced by stories. He exaggerates a bit when he says

There are only a few basic stories. If you think in stories, that means you are telling yourself the same thing over and over

but his point that stories allow storytellers to manipulate our minds deserves more emphasis. For me, one of the hardest parts of learning how to beat the stock market was to admit that I did poorly when I was influenced by stories, and did well mainly when I relied on numbers that are available and standardized for most companies, and on mechanical rules which varied little between companies (I sometimes use different rules for different industries, but beyond that I try to avoid adapting my approach to different circumstances).

For example, The stories I heard about Enron’s innovative management style gave me a gut feeling that it was a promising investment. But its numbers showed an uninteresting company, and persuaded me to postpone any investment.

But I’ve only told you a story here (it’s so much easier to do than provide rigorous evidence). If you really want good reasons, try testing for yourself story versus non-story approaches to something like the stock market.

(HT Patri).

An Improved Automated Market Maker

Posted by Peter on June 21, 2010
Posted in: Idea Futures. Tagged: , .

[See here and here for some context.]

John Salvatier has drawn my attention to a paper describing A Practical Liquidity-Sensitive Automated Market Maker [pdf] which fixes some of the drawbacks of the Automated Market Maker that Robin Hanson proposed.

Most importantly, it provides a good chance that the market maker makes money in roughly the manner that a profit-oriented human market maker would.

It starts out by providing a small amount of liquidity, and increases the amount of liquidity it provides as it profits from providing liquidity. This allows markets to initially make large moves in response to a small amount of trading volume, and then as a trading range develops that reflects agreement among traders, it takes increasingly large amounts of money to move the price.

A disadvantage of following this approach is that it provides little reward to being one of the first traders. If traders need to do a fair amount of research to evaluate the contract being traded, it may be that nobody is willing to inform himself without an expectation that trading volume will become significant. Robin Hanson’s version of the market maker is designed to subsidize this research. If we can predict that several traders will actively trade the contract without a clear-cut subsidy, then the liquidity-sensitive version of the market maker is likely to be appropriate. If we can predict that a subsidy is needed to generate trading activity, then the best approach is likely to be some combination of the two versions. The difficulty of predicting how much subsidy is needed to generate trading volume leaves much uncertainty.

[Updated 2010-07-01:
I’ve reread the paper more carefully in response to John’s question, and I see I was confused by the reference to “a variable b(q) that increases with market volume”. It seems that it is almost unrelated to what I think of as market volume, and is probably better described as related to the market maker’s holdings.

That means that the subsidy is less concentrated on later trading than I originally thought. If the first trader moves the price most of the way to the final price, he gets most of the subsidy. If the first trader is hesitant and wants to see that other traders don’t quickly find information that causes them to bet much against the first trader, then the first trader probably gets a good deal less subsidy under the new algorithm. The latter comes closer to describing how I approach trading on an Intrade contract where I’m the first to place orders.

I also wonder about the paper’s goal of preserving path independence. It seems to provide some mathematical elegance, but I suspect the market maker can do better if it is allowed to make a profit if the market cycles back to a prior state.
]

Awakening Giants

Posted by Peter on June 3, 2010
Posted in: Book Reviews, China, Economics.

Book review: Awakening Giants, Feet of Clay: Assessing the Economic Rise of China and India by Pranab Bardhan.

This short book has a few interesting ideas.

The most surprising ones involve favorable claims about China’s collectivist period (but without any claim that that period was better overall).

China under Mao apparently had a fairly decentralized economic system, with reasonable performance-based incentives for local officials, which meant that switching to functioning capitalism required less change than in Russia.

Chinese health apparently improved under Mao (in spite of famine), possibly more than it has since, at least by important measures such as life expectancy. This is reportedly due to more organized and widespread measures against ordinary communicable diseases under collectivism.

Stock Market Liquidity

Posted by Peter on May 11, 2010
Posted in: Investing. Tagged: .

One simple way to prevent fluctuations like those of last Thursday would be for stock exchanges to prohibit orders to buy or sell at the market.

That wouldn’t mean prohibiting orders that act a lot like market orders. People could still be allowed to place an order to sell at a limit of a penny. But having an explicit limit price would discourage people from entering orders that under rare conditions end up being executed at a price 99 percent lower than expected.

It wouldn’t even require that people take the time to type in a limit price. Systems could be designed to have a pseudo-market order that behaves a lot like existing market orders, but which has a default limit price that is, say, 5 percent worse than the last reported price.

However, it’s not obvious to me that those of us who didn’t sell at ridiculously low prices should want any changes in the system. Moderate amounts of money were transferred mainly from people who mistakenly thought they were sophisticated traders to people who actually were. People who are aware that they are amateurs rarely react fast enough to declines to have done anything before prices recovered. The decline looked like it was primarily the result of stop-loss strategies, and it’s hard to implement those without at least superficially imitating an expert investor.