The wealthy dead

A friend pointed out this new list of the highest earning dead celebrities, and as this article proclaims Elvis has been unseated by Kurt Cobain.

That musicians earn lots after they die comes as no shock, but I am very surprised by number 5 on the list.

Rounding out the top five were Beatle John Lennon at $US24 million ($31.76 million) and groundbreaking physicist Albert Einstein at $US20 million ($26.47 million), whose estate profited from such licensing deals as the popular Baby Einstein educational videos.

You can publish ground breaking work in several areas of physics, win a nobel prize, revolutionise the way we think about space and time and then your decendents make a fortune by lending your name to some children’s educational videos!

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Public health care

Recently I was accused of “increasingly exhibiting rational libertarian tendencies“. Now I’m sure this is true to some extent. While I think my normative goals in terms of social justice have stayed much the same, I’d certainly agree that my openness to methods of achieving these goals efficiently has changed. Hopefully this makes me rational. Libertarian, I’m not so sure.

In general I’m much more at ease than I once was with the use of markets to allocate goods efficiently. While I still think that inequality matters because low incomes are largely the result of poor fortune and we do need some method of redistributing wealth, in general though this is better done via a progressive taxation system and effective welfare than by price fixing and subsidies or by actual involvement in the production of services. Arguments for just how this is done though is meat for another post.

There is a select few areas though that I think deserve special consideration outside this general framework, because the alternatives are essentially either unfair or unworkable and the services provided are essential. In my view chief amongst these is health care.

Its easy to find problems with the health care system in Australia and other places with a similar system, bed shortages, long waiting lists and under resourcing. There is certainly plenty of room for fixes and considering better ways of delivering services. On the other hand, the radical solution to the problem that some would propose, is an entirely private health care system. I can only see this solution as far, far worse.

Amaranth: Was it failure of risk management or a failure caused by risk management?

In September the US Hedge fund Amaranth collapsed losing $6.5 billion dollars over a couple of weeks when its positions in natural gas futures turned bad. With prices falling, Amaranth was unable to off load its position and the losses continued to mount.

While it didn’t cause the sort of near disaster that the LTCM collapse triggered, it did wipe out almost the entire value of the fund which has now been taken over. Here is how the CEO of Amaranth described it:

In September 2006, a series of unusual and unpredictable market events caused the Funds’ natural gas positions (including spreads) to incur dramatic losses while the markets provided no economically viable means of exiting those positions. Despite all of our efforts, we were unable to close out the exposures in the public markets.

Market conditions deteriorated rapidly during the week of September 11. Material losses began early in the week, and we accelerated our efforts to reduce our exposures. On Thursday, September 14, the Funds experienced roughly $560 million in trading losses on their natural gas positions. We continued to attempt to reduce our natural gas exposures, while also selling other positions to raise cash in order to meet margin calls. As news of our losses began to sweep through the markets, our already limited access to market liquidity quickly dissipated.

The fund lost an average of $420 million per day for the first 14 trading days of September, totaling a final loss of around $6 billion.

Efficient Markets and the Law

I’ve been catching up on some reading and I found this article in The Economist which is a few weeks old. In general I seem to criticise those who rubbish the Efficient Markets Hypothesis too much, but then there is the US Supreme court who it seems may take it too seriously.

JAMIE OLIS knows better than most people that the ideas conjured up by economists in their ivory towers can have a big effect on the real world. The tax accountant, found guilty of committing fraud while working for Dynegy, an energy-trading firm, has been doing time since March 2004, in large part thanks to a controversial economic theory, the efficient markets hypothesis.

Not just a little bit of time mind you, but 24 years, at least until a court threw out the sentence.

…In 1988, in Basic Inc v Levinson, the court endorsed a theory known as “fraud on the market”, which relies on the efficient markets hypothesis. Because market prices reflect all available information, argued the [Supreme] court, misleading statements by a company will affect its share price. Investors rely on the integrity of the price as a guide to fundamental value. Thus, misleading statements defraud purchasers of the firm’s shares even if they do not rely directly on those statements, or are not even aware of them.

Which is fine except for the fact that we know that prices move around regardless of new information, at least not the sort of information that comes from public announcements. Similarly news may take some time to be absorbed by the market which may over-react, and it is well known that volatility clusters. Don’t announce a fraud when the market is already volatile, the moves are likely to be bigger. Its a very tough call to equate a market move after an announcement entirely to that announcement, or even know when do you consider the information fully incorporated.

Of course that hasn’t stopped the lawyers and Judges from using it.

Misbehavior of Markets: Mandelbrot

In 1963 Mandelbrot published research into the distribution of cotton prices based on a very long time series which found that, contrary to the general assumption that these price movements were normally distributed, they instead followed a pareto-levy distribution. While on the surface these two distributions don’t appear to be terribly different, (many small movements, and a few large ones), the implications are significantly different, most notably the pareto-levy distribution has an infinite variance.

This implies that rather than extreme market moves being so unlikely that they make little contribution to the overall evolution, they instead come to have a very significant contribution. In a normally distributed market, crashes and booms are vanishingly rare, in a pareto-levy one crashes occur and are a significant component of the final outcome.

Benoit Mandelbrot: Annoyingly full of himself.

I’m currently reading Mandebrot’s “The misbehavior of markets” which in time I will write a review of, but about 100 pages in I have to say I’m pretty tired of him stating every couple of pages how he discovered fat tails in market prices forty years ago, and has known the whole time that Modern Portfolio Theory, Black-Scholes etc was based on the wrong assumption of a normal distribution all that time. There appears to be some interesting stuff in the book, and there is no doubt some of the basic assumptions of finance theory need a look at and possibly re-grounding, but its not like no one in the past forty years hasn’t been dealing with this.

Even though it’s very much ad hoc, markets already attempt to account for the fact that Black-Scholes is flawed, by pricing in an implied volatility smile. Similarly fat tails have been used in risk models pretty widely by now. Neither are completely satisfactory but are both clear signs that market participants at least realised the flaws in the models being used, and have tried to adjust accordingly while retaining some framework that actually lets you get on with things. Certainly this is not the impression you get from the early parts of this book where it seems keen to show that Mandelbrot is virtually alone in appreciating the problems.

There is a maxim in creative writing that an author should “show not tell” as in you reveal the abstract qualities of personality etc by showing the details not telling the abstractions directly. It would be well for non-fiction authors to realise that they will come off much better by showing us how smart they are by revealing the genius of their arguments and discoveries rather than by telling us how smart they are every couple of pages.

Spinning a narrative

One of the topics discussed in Fooled by Randomness was the tendency of people in general, but journalists and business economists in particular, to attempt to spin any random series of events into some sort of coherent story. Rather than being content to report an event in its own right there is a compulsion to explain even if the link is tenuous.

He gives some typical “Bloomberg” examples (from the widely used news/trading service). Comments such as “Dow is up 1.03 on lower interest rates”, when there is little evidence that the two events are related, particularly when a 1 point move on the Dow is essentially it remaining unchanged. Essentially they are trying to explain noise as something real and this goes wider than the reporting on markets.

Other classic examples are journalistic explanation of polling data. A drop of a percent or two in the figures of one poll is read as having been the voter’s perceptions. This article in the SMH from earlier this year is a classic example:

The downturn in support for the Government over the past month indicates the tax cuts have failed to assuage public dissatisfaction over the rise in interest rates and petrol prices, and the fiasco following the death in Iraq of Private Jacob Kovco.

How much of a swing? 3 percentage points, which as Andrew Leigh explained at the time, once the margin of errors are taken into account, is a result not significant enough for any credible social scientist to draw a conclusion from.