The Twilight of the Leisure Class

Conspicuous leisure, conspicuous waste, conspicuous consumption. Veblen coins these terms in Theory of the Leisure Class to describe the strategies the noble and priestly classes employ to assert their status. Veblen observes that a life of leisure is the readiest evidence of the superior class, while anything having to do with the work-a-day world of earning a living is the occupation of the inferior class.

This argument does not ring true for today's society. If someone gave you the advice, “If you want to show that you are better than everyone else, then hang around obviously doing nothing productive, and even better, waste resources.” you would think they were utterly pathetic. And the fact that it doesn't ring true means we are different from many societies that have passed before us. We are seeing the twilight of conspicuous leisure, and of conspicuous waste and conspicuous consumption as well.

For the first two this is almost immediately evident. Leisure, conspicuous or not, is no longer viewed with envy.  Late-night infomercials might depict a life on a yacht free from work and worry as the ideal end result of the various get-rich-quick schemes, but the wealthy in society no longer are a class at leisure. The “one-percenters” work for a living, and the extremely wealthy who do not work for a living instead work for philanthropy. (So maybe we can add conspicuous philanthropy to the list, though the wealthy could then fairly complain that they can't win no matter what they do).

What goes for conspicuous leisure goes even more so for conspicuous waste. In our ecologically-conscious world, the notion of treating resources with disdain no longer signals pecuniary superiority, but rather boorishness and profligacy.  Our antipathy towards waste reflects in us being more frugal in what we consume. Veblen made a tight connection between conspicuous consumption and conspicuous waste – the former almost necessarily leads to the latter, so an end to the latter cannot help but reduce the former.

For conspicuous consumption, all you have to do is look around using a perspective from the consumption and advertising over the past decades when advertising appealed to being the pride of your family and the envy of you neighbors, to projecting success and culture, to commanding respect.  In the snail’s pace of social change, it wasn’t so long ago that we had the literal unveiling of the new year's automobiles, the adding and decreasing of chrome bumpers and ornaments, the rising and falling of tail fins, with the conspicuous consumer trading in for the new model every year. Now, with the exception of a smattering of high-end goods and designer labels, advertising focuses on the qualities of function and design; how much fun you can have with the product, how it will make your life easier or make you more attractive. If it is appealing to any image, it is not the one of “If you buy this, people will see that you must be rich and important” that was so dominant in the past. 

The end of the consumption arms race
The decline in conspicuous leisure knocks at least one leg out of the the relationship between tax breaks for the rich and job creation, because this relationship depends on the notion that if the rich, who are taken to be the job creators, are taxed more they will work less. But if status is evoked through work rather than leisure, then that relationship does not hold.  I do not know of the empirical work that has established this link in the past, but even if it exists, I question its relevance today. It is hard for me to imagine a CEO walking away from his job because his $25 million salary payday just nets him $15 million rather than $18 million.  Or for that matter not working as hard.  But in any case, one reason to walk away, the prestige of conspicuous leisure, has disappeared with the changing ethos of our society.

A reduction in the demand for conspicuous consumption also has implications for the economy. A drop in conspicuous consumption, not to mention in conspicuous waste, means a reduced demand for consumption. Even more than that, it means a change in the shape of the demand curve. As Veblen points out, “if the incentive to accumulation were the want of subsistence or of physical comfort, then the aggregate economic wants of a community might conceivably be satisfied at some point in the advance of industrial efficiency; but since the struggle is substantially a race for reputability on the basis of an invidious comparison, no approach to a definitive attainment is possible”. An end to conspicuous consumption means an end to a consumption arms race where demand can never be sated. There really is only so much you can eat, wear and drive, or click and stream, so if we take the “conspicuous” out of the equation we have a society going down a much different economic path.  I don't know how much of our production was geared toward deliberate but unnecessary discrimination of products, but whatever it was it is lower now.  And the higher end meant higher profit margins.  As everyone makes do with the functional commodity item, then by the definition of a commodity item the profits shrink.

Add to that a reduction in conspicuous leisure, and indeed more than that, having conspicuous work be what matters, and you have both lower demand for products and more people wanting to work.

Why Veblen's world is waning
Much of what we now demand simply does not fit in the conspicuous consumption equation. In particular, the tools of the virtual world, the iPhones and iMacs, the software and Internet, do not lend themselves to conspicuous consumption, any more than do light bulbs or electric outlets. Granted those on the lower rungs spend more of their income on the consumption of real goods than do those on the top rungs. And the share of income on goods that by nature are in limited supply, private goods, land, wine and art, even social status, is greater for the top rungs than for the lower. But for both, on the margin (and increasingly so over time ) consumption is becoming oriented more toward virtual goods – consuming YouTube videos, tweets and social networks, games and reality TV shows – and the hardware to access them. I suppose someone could come out with designer label, jewel-encrusted iPhones, but that just doesn’t seem to be the way things are heading. And how do you conspicuously consume what is out there for ready for the taking?

More important is that we now have better ways of establishing people’s positions in the social or pecuniary pecking order, for example by Googling them. And if you want to make a statement you don’t have to do it through invidious consumption of real goods, you can do it more effectively by leveraging the virtual world – YouTube, any of the various forms of social media, or a blog. Not that Gucci and Chanel are going to go out of business, but for most people that sort of status statement is becoming increasingly irrelevant. No matter what you are wearing and driving, a far better picture of you and your status is just a few clicks away. You don't have to drive a Ferrari to let everyone know you are rich and successful. If you are driving a Ferrari, what it will convey is that you – who as everyone who cares to Google you knows is worth tons of money – must like Ferraris.

(And, in any case, is the class distinction today the one that Veblen observed, one of direct overlord and humble worker? Do people give the same deference to those who can demonstrate the ability to indiscriminately buy whatever they want, to hang around the yacht club while others are working, to waste resources without a thought? In some quarters the objective is inconspicuous consumption).

The consummation of the industrial age
This is the way the Industrial Revolution was set up: Mass production of cheap, identical goods replacing the work of the artisan.  The entire point of industrialization, and what made the industrial revolution successful, was having production turn from luxury items for the rich to common-day products mass produced for the common masses.

As Mumford points out, industrialization changes what society values. The industrial society values what is new and fresh. Age goes hand-in-hand with rarity, but the industrial age puts an emphasis on the technologically advanced, the brand-new rather than on the rare. The industrial society also values conformity, (though at the same time decrying conformity and the resulting alienation of the crowd). This is because the industrial process is at its best, with the lowest cost and highest quality, when it is humming along producing many of the same product. There are those who will prefer a Rolls for other than purposes of conspicuous consumption, but even so will have to admit that any number of computer-designed, robot-welded cars rolling off the assembly line – and many cars must roll off to amortize the costs of development and production – are functionally superior. This is all the more true as we move into the technology space, to computers, phones and software, where newer and conforming products are not only better, but necessary. These are products that simply do not relate to the notions of sentimentality and well-worn comfort. 

Advertising post-conspicuous consumption
Industrialization is leading to a continuing convergence between the products that are consumed by the wealthy and the common man. To generate the fodder for conspicuous consumption, advertisers and marketers have waged a valiant battle for several generations against the process of industrialization by maintaining distinctions between functionally equivalent goods. Now advertising is beginning to pick its fights elsewhere.  One reason is that increasingly the medium of advertising is the Internet, either directly or because the next stop when an ad catches someone’s eye is to go to the Internet, and the Internet, and thus the ads, is more about information than about conveying status or image. Another reason is that unless the marketers try very hard, many goods are clearly going to be identical between the very rich and the not so rich. There was a time when cars were the focal point for conspicuous consumption; having a car singled out the wealthy, then having a car with chrome and fins. Now I drive an Acura TSX and so does Mark Zuckerberg. Having a refrigerator was once the province of the wealthy, now you and I can have the same kitchen appliances as an ostentatious Donald Trump – minus the gold trim. 

In some areas, most notably and importantly in electronics, the push to spur conspicuous consumption has been given up without a fight. In the sphere of the Internet we are egalitarian. The wealthiest of the one-tenth of the one percent are holding the same iPhone and using the same applications as my babysitter. As I write this I am sitting in the walkout basement of my son’s house, using a computer that is identical to that of one of my former billionaire bosses. And another of my sons has a big-screen TV and sound system that is indistinguishable from his. Because we spend so much of our time on our phone and in front of out computer and TV, in the new age there is not much difference between how my son spends time versus the very rich, one in a twelve-thousand square foot mansion in Greenwich while the other is in a starter home, both sitting in the corner of some room staring into a 21” screen.  So as we spend more and more of our time on the Internet and virtual world, we become accidental egalitarians. As far as this goes, and granted it has not yet gone that far, it is a commendable result for society even it is not so useful for the economy.  

Taken to its end, industrialization class distinctions as revealed by conspicuous consumption.  This points to the objective of industrial production: goods in the realm of common consumption become removed from social distinction. This is what Mumford meant when he stated that the machine is a communist. Products bear the same impersonal imprint. They either function or do not. There is no difference between the light bulb – or phone, or computer, or Kindle – of the common and the wealthy to signal a difference in status. The consummation of the industrial revolution, and insofar as we link the industrial revolution to capitalism, of capitalism as well, will occur when the same can be said in all areas of production.

The Bifurcated Society

Unless there are slaves to do the ugly, horrible, uninteresting work, culture and contemplation become almost impossible. Human slavery is wrong, insecure, and demoralizing. On mechanical slavery, on the slavery of the machine, the future of the world depends. – Oscar Wilde

An article in the New York Times last week made note of the lower mobility in the work force: “Americans enjoy less economic mobility than their peers in Canada and much of Western Europe. The mobility gap has been widely discussed in academic circles, but a sour season of mass unemployment and street protests has moved the discussion toward center stage”. So add another to the economic woes; not only unemployment, but less mobility if you are employed.

There is less mobility in the work force because the computers are not simply displacing jobs, they are taking out the middle. Computers are good at routine cognitive tasks in the middling white-collar range, the desk jobs, the jobs that require keeping track of things, making arithmetic calculations. They are not so good at motor tasks, the blue collar jobs that require coordination, manual dexterity and sense-of-the-world adjustments. Computers can crunch numbers but they can't drive a truck or make up a hotel room. When it comes to computers taking on human tasks, as Steven Parker notes, the hard problems are easy and the easy problems are hard.

Because they take out the middle, it is a lot harder to pursue the American dream by working your way up the ladder. Climbing up rung by rung, you will find a machine staring down. And it won't retire or move up the ladder to make room for you. Once in place, a retirement or promotion is not going to happen, it isn't going to be opening up a spot.

Futurists have seen this coming for along time, sort of. As automation got started, they saw robots taking over the manufacturing tasks and our day-to-day activities (serving us our dinner and the like), leaving people to do other things – leisure activities or getting jobs making the robots. Futurists always get it wrong because they take the present and multiply it by some number to get the future, and they have the essence of the issue wrong here as well. Although there are robots in industry, the biggest effect of computer technology is in an the area no futurist imagined. It is not improving the production of industrial goods, it is supplying the increasing demand for virtual goods. So the picture is not one of producing what we have always produced, but doing it with less labor, it is that we now want things produced that have not been produced in the past, and those things by their nature require less labor. That is, we are meeting the computers halfway by increasing our demand for the very things that they do best.

When God closes one door, He opens another
Ironically, even as they effect a widening of economic classes, robots, computers and automation are answering the bane of the industrial revolution, freeing many from the mind-numbing, routine jobs of the specialized factory floor that Marx reviled against as the source of worker subjugation and alienation. (Along with many of the modern-day clerical equivalents). The problem is that we are not seeing enough new, more productive and satisfying jobs rolling down the pike. So we might be seeing an end to worker alienation, but we also are seeing an end to work.

We have had an axiomatic view that when technology uproots us from jobs it opens up new ones, and the new ones are even better in pay and in job satisfaction. After all, somebody has to make all those robots. It is a comforting thought, but it is not really an axiom, perhaps just a lucky result that has obtained over the course of the industrial age. There was always a West where the workers could go, an expanding population, undeveloped countries, and new products and demand. The same may continue, but it doesn't look like it is.

Which sort of makes sense if we are moving toward living in a virtual world with virtual industry taking on increasing prominence, and with those industries not particularly labor intensive (or for that matter capital intensive – at least nothing like the era of steel and railroads), or not labor intensive for those with motor as opposed to cognitive skills. We aren't thinking too much about this right now. We focus on running out of resources, not on running out of new markets, more specifically new markets – both of new consumers and new products – that bring as many new jobs with them as are being displaced by machines. (Though this is all starting to get attention, for example in recent books by Erik Brynjolfsson and Andrew McAfee and by Tyler Cowen).

The Outsourcing Masses

Though we are not as unemployed as we might think. We just are not being paid for our work. Much of what we enjoy from our technological progress is a new sort of outsourcing. How much time do you spend on things that are made easier and that you now do for yourself with the help of computers? You do them now because computers have made it possible for you to do them. You take care of your appointments and a lot of the service issues, you get yourself directed via various phone prompts. You don't  employ anyone when you do these things.The book “The 4-Hour Workweek” suggested, among other things, outsourcing day-to-day tasks to people in India. But the largest area of outsourcing is not to India, Sri Lanka or China. Our jobs are being outsourced to us. The jobs are moving from the producer to the consumer side of the ledger. And some of that work comes as the guise of entertainment. How much of your work is being done as you do your e-mails and surf the web, keep yourselves busy with your apps as you commute to work? So it is not only that computers are replacing workers, they are turning consumers into unpaid workers.

Bifurcation and classes

In the earlier epochs of history, we find almost everywhere a complicated arrangement of society into various orders, a manifold gradation of social rank. In ancient Rome we have patricians, knights, plebeians, slaves; in the Middle Ages, feudal lords, vassals, guild-masters, journeymen, apprentices, serfs; in almost all of these classes, again, subordinate gradations. The modern bourgeois society that has sprouted from the ruins of feudal society has not done away with class antagonisms. It has but established new classes, new conditions of oppression, new forms of struggle in place of the old ones. Our epoch, the epoch of the bourgeoisie, possesses, however, this distinctive feature: it has simplified the class antagonisms. Society as a whole is more and more splitting up into two great hostile camps, into two great classes, directly facing each other: Bourgeoisie and Proletariat. – Karl Marx

Slave and Master for the Romans, Lord and Vassal in Feudal times, Bourgeoisie and Proletariat for the industrial capitalists. What is emerging now? Because computers allow us to lever our creativity and cognitive work in the same way that capital plant allowed those in the industrial revolution to lever their production of real goods, perhaps , as Murray and Herrnstein hypothesized when they proclaimed the emergence of a new “cognitive elite”, class division will increasingly be based on education and intelligence.

But although a bifurcation is occurring in jobs, the opposite is occurring in consumption. Granted those on the lower rungs spend more of their income on the consumption of real goods than do those on the top rungs. And the share of income on goods that by nature are in limited supply, like land, wine and art, even social status, is obviously greater for the top rungs than for the lower. But for both, consumption is increasingly oriented toward virtual goods – consuming YouTube videos, tweets and social networks, games and reality TV shows. These take little in terms of labor – or for that matter, capital – to produce. And the labor that is required is largely supplied by us as the consumers. Another instance of outsourcing.

And one notable area of consumption that by definition differentiates the classes, that of conspicuous consumption, is going by the wayside. Yes, I believe we are seeing the twilight of the era of conspicuous consumption. Not that Gucci and Chanel are going to go out of business, but for most people that sort of status statement is increasingly becoming irrelevant. No matter what you are wearing and driving, a far better picture of you and your status is just a few clicks away. You don't have to drive a Ferrari to let everyone know you are rich and successful. If you are driving a Ferrari, what it will convey is that you – who as everyone who cares to Google you knows is running a hedge fund and is worth tons of money – must like a Ferrari.

The Day the Earth Stood Still

A recent New York Times article critiquing of popular music for 2011 came away with the view that “2011 may well be remembered as the most numbing year for mainstream rock music in history. The genre didn’t produce a single great album, and the best of the middling walked blindly in footprints laid out years, even decades, earlier.”

The same could be said for the genre over much of the recent past.  And could be said for music in general, art in general, and culture in general. And for the basic structure of our lives in general, as well. A teenager today thinking back to the 1960 is peering into a past as removed in time as when I as a teenager looked back from the 1960s to the world of the 1910s. For me this was a distant and remote world shrouded behind World War II, the depression, and World War I, a world with which I shared little. Not so for today's teenager looking back to the 1960's, still listening to the Beatles and familiar with the epochs of James Bond movies running from Sean Connery to Daniel Craig. The conveniences of daily life were much changed from the 1910s and the 1960s, but not so from my teenage years to today. We had a refrigerator, TV, telephone and dishwasher. I drove my friend's Mustang. The refrigerator didn't have an ice maker, the phone was rotary, but then again, living in Nevada at the time, where the speed limit on the highway was whatever "is safe and sane" meant  I could drive the Mustang a lot faster then than we do today.

Given the amount of time we spend on-line and the ubiquity of computer chips in mediating our lives, you would think that we would have less connection with the fifty-year past. One reason we maintain this connection is that we have recordings and movies, while all we have from the 1910’s are books and grainy photographs. But there is another reason. Think of what we are really getting from the Cloud that might differentiate us from the past. For all the 4-G networks and iPads, what we have produced are differences in quantity, speed, and access, not differences in kind. Through on-line search we basically have a faster and more extensive encyclopedia, through on-line shopping we always have the latest catalog at our fingertips with operators always standing by, through e-mail we have a cheap personal telegraph.

Jaron Lanier makes this point: “Suppose that back in the 1980s I had said, ‘In a quarter century, when the digital revolution has made great progress and computer chips are millions of times faster than they are now, humanity will finally win the prize of being able to write a new encyclopedia and a new version of UNIX!’ It would have sounded utterly pathetic.”

What these new, improved modes of telegraph, encyclopedia, and retail have done for overall efficiency is a popular topic of debate. But the debate doesn’t end there. The effect that this has had on our lives is not only one of economics and productivity, but of culture.

In his 1985 book Amusing Ourselves to Death, Postman looks at the changes for our culture and our mode of thinking as we moved from relying on the written word to the instantaneous connection of the telegraph, then to the sound-bite laden, visual medium of television. Among many desultory effects one stands out: we became preoccupied with “news”, with knowing what is happened even when those things had not even the most remote value to us, and when, in any case, the speed of receiving that information was inconsequential. Postman asserts that the news of the day is a figment of our technological imagination. It is literally a media event.

This preoccupation actually started even before television. Television just leveraged the effect of the telegraph, which already had unleashed the demand for immediate reporting of irrelevant information from distant locations, by making it more entertaining and accessible.

Now we can add the internet, social networking, and email to the telegraph and television. We are getting better and better at keeping the serious at bay while wrapping ourselves in the absurd. Postman, perhaps reflecting on the founding of USAToday, considered the emergence of paragraph length news reports as "an astonishing tribute to the resonance of television’s epistemology". Now we have Twitter. Look at what are we seeing in a recent commercial from AT&T: Two tailgate heroes, eyes glued to their cell phones, turn such "breaking news" as a player's sprained ankle and a stolen mascot into something “so 42 seconds ago”, not to mention posting videos to Facebook with blazing speed.

News becomes a guiltless form of entertainment because we view news as weighty and worthy of attention. We get to have our chocolaty treat while arguing it is actually nutritious. But the ubiquity of the Cloud extends this beyond the six O’clock news. While the leading edge in the old media was entertainment masquerading as news, now we have entertainment masquerading as just about every component of our waking lives. Entertainment masquerading as social lives as we keep on top of what our friends (including all of our celebrities friends) are thinking about and doing at the moment. Entertainment masquerading as work as we e-mail colleagues incessantly and check out anything on the web that is even remotely related to work.

There is only so much that is really happening in the world at any moment, so to have sufficient content to fill our demand, we recycle and remix. We can see the same news in dozens of different venues, second hand links to a few original news items and thoughts. Or forgo the notion of news or thought altogether and simply follow someone as they go about their daily lives (which ultimately could become self-referential if they are going about their daily lives doing the same thing).

It seems that we are awash in information, but the actual information has hardly changed, it is just repackaged in many forms. Lanier also points this out: "It is astonishing how much of the chatter online is driven by fan responses to expression that was originally created within the sphere of old media and that is now being destroyed by the net. Comments about TV shows, major movies, commercial music releases, and video games must be responsible for almost as much bit traffic as porn. There is certainly nothing wrong with that, but since the web is killing the old media, we face a situation in which culture is effectively eating its own seed stock".

So for all the apparent newness we have become a culture of the remix. We think that we are in a technological revolution, but what we really have is more of the same, just faster, ever-present, and in color. We are mistaking high resolution and portability as an advancement of culture.

The Volatility Paradox

Volatility tends to drop when market risk is building up and leverage is rising, luring investors into complacency. Indeed, the lower volatility justifies investors taking on more leverage; if volatility has dropped by a third, why not take one and a half times the leverage? This pro-cyclical dynamic arising from lower volatility in times of increasing risk-taking is the volatility paradox. The main take-away from the volatility paradox is that we shouldn't use shorter-term, contemporary risk measures when they are very low.

But there isn't really a paradox, and we shouldn't ignore the low volatility. Unusually low volatility has value, it is just that if it is being viewed as a typical volatility measure it is being looked at in the wrong way. We can rely on short term volatility as a risk indicator, not as an exogenous measure of risk, but rather as endogenous manifestation of the dynamics of the market because low volatility may be telling you that everyone is levered to the hilt and is willing to snap up any asset that moves, that everyone is casting aside negative information with hardly a second thought.

When viewed as endogenously determined by the behavior of the market, the relationship between risk of crisis and unusually low levels of volatility is simple: If people are levered and are at the ready to snap up positions, if they are ready to arbitrage out price differences and make markets oblivious to risk at razor thin margins, then it won't take much of a price move to find the other side of a trade. If people don't care about negative information, then the information flows will hardly move prices. The result is low volatility, and this in turn leads to more leverage and then another round of the dynamics that feed the low volatility. The result will be a descending level of volatility that is telling you that the market had been lulled into complacency, or worse, is in full-speed-ahead risk taking fervor, and hence is vulnerable.

Of course even if it is more the latter, it still will be the case that a low volatility derived from recent history will likely reflect low volatility in the near future, because if people are levered and ready to buy anything, if they are at a level of exuberance that leads them to discount anything negative in the market, the odds are high that that the same behavior will persist for the next while. But then suddenly it won't. There is the chance that the floor will fall out and a crisis will be unleashed, and more than anything else, that is what we need to know for risk management.

We can see this when we think look at things from the other direction: what happens to volatility when the crisis finally hits. At that point no one wants to take on any risk, delevering has led to a reduction in liquidity, and so prices have to move a lot to entice buyers. The market is skittish, and so any news or rumors find everyone scurrying for cover. So for both liquidity and information reasons, prices move a lot more and thus volatility rises to the point that it is again not a useful measure for risk, but for the opposite reasons..

The diversification paradox

Related to the volatility paradox is what we can term the diversification paradox, which I discussed in a post some time back. As with volatility, correlations are low pre-crisis. So as is the case with low volatility, the low correlation and resulting apparent potential for diversification will lull investors into taking more risk. And because of the dynamics that create the low correlation, this in turn will feed into further reductions in correlation, thus adding to pro-cyclicality.

At least this is what will happen if we take the correlations as exogenous – that is if we say “they correlations are what they are, so let's throw them into our variance-covariance matrix and then let the optimizer rip”. But as with volatility, if we look at the correlations as being endogenous to the dynamics of the market, they give us warning signs. Low correlation tells us that everyone is evaluating the most subtle differences between assets – for example, are the transportation costs for the Ford's supply chain dropping relative to those of GM's – and is also searching out opportunities in hinterland, esoteric markets. One asset is being finely differentiated from the other, correlations are therefore low, and investors take more leverage and more exposure because of the apparent potential for risk reduction through diversification.

Of course we all know that when the crisis hits the correlations suddenly rise and the benefits of diversification go out the window. Thus, as I wrote in my earlier post, diversification works all the time, except when it really matters.

When the crisis finally hits, correlations shoot up from the same endogenous dynamics. Suddenly, the only thing that matters is risk, not the subtleties of earnings and the opportunities in Malaysian onyx mines. It is like high energy physics, where matter become an undifferentiated white-hot plasma; assets that are risky are all viewed the same way, all of the risky assets meld together. So correlations rise.

The Paradoxes and Risk Management

There are two points from this discussion of the volatility paradox and the related diversification paradox.

The first and well-known point is that if investors take these measures as exogenous – that is, if the data are treated as a given in the computation of the statistics and the statistics are then applied based on their statistical interpretation – then they will lead to pro-cyclical behavior. Higher leverage and risk taking in general will be apparently justified by the lower volatility of the market and by the greater ability to diversify as indicated by the lower correlations.

The second is that just because the volatility is not a good indicator of the risks lurking in the market doesn't mean it is not useful. If we recognize that volatility and correlation are endogenous measure that are a manifestation of market dynamics rather than exogenous statistics of market risk to be thrown into our risk management engines, if we dig deeper into the dynamics that are generating them as endogenous parts of the market dynamic, we will find that they actually are telling us far more about the markets.

The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This post expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff. Similarly, this post expresses the author's views and does not necessarily reflect those of the Department of Treasury or its staff.

Managing the 99 Percent

“And that,” put in the Director sententiously, “that is the secret of happiness and virtue—liking what you’ve got to do. All conditioning aims at that: making people like their un-escapable social destiny.” – Huxley, Brave New World

From: The McCourtny Consulting Group

To: The Endowment for the Preservation of the One Percent

Subject: Managing the 99 Percent

Whether or not it is put in sound-bite terms of “class warfare”, the “one percent” pitted against the “ninety-nine percent”, the fact of the matter is that the data showing a widening of income levels are undeniable, as are the push of a segment of the middle class to the near poor, the realization of lower social mobility, income levels that have broken the string of increasing standards of living from parents to children, and new doubts about education as a road to opportunity.

We are witnessing a simmering backlash in the face of the widening class distinction. It is wise to address the fundamental issues behind the backlash and consider approaches to deal with the problem, especially given that these conditions may be persistent and structural. Therefore, we have prepared a brief overview of approaches to the problem.

What to do

In the Feudal societies, class distinctions were determined by lineage, in the capitalist society by wealth, and more generally by the notion of a power elite that controls the key levers of society, be it in industry, government or the military. Whatever the source of the class distinctions, historically the ongoing concern of the dominating class has been to contain the pressures of alienation that can lead to the revolt of the masses.

What are the public relations strategies to control and manage this situation? We have considered a campaign based on the following messages to hoi polloi.

We are just like you. Hide wealth and then take a cue from the Mormon public relations campaign: washing the car, playing basketball, with the tag line “I'm a one percenter”. Some members of the Endowment are already primed for this approach, having explicitly told their highly compensated employees to cool it in terms of flaunting their wealth.

You are just like us: Create the perception of shared power and mobility, that hoi polloi influence the system and can change it if they want to. Point out that this is the connotation behind the term “hoi polloi” in ancient Greece. Maybe you haven't hit the daily double this time around, but you still have a shot. This approach already seems to be in play and working. Helped along by a long-running media campaign, many of the 99 percent who are unemployed as well as the growing number who are descending into the ranks of the nearly poor are ardent defenders of the wealthy and their historically low tax rates.

You are not like us, and you don't want to be like us. Make wealth appear unattractive. Money only causes problems, miserable lives; the upper class are a harmless bunch. England maintained class distinctions and the Crown where other countries were hit by revolution in part because the upper class wrapped itself in eccentricity and generally appeared harmless, if not even amusingly befuddled. However, although this worked for an aristocracy at leisure, it is not a good strategy to appear befuddled while running corporations.

You are not like us, but who is keeping track. This appears to be the most sustainable route for managing the situation, especially because technology is making it an ever more achievable strategy. Entertainment, keeping busy on the trivial. It worked for Rome, at least for a while. So it will be a constant theme in our proposal.

Too bad, just live with it. Given that, all else equal, people probably won't just live with it, eventually this requires the authoritarian, police state approach. As Dahl's Mr. Wormwood put it, : “I'm right and you're wrong, I'm big and you're small, and there's nothing you can do about it.” 

Proposal for the Campaign

We propose a campaign based on these multiple fronts that will leverage existing channels:

Reality TV. We have had the vicarious exploits of spectator sports for a long while, and now have created vicarious lives through Reality TV. This not only serves as a distraction. Properly employed (such as with the “Real Wives” series) it supports a “You wouldn't want to be like us” message.

Computer games and virtual lives. Add to the vicarious lives of spectator sports and reality TV the opportunity for virtual lives through computer games; everyone is building their own virtual mansions and fighting their virtual wars, in combat with their own Eastasia. This provides both distraction and empowered “You are just like us” moments.

Social networks. Talk about keeping people distracted on trivia. And we can have people feel socially connected with us by being our friends by creating carefully managed Facebook accounts. We can hire a staff to maintain these Facebook pages in a way that the joint messages of “We aren't having a lot of fun” and “We are just like you” are both kept at the fore.

Those on Facebook already blur the real with the fantasy; many create alternative lives on Facebook just as they do in their virtual games, and it turns out that the Facebook fantasy helps get our messages across. The Facebook personae are not exactly “Just like us”, but are more like us than is the reality. The average Facebook self depicts someone more wealthy and happy than the actual person. So it is not quite cohorting with the one percent, but on the other hand there is rarely any evidence of the economic struggles that seem to occupy the pages of the New York Times.

Open media. Just as there can be the sense of power in various combat games, for the disenfranchised there can be the sense of power, a sense that “You are just like us”, through their access to blogging, twittering, and other channels of open media. These can be manipulated to give the impression that their voices are being heard, that they matter. In this regard, we recommend that a team be hired to comment on various posts – perhaps outsourced to India or Sri Lanka – in order to give the appearance that people are listening, that the trivia is substance. 

And these are channels to burrow into so that the realities of the world and their place within it are obscured. Just as Facebook gives us the impression of a large community of friends and colleagues, Twitter allows the 99 percent to feel connected to the world at large, to believe that people out there somewhere hear their voices.

Viral hits buttress the “You are just like us, but just haven't hit your daily double yet” message. It doesn't matter that the viral hits have nothing more than fleeting entertainment value. The simple fact that a 99 percenter can draw the attention of millions is the exception that proves the rule.

Education-lite. Education poses a dilemma because it is essential to have a skilled workforce while at the same time preventing the side effect of heightened awareness of alienation. So the ideal educational system is one that provides the requisite work skills while inhibiting thought.

Adam Smith writes that such a path is possible, indeed that the working man “has no occasion to exert his understanding. . . . Of the great and extensive interests of his country he is altogether incapable of judging; His dexterity at his own particular trade seems, in this manner, to be acquired at the expense of his intellectual, social, and martial virtues". Smith proposed that the way out of this is for the government to provide public schooling for the working class. But what is a bane for Smith is a blessing for us: his working man is the man we want. 

Those in the upper-class in his era did not share Smith's interest in universal education. Rather, they saw the world as we do: education diminishes deference and fuels disobedience. And this same sentiment is echoed a century and a half later by no more ardent a defender of capitalism than Schumpeter, who argues that education in the face of manual labor and underemployment sows discontent, and “discontent breeds resentment”. The solution to this is to give the impression of education while in fact providing little more than the essentials of vocational training. Focus on accounting, computer science and the like while eschewing the impractical liberal arts. Have college be party time, the soma, sex and endless recreation that Huxley envisioned for the populace at large. If the majority of the ninety-nine percent can be herded down this path, then "sex, drugs and rock and roll" serves its purpose.

Open personal information. While we strenuously object to any of the “Too bad, just live with it” Orwellian tactics (and therefore also stress that any discussion along these lines be by phone and not by e-mail), there happen to be technologies that allow the requisite monitoring. Indeed, hoi polloi already provide this information voluntarily, often to the public at large. Between tweets, blogs, and our Facebook friends, not to mention those who write comments where registration with real names and e-mails is required, we have a treasure trove of data for any future efforts to manage the situation more directly. 

The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This post expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff. Similarly, this post expresses the author's views and does not necessarily reflect those of the Department of Treasury or its staff.

Class Warfare and Revolution (Circa 1850)

In a recent post I discuss six policies that spurred the Industrial Revolution in England – opening up immigration, weakening the guilds, investing in infrastructure, privatizing agricultural land, forcing a move to new energy sources, and policies for bringing capital to the new, capital-intensive technologies – and suggest that these policies have their analogues today as we face what history may view as another industrial revolution.

But that is only one part of the story of the Industrial Revolution. Another part is not always very pretty, but might also be instructive.  

Class Division in the New Economy

The rise of the capitalist class during the Industrial Revolution is well known, with a select few, the barons of industry, be it steel, rail, or textiles, catapulting to a level of wealth rarely known before. But less considered is the other tail of the distribution, the downward spiral of what today might be termed the middle class.

The story of the steel-driver John Henry’s race with the steam hammer is a type for the plight of English laborers overrun by the Industrial Revolution. Labor was caught in the sea-change of new technologies and economic organization. 

Hand work could not compete with the machines, no matter how great the workers' skill and determination. A whole generation of hand laborers kept up a desperate struggle, but with an inevitable end. The same occurred for the small farmers, who were squeezed out by the consolidation of farms that had been initiated by the policy of privatizing enclosures. Some gave up their land and drifted away to the towns to keep up the struggle a little longer as hand-loom weavers, but then became part of the factory labor class, just as others gave up their looms and devoted themselves entirely to farming for a while, but eventually sold their land and dropped into the class of agricultural laborers. 

The result was the same in either case: Household manufacture gave way to that of the factory and the small farms were consolidated. For the many who did both farming and hand work, their work, subsistence farms and homes were all lost.The farmers who lost access to the commons due to the policy of enclosures frequently failed to find alternative employment near home and became paupers and vagabonds.

Just as the factory system disenfranchised and commoditized the industrial workers, the farm workers became separated from the land. Three classes emerged in agriculture: the landlords, the tenant farmers, and the farm laborers. The landlord class was a comparatively small group, a few thousand, of nobility and gentry who owned by far the majority of agricultural land. Another class, the yeomen who owned and cultivated their own small farms, disappeared entirely, descending into the class of laborers.

Obviously, the Industrial Revolution ultimately increased prosperity, but for a time it made a wide swath of the populace worse off. The period of transition from the domestic to the factory system of industry and from the older to the new agriculture was one of almost unrelieved misery for those who could not integrate into the new economy, whether due to lack of capital or lack of physical or mental adaptability.

New Routes to Job Creation

While the hand-loom weavers kept up a hopeless struggle in the attics and cellars of the factory towns, their wages sinking lower and lower until the whole generation finally died out, and while the small farmers bowed to the competition with the larger producers, the plight of the farmers and hand laborers descended with a vengeance on their children. Many landed in parish poorhouses, and it didn’t take long before the factories discovered this fresh new source of labor. They began taking the poorhouse children as “apprentices”, signing indentures with their stewards, agreeing to give their wards room and board – and the promise of training – and then put them to work.

Children as young as seven years old worked in the cotton spinning factories. The children began work while extremely young and worked the same hours as the grown men and women. They could do many jobs in the factories just as well, and in some cases, such as when working with spindles and fine thread, even better than adults. They were remotely situated in apprentice houses built near the factories, the burdens of unrelieved labor and the harshness of their masters unnoticed by the community. The actual working hours in the factories in the earlier part of the 19th century were a technology-assisted twelve to fourteen hours a day; gas lights illuminated the factories and steam power worked without tiring. When the factory was running at full capacity the children were employed in two shifts, one in the day and another in the night. It was said that "their beds never got cold," one shift climbing into bed as the other got out. There was no effort to provide them with any training, nor education, nor time for recreation.

While the conditions were harsh in the factories, things could be worse. Here is an account of child labor in the mines. It is so heart-wrenching that it might be dismissed as sensationalism were it not based on the findings of an 1842 report of a Royal Commission charged with investigating the conditions of child labor in the mines:

Children began their life in the coal mines at five, six, or seven years of age. Girls and women worked like boys and men, they were less than half clothed, and worked alongside of men who were stark naked. There were from twelve to fourteen working hours in the twenty-four, and these were often at night. Little girls of six or eight years of age made ten to twelve trips a day up steep ladders to the surface, carrying half a hundred weight of coal in wooden buckets on their backs at each journey. Young women appeared before the commissioners, when summoned from their work, dressed merely in a pair of trousers, dripping wet from the water of the mine, and already weary with the labor of a day scarcely more than begun. A common form of labor consisted of drawing on hands and knees over the inequalities of a passageway not more than two feet or twenty-eight inches high a car or tub filled with three or four hundred weight of coal, attached by a chain and hook to a leather band around the waist.

(Also see Lord Shaftesbury’s speech to parliament).

The job creators, with the prosperity of England no doubt foremost in their minds, lobbied against the hand of regulation and labor reform. Their points were three-fold:

First, that abolishing child labor would harm those who promoted job creation and productivity. Manufacturers opposed the child labor laws as an unjust interference with their business, an unnecessary and burdensome obstacle to their success, and a threat of ruin to the class who provided employment to so many laborers and created the productive engine that was the source of commerce for the country.

Second, that if child labor were restricted England would be placed at a competitive disadvantage. This would not only affect the capitalist class, but affect the size of the pie to be distributed, and thus ultimately trickle down to affect the working class itself.

Third, that at a more fundamental level government regulation should be broadly cast aside because it was detrimental to competition and essential freedoms: freedom of labor, freedom of capital, and freedom of contract. If the employer and the employee were both satisfied with the conditions of their labor, why should the government interfere? How this related to children who had been indentured by their stewards is unclear.

There was, however, opposition slowly grinding out successes in one industry after another over the course of the decades, though the most oppressive industry, that of mining, being literally underground and hence less visible, was only addressed toward the tail end of the reform.

Elizabeth Barrett Browning's Cry of the Children, published in 1842, is an influential example of the outpouring of sympathy for the plight of child labor, but the most persuasive argument for reducing the hours of children did not come from sympathy as much as from economic practicality worthy of laissez faire. Work in such a stifling and harsh environment stunted the children’s growth and led to disease and degenerative conditions. Therefore, some in the capitalist class were won over, or at least muted in their opposition because they deemed it advisable to reduce the harsh labor conditions for the “physical preservation of the race”.

The Revolutions of 1848

There are different possibilities available at any historical moment; the socioeconomic sphere can adjust to change in any number of ways. In the face of the social tumult brought on by the industrial revolution, the course taken in Europe differed from that of England. In England awareness and change came about gradually through the force of government reforms. In Europe the epiphany occurred with the revolutions of 1848. As did the events in the England, these revolutions reflect some of the stresses and some of the glimmers of political and social activity we are seeing today.

The 1848 revolutions were the culmination of a number of stresses, some similar to those felt in England, which had been building over the course of decades. There were social costs incurred as the small farms and guilds of the artisans were replaced with larger, impersonal agricultural and industrial plants. There had been a decline in the standard of living compared to that of the previous generation.  The problems reached a crescendo in the years immediately preceding the 1848 revolutions because of the interrelated crises of years of poor harvests, a credit crunch brought on in part by the need to borrow in the face of the resulting high food prices, and an economic downturn precipitated by, among other things, a banking crisis. These all combined to lead to lower income and high unemployment. 

The revolutions of 1848 spread by force of ideology, spurred on by new modes of communication that, ironically, were facilitated by the concentration of the masses due to the factory system. The  revolutionary events began in January 1848 in Palermo, the provincial capital of Sicily. Uprisings were a regular occurrence there and in southern Italy in general, but this time they found more success and quickly spread from there to the Italian mainland. From there they moved on to Paris, where there were street demonstrations and clashes between demonstrators and police, with the demonstrators erecting barricades throughout the city. By March demonstrations and clashes between the demonstrators and police spread to Munich, Vienna and Budapest, and then to Milan and Berlin.

In most all cases the confrontations led to constitutional changes, dissolution of monarchies, and boarder political representation for the masses. But these changes ended up being short-lived; within a few years a counterrevolutionary wave washed many of these gains away. However, the 1848 revolutions represented the first time that there was such a broad outpouring of popular support, with the masses, mostly participating in non-violent protests, spanning many countries, religious groups and classes.

Occupy Wall Street, Social Unrest and Income Inequality

We are seeing the specter of instability in the growing protests of income inequality, economic distress of the middle class, and economic and political power of the very wealthy. There is Occupy Wall Street in the U.S., and similar protests ranging across the globe. In parts of Europe there is rioting in the streets, in parts of China protests have turned deadly.

A microcosm for these protests can be seen in Israel, which is among the first of the countries to stage such protests. In a one of my recent posts, "Workers of the World, Goodnight!", I recount my experience in the egalitarian Israel of the early 1980s, and contrast that with the Israel of today, where a handful of families basically have a controlling interest in the economy proper, and where the concentration of wealth at the top makes the U.S. look like a commune. This transformation over the past few decades tells us something about the roots of social unrest that have spread recently from Occupy Wall Street to other countries. The Israeli society that I saw three decades ago was one that faced the unrelenting specter of war. During times of crisis, of war or natural disaster where there is a randomness to existence that extends beyond wealth to issues of life and death, people choose to be more egalitarian. People know they might end up with the short end of the stick with the next roll of the dice, and that whatever they acquire will likely be transitory. So they first and foremost focus on keeping a social system and its support structure in place.

Unerring stability leads to the opposite course. For example, in the medieval societies where position remained unchanged for decades, even centuries, where land, the key source of wealth, passed inexorably from one generation to the next, where class distinctions dictated the path of your life and that of your children, an egalitarian notion was not even in the realm of consideration. There were the rich and there were the poor. It was as simple as that.

Absent a policy of income redistribution, capitalism plus stability leads to income disparities. Take stability out of the equation, and the distribution will narrow. Israel is more stable thanks to the efforts of the broad base of society, most notably through their military commitment And so Israeli society as a whole maintains the environment that allows the remarkable income disparity to occur. Because of this, Israeli society as a whole questions the social structure that gives rise to this disparity. They have a hand in creating that stable society, and could theoretically choose instead to move more toward one of instability. In the extreme case, doing so might be their best course.

A Reworking of Rawls' Theory of Justice

In The Theory of Justice, Rawls performs the thought experiment of developing a political system where those determining this system are operating under what he calls the veil of ignorance. The veil of ignorance prevents the contractors – those who are going to enter into the political contract that they have a hand in developing – from knowing their place in the resulting society. They do not know their assets, their endowments of intelligence and strength, even many of their preferences and values. They do not know their place in society, they do not even know the civilization and culture that has been achieved.

The veil of ignorance is an important vehicle for the development of his political theory. The exercise is trivial without it. If one's endowment is known at the time political system is being crafted, then obviously the endowed will push toward a winner-takes-all system while those on the other extreme will push for an aggressive redistribution of wealth.

The epistemological constraint imposed by the veil of ignorance creates the circumstances for the contractors to act in accordance with Rawls' fair principles, which include: The contractors cannot choose to advantage just themselves (since they do not know where they will fall in society); they cannot choose to risk massively disadvantaging others (because these others will defect); and they cannot risk massively disadvantaging themselves (because they must consider their descendants and their own capacity to stay true to the principles they choose). Thus, even if the contractors do not affirmatively seek fairness, their circumstances lead what they choose to end up being fair.

From their perch in the original position behind the veil of ignorance, Rawls' contractors seek to temper the worst possible outcomes. We might think of this as the contractors choosing a basic structure for society in which there position will be randomly assigned, or even where there is a chance that their enemy will assign them their place. Rawls offers several reasons why this is the natural result. First, the parties cannot rationally take risks because the veil of ignorance makes probabilistic calculations impossible. Second, the contractors are choosing the political system not only for themselves, but for their progeny, and with such high stakes, they will want to guard against throwing their progeny into a purgatory. And third, although the contractors do not know their preferences or what they will consider good and desirable, they do know that there will be some notion of the “good and desirable” that will motivate them, so they seek to secure circumstances that will allow them to pursue this.

We can take Rawls' construction to explore the implications of instability in a capitalist society. Suppose that the contractors are told that whatever system they put forward will be beset by occasional exogenous shocks that destroy wealth. The social and political system may continue through these shocks, but there is nothing they can do to affect the occurrence of the shocks or their result.

Take the two extremes of possible shocks: complete stability versus unrelenting instability. In the first case one's position and wealth are secure. Once you have it, you can't lose it. And if you don't have it, you can't get it. In the other extreme, society is essentially beset with economic revolution, and fortunes are made and lost.

Now back up and suppose that the contractors placed in the Rawlsian veil of ignorance know a little bit more than he allows, in particular, that they know what their initial state will be in terms of position and wealth when the political system is first set, and they also know the degree of instability that will surround that system. What happens when we add this additional knowledge to Rawls' original position?

The greater the instability, the less value there will be in their knowledge of their initial state. In the limit, the additional information of one's initial state means nothing, because everything will become randomized in short order. So we are pretty much back to Rawls' assumption of a veil of ignorance in terms of each person's initial state. Things do not exactly reduce to Rawls' argument, however, because we have an additional piece of information, namely that no matter what system we put in place, it cannot prevent the frequent and arbitrary change in each person's conditions. In this situation, there will be a move toward an egalitarian solution; those who know they will be at the top when the game begins will join those on the bottom rung to vote for an egalitarian system.

Indeed, on an inter-temporal basis an egalitarian system is inevitable in the roll-of-the-dice extreme, in the sense that over the many rolls of the dice sometimes one person will be on the top, sometimes another, and everyone will face the same distribution of wealth. If people are not myopic, that is, if they look at the results of this extreme as it plays out over a long period of time, they will find that the greater the instability – the more frequently the dice are tossed – the lower the dispersion of wealth will be. Indeed, for all practical purposes there will be no private property, because period by period the property will be sold off based on the reshuffling of fortunes. It is “here today, gone tomorrow”.

On the other hand, if there is no instability, and people know their initial states, if everything is set in stone and one's initial state will persist forever, then obviously the rich will vote for a system where the winners keep everything they get, while the losers in the lottery will vote, as they will always, for sharing the wealth.

(Note: We don't need a literal lottery; we can have hard work and talent take a part in getting people where they are, and that each time the world essentially starts over hard work and talent play a part in how wealth gets redistributed. But we need to recognize that luck also plays a role, and so we can still invoke the image of a lottery or a roll of the dice. And, as Rawls asserts, inborn talent comes from the luck of the draw. The joke that someone's best career move was in choosing their parents applies to more than inherited wealth).

Instability and Egalitarianism

This might help provide a context for some of the current debate on wealth, income distribution, and taxes, and the related protests arising throughout the world. Instability helps overcome one of Rawls concerns, and a concern, not always well articulated, that must be in the minds of the protesters and others among the “99 percent”: That the political system, though just, can gradually move toward a result that, ex post, is at variance with the principles that society initially agreed upon.

Rawls concedes that even if everyone acquires their property justly in accordance with the political system and all distributions are done freely in accordance with the agreed concept of justice, it is still possible that over time disparities in wealth may occur that undermine the values from overarching first principle. He states:

Even though the initial state may have been just, and subsequent social conditions may also have been just for some time, the accumulated results of many separate and seemingly fair agreements entered into by individuals and associations are likely over an extended period to undermine the background conditions required for free and fair agreements. Very considerable wealth and property may accumulate in a few hands, and these concentrations are likely to undermine fair equality of opportunity, the fair value of political liberties, and so on.

This gives rise to a possible social contract. Faced with a knowledge of their current state, the people can design a political system that is unstable, thus giving them at shot at the lottery in the future. Or they can move toward one that maintains stability, and in doing so establish the rich more securely. For the people to choose the latter route and participate in a government that entrenches the rich, they will demand an egalitarian structure similar to what they would under the Rawlsian veil of ignorance.

Conclusion

We cannot separate the issues of income distribution from the social system. As a starting point, a wide income distribution requires a developed society. This is somewhat of a tautology, because a distribution suggests a population to distribute, but income distribution is not very meaningful in a family clan. It is hard to be very rich when you are all tilling the land and are all facing risk of starvation. But even more than that, a wide income distribution requires a stable society, which means laws to maintain property rights, a government that is not confiscatory in taxation, and a military that protects the society from attack. It is impossible to discuss the economics without considering the social contract. That is why it is called political economy.

There are many social contracts that are possible. Although we have been focused on the trade off between income inequality and stability, Rawls considers social systems without using the degree of stability as a policy lever, so to speak. A society might decide to have system that is both stable and egalitarian, such as what we see in Scandinavia. The discussion is not one of capitalism versus socialism. We can take unfettered, eat-what-you-kill capitalism as a starting point. The knob that is being turned is the level of social stability. From their perch in my version of the veil of ignorance those who are wealthy in the initial state will choose to construct a society that has less inequality so that the knob can be turned to the “do not disturb” setting.

The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This post expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff. Similarly, this post expresses the author's views and does not necessarily reflect those of the Department of Treasury or its staff.

The iPhone, Siri, and the Turing Test

We can start counting the days until computers routinely win a Turing Test. It will happen for two reasons.

One reason, which is the basis for a post I wrote on the Turing Test earlier in the year, is that we are meeting the computers half way. The more we become twittering, texting beings, the easier it is for a computer to mimic us, because we are stripped of much of our human context and behave more like computers. 

The second reason is now readily apparent with the unfurling of the Apple iPhone4S and Siri, the digital assistant.  With the iPhone users accessing Siri to find restaurants, make appointments, and ask trivia-level questions (and with more areas of interaction added down the road),  Apple's servers are going to amass the queries of millions of people many times every day.  And as Google has shown with Google Translate, if a computer has enough raw material, it can pretty much figure this sort of thing out.

So as this database grows by orders of magnitude and the logic is refined accordingly, if a Turing Test is fashioned to distinguish a computer from a person in the day-to-day tasks of working with a personal assistant – in one room is hidden an iPhone, in another room a person, you interact with them as you would an executive assistant over the course of the day, and then at the end of the day you choose which one you think is the person – it is only a matter of time before the iPhone becomes indistinguishable from the human. In fact, to keep it from standing out, the iPhone will have to be dumbed down. 

In this respect, Apple's move toward a voice interface is brilliant. For one thing, no matter how well you do it, using a touchscreen on a phone is cumbersome. And although we have grown accustomed to it, as we have the desktop mouse and laptop touch pad, this isn't really the way we do things in life. Furthermore, hardware need only go so far. It is not like smart phone users are trying to model fluid dynamics. But while the hardware improvements at this point are marginal, for Siri it is open-field running. More and more sites can be added – travelocity, fandango, and what not – sites will be optimized for Siri and new sites will pop-up specifically for Siri. Logic and voice recognition will improve, and the move toward the iPhone as a conversational partner will accelerate. 

There already is an annual Turing Test underway, the Loebner competition, where a set of judges spend a few minutes conversing (via keyboard) with computers and with people, and then have to decide which is which. It is not a great test, because it is a competition rather than a normal human environment. The judges are trying to weed out the computer through types of questions and cadence of conversation in ways they wouldn’t in real life. A more reasonable Turing Test would be to invite a computer into a round of dinner conversations where the human subjects are not made aware that this is occurring. (They would all have to be remote conversations for obvious reasons). After the fact, subjects are told that some of their companions might have been computers, and only then are they asked to rank the guests by “humanness.”

A Personal Assistant Turing Test will be something like a mid-term. Computers may get to the final exam, but they will still have a ways to go. Free-ranging dinner conversation puts the bar high, because it brings in context and give and take.  The low bar, sort of the tests for remedial work, is one-liner text, or invective-laden argument, where the objective is to rant while ignoring anything the other person is saying. I go through a classic and humorous example of this in my other post. On the continuum from context-rich, intelligent conversation toward the increasingly vacuous – e-mail exchanges, online chat, and finally twittering – the digital assistant leans toward the latter. Its conversation is close to stateless, because each command is unanchored from all but the last inquiry and the information provided up to that point. One rung up is something like cocktail party chit-chat of the “do you know so-and-so”, “have you ever been to wherever” variety. For that, I think the iPhone and Siri will be able to shine. It can know just about everyone and everyplace.  

So if you love your iPhone now, just wait until you can chat with it over a couple of drinks.

A Crack in the Foundation: An error that has wended its way through economics for 77 years

This post is an introduction to a detective story about an error. An error that passed undetected by some of the greatest minds of the twentieth century, and led economics down a path that now must be cast into question. It is an error from 1934 Vienna that has lain hidden for the better part of a century, uncovered in 2011 in the academic halls of Imperial College of London. It is an error that is both obvious and startling after the fact, and is the result of a calculation that literally is off by an order of infinity.

A few weeks ago I attended a conference sponsored by the Santa Fe Institute, where I participated on a panel with Henry Kaufman, Bill Miller and Marty Leibowitz. The conference topic was Forecasting in the Face of Risk and Uncertainty. One of the presentations was by Ole Peters, from the Department of Mathematics at the Imperial College of London. His presentation compared time series analysis with ensemble analysis. Time series analysis takes one realization of a process and runs it over a very long time period and then looks at the distribution over the course of that run, whereas ensemble analysis creates many copies of the process and runs these over a shorter period, and then looks at the distribution of those results. Time series analysis is what you see over many years in one universe, ensemble analysis is what you see when you take many universes and integrate across them to look at the distributional properties.

Even if we use the same process for generating the paths as we do for the time series, these two approaches can lead to surprisingly different results for the ultimate distribution. This will always be true if a process is not ergodic, that is if it doesn't have the properties of creating a defined and unique distribution and leading to that distribution without regard to the starting point. Another way to think of an ergodic process is that over time it visits every possible state in proportion to its probability, and does so with the same proportions no matter where you start the process off. And one of the keystone processes analyzed in economics, the process of the inter-temporal compounding of wealth, is an example of a non-ergodic process. Peters presents a disarmingly simple example to show the difference between the time series and ensemble approaches for this process. Using a progression of simulated coin flips, he shows a case where the ensemble approach has a positive mean while the time series approach has one that is negative. On average people will make money while for the individual wealth will follow a straight line (on a log scale, at least) toward zero.

As Peters recounts in his presentation, economics has been almost unwavering in applying the ensemble approach. The reason is that in 1934 the Austrian mathematician Karl Menger wrote a paper that rejected unbounded utility functions. These unbounded functions include, for example, logarithmic utility, a particularly useful one because it corresponds to exponential growth, and thus is a natural for many time series processes (like compounded returns). Because his result is wrong, the motivation for focusing on the ensemble approach is ill founded. And, to make matters worse, in many important cases it is a time series approach that makes the most sense. After all, we only live one life, and we care about what is dealt to us in that life. If we enjoyed (and recognized that we enjoyed) reincarnation so that we could experience many alternative worlds – and better yet, if we experienced them all simultaneously -- perhaps it would be a different matter.

What is fascinating is that Menger’s paper has been cited widely by notable economists, including Samuelson, Arrow and Markowitz, Nobel laureates all. Peters recounts a number of these: In 1951, Arrow wrote a clearer version of Menger's argument, but failed to uncover the error while doing so. Ironically, by performing this service he helped propagate the development of economic theory along the wrong track. Arrow more recently wrote that "...a deeper understanding [of Bernoulli's St. Petersberg paradox] was achieved only with Karl Menger’s paper”. Markowitz accepted Menger's argument, stating that “we would have to assume that U[tility] was bounded to avoid paradoxes such as those of Bernoulli and Menger”. Samuelson waxed effusive regarding Menger's 1934 paper: “After 1738 nothing earthshaking was added to the findings of Daniel Bernoulli and his contemporaries until the quantum jump in analysis provided by Karl Menger”, and further that “Menger 1934 is a modern classic that stands above all criticism”. (And up until Peters’ paper, it seems it did indeed stand above all criticism, if there was any at all). That the paper was such a focus for so stellar a group of economists gives you a hint of its importance to the path economics has taken.

Not that the error is all that obscure, at least with the benefit of hindsight and a clear exposition. It boils down to Menger saying that the sum of a quantity A and a quantity B tends to infinity in the limit. Menger shows that A tends to infinity, and then argues that because of this, it doesn't matter what is going on with B, because infinity plus anything else is still infinity. Unless, of course, it happens that B is tending toward negative infinity even faster. Which, it turns out, is the case. So the sum, rather than having infinity as its limit, has negative infinity as its limit!