Broken Symmetry

Hayek and Group Selection Theory

From the first volume of Law, Legislation, and Liberty:

The other view, which has slowly and gradually advanced since antiquity but for a time was almost entirely overwhelmed by the more glamorous constructivist view, was that orderliness of society which greatly increased the effectiveness of individual action was not duly solely to institutions and practices which had been invented or designed for that purpose, but was largely due to a process described at first as 'growth' and later as 'evolution,' a process in which practices which had first been adopted for other reasons, or even purely accidentally, were preserved because they enabled the group in which they had arisen to prevail over others.

(Italics mine.)

Interesting Interview of Michael J. Mauboussin

At Simolean Sense:

Q: You were a top analyst for many years, can you pinpoint when you first became interested in a multidisciplinary approach to finance/investing?

A: I’d trace my thinking back to the moment I read Creating Shareholder Value by Al Rappaport, who I had the honor of working with on Expectations Investing. That book encouraged me to approach stock valuation in a way that was—and still is, to a large degree—different than the rest of the financial community. Specifically, he emphasized the importance of long-term cash flows, showed how competitive strategy analysis should be used, and made a persuasive case that expectations are the key to stock prices.

As I was implementing Rappaport’s ideas in the early 1990s, I started to read more widely in areas like evolutionary theory and psychology. Around the mid 1990s, Bill Miller, who’s now my boss, invited me to visit the Santa Fe Institute. SFI is dedicated to multidisciplinary research in the physical and social sciences. Immersion into the research at SFI really catalyzed my interest in applying multi-disciplinary approaches to the world of investing.

Via Reflections on Value Investing

Interesting to note Mauboussin's choice of words in a few places -- a perfect match to Charlie Munger's. Who is mimicking whom I cannot say for sure, but I'm guessing Munger has priority here.

One reason why academia does not appeal to me

If you’ve got someone interested in going across departments, spending part of the time in physics and part of the time elsewhere, their colleagues are going to kick them out. They’re not contributing fully to any single department. OK, every so often you’re going to get a huge benefit, but from day to day, where the universities are making appointments, they want the focus in one field.”

From Edward Carr via Marginal Revolution

How to Think about the Single Sentence Claiming Rule

PatentlyO and Hal Wegner have stirred up discussion of this issue again. Hal points out that it was raised first (at least in the recent past) by Federal Circuit Judge Plager:

a topic that gained much attention when first proposed by a respected former Law School Dean and member of the Federal Circuit. See S. Jay Plager, Challenges for Intellectual Property Law in the Twenty-First Century: Indeterminacy and Other Problems, 2001 U. Ill. L. Rev. 69, 72 (2001).

This is a topic that I touched on briefly in a letter comment to the FTC I submitted earlier this year. In a nutshell, I think patent reform needs to focus on fixing the quid pro quo of the patent system -- exclusive rights for teaching the world something new or nonobvious. People talk about the notice function of patents not working, and there are certainly fairness issues raised by that dysfunction, but what's even worse is the teaching function of patents not working. When engineers and scientists skilled in a given technology cannot read a patent and learn anything from it -- especially what it claims to be its invention -- then the system is broken.

So changing the single sentence rule of claiming could be a big improvement. But the way to change it -- the guiding principle for such a reform -- should be to make the claim language conform more closely to the set of symbols or nomenclature used by the field of engineers and scientists who work with a given technology. This is how claiming works already for chemicals and pharmaceuticals. Why shouldn't it be the same for software? Why not have pseudocode or UML diagrams in the claims?

Excellent Sentences from Rick Bookstaber

at Rick.Boostaber.com:

Commodities are not assets. They are factors of production. They do not generate returns, they have no claim on production. They have supply that flows out at a nearly fixed rate short term, and they comprise very small markets compared to the financial markets.

Via Prasanna

Renormalization Group in Macroeconomics

Should I be relieved that this was published in 1996?

A friend clued me in to the fact that macroeconomic theorists were applying the Ising Model a long time ago.

But how far have Prof. Aoki and his students and colleagues gotten with this?

What should the FTC and SEC do first to help consumers?

The answer is redesign financial statements. Don't leave it to the FASB, which is like letting the foxes guard the henhouse.

The occasion for this reflection came today as Christine Varney announced a series of workshops aimed at improving the Merger Guidelines. Lots of interesting hints in this speech. I was particularly interested in this topic:

[W]e are interested in your views on the use of more direct evidence that is not strictly based on inferences drawn from increases in market concentration. There are several categories of such evidence worth exploring: (1) evidence of the actual, post-merger competitive effects of consummated mergers, (2) evidence of "natural experiments" obtained by looking across different geographic markets, time periods, customer categories, or similar product markets; (3) evidence of the firms' post-merger plans; (4) evidence of customer views of post-merger competition; (5) historical evidence of actual head-to-head competition between the merging firms; and (6) historical evidence of actual or attempted coordination in the industry. Although the Agencies routinely rely heavily on these kinds of evidence to assess competitive effects, the Guidelines address their relevance only in passing and only secondarily, after the relevant market is defined and concentration in that market is measured. Courts also regularly rely on this type of evidence in assessing competitive effects.28 We are interested in views on whether we should adjust the Guidelines to address explicitly what kinds of direct evidence are pertinent and how they should be weighed.

Is it too much to ask that the FTC and the SEC coordinate on this? Recall that Goldman Sachs CEO Lloyd Blankfein recently suggested reforming the accounting rules to require all exposure to flow through to financial statements. Not only might these kinds of reforms benefit the SEC in enforcing its rules, it would give the FTC a better source of data -- at least for public companies -- on which to base econometric analyses of substitutability, for example. Needless to say, investors and ultimately consumers would benefit from having better information too.

Long time readers of Broken Symmetry may recall earlier posts (here, here, and here, for example) on how financial statement report only snapshots in time and time-averages of sales and costs of sales. These were all that was needed when buying and selling patterns changed only annually, or at fastest quarterly. To handle more rapid changes, you have to increase the sampling rate. What we need is a time-series of balance sheet accounts, or income/cash-flow statements on shorter intervals.

Having better designed financial statements would benefit consumers far more overall than even perfectly clear merger guidelines or perfectly efficient SEC enforcement.

How hard would it be for economists from the FTC to sit down with economists from the SEC and hammer out a set of economic data that should be required from public companies but that isn't in the financial statements now? To make it palatable politically, they could offer to get rid of Sarbanes-Oxley hassles in exchange for more information. Have a time-delay of the release of real-time balance sheet info to deal with the trade secret issues.

Patent Auctions, Patent Artifice, and Patent Artistry

From today's NYT:

“Yes, you can move in the direction of trading markets for patents, but these are complicated assets that are individualized and hard to value,” said Josh Lerner, an economist at the Harvard business school. “They are more like works of art than stocks.”

Couldn't have said it better myself. As somebody who has attended a couple of patent auctions, and even helped sell a lot at one, it is surprising to see the market presented as growing. The auction market is winding down, as Ocean Tomo's recent cancellation of its event in Paris demonstrates. There will always be an auction market at the low-end, but the larger portfolios are going to be bundled and exchanged more privately.

That's not to say that there isn't going to be some growth in the IP market. It's just that it will be growth that accommodates the artisanal qualities of IP that Prof. Lerner notes.

The "Liquidity Trap" in the Ising Model of Consumption and Savings

According to Wikipedia:

The term liquidity trap is used in monetarism to refer to a situation where a country's nominal interest rate has been lowered nearly to or equal to zero to avoid a recession, but the liquidity in the market created by these low interest rates does not stimulate the economy to full employment.

It's worth pointing out that the Ising Model of Consumption and Savings (introduced here) predicts that liquidity traps can occur in certain scenarios.

Recall that the system of N agents (individuals or firms) is subject to the influence of announced interest rates (by analogy to the magnetic field) and a money supply independent of the announced interest rates (by analogy to the heat bath). The situation where interest rates have been lowered to near zero is reflected by the curves for H=0. Notice that even at finite temperatures below the critical temperature Tc (i.e., when Tc/T > 1), agents may be self-organized into saving as a group.

Thus, within the Ising Model, the critical point marks the threshold amount of money supply necessary to prevent spontaneous symmetry breaking into either hoarding or spending behavior. Even crude estimates of this critical point might prove useful to policymakers.

It's worth noting a further prediction of the Ising Model -- that shifting to negative nominal interest rates might not be enough to shift the population from savings to consumption. Note the wide gap between the states of synchronized consumption and savings for the H=0+ and H=0- curves. It will take a very large negative move in interest rates to induce a phase transition from savings to consumption below the critical point. Good luck Sweden!

Douglas McGregor on Systems Theory

We study characteristics of cells, of organs, of the nervous system as a whole, of the human being as an organism, of groups, and of larger aggregations of human beings. Certain characteristics are common to all these "systems"; others are unique at each level. Water, for example, is composed of atoms of hydrogen and oxygen. Knowledge about these at the level of the atom would not give us knowledge of the properties of water, nor of the fact that water at temperatures below 32 degrees Fahrenheit becomes solid and floats.

Management's insistence that the individual is the unit of organization is as limiting as an engineer's insistence that the atom is the unit of physical systems. The limitations of a physical technology based at one level alone would be great indeed. A molecule is an assembly of atoms, to be sure, but certain relationships among the atoms result in molecules with given properties, whereas other relationships result in entirely different properties. These properties of molecules cannot be predicted solely on the basis of knowledge of the properties of atoms.

That's from The Professional Manager, published in 1967, which I picked up at D.G. Wills in La Jolla while on vacation. I'm still in the first chapter, but have been delighted with what I've discovered so far. McGregor points to Maslow as the foundation for his theory of human behavior, and comes out (in the passage above and its surrounding pages) very strongly in favor of group selection theory. This was just a few years before the new Atheists, especially Dawkins, effectively put the kibosh on multilevel selection theory in evolutionary biology -- a trend that has recently reversed.

A friend tells me that McGregor taught both Warren Bennis and Peter Drucker. It's very intellectually satisfying to find that McGregor shared so many of my personal inclinations. I may have more to say about this book in the future.

If one were to quibble with McGregor's last claim in the quoted passage (that properties of molecules cannot be predicted solely on the basis of properties of atoms), then one would point out that renormalization group methods give us some insights into how relationships at one scale affect dynamics at larger scales.

Great Minds Think Alike: Robert Shiller and Benjamin Graham Edition

From the profile of Shiller in Yale Alumni Magazine:

Shiller and Campbell did something that, on its face, did not make much sense. To get a better glimpse of the future, they looked further in the past. They compared stock prices at any given time with average corporate earnings over the previous ten years. Later on, they would discover that a classic investment textbook, Security Analysis, published in 1934 by Benjamin Graham (a mentor to Warren Buffett) and David Dodd, had advocated this same approach. Investors, Graham and Dodd wrote, should look at earnings for "not less than five years, preferably seven or ten years." But there is no record that the two men ever published such a data series themselves. Until Shiller and Campbell came along, long-term P/E ratios were virtually absent from public discussion.

Via Tyler Cowen at Marginal Revolution.

Rizzo on the Austrian Middle Ground

From the ThinkMarkets blog:

The traditional Keynesian view is that if equilibrium obtains it will be a very bad one: depression. But ordinarily the uncertainty of the real world makes the economy prone to all sorts of bubbles, liquidity traps, aggregate demand failures. In other words, it is as if the economy is always on the precipice of some great disaster. Keynes advocated the permanent “socialization of investment” as insurance against this tendency toward disequilibrium leading to horrible equilibria.

The Freshwater view, as I see it, is that we are (almost) always in a state of equilibrium. The only thing that can knock us out is inherently unpredictable shocks, usually of a supply or technological variety. Expectations are usually well-behaved and presumptively “rational” at least in the sense that we do not have to worry about big disturbances arising from this subjective (or “demand”) side of the picture.

The Austrian perspective is more balanced. Austrians have been saying that the current recession was precipitated by excessively low interest rate policy followed by the Fed. They say that the structure of production was distorted in at least two ways. First, investment relatively far from the consumption stage was stimulated as was consumption spending – both at the expense of the middle (a different middle here) and of the replacement/maintenance of capital. (Traditional Austrian view.) Second, low interest rates stimulated greater risk-taking on the part of economic agents. (“New Austrian” view a la Tyler Cowen.) This was not an exogenous change in risk preferences but endogenous, that is, caused by low interest rates, not irrational spirits.

The Ising Model of how Savings and Consumption are affected by money supply and interest rates is an Austrian model in the sense that Rizzo describes here. System-wide shifts from consumption to savings occur as phase transitions because of the (even weak) couplings of decisions by individuals.

The tricky part of any nonequilibrium model of dynamics is modeling how microdynamics aggregate into macrofluctuations when the coupling between individuals (or firms) is stronger. In the Ising model, both interest rates and money supply determine the relative strength of coupling -- low interest rates or high money supply tend to overwhelm the effects of coupling. But the effects of coupling can be modeled in as perturbations to equilibrium.

Austrian models are the middle ground because they provide a theory that connects Freshwater equilibrium models with Saltwater disequilibrium models.

Great Suggestions for Financial Reform

From Goldman Sachs CEO (and former lawyer) Lloyd Blankfein:

[A]ll of the exposures of a financial institution should be reflected through the P&L. Consider Structured Investment Vehicles or SIVs and other off-balance sheet vehicles that represented significant sources of funding for financial institutions around the world. Unfortunately, risk models failed to capture the risk inherent in these activities. Post Enron, that is quite amazing. If contingent liabilities and stand-by credit commitments don’t flow through the P&L, how can risk managers and regulators see the risks that a bank is exposed to?

Blankfein's views are balanced and obviously well-informed. We could do worse than to follow the lead of the leader of one of the handful of institutions that came through the crisis smelling like a rose. Goldman Sachs clearly had a better understanding of what they were doing and of how the system as a whole was functioning than did other stakeholders, including government regulators.

More on the Ising Model of Macroeconomics

A comment on Scott Sumner's *Money Illusion* blog has incited me to make a brief followup.

What the Ising Model of consumption and savings tells us is this:

*If* our neighbors decisions' to consume or save have even a very weak influence on our own decision to consume or save, then the decisions of the entire population will spontaneously correlate when interest rates are near zero and money supply is low.

The model is completely agnostic as to other dependent variables, such as expectations and so on. That's both its strength and its weakness.

"Everything is flowing" in Yosemite

Everything is flowing -- going somewhere, animals and so- called lifeless rocks as well as water. Thus the snow flows fast or slow in grand beauty-making glaciers and avalanches; the air in majestic floods carrying minerals, plant leaves, seeds, spores, with streams of music and fragrance; water streams carrying rocks... While the stars go streaming through space pulsed on and on forever like blood...in Nature's warm heart.

- John Muir

Unfortunately, smoke from wildfires that started as a controlled burn have turned normally blue skies into a nearly impenetrable brown and gray haze. Interesting fact: sequoia trees have adapted to live and reproduce best with forest fires burning through their groves every three to eight years.

Suppose we imagine the economy as an ecosystem. What would be the equivalent of the sequoia?