Friday 25 December 2009

The Golden Age of Grotesque

You may not believe it, but I've just realized we're approaching the end of the year and decade.

No, I don't live in a cave in the middle of the bush. Intellectually, I had already grasped the idea; it just did not "strike an emotional cord", if you like.

This epiphany came to me while reading Rortybomb's end-of-the-year posts.

Rortybomb is a blog I recommend, but not without a warning: it's a Yank blog. And Rortybomb's tastes in music are, well, Yank musical tastes. No offence meant.

Anyway, Rortybomb was exploring the question: did the 00s suck? He pointed to a Russian techno-dance duo as an example of dubious music; no problem here.

Not so sure with his choices, though.

Let's face it, I'm no expert, but for me, music, art in fact, is an image of its time. As I see it, it doesn't need to be "pretty" or pleasant.

Say, Baroque music still had religious overtones, inherited from the Renaissance, but it valued musical complexity and performer's technical ability.

Classical music, on the other hand, reflects the spirit of the mid and late Enlightenment. Its greatest values were melody, harmony, order. Think of Beethoven or Mozart.

Romanticism, on the other hand, was the embodiment of feeling, tragedy, and in the specific German case, heroism. And those are the values of Wagner.

The Golden Age of Grotesque

But ours is neither a time of harmony, nor of heroism; quite to the contrary. Instead, I believe our music should be monstrous, and dissonant.

In this spirit, I find that Marilyn Manson has done good things. You've gotta give credit to a band that says:

"This isn't music and we're not a band
We're five middle fingers on a motherfucking hand" (Vodevil, John 5 and Skold)

But my kudos don't go to Marilyn Manson...

Without further ado, the winners of the Golden Age of Grotesque nomination are: Rammstein and Nine Inch Nails.

Rammstein for diverse tracks, which reflect the mood of the 00s, often with a dose of black humour: Amerika, Mein Teil, Moskau, Benzin and Zerstoeren, in particular.

Mein Teil, for those not familiar, is inspired by the "German cannibal" case (Armin Meiwes and Bernd Brandes) and it gives a whole new meaning to "my bit" (as the chorus and title translate).

Amerika, on the other hand, isn't nearly as dark, as can be seen:

"We're all living in Amerika
Amerika ist wunderbar" (Amerika, collectively attributed to the band)

Nine Inch Nails for their consistently aggressive and haunting music, which for me reaches its apex in Year Zero:

"I should have listened to her, so hard to keep control
We kept on eating but our bloated belly's still not full
She gave us all she had but we went and took some more
Can't seem to shut her legs, our mother nature is a whore." (Survivalism, Trent Reznor)

Now, my WTF nomination goes to a young fellow, who composes nice, catchy songs, but whose lyrics I find peculiar: Ben Lee, for I Love Pop Music:

"I love pop music, this is how we do it
It's politics you can romance to
I love pop music, sprinkle sugar through it;
Philosophy that you can dance to".

On second thoughts, the idea of the cave in the middle of the bush doesn't sound that absurd.

Friday 18 December 2009

John Safran: The Lost Pilot

Dean Baker, MediaWatch and all you guys out there keeping an eye on the media:

Here you'll find John Safran's Lost Pilot (at least until next Friday 25th)...

Right-wing media, be afraid, be very afraid.

You've been warned.

Tuesday 1 December 2009

The Famous Efficient Market Hypothesis II:

Chronicle of a Death Foretold.

I went these days through some old paper clippings. You know: you read something, find it interesting, and decide to keep it. But you never use it again, and even forget about it.

Somehow that stuff never gets thrown away. And, surprisingly, one day it turns out it was a good idea to keep it, after all.

Re-reading those old clippings and photocopies, I had a clear feeling of déjà vu. Check this out:

"It is difficult to pick up a newspaper these days without seeing another article about a major company that has taken an unexpected financial loss due to derivatives transactions gone awry".

"That's not too old. Probably a 2007-2008 newspaper article", you might say. "Surely it talks about investment banks affected by sub-prime mortgages?"

Nope. This is over 14 years old: it's from a 1995 issue of the Harvard Business Review [0]. They are not talking about investment banks affected by sub-prime mortgages. The corporate casualties were in the manufacturing and mining/oil industries: Procter & Gamble Co, Metallgesellschaft AG, and Kashima Oil.

Some big financial players also had their fingers burnt around those years: Askin Capital (a group of hedge funds ominously specialising in mortgages), PaineWebber (mutual funds management) and Kidder, Peabody & Co (an investment bank). And, as the article was published, Barings Bank (which would go belly up later in 1995) had just started its way to doom.

Derivatives, for those unfamiliar, are financial "products" such as options, general swaps, CDS, CDO and CMO. They are called derivatives because their value "derives" from the value of an asset, subject to chance variations.

I will spare you of the statistical details, but to give you an idea of the complexity involved: until recently economists were not considered capable to understand derivatives.

So, the financial industry hired physicists and mathematicians (so-called rocket scientists, derivative geeks, or simply quants,): "The migration of physicists to the financial industry that started as a trickle in the late 1970s has now [1994] become a steady stream (…) In short, these days Wall Street, when compared to physics [departments], is Club Med".[1].

And quants were paid handsomely, too: apart from a very generous base pay, they were given bonuses, according to the profitability of the derivatives they designed and sold: "Last year [1993] times were good: derivatives experts fretted about how to avoid paying too much tax on bumper bonuses" [2]. And profitability depended to a large extent on the derivatives' complexity, which was just fine, with quants and their employers.

According to the same article, by 1994, though, things had changed for the worse for quants: "The travails of Procter & Gamble, a consumer goods manufacturer, and other American companies that lost money on esoteric swaps have deterred investors from buying anything unusual"

In fact, partly preceding these companies' "travails", partly reinforced by them, those years witnessed much soul-searching from the academic community and the financial industry.

To be sure, not all that soul-searching was radical: some was focused on the way derivatives should be used, as opposed to how they were used by these unfortunate companies. In a later article we'll discuss this in more detail.

Here we'll deal with the more radical criticism, directed not only against derivatives, but in general against financial theory as a whole.

A Little Bit of History.

What follows draws on an extraordinarily useful and informative 1993 article by Nancy A. Nichols [3], which I cannot possibly recommend enough (I apologize, though, for the detour).

Nichols' account dispels some misunderstandings related to how widely accepted was the Efficient Market Hypothesis (EMH) in financial practice (see my previous article in this Famous Financial Market Hypothesis series).

Nichols provides a succinct account of the historical development of the three main pillars of modern financial theory:

(1) Portfolio Theory by Prof. Harry Markowitz (early 1950s): the notion that an investor who does not diversify can't do better than an investor who does. As the market is already diversified, investors on average can't do better than the market.

(2) EMH by Prof. Eugene Fama (early 1960s). This hypothesis is equivalent to the Rational Expectations Hypothesis, developed around the same time by the late Prof. John Fraser Muth: "outcomes do not differ systematically (i.e. regularly or predictably) from what people expected them to be" [4]. Because errors are not systematic (i.e. they are random and averaging 0), they cannot be predicted: i.e. they are immediately factored in the prices of assets. In other words: there are no such things as bubbles.

(3) CAPM by Prof. William Sharpe and others (early to mid 1960s): used "to define the unique risk of holding stocks in general and then to judge the risk of any one stock, in relation to the market as a whole", assuming that the EMH was valid.

However, from the mid 1980s, empirical work (ironically, some of it by Prof Fama himself) demonstrated systematic and persistent anomalies incompatible with the EMH and CAPM.

For a while, these anomalies were ignored as mere curiosities. Eventually, though, the empirical evidence forced a reconsideration of the theory:

"Yet today [1993] (…) that belief [that all business is quantifiable and that markets can be studied scientifically] is under attack from all sides: from those who say finance uses the wrong scientific paradigm to those who say finance isn't a science at all but an art".

Nichols identified three main objector groups:

(1) The Revisionists: individuals like Prof. Robert J. Shiller, who "don't advocate throwing out the theories that make up modern finance, but they sure would like to tinker with them".

(2) The "Gadflies": individuals like the late Prof. Louis Lowenstein [5] and Samuel M. Miller, who "eschew the scientific approach altogether, arguing that investors aren't always rational and that managers' constant focus on the markets is ruining corporate America".

(3) The Chaos Cabal: individuals like J. Doyne Farmer and Norman Packard, who proposed the use of heterodox tools, coming from physics and complexity theory, to the financial markets.

However by 1996 - barely three years after Nichols' article - The Economist's editors were not only satisfied that the Chaos Cabal's efforts were entirely futile, but in an interesting example of non sequitur (ignoring both the Revisionists, the "Gadflies" or the entirely unacknowledged Post Keynesians) concluded that the EMH had prevailed: "Many have now concluded that formal chaos theory has nothing practical to offer (…) And such objections will come as no surprise to financial economists who believe that the idea of predicting price movements contradicts the theory that markets are more or less efficient". [6] My emphasis.

So, in one simple stroke all criticism directed towards the EMH and CAPM, in the first instance (but also against modern finance theory, by extension) was dismissed and we could happily go on with our lives.

Back to Derivatives.

After that long detour, you might be asking yourself what does it have to do with derivatives?

Check this quote (yes, yet another one): "[Derivatives] trading volume is well over $10 trillion - approaching the combined gross national product of the US, Japan and Europe - most of it unregulated because government agencies have yet to catch up. Increasingly, observers have begun to worry that a major misstep could vaporize financial markets." [7]

But modern financial theory was okay, wasn't it? The EMH and to a lesser extent the CAPM had prevailed at the end. That was The Economist's institutional opinion, shared by many in the financial industry. No wonder, for example, Prof. Bhagwan Chowdhry assuaged SciAm's concerns thus:

"Probably not. For one, the amount of money at risk is usually only a tiny fraction of the trading volume - as little as a few thousand dollars on a $100-million deal. For another, unlike real markets, derivative markets are zero-sum: for every big loser, there is also a big winner. Unless a player defaults (with debts exceeding assets), wealth can only be redistributed, not created or destroyed". My underlined.

That's the magic of old papers: a tragically wrong opinion that took into account, nonetheless, some of the main elements that 13 years later would indeed cause a financial meltdown of worldwide proportions.


[0] Harvard Business Review. Perspectives section. January-February 1995. Page 33.

[1] Scientific American. Science and Business section: Wall Street. October 1994. Page 126.

[2] The Economist. Derivatives section: Pain and Gain. 09/07/1994. Page 80.

[3] Nancy A. Nichols. "Efficient? Chaotic? What's the New Finance?" Harvard Business Review. March-April 1993. Page 50.

[4] Thomas J. Sargent. "Rational Expectations". The Concise Encyclopedia of Economics.

[5] Dennis Hevesi. "Louis Lowenstein, Professor of Business Law and Critic of Wall Street, Dies at 83". The New York Times, 25/04/2009.

[6] The Economist. Finance and Economics section: Chaos under a Cloud. 13/01/1996. Page 69.
[7] Scientific American. The Analytical Economist. Derivatives: Not the Real Thing. January 1995. Page 28.

Monday 23 November 2009

Lies, Damned Lies and Statistics.


Have you ever noticed how, according to newspapers, politicians or sundry pundits, everybody is wealthier, and yet, you seem to have difficulties making ends meet?

Well, I have. My first reaction was to question myself. But, in truth, although there was room for improvement, it wasn't enough to explain everything. After some reflection on the issue, I discovered that indeed something was wrong with those newspapers, politicians and sundry pundits.

And as regularly as I can, I will be publishing short articles about this.

Imagine only people...

You and I decide to go to this new chicken place, just around the corner, for lunch.

We order a whole Portuguese chicken, with peri-peri sauce, chips, salad and two beers. Altogether, $44.50.

You are about to dig into your food, when the mobile goes off. "I've gotta take this call", you offer as explanation, as you go outside.

Five minutes later you are back at the table, but where's your food? It's gone! Neither chicken, nor chips, an empty plate, a small plastic plate, next to, where you see a bill, a $20 note and a couple of coins.

Completely astonished, you barely manage: "Wh... whaaat?"

"Well, we had one chicken and we're two. So, on average, each of us had half a chicken. You pay for your half and I pay for mine", I reply sheepishly, after finishing YOUR beer.

Now, before you rush to deny that you would ever fall for that kind of scam, I've got to tell you: I'm sorry, but you're wrong. There is a good chance that you have fallen for this, many times. If this is a consolation, you're not alone.

Some Really Simple Statistics

Let's talk a bit about statistics. Don't be afraid: it won't hurt a bit.

Imagine two islands: Patagonia and Utopia. Both have equal populations (say, 10 inhabitants each) and equal total incomes ($10, each island).

So far, you can't tell one island from the other on the basis of their total incomes, as they are equal.

Now we introduce differences: in Patagonia all income goes to one person (say, the other nine are slaves); while in Utopia the aggregate income is equally divided between the 10 inhabitants.

This information is contained in the table below. The first column is simply the individuals' IDs, and the second column is their individual incomes (one column for Patagonia, another for Utopia).

If you go through the trouble, you'll find that both populations have the same average income: $1 = $ 10 (total island income)/10 people (island population). Still, while in Utopia everyone gets exactly the average, in Patagonia no one gets it: most get less (nothing, in fact) and one gets much more (does this remind you of your half chicken?).

If you have followed up to this point, you can already understand this:

(1) Patagonia and Utopia represent two extreme possible income distributions: absolute inequality (Patagonia) and absolute equality (Utopia).

(2) Real life income distributions are invariably intermediate cases between absolute equality and absolute inequality.

(3) Regardless, average measures of income (or wealth, or prices, or many other variables) are not good indexes. And they become more and more meaningless, the more a real case differs from absolute equality.

(4) There should be better measures of how your "average Joe" fares income-wise, one should hope. In fact, in most cases, there are such measures: the median income is an extremely simple one.

You might ask: what exactly is the median? In our example, is the individual income that's larger or equal than 50% of the remaining cases, and smaller or equal than 50% of the remaining cases. If we had nine individuals (instead of the 10), sorted according to their incomes, from lowest to highest, the median would be the income of the 5th individual: 4 individuals have lower or equal incomes, and 4 have higher or equal incomes.

In our case, though, as we have 10 individuals, the median is the income of the 5th individual plus the 6th, divided by 2: $0 in Patagonia and $1 in Utopia.

This little table shows together the average and median incomes in Patagonia and Utopia:

So, whenever you hear someone talking about incomes (or wages, wealth, bank account balances, taxes paid, prices) you need to know more details. A general statement (say, "incomes increase") means little, obviously. The average quantity doesn't add much more either, as you can see in the Patagonia example.

That's when you ask: "Ok, that's all good and well, but what's the median?"

If the median is lower than the mean or average, as it is in the Patagonia example, you know that a few people are earning much more than others.

If, on the other hand, no one cares to inform you about the median, even though it's reasonable to expect that such information exists, you have a good reason to believe that there is something wrong with the information provided.

Half a Chicken, on Average?

I'm sure you have solved those spot-the-differences puzzles from newspapers. Let's see if you can spot where the information provided is faulty or misleading. The quotes below come from real-life official media releases, op-eds, or news stories:

"In addition, real wages have increased by 20.8 per cent. This compares with the 1.8 per cent decline in real wages recorded over the whole 13 year term of the previous Labor Government".
Media release. Department of the Treasury (The Hon. Peter Costello, Treasurer). 30/08/2007.

"Figures released last Friday reveal another dimension of this wealth explosion in terms of financial assets like cash in the bank, shares, bonds and superannuation holdings. Every man, woman and child has, on average, almost $60,000 worth of these assets after debt is accounted for - and this has grown by almost half in the past two years".
Steve Burrell. "We're all richer. We just don't realise it". The Sydney Morning Herald, page 18, 02/10/2007.

"Bureau of Statistics figures show net household financial wealth (assets less liabilities) hit $1.2 trillion in the June quarter, up 23.3 per cent over the year. Breaking that down on a per capita basis, the financial wealth of each Australian hit a record $57,400 at the end of June".
Nassim Khadem. "Personal wealth bursts out all over". The Age, page 3, 29/09/2007.

Now, you might ask: does it matter? I believe it does. Governments need to justify their decisions; bosses need to pretend they are fair. It's our choice to believe them on blind faith.

A further resource on basic statistics is:

Statistics Every Writer Should Know. A simple guide to understanding basic statistics, for journalists and other writers who might not know math.

Friday 13 November 2009

The Famous Efficient Market Hypothesis

A few days ago, surfing the net, I found Rortybomb. Rortybomb is a US blog, presenting some seriously interesting discussions. Although American, I would highly recommend it to Australian readers, especially those interested in economics: its posts are thoughtful and the subsequent discussions are often quite relevant.

Wednesday 11 November 2009

About the Magpie

Well, maybe it's best to see this first post as a personal introduction and a "mission statement" of sorts.

I am a 48 yo male and I need to work for a living.

In a previous life I was considered upper middle-class and I had post-graduate education (Master's and started a PhD), but that was long ago.

Now I work manually and I could hardly be described as anything but low income earner.

Ideologically, I describe myself as an heterodox Marxist. This shows in my personal philosophical posture, which tends to be nihilistic. If you don't know much about Marxism, you'll probably be surprised to hear that Marxism is an extremely optimistic worldview. But, if you don't know much about it, you'll have to take my word for it.

I, in contrast, am deeply pessimistic. And I attribute this in part to my nihilism.

Which leads me to the next point of this post: I am writing this because I believe the world is ill. Maybe terminally so. I realize there is little I can do to make a difference. But I want to try and the only means I have to effect a difference is through my voice.

Don't get me wrong: I am not a profoundly "idealistic" character (idealistic in the sense of altruism). Marxists are often "idealistic" in this sense, although they are likely to deny it.

I am doing this because, as a good nihilist, I believe life has no intrinsic purpose. It's up to us to provide our life with one. So, as a good Magpie, I choose to fight, in the hope this may to some degree justify my own existence.

My promise to the reader is that I will try to be informative and fair.