Sunday, October 15, 2017

Can We have an ETF Meltdown?

What is the magic that allows us to have intraday liquidity through an ETF on a market that itself trades more or less by appointment?  Case in point: the high yield bond market.  Or emerging markets. Or just about any bond market short of sovereigns and maybe agencies.

Suppose there is a sudden rush for the exits in the high yield bond market. Those in the cash bonds know the drill. They will put in orders with the bank/dealer market makers. For a while those high yield bond trading desks will buy the bonds and hold them in inventory. But it won't take long for the trading desks to reach their capacity. After that point, they won't be buyers. They will act as agent -- also knows as riskless principal -- and look for someone on the other side of the trade. In the meantime the seller has to bide its time. The point is that on the cash bond side, it is not an intraday sort of a transaction. It can take days to find the other side for the trade. And anyone who is active in the high yield bond market knows that, so they structure their leverage and liquidity accordingly.

However, those in the ETFs by and large have no inkling that this is the way the market for high yield bonds works. As far as they can tell, the ETFs trade like an S&P 500 stock. You put in an order to sell, and you are done in minutes.

The reason there is typically high liquidity in the ETFs is that there is typically good two-way flow. And beyond the buyers and sellers are what are called authorized participants. The authorized participants keep the ETFs linked to the underlying cash bonds. They can create ETFs by buying up and bundling the underlying bonds, and they can take in the ETFs and unbundle them and sell the underlying bonds. In a functioning, two-way market, this all works the way arbitrage does for equities indexes. If the ETFs are at too high a price relative to the cash bonds, they grab the cash bonds to create and sell ETFs. If the ETFs are at too low a price relative to the cash bonds, they buy the ETFs and take the bonds to sell in the bank/dealer market.

It sounds simple, but it can't really be foolproof. You know there must be something that can go wrong when you have an instrument -- the high yield bond ETF -- that is as liquid as water even though the bonds it contains are almost the definition of an illiquid security. There is something akin to trying to cheat the law of conservation of momentum. And we all know that anytime something depends on some notion of arbitrage, things can go off the rails. I was in the middle of the portfolio insurance problems that led to the market crash in October, 1987. I knew all about option theory, but when the market was in free fall and the bid-offer spread for the S&P 500 futures was over a dollar, no one was in the mood to try to keep prices in line by doing delta hedging. Options traded in their own world. Implied volatilities were 80% and higher. The option market went into rotation -- trading one stock at a time throughout the day.

For the ETFs, things can go off the rails if the authorized participants can't do their job. If there is not a two-way market, and if the authorized participants' inventory is filled up with ETFs, and if they see that it will take days to get the bonds off of their hands, at the very time that prices are going crazy, they will be stepping away. At that point there is nothing tethering the ETFs to the cash market. The ETF market and the high yield bond market will each trade as their own thing, based on who needs to sell and who is there to buy. At that point it might as well be one market for Martian gravel and another for Enceladian ice cones.

Sure, that is taking it a little too far. There will be some real money investors who will finally step in and keep things from moving into a totally imaginary world. But for the time being the ETF market will, for all practical purposes, shut down. And, getting to the next chapter in this story, it is the "for all practical purposes" that matters.

A clear-thinking, experienced investor in, say, an ETF on an equity market index or gold or currency will not be bothered much by the failure of the high yield bond ETFs. They will get the point that the high yield ETF was creating a fiction of liquidity when there wasn't any, whereas in these equity and currency and commodity markets the underlying markets trade with pretty much the same liquidity as the ETF. But for many investors, all they will hear is that ETFs are in trouble. In the face of the major market dislocation in which the high yield bond problems are likely to be embroiled, people are already going to be in risk-off mode, and if they smell some sort of structural risk with these "newfangled ETFs" they will sell them, period. And there will be plenty of sources out there ready to spread the view that something is amiss.

And, getting to Soros's theory of reflexivity, the changing expectations that come from people in the market buying into this view means that those clear-thinking experienced investors will get out of these more liquid ETFs themselves. And if the authorized participants are still up for doing their job in those markets, that selling will feed back to drop the underlying markets in equities, currencies, and commodities.




Sunday, October 1, 2017

Out-there Scenarios I: ISIS is Funded by a Major Asset Management Firm

I break risk management into three levels, Versions 1.0, 2.0, and 3.0.

Risk Management 1.0 is the standard risk management of VaR and the like, where history is used as a guide, and thus where things work if the future is drawn from the same distribution as the past. Any approach that is looking at risks historically, whether using past prices or variance-covariance relationships or leverage numbers or credit ratings; whether using a normal distribution or a t distribution or a gamma distribution or a part of a distribution like semi-variance, is part of this.  If the future looks like the past in some specific ways, it works; if the futures deviates from the past it might not work.

Risk Management 2.0 is a reaction to the fact that the 1.0 methods failed during the 2008 crisis.  This failure is not surprising or unexpected by most of those working in risk management, because we understand the assumptions behind Version 1.0.  But sometimes this was not articulated well when the numbers were passed up the chain.  In any case, after 2008 risk management started to depend more visibly on stress testing. I say "more visibly" because anyone doing risk management over the past decades has done stress testing in one form or another. Certainly when there are non-linear risk-return tradeoffs, like with option exposures, it is a standard method.  But after 2008 it became de rigor in the analysis of bank risk, for example using CCAR.

And there is Risk Management 3.0, which I won't get into here.  It recognizes that a static stress will miss important dynamics that lead to feedback, contagion, and cascades.  And it is not something that can be readily addressed with the standard economics. You can check out my book, The End of Theory, or some of my papers while I was at the Office of Financial Research to get more on this.

Here I am focused on what we need to do before we can get to these dynamics: We need to know what is triggering a market dislocation. And we are particularly interested in triggers that are large in either magnitude or in the number of agents that are affected.  So even before worrying about the methods for dealing with crisis dynamics, the question to ask is: What can go wrong in a really big way.

I sometimes get at this by starting with something really extreme, and then dialing it back until it can be considered as a reasonable scenario. Reasonable does not mean it is likely to happen, but it also is not "what if an asteroid hits New York" either. Anyway, I want to run through some of the extreme scenarios that I have been thinking about. I'll put one out here and see if anyone responds, either with comments on it in particular, or with others that they are cooking up in a similar vein.

So, Out-there Scenario I: A large asset manager is rumored to be funding ISIS.

Suppose a rumor goes viral that a very large asset management firm is actually owned by, or at least is funding ISIS. This hits all the usual fake news outlets, and is then, of course, bounces into the real news if only as a "there is a rumor, unsubstantiated, making the rounds that...." The result will be large scale redemptions in that asset manager. This will start a downdraft in the markets. It will also lead to questions about other asset managers, and redemptions there as well. The resulting cascade could spread across the markets, erode confidence, and become a major market event.

Now, of course (at least I hope it is obvious) I am not saying specifically that this rumor is likely. But start with this and, as I suggested above, dial it down a bit. The point is, we can come up with scenarios where there can be massive redemptions in some particular major asset manager, and they can be exogenous to anything in the market, and on the face of it might be unreasonable.

One argument against this path to major redemptions hitting the market is that people can redeem by moving their holdings to another asset manager. If they do that there will be no actual selling of assets, and no market impact. This is the way investors will redeem if they continue to want to hold the assets and if they operate with professional aplomb. But the sort of people who would buy into a rumor like this are also likely to simply say, "give me my money", and then figure out what to do after that.

A little footnote: A few years ago the Office of Financial Research did a research study of the asset management community, with the key question being whether the largest asset should be SIFIs (systemically important financial institutions). The report was castigated, especially by the SEC, mostly, I think, because the SEC was honed for inter-agency rivalry. But in any case, no one threw the ISIS scenario into the report.


Tuesday, September 19, 2017

Risk Management in the Long Term

I work in a pension fund. And pension funds, as well as sovereign wealth funds -- which are like pension funds for an entire country -- need to take the long view. The liabilities can stretch out for twenty or thirty years. And a lot can happen in between. But some of this is not too hard to divine. In fact, ironically, the issues that extend to the long term are in some ways more predictable than those of the shorter term. Things like demographics, changes in demand due to the adoption of new technology, fixed income of retirement, and, unfortunately, climate change.

The thing about demographics is that you get plenty of warning. If the driving issue for risk is what twenty year-olds are up to, you get to know how many twenty year-olds you will be dealing with twenty years ahead of time. (Excluding immigration.) And, similarly, you have a pretty good head start in knowing what lies ahead as people retire, like, that they will live longer, and that there is a sizable group that does not have enough between savings (which is close to zero) and social security and pensions (which averages under $20K a year) to make a go of it.

Demographics is a slow motion tidal wave that washes over society. Look at how our institutions have changed as the baby boomers moved into school age (remember split sessions as elementary schools became overcrowded ) and then college age, and then became home buyers. And now they are moving into retirement, an age of dissaving, of heading off to Florida, and of consuming more and more health care resources. Will we soon see in reverse the housing boom that occurred when the baby boomers reached house-buying age. Will the cash strapped Millennials be able to pick up the inventory? In a time when dining rooms and living rooms are the housing equivalent of an appendix, will there be demand for what will be coming onto the market?

We don't know what lies ahead for technological innovation, but we do know the longer-term trend as the technology that we already have is improved and adopted. Jobs in transportation will shrink. Jobs generally will shrink. The oil, insurance, and auto industries will face huge disruption. The wonders of innovation will meet the realities of political will. The winner-takes-all business models, Amazon being the dominant case, will find increasing headwinds from the regulators and lawmakers.

What is true for the path of demographics is also true for climate change. We have a pretty good read on the direction, if not the magnitude, of climate change. There has been so much energy expended in fighting the pushback on whether climate change is real that we haven't had the energy to contemplate the full implications of its course. If you want to get a scary version of what can happen, read the New York Magazine article The Uninhabitable Earth. The author spoke to climate scientists about their views of the future, views that they generally do not share publicly because it is hard enough to put the simple, non-dire view out there without dodging tomatoes. The dire-view list includes, section by section in the article: heat death, the end of food, climate plagues, unbreathable air, perpetual war, permanent economic collapse, and poisoned oceans.

Where does all this lead? To something that is more concerning (well, not as concerning as heat death, the end of food, and the rest) than the trends themselves: social revolt. The ushering in of the industrial age had its Karl Marx and its hundred years of revolution rolling across the globe. What will we see rolling across the globe when the broadly predictable demographic, retirement, employment, and climate trends take their course during the next decades? (And I haven't even discussed the implications of all of this for rising inequality and marginalization.) When we have a younger generation trying to support an older one that outnumbers it by some multiple; when it is doing so without being able to find meaningful (or just about any) jobs; where the retirees do not have the wherewithal for self support; all with the backdrop of a climate that is making the earth uninhabitable in multiple ways?

Has the UFC Jumped the Shark?

Now, in the middle of hurricanes, Trump, and a (possibly) overheated stock market, here's a blog about something different and somewhat inconsequential: The mixed martial arts world, which pretty much means the UFC.

I have been interested in martial arts for a long time -- I have been training in Brazilian Jiu Jitsu for over twenty years -- and have enjoyed the increasing interest in mixed martial arts. But about a year ago the dominant organization for mixed martial arts was purchased by a consortium of WME and IMG for a staggering $4 billion. These are organizations that are not focused on sports, but on entertainment, and the UFC has followed the lead to increasingly become an entertainment enterprise. 

In its first incarnation, the UFC was a little better than a refereed bar fight. Such as it was, these fights are what got me interested in Brazilian Jiu Jitsu, because Royce Gracie, a member of the famous Gracie clan that brought BJJ to the U.S., defeated opponent after opponent regardless of the size differential using these ground-based techniques. I train at his nephew Renzo Gracie's academy in New York (I'm bottom right, Renzo is two to the left of me).

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Then in 2001 the UFC was bought by the Fertittas brothers, and it was rebuilt as a serious sports enterprise. Over time it attracted top athletes, first men, and then women, most famously Ronda Rousey, that fought in weight classes built on a professional structure. 

But if you want to recoup that sort of investment, you have to reach for a broader audience. You have to create buzz and spectacle. The poster child for this, of course, is the fight between Floyd Mayweather and Connor McGregor. This fight pitted two men who were undefeated in the boxing ring.  One with a 49-0 record, the other undefeated for the same reason that I remain undefeated as a professional boxer. He had never been in the ring. 

This fight looked more interesting than it fundamentally was. Mayweather promised to give the spectators a show, and the match lasted for ten rounds of boxing action. In part because Mayweather didn't bother to throw punches for the first rounds, and then let the exhausted Connor gamely trudge on until he leveled him with a barrage. The slow start could be chalked up to caution on Mayweather's part, making sure he understood an opponent that he had never seen in the ring before. Or it could be that he didn't want fans who spent hundreds of million of dollars to watch the fight head home after a few minutes. 

This fight will mark the turning point, when the sport, at least in its most popular venue, will have jumped the shark. Former UFC champion Benson Henderson put it succinctly, "It's a very slippery slope when you have a world champion boxer fighting an MMA guy for the sake of money, and he can't knock him out in the first round," Henderson said. "He has to make sure he carries him a little bit. For me, that's too close to skirting the edge [of a fixed fight].

Now Paulie Malignaggi, a sparring partner for McGregor and world champion in two weight divisions before retiring earlier this year, has been trying to get into the circus by fueling demand for a grudge match with McGregor based on a falling out after a video appeared that showed Malignaggi hitting the canvas during a sparring session. He argued it was a push, McGregor's camp called it a knock down. 

In any case, there is more showmanship where this is coming from. With Mayweather versus McGregor we had boxer versus MMA fighter.  But before that, we had the WWE star CM Punk come into the UFC octagon to get destroyed (surprise) by a UFC professional of no particular note. We are having a fight of 38 year-old Michael Bisping, who last fought a year ago, versus 36 year-old George St-Pierre, who retired five years ago. And we have another MMA versus pro wrestling bout being bandied about between Jon Jones and Brock Lesner. There is a huge weight discrepancy between them, so maybe it will be billed as David versus Goliath. It also could be billed along some lines related to the fact that both fighters have been banned from legitimate fights for failing drug tests. 

Wednesday, August 30, 2017

Megalomaniac

Many of us wonder what drives President Trump.  Or more uncharitably, what is the nature of his mental instability. The natural place to turn is the psychiatric community, but they have walled themselves off from the discussion because of the American Psychiatric Associations's Goldwater Rule, which prohibits them from diagnosing anyone they have not personally examined. Now a few people are peeking out from that wall.

In an Op-Ed piece yesterday in the New York Times, under the cover of a broad discussion of how decisions should be made on whether someone, say Trump, is unfit to govern, the authors, two psychiatrists, (one by the way a Democrat and the other a Republican), wrote this:

"Today, diagnosis is often linked to observable traits, making evaluation at a distance plausible. Even if Mr. Trump refused to cooperate, diagnosis might be the easy part — perhaps too easy. Whether or not they can say so, many experts believe that Mr. Trump has a narcissistic personality disorder." 

Starting with this opening, we have a comment from a reader, a professor emeritus of psychology, featured as one of the NYT picks, who wrote that "Donald Trump, in words and behavior, has every single symptom needed for an unequivocal diagnosis of Narcissistic Personality Disorder according to the latest diagnostic manual (DSM-V) of the American Psychiatric Association." 

I have heard people casually being described as narcissists, so I checked out what Narcissistic Personality Disorder really is. In the Wikipedia entry, the first thing I saw is a synonym: Megalomania. This does not bode well -- it is one thing call someone a narcissist, or to go further and have a serious clinical discussion a personality disorder.  It is another to be saying, in different words, that your country is run by a megalomaniac. 

Then I skipped down to the symptoms:

  1. Grandiosity with expectations of superior treatment from others
  2. Fixated on fantasies of power, success, intelligence, attractiveness, etc.
  3. Self-perception of being unique, superior and associated with high-status people and institutions
  4. Needing constant admiration from others
  5. Sense of entitlement to special treatment and to obedience from others
  6. Exploitative of others to achieve personal gain
  7. Unwilling to empathize with others' feelings, wishes, or needs
  8. Intensely envious of others and the belief that others are equally envious of them
  9. Pompous and arrogant demeanor

Reflecting on these symptoms, I would submit that there is more clarity for a diagnosis of President Trump based on his observed behavior over the course of his presidency than there would be by having a personal examination by a psychiatrist. Trump is mentally ill, the diagnosis is clear, and it is time for those in the psychiatric community to come forward. Literally, our country is being run by a megalomaniac. 

Friday, August 4, 2017

I'm going to start blogging again

I stopped doing posts on this blog in 2014. I found it too time consuming, and I had painted myself into a corner by the narrow topics, the tone, and the article-like discourse.  So I'm going to do a reset. I will just throw things out there that are on my mind, crafted to be one step better than stream of conciousness.  It will be more like Tweets without the character constraint.  At least that is my plan.

For now, as those of you who have found their way to this post might know, I came out with a new book a few months ago called The End of Theory. (I hate linking to Amazon, but that is where people will end up going.)

When I started it, my objective was to explain the use of agent-based modeling to deal with financial crises. I had been working on this at the Office of Financial Research. But in order to motivate the use of this new method, I felt I should explain why economics could not do the job. That took on a life of its own, and by the time I was done my "how-to" book on agent-based modeling had expanded to be a critique of neoclassical economics with the agent-based model proposed as a replacement -- a new paradigm.

I wish I had taken notes as I went along so I could figure out how the book morphed from my original intent. But in any case, I am proud of the end result, and I hope you will find it thought-provoking.

To get a sense of the ideas behind the book, here is a recent interview I gave for The Institute for New Economic Thinking which gets to the key themes.

And, for a more in-depth treatment, here is the webcast of a talk I gave in June at the OECD.

Tuesday, November 25, 2014

Uber: What could possibly go wrong

Uber at the core is nothing more than a bunch of guys who came up with a clever app for streamlining the way you call for a car.  Rather than phoning or texting, you tap on the app.  Rather than paying with cash or credit cards, you have an account.  And rather than depending on the reputation of the car company, you depend on the ratings-based reputation of the specific driver. (Another feature, the pre-determined fare, with that fare essentially including all fees including tip, is nothing new for car services). And, by the way, it is readily replicable by any other car services, including those that already have a reputation and experienced drivers.  

So it seems to me that it is only mildly innovative.  How do you build a successful world-wide  company based on this? I don’t think you do. We are already seeing some of what can go wrong.  We can attribute a lot of this to their own doing. But we are only getting started. Here are four other things that come to my mind. 

A meta app. If a number of Uber competitors, existing limo companies, and taxis put out similar apps, (which they are), the next stage will be a meta-app that looks across all of the companies, scans their car locations and prices, and combines this with the user’s preferences to find the best deal. I would bet that Uber will decline to be involved, but if a broad base of other limo companies do, and it ends up being Uber versus the world, I don't think that will turn out well for Uber. 

Uber’s costs are underestimated. To some degree Uber is thriving by creating a regulatory arbitrage.  It is operating without the constraints of existing car services and taxis. That gives it lower costs. But that is not going to last. The arbitrage window will close, and the related cost advantages will disappear.

The first out of the gate usually doesn’t win.  Uber is doing all the heavy lifting in terms of clearing regulatory barriers and local opposition, and getting consumers warmed up to the idea of using an app for calling cars.  It has made life harder for itself by defining its business as being more than an app and fighting its way through this morass.  But as many business school case studies have demonstrated, the company that blazes the trail is often not the one that stakes the biggest claim in the end.  If could be a set of future entrants.  Or it could simply be efficiencies that ultimately are picked up by existing car service without any one winner.  

Self-driving cars.  I’m not kidding -- and neither is Google.  Self-driving cars are, though it is hard for me to believe, predicted to become a consumer reality in five to ten years.  With these cars, the concept that is gaining momentum via Uber will become a reality.  Tap on your app, and a car will quickly appear to take you on your way.  This is not so far in the future, especially in the time scale of a company. The timeframe for profitability extends far into the future; indeed, many companies with high valuations don’t even turn a profit until five or ten years out. By then, the essence of Uber’s model might become irrelevant. 

People are attributing to Uber as a limo company what is really an app, and a new attitude by consumers towards car services that has come with it. If you have discovered a new and liberating method of obtaining transportation services, that is one thing, and you can thank Uber for bringing that to you.  But ultimately you won’t need an Uber driver for using it.  

Wednesday, November 19, 2014

On Death with Dignity

We take the will to live as a positive attribute, and naturally so; it is, of course in our genes.  Whatever subset of our species took a lackadaisical view toward the prospect of death was screened out long ago. We look with admiration on those who battle against terminal illness --  “She’s a real fighter” -- and look down on those who take their own lives. Fighting for your life is the genetic prime directive.   


Thus the recent death of Brittany Maynard spurred a flurry of news articles and posts on the Death with Dignity movement. There will be a lot more to come on this topic, and the movement will gather steam because whatever is in the crosshairs of the baby boomers weighs down on society as a whole. Soon the baby boomers will come to the last stage of their demographic wave, a wave that has progressed and altered society as it has moved through their life cycle, from crowding elementary schools into split session, to overcrowding colleges, to buying houses to retiring. The last area they can affect is the mode of dying, so this will become a topic we will increasingly hear about over the next few decades.  And ultimately some form of Death with Dignity will become standard in the US.  


I have weighed in on another medical issues in one of my past posts, making the controversial suggestion that people be compensated for some of the savings incurred if they select a cheaper but less efficacious course of treatment. Here I am going to barrel ahead with another one: a short vignette where I place the alternative to Death with Dignity in a disturbing but I hope illuminating context, that of a torturer and victim.  The victim is the one struggling with a painful, debilitating terminal illness.  The torturer is in part nature, in part the social norms that insist death proceed along its natural course, and in part the medical community that might be taking the Hippocratic Oath too literally. (And that, unfortunately, has a conflict of interest in keeping a dying patient in their revenue stream):


A particularly invidious development in techniques for torture, more common than many realize -- or are willing to admit -- starts with inducing periods of searing pain while a physician stands at the ready to assure the victim does not succumb to the torture and die prematurely, and indeed that he remains as alert as possible.  I mention dying prematurely because the spectre of death is another standard component of this brand of torture.  At the start, the victim is advised that no matter what transpires, the process will end in death.  Indeed, there is a program for increasing the stages of torture until death occurs. This program is determined before the torture has begun. The victim is given only a rough estimate of when termination will occur; the randomization is added so the victim remains in a state of uncertainty; this to add a psychological element to the torture.


The torture has been “improved” over time to match the physical pain with other aspects of psychological terror.  Probes are skillfully inserted into the victim’s brain, and slowly but steadily the victim’s motor skills are degraded.  Depending on the approach, this can occur by sequentially inducing paralysis -- first by subtle tremor, then seizures, and eventually ending in full paralysis, starting with the extremities, but then moving to the bowels and finally the lungs.  (This is a more clinically desirable replacement for the old school method of dismembering the extremities one at a time; the effect is functionally the same, but can be controlled to progress in a more psychologically devastating manner). More recently, thanks to better mapping of the brain, the degradation of motor skills has been accompanied by degradation of mental abilities, ranging from memory and speech to broader cognitive function. (Which, of course, cannot be allowed to progress too far too quickly, lest it inhibit the victim's awareness).


A common practice is to force the victim’s family members to observe the torture at every step, and even to encourage them to try to comfort the victim, but of course this is done with little effect as the torturer progresses the pain and dysfunction toward its inevitable end. Essentially this leads the victim to be tortured a second time at each stage, because he is left to observe his family’s helplessness in seeing what is transpiring, adding another clever wrinkle to this carefully developed strategy.


There comes a point where the victim and his loved ones plead with the torturer to bring it to its inevitable end, to speed up the clock that is set to bring the drama to its close.  But this falls on deaf ears; that would defeat the whole point.  There is no early exit from the meticulously planned progression.


And yet another wrinkle is being considered, though still under research and subject to the approval by the ethics board under which the torture establishment operates. In the room, which, despite its clinical appearance and ongoing medical support, we literally can term a torture chamber, is a switch that a loved one can pull to speed up the termination. But this is effectuated at the peril of incarceration. So now the drama is confounded: the victim has to absorb the torture to protect his loved one, the loved one is torn to save the victim while sacrificing herself.  

Thursday, October 23, 2014

Ex Ante versus Ex Post Social Policy

I have written various posts on social policy related to the question of whether and how we redistribute income. One argument of equal opportunity and social egalitarianism is that it is fair to control for the randomness of life. For example, take the luck of the draw in who your parents are. If your best career choice was to be born into a wealthy family, if you got ahead because your father could pull strings to get you an internship at a big investment bank; because you built up your high school resume by spending a summer building houses in Tibet while a classmate had to spend the summer working at the 7-11; or because you could afford two years of one-on-one tutoring for the SAT, the result might be to score higher in an objective standard of selection and have a thriving career and high income as a result. But is that objective standard a fair standard, is it really merit based?

I think of income redistribution as an ex post policy. Another approach is to make ex ante adjustments to level the playing field, and then step away and let the chips fall where they may. When properly executed the ex ante approach is consistent with a meritocracy, and indeed creates a better, deeper and more successful meritocracy than ignoring the differences in essential endowments. 

Assume that there is an objective standard for merit, and a test that correctly ranks the subjects in terms of that standard. (For the record, though basing merit on a testing regime is common in many societies, I do not advocate it). Also assume that we can identify the factors that govern success on the test that are within the control of those taking the test, such as how hard they work, as well identify as the factors that are beyond their control. Given these two assumptions, one scheme for the redistribution, suggested by John Roemer (and in this short post I cannot do justice to his argument and stray from it in various respect), is first to define what constitutes the endowment of important characteristics that are outside a person's control, and then assign people to cohorts based on their levels of this endowment.  For example, if the endowment is parents' wealth and parents’ education, we place people into cohorts based on the level of these two factors, with the cohorts made narrow enough so that we can take all those in each cohort as being the same with respect to the endowment.

The social policy is to reward the top one percent of those in each cohort equally, and redistribute as need be in order to do so, and do so for the next percentile across each cohort, and so on all the way down. The idea is that the cohorts take into account differences due to what is beyond a person’s control – the endowments on which the cohorts were based – whereas the person’s place within the cohort is based on those things that are within their control, such as how much effort they expend. That is, by definition a person is not responsible for his cohort, and should not be rewarded or disadvantaged by it, but he is responsible for where he sits in that cohort.  So when we make decisions in terms of social policy, whether it be redistribution of income or equal opportunity, we adjust percentile by percentile across the cohorts.

Redistributing income or other rewards percentile by percentile across the cohorts is an ex post approach to social egalitarianism. It is ex post because we look at results versus the endowment and ask how we can make things fairer given the outcomes, where we have determined that fairness means people should be accountable and rewarded only for those things that are within their control.  

We can use this methodology on an ex ante basis, where we adjust to create equal opportunity rather than equal ex post reward. Applying the cohort approach ex ante is consistent with a merit-based policy.  Doing so requires one more assumption, namely that we only put in the endowment things that are both outside the person’s control and also are improvable if targeted with resources. The aspects of the endowment that we adjust for are those that only make a difference over time and where any reallocation occurs before that difference is significant. This means we do not adjust for innate ability or genetically-based advantage, even though these are things that are outside of one’s control. We do not define the cohorts based on these things, we do not equilibrate these through matching percentile by percentile across the cohorts. 

To give a sense of the ex ante social program which melds social egalitarianism with the objectives of a meritocracy, consider the following, which makes a good story and also happens to relate to an actual situation. A number of ten year-olds are trying out for a spot on the school's tennis team.  There is one spot available, and at the end of the day it comes down to a match between two boys. One has taken tennis lessons for years and practiced many times a week, the other has only played casually every now and then. The well-trained boy wins the match, but only barely. Given his lower endowment of lessons and practice, the loser is a remarkable talent. On the basis of an ex post meritocracy where the established metric was who won the match, the comparatively mediocre boy got the spot.  Yet what is a meritocracy ex post is a mediocrity ex ante. Absent the resources for training and competition the inexperienced boy would receive from being on the team, he goes back to other activities, and the world must make due with one less exceptional tennis player.  We will all survive; but the point repeats itself many times over in fields that are weightier.

If we take the amount of tennis training as the endowment that is outside one’s control, the boy without the past training might be at the top one percent of the bottom cohort, while the boy who beat him might be in the middle range of the top cohort. A merit-based social policy will reallocate resources for training to the inexperienced boy; perhaps a level of resources equal to that which the top one percent of the top cohort is receiving.  If our measures are correct, and if, as assumed above, the reallocation is given early enough in the child’s formative period, we will have someone who is exceptional at tennis who otherwise would have fallen by the wayside. And we will have used those resources more efficiently than if we kept them with the other boy.

The approach I am describing is not the one we are take in the U.S. when we attempt to level the playing field by making adjustments to create equal opportunity. The social program we follow in the U.S. fails in part because it does not distinguish between that which is within and outside of one’s control. It does not even attempt to define cohorts and pick across the various percentiles to reflect effort.  And when it moves into ex ante sphere, it throws resources at differences that are not improvable. (There is one program that might appear to move in this direction: The top ten percent of students from every Texas high school are admitted into the university system. We can think of each school as representing a cohort, with the program giving the same opportunity to those in the top decile of each. But it is pointed in the direction of ex post rather than ex ante social egalitarianism because by the time of high school graduation a student who has had poor preparation is likely to be too far gone for the equal opportunity to yield equal results).


In addition to fostering a fairer society, the ex ante approach described above will yield better results than running people through the merit-based process absent this social policy because there will be a  larger group that is equivalent to the top decile of the top cohort. But no matter how well we execute ex ante social egalitarianism, we cannot get away from addressing it ex post as well. Not everything can be measured, and some things that can be measured cannot be mitigated. At some point we have to say we have done enough; we do not want the end result to be physicians equally drawn from the top of each cohort if, at the end of the day, all of the ameliorative actions have failed to close the gap. The question that remains then is at that point, ex post, do we enact a social policy to redistribute income, or do we consider the social task to be completed?