Economy


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I stumbled on to this book a few weeks ago and immediately picked it up after a quick browse through the sections of the book. I had promptly placed it in my books-to-read list. I love anything related to information theory mainly because of its inter-disciplinary applications. The principles of information theory are applicable in a wide range of fields. In fact it will hard to pinpoint a specific area where concepts from information theory have not been applied. In this post, I will summarize the main points of the book.

 

Prologue : The Eternal War

The chapter is titled so, because there is a conflict between entropy and information. The entropy is the incessant march towards disorder. One of the ways that I can relate to is my music practice. If I don’t practice my music for long, I find it difficult to retrain my fingers and get back my muscle memory. "That which you don’t use atrophies". Entropy is also something similar. In the absence of any mechanisms to create information, the disorder of the system increases. This obviously raises a question about the mechanisms that allow the information to battle randomness and grow. The book is mainly about describing the mechanisms by which the information grows, the physical order of our world increases – that makes our planet unique, rich and uneven, from atoms to economies. The author focuses on planet earth as this is a special place where information lives, grows and hides in an otherwise mostly barren universe.

In the prologue, the author says that the book would answer the following questions:

  • What is Information ?
  • Where does it come from ?
  • Why is information concentrated on our planet?
  • Why does it grow on our planet ?
  • What are the natural, social and economic mechanisms that allow it to grow ?
  • How do the various mechanisms contribute to social and economic unevenness of the global economy ?
  • How does the social accumulation of information improve our capacity to accumulate even more information?


Introduction : From Atoms to People to Economies

The chapter starts with the story of Ludwig Boltzmann, the famous scientist who committed suicide. Though the exact reason is not known, the author speculates that it could be the apparent conflict between his theory and the order prevalent in the world. His theory was that there is always a march towards disorder, which stumped him because there were so many fascinating things in the nature that were orderly, systematic, almost giving an impression that there was a creator up there who was designing our world. The biggest sin that Ludwig committed, given the context of scientific temper at his time, was that he had worked across spatial scales. His theory made connections between atoms and gases, both belonging to different spatial scales. At that point in time, any connection between various spatial scales was considered as a sin.

At the turn of twentieth century, Ludwig was vindicated. There was immense cross-fertilization of ideas amongst many fields. Yet not all of the cross-fertilization took place near known scientific boundaries. Amid these multidisciplinary tangos, there was one concept that was promiscuous enough to play the field. This was the idea of information. In the twentieth century, the study of information was inspired by war as there was a urgent need to encode and decode messages effectively. The field took off after the revolutionary paper by Claude Shannon and Warren Weaver. Information as a concept found its followers in almost every field for the simple reason that it could be applied to microscopic as well as macroscopic worlds. It was the first truly scale independent concept. Even though the idea of information grew in prominence, many began to forget one crucial aspect of information

We forget about the physicality of information that had troubled Boltzmann. The word information became a synonym for the ethereal, the unphysical, the digital, the weightless, the immaterial. But information is physical. It is as physical as Boltzmann’s atoms or the energy they carry in their motion. Information is not tangible; it is not a solid or a fluid. It does not have its own particle either, but it is as physical as movement and temperature, which also do not have particles of their own. Information is incorporeal, but it is always physically embodied. Information is not a thing; rather, it is the arrangement of physical things. It is physical order, like what distinguishes different shuffles of a deck of cards.

One of the highlights of the work of Shannon and Weaver is that they divorced the idea of information and message. Colloquially we can use both the terms interchangeably. However the need to divorce the two was needed so that further developments in the field could happen. Whatever gets transmitted between two devices, two people, is information. It is humans who automatically interpret the information as a meaning, given the various contextual factors. This clear demarcation was given because technically , one could now focus on sending any kind of messages whether the message meant anything or not. Shannon also came up with a formula for encoding an arbitrary message with maximum efficiency. This formula looked identical to the Boltzmann’s formula.

The beauty of information being scale independent means that one can use principles of information theory to describe everything from atoms to economies. In all the previous attempts, natural sciences described the atom to human connection, the social sciences described the connection between humans and economies. Using the concept of information, one can analyze across all scales. The content of book is laid out in such a way that it describes the history of the universe, centered not on the arrow of time but on the arrow of complexity.

It is the accumulation of information and of our ability to process information that defines the arrow of growth encompassing the physical, the biological, the social, and the economic, and which extends from the origin of the universe to our modern economy. It is the growth of information that unifies the emergence of life with the growth of economies, and the emergence of complexity with the origins of wealth.

The Secret to Time Travel

This book made me look at child birth from a completely different perspective. The author compares child birth as an example of time travel; the baby is transferred from an environment(mother’s womb) that has essentially remained same since the last 1000 years in to 21st century world that is largely alien for the species. There are a ton of machines, gadgets, technologies, objects that are realizations of human knowledge and human knowhow. All the objects that we seen around embody information and imagination. The author uses two central actors, amongst many, to describe the way information grows, i.e.

  1. Physical objects: physical embodiment of information
  2. People: fundamental embodiment of knowledge and knowhow

The fundamental perspective of the author is,

Economy is the system by which people accumulate knowledge and knowhow to create packets of physical order, or products, that augment our capacity to accumulate more knowledge and knowhow and, in turn, accumulate more information.

How are humans different from other species on the planet ?

The fact that objects embody information and imagination may seem obvious. Information is a fundamental aspect of nature, one that is older than life itself. It is also an aspect of nature that accelerated with life. Consider the replication of information-rich molecules, such as DNA and RNA. The replication of DNA and RNA is not the replication of matter but the replication of the information that is embodied in matter. Living organisms are highly organized structures that process and produce information. Yet, our focus here will not be on the information-generating capacity that is embodied in the intimacy of our cells but that which emerged with humans and society. Humans are special animals when it comes to information, because unlike other species, we have developed an enormous ability to encode large volumes of information outside our bodies.

Humans are able to create physical instantiations of the objects we imagine, while other species are stuck with nature’s inventory.

 
The Body of the Meaningless

This chapter clarifies the differences amongst various terms used in information theory. Terms such as entropy and information are used interchangeably. Indeed they can be used in some situations but not always. Shannon’s definition of information relates to the number of bits required to encode a message with maximum efficiency. In a sense, a highly regular correlation rich structure has less information and a randomized set of instructions in a message has more information. He termed this as "entropy"(von Neumann told Shannon that calling his measure entropy would guarantee Shannon’s victory in every argument, since nobody really knew what entropy was). If I consider my laptop, it contains many documents, pictures, videos etc. In Shannon’s language, if I randomly switch the bits in my computer, the information increases. But this doesn’t go with our intuitive definition of information. Ideally the more regular, the more ordered the data is, there is more information in to it. So, there is a need to expand the definition of entropy as defined by Shannon so that one can use those concepts to talk about information that we can relate to.

The author gives a nice analogy of a half-filled stadium to show the difference between entropy as defined in statistical physics and entropy as defined by Shannon. In statistical physics, entropy is dependent on "multiplicity of states". A highly disordered system tends to have higher multiplicity of states and hence has higher entropy. However it is not necessary that a higher entropy system is necessarily more disordered. In other words, disorder can be equated to higher entropy but not always. In the physical sciences, information has always been referred to something that has order. So, in physical states, information is the opposite of entropy. The ordered states, commonly referred to as information rich states are highly correlated structures. These information rich structures are also uncommon and peculiar structures in the nature.

The author uses the example of Rubik’s cube to illustrate the rarity of ordered states in the nature. Rubik’s cube has 4.3 × 10^9 possible states and the perfect state can be obtained in less than 20 moves. However getting to this ordered state requires a specific movement of the cube that one is called a genius if he can reach to an ordered state in less than 30 moves. This example can be extrapolated to the nature. The growth of entropy is like a Rubik’s cube in the hands of a child. In nature information is rare not only because information-rich states are uncommon but also because they are inaccessible given the way in which nature explores the possible states. The author provides a few nice examples that show the connection between multiplicity of states and the ability to process information,i.e. compute

The main idea of this chapter is to look at the word "information" as defined by Shannon, and then reconcile the concept with the colloquial meaning of the word information and the work of Boltzmann.

The Eternal Anomaly

If the natural tendency of a system is to move towards disorder, move towards higher entropy, how does one explain the information explosion on our planet ? If we look around the planet, it is amazing to see so many beautiful creations of the nature. Why didn’t our planet disintegrate in to chaos ? Why does information grow on our planet ? To explain this phenomenon, the author introduces the theory put forth by Ilya Prigogine. The main idea of the theory is

Information emerges naturally in the steady states of physical systems that are out-of-equilibrium.

The author unpacks the above statement using many examples such as marble in a bowl, box filled with gas, whirlpool in a sink etc. Prigogine realized that although Boltzmann’s theory was correct, it did not apply to what we observe on Earth because our planet is an out-of-equilibrium pocket inside a larger system-the universe-that is moving toward equilibrium. In fact, our planet has never been close to any form of equilibrium. Prigogine did the math and showed that out-of-equilibrium systems give rise to information-rich steady states. So, that explains "Where information comes from ?". In an out-of-equilibrium system, such as Earth, the emergence of information is expected. It is no longer an anomaly. The bad news, however, is that entropy is always lurking on the borders of information-rich anomalies, waiting to devour these anomalies as soon as it gets the chance. Yet information has found ways to fight back. As a result, we live on a planet where information is "sticky" enough to be recombined and created. This stickiness, which is essential for the emergence of life and economies, also hinges on additional fundamental physical properties.

The author explains three mechanisms that make the information sticky. The first mechanism flows from Prigogine’s math that states that out-of-equilibrium systems self-organize into steady states in which order emerges spontaneously, minimizing the destruction of information. The second mechanism comes from Schrodinger’s theory that says Solids are essential to explain the information-rich nature of the life. The third mechanism by which information grows is matter’s ability to process information, or the ability of the matter to compute. The author explains wonderfully all the three aspects that make information "sticky"

The main idea of this chapter is to view our planet as out-of-equilibrium system. The other idea communicated by the author is that of "entropy barrier". I love this concept as it is philosophically aligned with what I believe, "Life is a Martingale".

Time is irreversible in a statistical system because the chaotic nature of systems of many particles implies that an infinite amount of information would be needed to reverse the evolution of the system. This also means that statistical systems cannot go backward because there are an infinite number of paths that are compatible with any present. As statistical systems move forward, they quickly forget how to go back. This infiniteness is what Prigogine calls the entropy barrier, and it is what provides a perspective of time that is not spatialized like the theories of time advanced by Newton and Einstein. For Prigogine, the past is not just unreachable; it simply does not exist. There is no past, although there was a past. In our universe, there is no past, and no future, but only a present that is being calculated at every instant. This instantaneous nature of reality is deep because it helps us connect statistical physics with computation. The instantaneous universe of Prigogine implies that the past is unreachable because it is incomputable at the micro level. Prigogine’s entropy barrier forbids the present to evolve into the past, except in idealized systems

Crystallized Imagination

The author starts off by giving his perspective on life

Life is all about : moving around and processing information, helping information grow while interacting in a social context.

If you reflect on the above statement a bit, I guess you will at least concur with some part of it, if not the entire statement. Our society’s ability to accumulate information requires flows of energy, the physical storage of information in solid objects, and of course our collective ability to compute. The flow of energy that keeps our planet’s information growing is clearly that coming from the sun. Plants capture that energy and transform it into sugar, and over long periods of time they degrade into the mineral fuel we know as oil. But as a species, we have also developed an amazing capacity to make information last. We have learned to accumulate information in objects, starting from the time we built our first stone axes to the invention of the latest computer.

The easiest way to get a grasp on the "accumulating information in an object" is via comparing "apple" that is product of a tree, and "Apple" product from Silicon valley. The former is a product available in the nature and we internalize in our minds while the latter is an instantiation of the knowledge in our head. Both products are packets of information, but only the latter is a crystal of imagination. The author cites two examples of MIT lab scientists who are working on robotic arms and optogenetics. They are trying to create objects that crystallize imagination, and by doing so, they are endowing our species with new capacities. The author gives several contexts where thinking about products in a different way changes several preexisting metrics and notions that we carry on in our head. For example, Chile is a potential exporter of copper and one might argue that other countries are exploiting Chile. However by looking at the value generated in the finished products that use copper, the value of copper itself goes up. So, who is exploiting whom? Isn’t Chile free-riding on the crystallized imagination of other people?

Thinking about products as crystals of imagination helps us understand the importance of the source of the information that is embodied in a product. Complex products are not just arrangements of atoms that perform functions; rather, they are ordered arrangements of atoms that originated as imagination.

Amplifiers

The chapter is titled so, to emphasize the amplifying nature of the objects. Each object can be thought of as a crystallization of knowledge and knowhow and these objects become important to all of us because they enhance our capacities to do other things with it. Take laptop for instance. It is a product of someone else’s imagination and we get to use it to produce some other objects. There is no need to know what’s behind the hood for every object that we use. In the words of the author,

Products are magical because they augment our capacities

Objects are much more than merely a form of communication.

Our ability to crystallize imagination into products, although expressive, is different from our ability to verbally articulate ideas. An important difference is that products can augment our capacities in ways that narrative descriptions cannot. Talking about toothpaste does not help you clean your teeth, just as talking about the chemistry of gasoline will not fill up your car with gas. It is the toothpaste’s embodiment of the practical uses of knowledge, knowhow, and imagination, not a narrative description of them, that endows other people with those practical uses. Without this physical embodiment the practical uses of knowledge and knowhow cannot be transmitted. Crystallizing imagination is therefore essential for sharing the practical uses of the knowledge that we accumulate in our mind. Without our ability to crystallize imagination, the practical uses of knowledge would not exist, because that practicality does not reside solely in the idea but hinges on the tangibility of the implementation. Once again, the physicality of products-whether tangible or digital-augments us.

The main idea of this chapter is to describe products as physical embodiments of information, carrying the practical uses of knowledge, knowhow, and imagination. Our capacity to create products that augment us also helps define the overall complexity of our society.

This time, It’s personal

If we look at various products, the knowledge and knowhow for creating these products are geographically biased, though it is coming down a bit at least on the software front. The reason for this geographical bias is that crystallization of any product requires a great amount of knowledge and knowhow. The learning in almost all the cases is experimental and social. Bookish knowledge alone is not enough. You need a certain set of environment where you can interact, share ideas, experiment, learn from trial and errors. Each geographical region has its own idiosyncrasies and hence gives rise to different codifications of knowledge and knowhow. So, this means that there is certainly going to be geographical bias in the products we see. So, this naturally limits the growth of information. The author introduces a term, person-byte, meaning maximum knowledge and knowhow carrying capacity of a human. Is there a limit for human knowledge? Well, let’s talk about knowledge that one can accumulate over a period of ones working life. If I take my own example, there is a limit to how much math you can do, what kind of stats I can work on, what kind of models that I can build, the amount of code I can write. All these ultimately limit the growth of information. In that sense, a person-byte is a nifty idea that says that for information to grow, there needs to be a network of people where the collective person-bytes of the group is more than the individual person-byte.

The person-byte limit implies that the accumulation of large amounts of knowledge and knowhow are limited by both the individual constraints of social and experiential learning and the collective constraints brought by our need to chop up large volumes of knowledge and knowhow and distribute them in networks of individuals.

Links are not free

If one harks back to the time Henry Ford’s Model-T factory, it was considered as a poster child of industrial economy. It stood for the efficiency gained through scale. The output of the factory, the car, was a complex product and the rationale was, it was better to chunk out this complex task in to 7,882 tasks. It is another matter of debate whether there was a need for 7,882 individual tasks or not. One takeaway could be that complex products needs giant factories. Based on that takeaway, we should be having innumerable giant factories, given the complexity of products that we see in today’s world. This is where the author introduces a second level of quantization of knowledge and knowhow; firm-byte. This is a conceptual term that gives a upper limit on the amount of knowledge and knowhow a firm can possess. So, if a product requires more number of firm-bytes, there is a need for a network of firms. The factors that limit the size of the firm has been studied under "transaction cost theory" extensively. The author gives an overview of the theory that says

There are fundamental forces that limit the size of the networks we know as firms, and hence that there is a limit to the knowledge and knowhow these networks can accumulate. Moreover, it also tells us that there is a fundamental relationship between the cost of the links and the size of these networks: the cheaper the link, the larger the network.

It all comes down to links. If you take a typical Barbie doll, the various steps in the start to scratch process happen in twenty different countries. What has made possible this splintering up of the manufacturing process? It is not because the product is complicated. It is because the cost of creating a links between a set of firms has become easy. This could be attributed to reducing transportation costs, revolution in communication technologies, standardization of parts etc. In all the cases where market links have become cheaper, we have seen vast networks of firms participating together. There are innumerable examples that fall in to this category(iPad, iPhone,laptops,cell phones,…)

Does it mean that making the cost of market links cheaper will automatically give rise to increase in information via crystallization of many other products? Not necessarily. We observe links that are inherently expensive depending on the frequency and specificity of the transaction.

In Links We Trust

This chapter explores the role of "trust" in formation of networks. Social networks and social institutions help determine the size, adaptability, and composition of the networks humans need to accumulate knowledge and knowhow. When it comes to size, the ability of societies to grow large networks is connected to the level of trust of the underlying society. When it comes to the composition of networks, social institutions and preexisting social networks affect the composition of the professional networks we form in two important ways. On the one hand, a society’s level of trust determines whether networks are more likely to piggyback on family relations. On the other hand, people find work through personal contacts, and firms tend to hire individuals who trace the social networks of their employees.

The takeaway from this chapter is that social networks and institutions are also known to affect the adaptability of firms and networks of firms.

The Evolution of Economic Complexity

If one’s intention were to study the geographical distribution of knowledge and knowhow, one inevitably comes up with an issue- knowledge and knowhow are intangibles. How does one cull out of these things for various geographies ? The author’s first attempt is to look at the location of various industries that produce complex objects to simple objects. In this context, he uses the concept of "nestedness" from ecology and does number crunching to show that

There is a clear trend showing that the most complex products tend to be produced in a few diverse countries, while simpler products tend to be produced in most countries, including those that produce only a handful of products. This is consistent with the idea that industries present everywhere are those that require less knowledge and knowhow.

The author ties back his person-byte theory to the observations from the data. In a sense, the inference is commonsensical. The knowledge and knowhow of specialized products is sticky and biased towards specific geographical areas where or ubiquitous products, the knowledge and knowhow is spread across a wide range of geographies.

The Sixth Substance

If one looks at the models describing economic growth, the five common factors used in the literature are

  1. Land
  2. Labor
  3. Physical Capital
  4. Human Capital
  5. Social Capital

The author connects these five factors to the principles explained in the previous chapters. For example, the physical capital is the physical embodiment of information that carries the practical uses of the knowledge and knowhow used in their creation. Physical capital is made of embodied information and it is equivalent to the crystals of imagination described in the previous chapters. The author introduces a metric "economic complexity" that takes in to consideration diversity of exporting country, diversity of the country to which export is being made, the ubiquity of the product exported. The author tests his model for predictive accuracy and shows that it performs well.

Epilogue

The last section of the book highlight the main points from the book. In a sense, it makes my summary redundant as the author provides a far more concise summary. So, if you are short on time, you might just want to go over the last 10 pages of the book.

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LIBOR is the reference rate for 70 percent of the U.S. futures market, most of the swaps market, and nearly half of U.S. adjustable-rate mortgages. LIBOR, undoubtedly can be called the world’s most important number. It was conceptualized to meet a certain need, i.e. “what rate should be used for a floating rate note? “. Primarily it was used in the payoff computation of Eurodollar futures and subsequently it was used in interest rate swaps, derivatives on interest rate swaps, basis swaps, mortgages etc. The fact that LIBOR became a rigged rate was known to a few people in the financial world, i.e. rate traders, derivative traders, hedge fund managers, agencies that published LIBOR every morning. However it was known to a far wider audience after the 2008 WSJ article that screamed, “Emperor is naked ”. The title of this book is apt as it describes the situation before the regulatory agencies took action. Everybody knew what’s going on but nobody said anything. Too much was at stake.

The book reads like some crime thriller based in some fictional land; the only difference is that it is a true story and the victims are state governments, municipalities, rail transport authorities, and many other institutional investors who have lost billions of dollars. The perpetrators in the story are yet to given punishment. Yes, some of them have quit their jobs but NOBODY is yet behind bars! The most saddening aspect of the story is there have been merely a few cosmetic changes made to LIBOR and it is still being used as a reference rate in market place. The book talks about few people who singlehandedly tried to fight against LIBOR. Sadly, their voices were squashed as there were too many people who wanted status-quo. Several traders are going to be tried in 2015 and the author hopes that some justice would be doled out.

By the end of the book, a reader is left with an uneasy feeling about financial markets. If LIBOR can be rigged, what other benchmarks are currently being rigged? Is ISDAFIX being rigged? Is there a currency-fixing scandal waiting to be uncovered?

If you are curious to know the answers to any of the following questions, then the book might be worth a read.

  1. How did two WSJ journalists uncover the fact the LIBOR was rigged? Why did they analyze Credit Default Swap market?
  2. What were the political and economic conditions that led to the flourishing of Eurodollar business?
  3. How was LIBOR computed by British Bankers Association?
  4. LIBOR was set by primarily UK based banks. So, why was it being used as a reference rate for student loans, mortgage loans in US?
  5. What role did interbank brokerage companies play in manipulating LIBOR?
  6. Did Bank of England know about the fact that LIBOR was rigged?
  7. Did U.S Treasury know about the fact that LIBOR was rigged?
  8. What was modus operandi for manipulating LIBOR rate?
  9. How did Tom Alexander William Hayes, Yen-LIBOR trader, manage to rig LIBOR?
  10. Why did banks quote artificially low offer rates when polled every morning?
  11. What was the role of Barclays bank in the whole affair? Why did Bob Diamond resign after the scandal erupted?
  12. Why did British Banker’s association try to cover up the whole affair after WSJ article? What was their motive?
  13. If there were no subprime crisis in US, do you think LIBOR sham would have been exposed? Why or Why not?
  14. Why didn’t the regulators act ?
  15. Who were the major hedge funds involved in the controversy ?
  16. Why did Gensler, the former chairman of CFTC, fail in his mission of abolishing LIBOR?
  17. Interest rate swaps are complicated to value. So, why did municipalities, railways etc. fall in to the trap of investing in them?
  18. Why did Charles Schwab file suit against Wall Street banks?
  19. What happened to traders implicated in LIBOR and EURIBOR scandals?
  20. Post LIBOR scandal, what changes have been made to compute LIBOR?
  21. Is ISDAFIX benchmark rigged too?
  22. Should IR swaps be traded on an exchange? Why did Gensler’s effort in pushing reforms for IR swaps trading, go in vain ?
  23. Was LIBOR waiting to be rigged? Could there have been a better mechanism to capture reference rate?
  24. People have lost faith in benchmark rates and increasingly we are seeing manipulation is not the exception but the rule. Does the author have any suggestions for restoring investors’ faith in benchmark rates?

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Introduction

The author begins the book with a slew of examples involving predictions that never materialized. These examples span a wide range of fields like economics, social sciences, finance, politics, etc. The author also sneaks in examples of his parents and grandparents lives to show how their lives panned out in ways that were completely unpredictable. Well, Do these examples prove anything ? You can quote volumes of predictions going wrong , but if you ask the people who predicted them, they always seem to have a defense. What are the common answers that experts give, when asked about the failed predictions

  • “I was almost right”  -  It would have happened if I was not blindsided by this event
  • “Self-negating prophecy” -  I predicted the right thing but since there was a massive remediation to the prediction, it never came true ( example – guys who predicted that Y2K would spell disaster)
  • “Wait and See Twist” – It has not happened as yet but it will soon happen

Defense that involves carefully parsing the forecast and saying that original prediction meant something else and was far more elastic in intent.

So, even if one lists down a set of predictions that went wrong , it is rather difficult to actually rigorously state that the prediction went wrong. Again whoever quotes a set of predictions going wrong is accused of cherry picking specific predictions. What’s needed is the ”rate of failure" to understand whether expert predictions work ? But to compute the rate of failure, we need hits too . How do you identify hits ? What if the an expert has a poor failure rate but hits bulls eye for the event that we picked ? How does one identify a dart thrower Vs an expert giving right prediction ? So, even though it is easy to identify certain specific instances where predictions have gone wrong , if we take logic and evidence in to consideration, "figuring out how experts are at predicting future" is a challenging question. One might have to dedicate one’s whole life to carry on such an experiment and see what results it throws up. One man has done this feat. Philip Tetlock, a professor at Haas School has conducted one such experiment spanning over 2 decades collating about 27,450 predictions and their outcomes by interviewing and collecting prediction statements from a diverse set of experts in various fields. It is possibly one of the most scientific experiments conducted to answer the question of expert’s rate of failure. The result of Tetlock’s experiment was that expert guesses were as good as random guesses,i.e a dart throwing monkey. He also noticed two other things. There were experts who did pathetic as compared to coin toss. The other interesting thing that he noticed was the experts who had a lower rate of failure in their predictions has one thing in common. They had a different style of thinking.

The experts who were more accurate than others tended to be much less confident that they were right.

This meant that they had no prior template to fit the world events. They were self-critical about their own opinions as well as others. Basically they predicted with a healthy dose of skepticism towards any predictions. This book basically tries to discuss this specific style of thinking using the analogy of Hedgehog Vs Fox.The sum and substance of Tetlock’s study was " Foxes beat Hedgehogs".

The unpredictable world

The author says that predictions work extremely well when the system governing the response variable and its predictors follow a linear model. The planetary system, occurrence of tides, etc. are all systems that are linear in nature, i.e the equation is in some linear form and can be estimated with surprising accuracy. So ,we are in position to exactly say the time for a solar eclipse at a certain location on earth but are terribly poor at predicting events like demographic, political and social events. Why? The entire system is non-linear and feedback dependent. Slight changes to the input data creates a great model uncertainty. The author makes a strong argument against modeling any non-linear system, i.e pretty much every forecast that we see in the media.

This chapter concentrates on two areas of predictions,demographic predictions and oil price predictions. Through a series of predictions , a case is made that non-linear systems are dependent on "monkey bite" moments, a phrase that means that trivial events can have unimaginable consequences. Well the actual phrase was used by Winston Churchill when he wrote that a money-bite caused a war between Greece and Turkey. Its the butterfly effect. The chapter ends with a clear message , i.e price of oil is fundamentally unpredictable and so are demographic trends. However both the fields employ tons of experts to dish out opinions and report. Why ? Answer is simple : There is a demand for forecasts , i.e. ‘Seer – Sucker theory'(No matter how much evidence exists that seers do not exist, suckers will pay for the existence of seers).

In the minds of experts

This chapter talks about human brain and why it is hardwired in a way to see patterns when they aren’t. It cites an example of Arnold Tonybee , an expert who became insanely famous predicting stuff and was subsequently criticized by many when his predictions failed to materialize. Centuries of human brain development has equipped to see patterns when there are. Failing to spot real patterns is a matter of life and death. However evolution has not put a penalty or hardwired the brain in the case of Type II error, seeing a pattern when there isn’t. So, basically human brain does not have intuitive sense of randomness. Hence we come across people who keep on predicting stuff despite knowing that the underlying process is random.

What about experts ? What’s going on in the mind of experts ? The author uses Philip Tetlock’s conclusion that Experts in a specific field had a greater rate of failure than people outside the field,i.e hedgehogs fare badly as compared to foxes. As the saying goes, "Theory is the root of all Evil", hedgehogs are blinded by confirmation bias. As they amass more and more knowledge, they are blinded by their own subconscious beliefs and start picking and selecting information that suits their overall theory. In a classic book on Volatility by Ricardo Rebonato, I came across a similar analogy. Option valuation can be done in two ways, one an option-replication argument (the "hedgehog approach") , the second is a "fox approach" where you don’t stick to one theory and incorporate a healthy dose of randomness in valuing and trading of options. People who stick to option-replication argument are typically seen in academia spinning yarns(theories), all basically resting on this one hedgehog theory of option-replication. In fact Taleb in one of his books says that pricing and trading anything beyond plain vanilla European options is very complicated and error prone and any amount of math cannot come to our rescue.

The takeaway from this chapter is that Foxes are right about a lot of things. Hedgehogs are mostly wrong. They are deluded despite their brilliance.In fact they are deluded because of their brilliance

Books like these made me wonder," Whether there is money to be made in long only investing?" As they say , Stocks Are Stories, Bonds Are Mathematics. In my work environment, I see people around me who have invested their lives in stories(stocks) and have chosen "long only stock picking" as a career. They religiously weave stories in their minds by following stock specific information and talk about them with their tribe. With an increasingly non-linear world around, where "monkey-bite" moments have far reaching consequences and where info overload is leading to more and more confirmation-bias, it looks like hedgehogs are going to lose out to foxes.

The experts agree : expect much more of the same

This chapter talks about findings from behavioral economics and gives examples of status quo bias, anchoring-and-adjustment bias, availability heuristic, representative heuristic. The rationale behind mentioning these biases is that author wants to make a point that neither hedgehogs nor foxes are good at getting over these biases always. He also debunks `scenario-planning’ as another bogus exercise and if facts are to be taken at face values, umpteen scenario analysis sessions at various MNCs and other firms around the world , hardly have given rise to any meaningful correct predictions. The problem with scenario planning as explained in this chapter is that, foxes tend to run to the other extreme of hedgehog’s stance. It is mainly to draw attention to the people who are carried away from status-quo bias. However by going to other extreme, they are often blinded by representative bias.

Unsettled by uncertainty

This section mentions that everyone one of us is unsettled by uncertainty and it is hard to live and accept uncertainty. Hence the craving for experts and their predictions. Also for a guy who is already hedgehog for a certain number of years, it is difficult to crossover and become a fox as he/she senses a financial and psychological cost to it. I came to know from this book that Robert Schiller who is known to have predicted real estate crisis hardly did any thing in the meetings and committees that he was part of. In his own words, there was a great disincentive if he would have voiced his opinions more aggressively. Basically that means he was trying to fit in and align with his personal incentives. Nothing wrong with it. May be that the way world is. The point to be noted is , status-quo bias is tough to fight.

Everyone loves a hedgehog

The content in this chapter revolves around this behavior of most of us – ‘We tend to forget misses and focus on hits’. All the experts who have failed in predictions are forgiven easily.The TV channels, the columnists, and many more people do not criticize them. However they latch on to their hits and do not even mention their past failures in prediction. Its like

Heads : I win , Tails : You forget that we had a bet.

This coupled with hedgehogs who exhibit oodles of confidence in their predictions makes us all suckers for their statements.We give in. The chapter is interesting as it cites many examples like Peter Schiff, Robert Shiller( who were hailed as people who predicted crisis correctly) and shows that in each of the cases, they really did not make the prediction in the way media has projected it. In a way, it seems to say that we are suckers for certainty and there are hedgehogs who basically deliver it. Looks like a perfect demand supply equation. Who cares whether the predictions went right or wrong.. May be the poor investor in the fund whose manager made a call after listening to hedgehogs.

When prophets fail

This chapter talks about the cognitive dissonance and its role in experts life or a hedgehogs life. Cognitive dissonance , in modern psychology, means rationalizing the events to suit one’s philosophy and thinking. When hedgehogs find that their predictions have not come true, cognitive dissonance comes in to play and then they rationalize their failure at prediction. Two most common ways to duck their failure is 1) time is still ticking, they got it wrong on the time scale. 2) they misremember things to suit their needs (hindsight bias). The author cites a few examples of cognitive dissonance in play. He goes on to say that not only hedgehogs but also the fans of hedgehogs can undergo cognitive dissonance and they conveniently misremember stuff.

The end is nigh

The last chapter praises fox thinking and says that there are three components to Fox mode of thinking

  • Aggregation: By aggregating opinions from diverse range of sources, one is better prepared to acknowledge uncertainty of a specific prediction
  • Meta cognition: Constantly think about how you think
  • Humility: Have a healthy dose of skepticism about any forecast that you make. In-case any of your forecasts is a hit, be humble to accept that chance played a role ( George Soros constantly does that)

By incorporating these components in to our everyday thinking, it is likely that we will be prepared to face the future in a better way.

 

takeawayTakeaway :

The book is an accessible introduction to Philip Tetlock’s research. The author puts a spin on one of the Tetlock’s conclusion, i.e there are two types of experts, Hedgehogs and Foxes. Hedgehogs believe in one big theory whereas Foxes have a more elastic kind of thinking. The takeaway from this book is that developing a Fox style of thinking is a better alternative in this non-linear unpredictable world. The book does not criticize experts(Hedgehogs) but gives an explanation about a) why they dish out opinions with such certainty? and b) Why do we constantly seek out for such experts ? After reading this book, I guess it will make make any reader take "predictions" with a healthy dose of skepticism, if he/she is not already doing so.

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This book introduced me to a new term, ‘disaster tourism’ Smile. People who visit places where financial disasters occur. Michael Lewis goes on one such tour to Iceland, Greece, Ireland and Germany. This book recounts his experiences of the visits and in turn gives a reader some idea of “What the hell is going on in these countries that is causing stock markets to gyrate wildly, investors to panic and making world leaders increasingly edgy?”

The book starts by talking about Kyle Bass, a successful hedge fund manager from Texas who minted money by shorting during the mortgage crisis. After tasting blood in the mortgage market, he then starts buying CDS on countries from Goldman and other Wall Street firms for as little as $1100 for an insurance of $1 Million Iceland bond. Basically a $700,000 return on investment of $1100 ( assuming that Iceland defaults and pays 70 percent of the bond value). When Michael Lewis goes to interview Kyle Bass during his preparation for the book,`The Big Short’, he is amazed by the hedge fund manager’s strategy. How does a guy who has never gone beyond US know things about Iceland and more importantly how is so sure that he is shorting the entire country ? This makes him curious enough to investigate first hand the situation in these countries. In a sense, this book is a sequel to the book ‘The Big Short’ and talks about the disasters happening in four countries, Iceland, Greece, Ireland and Germany.

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Iceland

A country with 0.3 million population( think of a medium sized town in India) gets in to $140B debt, 8.5 times the GDP of the country. This happened so quickly between 2003 and 2007 that it is really unbelievable. How did a country whose primary occupation was fishing and smelting aluminum become a hedge fund ? Michael Lewis narrative mentions some key turn of events that changed the fate of the country. Firstly, the introduction of fishing quota and fish securitization( I had never heard of such a thing before..Last time I read about it was in some graphic novel that talked about the downfall of a hypothetical economy).This quota made fishing activity concentrated in a few hands and the other people were left exploring for alternatives. Some of them joined smelting aluminum work. The others headed for education and soon Iceland was minting PhDs. With so many PhDs who obviously did not want to fish nor spend time in aluminum factories,the situation was odd.They wanted to work on something new and sadly they latched on to the most hyped up job in US markets and world wide, “The Investment Banker”. They all wanted to do investment banking.

Carrying the traits of fisherman, i.e aggressive risk taking to banking to finance was a disaster. The most profitable trade was the carry trade and every Tom Dick and Harry became traders. Most of these I-bankers created artificial inflation by traded assets amongst themselves. This had to end as all the price inflation and growth was actually a result of a few people who managed to borrow insane amounts of short term foreign capital and infused it in to the country. All the signs of prosperity were bogus. In 2007 Icelanders owned 50 times more foreign assets than in 2002. The emperor was finally naked in Oct 2008 , when the country was declared bankrupt. After the subprime crisis all the hedge funds and FIIs who invested in Iceland to get eye popping returns actually got their eyes popped literally and withdrew all their money. Where is Iceland headed ? God knows. May be they will go back to fishing!

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Greece

A country with 11 million population( think of one of the Indian cities) gets in to $1.2 T debt. That’s right. It is a T with a capital T…We are talking about Trillions here. Basically it is equivalent to GDP of India in 2008. If you read about the bail out packages that are being doled out, they are paltry compared to the mess Greece is in . So, what made such a small country in to debt ridden country ? Michael Lewis meets with accountants, lawyers , monks , politicians and weaves an interesting narrative exploring the reasons for the current situation. He says the government is the culprit and quotes a few numbers that are insane. For example National Rail Road earns 100M euros and has 800M euros as expenses.Govt employed personnel earn thrice that of a private sector employee. The author’s meeting with accountants and lawyers convinces him that the extent of corruption and malpractices that are practiced by EVERYONE in the country can fill libraries. Tax evasion was rampant and the politicians cooked up numbers to gain in to entry in Euro zone. All numbers quoted by the Govt were fraud numbers. The party goes on for years.

Finally the music stops in Oct 2009 when the then prime minister Kostas Karamanis gets involved in a scandal and the nation goes to polls. The scandal in itself an alarming story that involves Vatopaidi Monastery in Greece. Amazing what simple living monks can do to a country. In a matter of few years these so called simpletons become the real estate emperors in Greece. The political changes in Oct 2009 brought George Papandreou to power. He immediately realized there was nothing in the Govt coffers to spend and everything was a fraud. He had no choice but to come clean about the govt. In the recent past he has taken quite a few measures like job cuts, compensation reductions, etc. applicable to the Govt employees. Obviously this has resulted in massive unrest. From reading this story it is evident that is not a question of whether Greece will default, it is only a question of when will it do so.

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Ireland

This is the story of a country which went from a budget surplus in 2007 to Budget Deficit of 32% of GDP, from an unemployment rate of 4% in 2006 to 14% in 2010. Real estate bubble meant $106B dollars of losses for the three biggest banks in Ireland. As recently as 1980s the country was one of the poorest countries in the world and it became one of the richest countries by 2007 . How did this miracle happen ? Michael Lewis answers this question and in turn gets an answer to his question, `What the hell is wrong with Ireland’ Till 2007 if you had asked any academic, he would give amazing explanations for turn around of Ireland which were good as sound bytes in the media but were actually shallow arguments. So, How did Ireland become rich? Well, as the author finds out from the eyes of a skeptical  Dublin University professor , Morgan Kelly, that there was no miracle in the first place. People just went berserk. 20% of the workforce was employed in building houses. 25% of the GDP came from construction industry. Basically the Irelanders followed this philosophy,

“We are going to get rich by building houses for each other”.

Alas! the housing bubble crashed and so too the banks that lent money in pursuit of higher growth rates. They were a few people who alarmed everybody about it, for example a research analyst in Morgan Stanley wrote a scathing report on Ireland Banks. However since the banks were clients of Morgan Stanley, the report was thoroughly massaged, or in the other words fabricated to death so that the fee keeps coming from these banks. It was elaborate Ponzi Scheme played by banks,government at the cost of Irelanders. As of today, the situation is : the government that has bailed out the banks , are living on life line , i.e , the short term loans from European Central Bank. When the lifeline stops, Ireland will collapse ? Since the time most of Poles( People emigrated from Poland in large numbers to Ireland ) have left Ireland, people have lost faith and are silently witnessing the failure of the government, Where will growth come from ? After spending time with academics, politicians, lawyers, banker, the author seems to be saying, “Nobody Knows’”

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Germany

Germany had no real estate bubble in the country. Prices were very much in line. There were no crappy domestic loans. So, why did Germany get affected by the subprime crisis ? The author weaves a nice spin on the German culture saying that Germans are a bunch of people who are obsessed about combination of clean & dirty , i.e clean exterior-dirty interior, clean form-dirty content. They are actually mirror images of Greece, Iceland, Ireland stories. Other countries used foreign money to fuel various forms of insanity. The Germans, through their bankers , used their own money to enable foreigners to behave insanely. They were on buy side of all the crappy subprime mortgages issued on wall street by Goldman, Morgan Stanley etc. Though they kept their external image clean, their internals were crappy. They bought bonds like crazy always trusting the ratings that were assigned to the mortgages.

With the bubble bursting ,their banks have taken a beating. However there is a crucial difference between the cultures here. Unlike US banking CEOs who are handed hefty bonus despite the crisis, some of the German CEOs were imprisoned. They were looked down upon the society. All said and done, Germany has a crucial role to play in Europe’s future mainly because of its relationship with ECB. If the struggling European Nations are downgraded to Junk, then there will be a serious problem with ECB and there is a chance that ECB might itself default. Can Germany suck up all the losses of its neighbors ? Economically the best solution but Politically it won’t fly. So where does this lead to ? Will there be Euro Currency at all, if all the countries fall like nine pins? It’s a very uncertain future in Europe and I guess these stories mentioned in the book makes any reader shudder at the question ,”What’s future for European Finance ?” It looks like it just a matter of time when things will apart ?

California

Michael Lewis focuses on California to bring out the systemic issue in various cultures that is causing problems. Even though he talks about various countries and their financial problems, he is pointing towards a larger malaise afflicting various countries, i.e the problem of failing to self regulate.

The situation facing various countries and California is summarized by the author using a nice analogy.

Entire countries were told,”The lights are out. You can do whatever you want and no will ever know.” What they wanted to with the money in the dark varied. Americans wanted to own homes far larger than they can afford.Islanders wanted to stop fishing and become investment bankers. Germans wanted to be more German, the Irish wanted to stop being Irish. Greeks wanted to turn their government in to a stuffed animal with fantastic sums so that the Govt can give it to as many citizens as possible.

In all the cases, there is a pattern here. Self regulation is thrown to the winds and in the longer term every one suffers. The story about California was new to me as I had never known that Vallejo, a city in California has gone bankrupt.Based on what the situation is right now, it is predicted that many more cities are going to be bankrupt. The most affected state as such is supposed to be California. The author starts off describing the situation in California by narrating an incident relating to Meredith Whitney where she predicts that municipal markets are going to be next victim of the subprime crisis. Indeed as the situation unfolds, as Vallejo’s bankruptcy makes it clear that there is a systemic problem lurking here and if things don’t change, it is probably only a matter of time before there would be many more cities going bankrupt.

imageTakeaway :

The book gives cultural, economic, political reasons for the bleak situation in Iceland, Greece, Ireland, Germany and California state . Its a real page turner and probably gives a better picture of Europe’s situation than what one can infer from various confusing articles in the media.

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These books are written by the Father-Son duo of Irwin & Peter Schiff, albeit at various points in time. The first book titled, ”How an economy grows and Why it doesn’t ?” was written by Irwin A Schiff in 1979 and his son has followed it up in 2010 with the second book titled,” How an economy grows and Why it crashes?”. Both books give a chance to ponder over the situation that US is in, financial crisis of 2008 which is still on with full force in 2011. I have summarized the first book here. In this post, I will try to summarize second book , that the author, Peter Schiff calls it “a riff of the original one”.

Out of 220 odd pages of the book, first 130 odd pages is mostly a repeat of first book, in words and few illustrations. I prefer the graphic novel approach of the first book than the textual description of the situation. The first book ends with senator finally comes out and openly declares that he can do nothing but ask the islanders to go back to fishing. This book takes a different route, obviously looking at what has happened in the last 20 years- ”the rise of China”. Just when the senator is thinking of talking openly to the public, there is lifeline that appears – Sinopia. BTW the main island of the story is given an obvious name Usonia. Sinopia was a strange island where all citizens were required to fish but their catch did not belong to them. Instead the fish were turned over to the kind who then decided which subjects deserved to get some back. This system did not provide much fish per capita but there was huge income (fish) disparity in the island. Seeing the progress of Usonia, Sinopian king decided that he would somehow possess Fish reserve notes that were supposedly seen to be key to advancement. Thus he knocked on the doors of Usonia to exchange real fish to Fish reserve notes. This was a lifeline to Usonia who realized that their notes were actually worthless. This lifeline got back fish in to the reserves, prices began to cool down, consumption was back, island was back to functioning state..all becoz of Sinopia.Sinopian king now used these notes to buy tools from USonia and left over notes were parked in Fish reserve bank as Sinopia had no robust banking system. Sinopian king made a policy that whoever purchased tools from the king could keep all the extra fish they caught. Also he did a devious thing. He required his citizens to swap their extra fish for Fish reserve notes. Basically the king hedged his risk and the counterparty was his own islanders. With flushed Fish reserve notes, the Sinopians started pumping in money in USonia as savings and thus Usonia was flush with funds and credit, thus creating a spending binge atmosphere on the island. With most of production work happening in Sinopia, Usonia now concentrated on Service sector. With Sinopians willingness to accumulate notes, trade relationship was a skewed one where one island largely produced and other island consumed.

One of the residents of an island, Bongobia , realizes that there was a threat that Usonia might not be able redeem the note with fish and hence started to hammer the fish reserve counter to exchange notes with fish quickly. Senator-in-Chief has no option but to close the Fish reserves window. From then on, the Fish Reserve notes on the international market would be determined only by what someone was prepared to trade for them, not because they could be redeemed for fish. In truth, the notes’ value hanged on Usonia’s status as a great economic and military power. No disaster happened after closing the fish window and Usonia experienced unprecedented growth on the back of consumer spending, demand of Fish reserve notes.

The book then moves on to creating characters and extending the story to narrate the housing market crisis in US.

With the service sector in full swing, Usonian bank loan officers cast their eyes on island’s sleepy hut loan market. To become popular, Senator Cliff Cod devised a plan where govt would ensure that everyone could get a hut loan. He creates Finni Mae and Fishy Mac to buy hut loans from the market.The hut lending program was a massive hit amongst banks as they were earning risk-free profits. Another agency Sushi Mae started to underwrite loans to youngsters who wished to enroll in surfing schools. These agencies created a big industry where hut building, hut selling and hut decorating industries took off. BTW, no actual fish was being generated, nothing productive was happening. Loans were being now being made not because they were necessarily the best use of savings, but because the senators had a political stake in encouraging hut ownership and education. The senate gave tax breaks on hut loans and thus stimulated the activity to crazy levels. With the influx of Sinopian fish, there was amazing amount of credit available and risk was conveniently ignored.

In this environment enters , Manny Fund. Manny starts to offer a different type of loan “hut fish extractions” in which hut owners refinanced existing loans with bigger loans, given the appreciation of hut value since their investment. Thus it was all more easy credit available for islanders. Huts started becoming more luxurious and hut values reached stratospheric levels. Islanders now started looking at hut as short term investment rather than a place to stay….. It had to happen someday. The hut market took a down turn and every associated industry felt the pain. Unlike any sectoral downturn, this was a credit based pain . It was like removing oxygen from the air and hence everybody started to suffer. The govt could only do one thing – urge consumers to spend more. It wanted to somehow spend through the crisis. Stimulus was not working. In need of fish, it desperately took a loan from Sinopia. Its ploy as usual was to pay back using Fish Reserve Notes.

Despite the bailouts, Usonia was going nowhere out of the crisis. In such a scenario, Barry Ocuda becomes the new Senator-in-Chief after promising the islanders on the theme of “transformation”. He started pushing the Fish reserve notes to the public by giving them assistance explicitly and implicitly(incentives to first time hut buyers), increase direct aid to schools , tried to create some construction jobs etc. Was this spending the most efficient use of island’s resources ? Instead of market deciding the resources, a small group of people started making decisions. While this massive plan was put to practice, there was one problem. Usonia was completely out of fish. Instead of taking harsh measures, it took an easier option. Borrow more. It reached a situation where most of the debt was funded by other islands.

However things started to change in Sinopia. In a turn of events Sinopia stopped buying Fish Reserve Notes as it was seen as unnecessary for all the goods and services could be produced and consumed in Sinopia itself. Why bother about Usonia, when all the resources are in the homeland ? With Fish Reserve notes demand falling Usonia was basically stuck. Other Islands followed Sinopia in cutting down the demand for Fish Reserve Notes. Amidst such a situation, a Sinopian ship landed on Usonia shores with loads of fish. As usual Usonian govt thought that Sinopia was interested in swapping fish for Reserve notes. In a devastating move for Usonia, Sinopians instead chose to use their original fish to buy out all the major corporation in USonia, huts, services etc. In one move, Usonia became an impoverished island. Barry Ocuda had no choice but to openly ask the islanders to start fishing again.

The book’s message is very clear. If US keeps its spending and borrowing levels the same, it is soon going to be hit by hyperinflation and the country will face an economic devastation.

imageTakeaway

This book brings the china factor in to the equation and shows the deadly consequences to the US in the times to come. Hyperinflation, currency default and ultimate economic devastation will be a reality to US unless it takes harsh measures. “Will it ? “ , is something that time would reveal.

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This is a graphic novel explaining the growth of a general economy from its barebones structure to a full-fledged economic system. Through an allegory , the author shows the deep malaise in the functioning of US economy. It starts off with three men on an island Able, Baker and Charlie who merely catch fish,eat, sleep. There is no credit, no investments, no savings to begin with. Able gets a brainwave to make a fishing net that will save him some time to pursue other activities. He under consumes for a day, takes risk , comes up with a fishing net, thus managing to catch 2 fish per day instead of 1 fish. This is the first time the island has a saving and a capital equipment (net). It is also the first time when one of the islanders can do some other activity than merely taking care of survival.

With the new savings, Abel can choose one of the options 1) Save what he has saved 2) Consume what he saved 3) Loan out what he has saved 4) Invest what he has saved 5) Combination of the above options. The author quickly argues that the only way Abel can increase his wealth is by making his wealth available to other members of his community. Baker and Charlie make use of the loan and build their own nets. With more savings, Baker and Charlie build a bigger net (Bigger Capital project) and thus are able to generate far more savings for themselves and the island. This savings were possible only because Abel in the first place did not lend loans for frivolous activities like vacationing etc. Capital Loans were preferred to Unnecessary Consumer Loans as the former increases savings while the latter reduces savings. The point that the author makes is, “Loans for consumption purposes reduce the amount of funds available to finance both capital projects and the production of more consumer goods, and hence can ONLY lower society’s standard of living.

The increased prosperity of the island gives rise to a need for “effective storage of fish”, and hence fish savings&loan operations kicks off by MaxGoodBank. Its intention is a noble one where it lends to the needy people who pay interest and takes fish deposits and pays the depositors specific number of fish for entrusting the fish with MaxGoodBank. So, island has now savings, credit and investments well oiled in to the society.There is also Manny Fund which invests in risky projects and islanders who have the appetite to take risk invest their fish in Manny Fund and get returns / lose their fish based on the performance of the projects that Manny Fund invests in. However the losses of Manny Fund doesn’t threaten the society’s credit structure.

So, All is well until the islanders decide that they need a govt to take care of law and order situation, protect life and property. The problem starts when Democracy takes an ugly dimension the elected senators become so powerful that they control courts and dispense laws whatever they deem appropriate. Franklin Dee V becomes a senator and he starts making some nasty moves to gain power and sustain power over periodic elections. He passes a law whereby MaxGoodBank is forced to give low interest loans for business, school, minorities and other sections of the society. This in itself is not bad, but by extending the line of credit to people who have no hope of paying it back, wreaks havoc in the system. Franklin Dee V creates another phantom , the Franklin Reserve Notes which say that govt would guarantee fish in return to the printed notes. Basically in a way , Govt has forced MaxGoodBank to exchange fish to some printed paper. Soon, he realizes that his coffers are empty and there is no way he can give back the promised fish for each Franklin Reserve Note. He goes to senators with the plea that their “Franklin Reserve System” could be a catastrophe to the Island.

In this situation, Senators employ fish technicians who work on fish skins and skeletal and turn them in to fish by putting meat from original fish. Basically they are creating fraud fish which are lesser in value than the original fish. In order to cover up their fraud , the senators pass a law that only official fish , marketed as officially decontaminated fish, would be used in the society.They also pass fraudulent laws which create a situation where islanders deposit skeletal remains of fish with Fish Bank. MaxGoodBank sees through this ploy and refuses to cooperate. He is promptly removed and Chesley Bartin is appointed as the new director of Fish Bank. Soon with official fish floated around in the island that were half the size of original fish and naturally there was inflation. The price of everything doubled and consumers were at loss to explain the reasons behind it. Meanwhile the govt congratulated themselves and the islanders saying that inflation was a sign of prosperity. This went for quite sometime until the official fish was 1/3 the size of original fish and prices in the island skyrocketed to 200% from what they were before Franklin Reserve notes.

Islanders saw that they were getting 1/3 of the fish that were available in the sea and started using offshore fish banks. Senators realized the threat it posed to their well being and promptly passed a law to regulate fish that were being deposited in offshore banks. Soon, there was an underground economy for original fish as some islanders did not think that they should give away fish for Franklin Reserve Notes. Subsequently, the shortage forced the prices to jump by 600%. People were laid off, there was unemployment everywhere. What did the govt do ?They chose the easy way out – “Unemployment Insurance” and printed away to glory. These notes created a run on fish bank and there was a severe fish bank crisis in the Island. Chesley Bartin, the director had no clue and ran to the rescue of the govt for a possible solution. The govt ran out of fraudulent tricks and called the economists for a solution. Economists offered “Expand Credit” and “Lower Taxes” solution which obviously were useless as Island was already crippled with no credit. How can you expand credit in a situation credit situation had been manipulated to the hilt?. The situation becomes unmanageable and Franklin Dee V finally asks the islanders to start fishing again and quickly. The Island is back to square one, but with more disastrous situation,  where there are only few people who know how to fish but MANY people who need fish.

The book ends with reiterating that

  • Vote seeking Politicians bring mayhem by interfering in the economic systems and tools
  • Minimum wage law is actually counter-productive
  • Consumer credit wastes credit and it costs society in the sense that there is less credit available for Commercial purposes

Hence the author suggest a possible solution for this island : Government should outlaw bank credit to finance activities that fall under consumer credit. This will kick off a wave of layoffs, painful readjustment of life styles, but ultimately the island would be in a better situation as everything would adjust downwards. Basically a deflation is the cure suggested as the solution to the islanders. However this seems impossible to happen as the ones that will be deeply hurt in the process is the government( that has become bankrupt), is in charge of passing these strict measures. The book leaves the reader with an obvious question – “Is the Island economy doomed, now that it is in this crisis and govt. would never take harsh measures?”

imageTakeaway :

The book was written in 1979 and the situation mentioned in the book is similar to what US is facing now. “Does it take that long for markets, people, other trade countries to see that ‘Emperor has no clothes’ “?, is a question this book leaves you with.

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Last week has been a pretty unproductive week. Fell ill on Tue and Wed. Barely managed to work for a few hours on Thu. But by Friday I was back to normalcy. Generally one of the ways I get over from an inertia state to an active state is to read something interesting. So, picked up this frequel( from the back cover : nice name for freakonomics sequel ). I knew there was a lot of controversy relating to this book. Some people argued that authors got it completely wrong as far as global warming is concerned. Some argued it was a hotch potch of some articles.

Whatever others have to say about this, I have found this book a real page turner. Even though some people criticized the book saying that it was a mish mash of random thoughts, the author clearly mention their intention in the very first note. They identify the theme as “role of incentives” and their hypothesis is that people respond to incentives which are not necessarily predictable. These stories are based on “economic approach” where the underlying premise is that behavior is driven by a rich set of values and preferences.

While presenting this opinion about incentives, authors introduce a number of interesting examples like the following

Image 1.This campaign by US Dept of transportation urging people not to drive drunk. Authors estimate that walking while drunk is 8 times fatal than driving drunk. Simple alternative (a seemingly safe one) to driving drunk is actually more dangerous.

2. How Cable TV might have improved the status of women in India

There are 5 chapters in the book with each chapter filled with umpteen number of stories, where results are presented based on the economic approach, looking at micro data, trying to ask questions and teasing out some answers. In a sense, this kind of thing actually makes economics interesting I guess. Its the same with stock market . Long term predictions(read anything more than a couple of months) are very difficult. Near term predictions are also not great too. If one looks at stock market data, almost everyone is dealing with the same starting point, univariate time series of stock prices, option quotes. You can do a low frequency, medium frequency or high frequency analysis. More and more I get exposed to data, I have a feeling that there is money to be made only in high frequency trades ..

Coming back to the book,

ImageHow is a street prostitute similar to deparment store santa ?

The first chapter is about authors understanding demand curves of prostitutes. One of the challenges of asking questions about such topics is data. Everyone knows the more sensitive the topic is, the more difficult it is to procure data. Drugs, Violence, Sex are some of the things where getting data becomes a dangerous adventure. So, credit does go to Sudhir Venkatesh’s hard work to actually get the data in the first place. Once you have some structured data , slicing and dicing is the fun part and here is where the authors excel is bringing out some interesting observations. In creating a narrative, the authors come out with a lot of aspects about women, women’s lives, prewar prostitution etc. Here are some aspects mentioned in the book

  • It is hard to be a woman , be it developing countries or developed countries, say the authors. Practices such as breast ironing , abandoning girl childs in China, pay scale mismatch in corporate America etc. make it difficult to lead a woman’s life
  • Prostitution has by far managed to be a woman’s game( though things are changing pretty fast:) )
  • Prewar prostitutes were earning far more than the current street prostitutes. It is argued that one of the reasons could be the rise of premarital sex.
  • Whole lot of observations are based on the working paper, Empirical Analysis of Street-level Prostitution . It’s abstract says the following :
    • Combining transaction-level data on street prostitutes with ethnographic observation and official police force data, we analyze the economics of prostitution in Chicago. Prostitution, because it is a market, is much more geographically concentrated than other
      criminal activity. Street prostitutes earn roughly $25-$30 per hour, roughly four times their hourly wage in other activities, but this higher wage represents relatively meager compensation for the significant risk they bear. Prostitution activities are organized very
      differently across neighborhoods. Where pimps are active, prostitutes appear to do better, with pimps both providing protection and paying efficiency wages. Condoms are used only one-fourth of the time and the price premium for unprotected sex is small. The
      supply of prostitutes is relatively elastic, as evidenced by the supply response to a 4th of July demand shock. Although technically illegal, punishments are minimal for prostitutes and johns. A prostitute is more likely to have sex with a police officer than to
      get officially arrested by one. We estimate that there are 4,400 street prostitutes active in Chicago in an average week.
  • Reference to NYTimes article(The economy of desire) which makes a case(weak one though) that having a relative in the family with AIDS changes the sexual behavior as well as self-reported identity and desire of a person
  • Article supporting Larry Summers Hypothesis – He, Once a She, Offers Own View On Science Spat
  • Why legalizing sex work is dangerous for sex workers .. Taboo / Illegal things are priced at a premium. Once you remove restrictions, prices drop like crazy and thats bad news for escorts. From the freakonomics blog , here is an interview with a high profile prostitute.
    Link A Call Girl’s View of the Spitzer Affair

Authors finally after all these stories, anecdotes, empirical evidence suggest that street prostitute is similar to a department store santa, they both take advantage of short-term job opportunities bought about by holiday spikes in demand


ImageWhy should Suicide bombers buy Life Insurance?

As I began reading this note, I had a feeling that it was similar to “outliers” , Gladwell, story all over. Thankfully the authors mention that the point was already made by several other books and stop belabouring the same point. The whole chapter revolves around Craid Feied who manages to set up a database for ER and thus revolutionizes information management systems in a lot of hospitals. Some of the interesting things mentioned in this part are

  • The effect of surname in academic profession 🙂 Link : The benefits of being economic professor A ( and not Z)
  • Deliberate Practice has 3 components. Setting specific goals, obtaining immediate feedbacks , and concentrating as much on technique as on outcome
  • Why terrorism is so cheap and easy ?
  • How the estate tax has an impact on the death rates of people who inherit tons of money ? very funny things mentioned in this context
  • The most interesting part is the fact that hospital database is being used to track terrorists

The authors answer the question about suicide bombers . The database suggests that one of the defining characteristic of a suicide bomber is , he /she doesn’t buy life insurance. So the quirky take on that fact is : Suicide bombers should buy life insurance to leave no trail behind them.

Unbelievable Stories about Apathy and Altruism

This part was a little dragging. Behavioral economics, apathy shown by 38 people towards a murder in a NY neighborhood, stories about altruism etc are the aspects touched upon

ImageFix is in – and It’s cheap and Simple

I think this is the BEST chapter in the book

Premise under which the narrative is built around : Cheap and Simple fixes often address problems that seem impervious to any solution.

  • Starts off with the story of Hungarian Scientist Ignatz Semmelweis who came up with a simple fix to solve perpetual fever, something witnessed immediately after child birth in many hospitals. Fix was : Disinfect your hands before operating on maternity patients. Simple but powerful fix which has saved innumerable lives till date.
  • Polio is another vaccine which can be considered as a fix. Instead of dealing with the problem after the fact, see to it it doesn’t arise in the first place.
  • McNamara fix of seat belts in cars to prevent fatalities
  • Nathan’s solution to hurricanes is fascinating. A little dig in to Nathan’s intellectual venture gives a superb account of what he and his team is up to.

What do Al Gore and Mount Pintabu have in common ?

Reader meet Nathan and his team again in this chapter where the solution to global warming is presented in a different way. There is a considerable debate about this chapter. I have no clue on what is right and what is wrong about global warming. The only thing I feel is the solution of actually spraying something in the air to global warming is lateral thinking.. Who knows, it might work.

To digress at this point, recently I came across an interesting example of lateral thinking. This was long time ago when prince of Turkey wanted to modernize the society. He did not want women to wear burkhas!. Well the usual boring way to stop women from wearing burkhas is to impose some law, penalty, etc… However he was a great lateral thinker. He passed a law where , “All prostitutes were ordered to wear burkha” .Behavior change among normal women was immediate !!. Terrific example of how you can fix things, change aspects of societal behavior by lateral thinking…… May be Nathan and his team need to be given a hearing and funding to see whether their lateral solutions works..Who knows, it might just work…

My takeaway from this book : Understanding data and teasing out answers to interesting questions is a great fun activity. If one spends enough time gathering data or visualizing data, one is bound to ask useful questions. Lateral thinking and open minded ness towards solutions usually result in interesting solutions.