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September 27, 2009

Economist's View - 4 new articles

When You Believe in Things That You Don't Understand...

Robert Shiller defends financial innovation:

In defense of financial innovation, by Robert Shiller, Commentary, Financial Times: Many appear to think that the increasing complexity of financial products is the source of the world financial crisis. In response to it, many argue that regulators should actively discourage complexity. ... They do have a point. Unnecessary complexity can be a problem ... if the complexity is used to obfuscate and deceive, or if people do not have good advice on how to use them properly. ...
But any effort to deal with these problems has to recognize that increased complexity offers potential rewards as well as risks. New products must have an interface with consumers that is simple enough to make them comprehensible, so that they will want these products and use them correctly. But the products themselves do not have to be simple.
The advance of civilization has brought immense new complexity to the devices we use every day. ... People do not need to understand the complexity of these devices, which have been engineered to be simple to operate.
Financial markets have in some ways shared in this growth in complexity, with electronic databases and trading systems. But the actual financial products have not advanced as much. We are still mostly investing in plain vanilla products such as shares in corporations or ordinary nominal bonds, products that have not changed fundamentally in centuries.
Why have financial products remained mostly so simple? I believe the problem is trust. ... People are ... worried about hazards of financial products or the integrity of those who offer them. ... When people invest for their children's education or their retirement, they ... may not be able to rebound from mistaken purchases of faulty financial devices...
Thus, to facilitate financial progress, we need regulators who ensure trust in sophisticated products. ... They must ... be open to ... complex ideas ... that have the potential to improve public welfare.
Unfortunately, the crisis has sharply reduced trust in our financial system..., people do not trust some good innovations that could protect them better. ... I have proposed ... "continuous workout mortgages"...[to] protect against exigencies such as recessions or drops in home prices. Had such mortgages been offered before this crisis, we would not have the rash of foreclosures. Yet, even after the crisis, regulators seem to be assuming a plain vanilla mortgage is just what we need for the future. ...
Another innovation that is underused is retirement annuities... There are ... annuities that protect people against outliving their wealth,... that protect against inflation,... that protect against having problems in old age... and generational annuities that exploit the possibilities of intergenerational risk sharing. But most people do not make use of any of these.
Ideally, all of these protections for retirement income should be rolled into a unified product. Such products are not generally available yet. Certainly, people might be mistrustful of committing their life savings to such a complex new product at first even if it were available. So, such products are not offered and people often do nothing to protect themselves against most of these risks.
Behind the creation of any such new retail products there needs to be an increasingly complex financial infrastructure... It is critical that we take the opportunity of the crisis to promote innovation-enhancing financial regulation and not let this be eclipsed by superficially popular issues. ... Regulatory agencies need to be given a stronger mission of encouraging innovation. ...

Something has to assure people that these product are safe before they will purchase them. We might have expected the market to regulate risk not so long ago, and trusted it to do so, but that seems like a bad bet now. An "interface with consumers that is simple enough to make [the products] comprehensible" could build trust if people could believe that the person doing the simplifying had considered and understood every possible risk that is attached to the product, but did anybody really comprehend the big picture in our most recent crisis? If there were such people, there weren't very many of them, not enough to inspire confidence and trust more generally.

Another method of building confidence is ratings agencies, but they won't be trusted again any time soon. Regulators that make the public confident that nothing can go wrong would help too, but building that kind of trust in regulators after what just happened is a tall order. Private insurance of some sort is an option, but absent some sort of government guarantee, can private insurance companies be trusted with your life savings if there is a severe financial meltdown? People have even lost faith in government's ability to insure people against medical and financial calamity in old age, so when it comes to providing financial insurance, government is not the solid, trusted institution it was not so long ago.

As you tick down the list of ways trust might be restored, you find one failure after another in terms of providing reliable information on the risks of particular financial products or strategies, and no matter what regulators or anyone else tries to do to rebuild the trust in financial institutions and products that has been lost, recent track records make it likely that this will be a long, drawn out process. Given that forgetting about such risks over time seems to be an ingredient in the development of bubbles, I'll let you decide whether that's good or bad.

"Gold Buggery"

Barkley Rosser:

Washington Post Puffs Gold Buggery, by Barkley Rosser: The business section of today's Washington Post contains one of the most ridiculous news stories I have seen yet. I would not mind if this were a column, but "What's Making Gold a Hot Commodity" by Frank Ahrens is supposedly a news story, and as such it should not contain whoppingly erroneous statements without some correction. So, Ahrens himself says the following: "In the long term, with each new dollar introduced into the system, each dollar you hold becomes worth less. That's more than just inflation, which we think of as simply rising prices. That's debasement of not only our currency, but the globe's reserve currency." It may well be that nonsensical thinking such as has this pushed the price of gold back over $1,000 per ounce again, but why should a business section reporter repeat it without the slightest doubt. It is not even good monetarism, as monetarists only view money supply expansions beyond growth of real output and not offset by velocity changes as inflationary. A bit later, Ahrens uncritically quotes Peter Boockvar, an equities trader at Miller Tabak: "It amazes me that any self-respecting central banker is not alarmed that gold is over $1,000 an ounce and the dollar is trading at all-time record lows." All-time record lows? Only against gold. Currently the dollar is about 1.46 against the euro, while it hit 1.5990 in July 2008. It is around 92 against the yen, but in 1995 got as low as 79.95. It is a bit over 1.5 against the pound, but was at 1.98 last year (and further back in history was over 4.0). Utter drivel. I do recognize that later in the article Ahrens brings up some factors that might caution people a bit against buying gold too frenziedly, such as how much of it is held by central banks, and how little demand for it is due to industrial use (only about 10%). But he never mentions that it has already been above $1,000 twice before, only to fall back, and in the late 1970s was much higher in real terms, at well over $800, only to fall very far below that and stay well below that for decades. The warnings could have been a bit clearer, along with avoiding mindlessly repeating totally ridiculous non-facts spouted by wacko gold bugs.

"250 Years of Clever Counting"

Stephen Ziliak emails:

Only moralists and economists know that Adam Smith's Theory of Moral Sentiments (1759) turned 250 years old this year.
However worthy an Adam Smith party, I thought you'd like to know about another party and sentiment, "Arthur's Day" - the Guinness Brewery's 250th birthday party - to be celebrated Thursday, September 24th, all over the world:
My article, "Great Lease, Arthur Guinness - Lovely Day for a Gosset!" (prepared for a special "Beeronomics" issue of the Journal of Wine Economics), shows how clever counting at Guinness did not stop two and a half centuries ago when Arthur signed a 9,000 year lease for the brewery, house, and land at St. James's Gate in exchange for 45 pounds a year (nominal, not inflation adjusted)!
"The great innovation in statistics in the era after Galton and Pearson was made in the private sector of the economy, between 1904 and 1937, at Guinness's Laboratory, to the end of improving, however gradually, production of a consistent beer at efficient economies of scale" (Ziliak 2009, p. 4).

Here's the article "Great Lease, Arthur Guinness—Lovely Day for a Gosset!":

Abstract: Small sample theory—the great innovation in statistical method in the period after Galton and Pearson—was ironically discovered by a brewer during routine work performed at a large brewery, Arthur Guinness, Son & Company, Ltd. For four decades William S. Gosset applied small sample experiments to the palpable end of improving, however gradually, the production and control of a consistent unpasteurized beer when packaged and sold at efficient economies of scale. Introducing, "Guinnessometrics." Annual output of stout at Guinness's Brewery may have topped 100 million gallons but Gosset's scientific knowledge was built one barleycorn at a time; in fact, the inventor of small sample theory worked closely with botanists and breeders. In the process, the brewer, William Sealy Gosset (1876-1937) aka "Student," an Oxford-trained chemist—though self-trained in statistics—solved a problem in the classical theory of errors which had eluded statisticians from Laplace to Pearson. In addition, though few have noticed, Gosset's exacting theory of errors, both random and real, marked a significant advance over ambiguous reports of plant life and fermentation asserted by chemists from Priestley and Lavoisier down to Pasteur and Johannsen, working at the Carlsberg Laboratory. Central to the Guinness brewer's success was his persistent economic interpretation of uncertainty, what Ziliak and McCloskey (2008) call the "size matters/how much" question of any series of experiments. An enlightened change in Guinness human resources policy gave an incentive structure that also seems to have nudged "Student," who rose in position to Head Brewer, to find a profit when the opportunity knocked. Beginning in 1893, Guinness vested "scientific brewers" such as Gosset with managerial authority. In fact Gosset was at times involved with price negotiations over hundreds of tons of barley and hops—perhaps hours or minutes before he ran (that is, calculated) a regression on related material. In brewing circles William Gosset is remembered less nowadays than he might be. He did not give two cents for arbitrary rules about statistical significance—at the 5% level or any level arbitrarily assumed. How the odds should be set depends on the importance of the issues at stake and the cost of getting new material, he said from 1904. Yet even in brewing journals, both academic and trade, and for the past 85 years, statistical significance at the 5% level continues to draw its arbitrary line segregating a meaningful from a non-meaningful result, a better barley from a worse.

links for 2009-09-26

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