Flying Solow

As frequent reader may remember, I've a soft spot for Robert Solow. He spoke to my senior seminar. Short of Samuelson, also at the Tute at the time, you couldn't get much higher on the economics totem pole.

Back before the Arab Oil Embargo, the standard beneficent description of Federal debt was, "don't worry, we owe it to ourselves". After 1973, that wasn't so much true. In the run up to The Great Recession, some wags among the pundit class were heard to say, "the US economy is based on minimum wage workers buying McMansions with Chinese money". That was largely true, too.

Today, Solow takes on debt in the NY Times. Not terribly surprisingly, I find he's right. The only kvetch I have with his prose is that he doesn't directly repudiate the "government debt steals from private capitalists". American corporations are sitting on more than a trillion dollars, much of it stashed overseas, attempting to extort even less tax than their already sweet deal.

In the long run we need a clear plan to reduce the ratio of publicly held debt to national income. But for now the best chance to reinvigorate the economy, spur business investment and encourage consumer spending is through public borrowing and spending. Instead, we're heading into an ill-advised, across-the-board austerity program.

I See the World in Black and White

Once again, thanks to "Revolutionary" Dave for finding something interesting in the world of quant. The post-mortem is too long for the average trip to the loo, but the appendix on Value at Risk (VaR) which is the metric to be modeled, can be read. VaR is just a number of dollars assumed to be lost under varying circumstances (wiki piece). Dave's take on the Excel/R conflict is spot on.

The trader who had instructed the modeler to develop the new VaR model (and to whom the modeler reported at the time), CIO Market Risk, and the modeler himself also believed that the Basel I model was too conservative -- that is, that it was producing a higher VaR than was appropriate.

This is the heart of the continuing quant problem: unlike natural/mechanical processes, human processes (accounting and finance especially, since they only exist as games with arbitrary rules) are subject to "unexplained" perturbations. This is what Black Swans are. Black Swans exist in nature, the archetype being the Alvarez/Yucatan asteroid. The difference is that such natural Black Swans are exogenous to the process, while human Black Swans are largely endogenous; they happen because participants can and do change the rules for self-benefit. Such manipulation is generally impossible to model.

The Model Review Group performed only limited back-testing of the model, comparing the VaR under the new model computed using historical data to the daily profit-and-loss over a subset of trading days during a two-month period. The modeler informed the Model Review Group that CIO lacked the data necessary for more extensive back-testing of the model (running the comparison required position data for the 264 previous trading days, meaning that a back-test for September 2011 would require position data from September 2010). Neither the Model Review Group nor CIO Market Risk expressed concerns about the lack of more extensive historical position data.

Again, using more historical data may only have been useful for face-validity purposes. As always, the fiddlers fiddled:

There is some evidence the Model Review Group accelerated its review as a result of this pressure, and in so doing it may have been more willing to overlook the operational flaws apparent during the approval process.

While Excel is really not appropriate to any activity beyond vanilla accounting, the failure here (as with The Great Recession) was the result of Rand-ian self-interest. The real Adam Smith posited an economy in which each actor is not only autonomous, but also bereft of market power to impose collateral damage. Finance is all about collateral damage; that's how they earn it.

Here, it gets really interesting:

On January 26, the Model Review Group discovered that, for purposes of a pricing step used in the VaR calculation, CIO was using something called the "West End" analytic suite rather than Numerix, an approved vendor model that the Model Review Group had thought was being used. The Model Review Group had never reviewed or approved West End, which (like Numerix) had been developed by the modeler.

Turns out that Numerix is built on Excel (at least in part): "All Numerix functions are available via Microsoft ® Excel® as an add-in".

If you've ever inherited an analysis application executed in 1-2-3/Excel macros, you have my condolences been there done that.

In sum: while the use of Excel, even if it's also used by a major analytics vendor, is problematic; the cause, as with The Great Recession, was corruption and not only the Suits in this case. What's especially galling is that these quants are often some sort of math-y Ph.D., yet use Excel in haphazard ways. The poor will always be with us.

A Bigger Piece of the Pie

Sometimes quants have their heads in the sand (or some other dark place). This post on the beauty of market segmentation in insurance floated by recently. Another case of ignoring Your Good Mother's Warning: "what would the world be like if everybody behaved as you do?" Here we find the few profiting from the exploitation (largely legal, alas) of the many.

When I was in school, there was a class called "Risk and Insurance". I think I took it, because I remember the text was an Irwin book, notable for the standard Irwin livery of baby blue binding. From the point of view of the macro-economist, the point is shared risk. From the point of view of the micro-economist, it is risk avoidance (and claim payment). It's no accident that the largest criminal in The Great Recession was AIG, an insurance company. It exploited failures in law to purvey unfunded insurance.

Charpentier makes the micro-economist's argument:

If we consider two companies, one segmenting, while the other one has a flat rate, then older drivers will go to the first company (since insurance is cheaper) while younger ones will go to the second one (again, it is cheaper). The problem is that the second company implicitly hopes that older drivers will compensate the risk.

The issue, of course, is that policy (the political structure) permits such Darwinist commerce. Taken to the extreme, as The Great Recession proved, capital will always seek to socialize cost and privatize profit. Production of widgets is secondary to the true goal: make capital relatively richer than labor. Being short-sighted, capital cares not for raising all boats (which provides output which is not sustainable if sold only to the .1%). In the case of insurance market segmentation, the inevitable end is transforming shared risk (insurance) into pre-paid consumption.

"Medicare for All" was a name given to an effort, failed of course, to broaden the base of health insurance. Disallowing of segmentation, arguably segmentation falls under anti-trust laws, not only broadens the base, but in doing so level the playing field, making all insurers equal. Much like Adam Smith's pin manufacturers. Not what they want, of course.

Reporting in the New York Times yesterday and today makes manifest the failure (because it's simply incapable) of quant. From yesterday we read that S&P fiddled, and intentionally fiddled the models, while today that J.P. Morgan fiddled. While quant may have intended to do the right thing (whatever that is), policy always trumps data, given the chance.

One S&P staffer, at least, tried to fight the good fight:

The idea of asking bankers what they thought about a change in the firm's methods shocked some S.& P. analysts and executives, including one who fired back, "What does 'rating implication' have to do with the search for truth? Are you implying that we might actually reject or stifle 'superior analytics' for market considerations?"

Ummm, yes, yes you did.

For those who've been attempting to foist responsibility off on the GSEs, you're full of shit and always have been. This was a private capital raid on the public, and thence the taxpayer once their sandcastles collapsed. The entire mess was driven by the lust for profit, the public and even shareholders be damned. It wasn't some government agency or GSE ordering the financial services industry to inflate house prices. Yes, Dubya and Greenspan started the snowball rolling by cratering interest rates, but without the rating agencies dousing these derivatives with their holy water, the process couldn't have continued.

Accounts of the financial crisis have shown that credit analysts placed too much trust in their models. They routinely relied on historical projections that failed in an environment where home prices were falling fast.

The Justice Department contends it was more than just naïveté. The suit claims that S.& P. employees deliberately used models to produce inflated, fraudulent ratings.

Once again, was it just the Suits, or the quants, too who fiddled while the US burned? In the words of Murphy, "admit nothing, deny everything, demand proof":

Rating agencies are paid to evaluate securities by the issuers. An issuer might decide not to use a rating if it were lower than those available from rivals. In that case, the credit rating agency might lose valuable fees.

According to the Justice Department, S.& P. started to tinker with its models relatively early in the housing boom.

It was a marketing reaction, just as the non co-opted have said from the beginning:

S.& P. used a model called E3 to help rate certain types of C.D.O.'s. The problem, according to the Justice Department, is that the model could turn out ratings that did not meet the issuers' expectations.

In such cases S.& P. had a solution, the suit said. The credit rating firm switched to a different model -- a more forgiving version called E3 Low -- that could provide more attractive ratings on certain C.D.O.'s.
...
The suit says S.& P. gave instructions on when to use E3 Low. "If the transaction passes E3.0, GREAT!!," the instructions said, according to the government. But if it does not, "then use E3 Low."

"Guilty, guilty, guilty!" Who's more guilty, the quants or the Suits? You decide.

David and Goliath

Stockman gets it!!! He's been going up against the Lunatic Right Goliath since his apostasy coming out party, back in 2010 (or thereabouts).

Always remember: housing generates no fiduciary return. Yes, if you're in the psychic income crowd there'll be some of that, but you can't use psychic dollars to pay the mortgage. It matters not how much emotional money your new McMansion provides, you need increasing income to pay for more house. We still have massive unemployment and declining median income. There's fiddling going on, again.

"Gerry From Princeton, You're on the Line"

Turns out that Princeton has more than one smart guy in the room. More than a few of the missives here have been pointed at the DNC's incompetence, in 2010 and 2012. Based on desultory reporting, it was clear that the notion that the Lunatic Right is on the ropes was simply stupid.

Today's Times offers up a data based study (from whence the data, if I knew, I'd have written it) showing how the Lunatic Right has transformed itself into a permanent ruling minority.

Democrats received 1.4 million more votes for the House of Representatives, yet Republicans won control of the House by a 234 to 201 margin.

Given the structure of American government, these lunatics will: block any progress with its House majority, defy Federal law in states where it controls government (currently 17 a nice graphic), and continue to manipulate voting rights to institutionalize itself.

... gerrymandering is a major form of disenfranchisement. In the seven states where Republicans redrew the districts, 16.7 million votes were cast for Republicans and 16.4 million votes were cast for Democrats. This elected 73 Republicans and 34 Democrats.

And it gets worse:

... Mr. Carrico's proposal applied nationwide would have elected Mitt Romney, despite the fact that he won five million fewer votes than Mr. Obama. This is basically an admission of defeat by Republicans in swing states. Mr. Carrico's constituents might well ask whether these changes serve their interests or those of the Republican National Committee.

Here, Wang slaps on his rose colored glasses: of course the constituents approve; they're the Sunnis grinding the Shiites under their heel. It is naked power, applied nakedly. If you look at the USA Today maps, you'll see that these Lunatic Right states are, save 3, in the South and Mountain states. In other words, states of stupidity.

Money For Something

Today's Times brings us yet another plaint that money just doesn't buy so much money anymore.

"Where is someone supposed to get yield these days?" said Emma B. Rasiel, an associate professor of economics. That's what got us thinking."

The problem for these fledgling financiers is the same one faced by their white-shoe elders: buying and selling stocks and bonds in the market isn't investing in companies, it's gambling with other like minded folks. It's a zero-sum game. The underlying issue is that returns, in real terms, are generated by technology (modulo corruption) progress. Buying stock or bonds in a public offering is investing. Trading such instruments later is not, it's just gambling. Ignorance, or denial, of this fundamental truth is what caused The Great Recession: the vig on all those McMansion loans had to come from the income streams of the mortgage holders. And for those incomes to increase, a necessity given that the bulk of these mortgages were adjustable upward, requires increasing wages and increasing productivity. While productivity has been increasing over the last decade and a half, little of that increase has made itself into wages. Those holding moolah, and wanting risk free returns, turned to housing en masse. As as lemmings do, they all drowned. If you've not heard it, here's the link for the NPR piece "The Giant Pool of Money". NPR produced follow-ups, described in the wiki.

The avowed purpose of the successive QEs was to bring into productive status ever more real investments, which would not have been feasible at higher interest rates. This is classic Lunatic Right trickledown economics: make life easier for those that already have it easy, and the rest of the boats will rise. If capitalists were the homo economicus of theory, then previously marginal physical investments become viable, and are done. Of course, it hasn't happened. Why?

For one thing, in technology the return period for physical investment continues to shrink. The reason for that has been the relentless boot heel of Moore's Law: more and more transistors packed into chips each year. The facilities to make ever denser chips get leapfrogged in tens of months. Long term investment in physical capital in tech is kind of non-existent; there is no long term. It's not like building a railroad or blast furnace in 1870, where one could expect to reap returns for decades. Churn in tech has killed that off.

Apple has had to churn out a "new" iPhone about once a year, just to keep people interested. If you're of a certain age, you may remember the American auto companies being accused of planned obsolescence in the 50's and 60's, compared to European companies. Change a tail fin here or a grill there. Apple's been doing just that for more than half a decade. And they do it because some other company can build on the latest tech, which didn't even exist when the current iThing was finalized.

The end result is that long term physical investment is an oxymoron, in a growing number of industries.

If there isn't the opportunity to exploit physical investment for multiple years, then there isn't a moolah flow to support paying interest to bondholders. In other words, the reason that Apple and all the others are holding trillions of moolah is simply because they can't find useful purposes for the money. The Fed is still pushing a string.

The adulation that housing is "coming back" is a sure sign that capitalists still don't have productive uses for moolah. The only way to generate demand for more capital is to increase demand for current widgets with current tech. And that's fiscal policy, which amounts to divvying up the pie more equitably. Socialism! But the Lunatic Right want deflation, since that's even less risky than Treasuries, which aren't paying much. And they aren't paying much because there's just not much need for physical investment. Moolah is fungible, the economist's fancy word for "it's all one big pot of stuff", and if demand for physical investment were to accelerate the inevitable result is higher returns across the board.

The true danger: as (and if) moolah flows into shares, then we have what the pros call "asset inflation"; more money chasing a fixed number of widgets. Clearly, the stock market has risen far more than macro measures justify. We're near, if not in, Ponzi territory.

This lack of demand for physical capital can't be fixed by the Fed. Marx is looking righter by the day.