A Glimpse into the Past

A friend recently loaned me Shoshana Zuboff's amazing book, In the Age of the Smart Machine. Providing a detailed and fascinating history of technology in the workplace, Zuboff's study provides a captivating analysis of the extensive changes worker's faced with the adoption of modern information technology. 

I wanted to share this passage, which comes from an early chapter in the book. While a little off the book's central theme, it gives the reader an idea of how much workplace norms have changed since the beginning of the Industrial Revolution. Clearly, the values and mores of what we now call the working class have little parallel in early societies.

One study of Birmingham, England, from 1766 to 1876, found that well into the nineteenth century, workers continued to celebrate Saint Monday – a weekly day of leisure spent in the alehouse enjoying drink, bar games, entertainments, “pugilism,” and animal fights. The tradition of Saint Monday followed from the bouts of weekend drinking and represented deeply held attitudes toward a potential surplus of wages: “The men … [are] regulated by the expense of their families, and their necessities; it is well known that they will not go further than necessity prompts them."

The industrial entrepreneurs tried, usually without success, to prohibit the observance of Monday as a holiday. Boulton and Watt’s first enterprise foundered on the continual drunkenness of their work force. The owner of a button-making factory decided that although he would not be able to control his workers, he would make an effort to train his apprentices in more industrious work habits. His diary records his frustration: “This evening Edward Lingard’s misconduct in going to the Public House in the afternoon for drink, contrary to my inclination and notwithstanding I had forbidden him from it only yesterday – this I say, and meeting him on his way back, induced me to hastily strike him. With which my middle finger was so stunned as to give me much pain.” In addition to the time lost through observing Monday as a holiday, harvest time and other traditional feast days kept workers away. In 1776, the famous Josiah Wedgwood, who pioneered new techniques of pottery production and business management, wrote to a colleague: “Our men have been at play 7 days this week, it being Burlem Wakes. I have rough’d and smoothed them over, & promised them a long Xmas, but I know it is all in vain, for Wakes must be observed though the World was to end with them.”

Nineteenth-century American industrialists faced a similar set of problems when it came to honing the worker’s body as an instrument of production. The owner of a Pennsylvania ironworks complained of frequent “frolicking” that sometimes lasted for days, along with hunting, harvesting, wedding parties, and holiday celebrations. One manufacturer filled his diary with these notes: “All hands drunk; Jacob Ventling hunting; molders all agree to quit work and went to the beach. Peter Cox very drunk and gone to bed… Edward Rutter off a-drinking. It was reported that he got drunk on cheese.” In 1817, a Medford shipbuilder refused his men grog privileges, and they all quit. The ship’s carpenter in one New York Shipyard describes the typical work-day: cakes and pastries in the early morning and again in the late morning, a trip to the grog shop by eleven for whiskey, a big lunch at half past three, a visit from the candyman at five, and supper, ending the work day, at sundown. He recalled one worker who left for grog ten times a day. A cigar manufacturer complained that his men worked no more than two or three hours a day; the rest of the time was spent in the beer saloon, playing pinochle. Coopers were famous for a four-day work wee; and the potters in Trenton, New Jersey, immigrants from Staffordshire, were known to work in “great bursts of activity” and then lay off for several days.

What Theory Wrought

The Moment of Reckoning

The Financial Crisis of 2008, like many of the financial crises that preceded it over the last 30 years, was a moment of reckoning for financial economists and professionals. While Wall Street titans and former world-saviors like Alan Greenspan paraded in front of the US Congress to discuss various their personal involvement in this global catastrophe, the rest of the community was left to ponder a simple, but unrelenting, question: “How did we let this happen?”

For many, this kind of thing was never supposed to happen; in economist terms, it was theoretically impossible, a ten-sigma kind of event. Stories abound about young financial analysts who presented models that these kinds of events could only happen once in 10,000 years,[1] seemingly unaware of the similarly unexpected collapse of Long Term Capital Management barely a decade ago. Others were devastated as they watched carefully priced financial portfolios evaporate into thin air. The market is rational and efficient, they would say. The prices of various financial products corresponded perfectly to the aggregate sum of the information available. As more than 4 trillion dollars of wealth was lost, it became quickly clear that something was fundamentally wrong.[2]

The suffering was of this global financial meltdown shared by many, and few were exempt from this collective intellectual and professional failure. Yet there were exceptions, and they were definitely notable. Nicolas Nassim Taleb, famous for his “Black Swan” proclamations of market calamity, watched hedge funds based on his theory increased in value nearly seven times over.[3] John Paulson, manager of the Paulson and Co. hedge fund, made 15 billion dollars in a single trade that bet against the housing market.[4] And Dick Thaler, a Professor at the Booth School of Business at the University of Chicago, saw his branch of Behavioral Economics grow into one of the most influential theories in finance today.

Following Justin Fox’s book The Myth of Rational Markets,[5] this paper will present a portion of the intellectual history that led up to this historic event. While partially reductive, it splits financial theorists into two basic camps: those who describe the market as fundamentally efficient and those who focus on its irrationality. Although not nearly as comprehensive as Fox’s book, an impossible task considering the length of this essay, the following pages will describe the general rise of Effecient Market Theory (EMT), especially the version championed by Eugene Fama, to becoming one of the basic pillars of modern finance. At the same time, it will look at a few of the stories of those professionals and theorists who vocally criticized EMT and how recent events have vindicated their work.

While I won’t be able to settle the behavioral vs. rational debate, I will provide perspective on how this debate continues to influence the practice of finance today. Most importantly, I hope to show how neither theory can provide of perfectly accurate description of the market, and how both theories support the assumptions of the other.

What We Once Knew

For most of its history, the study of economics concerned the nature of man as much as the nature of business and transactions. Adam Smith, the founder of modern economic thought, did not originally develop his famous “invisible hand” in the book usually credited for creating the study of economics – The Wealth of Nations. In fact, the theory was developed earlier, in his Theory of Moral Sentiments, a comprehensive psychological analysis of man. This concept is elaborated during a section on utility, which Smith recognizes as an inconsistent quality that is not always properly appreciated by society. As he explains,

But that this fitness, this happy contrivance of any production of art, should often be more valued, than the very end for which it was intended; and that the exact adjustment of the means for attaining any conveniency or pleasure, should frequently be more regarded, than that very conveniency or pleasure, in the attainment of which their whole merit would seem to consist, has not, so far as I know, been yet taken notice of by any body. That this however is very frequently the case, may be observed in a thousand instances, both in the most frivolous and in the most important concerns of human life.[6]

This is just one of many examples from Smith that demonstrate his lack of faith in the underlying rationality of man. Throughout the chapter, he constantly rails against man’s “frivolity,” repeatedly pointing out how utility is ignored in favor of fashion or a sense of proper order. The master that orders a room cleared is going against his basic need to use the furniture in the room; the owner of a watch does not improve his own punctuality if he trades his current watch in for one that is more expensive.

In fact, this underlying lack of rationality drives many to ruin. Smith goes so far as to blame tailors for creating extra pockets for no other need that to stuff more useless junk in them. He writes with a certain sense of despair about his contemporaries’ habit of walking “about loaded with a multitude of baubles, in weight and sometimes in value not inferior to an ordinary Jew's-box, some of which may sometimes be of some little use, but all of which might at all times be very well spared, and of which the whole utility is certainly not worth the fatigue of bearing the burden."[7]

Yet, this fundamental “frivolity” comes to benefit mankind as a whole. As Smith explains,

And it is well that nature imposes upon us in this manner. It is this deception which rouses and keeps in continual motion the industry of mankind. It is this which first prompted them to cultivate the ground, to build houses, to found cities and commonwealths, and to invent and improve all the sciences and arts, which ennoble and embellish human life; which have entirely changed the whole face of the globe, have turned the rude forests of nature into agreeable and fertile plains, and made the trackless and barren ocean a new fund of subsistence, and the great high road of communication to the different nations of the earth.

In other words, while we may be obsessed with useless nonsense, trinkets and trash, our obsession with attaining these things have caused mankind to do remarkable things. Our desire to consume, while not rational, creates cities, fields and roads, in essence the fundamental elements of society itself.

This turn of logic leads Smith to his explanation of the invisible hand,

The rich only select from the heap what is most precious and agreeable. They consume little more than the poor, and in spite of their natural selfishness and rapacity, though they mean only their own conveniency, though the sole end which they propose from the labours of all the thousands whom they employ, be the gratification of their own vain and insatiable desires, they divide with the poor the produce of all their improvements. They are led by an invisible hand to make nearly the same distribution of the necessaries of life, which would have been made, had the earth been divided into equal portions among all its inhabitants, and thus without intending it, without knowing it, advance the interest of the society, and afford means to the multiplication of the species.[8]

Already, we have the elements of the fundamental debate within economics. People are inherently irrational, and their behavior is largely selfish and directed to fulfilling unnecessary desires. Yet, in the aggregate, this kind of behavior has led society to flourish. Frivolity inspires the creation of the useful things, and more importantly, irrational behavior still leads to an efficient distribution of resources among all members of society. While creating economics, Smith has already created its greatest debate. Are markets, the result of irrational men, rational as well?

The Market Can’t be Beaten

Neoclassical economics solves the dichotomy existing between man’s self-interest and the societal greater good by simply removing Adam Smith’s concept of “frivolity,” man’s basic lack of rationality. This “bleaching” of man’s psychological dispositions allowed for a new level of sophistication in economic modeling and economic mathematics.[9] Paul Samuelson’s Foundations of Economic Analysis set the standard for this kind of work, demonstrating “that a comparatively small number of mathematical propositions contain the formal (or logical) basis of much of economic theory.”[10]

Others dealt with this issue by denigrating each individual’s role in the final total outcome. John Maynard Keynes was particularly harsh in this critique. As he explains in The General Theory of Employment, Interest, and Money,

Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.[11]

Keynes’ point here is to show how limited each individual’s knowledge when compared to the behavior of the market as a whole. To understand the movement of a stock, an investor needs to understand everyone else’s opinion of that stock at the exact moment he chooses to investment. This is an absurd assumption, which Keynes sees happening at a variety of levels. It is a layering of assumptions to the “fourth, fifth and higher degrees.”

Keynes takes this a step further. Not only does the individual have little effect or understanding of the market’s general direction, the stock market, in particular, may be of little use to society. This is a direct deviation from Smith, but Keynes had the benefit of witnessing the stock market collapse that led to the Great Depression. This was more than enough evidence to conclude that the market was essentially instable, the result of widespread speculative behavior that was no different from the mechanics of a casino. The only people earning long-term profits were the brokers, who collect fees on all trades and prey on the gullibility of average investors.

But it’s not just the speculators causing instability. In fact, the general nature of investing is, in fact, instable. Instead of basing our investment decisions on some rational calculation of the utility it may bring us, something much more primal is at work. As Keynes explains,

Our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits — of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.

The consequences of these motivations are profound. Slumps may be much worse than anticipated, as consumer confidence may lead to the separation of prices from real conditions. The market may rise and fall only because of baseless fears of a change in government. Prices may be entirely wrong.

The Rise of Rational Market Theory

From these foundations, finally, came the emergence of Eugene Fama’s theory of rational markets. While the University of Chicago-based professor doesn’t necessarily disagree with Keynes’s ideas, he states that these errors in market pricing are quickly fixed, as long as the flow of information is fast enough. As he explains,

In a dynamic economy, there will always be new information which causes intrinsic values to change over time. As a result, people who can consistently predict the appearance of new information and evaluate its effects on intrinsic values will usually make larger profits than can people who do not have this talent. The fact that the activities of these superior analysts help make successive price changes independent does not imply that their expected profits cannot be greater than those of the investor who follows some naïve buy-and-hold policy.[12]

Although he allows for some people to beat the market, Fama quickly returns to Keynes. Once there are enough “superior analysts” competing over new pieces of information, the ability for any person to significantly exploit it becomes essentially meaningless. The market cannot be beaten, and prices reflect all available information.

Fama’s theory describes the stock market as a shark tank,[13] whose inhabitants feast on every available new and juicy piece of business information that will allow them to turn a quick profit. When there are only a few sharks, they can easily capture every piece of information and profit. But as the number of sharks increase, it becomes next to impossible for any single shark to stay ahead of the others in the hunt.

The constant flurry of competition results in one of the most essential characteristics of changing stock prices – the random walk. As Fama explains, “the theory of random walks says that the future path of the price level of a security is no more predictable than the path of a series of cumulated random numbers. In statistical terms the theory says that successive price changes are independent, identically distributed random variables.” If prices fluctuate randomly, Fama explains, then it is impossible for any investor to predict the future based on past information.

Fama and his colleagues in Chicago were able to demonstrate in several different empirical studies that the market is capable of turning new information into price adjustments, at least up to a certain degree. Tests of weak-form market efficiency, where market prices properly reflect all previously available market data, provide empirical proof of the relationship between information and prices.[14] The only places where Fama could identify a failure in the movement of information came from corporate insiders and certain specialists that maintained a monopoly on some forms of information.

Fama’s identification of a relationship between information and asset prices led to other breakthroughs in the study of financial markets. Most notably, Fama worked on and extensively tested the Capital Asset Pricing Model, which states that an individual asset’s future price is can be predicted based on the relationship of the asset and the market’s previous fluctuations. Although Fama eventually concluded that other pieces of information needed to be included to get an accurate prediction of the future price,[15] his work showed that the underlining connection between available information and asset prices held.

It’s difficult to understate the influence of Fama’s ideas on the modern practice and study of finance. Staple formulas for MBA classes on finance assume this underlying relationship between prices and information. They include Gordon’s growth model, which is used to predict the future price of a security based on a future dividend, Markowitz’s Modern Portfolio Theory, which shows how diversification can minimize risk, and the Black-Scholes Derivative Pricing Model.

The practice of finance is also based around this profound idea. Financial analysis, stock market indices, and laws on insider trading and company disclosure all play a role in the control and distribution of information. Together, they are meant to make prices more accurate, as investors will be able to quickly react to changes in information and remove inefficiencies.

The Human Side of Markets

The power of Fama’s ideas is also illustrated in the emergence of Behavioral Economics and its leading propent, Richard Thaler. In many ways, this theory can only be thought of as a reaction to the paradigm Fama established. While Behavioral Economics does not seek to dismiss the relationship between information and investor behavior, it does seek to show that prices can be wrong, as Keynes asserted, and that investors do not respond to new pieces of information in rational ways. This assumption in Fama’s model, which in some ways can be brought back to the fundamental problem illustrated by Smith, does not hold in world full of blow-ups, bank runs and crises.

Much of the work that would eventually become Dick Thaler’s brand of Behavioral Economics was started by a pair of psychological researcher named Amos Tversky and Daniel Kahneman. Their work is a return to Keynes’ statement that investors’ actions are not “the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.” In the real world, people don’t calculate utility, or often even basic probabilities, instead relying on a series of mental shortcuts called heuristics.

Heuristics serve an important part of our general psychological make-up. They help us process information quickly, and allow us to conserve mental resources when being faced with the thousands of decisions we have to make each day. Unfortunately, while heuristics are very important for our day-to-day living, judgments that utilize heuristics are often wrong and biased.

Much of Kahneman and Tversky’s work is characterized by the many different games and tests they created to show that people often make simple mistakes when faced with uncertainty. One of the typical problems they showed presented the difficulties in assessing probabilities. When given the choice of 450 dollars or a fifty percent chance of winning either zero or 1,000 dollars, a majority of test subjects chose 450.[16] If anyone would take the time to calculate the probabilities, they would find that a fifty percent shot at 1,000 dollars has the higher pay off (five hundred dollars; this is calculated by multiplying the final pay offs with their probability and adding the results). People were regularly making the wrong decisions.

Moreover, people’s flaws in judgment lead them to struggle when assessing risks. As Kahneman and Tversky explain,

Choices among risky prospects exhibit several pervasive effects that are inconsistent with the basic tenets of utility theory. In particular, people underweight outcomes that are merely probable in comparison with outcomes that are obtained with certainty. This tendency, called the certainty effect, contributed to risk aversion in choices involving sure gains and to rick seeking in choices involving sure losses.

Richard Thaler seized upon these ideas when developing a theory of Behavioral Economics. One of the most profound revelations of his work was that the stock market consistently overreacts. While information continues to affect prices, as Fama pointed out, these reactions are unpredictable and much larger than what the information would dictate. [17] In particular, investors seem to “attach disproportionate importance on short-run economic developments.” This behavior wasn’t limited to uneducated home investors. Even professional forecasters overreacted to the news.

This wasn’t the only piece of irrational behavior in the stock market. Thaler was able to empirically prove the price earnings ratio anomaly, a statistical trend that goes directly against the models based on the Efficient Markets Theory. This anomaly goes something like this: with all other factors being equal, stocks with extremely low price earnings ratios bring much larger risk-adjusted returns than those with high price earnings ratios. Thaler also focused on the January effect, where returns in the first month of the year were consistently better than those in other months. Thaler also showed that people tend to value losses much higher than gains, while choosing to stick to the status quo, whenever possible. This leads to scenarios where highly risky behavior was taken because of nearly “certain” returns.

Other theorists have since joined in the chorus. Nicolas Nassim Taleb, an investor and professor at the Polytechnic Institute of New York, coined the term “Black Swan,” to describe the effect of improbable and unexpected events on people’s behavior.[18] Because black swans are not expected, they tend to have disproportionately large effects. Much of the consequences of black swans come from our biases and judgment errors, many of which were already described by Tversky and Kahneman.

Take together, these new illustrations of people’s inherent flaws place a serious dent in the image of a perfectly operating, rational market. Instead of a well-operating machine churning information into prices, Behavioral Economics sees a world full of panics, mistakes and dramatic swings. With recent events becoming strong vindication for this model, the behavioralists are starting to gain converts. The most shocking of these is Eugene Fama himself, who in a recent paper with French wrote that,

Offsetting actions by informed investors do not typically suffice to cause the price effects of erroneous beliefs to disappear within the passage of time […] The more extreme tangency portfolio produced by the value premium suggests, however that behavioral biases are more prevalent among investors […] The extreme returns of momentum portfolios and the extreme tangency portfolio produced by these returns suggest that relatively little wealth is controlled by informed investors who understand momentum, perhaps because almost all investors are subject to the underreaction to firm-specific information.[19]

In short, Fama’s own research points to how the shark tank metaphor does not actually work in the real world. There are too many mistaken investors, and not enough well-informed investors, for the actions of a few sharks to properly correct mistaken prices. Moreover, the effectiveness of the sharks is compromised because they themselves are victim to biases and incorrect reactions. This, in no lesser terms, is a stunning turn around.

The Fall of High Theory

What does it mean to live in a world where the efficient market theory doesn’t hold? To start, the foundations of modern financial theory have to be openly questioned. All theories stemming from the efficient market theory are inaccurate at best, and at worst, utterly inapplicable to the real world. In fact, when Justin Fox, the writer of The Myth of the Rational Market, contacted Fama to discuss the results of his recent research, Fama answered that if prices were incorrect, calculations on the cost of capital are no longer relevant. “That’s why I don’t teach corporate finance anymore,” is all he could add.[20]
If we follow Fama’s logic, much of academic finance needs to be reassessed. The most problematic models are those that rely on the relationship between an asset and the market, while using the past volatility of an asset to predict future performance. This includes CAPM, the Black-Scholes Model and Modern Portfolio Theory. Their most flagrant problem isn’t that they are inaccurate, it’s that they provide the illusion of precision (turning out numerical values for price fluctuations and risk) when people’s behavior is, by its very nature, anathema to precise prediction. As Henry Poincare wrote a century ago,

When men are brought together, they no longer decide by chance and independently of each other, but react upon one another. Many causes come into action, they trouble the men and draw them this way and that, but there is one thing they cannot destroy, the habits they have of Panurge’s sheep.[21]

At the same time, many behavioralists are not seeking to dismiss the efficient market theory entirely, in part because they have no other place to turn. Accounting for errors in human behavior and wild inaccuracies make it impossible to predict economic phenomena. While everyone understands that the current financial models taught in MBA classes are bad, there is an implicit assumption that there won’t ever be another model that provides a high degree of accuracy. Moreover, the relationship between prices and information still holds. As Fama points out, when people are properly informed, the prices are correct. The problem, then, is that people just don’t have the proper information to base their decisions on. In all likelihood, they never will.

This isn’t the first time this problem has been faced. In fact, Benoit Mandelbrot, the distinguished mathematician who developed fractals, among many other major contributions to modern statistical thought, began criticizing the tools that led to efficient market theory in 1964. Unfortunately, the response to these criticisms was not encouraging.

Mandelbrot, like Prime Minister Churchill before him, promised us not utopia, but blood, sweat, toil and tears. If he is right, almost all our statistical tools are obsolete …, past econometric work is meaningless.[22]

It would benefit us all to return to these roots and reinvestigate the statistical tools that we already knew were lacking. If they prove much of current financial theory wrong, so be it.

References

[1] Taleb, Nicolas Nassim “The Fourth Quadrant: A Map of the Limits of Statistics” Edge: The Third Culture September 15, 2008 http://www.edge.org/3rd_culture/taleb08/taleb08_index.html

[2] Landler, Mark “I.M.F. Puts Bank Losses From Global Financial Crisis at $4.1 Trillion” The New York Times April 21, 2009 http://www.nytimes.com/2009/04/22/business/global/22fund.html

[3] Patterson, Scott “October Pain was ‘Black Swan’ gain” The Wall Street Journal November 6, 2008 http://online.wsj.com/article/SB122567265138591705.html

[4] Zuckerman, Gregory The Greatest Trade Ever Crown Business, November 3, 2009

[5] Fox, Justin The Myth of Rational Markets HarperBusiness. June 9, 2009

[6] Smith, Adam The Theory of Moral Sentiments 6th Edition. London: A. Millar 1790. Section 4, Chapter I, Paragraph 3. http://www.econlib.org/library/Smith/smMS4.html

[7] Smith. Section 4, Chapter I, Paragraph 6.

[8] Smith. Section 4, Chapter I, Paragraph 10.

[9] Arnsperger, Christian and Varoufakis, Yanis “What is neo-classical economics?” post-autistic economics review Issue no. 38, 1 July 2006. Article 1. http://www.paecon.net/PAEReview/issue38/ArnspergerVaroufakis38.htm

[10] Savage, L. J. “Samuelson's Foundations: Its Mathematics” The Journal of Political Economy Vol. 56, No. 3 (Jun., 1948), pp. 200-202 http://www.jstor.org/stable/1825769

[11] Keynes, John Maynard The General Theory of Employment, Interest, and Money. Marxists.org, 2002 http://www.marxists.org/reference/subject/economics/keynes/general-theory/ch12.htm

[12] Fama, Eugene “The Behavior of Stock-Market Prices” The Journal of Business Vol. 38, No. 1. (Jan., 1965), pp. 34-105. http://stevereads.com/papers_to_read/the_behavior_of_stock_market_prices.pdf

[13] This metaphor was originally developed by Scott Patterson in The Quants.

[14] Fama, Eugene “Efficient Capital Markets: A Review of Theory and Empirical Work” The Journal of Finance, Vol. 25, No. 2, Papers and Proceedings of the Twenty-Eighth Annual Meeting of the American Finance Association New York, N.Y. December, 28-30, 1969(May, 1970), pp. 383-417 http://efinance.org.cn/cn/fm/Efficient%20Capital%20Markets%20A%20Review%20of%20Theory%20and%20Empirical%20Work.pdf

[15] Fama, Eugene and French, Kenneth “The Capital Asset Pricing Model: Theory and Evidence” Journal of Economic Perspectives—Volume 18, Number 3—Summer 2004 —Pages 25– 46 http://pubs.aeaweb.org/doi/pdfplus/10.1257/0895330042162430

[16] Kahneman, Daniel and Tversky, Amos “Prospect Theory: An Analysis of Decision under Risk” Econometrica Volume 47, Issue 2 (Mar., 1979) 263-292 http://www.hss.caltech.edu/~camerer/Ec101/ProspectTheory.pdf

[17] De Bondt, Werner and Thaler, Richard “Does the Stock Market Overreact?” The Journal of Finance Vol. XL, No. 3, July 1985. http://www.jstor.org/sici?sici=0022-1082%28198507%2940%3A3%3C793%3ADTSMO%3E2.0.CO%3B2-Q

[18] Taleb, Nicolas Nassim The Black Swan: The Impact of the Highly Improbable. New York: Random House and Penguin.

[19] Fama, Eugene and French, Kenneth “Disagreement, Tastes and Asset Prices” The Journal of Financial Economics 83 (2007) 667-689 http://wenku.baidu.com/view/1180d9eb6294dd88d0d26b56.html

[20] Fox, Justin The Myth of Rational Markets HarperBusiness. June 9, 2009

[21] Poincare, Henri Science and Method. Dover, 1952

[22] Mandelbrot, Benoit Fractals and Scaling in Finance Springer, New York, 1997

The Politics of Deficits and Debts

The frequent worry of the American right is the current state of the US debt. You hear it in just about every fiscal conversation. This makes me want to ask, "Do you think that a government has to be debt free?"

In fact, it really doesn't. A government does not face the same debt constraints as a business. In fact, all of government need to do is reduce the annual budget deficit (plus interest) below the inflation rate in order to make its debt levels sustainable.

Even the aggressive debt reduction proposed by the President's debt commission only sought to reduce the debt, over time, to less that 40% of GDP. Their plan continues to run a budget deficit for another 15 years or so. It recommends only an average annual budget cut of 461 billion dollars spread over 18 years. Obviously, considering the state of the economy, they start small and build over time.

The commission rightly points out that the real issue in solving America's debt problem is reducing the amount of money we spend on health care. That takes reforming the health care industry, not just government's role in it. Health care already accounts for 20% of government spending, which is higher than any European country with their "socialist" medical systems. To make matters worse, the rate of spending is growing fast. 

Clearly something is wrong, and we need policies to reduce this spending (while taking care of our people), or we will, in fact, go completely broke. The debt commission gets the ball rolling by recommending that a public option is included in Obama's reform of the health care system. But thanks to the way health care markets work, you can reduce the amount we spend on health care and make it more equitable at the same time. The current health bill should be a big start.

There are many other good ideas being pushed around right now on how the US's long-term deficit can be reduced. Again, start with the debt commission. This includes tax reform, military spending, increasing government efficiency and reducing spending in other discretionary programs.

And before you start screaming liberal-commie-nazi whatever, one of the co-chairs of this commission is Alan Simpson, the former Senator from Wyoming and a pretty hardcore conservative. He's not alone. Republicans actually made up half of the commission. True to form, their plan does not even recommend increases in taxes. Instead, they decrease tax rates and eliminate expenditures through a simplified system. This should result in higher tax revenues. So, it seems like there's considerable flexibility in a combination of tax increases and spending cuts to balance the budget.

While all of these proposals are important, it's important to understand the politics of the current debate. All of this debt posturing has nothing to do with deficits and everything to do with enforcing a specific vision of society on America during a time of crisis. This includes eliminating public unions even after they've agreed to take pay cuts and canceling programs for the poor to continue tax breaks for the rich. The party of "fiscal conservatism" just fought tooth and nail to make sure that rich people got additional tax cuts. They have reiterated, time and again, that they want these to be permanent. I'll believe a conservative that says he's serious about the budget the moment they stop giving millionaires handouts.

The people that actually care about the deficit (not deficit politics) already took a good stab at it through the health care reform. And who is trying to dismantle that? Why, the people that keep talking about the deficit of course. 

To make matters worse, the Republican Party spends an exorbitant amount of time on nonsense like defunding planned parenthood, attacking NPR and eliminating relatively tiny poverty programs . This is just crappy political gamesmanship. And it sucks that it happens, because while these millionaires in Washington might be doing perfectly fine, many, many people are suffering.

The long-term deficit is an issue, but I need to reiterate that now is not the time to cut government spending. Unemployment is still at 9 percent. You can't collect taxes from people without jobs, and you can't in good conscience cut their benefits when there are no jobs for them. Even worse, cutting spending at the rates originally proposed by the House GOP would cost another 700,000 jobs.

Depressed spending can lead to a downward spiral, and spending cuts now might not do any good since they'll be offset by the spending on the newly employed. Get unemployment down to 6 percent, and then start pulling back. Then there will be a tax base back in place that we can actually work with. And then we can assess program cuts and tax increases.

One last thing, if anyone out there want to play apocalypse watch, the best place to go is check 10-year US treasury rates. As rates go up, they indicate that the market is losing its confidence in the government's ability to pay off its debt (at least for the next 10 years). They are pretty damn low right now, and considerably lower than the historical average.

In other words, investors thought the Reagan administration was going to be far less likely to pay off its debts than the current one. Funny how that is, given the rhetoric surrounding Washington these days.

Now and Then

Without a doubt, recent government efforts meant to reduce the effects of the financial crisis often seem inaccessible and arcane. Much of the recent debate has focused on things like "bailouts," "backdoor loans" and "quantitative easing. While we deal with the efforts of an interventionist Fed today, we can take a lot about previous efforts during financial panics.

Liaquat Ahamed's Lords of Finance, the story of the key central bankers during the interwar period, obviously deals with these issues extensively. Two stand out: efforts to stem the banking panic (today's TARP and bailouts) and the decision to abandon the gold standard (similar to today's lax monetary policy at the Fed). The latter was the most important pieces of monetary policy in the first half of the Twentieth Century. There were many efforts to mitigate the effects of the depression in the US, but none were as effective. As Ahmad writes, monetary easing was "one step that succeeded beyond anyone's wildest expectations in getting the economy moving again."

Efforts to stem the banking crisis were also eerily similar to the Fed's response to the collapse of Bear, Lehman and the rest of the American financial system. How did it happen back then? Roosevelt had four brilliant young economic advisers during his first term: Dean Acheson, undersecretary of the Treasury, James Warburg, Roosevelt's direct adviser on economics, Lewis Douglas, the budget director, and George L. Harrison, the head of the New York Fed. These men were instrumental in the first maneuvers that Roosevelt conducted to save America's banking system, which was on the verge of collapse. Something like 7000 banks failed between 1931 and 1933, the New York Fed ran out of gold reserves supporting the system (it lost $350 million dollars on March 3, 1932), and almost half of the currency in circulation was withdrawn from banks. In a span of eight days, they stopped this cascading disaster right in its tracks. Hoover had been trying to do it for three years already.

I'll let Ahamed take it from here:

Every one of Roosevelt's advisers, including Harrison, believed that having stabilized the banking system, they could rely on the traditional levers - expanding credit, undertaking open market operations - to get the economy moving again. Most important, none of them could see any reason for breaking with gold.

note: This means abandoning the gold standard and devaluing America's currency. This would create inflationary pressure in the US, as foreigners could buy American goods at a lower price - in their currency - and Americans would have a harder time importing goods. This increase in demand for American currency leads to inflation, which is a good thing when a country has high unemployment and depressed aggregate demand.

Pitted against this array of economic expertise was one man - the president himself. Roosevelt did not even pretend to grasp fully the subtleties of international finance; but unlike Churchill, he refused to allow himself to be in the let bit intimidated by the subject's technicalities - when told by one of his advisers that something was impossible, his response was "Poppycock!" Instead, he approached the subject with a sort of casual insouciance that his economic advisers found unnerving but which nevertheless allowed him to cut through the complications and go to the heart of the matter.

His simplistic view was that since the Depression had been associated with falling prices, recovery could only come about when prices began going the other way. His advisers patiently tried to explain to him that he had the causality backward – that rising prices would be the result of recovery, not its cause. They were themselves only half right. For in an economy where everything is connected, there is often no clear distinction between cause and effect. True, in the initial stages of the Depression the collapse in economic activity had driven prices downward. But once in motion, falling prices created their own dynamic. By raising the real cost of borrowing, they had discouraged investment and thus caused economic activity to weaken further. Effect became cause and cause became effect. Roosevelt would have been unable to articulate all the linkages very clearly. But he had an intuitive understanding that the key was to reverse the process of deflation and kept insisting that the solution to the Depression was to get prices moving upward.

Roosevelt ended up adopting a policy on gold similar to the research of George Warren, a Cornell economics professor who was an expert on farming. And the actual mechanism for accomplishing this was through a farming bill, with an amendment that most people overlooked. It was a reckless and foolish decision that appalled most of the people working for him and caused outrage among the world’s financial experts. But, as Russell Leffingwell, a Morgan partner, wrote to Roosevelt, “your action in going off gold saved the country from complete collapse.”

Days after Roosevelt's decision, the Dow jumped 15 percent, one of the highest increases in its history. During the following three months, wholesale prices jumped by 45 percent and stock prices doubled. With prices rising, the real cost of borrowing money plummeted. New orders for heavy machinery soared by 100 percent, auto sales doubled, and overall industrial production shot up 50 percent.

This is exactly what should have happened if the stimulus had any real teeth. We are where we are because of a true lack of guts. Roosevelt may have been insane for doing what he did, but his hard-headedness and iron cajones prove why he is a true American hero.

Inequality Matters, pt.3

Wrapping up this conversation on inequality (see part 1 and part 2), there is still plenty of opportunity to further clarify the economics behind wealth distribution. There are several issues that deserve attention, which only strengthen the argument for more equitable wealth distribution in the US.

How a financial crisis works

The Right likes to make the claim that "wealth distribution leads to economic bubbles." While this is emotionally resonant, this doesn't have much real-world support. Anyone is welcome to review the history of financial crises if they disagree.

What you'll notice in all of these cases is that a financial crisis is generally driven by speculation and twisted market psychology. The primary actors in all of these situations are unscrupulous bankers and executives who spur on financial speculation completely disassociated with economic reality, often committing fraud at the same time. Once their little back room poker game collapsed, economic chaos inside.

Don't worry, these scumbags routinely came out of the situation OK. It was everyone else who had to suffer.

A more equitable country is a stronger country

Of course, there is a limit to my argument about income redistribution. The statistic cited in the previous post, about how lower income people spend more than upper income people, only concern spending levels occurring after specific and focused tax breaks designed to stimulate the economy (in this instance, the stimulus of 2008). What would be truly damning is an assessment of US economic growth and marginal tax rates, with data that shows that at higher top marginal tax rates, GDP suffers.

Unfortunately, you won't find data supporting that argument either. In fact, you'll find just the opposite. There is no correlation between increased tax rates and GDP growth, and there is an inverse relationship between GDP growth and tax rates for the top 1/10 of earners.

Income tax rate vs GDP and receipts

I'll admit that the first case has limitations, and that a universal 90 percent tax rate would be disastrous. But the US has never seen anything like this, nor is anyone asking for it. All I want is a tax distribution similar to the one we had before 1980.

Top margin income tax rate vs GDP

All other things equal, the United States was economically stronger during periods where high tax rates for the very top margin prevented the accumulation of wealth. The revenues from that top margin were spent on infrastructure, schools and the like. The greatest public works project in world history, the development of the interstate system, began in 1956, at the height of 90 percent taxes for the top margin (remember, this doesn't mean that people earning 500k have to pay 450k in taxes; it just means that all money earned over a certain limit, say 400k, is taxed that way; there's still plenty of incentive to get super rich, even in this harsh of a system).

This kind of spending, by the way, benefits the poor more than the rich, creating low-income jobs and providing for the kind of community development (through schools) that the rich don't need.

The stimulus myth

The only strong correlation identified in the previous article was between GDP growth and total tax revenue.

This leads to an obvious conclusion: if you are concerned about short term deficits during an economic slump, the first order of business is to spend enough money to get people back to work and economic growth back on track. This kind of spending, not surprisingly, would benefit the poor over the rich, by making sure that the poor people who lost their jobs got back to work.

This never happened. Fiscal stimulus didn't "fail" as the right would like us to believe; it was simply never tried.

The Obama stimulus package was way too small to begin with, and it was offset by decreases in government spending at the state and local level. Germany, for example, paid to keep almost everyone employed and ended up spending much more money during the crisis than the US.

Not surprisingly, their economy is now leaving ours in the dust, growing at a rate of 9 percent annually.

At the same time, government employment rates are dropping at a scary rate. This will only put more people on the dole and make matters worse.

And while many people, have expressed concern about taking on too much public debt to restore the economy, it is important to keep in mind that this is not the highest debt level our country has faced.

Moreover, most of the current short-term debt countries around the world face is coming from lost revenues due to the downturn and paying for the newly unemployed masses.

A truly fiscally responsible government, and that includes one that addresses the increasing cost of health care in the US (which, um, the Democrats just did), will be able to pay these short-term debts down. And they will do this by eliminating massive tax breaks for the wealthy and restoring a tax system that I have been arguing for throughout.

Behind the wizard's curtain

In Wisconsin, need I remind everyone, thousands of public workers face benefit cuts and the destruction of their unions. In Washington, major programs like financial regulation, food stamps, the new health care bill and education face cuts. Entire government agencies, like the EPA, face defunding, which would lead to thousands of government workers losing their jobs.

Both situations are tragic examples of the politics of austerity. Both are the results of political games brought on fiscal crises that didn't exist. In Wisconsin, the budget crisis is the result of tax breaks to businesses that eliminated a pre-existing budget surplus. In Washington, Congressional Republicans insisted on granting 75 billion dollars in tax breaks to people earning more than 250k a year (from the original Economist article). With this gap in place, they've decided to cut the budget by 61 billion dollars.

Sadly, these won't even accomplish much. Having gutted most of the government, many people will lose their jobs. Economic recovery, the only thing that will eventually lead to increased tax revenues, will be further away. We'll end up playing this same game again in a couple years, with the backdrop of an even worse economic situation.

This is why inequality and an inefficient up tax system matter. Not renewing the Bush-era tax cuts would have given government more lee-way to improve the economy and not force through cuts that will harm middle class Americans. The writing is all over the wall. Police officers are getting fired, schools are closing, teachers are being forced out, and the budget cuts just keep coming. This isn't fiscal responsibility. It's economic warfare by other means, and average Americans are consistently the victims. Fixing this trend is more than possible, and it starts by acknowledging that growing inequality is at the root of most of these problems.

Inequality Matters, pt. 2

Continuing the theme of the previous post, let's not forget the fact that giving money to poor people is actually good for the economy. In fact, it's much better for the economy than giving the same money to rich people. The Economist's Democracy in America blog recently published this chart from the CBO. 

Although a little number heavy, it shows that when poor people get a dollar, they tend to spend $1.28 (poor Americans are funny like that, spending more than what they have). When a rich person gets a dollar, just over three quarters of it gets spent.

What happens to the rest of the money? Here things get a little more complicated. There's no guarantee that money saved by the wealthy will go towards useful business investment. CDO's, for example, don't really fuel much business growth, since they're mostly bets on other securities. The market for them in 2006 was 2 trillion dollars. Stocks and bonds bought in secondary markets don't directly help businesses either, since the money is moved from one investor to another. It's usually people like Goldman making all the real money. Almost all stock trading through formal exchanges are considered "secondary" exchanges.

And if money saved goes to a business, there's no guarantee that it will be spent on real investment. Companies are currently sitting on 1 trillion dollars in cash, and they have little plans to hire. On the other hand, these same companies are seeing record profits. Reducing unemployment is not their concern, nor should it be.

There's a balance to be struck. For all of the hysteria surrounding the debate over wealth redistribution, no one (other than a few on the Right oddly) ever mentions a communist-style universal equality (although most communist societies, in particular China, and incredibily inequal, but whatever). Extreme inequality ruins people's incentives to work hard just as effectively as extreme equality. Mother Jones' set of charts talks about the income distribution that Americans consider reasonable, and it's clear that a system where 10 percent of the people own 90 percent of the wealth is not what they want.

When the economics are sound, real data supports the theory and it follows the confirmed desires of the American people, there is little room to argue against having more redistribution of income.

Inequality Matters, pt. 1

Mother Jones, true to it's modus operandi, has a series of charts addressing income inequality. In case you didn't know already, this blog loves charts (Mother Jones only one some days). While they're all great, this chart stands out.

The second chart is probably stronger. While the share of after-tax income for the top 20 percent has climbed steadily since 1979, it's declined for everyone else. It's important to point out that this is a dynamic view of inequality, not incomes of middle class people per se, although they've been declining over the last ten years too. Instead, see it as the wealthy's income forming an ever greater share of the economy, the rate at which inequality is growing. It's growing fast.

There's a big challenge when discussing these issues in the US, especially with those on the Right that are wedded to the current economic and political regime. Many Americans see income inequality as the result of hard-work and education, making something like this seem more natural. They would see measures to limit income inequality as an assault on the incentives to build businesses and grow the economy as a whole.

They're wrong. And they're wrong for the very arguments that they provide: income inequality reduces the incentives for people to try and succeed. Why should people try hard or be entrepreneurial in the current economy? You have at least a one in ten chance of being unemployed, and if you've got a job, you're salary probably isn't too far from a extremely disappointing 31k a year. Your benefits suck, and you have no hope of it getting any better. Why, indeed, would anyone work hard?

Tyler Cowen argues that most of America's success came from the fact that average, uneducated people could be very successful. You see this all the time when you look at the Great Depression. It's remarkable how many powerful people on Wall Street and abroad had nothing more than a high school education. Even this was rare, since only 6.4 percent of Americans at that time even completed high school.

Now, even a law degree (and 200k in debt) isn't even much of a guarantee you'll land a decent job.  The whole result of the de-unionization de-regulation of the US economy has been to make it almost impossible for regular Americans to succeed. Not surprisingly, America now has one of the lowest levels of intergenerational economic ability in the world. In simpler terms, the American dream is dying: people born rich stay rich, people born poor stay poor, and the gap between them grows wider every day.

Oh yeah, and what are those economically mobile countries out there, rewarding hard work with higher economic status? They're those socialist hell-holes France, Germany, Sweden, Canada, Finland, Norway, and Denmark. Funny how that works, isn't it?

Nominal Numbers Make No F***ing Sense!

I'm begging you all, please, please, please, stop using nominal numbers when you are talking about economic data over time. They are meaningless and only serve to stir up emotions. Thomas is the latest culprit (sorry bud), writing "I also believe that on average each American home receives $17,000 worth of entitlements." What does this number mean, what is it comparable to?

I'm pretty sure that when most on the Right think about entitlement spending, they think of something like this (my data comes from here http://bit.ly/geAhBE):

But these are nominal numbers. They value of a dollar in 2008 is different than the value of a dollar in 2001, which makes a direct comparison impossible. On the other hand, you can make direct comparisons as a percentage of GPD. What do you get?

Entitlements haven't really increase at all in 10 years, other than a spike in 2009 because GDP actually decreased. So can someone tell me where exactly this great entitlement problem is, demanding we cut the hell out of social security?

People worried about immediate spending and tax levels deserve some recognition. Taxes are at their lowest, and spending is at its highest, for the first time since 1945, which, by the way, was the last time we faced an economic downturn this serious. (I apologize for the tiny font, a better version of the table can be found here http://bit.ly/ibAiUq)

But this is just more evidence that we need to fix our economy (and run elevated spending levels like in the 40s) before worrying about anything else.

Oil, taxes and the real costs of fossil fuel consumption

Debates over climate change often involve both sides pulling up very different data when it comes to the taxes on oil companies, and this post is an attempt to sort all of this out. Part of this comes from my belief that neither side's data is tainted. I could easily be wrong with this, since the original source of my data often comes from a climate study institute. If you buy that the numbers are fair, a little digging is necessary if we're going to figure out how fairly our tax system treats oil companies.

More importantly though, I'm trying to answer some larger questions: Should we use taxes to make fossils more expensive than other energy sources, and is our tax code currently preventing us from doing that? It's impossible to answer these questions unless we have a full understanding of what oil actually costs the American people.

Scope of usage

This comes up in different ways. In this report from the Tax Foundation that's been making the rounds recently, the study encompassed subsidies/ tax breaks to companies receive to produce electricity. Crude oil goes to a lot of different sources, and one of the big gaps in looking at oil consumption is gasoline.

Gasoline has some interesting tax elements to it. Favoring oil companies is the depletion allowance. There are good arguments both for and against this allowance, but this can and should be considered a tax break for oil and mineral companies. That's not considered in Thomas' data.

On the other side of things, there's also a lot of tax breaks for increased efficiency and buying cars with higher gas mileage.  I'm not sure if my data encompasses this as "green tax breaks." But they should be considered that.

So just taking those two, both sides are probably underestimating tax incentives given to oil companies and money going towards green technology. And these are two examples; thousands of more exist.

Scope of operations

One of the big issues in our debate is the scale of operations of some of the companies we are looking at. Thomas perfectly correct (and I am wrong for generalizing) when he says that American oil companies do invest a lot in communities, create jobs and contribute a large amount of money to governments.

My criticism has been of international oil corporations, and Exxon Mobile in particular. The supermajor oil producers can hardly be considered American companies. Exxon, for example, conducts most of its business outside of the US, where it pays taxes, but its sizable American revenue is not taxed here. This is a specific case, not reflective the of the industry as a whole, but still a problem.

Also, when looking at the supermajor's tax expenses, they are granted a specific tax credit for having foreign operations. This is supposed to prevent double taxation (I'm tax exempt in the US because of it), but many people (probably all on the left, but whatever) have pointed out that this is exploited by oil companies to avoid taxes altogether. Essentially, they use this to declare revenues in the most tax friendly environment, and that seems to be not the US. This kind of stuff is definitely not included in the report Thomas published.

Economies of Scale

Part of the reason that you should definitely have higher subsidies for an emerging industry like renewable energy is that the cost of production goes down the larger the industry gets. This is a part of every economics class and called economies of scale. From a policy standpoint, subsidizing heavily now will pay big dividends later on, since a larger renewable industry will produce electricity much more cheaply on a per unit basis than a smaller one.

Economies of scale also give oil companies a barrier against competition from other forms of energy. Since they benefit largely from being in a highly developed industry, companies that focus on renewables must spend much more on investment to compete. It gives oil basically a natural monopoly in energy markets.

Externalities

The full price of oil is not just what we pay at the pump. It also includes all of the other costs that a fossil fuel based economy forces us to endure. In particular, this includes pollution clean up and the effects of global climate change.

While oil companies pay when there's an oil spill (partly), no one pays for the pollution created when oil is consumed. Because there is a cost associated with this pollution, it is necessary for government to increase the cost of oil to offset this cost. If you compare oil taxes in the US to those in other countries, it seems clear that we are not fully accounting for all of the other costs that burning fossil fuels brings. This is strong justification for taxing oil companies and oil consumption more than the taxes in other industries.

In fact, increasing the cost of oil now in order to limit the effects of global climate change will actually be more economically efficient in the long run.

A world without oil

All things being equal, if you could derive all of the world's energy without using a drop of oil, would you? For me it's an easy decision. Oil is a dirty fuel, whose emissions are poisoning our atmosphere and whose profits go to supporting corrupt regimes around the world that actively seek the destruction of our country. When talking about oil's role in the US energy mix, you cannot ignore the fact that OPEC accounts for 45% of global oil production, generating more than 700 billion dollars a year. Cutting US oil consumption means going after the oil that these countries produce. Americans oil companies will likely always have a large market for their product here.

If, for example, the US was not oil hungry, we would have never needed to invade Iraq, as Sadam's regime would have had no material base to stand on. A huge portion of US security spending goes towards Middle Eastern countries, which is something we simply wouldn't have to do if we didn't depend so much on the supply of foreign oil. While everyone is celebrating the recent events in Egypt, let's not fool ourselves into believing that the Saudis are one iota better or that the US doesn't a key role in keeping this brutal regime in power.