Broken Symmetry

What's the New Exit for Patents?

I'm intrigued by the way crowdsourced funding is upsetting the balance of power in financing new films, and companies. The basic trend is toward less and less friction (or what Coase calls "transaction costs") in obtaining financing. At the limit, we have perfectly efficient financing in which ideas receive funding up to the opportunity cost of capital (i.e., up to the next best startup or film that could have been funded). Five years ago, things looked grim thanks to the costs of SOX and the resulting shift of new listings overseas. Technology to the rescue! Gives warm fuzzies to those who tend to be more pessimistic.

But is there less friction for inventors and patentees? Maybe a little, but not the dramatic shift we've seen in private equity financing. And why not? Here things get murky. Looking at equity financing, we can see that at least part of the reason crowdsourced financing has taken off is because of the new "exit" opportunities it offers. At least in relative terms, people prefer what they get from contributing on kickstarter to watching their money go down the tubes in a Facebook IPO. Are there new exit opportunities for inventors and patentees? Nope. It's the same exit opportunities that have always been there. So is there less friction? Maybe a little less. But without the new exit opportunities, it's unclear whether what appears to be reduced friction for inventors and patentees is, in fact, improved allocative efficiency, or whether instead it's an opportunistic redistribution of wealth. We shall see.

Regardless, it's worth asking: if we could dramatically reduce the friction for inventors and patentees, would the public at large view the patent system as more effective or less effective at its goal of promoting innovation? The answer, I think, depends not on whether friction is reduced, but how. It seems to me that there is simply no (lasting) benefit to any stakeholder in the patent system to reducing the friction in reallocations of ownership until the friction in exits can be reduced even further. Universities avoid the problem by limiting the intake to their pipeline, which is wiser than clogging it up with inventory that goes stale. What's the new exit? That's the billion dollar question to be answered by anybody with an interest in seeing the patent system evolve.

Systemic Risk and Stability in Financial Networks

by Acemoglu, Ozdaglar, and Tahbaz-Selehi:

This paper provides a tractable theoretical framework for the study of the economic forces shap- ing the relationship between the structure of the financial network and systemic risk. We show that as long as the magnitude (or the number) of negative shocks is below a critical threshold, a more equal distribution of interbank obligations leads to less fragility. In particular, all else equal, the sparsely connected ring financial network (corresponding to a credit chain) is the most fragile of all configura- tions, whereas the highly interconnected complete financial network is the configuration least prone to contagion. In line with the observations made by Allen and Gale (2000), our results establish that, in the more complete networks, the losses of a distressed bank are passed to a larger number of counterparties, guaranteeing a more efficient use of the excess liquidity in the system in forestalling defaults.

We also show that when negative shocks are larger than a certain threshold, the second view on the relationship between the structure of the financial network and the extent of contagion prevails. In particular, completeness is no longer a guarantee for stability. Rather, in the face of large shocks, financial networks in which banks are only weakly connected to one another would be less prone to systemic failures. Such a “phase transition” is due to the fact that, the senior liabilities of banks, as well as the excess liquidity within the financial network, can act as shock absorbers. Weak interconnections guarantee that the more senior creditors of a distressed bank bear most of the losses and hence, protect the rest of the system against cascading defaults.

The model of cash-flow among the banks (see equation 1 at section 2.4) has at least some superficial similarities to a 2-D Ising Model, and the authors could probably capture the dynamics they're modeling with an even more parsimonious model than they've given in this paper. But it's encouraging to see economists moving in this direction. See An Economy Made of Glass.

On a not unrelated-note, they solve for equilibrium here with Brouwer's Fixed Point Theorem. I am aware of a historical explanation for this, but it still surprises me to see models being set up to be solved this way given the instrumental challenge of testing the same models with empirical data. I have an ongoing and unfulfilled wish to see folks like Acemoglu et al. take the time to meet and discuss their models with folks like Jon Kleinberg and Steve Strogatz at Cornell. Economists just don't seem to be getting enough leverage out of the more recent applied math on networks or glass transitions.

What Would Hamilton Do?

From Michael McConnell:

But here is the irony. All this high‐toned government, the unelected and long‐termed Governors of the Federal Reserve, supported by Senators and Representatives serving for decades these establishment figures are the ones who have created the current mess. They did nothing to curb budget deficits or to reform entitlements when it might have been done less painfully. They wallowed in earmarks and budget gimmickry, set unrealistically low interest rates, borrowed ever‐increasing sums of money to satisfy current expenses, and made promises that are unsustainable but somehow never get contained. And it is the placard‐waving, Jeffersonian common horde flocking to town halls and filling town squares, who have become the champions of Hamiltonian concern for the long run: “Spend less, tax less and borrow less,” they say. Bring back the Hamiltonian dream, where penniless bastards from nowhere can rise by the sheer force of intellect, hard work, and audacity to succeed in an America that prefers opportunity to entitlement, that lets losing businesses fail, and winning businesses make serious money.

How ironic it will be if Hamilton’s dream of a national blessing were restored by the very low‐toned, democratic, unruly politics that he thought incapable of it.

The last bit brings to mind Franklin's reply to the woman who asked him, immediately after the Constitutional Convention adjourned, what kind of government had they had given us. I guess we've done alright by Franklin so far.

Resolving the St. Petersburg Paradox and the Flaws in the Efficient Market Hypothesis Too

How much would you pay to play a game in which a coin was flipped, and each time it landed heads the payout was doubled from a starting value of $1? The expected value of this game is not finite, and yet most people are not willing to pay more than a few bucks for it, much less borrow to play.

This is the so-called St. Petersburg Paradox. The earliest solution was proposed by Bernoulli, who suggested that the value people attached to their wealth went as a logarithmic rather than linear function of increasing wealth. Given that assumption, he calculated the amount a person should be willing to wager as log(change in wealth due to payout from lottery) - log (wealth - wager).

But this calculation is not quite correct even though it resolves the paradox by explaining why most people won't wager much: People won't wager much because that logarithm runs off to infinity fast as the wager approaches even a fraction of wealth -- producing a zero in the denominator.

One way to see that this calculation is incorrect is because it treats the wager as a static cost, existing independent of how the payoff increases with increasing flips. Another way to say the same thing is that the wager has time-value in the form of interest. So the expected value and the wager should be treated together in the utility function in successive flips of the coin. What you should wager depends not just on how much, but when the payoff comes.

Ole Peters tells the full story of the St. Petersburg Paradox, including the errors in its analysis later introduced by economist Karl Menger, and propagated by Arrow and Samuelson, in glorious detail here.

I am grateful to Rick Bookstaber for pointing me to the paper.

"So what?" you might ask. Well, if one gets into the habit of treating economic variables as time-series rather than ensemble averages -- as the correction demands -- then one immediately is forced out into the realm of non-equilibrium statistical mechanics and dynamics.

Ole Peters and Alexander Adamou have already proposed a correction to EMH. According to them, it is not prices that are efficient and cannot be arbitraged, but rather the use of leverage to produce larger than logarithmic gains.

I'm completely drowning in patent litigation right now, but eventually I would like to offer some thoughts on what these papers mean for competition and innovation policy. What should be considered analogous to leverage in intellectual property markets?

The potential implications for investors are also interesting and need to be thought through. Do we now have a quantitative insight into how and why so many of the investors who have consistently beat the market over the past few decades have advised against leverage. Buffett, in particular, is famous from eschewing leverage and advising others to do the same.

Patent Reform through the Creation of Economic Facts

This piece by Hernando de Soto on the "Destruction of Economic Facts" caught my eye not long ago:

During the second half of the 19th century, the world's biggest economies endured a series of brutal recessions. At the time, most forms of reliable economic knowledge were organized within feudal, patrimonial, and tribal relationships. If you wanted to know who owned land or owed a debt, it was a fact recorded locally—and most likely shielded from outsiders. At the same time, the world was expanding. Travel between cities and countries became more common and global trade increased. The result was a huge rift between the old, fragmented social order and the needs of a rising, globalizing market economy.

To prevent the breakdown of industrial and commercial progress, hundreds of creative reformers concluded that the world needed a shared set of facts. Knowledge had to be gathered, organized, standardized, recorded, continually updated, and easily accessible—so that all players in the world's widening markets could, in the words of France's free-banking champion Charles Coquelin, "pick up the thousands of filaments that businesses are creating between themselves."

The result was the invention of the first massive "public memory systems" to record and classify—in rule-bound, certified, and publicly accessible registries, titles, balance sheets, and statements of account—all the relevant knowledge available, whether intangible (stocks, commercial paper, deeds, ledgers, contracts, patents, companies, and promissory notes), or tangible (land, buildings, boats, machines, etc.). Knowing who owned and owed, and fixing that information in public records, made it possible for investors to infer value, take risks, and track results. The final product was a revolutionary form of knowledge: "economic facts."

The patent system is an example of one of these "public memory systems," which has facilitated transactions in intangible (exclulsionary) rights.

The focus of de Soto's attention is on the financial services industry, and in particular on how innovation in financial services has destabilized and undermined the consistence of public memory systems. On his view, this is a root cause of our ongoing recession:

Over the past 20 years, Americans and Europeans have quietly gone about destroying these facts. The very systems that could have provided markets and governments with the means to understand the global financial crisis—and to prevent another one—are being eroded. Governments have allowed shadow markets to develop and reach a size beyond comprehension. Mortgages have been granted and recorded with such inattention that homeowners and banks often don't know and can't prove who owns their homes. In a few short decades the West undercut 150 years of legal reforms that made the global economy possible.

Go ahead and click through to read the whole piece. His is profound insight. Note one earlier link on BS to a similarly thought provoking piece by de Soto.

What about the patent system? Has the patent system undergone a similar destruction of economic facts over the last twenty years?

Not really. More the opposite seems to be true, in fact. At least since the Federal Circuit was established, and especially lately since patent office records worldwide are now available online, the patent system has never functioned more effectively.

And yet, even with all of these improvements, it seems to me that the patent system has not yet been able to provide enough "economic facts" for the market to transition from litigation to transactional norms in handling the allocation and reallocation of patent rights. In effect, there has been no destruction of economic facts within the patent system because the patent system never created economic facts to begin with.

The production of "economic facts" in the sense that de Soto describes should be the ultimate goal of any patent reform. We have seen many incremental and even discontinuous leaps in that direction over the past few decades. But we are not there yet.

Problems with ascertaining title and encumbrances on title are foundational to any economic facts about patents. The systems for handling these economic facts with respect to real property and even copyright are more highly developed than they are for patents, even though title goes to the very root of how patents are valued now because problems with standing can result in zero returns to enforcement.

All of the issues that have been addressed lately, including Therasense yesterday, will help move us incrementally closer to a world in which patent rights transact without litigation. But a focus on the creation and maintenance of a "public memory system" -- a source of "economic facts" about patent valuation -- will get us there quicker.

At the end of the day, valuing patent portfolios is not more complex than the valuation of collateralized debt obligations, currency derivatives, or interest rate swaps. The difference is that those intangibles have (or at least had) a foundation of "economic facts" to facilitate transactions.

The Future of Technology Transfer in the United States

-- hanging in the balance. From yesterday's transcript in Stanford v. Roche:

JUSTICE BREYER: My point is that it's somewhat remarkable because of this new statute, now that happens to only to inventions in those areas that are inventions of the contractor who, by the way, invents nothing. Human beings invent things, not entities like universities.

MR. FLEMING: That's quite so.

Based on the transcript, I am hopeful that the Supreme Court gets what is so important about this case. So much hangs in the balance.

For a good background on the case, see this note by Ronald Mann on the Scotusblog.

Pam Karlan taught me Constitutional Law at Stanford Law School. I spent an uncomfortable amount of time arguing with her in front of the class. I have the highest respect for her advocacy, but evenhandedness was not one of her strengths, at least when I took her class.

Symmetry and Entropy in Market Bubbles and Crashes

From Dion Harmon, Marcus A. M. de Aguiar, David D. Chinellato, Dan Braha, Irving R. Epstein, Yaneer Bar-Yam:

Predicting panic is of critical importance in many areas of human and animal behavior, notably in the context of economics. The recent financial crisis is a case in point. Panic may be due to a specific external threat, or self-generated nervousness. Here we show that the recent economic crisis and earlier large single-day panics were preceded by extended periods of high levels of market mimicry --- direct evidence of uncertainty and nervousness, and of the comparatively weak influence of external news. High levels of mimicry can be a quite general indicator of the potential for self-organized crises.

Via Physics arXiv blog.

What I like about this work is how at the conceptual level it fits with other theories of markets making phase transitions between high and low entropy states, with symmetries breaking as the transition begins and picks up steam.

There is a lot of talk about whether Quantitative Easing has done much. Folks like Scott Sumner seem to be arguing that it has not because market expectations were adjusted at the moment QE was announced (or quickly thereafer). I'm more skeptical about that claim because I imagine that it takes more than days or even weeks for organizations to propagate new information about prospective rates through their entire ranks, such that there remains an impedance mismatch between Fed signals and market reactions. But at an even more fundamental level, the market response to Fed signals does not appear to be linear within some regimes, including the one we live in now, which looks to me like a liquidity trap, albeit not homogeneously sticky for all industries and firms. (Consumer internet, in particular, seems to be attracting capital investment at an accelerated pace compared even with hardware and software solutions providers.)

Tyler Cowen on Methodological Individualism

Over at MR, Tyler offers some thoughts and a wealth of interesting links on the subject.

Foucault understood how actual historical explanation relies on the use of broad categories, classes, and exemplars, and in a manner which is not logically reducible to statements about individual beliefs and desires. The writer (theorist) has nothing close to a complete mental model of how the interacting categories reduce to component individual parts, and so some or most of the moving parts of the explanation retain their autonomy at a partially macro level. The Austrians will kick and scream on this one, but if you combine imperfect information and the sense/reference distinction, methodological individualism ends up as more of a slogan than anything else. There is a reflective equilibrium to the explanatory process, and micro relies on some macro foundations, not just vice versa, and individuals rely on the social for some of their cues. Atomistic reduction to the level of the individual in general will not succeed.

For earlier posts on the horribles that result from methodological individualist theory in antitrust law, see here. Also note that Kenneth Arrow has expressed at least strong skepticism about methodological individualism. The picture that develops is of a feedback loop between individuals, groups, and the set of formal rules and procedures for encoding and transmitting them. We can't understand the behavior of the system with a myopic focus on any single part.

Henry Manne on the Limitations of Behavioral Economics

Here:

The problem in traditional economics style (I think “style” a more appropriate word here than “methodology”) is a general failure to keep separate that part of economic assumptions which pertains to individual behavior and that which properly pertains to aggregate behavior. About the latter, BE has very little to say (here I am talking exclusively abut microeconomics, as I am really not sure how much relevance BE, aka psychology, has to macro areas), and Alchian simply carries the day.

Part of a Truth on the Market Symposium on the same.

The Coase Theorem Does Not Apply to Multilateral Agreements

In The Problem of Social Cost (available here), Ronald Coase presented the case for what became his eponymous Theorem. In short, Coase argued that in the absence of transactions costs, parties would contract around default legal rules to achieve an economically efficient allocation of resources. As a result, in the absence of transactions costs, lawmakers should only need to ensure a clear definition of property rights and the enforcement of contracts, without worrying too much about who starts off with the property rights. The Coase Theorem has been on my mind a bit lately thanks, in part, to the Supreme Court grant of certiorari in the Stanford v. Roche case. If transactions costs could be ignored, then (according to Coase) none of the stakeholders in the tech transfer system should worry too much about a reallocation of ownership rights by the Supreme Court. An economically efficient bargain would always be reachable under a new allocation of rights -- assuming the transactions costs can be ignored.

But can they? Of course not. The uncertainty associated with tech transfer investments is often so great as to swamp the costs of negotiating these agreements. In this post, however, I want to abstract away from the specific economics of tech transfer, mortgage finance, corporate chartering, insurance, derivatives, or any other economically multilateral agreement in order to emphasize just how limited the Coase Theorem is in its general applicability to the analysis of large-scale social costs.

The Problem of Social Costs makes its case using a hypothetical example of a negotiation between a rancher and a farmer over who should have to pay for a fence and/or crop damage. That archetypical case comes in the first main section of the paper, titled "The Reciprocal Nature of the Problem." Coase's hypothetical is explicitly a bilateral agreement. Coase's emphasis of the "reciprocal" nature of the problem is implicitly bilateral in its symmetry.

So what? Consider the graph below, which compares how the transactions costs of bilateral contracts and the transactions costs of trilateral contracts add up as a population of parties increases. The calculation of both is based on the assumption that each party to an agreement (whether bilateral or trilateral) will pay the same fee for entering into an agreement. The calculation of both is made assuming every party in the population will enter into a single agreement with every unique combination of counter-parties. (In detail, these are total unique combinations of two and three picks from a population of n graphed as a function of n.) The graph shows how the relative difference in transactions costs diverges dramatically even for a population of 15 parties.

The difference is even more dramatic for a population of 100 parties.

What does this mean? At the very least it means that in policy debates about the allocation or reallocation of resources whose use involve three or more distinct economic interests (i.e., stakeholders), the Coase Theorem should not be invoked, or at the very least invoked only after everybody is satisfied that the transactions costs are completely overwhelmed by the economic benefits of a bargain.

But nearly every policy question involves more than two stakeholders. Even consumer transactions -- which seem like the quintessential bilateral agreement -- have indirect effects, compensated for through indemnifications and warranties. In other words, the Coase Theorem simply doesn't apply to any practical policy problem of interest.

At the same time, the Coase Theorem was very useful because it focusses our attention on transactions costs. In many cases, it may be easier to lower transactions costs than to decide how rights should be allocated. My point in this post is not to say that The Problem of Social Cost was fundamentally wrong, or even useless. Rather, I want to point out that we can usefully analyze transactions costs by breaking them out according to the number of parties necessary to an agreement.

This point gains strength as the number and variety of multilateral agreements increases. Nothing much at all seems to happen in our economy without getting buy-in from a host of stakeholders, either formally or informally. And the biggest economic issues of our day -- from Fed policy, to mortgage financing, to tech transfer models -- are all examples of vast, multilateral negotiations. Our world is no longer Coasean.

Positional goods present an especially interesting application of this analysis of transactions by number of parties. A positional good, by definition, is a good whose value depends both on the supply available and on the demand for the good by other consumers. Every transaction involving a positional good is at least a trilateral agreement, and arguably much more multilateral than that since the other consumer might not be based on the activity of a particular person, but rather on a general perception of the activity of an entire group of other consumers. The Coase Theorem simply doesn't apply to positional goods.

RIP Mandelbrot

A man after my own heart. Here's a short autobiographical summary of his intellectual odyssey. And here's a recent paper (via Marginal Revolution) applying some of his insights. I particularly liked this bit:

Economic systems tend to be around the critical point in general. Open markets are typical examples. When there are more buyers than sellers, the market price goes up causing decrease in the number of buyers and increase in sellers. Such well-known pulling back mechanism obviously keeps the system around the critical point. The important fact is that this criticality does not stabilize the absolute value of the market price but only stabilizes the statistics of market price fluctuations to follow the critical fluctuations. As the dealers in open markets tend to care about only the relative market price, whether it goes up or down, so the absolute value of the market price is nearly meaningless for the determination of the market price. Therefore, the market prices generally wander almost randomly having statistics characterized by the critical point.

What I picture is market price signals synchronizing the flux of supply with the flux of demand. See also the summary of the paper by Fretter, Krumov, Weihe, Müller-Hannemann, and Hütt.

Broken Symmetries and the Culture of the Ants

From Deborah M. Gordon:

Ants can show us how the rhythm of local interactions creates patterns in the behavior and development of large groups.

Via Teppo Felin at Orgtheory What Gordon suggests is that spatial and temporal periodicities could be used to coordinate (unconsciously) the behavior of groups of people. Isn't this what Thomas Schelling suggested decades ago? Why haven't economists (in particular) made more progress on these fronts? Here are my guesses:

1. The rational expectations model of group behavior is operationalized through revealed preferences, and tests of the model have been possible only through aggregate statistics like the CPI. (Maybe Google will have a hand in more fine-grained tests.)
2. Most economists never ask the why or how questions when it comes to preference formation. Take the Becker and Stigler classic as evidence.
3. (Most importantly) The data didn't exist at least until Csikszentmihalyi started handing out pagers for the ESM project in the 1980s.

One and two haven't changed.

Martin Wolf on the Declaration of Trade War with China

From today's FT:

Has the time for a currency war with China arrived? The answer looks increasingly to be yes. The politics and economics of an assault on Chinese exchange rate policy are increasingly convincing. The idea is, of course, deeply disturbing. But I no longer believe there is an alternative.

We have to address four questions. Is China a “currency manipulator”? If it is, does it matter? What might China reasonably be asked to do? Finally, can other countries shift China’s policies, with limited collateral damage?

Very good analysis of the options for recourse. What a mess.

Macroeconomic Resilience Revealed

Welcome to the non-anonymous blogosphere, Ashwin!

It only took six months for my prediction to come true.

Looking forward to hearing more about the stealth project.

Following up on American Real Estate and Inflation

From Negative Feedback in Money Supply, the Chinese Peg, and American Real Estate:

The Chinese government cannot accumulate dollars indefinitely. The peg must be removed at some point. American real estate looks like a great bet in view of that contingency, despite its ugly state at the moment.

And now CIC Seeks Harvard's U.S. Real-Estate Portfolio:

In a major push into the battered U.S. commercial real-estate market, China's $300 billion sovereign-wealth fund is in advanced talks with Harvard University's endowment to buy its stakes in half a dozen U.S.-focused real-estate funds for about $500 million, according to people familiar with the matter.

Similarly, whereas deflation seems more likely over the next few months due to swollen inventories, inflation should be the much larger concern:

Trouble down on the farm? Soaring wheat prices—September futures hit $7.11 a bushel Wednesday, up 58% from June's lows—are triggering fears of a repeat of 2008's food riots. But the real problems may lie further afield: in volatility and inflation.

Time to kick our job creation engine into high gear? Let's improve the middle management of R&D commercialization. There is plenty of room for improvement.

Inflation and Commercial Research and Development

Guess when these words were written:

The Democrats may or may not be less concerned with a balanced federal budget than the Republicans.... [T]he responsible Republican leadership has said again and again that if business should really turn down they would not hesitate to lower taxes or make whatever deficit-producing moves were necessary to restore prosperity and eliminate unemployment....

Even if this change in policy had not become generally accepted, certain other changes have occurred that would produce much the same results, though possibly not so quickly.... [Historically], much of the federal revenue came from customs duties and similar excise sources. These fluctuated moderately with the level of prosperity but as a whole were fairly stable. Today, in contrast, 80 per cent of the federal revenue comes from corporate and personal income taxes. This means that any sharp decline in the general level of business causes a corresponding decline in revenue.

Meanwhile, various devices such as farm price supports and unemployment compensation have been imbedded in the laws. At just the time that a business decline would be greatly reducing the federal government's income, expenditures in these fields made mandatory by legislation would cause governmental expenses to mount sharply. Add to this the definite intention of reversing any unfavorable business trend by cutting taxes, building more public works, and lending money to various hard-pressed business groups, and it becomes increasingly plain that if a real depression were to occur the federal deficit would easily run at a rate of...

Martin Wolf on the Perils of the Land Cycle

Martin Wolf in the Financial Times (free registration required):

I am a land speculator – a mini-aristocrat in a land where private appropriation of the fruits of others’ efforts has long been a prime route to wealth. This appropriation of the rise in the value of land is not just unfair: what have I done to deserve this increase in my wealth? It has obviously dire consequences.

The problem is compounded in California by the redistributive transfer from individuals to corporations that is Proposition 13. The other day, a puzzling question came up: Why haven't voters in California managed at least to repeal Prop. 13 to the extent it benefits for-profit corporations?

Andrew Lo on Physics Envy and the Financial Crisis

Available here:

Faith in any person or organization claiming to have a deep and intuitive grasp of market opportunities and risks is no better or worse than putting the same faith and money behind a mysterious black-box strategy. What matters in each case is the transparency of the process, an opportunity to assess the plausibility and limitations of the ideas on which a strategy is based, clarity about expectations for risks as well as returns, an alignment of incentives between the investment manager and the investor, and proper accountability for successes and failures. Part of the recent distrust of quantitative models is that they are inanimate, and therefore inherently difficult to trust. Even when we manage to develop a certain level of comfort with a quantitative strategy, ongoing due diligence is needed to assess the consistency, integrity, and incentives of the human beings responsible for implementing the strategy. It is important to distinguish our emotional needs from the formal process of assessing the models themselves, for which a degree of quantitative literacy will always be required.

Lo improves a number of arguments that long-time readers of B.S. may find familiar. I couldn't agree more with his conclusions.

For an extended discussion of the history of the crisis, I recommend Gillian Tett's Fool's Gold.

Andy Grove on the Human Capital Needed for Scaling

This is easily the most insightful analysis of the most important issue the United States now faces that I have read this month:

Since the early days of Silicon Valley, the money invested in companies has increased dramatically, only to produce fewer jobs. Simply put, the U.S. has become wildly inefficient at creating American tech jobs. We may be less aware of this growing inefficiency, however, because our history of creating jobs over the past few decades has been spectacular -- masking our greater and greater spending to create each position.

My hope is that the loosening of the currency peg will help reverse some of these trends over the coming decades.

Rick Bookstaber on Derivatives in the Financial Reform Bill

Available on his blog:

The bill divides the regulation of OTC derivatives between the SEC and the CFTC, assigning the SEC regulatory authority over some – but not all – securities-related derivatives and the CFTC authority for others, such as indexes of those securities. In a world where financial engineering can create an asset in any number of ways, this is an approach that is just asking to be gamed.

Let me illustrate this with a simple example. When I ran a long-short equity hedge fund a few years ago, I traded in the U.K. equity market. However, I never bought or sold a U.K. stock. I only traded total return swaps on U.K. equities. The reason I took this circuitous route is that by using a total return swap, I avoided the tax that the U.K. puts on stock transactions. My broker bought the stock I wanted and kept it on its books (apparently the transaction tax did not apply to the broker) and then the broker executed a swap with me. The swap gave me a payment equal to the return from the stock in exchange for a payment from me to the broker. Of course, this payment to my broker was identical to the cost of funding the stock.

Popping Bubbles With Sornette

Here's the arXiv blog's summary of his latest gambit:

Sornette says there are two parts to his forecasting method. First, he says bubbles are markets experiencing greater-then-exponential growth. That makes them straightforward to spot, something that surprisingly hasn't been possible before.

Second, he says these bubble markets display the tell signs of the human behaviour that drives them. In particular, people tend to follow each other and this result in a kind of herding behaviour that causes prices to fluctuate in a periodic fashion.

I find the particular mathematical model (of log periodic oscillations) less interesting than what it's trying to capture in the underlying market dynamics. Canonical neoclassical models of markets give no insight into correlation and synchronization of market actors. These dynamics are the most obvious and important new facts about markets we (as global market participants) have learned as a result of the ongoing crisis. It would be nice to see more of these ideas percolate out into economic analysis of law, for example.

See here for an earlier post on Sornette. And here for my favorite model of synchronization -- introduced in a paper by Zanette and Kuperman.

What do B.S. readers think of Sornette's work?

Thought Experiment on Banking Reform

What would result from a law being passed that imposed a high (say 50%) tax on bank profits beyond what could be earned by continuously compounding interest on reserves (say, at a rate fixed to short-term treasuries)?

Would that result be better or worse than permitting particular banks to reap large profits by pioneering new markets that eventually (through slavish imitation) crash, at high cost to the entire economy?

Isn't part of the problem with the financial services industry that it attracts the most aggressive, risk-preferring individuals? Would it be so terrible if those individuals were forced into other professions or jurisdictions?

A de facto Glass-Steagall?

Posner on Rational Bubbles and Adaptive Expectations

From the Becker-Posner blog:

Thus I don’t think bubble behavior is necessarily or even characteristically irrational. Often, including in the case of the housing and housing-credit bubbles, it is a rational adaptation to uncertainty. It is not efficient behavior in an overall social sense, and so efforts at detection and prevention of bubbles are probably worthwhile. Given the abundant warning signs and explicit warnings of a housing bubble and a housing-credit bubble, the failure of the Federal Reserve under Greenspan and Bernanke, the federal housing authorities, other economic organs of government, and almost the entire economics profession to detect these bubbles cries out for an explanation.

Becker's post is also worth reading.

Gene Fama could have a brilliant second act in his career by tackling non-equilibrium models of bubbles head on. Nobody could think more clearly about non-equilibrum models than he, were he to commit himself to that goal.

Eric Smith and Duncan Foley on the Parallels between Economics and Thermodynamics

Available here:

The most important point of this paper (more important than the establishment of formal parallels between thermodynamics and utility economics) is that economics, because it does not recognize an equation of state or define prices intrinsically in terms of equilibrium, lacks the close relation between measurement and theory physical thermodynamics enjoys.

There's plenty more where that came from at Eric Smith's page.

What would Gene Fama say?

Since the last post happened to relate to Buffett's purchase of Burlington Northern, I couldn't help mentioning an investment opportunity that's had my attention of late:

A train ferry is a ship designed to carry railway vehicles. Typically, one level of the ship is fitted with railway tracks, and the vessel has a door at the front and/or rear to give access to the wharves. In the United States, train ferries are referred to as "car ferries". The wharf (sometimes called a "slip") has a ramp, linkspan or "apron", balanced by weights, that connects the railway proper to the ship, allowing for the water level to rise and fall with the tides. For an example of a specialized slip to receive railcars see ferry slip.

While railway vehicles can be and are shipped on the decks or in the holds of ordinary ships, purpose-built train ferries are much quicker to load and unload, especially as several vehicles can be loaded or unloaded at once. A train ferry that is a barge is called a car float.

Burlington Northern might or might not own a few of these. But given the investment Buffett is putting into railways, one can't help wondering why some rail ferry owners are selling at a discount.