Monday, December 12, 2011

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.

Monday, November 28, 2011

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.

Tuesday, November 8, 2011

Class Warfare and Revolution (Circa 1850)

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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.



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.

Friday, October 21, 2011

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.

Sunday, October 16, 2011

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.

Thursday, October 13, 2011

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!

Monday, September 26, 2011

What can we learn from the policies that spurred the Industrial Revolution?


Some of the dominant policy issues of today – immigration, energy, the emergence of China – have their analogues in the great Industrial Revolution. The key government policies that laid the foundation for the Industrial Revolution in England include supporting the immigration of skilled workers, allowing for private ownership of farm land, weakening the unions of the day (the guilds), and addressing the energy crisis (in charcoal). And contrary policies in Italy and Spain – countries that were far wealthier and advanced than was pre-Industrial Revolution England – derailed a similar revolution from occurring in continental Europe.

England would not have been anyone's first bet as the cradle of the Industrial Revolution. When compared to the developed countries of the time, such as Italy, the Netherlands, France, and Germany, sixteenth century England was an also-ran, and had fewer than 4 million inhabitants, compared to 15 million in France, 11 million in Italy, and 7 million in Spain. We all know the key innovations and developments that sparked the Industrial Revolution:

Textiles. For centuries preceding the Industrial Revolution England produced the best wool in Europe, and from the fourteenth century onward moved more and more into the production of woolen cloth. Wool and woolen cloth represented the bulk of English exports. Four inventions mechanized textile manufacturing and ushered in the Industrial Revolution: the spinning-jenny, patented by Hargreaves in 1770; the water frame, invented by Arkwright in 1769; Crompton's mule introduced in 1779; and the self-acting mule, which was brought into use until Roberts improved it in 1825. The most famous invention of all, patented by Cartwright in 1785, was the power-loom. And add to these a critical one from America: the cotton gin.

Coal and Iron. Meanwhile, the iron industry had been equally revolutionized by the invention of smelting by pit-coal brought into use between 1740 and 1750, and by the application in 1788 of the steam-engine to blast furnaces. In the eight years that followed, the amount of iron manufactured nearly doubled. Improvements were introduced in puddling, rolling, and other processes. The production of coal increased more than proportionately. The smelting of iron and the use of the steam-engine created fresh demand for coal, so capital and innovation extended to mining, leading to steam pumps, timber roof supports, and safety lamps.

The factory system. Prior to the Industrial Revolution, manufacturing was organized according to the "domestic system". Manufacturing was carried on in houses by a master working with a few journeymen and apprentices, usually in country villages. The implements of manufacture belonged to the master. The raw material—wool, linen, metal, or whatever —was the property of a town merchant or capitalist, who distributed it to the manufacturers in their houses in the villages, paying them for the product and then selling or exporting it. The power spinning machines were too large to be used in a house and required a large scale power plant. As a result, the Industrial Revolution led to an increase in the size of plants and a resulting concentration of labor and capital into centralized production centers. Shipbuilding, textile manufacture and the like required plants worth millions of pounds with hundreds of workers. Manufacturing thus moved from the traditional domestic or guild system to what became known as the factory system. The factory system brought with it capital-intensive production methods, power, and regimented laborer. 

Less discussed are the government policies that provided the foundation and then nurtured these innovations:

Investing in infrastructure
The roads in England were in terrible condition at the start of the Industrial Revolution. It took a week or more for a coach to go from London to Edinburgh. Ruts were four feet deep, hardly a mile could be passed without seeing carts broken down.

Infrastructure projects, both by private turnpike companies and by public authorities, covered England with good roads. And even more important that the roads was the development of the infrastructure of the waterways. The first canal was completed in 1761, and within a few years a system of canals gave ready transportation for goods through all parts of the country. The investment in infrastructure, augmented by the introduction of steam engines for both rail and boats, was one of the most critical foundations for expansion of the Industrial Revolution, and indeed for the nineteenth century in general.

Opening immigration for skilled workers
Another policy that enhanced England’s position for industrialization was the influx of skilled immigrant. Persecution in France and Spain and economic difficulties in Spain and elsewhere drove people to more hospitable countries, with England at the top of the list. This immigration was not merely an infusion of labor, but of skilled labor that brought with it new methods of production: Flemish cloth; Walloon weavers, thread-makers and iron smiths; French Huguenots silk-weavers; clocks and metal goods from Normandy and Brittany; Spanish needles; Venetian glass; fine milled paper from Germany.

Not surprisingly, the immigrants were frequently harassed by English craftsmen, who saw in them as potentially dangerous competitors. But the Crown had policies to protect them, and ultimately the English craftsmen learned their techniques and often improved them.

Weakening the guilds
The influx of immigrants could only benefit England to the extent they were allowed to ply their trades. The English government put policies in place that assured this. In England the government – through the action of the Crown – did not permit restrictive practices of the crafts guilds In the cities, guilds also weakened because of the domination of the mercantile class, which controlled the market and the raw material of the craftsmen. Many immigrants did not stay in the cities, because once in the countryside the power of the guilds was dampened further.

In contrast to England, where manufacturing escaped from the controls of the city guilds, thereby allowing skilled immigrant, in Italy the guilds remained dominant, thwarting the few attempts to introduce innovations. Manufacturing remained stagnant in Italy, entrenched in the past. The result was a gradual replacement of Italian goods and services by foreign ones because the English – along with the Dutch and the French – could offer lower prices due to their innovations in production. Italian products were of a higher quality, but Italian manufacturers were constrained by guild regulations to use less efficient, traditional methods. The English and the Dutch swamped the textile market. Their products were inferior, lighter and less durable than the Italian products, but they cost a good deal less.

And not only did Italy lag in efficiencies of production. The guilds led to higher labor costs. Competition lowered wages outside Italy; while within Italy the guild organization kept wages up. At the beginning of the seventeenth century, Italian wages were out of step with wages in other countries. As a result there was a marked decline in Italian exports along with reduced investment in manufacturing and shipping.

Establishing private agricultural land
Traditionally the agricultural land in England was largely held in commons. Towards the late 1600's the government enacted laws that permitted enclosures, effectively privatizing land. Enclosing agricultural lands provided a scale of production and a level of control by the owners that led the to radically improved the efficiency of agricultural production. Rotation of crops, better fertilizers, drainage, breeding of better livestock (by one contemporary estimate, between the early and late 1700s black cattle increased from 370 pounds to 800 pounds, and sheep from 28 pounds to 80 pounds), were among the characteristics of the new farming, and these were practical only to those who had some capital, knowledge, and enterprise – all of which came more naturally to larger tracts of land under private ownership.

These improvements led to a cascade of further consolidation because those who continued to work the small farms could not compete and so sold them to neighboring landowners who had already created a production edge through earlier consolidation.

As with most of the other policies, enclosures came with its social costs. A popular piece of doggerel declared that:
The law locks up the man or woman
Who steals the goose from off the common;
But leaves the greater villain loose
Who steals the common from the goose."

Nonetheless, the resulting agricultural revolution played a large part in the industrial revolution. Not only in terms of the production of food to fuel the labor, but in the flow of farmers into the industrial sector.

Overcoming the energy crisis by forcing a move to new energy sources
The Industrial Revolution can be viewed as the control and redirection of energy toward production. But early on this was stymied because of deforestation and the resulting shortage of the primary fuel of the time: charcoal. To give an idea of the shortage, as early as the 1500's and into the 1600's the price of oak (primarily used in shipbuilding) rose twelve-fold, and the price of timber for charcoal increased five-fold.

In the sixteenth century England ordered a governmental inquiry into timber wastage and deforestation and then instituted a number of Acts of Parliament to suppress the cutting of timber for industrial purposes. As a result, foundries were forced to reduce their activities and England began to use coal for heating and in industrial processes. People were wary of the toxic fumes, but had no alternative. The transport of coal by sea from Newcastle to London increased from 35,000 is 1550 to 560,000 tons a century late. By 1738 a French traveler wrote that coal was "the soul of all English Industries."

As it turned out, this energy crisis, by forcing a move toward coal (and helped in that regard by the fact that England was relatively sparsely populated by forests in the first place but was abundant in coal), ended up helping to push England down the road towards industrialization.

Bringing in capital
Capital had not existed in any large amounts in medieval England, and even in the later centuries there was no group that focused on investing capital into industry. Agriculture and manufacturing were carried on with very small capital, usually the capital each farmer, artisan, or merchant might have of his own. There was no use of credit either from individuals or from banks for industrial development.

But capital was required to buy the new machinery at the heart of the industrial age. These machines were far too expensive for the old cottage weavers. Capital therefore had to be brought into manufacturing. This capital came from various directions.

Capital from Privateering
Privateering, also known as commerce-raiding, was basically government-sanctioned piracy. Strange as it may seem, with the development of England's seafaring capability and the flow of precious cargo from the Americas, privateering became an important source of capital accumulation in England. Indeed, in the three years following the defeat of the Spanish Armada in 1588, over two hundred English ships were involved in privateering, and over three hundred foreign ships were captured.

Capital from Spain
Meanwhile, Spain, which had an early lead on capital because of the influx of American treasure, enjoyed a period of splendor and economic superiority but lacked the human capital due to a cultural antipathy, even prejudice toward productive labor, to put that capital to good use.

So Spanish merchants turned to foreign producers and provided their capital to the foreign enterprises. A Venetian ambassador remarked, "Spain cannot exist unless relieved by others, nor can the rest of the world exist without the money of Spain."

The capital from the Americas thus provided Spain with purchasing power but ultimately stimulated the development of Holland, England, France, and other European countries.This prosperity, easily funded but inevitably of limited duration, led many to abandon farming and to regard craft and mercantile activities as menial occupations. Instead resources poured into the academies, whose product occupied the clergy and the increasingly bloated government bureaucracy rather than productive industry – and disguised structural unemployment as well. 

In 1675 Alfonso Nuñez de Castro wrote:
Let London manufacture those fabrics of hers to her heart's content; Holland her chambrays; Florence her cloth; the Indies their beaver and vicuna; Milan her brocades; Italy and Flanders their linens, so long as our capital can enjoy them; the only thing it proves is that all nations train journeymen for Madrid and that Madrid is the queen of Parliaments, for all the world serves her and she serves nobody.

In short, seventeenth century Spain lacked entrepreneurs and artisans but had an overabundance of bureaucrats, lawyers. As England was building the foundation for the industrial revolution, easy-come-easy-go Spain provided capital even as it sank into decline.

Capital from rescinding primogeniture
The economic way of life in medieval England was framed by two economic realities: Virtually all wealth was in the form of land, and the land could not be sold. Wealth was held in land even up to the seventeenth century it was the universal outlet for savings in England-primarily because there were not many alternative investments. As late as the sixteenth century, more than 80 percent of production was based on agriculture. What limited industry there was bore little resemblance to the Industrial Age that would follow centuries later. Some towns had specialized industry-brewing, salt making, iron working, paper mills-but this was still not characteristic of the economy as a whole. And because land was the preponderant store of wealth, it was also the source of social stature and political power. A large landed estate gave its owner great local influence in controlling elections and sharing in patronage and opened the door for him to join the gentry.

As early as the time of the Norman Conquest in 1066, land could not be sold or even used as collateral for a loan because feudal lords exchanged it for a knight's military service. A knight could no more transfer his land than he could pass on his military obligation. This this limitation on the right to transfer land carried the weight of law because of another import into England: primogeniture. Landholders had a right to their land only for the course of their lives, after which the deed was transferred according to the rules of primogeniture, which meant it generally passed to the oldest son.
The cost of having capital be literally land-locked capital became increasingly apparent on a practical level as new avenues for wealth and investment opened up. The development of overseas commerce and the increasing involvement of leading merchants in the lucrative business of lending money to the government expanded investment opportunities. Finally, there were prospects for building fortunes apart from land ownership. The landed gentry had an incentive to extract the wealth from their land to pursue other opportunities, so various artifices were used to circumvent primogeniture.`
The new-found liquidity in the land progressed during the Tudor and early Stuart reigns, resulting in the rapid growth and independence of the English gentry and their servants. Now that land could be used as collateral, it opened up new possibilities for borrowing and lending. An embryonic capital market developed in London, and by the seventeenth century in other cites as well. The end of primogeniture thus helped allow capital to find its way into financing the emerging opportunities of the Industrial Revolution.

Breaking down class barriers for artisans and engineers
In the Middle Ages, science and technology were separate and distinct. Science was philosophy; technology was craft. Science had no interest in technological affairs, and technological developments were the fruits of uneducated artisans. For example, physicians viewed themselves as scientists and philosophers, and so had nothing to do with the surgeons, who were considered technicians and simple artisans.

But developments in ocean navigation, in the watch and clock industry, and in experimental science required increasing numbers of precision instruments which in turn led to a new, superior sort of technician who could interact with the scientists, with both the technician and the scientist engaged in similar problems. It required an elevation in the status of the artisans, engineers and skilled workers, and a partnership between these occupations and the more elite and lettered of science and philosophy. This interaction between the philosopher-scientist and the artisan was promoted by so august a body as The Royal Society of London, which charged some of its members with compiling a history of artisan trades and techniques.

This new attitude, an attitude toward science that placed pragmatism before idealism, that applied mathematics to explaining the real world, and that introduced experimentation and empiricism (along with statistical methods – the experimenters of the seventeenth century endlessly recorded, cataloged, and counted) as an integral part of the scientific process, underlies the inventions of the Industrial Revolution. The willingness to have science deal with the practical rather than the philosophical, to solve the concrete problems of production, and to team up with the skilled artisans – a partnership across class lines that was unique to England -- was critical for the technological developments behind the Industrial Revolution.

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.





Monday, August 29, 2011

Workers of the world, good night!

I spent the 1981-82 school year in Israel as a visiting professor at the Hebrew University in Jerusalem through a Fulbright Fellowship. This was the year of the bombing of the Ossiraq Nuclear reactor near Baghdad and the Lebanon War. Though less threatening than the 1967 Six-Day War and the 1974 Yom Kippur war, the cost in lives was palpable, because of the small size of Israel and the many interrelationships of its society. Our babysitter there, still a high school student, had six friends killed. One of the professors that I worked with at the Hebrew University lost his son, a mathematician who served as a tank commander. (There are not many countries where tank commanders hold PhD's in mathematics).

During the war I was traveling throughout Israel with a biblical geography class. We drove through the narrow mountain pass by Mount Carmel, part of the ancient international coastal highway that the Egyptian army used 3000 years ago as they marched to points east. On this same route, now a paved highway but still cutting narrowly through the mountains, our tour bus followed behind an army truck with artillery shells stacked on its open bed. Later that day we arrived at the remains of the ancient fortified city of Hatzor which was strategically stationed to protect against Assyrians approaching from the north. A mobile antiaircraft installation now stood on a rise a stone's throw away, its missiles pointed northward.

For all the distress and tragedy that surrounded that war, one thing that it brought forward was the great vitality of Israeli society. Being at such risk and having the realization of death so nearby made life valued and vibrant. It brought the things of importance to the forefront. There was no space for trivialities, no discussion of prestige addresses or showy cars; no concern with the quality of restaurants or the latest social scene. The Israeli society of 1981 was true to the country's egalitarian roots, the idealism of the Zionist movement embodied in the socialist Kibbutzim.

Things are different now. Protests have erupted in Israel decrying the wide disparity in the distribution of income, a widening gap that is seen in few other developed economies. A handful of families that dominate the Israeli economy are the targets of the protests. The tax code allows the families to recycle their capital with hardly any dampening effect, leapfrogging to seize one enterprise after the next in what the Israelis term a pyramid strategy. They control some 30 percent of the economy, including the banks, supermarket chains, cellphone and insurance companies, and media.

Just as Greece, one of the economically weakest EU countries, became the canary in the coal mine for credit issues that then struck the European countries more broadly, Israel, historically one of the most egalitarian countries and now one with the greatest disparity in the distribution of income, may become the canary in the coal mine for a broad crisis in the socioeconomic realm.

Israel may have made the biggest u-turn in terms of social disparity, but it is not alone. Similar disparities are emerging in the United States. Since 1993, more than half of the nation’s income growth has been captured by the top 1 percent of earners, and the gains have grown larger over time: from 2002 to 2007, out of every three dollars of national income growth, the top 1 percent of earners captured two.

The most recent of a drum roll of articles that have appeared in the last several years on the subject appears in, “Can the Middle Class be Saved?” in this month's Atlantic.

The author Don Peck writes:
America’s classes are separating and changing. A tiny elite continues to float up and away from everyone else. Below it, suspended, sits what might be thought of as the professional middle class—unexceptional college graduates for whom the arrow of fortune points mostly sideways, and an upper tier of college graduates and postgraduates for whom it points progressively upward, but not spectacularly so. The professional middle class has grown anxious since the crash, and not without reason. Yet these anxieties should not distract us from a second, more important, cleavage in American society—the one between college graduates and everyone else....The return on education has risen in recent decades, producing more-severe income stratification. But even among the meritocratic elite, the economy’s evolution has produced a startling divergence.

These disparities in the U.S. are not the subject of protests as in Israel. At least not yet. Right now the opposite seems to be the case. Surprisingly and somewhat inexplicably those who would be the natural vanguard of such protest--the unemployed, underemployed, and more broadly those who see their standard of living diminishing --continue to root for the success and the protection of the wealthy. But things can change quickly; draw a line from the emerging focus on the "Acela Corridor" elites.

Capitalism-lite: Can you spell 'capitalism' without capital?
Among the many sources of this rising disparity in income is the changing nature of capitalism. A little bit of capital goes a lot further in building out the virtual world than it did in the burgeoning industrial revolution with its railroads, steam-driven mills and iron foundries, or even in the pre-rust belt, brick and mortar 20th century. Not only does it take less capital, the capital that is required need not be committed for very long before the outcome of the enterprise is manifest.

The reduced capital requirements for creating even multibillion dollar businesses can be thought of as providing a new type of leverage, what might be called functional leverage. Functional leverage means that a given amount of capital can capture a greater base of production. Which means that it is easier for the entrepreneur to bootstrap up from one enterprise to the next while maintaining a much higher equity stake than would have occurred during the period of capital intensive production. Think of the trajectory of Google, Facebook, LinkedIn or GroupOn. How much capital was needed to push the businesses past the billion dollar valuation mark, and how long was that capital required? When the IPOs in these businesses finally do occur, it is not so much to allow access to further capital as to provide a channel for the owners to monetize their stake.

Functional leverage widens the distribution of income by changing the odds and payout for risk-taking activities. Think of a casino where the bet limit is kept low and the odds of winning are close to fifty percent. At the end of the day there will be winners and losers, but the implications for their relative wealth will be small; the distribution of income that arises will be tight around the mean. With functional leverage of the new capitalism, the casino allows very high limits and the bets are ones with high odds but high payoffs. Such a casino alters the distribution of wealth by creating a large right-hand tail.

Thus the rise of the super-elite is not a product of educational differences, but rather a result of the new capitalism which creates bigger winners, and does so much more quickly than in the capital-intensive capitalist era. Less capital is needed, it is applied for a shorter period before the results are realized, and because less capital is required, the entrepreneur captures more of the value of the enterprise. The result is an accentuation in the very wealthy.

The new capitalism also comes with its version of the monopoly power that catapulted the Gettys and Rockerfellers into the stratosphere: lock-in. Lock-in occurs when consumers have invested so much in a product that its not worth making a switch even if a competitor is offering a marginally better product. Think of transferring all your Gmail or Facebook connections to someplace else, or running up the learning curve for using an alternative to Windows. Lock-in creates barriers to entry and pricing power not unlike that enjoyed in the past century by the barons of steel, railroads and oil, albeit through a much different mechanism.

Of course, the move toward capitalism-lite is not the only force behind the widening distribution of income. It might explain what is occurring on the right-hand tail, but there is another edge to the scissors: workers are being pushed further toward the left tail. For example, financial innovation that allows a broader group to enter the game and increase risk to their wealth in the process – extending down to the lower middle class. Financial innovations in the mortgage market are the prime example. And there is the change in manufacturing. Since 2000, U.S. manufacturing has lost a third of its jobs. As Peck notes, the real median wages of men have fallen by 32 percent since their peak in 1973 once you account for the those who have become unemployed. Part of this is due to global competition, but part of it is increased efficiency and a move toward products that are less labor intensive. We have remained preeminent in agriculture even though now only two percent of the U.S. workforce are farmers. The same might now be occurring in industry. Also, there is what I have called the consumption trap – as more of our time is spent in the virtual world, there is dwindling demand for goods that are labor (and capital) intensive.

Marx considered the role of labor and capital during the Industrial Revolution and called capital the king and workers the subjugated. Now we may be moving into an era of capitalism where capital -- and workers -- become incidental.

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