Comments on economic education

http://organizationsandmarkets.com/2007/11/14/a-plea-for-economic-education/

One thing that often surprises people is the degree to which people working in Wall Street investment banks tend to not be “economic conservatives.” Investment banks are huge bureaucracies, and the people in them are generally not allergic to working in large bureaucracies. Also people who work on the raw edge of markets everyday see some of the limitations of said markets. Lots of Rubin Democrats in the banks.

People like George Soros and Warren Buffet have warned against market fundamentalism, and I don’t recall anyone out of a major Wall Street investment bank that has recently called for unfettered capitalism. (Hedge funds are different.)

One of the funny ironies involves sitting at a trading desk at the center of global capitalism, and going through a maddening socialist central-planning bureaucracy trying to get a phone installed.

A brief history of recent US finance

http://www.rgemonitor.com/content/view/226049/86/

50 Cent: Really? Explain how US banks were able to offer fixed rate mortgages before the 1980s without a liquid market for derivatives.

Simple. Between 1933 and 1980, the Federal Reserve set interest rates. Under regulation Q, all retail savings rates in the United States were set at 5.25% and checking account interest was set at zero. Once retail savings were fixed, then the government through FHA set the lending rates at below market rates, making it easy for people to finance home purchases.

It was a massive successful system that worked for about 50 years, but ended up being unsustainable. One thing that killed it was the inflation of the 1970’s. Once you had inflation, people were no longer willing to save at 5.25% when inflation was at 10%, and people invented clever things like money market accounts and certificate of deposits to circumvent Regulation Q. Another thing the fact that the government couldn’t increase interest rates meant that it didn’t have a way of controlling the inflation of the 1970’s. Also, the US government could pretty easily set interest rates and do whatever it wanted domestically in 1933 to 1965 when US markets were the only game in town. In 1948, if you didn’t like the lousy interest that the US government was setting for you, you pretty much were stuck since there was no where else in the world you could move your money to. This stopped being true in the 1960’s which was one reason the system broke done. Another was Vietnam and the Great Society. Have a major war and not increasing taxes means that the wealth has got to come from somewhere………..

So finally in 1980. the US government gave up, deregulated interest rates. This quickly lead to a huge set of banks making stupid loans creating an early savings and loan crisis in the US. It also very quickly lead to the formation of a derivatives market in the mid-1980’s. By the early-1990’s, there was a demand for people who could calculate the value of those derivatives, which led to lots of physics Ph.D.’s being hired on Wall Street.

The Chinese financial system looks in some ways like the US financial system of 1965, but there are lots of pressures for floating interest and currency rates. It’s not that floating interest or currency rates are morally better or worse, it’s that like the US in the late-1970’s, China is finding that it *must* to certain things in order to avoid chaos. What I find fascinating about the history of US finance from 1970 to 1990 is that pretty much *none* of it was planned.

The other thing is that among the financial innovations that people found scary in the late 1970’s were money market funds and certificate of deposits. Money market funds turn out to be a great thing since it means that you can basically have a checking account that pays interest, which is a hellishly difficult thing to create.

Also, one curious thing is that the US retail derivatives market is not nearly as well developed as the Asian or European markets. In the US, you can’t go into a bank, and buy a complex structured note, and there are dozens of legal, cultural,. and regulatory reasons why not. In the UK, you can.

Systems of social control - How Chomsky is right — and wrong

In George Orwell’s 1984, Winston Smith asks O’Brien whether the things that Smith has read in the secret banned book are true. O’Brien’s reply is “As description, yes. The programme it sets forth is nonsense.”

I keep thinking about this in relation the writings of Noam Chomsky

http://www.thirdworldtraveler.com/Chomsky/Noam_Chomsky.html

who I think is a wonderfully lucid and accurate description on how the power elites in developed nations keep their control by corporate control of the media. My big difference with Chomsky, is that he assumes that there is a better system out there, and I’m skeptical. Part of the reason I’m skeptical is that I’ve been in academia. Presumably the academics that write about systems of social control want to model society in the image of academia, and in any case they have the power to model academia after their vision of a perfect society. However, my first hand experience is that the world of academia has a rigid caste system and is exploitive in a way that is unheard of in the “corrupt world of business and politics.” Let’s be brutally honest about this, academia is a world of lords (tenured faculty) and serfs (adjuncts and graduate students). The one nice thing about the academia is that academics don’t run society, and there are enough social limits to keep the dysfunctions of academia inside of academia, where they are harmless. In cases where academics have free rein to run a society, the results have invariably been disastrous. The one clear modern example where you had academics running a society was the Khmer Rouge.

Let me give you an obvious example of how the power elite in the United States maintains control over society, and why it isn’t such a bad thing. I want to invite you to a speech by Chomsky. Except that you can’t go because you have to work. Why do you have to work? Just quit your job, and join the revolution. Well, because you have this mortgage and you have car payments, and you just bought this big giant big screen HDTV and you want to catch the latest episode of Lost. Well why don’t you get rid of these things, become a hermit, quit your job, and join the revolution. Well, I just saw this commercial that makes me want to buy this bigger HDTV and I don’t want my neighbors to think that I am a “loser” for having a small HDTV or a small house. Why do you think you are a loser if you aren’t a business success and have a small television? Well, there is this commercial that I saw while I was watching Lost….. And….

So who ends up joining the demonstration. It’s people who don’t care about money and status, and these people generally have no money and connections and so are harmless. The US doesn’t have political prisoners, because anyone that wants to change the system in a way that is unacceptable to the power elite either by bought out or ignored. I’m a good example of this. I say good things about the power elite, because the power elite dumps enough money in front of me to keep me happy and controlled. If the checks stop coming, I become unhappy and uncontrolled, and seeing that I have some useful talents, the people that run the United States don’t want to see me uncontrolled. And this is true for most of the people living in the United States.

So what the hell is wrong with the system????

Personally I don’t think that there is much wrong with the system (and that’s largely because of those semi-monthly paychecks that I get from it that allow me to satisfy the urges that the system makes me thing that I have). Basically what is happening is that the rich and powerful are bribing the less rich and less powerful with wealth and goodies so that the rich and powerful can keep their wealth and goodies.

Chomsky does have a problem because he has a model of economics in which the wealth that the developed world has has to come from exploitation of the third world. That HDTV? Where did it come from? Chomsky would argue that it came from a slave labor factory in China. But that is not what is happening.

The Chinese government is bright enough to know that they just can’t stay in power through tanks and torture. There aren’t enough soldiers and police to keep control, and then you run into the problem of keeping control of the soldiers and police. So the Chinese government has copied the American government and is trying to stay in power by bribing the masses. People work in Chinese sweatshops because *they* want their goodies, *they* want to be seen as a success, and *they* want a bigger house and motorbike than their neighbors. And as long as the checks keep coming, people are too exhausted to demonstrate. If you look in situations where people *are* demonstrating in China, it’s largely because of economic issues. Their checks aren’t big enough. So people make noise, and when they get a fat enough check, they stop making noise. The system isn’t quite as developed in China, so the government has to sometimes resort to jailing dissidents, but what the government is trying to push for is a system like that American system in which the dissidents are harmless and jailing them causes more problems than ignoring them.  The ideal system would be one in which anyone who wants to destroy the system, gets to join the party.  *wink*

For this system to continue to work both the US and Chinese economic and political elites need to generate enough wealth to keep their populations satisfied, and they need to be open enough so that people (like me) that could be threat to the basic stability of the system, get bought out. That’s not a bad thing, and it’s a heck of a lot better than what the academics have come up with…….

Let be close by pointing out the fatal flaw that academics have that I think causes them create such hellish systems. Academics think that they are smarter than everyone else. The people who get a paycheck, buy a high-definition TV, and then relax to watch Lost, they are stupid sheep in the eyes of academics. They should be reading about Chomsky or joining the revolution. The trouble with this attitude is that it means that academics ignore the ideas and perspectives of non-academics, and so when they get into a position of power, they know what is right, everyone else is wrong, and this causes hell to happen…..

So now that I’ve told you all of this, are you going to go out and revolt…… I don’t think so. I think you are just going to go into the refrigerator, pull out a cold beverage and watch TV….. which is exactly what the power elites wants you to do…..

China and the socialist calculation debate

http://organizationsandmarkets.com/2007/09/04/what-does-austrian-economics-predict/ 

One big prediction…..

If the essential problem with socialist systems is calcuation, then a government owned system in which the institutions have been set up so that these calculations can be performed in a real market (and not an Oskar Lange pseudo-market) will work.

That’s the system currently in place in China, and Chinese economic reform can be seen in the context of creating a real market to resolve the socialist calculation problem in the context of public ownership. A lot of this works because there aren’t vertical command and control systems, which means that actual decisions are taking place at a lower level.

Also there is a fundamental tension between prediction and human freedom. If something is predictable than that means that you don’t have the freedom to change it, whereas if you to have the freedom to change something that renders it less predictable.

Comments on biography on von Mises

http://organizationsandmarkets.com/2007/09/04/new-mises-biography/

Great link, and I learned a bit more about why I find myself so attracted to von Mises and his ideas. The social situation of a Chinese-American circa 2007 is very similar to the social situation of an Austrian Jews circa 1880, and like von Mises, my family background is that of “fallen aristocracy.” Being “fallen aristocracy” puts you under a huge amount of psychological pressure, because you are surrounded by bits and pieces of past glory in the middle of the meagre present.

The conflicted and complex feelings that liberal Austrians had with the Habsburg monarchy and the irony of supporters of liberalism supporting an at times repressive monarchy parallels the very complex feelings that I have toward the Chinese Communist Party.

At times it is extremely painful for me to read about the history of Austria in the late 19th century because I know what happened in the 20th century. This is especially the case, because I doubt that anyone living in Austria would could have imagined how bad things would have gotten over the next 100 years, and that knowledge is frightening when you look around the United States in 2007, and realize that the fact things look nice and stable right now, doesn’t mean that it can’t all fall apart in horrific ways.

One reason I like Austrian economics over mainstrean economics is that in Austrian economics, people matter. In mainstream economics, there is no room for human will and human choice. We are all “robots” (and the word robot is related to the forms of serfdom described in the early parts of the book). My hope is that future people will look at what I did and note that I did what I could to keep the United States and indeed the entire world from going down the path that Austria did.

The one thing that I disagree with is with the title of the book, von Mises was not the last knight of liberalism.

—–

The one other thing that I thought the book brought out in the conflict between von Mises and the Randians is how basic assumptions about how the world works influences human behavior. If one believes as von Mises and Hayek does that the knowledge of the invididual is limited, then one is going to be very nice and polite toward people who you disagree with since they might will be right, and even if they aren’t, the have access to part of the truth that you need.

If one believes that one is in possession of the truth, then there is no reason to be civil toward people who you disagree with.

One other point is that I once made the statement that I learned a huge amount about Chinese nationalism by studying Hungarian nationalism, and the biography about von Mises touches on some of the things that I found. For example, there was a very strong debate over what it meant to be “Hungarian” and one of the ideas that lost was the idea of “Hungaranius” which was an inclusive notion of Hungarianness based on Latin. One curious parallel was the vital role of Latin in the Hungarian identity in the 19th century and the important role of Latin in my own life and in the development of the idea of “Confucianism.”

Now I had no idea that there would be such deep parallels between the struggles and the debates about “What it means to be Hungarian?” versus the struggles and debates about “What it means to be Chinese?”  or ‘What does it mean to be American?”  I just randomly picked up a few books in an used book shop a few years ago, and one was about the last years of the Habsburgs.

Why I am an Austrian

The history of Austrian economics in the United States was that because Austrian economists were “anti-New Deal” they formed an political marriage with the “old Right” in the United States.The reason I find Austrian economics interesting is because a lot of the analysis of Austrian economics fits nicely with Confucian social analysis. This creates a synthesis that is very different than what Murray Rothbard has come up with.

In particular, the three things that I find useful about Austrian economics is that conventional neo-classical economics assumes a pre-existing institutional structure, which may not exist in the case of a developing country like China. Neo-classical models can come up with a good theory that calculate equilibrium values if you do something with interest rates, but what happens if you don’t have a banking system or if you have an industral infrastructure that reacts in a non-conventional way to interest rates. The problems that China presents involve creating institutions, and neo-classical economics says nothing about the types of institutions you should create and how to create them.

By contrast, Austrian economics begins at the very core with “human desire”. You look at the individual and how he or she behaves, and then you zoom out and look at how collections of individuals behave. With this view, you can try to figure out what institutions need to be created and how to create them.  The big success of the Austrians was to figure out what the essential problem with central planning is, which is that central planning simply cannot handle all of the economic calculations necessary to run a national economy, and those calculations have to be done through some sort of market mechanism.

The second thing that then that I find useful about Austrian economics is that Austrian economics thinks about the process of wealth creation, whereas neo-classical economics really doesn’t have anything useful that I can see about the process of wealth creation. Neo-classical economics mainly concerns itself with how to efficiently redistribution wealth that is already existing, but it doesn’t have a theory about how to actually create wealth. Neither do Austrians, but they are thinking about the topic.

The final thing that I find useful about Austrian economics is that it concerns itself with imperfect information. What do you do if you don’t know what is going on? This is particularly important in Chinese economic reform because the process of Chinese economic reform has been a process of learning.

Within the framework, I’ve come up with different conclusions and views than von Mises and Rothbard. In particular, von Mises’s notion that private managers in large private corporations act differently than private managers in large socialist state corporations is in my empirical experience, wrong. This also fits with the experience in China. In the early-1980’s China was able to have huge bursts in agricultural production by making farmers individual entrepreneurs. These policies also worked very well with small companies, but in large companies, these policies failed miserably

One thing that I noticed is that I’m more concerned with institutions than the typical Austrian, and I  think figured out why.  It turns out that my thinking was very similar to the “Texas institutionists” which was odd because even though I live in Texas, I wasn’t aware of them.  So I was thinking about what we were seeing that caused us to see the world in the same way, and it hit me that it was because of the oil industry.  I worked in a major oil company for a number of years, and the bureaucracy and the culture within a private oil company is the same as within a state-owned oil company is the same as frankly within a large bureaucratic institution like the Communist Party of China.  The reason that big business gets along well with the Communist Party of China is that the people and the culture within them are pretty much the same.  The only difference is at the top where there is a need not to go bankrupt in private corporations which is not present in state enterprises.

So I while I agree with von Mises and Hayek’s ideas on the central nature of economic calculation, and I agree about the importance of entreprenurship in small companies, I just don’t think that their description of the difference between large state companies and large private companies is correct.

Notes on “Institutions, Financial Development, and Corporate Investment: Evidence from An Implied Return on Capital in China”

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=965631

This is another one of a long line of papers purporting to show that state-owned enterprises are more inefficient than other forms and therefore the Chinese financial system is vastly misallocating capital.

Like other such papers, it has a number of methodological flaws:

1) It doesn’t correct for the differences between state-owned enterprises and non-state owned firms.  The big one is that money losing SOE’s are responsible for a great deal of social welfare spending.  If you remove those social obligations from SOE’s, it might make the firm more efficient, but someone else needs to pick up the tab.

2) The other problem is that China has a huge number of tiny SOE’s which don’t make that much money in contrast to a small number of huge SOE’s which do.  The result of this is that if you do a factors analysis, you pick up the huge number of tiny SOE’s which are losing money, but I suspect that if you weight things by industry size, you’ll find that the bulk of bank loans are no longer going to these small SOE’s.

3) Finally, something that is consistent in these studies is that “mixed” or “collective” enterprises do as well as “private” ones.  This makes no sense if you believe that the cause of inefficiency is state ownership, but it makes perfect sense if you assume that there is some “cherry picking” going on.  Basically, any SOE which isn’t hopeless is going to find investors, and not be an SOE.

One thing that I’d like to do at some point is to dig into the NBS data, and write a paper on this.  The trouble is that I’m already booked to write three papers, and part of the reason I’ve limited myself to three papers this year is so that I don’t try to write ten.

This has some relationship to my affinity to Austrian economics.  Austrians look at numbers with a lot of skepticism and focus on the idea that we don’t really know that much about economics.  This sort of skepticism about quantitative data, I find refreshing among economics.  In the literature trying to analyze quantitative performance of Chinese firms, I’ve rarely found that the author goes in and questions the numbers and the meaning of the numbers.

Why quantitative finance is important for a quantitative theory of Austrian economics

The reason that derivative markets and quantitative finance is important in developing a quantitative theory of Austrian economics is that you end up with observable quantities, which allow for hypothesis testing.

Thoughts on the history of US Securities Law and Austrian economics

I have a pile of books, and when I get bored, I often just choose a book at random and start reading it.  The lucky book of the day was a book on US Securities Law, and I’ve started reviewing those books in the last few days.

The thing that interests me is not so much American Securities Law as it currently exists, but howAmerican Securities Law developed over time.  The interesting thing about US Securities Law is that most of it has developed without much input from the legislative bodies.  Except for the passage of key bills such as the Securities Act of 1933 and the Securities Exchange Act of 1934, most of US securities law has developed through an interaction between the courts and the SEC.  In particular, most of the issues of what is in the PRC Securities Law are issues that were developed through a detailed development of rule 10b-5.

The implication of this to the PRC, is that it would appear to me that the lack of “Western democratic institutions” aren’t a major barrier to the development of PRC Securities Law and PRC Corporate Law, because democratic institutions weren’t that important in the development of those laws in the United States.  One thing that I’ll be thinking about over the next few months is to look at the development of Securities Law in the United States and try to look at the analogous institutions in China.  In particular, I’m interested in the exact dynamics between the SEC and the Federal Courts.

The other thing that I’ll be thinking about is the relationship between these ideas and Austrian economics.  The two things that I’ll be thinking about are:

1. the relationship between Austrian economics and the use of empirical data.  Austrian economics prides itself on being derivable from the principles of interactions between individuals, but at the same time I get the sense that a lot of Austrian economics (such as Rothbard) is maybe a little too ideological, and not sufficiently empirical,
2. the other thing that I think is a weakness of Austrian economics is the theory of the firm.  Austrian economics at its core is about the interactions between individuals, but I think there is insufficient thought given to how individuals form institutions.  This fits in with my interest in securities law and corporate law.  It would appear to me that corporations are creatures of the state rather than entities spontaneously produced by individuals.

One other thing.  It occurs to me that the reason I don’t like neo-classical economics is that I’m too familiar with how corporations work to believe that they maximize profit, and I’m too familar with myself to believe that individuals maximize utility.  Where I think the pricing system comes to play is not the corporations maximize profit, but rather than corporations with large losses cease to exist.

So among the many things I have to do over the next year are:

1. read more von Mises and Hayek
2. figure out what neo-Austrianism is
3. read more about institutionalism
4. read more economics papers.  I have to learn to talk the talk.

One final thing.  The reason that I’m interested in Austrian economics is that it has a very good explanation for the deficiencies of the Chinese economy under central planning with the economic calculation problem and Hayek’s “road to serfdom” analysis.  Also the building blocks of Austrian economics provides the potential for understanding and making public policies decisions about the Chinese economy.

This is in contrast to neo-classical economics.  I can’t think of a single useful insight that neo-classicial economics can bring to analyzing the Chinese economy.

Status report - Passion and economics / Poetry and programming

Did a lot of reading this weekend  on papers detail with incomplete markets and utility based pricing.

I didn’t realize how the concept of “incomplete markets” was so tightly mixed in with neo-classical economics.  The basic problem with neo-classical economics when applied to derivatives pricing is that neo-classical economics assumes equilibrium states and in an equilibrium state there is no need for a market.  I think I can “go Austrian” and assume that you have a lot of actors with different utility functions.  One immediate consequence of this is that the trading volume of Shanghai warrants should be a function of the price volatility.  If the price is constant then everything moves to equilibrium, but if the price starts changing, then people will start trading derivatives back and forth.

All this connects with my earlier posts about passion and emotion.  Neoclassical economics assumes rationality on the part of people participating in a market, whereas Austrian economics by focusing on the individual allows for passion and emotion.  Passion can be almost defined as an irrational willingness to decrease individual utility, which breaks the assumptions of neoclassical economics.

This creates a duality which I think is apt

neo-classical economics <-> Austrian economics

Plato <-> Aristole

Song Learning Neo-Confucianism <-> Han Learning / Evidential school

Chu Xi <-> Dai Zhen

Part of the reason I distrust neoclassical economics is that I’ve worked in a corporation.  You just are not going to be able to convince me that corporations are rational profit maximizers.

I need to read more about Veblen.  I think I can describe my economic views about the Chinese economy as Austrian institutionalism.  You begin with the Austrian view of individual choice as the basis for an economy.  You then look at how these choices influence and are influenced by economic institutions.  Then and only then, you see how these economic institutions behave give certain economic inputs.  The problem with applying neo-classical economics to China is that they assume that a certain institutional structure already exists, and it doesn’t.

Anyway, I now have a testable prediction which is that the volume of warrant trades on Shanghai is a function of the daily shift in prices.  This will be one of the things that I want to graph once my system comes back up.  Right now things are broken because python 2.5 is out and not all of the packages have been upgraded.  I looks like to integrate vtk, quantlib, and python will take a lot of thinking.

The other thing I want to do is to review some of the papers on the Malliavin calculus.  The problem with the Malliavin calculus is that it should be a calculus.  There should be a canned set of rules that will let you apply it to a derivatives pricing situation.  Something like Feymann rules.

OK now that I seem rational, do I have permission to go a little nuts?

Maybe not now….  But…..  There is a “craziness quotient” that I have to keep aware of.  If I start looking to crazy people tend to get scared and turn off.  So before I go crazy, I have to wear the nice suit, and look “normal.”  See I can talk about economics and program C++, so I must not be too insane, and then once I “fake normal” *then* I can take off the mask and let people know how cracked I really am.

The problem is that I’m getting a little tired of the mask.  Businesses just want the C++ programmer and the nice quantitative models.  What they don’t realize is that programming and model building is a creative, artistic process, and you just have to put up with a bit of insanity to get the good stuff.

Writing good code is a lot like writing poetry.  In fact it *is* writing poetry.  When you code something, you are trying to strip the process to its creative essence, you are using odd rules of meter and rhyming (each open brace in C++ must be followed by a close brace), and making interesting allusions in the form of library calls.

The problem with the code at work that I’ve written in the last two or three weeks is that my heart just isn’t in it.  Yes the code works, but it is not particularly elegant or graceful or beautiful.  I’m just too upset about my work environment to write poetry about it.