Posts Tagged ‘economics’

To what extent can we quantify human action?

Given rapidly expanding computational capacity and the proliferation of cheap sensors, there is a large, distributed trend towards human quantification. Wired Magazine confidently threw it on the cover of its July 2009 issue, celebrating self-tracking as popularized by the Nike + iPod system. It’s certainly a trend with a lot of momentum, and I imagine a lot of success will be had by people building businesses around it, but I’m increasingly worried about the way in which the concept is treated in gushing terms and without an understanding of its limitations.

To be clear, I think there is solid evidence that making explicit certain types of information can induce better behavior. One of the best examples is the feedback loop created by displaying energy use in real-time to homeowners, a practice that has been shown to reduce energy consumption. In fact, anyone who has driven a Prius can probably attest to their effort to keep the real-time MPG monitor in the higher numbers, an effort that changed my driving habit for the more efficient.

But I think too much exuberance for human quantification runs the risk of falling prey to a form of techno-utopianism that has already stricken many fields.

This post was catalyzed by two recent articles. The first, by copyright crusader turned political reformer, Larry Lessig, is an extended critique of the drive towards more transparency in government. He writes,

“We are not thinking critically enough about where and when transparency works, and where and when it may lead to confusion, or to worse. And I fear that the inevitable success of this movement–if pursued alone, without any sensitivity to the full complexity of the idea of perfect openness–will inspire not reform, but disgust.”

For Lessig, the work of groups like the Sunlight Foundation or MAPLight (“money and politics: illuminating the connection”) are too simplistic. The problems these groups rightfully seek to fix are too complex to be solved by transparency alone.

“This is the problem of attention-span. To understand something–an essay, an argument, a proof of innocence– requires a certain amount of attention. But on many issues, the average, or even rational, amount of attention given to understand many of these correlations, and their defamatory implications, is almost always less than the amount of time required. The result is a systemic misunderstanding–at least if the story is reported in a context, or in a manner, that does not neutralize such misunderstanding. The listing and correlating of data hardly qualifies as such a context. Understanding how and why some stories will be understood, or not understood, provides the key to grasping what is wrong with the tyranny of transparency.”

Now, perhaps the people who need to know the entire story – the trial judges, the political decision-makers – will take the time to look past a simplistic “money + politician = bribe” equation, but I think the worry is legitimate. The reason for the worry is the seductiveness of simplicity.

This is a point Paul Krugman makes strongly in his recent essay about failure of economists to predict or avoid the current recession. As he chronicles the shortcomings of modern economic thought, he writes,

“As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth.”

The “impressive-looking mathematics” are the economic models that academics have conceived and investors embraced. The short-comings of these have been noted time-and-again by critics like Nassim Nicholas Taleb or Richard Bookstaber (whose book I reviewed here), but these are minority voices. Bookstaber’s Congressional testimony is actually quoted by Krugman:

One thing that seems clear is that risk models that are designed to function in normal market conditions should not be relied upon to predict outcomes in times of crisis. On this account, VaR doesn’t kill banks; executives who don’t recognize the limits of VaR [the value-at-risk financial model] kill banks. As Bookstaber put it, “one has to look beyond VaR, to culprits such as sheer stupidity or collective management failure: The risk managers missed the growing inventory [of risky assets], or did not have the courage of their conviction to insist on its reduction, or the senior management was not willing to heed their demands. In other words, models succeed because they meet the needs of real human beings, and VaR was just what they needed during the boom.

This, to me, is the same point that Lessig was making – technologically-induced simplicity (in the form of “money + politician = bribe” or VaR) is seductive and likely to be misinterpreted to the detriment of society.

Certainly some people understand this. Carl Malamud, who has led an impressive effort to opening up government, responded to Lessig’s article as such,

“Lessig’s point is that transparency, naked and by itself, with no broader and deeper aims, will not automatically produce good results, and may indeed produce randomness in our government or far worse. Merely revealing data is not enough. One must work with it, work with policy, and monitor effects. Transparency without a long-term commitment to policy is transparency without context, transparency that is merely naked…”

The parallel for Krugman’s world is, very likely, the work of behavioral economists who are placing humanity’s knack for irrational activity within the framework of economic thought. However, in his vehement response to Krugman’s essay, U Chicago professor John Cochrane writes,

“The sad fact is that few in Washington pay the slightest attention to modern macroeconomic research…”

This is what Lessig calls “the problem of attention-span,” and even were Krugman and Cochrane to coalesce into a sophisticated macroeconomic theory that took into account the limits of human quantification, I fear the simple, erroneous models will win the day (again).

Update: Tim Wu responds to Lessig’s piece with an important reminder that civic virtue is the key ingredient, not technology.

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I just went to a very interesting book talk by Stanley Nollen, a professor at Georgetown, and Neil Gregory of the IFC. Their new book, “New Industries from New Places: the Emergence of Hardware and Software Industries in India and China,” examines the reasons for the rise of different ICT sectors in the two Asian giants.

They began by showing graphs of the exponential rise in software revenues in both China and India since the 1990s, but when broken down into exports and imports, it becomes clear that Indian software is predominently written for exportation while Chinese software is for the domestic market. And although India does not have a similarly developed hardware industry, when that sector is analyzed, Chinese hardware is overwhelmingly exported while what hardware India does make is for domestic consumption.

A number of explanations are typically given for the difference, notably India’s English language proficiency, its higher education system that created a large labor pool of software engineers, and the overbearing regulation that was not extended to Indian software firms. The authors of this book believe that while these are necessary explanations, they are not sufficient. Using a variety of data, including firm-level interviews with 300 Chinese and Indian companies, they think they have flushed out the answer.

Their research suggests that Indian management, not labor, and their pool of larger, better educated professionals were largely responsible. The management can be applauded for seeking quality certifications for Indian software firms and utilizing the diaspora ties. Further, they strategically partnered with far more American software companies than the Chinese did – 60% of surveyed Indian firms had Western partners, compared to only 12% in China. (There was a lot of data thrown into the presentation that focused on the software industry, but I didn’t copy most of it down.) A final reason offered by the authors, more tentatively, was a cultural explanation – Indians tend to be more outspoken and tolerant of ambiguity. Because software creation is a creative enterprise, perhaps they have an inherent comparative advantage.

During the Q&A, Professor Mike Nelson offered some helpful insights from his time with the American IT industry:

• In hardware, you can thrive with 2-3 clients whereas in software, you need many more. Therefore, overcoming the “foreignness” of China is more of a factor than in India where multiple Western clients can be easily courted due to the relative institutional familiarity.
• Timezones shouldn’t be discounted – India is apparently much easier to schedule with than China.
• Given India’s relative governance instability, software (with lower fixed costs) is a more flexible industry – Wipro or Infosys can leave localities more easily than OEMs.

Overall a very interesting talk that adds great data to the debate while debunking commonly held beliefs like the importance of Y2K.

In Tim Wu’s new review of Jonathan Zittrain’s The Future of the Internet and How to Stop It, the Columbia Law professor spends considerable time explaining how the economics of media have historically led to a consolidation that many would see as anathema to the diverse marketplace of ideas that we want. His discussion is well worth a read, but what I thought was most important from the piece was his mention of the many threats to the generative Internet:

“But I must part company with Zittrain over his main and more somber argument: that security crises will form the driving narrative of the Internet’s future. I do not doubt that there will be never-ending security problems and reactions. But the question is not whether cybersecurity will matter, but whether it will matter most. Zittrain’s security saga does not look to me like a full account of the future. He is leaving out many of the external forces that will change the Internet. One is the power of government, which, especially overseas, has begun reshaping the network to fit its obsessions. Another is the combined forces of language and culture, which are driving a once-global Internet into something more like a series of national ones: a Japanese Internet, a Spanish Internet, and so on.

But most important, the real story may lie in the power of industry structure and the long trend toward centralized control in the media industries. Over the last decade, the Internet has become interwoven with media and communications industries collectively worth trillions, with economics all of their own. Unlike Zittrain, I think that industry dynamics, more than a demand for safe appliances, will determine the future of this strange and extraordinary medium.”

A Typology of Threats to the ‘Net

So which threat is the most disconcerting? He points to four:

1. Zittrain‘s security-driven adoption of sterile devices,
2. Wu‘s economic-driven centralization,
3. Zuckerman‘s culture- and language-driven splintered Internet, or
4. Barlow‘s government intervention

Personally, I’m inclined to think a splintered net is the most troublesome because it destroys the forum for international conversation and deliberation we wanted the Internet to become. But what macro trend concerns you?

I just finished Richard Bookstaber’s A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation and my head is spinning from the packed pages with dire implications for our financial system. Bookstaber’s decades of running risk-management for Morgan Stanley, Salomon Brothers and assorted hedge funds make this 2007 book seem almost prescient in light of today’s subprime-induced meltdown.

Bookstaber’s central argument is that financial innovation – Wall Street geniuses creating new products – increases the complexity of the market to an extent that it is impossible to understand and manage, leading to the dramatic events of the past twenty years. These are dramas Bookstaber saw first-hand, and by his own admission, helped engineer as an MIT PhD working on the cutting edge of finance.

The book is both history and theory, though being far from a finance expert (I often relied on my Dad’s explanations over the past two days), the theory was far more interesting and will be the topic of this post.

The history, though, is also compelling. It chronicles the numerous catastrophes of the past 25 years including 1987′s crash, the Internet bubble and Long Term Capital Management’s implosion. Bookstaber explains how these disasters were not due to outside forces (say, an oil shock), but due to the financial system itself. As investment strategies became increasingly sophisticated, aided by top mathematical models and cutting-edge technology, failure increased. The opposite should have been true: Nobel Prize winning academics were devising financial products and investment strategies to more fully quantify the market. However, fundamental, endogenous differences prove to be insurmountable barriers to financial perfection. The reasons are two-fold: the normality of accidents and the limits of human knowledge.

Complexity, Tight Coupling and Normal Accidents

I first encountered Charles Perrow’s book, Normal Accidents, while reading about another interest of mine: climbing. In his impressive book, Deep Survival, Laurence Gonzalez draws heavily upon Perrow’s insights to explain why accidents in outdoor sports are not only likely, they are standard. The idea showed up again when studying nuclear reactors in my Science, Technology and the Global Arena course last semester. A theory that applies equally well to climbing Mt. Hood, Three Mile Island and the fall of Long Term Capital Management should clearly be required reading, but many remain unfamiliar with Perrow’s brainchild, now decades old.

A normal accident is one which unavoidable due to the structure of the system. Systems which lead to normal accidents are complex and tightly coupled. Complex systems are nonlinear structures where actions in one area cause events among the system. No individual completely understands a complex system, whether it be a space shuttle or modern market, and no amount of testing will ever uncover every possible outcome. By itself, a complex system isn’t prone to catastrophic accidents; the problem comes when the system is also tightly-coupled, meaning processes are time-dependent. If a book isn’t reshelved at a library immediately, no serious problem emerges because a library isn’t tighly-coupled. If, however, a nuclear reactor safeguard doesn’t kick in immediately, a cascade of errors will quickly lead to disaster. There is little slack in a tightly-coupled system, so exactness is important.

Today’s financial markets are both complex and tightly-coupled. They are complex, in large part, because banks hold leverage around the world – meaning that problems in Japan can quickly reach Brazil, even if no direct economic connection exists. “The tight coupling in financial markets comes from the nonstop information flow and unquenchable demand for instant liqudity.” The result is the presence of normal accidents of historic proportions. The history of financial markets also shows this: the famous Dutch tulip mania only reached manic proportions when someone had the bright idea of creating forward contracts, so traders could “buy” tulips that didn’t even exist and proceed to trade those pieces of paper on the expectation of a flower crop.

Financial markets, complex and tightly-coupled, are bound to have failures like the one crippling the economy today. The easy answer, resonating especially hard today, is to regulate the industry. Yet, the most common forms of regulation only add to complexity, and thus accidents. Bookstaber argues that regulation should seek to reduce complexity in the first place, rather than try to control it after the fact.

The Limits of Knowledge

The second theoretical discussion, and where I think Bookstaber is at his strongest, is in his discussion of the limits of human knowledge. In it, he channels some of Nassim Nicholas Taleb‘s “black swan” proposition, but curiously fails to mention his fellow quant-turned-critic. Bookstaber takes three decently well-known concepts and molds what I found to be a spectacular chapter about epistomology (can epistomology be spectacular?).

The first of those is Kurt Godel’s proof that nothing can be proven invariably. The primary example are the self-referential statements known as the Liar Paradox. “This statement is a lie” cannot be true because doing so would contradict it. Godel’s point that not everything followed a logical path was magnified by Wener Heisenberg’s famous Uncertainty Principle which showed that by simply observing a particle, it was changed. The result was a recognition that it was impossible to objectively know something precisely, and the harder we tried, the more variance resulted. The ability to know the future disappeared because we could not accurately know the past or present. Bookstaber writes,

“This metaphor extens neatly into the world of financial markets. In the purely mechanistic universe of classical physics, we could apply Newtonian laws to project the future course of nature, if only we knew the location and velocity of every particle. In the world of finance, the elementary particples are the financial assets. In a purely mechanistic financial world, if we knew the position each investor has in each asset and the ability and willingness of liquidity providers to take on those assets in the event of a forced liquidation, we would be able to understand the market’s vulnerability… Practically, it wouldn’t work. Just as the atomic world turned out to be more complex than Laplece [Heisenberg's predecessor] conceived, the financial world may be similarly comlex and not reducible to a simple causality.”

The reasons are manifold, but rest primarily on the fact that traders do not exist in a vacuum and do not hold perfect information. Transparency increases result in liquidity decreases – as we seek to observe (by increasing transparency), we change the market (by altering the supply of liquidity).

The final piece of Bookstaber’s argument for accepting human ignorance is the work of Edward Lorenz, commonly known as the “butterfly effect.” So-called because a hypothetical flap of a butterfly’s wings may be magnified over weeks to effect the weather across the globe, it comes out of the recognition that minuscule perturbations can have astronomic repercussions. Indeed, because because Heisenberg showed that we cannot measure without some error, “for many dynamic systems our forecast errors will grow to the point that even an approximation will be out of our hands.” As Kevin Kelly pointed out, increased understanding only leads to increased awareness of ignorance.

Coarse Behavior

Then what about the billions of dollars run through advanced algorithmic trading schemes? How should an investment firm structure to avoid normal accidents? Bookstaber is weakest when it comes to recommendations (possibly because he is not a policy wonk, possibly because he runs a hedge fund of his own), but he does include some interesting discussion of the value of coars behavior.

Looking to biology, Bookstaber sees the cockroach as the ideal risk-manager; after all, it has survived tectonic changes in environment and continues to outwit human predators. The reason is because its defense mechanism consists of the rather unsophisticated rule: if a puff of air is detected by its fiber nervous system, it scurries. The puffs may or may not signal an approaching predator, but the cockroach runs anyways. As Bookstaber writes, “This risk-management structure is extremely coarse; it ignores a wide set of information about the environment – visual and olfactory cues, for example – that one would think an optimal risk management system would take into account.” That is, the cockroach filters out all but the essential, if at times inaccurate, indicator of doom. As Clay Shirky said at this year’s Web 2.0 Expo, it’s not information overload, it’s filter failure.

Compare this to animals like the oddly named furu, a finely-tuned product of Darwinian selection – specialized in almost every way for its environment. The furu, though, suffered near extinction when an alien species was introduced to its lake. The parallels are clever: highly specialized financial models and strategies cannot last in a complex, tightly-coupled market where change comes fast and furious. Although fine-tuning may yield short-term payoff, the inevitable result (2-3 years in Bookstaber’s observation) is extinction.

Instead, he advocates an investment strategy configured for the unknown. In addition, the strategist seeking to avoid the fate of the book cover’s Icarus should simplify organizational complexity and introduce slack when possible by decoupling processes. The take-aways are many, but as endogenous pressures continue to wreack havoc on the market, Bookstaber provides a powerful argument against increased innovation which only introduces more normal accidents.

If you liked The Black Swan or Fooled by Randomness, or want to better understand today’s economy, I cannot recommend this book enough.

It seems the media likes nothing better than a good symbol and nothing says “Rise of China” like the Beijing Olympics. Picking up on the theme, David Brooks has an article on collectivism versus individualism where he provokes that China’s rise through collectivism is a threat to the power of the American dream.

Touching on a topic I mentioned a while back, Brooks explains the fundamental differences in worldview held by Asia and the West. While the West values individuals and their success, Asians seem to prioritize collective harmony. For example, show a fish tank to an American and he sees the biggest fish and its actions. An Asian, on the other hand, sees the relationships between the fish. In experiment after experiment, “Americans usually see individuals; Chinese and other Asians see contexts.”

For much of history, individualist societies excelled economically, but Brooks thinks the rise of China may point to a change in that narrative.

“But what happens if collectivist societies snap out of their economic stagnation? What happens if collectivist societies, especially those in Asia, rise economically and come to rival the West? A new sort of global conversation develops.

The opening ceremony in Beijing was a statement in that conversation. It was part of China’s assertion that development doesn’t come only through Western, liberal means, but also through Eastern and collective ones.”

However, I think Brooks is missing a key point. I’m not an expert on either economics or China, but my understanding of the rise of China is that it hinged upon economic liberalization led by Deng Xiaoping. By opening up to international trade and moving towards a market system, China paved the way to the double-digit growth which has characterized its recent years.

What Brooks alleges, then, is that China has embraced capitalism while maintaining a collectivist spirit. In Ted Koppel’s recent miniseries entitled “The People’s Republic of Capitalism,” he interviewed a Western-educated Chinese youth who thought government censorship and repression was acceptable because it was bringing China out of poverty and improving millions of lives. Brooks sees this sentiment, which I believe is widespread, as a collectivist capitalism.

I disagree. I think it is driven by self-interest; it is individualistic. Those suppressed are not supporting the suppression. They don’t think collective harmony for growth is good, like Brooks supposes. The Koppel interview shows citizens who are being personally benefited by markets – the selfishly driven interaction of individuals. The rise of China – an economic phenomenon of GDP growth – comes with increased individualism. My intuition is that while it may masquerade as collectivism (“all of China is benefiting from this system, so suppression of dissent is okay”), it is really individuals seeing themselves benefit and liking it. Brooks thesis, as I understand it, would be supported by an active Falun Gong member supporting his suppression because his family is richer than last year. And, although I haven’t looked hard, I don’t think that is happening.

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