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.

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.)

SEC Demands More Real-Time Balance Sheet Data

It's about @#$@# time! WSJ reports: (see their graphic especially)

The agency's staff has been considering whether banks should be required to provide more frequent disclosure of their average borrowings, which would give a better picture of their debt throughout a quarterly period than do period-end figures.

See related posts: (by Nyquist-Shannon, quarterly balance sheet sampling permits only semiannual and longer term trends to be spotted)

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

Great Suggestions for Financial Reform (from Lloyd Blankfein)

Why Accounting Information Should Be Reported in Real Time

Schapiro's remarks are still ringing in my ears:

"Rather than relying on carefully staged quarterly and annual snapshots, investors and creditors should have access to a complete real-life picture of a company's financial situation," the senators wrote to SEC Chairman Mary Schapiro, citing the Journal articles, among other things.

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...

Scott Adams Makes the Case for Investing with your Gut

Funny weekend reading:

When I heard that BP was destroying a big portion of Earth, with no serious discussion of cutting their dividend, I had two thoughts: 1) I hate them, and 2) This would be an excellent time to buy their stock. And so I did. Although I should have waited a week.

People ask me how it feels to take the side of moral bankruptcy. Answer: Pretty good! Thanks for asking. How's it feel to be a disgruntled victim?

Reprise: An Economy Made of Glass

Want a handwavy physics-based explanation for what happened at 2:45 p.m. on Thursday, May 6, 2010? Here's a post from the B.S. archives:

[I]f an economy is modeled as cross-linked clusters of synchronized oscillations, then we might expect to see viscoelasticity and time-dependent transitions in its equilibriums also. Should bubbles and crashes be modeled as viscoelastic creep?

Such an analogy might offer practical value to financial regulators. Generally speaking, the fragility of a glass will depend on the size and shape of the molecular clusters and the number of cross-links among them. The bigger the clusters and the more the cross-links, the more fragile the glass to external shocks. Smaller clusters and fewer cross-links mean less viscosity and elasticity.

We're so heavily cross-linked through digital exchanges and statistical arbitrage, when that big market sell order came through for P&G, the whole market splintered into a thousand desynchronized clusters.

Something I'd like to read more about is what happened in the bond markets at 2:45 p.m. Anybody have a link? Is it the case that credit still gets traded almost entirely by humans? I generally wonder why we don't trade credit the way we trade equity. What are the historical and practical reasons for the fact that we have public indices for equity, but not debt?

CEOs in it for the Long Haul

From Morton Hansen:

This article contains the first ranking that shows which CEOs of large public companies performed best over their entire time in office—or, for those still in the job, up until September 30, 2009. To compile our results, we collected data on close to 2,000 CEOs worldwide.

Thanks to Bob Sutton for turning me on to Hansen's work.

The Social Benefit of Banking

From the profile of Joe Evans in the WSJ:

"Real wealth accumulation in banking is the law of compound interest for long periods of time," he says, criticizing bank CEOs and directors who became obsessed with their stock price.

By extension, wealth accumulation that occurs faster than interest can compound on principal must be derived from pecuniary transfers -- or at least the transactions costs charged for those transfers.

One of the simplest ways to check whether growth of a process is sustainable is to look at whether a stock price is going up faster than the company's free cash-flow can compound interest, even at an exponential rate. If so, then the market is guessing. Maybe it's guessing right. But it's still just guessing.

Markov Tree Options Pricing?

From friend of Broken Symmetry Harish Bhat and his student Nitesh Kumar:

This paper questions one of the fundamental assumptions made in options pricing: that the daily returns of a stock are independent and identically distributed (IID). We apply an estimation procedure to years of daily return data for all stocks in the French CAC-40 index. We find six stocks whose log returns are best modeled by a first-orderMarkov chain, not an IID sequence. We further propose the Markov tree (MT) model, a modification of the standard binomial options pricing model, that takes into account this first-orderMarkov behavior. Empirical tests reveal that, for the six stocks found earlier, the MT model’s option prices agree very closelywith market prices.

With a wink to commenters from yesterday. All models are wrong; but some are less wrong than others. See also earlier ruminations on assumptions of independence in price models.

An Op Amp with Positive Gain?

From the WSJ:

ETF Portfolio Management is using ETFs to create a twist on a hedge-fund strategy called "trend following," which bets on sustained price movements to make returns with low correlation to the broad market. Trend-following funds are part of a group managing $92 billion that returned 18% last year when broader markets plunged, according to Hedge Fund Research. ETF Portfolio Management's funds and the broad group of trend-following hedge funds have slightly negative returns in 2009.

What's new is the ETF implementation, not the strategy of course:

Analyses of rational speculation usually presume that it dampens fluctuations caused by "noise" traders. This is not necessarily the case if noise traders follow positive-feedback strategies--buy when prices rise and sell when prices fall. It may pay to jump on the bandwagon and purchase ahead of noise demand. If rational speculators' early buying triggers positive-feedback trading, then an increase in the number of forward-looking speculators can increase volatility about fundamentals. This model is consistent with a number of empirical observations about the correlation of asset returns, the overreaction of prices to news, price bubbles, and expectations. Coauthors are Andrei Shleifer, Lawrence H. Summers, and Robert J. Waldmann. Copyright 1990 by American Finance Association.

Rick Bookstaber is on the right track suggesting that a central clearinghouse of information on the positions held is probably necessary to stablize the system, at least for now. There are probably stability criteria that can be defined for the market, but no amount of theory will be sufficient without an empirical foundation.

Geanakoplos and Farmer on the Nonequilibrium Statistical Mechanics of Markets

The WSJ leads with Geanakoplos today and Marginal Revolution picks the story up. Skimming through SSRN publications by Geanakoplos, I find this chestnut:

An alternative point of view is that, due to a lack of a perfect rational ity, the market is not in perfect equilibrium and thus prices do not simply passively reflect new information. Under this view the market acts as a non-linear dynamical system: agents process information via decision-making rules that respond to prices and other inputs, and prices are formed as a result of agent decisions. Since this information processing is imperfect, the resulting feedback loop amplies noise. As a result a signicant component of volatility is generated by the market itself.

From a paper co-authored with J. Doyne Farmer.

What makes a market concentrated?

Does this qualify?

These days, bulge-bracket banks -- notably Goldman, Sachs & Co. and Morgan Stanley -- pretty much have a lock on underwriting new issues. (Goldman Sachs, for example, was co-lead manager on five of the seven IPOs that late-September week, and only Vitacost.com turned to bookrunners who weren't bulge-bracket banks.)

Not only does their "brand" dominate, but they've done a good job of convincing pre-IPO companies of their worth. "The common joke is that no CEO gets fired for hiring Goldman Sachs," says Cowen's Biele.

Domination means that these larger banks can pretty much dictate IPO terms. With very few exceptions, they demand IPOs of $100 million or more "to make it worth their while," one venture capitalist says.

That translates into a minimum valuation of $400 million to $500 million, which excludes a whole universe of high-growth, middle-market concerns.

But the FTC and DOJ by themselves cannot solve this problem. They need to work with SEC to clear the hurdles to smaller companies making offerings. Without an IPO option, these companies have to negotiate with potential acquirers with zero leverage.

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.

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.

Mark Cuban on Trading versus Investing

From his blog:

The government should raises taxes significantly on profits from short term capital gains on the sale of public stocks, indexes, commodities, futures held for 24 hours or less and extend the length of time required to qualify for Long Term capital gains and reduce the tax rate on Long Term gains. This will discourage flash trading, ETFs that move markets purely on cash inflows rather than fundamentals and also reduce the amount of speculation on commodities. It will also reward companies that act in the financial interests of long term holders and their employers. I think the impact on the economy would be far fewer layoffs as CEOs find themselves with more shareholders who think long term rather than short term. Believe it or not, there are shareholders who are fine with companies not beating their numbers if the company is making progress towards a clearly defined goal. I don’t care if the P/E of the stocks I own is 14 or 20. I want the companies investing in being a great company rather than trying to make traders of their stock happy. Most CEOs give great lipservice to this approach, but they are so focused on marking to market their own personal stock portfolios, they emphasize stock performance over doing the right thing for the company. Taxation can change the focus on public companies and stock trading. That would be a great thing for the economy.

Great ideas. As an alternative, one could increase the frequency of financial statement reporting -- for example, by requiring public companies to report a time-delayed real-time series of cash-flows -- so that higher frequency trading was based on more substantive information about the value of the security.

Leverage Causes Fat Tails and Clustered Volatility

From Stefan Thurner, J. Doyne Farmer, John Geanakoplos:

When funds use leverage, price fluctuations become heavy tailed and display clustered volatility, similar to what is observed in real markets. Previous explanations of fat tails and clustered volatility depended on 'irrational behavior', such as trend following. We show that the immediate cause of the increase in extreme risks in our model is the risk control policy of the banks: A prudent bank makes itself locally safer by putting a limit to leverage, so when a fund exceeds its leverage limit, it must partially repay its loan by selling the asset. Unfortunately this sometimes happens to all the funds simultaneously when the price is already falling. The resulting nonlinear feedback amplifies downward price movements. At the extreme this causes crashes, but the effect is seen at every time scale, producing a power law of price disturbances. A standard (supposedly more sophisticated) risk control policy by individual banks makes these extreme fluctuations even worse. Thus it is the very effort to control risk at the local level that creates excessive risk at the aggregate level, which shows up as fat tails and clustered volatility.

Netflix Culture

From MG Siegler at Techcruch: (why did he leave Venturebeat for what is turning into a rag?)

The real company values, as opposed to the nice-sounding values, are shown by who gets rewarded, promoted, or let go. Real company values are the behaviors and skills that we particularly value in fellow employees.

PowerPoint here.

The Netflix definition of values is the more coherent, and reminds me of Teece's capabilities models and Nelson and Winter's routines. So how is it that when we think of "company values" we think more of the aspirational statements that seem to have so little impact on how companies operate? Sometimes it seems that the more publicly committed an organization on a particular issue, the less trustworthy its commmitment. Like individuals, organizations that do things don't need to proclaim their ability to do said things.

Thoughts on High-Frequency Trading

I've been thinking about doing a longer post on this topic for a while since it fits so well with the idea of applying Fourier analysis to market regulation. Tyler Cowen blogs about it today:

The correct judgment of efficiency occurs at the system-wide level, not at the level of the individual trading strategy. The short-run story is that private profits exceed social returns but in the longer run the trading activity and liquidity brings increasing social returns and better communication of information.

Especially interesting was the comment from Matt Belcher:

I'm a high-frequency trader so take my comments on that basis. Prior to high-frequency trading and fully-electronic markets, the most trading profits went to the physically largest and most charismatic traders on the trading floors. By being large or gregarious they were more easily able to get the attention of brokers and get filled on their orders first, effectively front-running the other traders on the floor. On the NYSE, the specialist in charge of the book also could also extract profits at will. Since the advent of HFT, profits have moved from these traders to the ones with the best computer scientists. You can argue whether the new market is more efficient or fair, but you can't claim that the old one was somehow perfect and impossible to manipulate.

Putting aside fraud like churning and front-running (i.e., assuming the government is monitoring it!), from a social perspective HFT simply turns the fastest firms into the market makers by giving them a competitive advantage over other market makers in profiting on the spread. One could make a good argument, then, that the investments in HFT are a waste from a social perspective. Given the fact that the frequency of new information about public company stock, for example, becomes available on a time-scale much, much longer than the difference in time-scale between the last generation of market makers and the new generation of HFT market makers, this looks like a classic case of the croupiers on Wall Street taking another cut from the public.

But the argument is not so simple. A key empirical question is whether, in fact, the bid-ask spread has narrowed as a result of HFT. If so, then over a long-enough period of time, it may be that the social benefits of a narrower spread make up for the costs of investing in HFT.

A big picture issue is that the frequency of trading is dependent upon what sorts of information and analysis are done by the trader. If you're going to be day trading, then you ought to have access to HFT technology. If you're buying on fundamentals, then from an IRR perspective, whether you have HFT technology at your disposal will matter only when you're moving around a significant number of the total outstanding shares in a company.

Silly Physicist! Bubbles Need Financing

From the WSJ:

At the summit of the Group of Eight leading nations in L'Aquila, Italy, next week, Ms. Merkel will urge leaders including U.S. President Barack Obama to rein in ballooning budget deficits as soon as the recovery allows, or risk another debt crisis.

She has also called on central banks to reverse their unorthodox measures to increase borrowing and lending once the paralysis in credit markets eases.

Normal, prudent policies should return once economic activity rebounds to its level before last year's downturn, Ms. Merkel says. "Then it will be important for us to take care that we don't set up the next crisis right away by taking too-high risks," Ms. Merkel said in her airy, modern chancellery office overlooking the Reichstag parliament building.

Hmm... Didn't she learn any economics? What about Keynes?

Ms. Merkel, a 54-year-old former particle physicist who grew up in communist East Germany, is strong favorite to remain in office after German elections on Sept. 27.

Well that explains it. I guess she expects actual data to support her economic theories! Actually, I think the WSJ may have gotten this slightly wrong. She is a Physical Chemist.

Via ThinkMarkets.

Highlights from the 2009 IP Business Congress

Monday and Tuesday of this week I attended the second annual IP Business Congress, which this year was venued at the Four Seasons Hotel in Chicago. There were almost 400 attendees at the event, which was a good turnout given the economic climate. Attendees represented stakeholders in nearly every part of the IP Market, both primary and secondary. As expected, the panels organized by IAM magazine were excellent and informative, especially the question and answer sessions afterward. This is an event that I expect to put on my calendar annually.

Highlights for me as an attendee to this event included (1) the first panel on Monday on the state of IP rights in China, India, Japan, Europe, and the United States; (2) the panel on patent pools on Monday afternoon; (3) the panel on open innovation on Monday afternoon; and (4) the Gala dinner on Monday night. Tuesday's panels were also excellent, but of less interest to me because of my more direct involvement with many of the issues addressed on Tuesday.

State of IP Rights Internationally

Harvey (expert on China) kicked things off by noting how IP rights had been a strong influence on the development of rule of law more generally in China: IP was the first private property right to be recognized by the Chinese government after the cultural revolution. Harvey also explained that in number of lawsuits, there is more IP litigation in China than in any other nation. The picture he painted was of a thriving IP system in China that was operating decoupled from the rest of the IP world. The coupling of China's IP system into the rest of the world's will produce winners and losers of epic proportion, and now is the time for us to think strategically about how to prepare our clients and customers for this inevitable merge of the Chinese system into the rest of the world.

McGinley (EPO Officer) followed Harvey with sobering statistics on the patent application bubble that is growing inside the US, EPO, and Japanese patent offices: 2 million applications althogether are now pending inside these offices. Given how the rate of examination has not kept up with the rate of growth in filing, McGinley suggested that the system was beginning to resemble a pyramid scheme! This was a brave position for a government official to take, but everybody in the system should appreciate what McGinley is trying to do. Where might we have been had more financial regulatory authorities here in the U.S. pointed out the pyramid-scheme-like growth of the subprime mortgage market? McGinley was short on answers as to how to solve the problem, but he did suggest that Chinese officials were probably at the top in terms of training practices and the reduction of systematic errors in examination. This seemed unsurprising to this listener given the on-the-ground experience of many Chinese with more complex manufacturing workflows!

The presenter from Japan had little of interest to say, and presented some confusing interpretations of statistics on patenting in Japan. For example, he pointed out that the largest number of patents issued in Japan were to computer companies rather than pharma companies. Pharma companies need only one well-drafted and prosecuted patent to protect their products. This is not very surprising, and is true everywhere in the world.

Basheer from India gave in many ways the most interesting presentation. His was mostly a diplomatic presentation of facts about the IP market in India, where the political agenda is driven by the success of generic drug manufacturers. As a few BS readers may know, Basheer is also one of the authors of the consistently excellent (but very detailed!) Spicy IP blog. From listening to Basheer, one could piece together a picture of India in a critical state, in which more or less IP protection could result from a sharp push in either direction. Too difficult to call for the time being. On my view, it seems that Indian biotech and pharma researchers have a regulatory arbitrage over their U.S. counterparts, who have many years of redtape to cut through before carrying out even relatively safe clinical trials! Note that beating heart transplants are now being carried out in Indian hospitals. There are many high-risk, high-reward medical treatments now avaiable in India that may never be available in the United States. Another trend to watch carefully.

The first question/comment for this panel was also notable. It came from Sherry Knowles of GSK, who noted that Chinese generic manufacturers were getting drugs to market before US manufacturers by simply scraping clinical data off the clinicaltrials.gov website on which U.S. manufacturers, such as GSK, have to post their data by law! There's one for the USTR to call to Chinese government attention.

Patent Pooling

The Monday afternoon panel on patent pools included Sisvel founder Dini, Hinman from Verizon, and Michel from the FTC. Dini gave a great pitch for hiring independent administrators (such as Sisvel) for allocating profits among patent pool participants, and for getting such admins involved at as early a stage as possible. Michel gave a presentation of the recent history of FTC regulation of patent pools, including a summary of the federal court holdings relating to Rambus's participation in JEDEC. Hinman talked about the perils of patent pool participation, and noted that even opt-out could be anti-competitive. Referring to one patent pool in particular, he pointed out that all but two industry participants had entered. I saw Michel scribbling notes!

The upshot is that if your company is involved with patent pools, you need to hire experienced outside counsel with knowledge at the interface of IP and Antitrust law to help ensure your business strategy reduces the risk of antitrust liability. Your author knows and works with a few such experts, and is happy to make an intro. Note that most corporate lawyers or IP lawyers will not be aware of the perils of competition law because the Bush and Clinton administrations were relatively lax on this front. All indications are that the Obama administration will be more active in enforcing competition law.

Open Innovation

By now the term "open innovation" has become relatively well-known within the business community. Some IP owners may believe that open innovation represents a form of socialism -- an alternative to a system of property rights. Attendance to this panel would have been the antidote to such misunderstandings of this theory. Panelists Weedman from P&G, Simonton from Exelixis, and Bergelt from the Open Innovation Network (and formerly of Paradox) talked about the dynamic growth that the feedback loops established by open innovation networks facilitate for the companies that take open innovation seriously.

Because the theory of open innovation is a paradigm shift from traditional neoclassical economic theories, only a handful of businesses (including P&G and Exelixis) have been fortunate enough to find leaders willing to foster the organizational commitments necessary to make open innovation work. This business model is the future of every large public corporation in the world. Watching these businesses continue to outgrow their competitors, others will eventually follow.

Gala Dinner

One of the best parts of the event was meeting the attendees. Over drinks before the Gala dinner, I had the chance to catch up with Niels Reimers, who later that evening was inducted into the IP Hall of Fame for his path-breaking work in technology transfer. In this rare moment of opportunity, I had the chance to ask Niels about how he worked at Stanford. By Niels's description, he was practicing the same technique followed by the best founders and managers in Silicon Valley both then and now -- "management by walking around." Dave Packard and Bill Hewlett, Bill Perry at ESL, and Nils at Stanford were all doing management by walking around. Niels's personal accounts of his work connecting Stanford music department (!) professor John Chowning with Hamamatsu corporation engineers were a highlight among highlights for this event.

Later, when Niels cited the Teece Model of innovation in his acceptance speech, I nearly fell out of my chair. The same model was cited by FTC Commissioner Tom Rosch in his speech about new theories in competition law on June 1, 2009. Note that Teece was also cited in the explanation of systems theory provided in your author's letter comment to the FTC on the Evolving IP Marketplace.

Final Thoughts

Another highlight made possible by my attendance to the event, but not directly related thereto, was an invitation to a breakfast with Congressman Bill Foster on Tuesday morning. I am already a fan. Foster is an entrepreneur and physicist who decided (after 22 years of building superconducting magnets to detect subatomic particles) to roll up his sleeves and try to help fix government. I'm pretty sure there's nobody else in Congress who would know what the title of this blog refers to. The discussion of the patent system and innovation at this breakfast was the best I've heard ever anywhere, but it also revealed to me the underlying problem facing patent reform: nobody has a complete view of the whole system. Almost everybody (at least) focuses on the broken incentives and procedures facing them in their subsystem, without stepping back to see how all of the subsystems coalesce into an competitive and innovative ecosystem. Nonetheless, the kinds of questions asked and answers given at this breakfast suggest that already the level of discourse has progressed far beyond the pat answers that were served up last year when patent reform was before Congress. There is more widespread awareness at least of how the public has been manipulated to some extent by the more technologically sophisticated and media-connected subset of stakeholders in the system. Perhaps we will have sensible patent reform after all. Here's to that hope.

Judge Posner on the Systems Theory of the Financial Crisis

Yet even if all firms that create systemic risk decided to shrink, or to reduce their interactions with other financial firms, systemic risk would not be eliminated. For such risk is a property of the financial system rather than of individual firms. That is, systemic risk is correlated risk. If the entire banking industry were heavily invested in home mortgages, and a housing bubble caused a drastic fall in the value of those mortgages, it wouldn't matter if the industry consisted of 10,000 banks of equal (and therefore equally small) size that had no dealings with other financial firms. The whole industry would be brought down.

Read the whole post here.

The Glassy State of the Financial Services Industry

How might financial regulators have identified a problem with our market? By looking at cross-correlations like this one:

Again, this is from the paper on synchronized clusters reviewed here.

More on the Glassy Economy

I had to revisit the paper by Yik Wen Goo, Tong Wei Lian, Wei Guang Ong, Wen Ting Choi, and Siew-Ann Cheong, which I reviewed earlier here. As explained in the earlier review, these researchers found correlations in public security prices by looking for cross-correlation at successively longer and longer time scales. Lo and hehold, they were able to identify synchronized clusters that way:

We call these small clusters of very strongly correlated stocks financial atoms. The correlation levels within financial atoms rise significantly above the background level c0, because the dynamics of atomic stocks are coherent over time scales much longer than the average trading interval, which plays the role of the ‘nuclear/electronic’ time scale. The existence of such financial atoms is evident from earlier studies [citations omitted], where they are referred to as synchronized clusters. However, the separation of ‘nuclear/electronic’ and atomic time scales was not recognized. The potential of using financial atoms as effective variables to describe real financial markets is also not widely appreciated.

So not only is it possible that the economy is in a glassy state, there is some numerical data demonstrating that it actually is.

Their use of terminology is unfortunate, because it would be better to think of individuals as the "atoms" of an economy on my view. In that case, corporations would be molecules, and what they call "financial atoms" would be analogous to the chains and sheets of molecules described in the post yesterday on an economy made of glass.

Before I saw the White Paper from the Obama administration, I was hoping they had people that were already doing this kind of analysis. I'm no longer so optimistic. Can I ask for help from anybody and everybody who understands this type of analysis in educating the public and government in its implications? We'll all be better off that way in the end.

More Evidence for Synchronized Flow

Ironman provides an excellent review of some posts on Broken Symmetry, and (even better) provides a beautiful review of how the frequency spectrum of price fluctuations alternates between Gaussian and Levy statistics at Political Calculations:

We thought it would be appropriate to close out this post by reviewing the modern era of the stock market (or rather, most of it!) with our charts that identify the periods where Gaussian rules would apply, and the periods where Lévy flights rule. While we consider the modern era of the U.S. stock market to have begun in January 1952, we'll pick up the action in June 1954, extending to when the most recent period of disorder began in January 2008:

The bottom line here is that you can't understand build up a realistic model of an economy starting from the assumption that preferences are time-independent. The better way to start is with the assumption that preferences are oscillatory. I call this "the fundamental hypothesis of periodicity," and it produces the hypothesis of rationality at the limit of ergodicity -- i.e., when preferences behave the same way from one time-window to the next.

A Systems Theory of Financial Regulation

From Geithner and Summers:

First, existing regulation focuses on the safety and soundness of individual institutions but not the stability of the system as a whole. As a result, institutions were not required to maintain sufficient capital or liquidity to keep them safe in times of system-wide stress. In a world in which the troubles of a few large firms can put the entire system at risk, that approach is insufficient.

Perfectly consistent with Summers's column on "Regulatory Systems Design" almost a year ago today.

For a systems theory of patent law, see Question 9 here.