Archive for the ‘Economics’ Category

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Bonus culture-vultures

Published by peter on 2009-02-11 in Corporate culture and Economics. 0 Comments

Since this post is certain to be controversial, let me state some things at the outset for the avoidance of any doubt:

  • Owners of companies have the legal and moral right to establish any legal payment policies they so wish.  Thus, if the econopopulists now living at 10 and 11 Downing Street, London, wish to abolish bonus payments to managers at the banks our government owns, then they have every right to do so.   As company owners, they do not need to give reasons for their actions.   As elected officials in a democracy, however, rational justification and evidence of due deliberation behooves them.
  • People who fail should not be rewarded for that failure.  Those who placed bad bets on house prices or credit swaps should not receive financial rewards for their bad bets.

But in all the Grand Populist Upswelling of Outrage (GPUO) fed or created by the media in Britain, in France and the USA (and maybe elsewhere) this last week over bonus payments to managers in the financial sector, there are some aspects which I’ve either seen little of, or not seen reported at all.

  • The first is that not all business units of all banks and financial institutions failed, these last 6 or 18 months.   Some parts of even the bankrupt banks made profits, sometimes large profits.  The managers who made those profits, particularly at a time of global economic doom, deserve whatever bonus payments they were promised.
  • Second, many bonus payments are subject to legally-binding employment contracts.  Any half-decent financier would not have accepted a senior position without first having a written, legally-binding statement of what he or she was owed in payment under what circumstances.  New owners or not, even owners living in Downing Street, have a legal and moral obligation to fulfil legally-binding contracts.
  • Finally, in all the nonsense spoken about a “bonus culture” in banks, I have nowhere seen any discussion as to WHY bonus payments are common in the financial world.   The first reason is that financial markets are capricious:  despite all the boastful talk about skills and experience, and despite the multi-terabytes of computer memory, the massively-high bandwidths of connection, and the arrays of rocket scientists deployed, the taking of positions in markets is still a matter of taking views on the future, and betting these views against other views.   The future is uncertain, so bets can lose, as well as win,  and these two outcomes may happen regardless of the skills or expertise or resources applied to the taking of a view.  People may be just lucky or unlucky – even clever, experienced, well-resourced, cautious, nice people.    The second reason is that when bets win, they may win big.    If  a company makes hundreds of millions of dollars profit from a one or a handful of trades, it can seem most unfair to those deciding what trades to do that all of this capricious, windfall gain should accrue just to the shareholders.  Those doing the trading therefore ask, quite reasonably in my opinion, for a share of this windfall gain.   Most companies have then a choice:  give a few percent of these capricious windfalls to the staff doing the work as bonus payments, or risk losing the staff to the competitor down the street who will.   No rational, long-term manager would choose the latter option, and no rational, long-term shareholder would force him or her to.

Nothing in what I have written here should lead you to conclude that I consider the occupants of 10 and 11 Downing Street to be rational, long-term managers of the companies our Government owns.  The occupants of Downing Street, it seems to me, have their eyes firmly fixed on the next election, and the Government’s re-election thereat, and pretty-much nothing else.    Neither rationality nor long-termism feature in such gazing, sadly.  If it did, we would be reading in our media the details of the new, 20-year, national infrastructure projects about to commence – thereby creating domestic UK employment, supporting local supplier firms, supporting demand, and providing a basis for future prosperity –  and not econopopulist nonsense about stopping bonuses to bankers.  Can anyone even name, let alone describe, a single infrastructure project that the UK plans to embark upon now?
POSTSCRIPT (2009-03-29):  The International Herald Tribune has carried an oped article by Jake DeSantis, comprising a letter to resign his position as an executive vice president of the American International Group’s financial products unit.  His letter examplifies my first bullet point above:  not all business units of failed financial institutions were or are failing, and it is unfair and irrational to punish those still successful.  Punishment is irrational both tactically – since offended staff will soon leave – and strategically – since failed institutions still operating need to have some successful product lines to stay in business.

“As most of us have done nothing wrong, guilt is not a motivation to surrender our earnings. We have worked 12 long months under these contracts and now deserve to be paid as promised. None of us should be cheated of our payments any more than a plumber should be cheated after he has fixed the pipes but a careless electrician causes a fire that burns down the house. “

Old, beardy revolutionaries wielding spreadsheets

Published by peter on 2009-02-06 in Economics, Globalization, Manufacturing and Prophecy. 0 Comments

If you were aiming to model global, 21st-century capitalism, the obvious place to start would not be with a model of the firm based on mid-Victorian Lancashire textile manufacturing companies.   Firstly, the textile industry developed in Lancashire in the 18th century because only here (and almost nowhere else) was the climate sufficiently conducive for the then leading-edge technology to operate successfully.  (The air needed sufficient dampness, but not heat, for the cotton fibres not to be broken by the early textile machines.)   Technology in most industries has progressed so much in the two centuries since that very few industries are now tied to specific climates.     So industries are mostly not tied to place any more.
Secondly, large swathes of  work – even most work undertaken in companies described as manufacturers – is not anything a Victorian economist would recognize as manufacturing.  Rather it would be better described as symbol analysis and manipulation.  A relative of mine recently embarked on training as a surface-materials mixer for a road-building company – a great job, all done inside in an airconditioned office, mixing different ingredients and assessing the results, achieved by moving graphic objects around on a computer screen.  Of course, some person still has to be outside moving and switching on the automated machinery which actually lays the road surface once it has been created, so not every task is symbol processing.     But mixing is no longer done by eye, by a man using using a shovel in front of a furnace.  The relevant attribute of symbol manipulation – unlike, say the operation of a loom – is that this too is something no longer tied to place, thanks to our global telecommunications infrastructure and to digitisation.  Thus, the processing of US insurance claims can move from Hoboken, New Jersey, to Bangalore and Mauritius, and then maybe back again, if circumstances so dictate.
Thirdly, for companies whose sole business involves symbol manipulation – eg, banks, investment firms, graphics designers, media companies, software developers, consultancy companies, etc – the economics of traditional manufacturing industry no longer applies.  Information is a product whose value increases as more people use it, and whose marginal costs of production can decline to zero with multiple users.  It costs Microsoft  between US$1 and $2 billion to develop the first copy of each new generation of its Windows operating system, but less than $1 each for the second and subsequent copies;  the cost of producing these subsequent copies comprises only the cost of the media used to store the product (a DVD or a filestore).   (Of course, I am not including the cost of marketing and distribution in this statement of the cost of production.)  Similarly, a well-crafted, well-timed IPO and financial plan may raise (to cite the case of one IPO whose writing we led) US$5 billion on the world’s capital markets if successful, and nothing at all if less-well crafted or placed at a different time.  These information-economy attributes also apply to those parts of so-called manufacturing companies which undertake symbol manipulation:  the design team of Mazda cars for example, which relocated from Japan to the UK because London is a world-centre of art, design and marketing, or the 2-man in-house forex-trading desk which two decades ago first enriched and then almost bankrupted Australia’s largest defence electronics firm, AWA.
So, although I do not share the sentiment, I think it fine for someone to express a personal dislike of an alleged bonus culture in our banks and financial sector companies, as Alex Goodall has done.  But to argue against this feature of our modern world using a micro-economic model based on mid-Victorian manufacturing would seem inappropriate.   Much as I admire Karl Marx for his startling and still-interesting contributions to the 250-year-old conversation that is economic theory, for his insightful criticisms of the world he knew, and for his desire to make that world better for all, his model of the firm describes almost nothing about the world of 21st-century business that I know.

Ed Witten, meet Gerard Debreu

Published by peter on 2009-02-04 in Economics, Politics and Religion. 0 Comments

Oliver Kamm has a post arguing that theology is not an academic discipline, since (he asserts) it does not aim to discover anything new.   I am not qualified to assess this claim about theology (and, to be honest, nor do I think is he).  But I am intrigued that so many of the lord high panjandrums of contemporary western society, including  the normally-reasonable Mr Kamm, treat theology with such disdain, but present no such criticisms of mathematical physics or neoclassical mathematical economics.
What are the epistemological differences between theology and (say) string theory?  Most religious believers will claim to have had personal, direct contact with the divine, and these personal experiences provide evidence for their beliefs and/or practices.  Such evidence is personal and subjective; only rarely, if ever, is more than one person involved in these experiences, and these experiences and contacts are almost never able to be independently and objectively verified, or repeated, or deconstructed, or analyzed with experimental methods. But for all its many failings, this evidence is significantly greater, deeper and more compelling than anything yet presented for that part of mathematical physics known as string theory.   No objective, experimental or other, evidence yet exists that the universe is comprised of invisible entities, known as strings, vibrating in additional dimensions to our own three of space and one of time.  Indeed, it may be the case that no such objective evidence COULD even exist, since these entities are supposed to inhabit additional space-time dimensions inaccessible to us.   To my knowledge, no string theorist has yet claimed to have personal direct experience of these objects of their study.  Thus all of theology – even that part which claims the world is run by large extra-terrestrial lizards  – has firmer epistemological grounding than any part of string theory, or its younger siblings, such as M-theory, which posits a universe comprised of large, multi-dimensional objects called branes.
And what of the epistemological differences, if any, between theology and mainstream mathematical  economics?      Despite what a reasonable observer might think, mathematical economics is not concerned at all with economy or society, or the economic transactions which so dominate most of our lives.  Rather, mathematical economics studies abstract mathematical objects, called (in that enmystifying manner which western academics have made their own) “economies”.  These economies do not exist anywhere, not even in an ideal form, they bear no relationships whatever to anything a contemporary westerner would call to mind when the word “economy” is read or spoken aloud, and the study of their mathematical  properties has no relevance to any question any politically-engaged person might wish answered about the allocation of resources or the sources and distribution of wealth.   How could  it, when the entities of study are such abstracted objects, in some cases significantly simpler, in other cases more complex, than the real-world markets and economies which surround us?
Which of the two, then – theology or mathematical economics – deals with matters of importance in people’s lives?  Which of the two aims to talk about their direct, personal experiences?  Which addresses questions people have in their everyday lives, or even about those questions which societies only raise every generation or so?  Which, despite its failings and flaws, deserves our respect for its relevance and attempt at finding meaning, and which deserves disdain for wasting so many of our society’s scarce resources on self-indulgent, technique-besotted,  status-ridden, exclusivist, navel-gazing?
As is probably clear by now, if I ruled the world, the string theorists and the mathematical economists would all receive compulsory re-education as theologians.   Of course, given what I have just written above, they should all prosper in their new careers.

Retroflexive decision-making

Published by peter on 2009-01-18 in Corporate culture, Decision theory, Economics, Probability theory and Uncertainty. 0 Comments

How do companies make major decisions?  The gurus of classical Decision Theory – people like economist Jimmie Savage and statistician Dennis Lindley – tell us that there is only one correct way to make decisions:  List all the possible actions, list the potential consequences of each action, assign utilities  and probabilities of occurrence to each consequence, multiply these numbers together for each consequence and then add the resulting products for each action to get an expected utility for each action, and finally choose that action which maximizes expected utility.
There are many, many problems with this model, not least that it is not what companies – or intelligent, purposive individuals for that matter – actually do.  Those who have worked in companies know that nothing so simplistic or static describes intelligent, rational decision making, nor should it.  Moreover, that their model was flawed as a description of reality was known at the time to Savage, Lindley, et al,  because it was pointed out to them six decades ago by people such as George Shackle, an economist who had actually worked in industry and who drew on his experience.  The mute, autistic behemoth that is mathematical economics, however, does not stop or change direction merely because its utter disconnection with empirical reality is noticed by someone, and so – TO THIS VERY DAY – students in business schools still learn the classical theory.  I guess for the students it’s a case of:  Who are we going to believe – our textbooks, or our own eyes?    From my first year as an undergraduate taking Economics 101, I had trouble believing my textbooks.
So what might be a better model of decision-making?  First, we need to recognize that corporate decision-making is almost always something dynamic, not static – it takes place over time, not in a single stage of analysis, and we would do better to describe a process, rather than just giving a formula for calculating an outcome.   Second, precisely because the process is dynamic, many of the inputs assumed by the classical model do not exist, or are not known to the participants, at the start, but emerge in the course of the decision-making process.   Here, I mean things such as:  possible actions, potential consequences, preferences (or utilities), and measures of uncertainty (which may or may not include probabilities).     Third, in large organizations, decision-making is a group activity, with inputs and comments from many people.   If you believe – as Savage and Lindley did – that there is only one correct way to make a decision, then your model would contain no scope for subjective inputs or stakeholder revisions, which is yet another of the many failings of the classical model.    Fourth, in the real world, people need to consider – and do consider – the potential downsides as well as the upsides of an action, and they need to do this – and they do do this – separately, not merged into a summary statistic such as “utility”.   So, if  one possible consequence of an action-option is catastrophic loss, then no amount of maximum-expected-utility quantitative summary gibberish should permit a rational decision-maker to choose that option without great pause (or insurance).   Shackle knew this, so his model considers downsides as well as upsides.   That Savage and his pals ignored this one can only assume is the result of the impossibility of catastrophic loss ever occurring to a tenured academic.
So let us try to articulate a staged process for what companies actually do when they make major decisions, such as major investments or new business planning:

  1. Describe the present situation and the way or ways it may evolve in the future.  We call these different future paths scenarios.   Making assumptions about the present and the future is also called taking a view.
  2. For each scenario, identify a list of possible actions, able to be executed under the scenario.
  3. For each scenario and action, identify the possible upsides and downsides.
  4. Some actions under some scenarios will have attractive upsides.   What can be done to increase the likelihood of these upsides occurring?  What can be done to make them even more attractive?
  5. Some actions under some scenarios will have unattractive downsides.   What can be done to eliminate these downsides altogether or to decrease their likelihood of occurring?   What can be done to ameliorate, to mitigate, to distribute to others, or to postpone the effects of these downsides?
  6. In the light of what was learned in doing steps 1-5, go back to step 1 and repeat it.
  7. In the light of what was learned in doing steps 1-6, go back to step 2 and repeat steps 2-5.  For example, by modifying or combining actions, it may be possible to shift attractive upsides or unattractive downsides from one action to another.
  8. As new information comes to hand, occasionally repeat step 1. Repeat step 7 as often as time permits.

This decision process will be familiar to anyone who has prepared a business plan for a new venture, either for personal investment, or for financial investors and bankers, or for business partners.   Having access to spreadsheet software such as Lotus 1-2-3 or Microsoft EXCEL has certainly made this process easier to undertake.  But, contrary to the beliefs of many, people made major decisions before the invention of spreadsheets, and they did so using processes similar to this, as Shackle’s work evidences.
Because this model involves revision of initial ideas in repeated stages, it bears some resemblance to the retroflexive argumentation theory of philosopher Harald Wohlrapp.  Hence, I call it Retroflexive Decision Theory.  I will explore this model in more detail in future posts.
References:
D. Lindley [1985]:  Making Decisions.  Second Edition. London, UK: John Wiley and Sons.
L. J. Savage [1950]: The Foundations of Statistics.  New York, NY, USA:  Wiley.
G. L. S. Shackle [1961]: Decision, Order and Time in Human Affairs. Cambridge, UK:  Cambridge University Press.
H. Wohlrapp [1998]:  A new light on non-deductive argumentation schemes.  Argumentation, 12: 341-350.

Adults at the helm, again

Published by peter on 2008-11-24 in Africa, Economics, Politics and Post-Industrial Nomads. 0 Comments

Africans will note that President-elect Barack Obama has selected his homeboy, the admirable Timothy Geithner,  as his nominee for Treasury Secretary.  Geithner spent part of his childhood in East Africa.  I’m sure it was professional competence and not fluency in Dholuo which got him the job.
And here’s The Economist:

“Assuming he is nominated Mr Geithner brings two crucial qualities. First, he represents continuity. From the first days of the crisis last year, he has worked hand in glove with Ben Bernanke, the Fed chairman, and Mr Paulson. He can continue to do so while awaiting confirmation. If Citigroup, for example, needs federal help, Mr Geithner will be involved. An unknown when he joined the New York Fed in 2003, he is now a familiar face to the most senior executives on Wall Street and to central bankers and finance ministers overseas.
Second, he represents competence. He has spent more time on financial crises, from Mexico and Thailand to Brazil and Argentina, than probably any other policymaker in office today. Mr Geithner understands better than almost anyone that in crises you throw out the forecast and focus on avoiding low probability events with catastrophic consequences. Such judgments are excruciating: do too little, and you undermine confidence and generate a bigger crisis that needs even bigger policy action. Do too much, and you look panicked and invite blowback from Wall Street, Congress and the press. At times during the crisis Mr Geithner would counsel Mr Bernanke on the importance of the right “ratio of drama to effectiveness”.
Ah, glorious, glorious competence. How we’ve missed you.”

Organizational Cognition

Published by peter on 2008-11-24 in Decision theory, Economics, Joint-Action Society and Team working. 0 Comments

Over at Unrepentant Generalist, Eric Nehrlich is asking interesting questions about organizational cognition.   His post brings to mind the studies of decision-making by traders in financial markets undertaken in recent years by Donald MacKenzie at Edinburgh University, who argues that the locus of decision-making is usually not an individual trader, nor a group of traders working for a single company, nor even a group of traders working for a single company together with their computer models, but a group of traders working for a single company with their computer models and with their competitors. Information about market events, trends and opportunities is passed from traders at one company to traders from another through informal contacts and personal networks, and this information then informs decision-making by all of them.
It is possible, of course, for traders to pass false or self-serving information to competitors, but in an environment of repeated interactions and of job movements, the negative consequences of such actions will eventually be felt by the perpetrators themselves.  As evolutionary game theory would predict, everyone thus has long-term incentives to behave honourably in the short-term.  Of course, different market participants may evaluate this long-term/short-term tradeoff differently, and so we may still see the creation and diffusion of false rumours, something which financial markets regulators have tried to prevent.
Reference:
Donald MacKenzie [2009]: Material Markets: How Economic Agents are Constructed.  Oxford, UK:  Oxford University Press.

Why vote?

Published by peter on 2008-11-02 in Anthropology, Culture, Decision theory and Economics. 0 Comments

Someone once joked that economists are people who see something working in practice, and then wonder if it will also work in theory.   One practice that mainstream economists have long failed to explain theoretically is voting.    Following the (so-called) rational choice models of Arrow and Downs, they calculate the likely net monetary benefit of voting to an individual voter, and compare that to the likely net costs to the voter.  With long queues due to inadequately-resourced or incompetently-managed voting administrations (such as those in many US states), these costs can be considerable.  Since one vote is very unlikely to have any marginal consequences, economists are stumped as to why any person votes.
One explanation for voting, of course, is that voters are indeed feeble-minded or irrational, unable to calculate the costs and benefits themselves, or, if they can, unable to act in their own self-interest.   This is the standard explanation, and it strikes me as morally reprehensible:  a failure to explain or model some phenomenon theoretically is justified on the grounds that the phenomenon should not exist.
Another explanation for voting may be that the rational-choice models understate the benefits or overstate the costs to individuals of voting.   Some economists, as if in a parody of themselves, have now  – in 2008!  – discovered altruism.  Factor in the benefits to others,  this study claims, and the balance of benefits to costs may move more in favour of benefits.
A third explanation for voting may be that rational-choice models are simply inappropriate to the phenomena under study.  The rational choice model assumes that citizens in a democracy are passive consumers of political ideas and proposals, with their only action being the selection of representatives at election times.   Since at least the English Peasants’ Revolt of 1381, this quaint notion of a passive citizenry has been rebutted repeatedly by direct political action by citizens.  The most famous example, of course, was the uprising against colonial taxation known as the American War of Independence, which, one imagines, some economist or two may have heard speak of.   There’s also the various revolutions and uprisings of 1789, 1791, 1848, 1854, 1871, 1905, 1910, 1917, 1926, 1949, 1953, 1956, 1968 and 1989, just to list the most important since economics began to be studied systematically.
An historically-informed observer would surely conclude that a model of voting in which citizens produce as well as consume political ideas is likely to have more calibrative traction than one in which citizens do nothing except (if they so choose) vote.   Such a theory already exists in political science, where it goes under the name of deliberative democracy.   One wonders what terrors would strike the earth were an economist to read the relevant literature before modeling some domain.
People vote not only out of their own self-interest (if they ever do that), but also to influence the direction of their country, to act in solidarity with others, to elect to join a group, to demonstrate membership of a group, to respond to peer pressure, because the law requires they do, or to exercise a hard-won civil right.  Only a person with no sense of history – an economist, say – would fail to understand the importance – indeed, the extreme rationality – of this last factor, especially during a year when a major political party has nominated a black candidate for President of the USA, and the other party a woman for Veep.  At the founding of the USA, neither candidate would have been allowed to vote.
Not for the first time, mainstream economics has ignored social structures and processes when studying social phenomena, focusing only on those factors which can be assigned to an individual (indeed, some idealized, self-interested, desiccated calculating machine) and, within these, only on factors able to be quantified.   The big question here is not why people vote, which is obvious, but why economists seem unable to recognize social structures and processes which can be clearly seen by most everyone else.  What is it about mainstream economists that makes them autistic in this regard?   Do they simply have an under-supply of inter-personal intelligence, unable to empathize with or reason about others?
 
References and Acknowledgments:
Hat-tip to Normblog. 
Kenneth J. Arrow [1951]: Social Choice and Individual Values. New York City, NY, USA: Wiley.
J. Bessette [1980]: “Deliberative Democracy: The majority principle in republican government”,  pp. 102-116, in: R. A. Goldwin and W. A. Schambra (Editors): How Democratic is the Constitution? Washington, DC, USA: American Enterprise Institute.
James Bohman and William Rehg (Editors) [1997]: Deliberative Democracy:  Essays on Reason and Politics.  Cambridge, MA, USA: MIT Press.
Anthony Downs [1957]: An Economic Theory of Democracy. New York City, NY, USA: Harper and Row.

Kaleidic moments

Published by peter on 2008-10-27 in Economics, Prophecy and Uncertainty. 0 Comments

Is the economy like a pendulum, gradually oscillating around a fixed point until it reaches a static equilibrium?  This metaphor, borrowed from Newtonian physics, still dominates mainstream economic thinking and discussion.  Not all economists have agreed, not least because the mechanistic Newtonian viewpoint seems to allow no place for new information to arrive or for changes in subjective responses.   The 20th-century economists George Shackle and Ludwig Lachmann, for example, argued that a much more realistic metaphor for the modern economy is a kaleidoscope.  The economy is a “kaleidic society, interspersing its moments or intervals of order, assurance and beauty with sudden disintegration and a cascade into a new pattern.” (Shackle 1972, p.76).
The arrival of new information, or changes in the perceptions and actions of marketplace participants, or changes in their subjective beliefs and intentions, are the events which trigger these sudden disruptions and discontinuous realignments.   Recent events in the financial markets show we are in a kaleidic moment right now.  If there’s an invisible hand, it’s not holding a pendulum but busy shaking the kaleidoscope.
Reference:
Geoge L S Shackle [1972]: Epistemics and Economics.  Cambridge, UK:  Cambridge University Press.
 

The second time as farce

Published by peter on 2008-10-15 in Economics and Forecasting. 0 Comments

Karl Marx was correct, it seems, in predicting that capitalism would suffer recurring crises.  What he seems to have overlooked is the impact of his own predictions (with companies and governments taking steps to eliminate or ameliorate the worst effects of the system), and capitalism’s adaptability.  With the socialization of the means of exchange taking place in much of the western world this month, capitalism has shown that it is even willing to adopt its own antithesis in order to survive.

Macro-economic models

Published by peter on 2008-05-13 in Decision theory, Economics and Forecasting. 0 Comments

The New Zealand-born economist, Bill Phillips, is best known for identifying an empirical relationship between a country’s inflation rate and its unemployment, the so-called Phillips curve.  However, before becoming an economist, Phillips had been an engineer, and in 1949 he built one of the first models of a national economy, the MONIAC.  MONIAC used flows of coloured water to represent money flows through an economy, and perhaps explains (or is a reflection of) traditional economics’ obsession with distinguishing stocks from flows.
In the 1970s, the Australian cartoonist Bruce Petty also built a physical model of a national economy, but this time with seats for several human operators, representing variously The Government, The Unions, Big Business, etc.   Instead of the hydraulic flows used by Phillips, Petty’s model used mechanical levers and pulleys, which impacted in convoluted ways on the machine and on the other operators.   This model looked something built by Heath Robinson or Rube Goldberg, and was immense fun to watch it at work.   I’ve not yet been able to find a video of Petty’s model at work.