Wednesday, 27 May 2009

How to improve the study of economics - two ideas.

There is a very marked difference between the progress of most sciences and the progress of economics. In most sciences people come up with assorted theories, they design experiments and then theories either flourish or they get shot down, never to be seen again. The bulk of the ideas in physics for example, are uncontroversial, there are very few "alternative" theories which hang around for long. In economics however things are very different. It is almost impossible to do any meaningful experiments. For this reason bad theories can hang around for ages, perhaps forever.

I'd like to present two ideas for making improved progress in economics:

1. Build computer simulations.

In recent years computers have become comfortably fast enough so that they could run simulations of entire populations. Simulating economies could revolutionize the subject in several ways.
  • The process of trying to get a simulation to show all the same patterns as a real economy would, in itself, be an enlightening experience.
  • Once a working simulation has been built, new theories could be tested within it.
  • The accuracy of peoples simulations would give bragging rights to the best economists rather than the economists with the most popular ideas.
2. Change the nature of research papers...

I recently saw a short bio-pic about the economist Murry Rothbard in which it was stated that he was a prolific author, apparently he wrote 20 books - I immediately thought to myself - that guarantees that his work will never be properly digested. If I want to learn about his best ideas, which of his 20 books do I read? Do I have to read all of them? How about having the default format for a "paper" being an html document with hyperlinks. Encourage multiple iterations where readers give feedback about sections they found hard to understand or disagreed with. Allow the author to re-write sections, correct errors and add additional documents linked from the original to expand on points that some readers thought needed further detail or thought contentious.

I my time in academia I noticed that scientists were encouraged to write as many papers as possible. This led to a situation where if you had two closely related ideas in a field you would be encouraged to write them up in two separate papers. It also led to a situation where scientists were discouraged from making things too clear in their papers because that meant that others could too easily use your ideas to generate their own papers which may then diminish your opportunities for publishing in that field in the future. This system is a minor handicap in a field with good opportunities for experimentation where bad theories will get thrown out - but in economics its a disaster - a recipe for a never ending stream of repeated errors.

If instead, economists were rewarded for the quality of their work rather than the quantity, then perhaps the field could take a few steps forward.

Tuesday, 26 May 2009

Pensions casino - supporting articles on the BBC

Back in March I wrote a blog entry The pensions casino - an alternative. Then just today I came across this article and this article both on the BBC news website and which both support my prognosis... they could have just subscribed to my blog instead.

Monday, 25 May 2009

Fractional reserve banking - at last some support!


On the 28th of March 2009 I wrote a blog entry called The most important thing to understand about banks. It was the result of my research in to fractional reserve banking. The key thing that I had worked out was that it was just too easy for bankers to earn money. Or more specifically, if the "money multiplier" was M and the banks could lend money to borrowers with the borrowers paying interest at rate I, then the amount of interest that banks could earn on their starting reserves was effectively (M x I). At the time I felt like I was the only person on the planet to have worked this out because I had never seen anyone else say it. I thought that perhaps I had made some mistake. But then I came across the following, rather long (3.5 hours!), but very good, documentary called The Money Masters - How International Bankers Gained Control of America, and at 19 mins 25 seconds in to the movie they say
"every bank in the U.S. is allowed to loan out at least ten times more money than they actually have, thats why they get rich on charging lets say 8% interest -its not really 8% per year which is their income, its 80%, thats why bank buildings are always the largest in town".
I was right!

So while I am happy to find some support for my conclusions, I am not at all happy with the way the banks are screwing the rest of the economy.

Tuesday, 19 May 2009

Politicians know nothing about banking

I came across a link to the House of Commons Treasury Committee report on the banking crisis in the UK, entitled "Banking Crisis: dealing with the failure of the UK banks" here. I thought this would be a good time to check out just how well understood the problems of fractional reserve banking and fiat money are amongst politicians. To test this I did a little search to find out how many occurrences of certain key phrases there were in the 129 page document. And here are the results:
  • "Fractional reserve" - NIL
  • "Money multiplier" - NIL
  • "money supply" - NIL
  • "M3" - NIL
  • "Reserve requirements" - NIL
  • "Fiat currency" - NIL
  • "Gold standard" - NIL
  • "High powered money" - NIL
  • "Monetary base" - NIL
No wonder the banks have been able to pull the wool over the eyes of politicians for so long.

Saturday, 9 May 2009

Capital gains tax - part legitimate - part theft

I'm in the middle of reading George Cooper's "The Origin of Financial Crises". After looking at the section called "A brief aside - on the topic of inflation and taxation" I realized something that had never occurred to me before, about capital gains tax. I already knew that when the government print (or otherwise allow the creation of) new money, then this is a kind of tax. If the total money supply went up 10% then in the long term the spending power of our savings would diminish by 10% and the government would have an extra load of money in its coffers. But I had also assumed that if, instead of having our savings in cash we had it held in some asset like gold for example then our "savings" would be protected from the government... but I was wrong! And here's why:

Imagine a world in which, for decades, most countries had a near zero inflation rate (hard to imagine I know!). Now lets say you'd been tipped off that your government was about to double its money supply overnight. In preparation for this you use all your savings to buy gold. The government then create the new money and as expected the value of your national currency halves relative to other currencies of the world. The value of your gold, as measured in any foreign currency, remains unchanged - but measured in your own currency appears to have doubled. Now here comes the nasty surprise - when you then try to sell your gold back in to your own currency, your government step in and say "please pay us capital gains tax!". That's not fair. Your capital has not gained any value at all! Its the same stuff! Its value, as measured in any other currency, has not changed! Why should you have to pay a "gains" tax when there has been no gain!

Now you may be wondering why I've given this entry the title of "part legitimate - part theft" and that's because I can see a legitimate reason for capital gains tax. If, during a low inflationary period, a rich person invests in some stock that genuinely rises in value (as measured in any currency) then I think it is reasonable to tax the gain. After all, why should we allow rich people to gain extra money simply by virtue of being rich. So in conclusion I'd say that taxing any genuine component of a gain is legitimate, but taxing "imaginary" gains, caused by the government printing money, is simply theft.

I wonder if this observation could be grounds for withholding part of your capital gains tax?
  • Perhaps you could legitimately only report your estimated "true" capital gains after having allowed for any government-induced inflation?
  • If a tax is called a "gains" tax, are the inland revenue allowed to tax you when there are no gains? If a tax was called a "bicycle trading profits tax" and you made some money by trading cheese, would the inland revenue be allowed to use the bicycle tax to take money from your cheese trading profits? Would any lawyers out there care to comment?
P.S. I was just explaining the contents of this blog entry to someone else who didn't quite get it and I had to try explaining the story from another angle. So here it is. Imagine you've saved £10,000 which will buy you a new car, call it the Toyota ZPF-X, when your current old banger finally conks out. Of course you've already paid income tax on this money. Now you stored this money in some kind of stock/bond/gold/whatever. Now fast forward a few years and your old banger finally dies. The government have been printing loads of money and so now inflation has caused the same Toyota ZPF-X to cost £15,000. Your investment has protected you against your currencies inflation, and it is now worth £15,000. Your savings have stood still - you started with enough money to buy the car and you've ended up with enough money to buy that same car... you've already paid the income tax on that money. But now the government want to tax you for a second time on your "gain".

Sunday, 3 May 2009

Rational Exuberance

Professor Robert Shiller subscribes to a theory about the psychology of asset bubbles called "irrational exuberance". The theory makes three basic claims about asset bubbles.
  1. They get triggered by something external.
  2. The prices rise because of a contagious fever of excitement about getting rich based on stories they hear from their friends and in the media.
  3. The bubble bursts at some point because it can not rise forever, but we have little clue of the timing.
After thinking about the psychology of bubbles from an AI standpoint, I have come to the conclusion that he may be wrong on all three counts.

I'd like to propose my theory of asset bubbles which I will call "rational exuberance". Now the first step in describing my theory is to consider our thought processes in determining what we are willing to pay for an asset. I suggest that it is made up from two components that are considered separately and then combined in to a final conclusion. The components are:

A) The estimated reasonable price of the asset excluding any thoughts about how the assets price may change in the future. This is a kind of true price which reflects how much we desire the asset for its own sake, rather than as a speculative investment.

B) Our estimate of what we expect the price to be at the time when we expect to sell the asset.

Now in a stable, zero inflation, environment, estimates A and B would be one and the same value. However we would generally expect B to be different to A because of a combination of factors including general inflation, immigration rates, the birth rate, unemployment rates, social trends, the rate of housebuilding and all sorts of complicated things that people find hard to predict. I would suggest that people generally feel unable to estimate the sum total of these effects and so instead will use what I will call the "insect tracking" method:

Imagine someone observing a small spider that has just been placed on a stick. They have no idea about its motivations or what its going to do, but then they see it start to crawl in a particular direction along the stick, at first they are not sure whether its going to keep going in the same direction or perhaps it will suddenly stop or maybe head in the opposite direction.... but then imagine that it appeared to move fairly constantly in a particular direction (lets say from left to right) for several seconds. The longer it kept going, the more confident the observer would become that in the next instant it would be further right than it is now. This kind of prediction based on previous events without the slightest understanding of the underlying driving forces is both completely natural and makes good logical sense. It is certainly true that with almost any system you care to observe in life, its future behavior tends to be the same as its past behavior at least in the short term. In the longer terms things can change. Let us say that our spider suddenly (and of course unexpectedly) stopped. What will happen next? Well the fact that its behavior suddenly changed (from moving to stationary) makes us suddenly less confident about where it will be in the next instant. I could go in to a lot of detail about the relationship between its behavior up to a particular point in time and our prediction of what will happen in the next instant afterwards, but for now I will summarize it with the statement "The longer a system is observed displaying behavior X, the more confident we become in the assumption that in the next instant it will continue to display behavior X". Now I am going to add an additional complication to the insect watching analogy. Let us say that we have arranged to have a heat source placed at the right hand end of the stick. The temperature at the end of the stick is known to be uncomfortably hot for the spider. Now lets run the experiment again: the spider, as before, heads off from left to right - and again the longer it continues to travel in this direction the more confident we become that it will continue to do so, but this time we need to add a proviso - we know that the spider will not carry on walking right up the the heat source - we know that's too hot. We know it will have to stop at some point. So now our spider watching prediction could be summarized as follows. "The longer a system is observed displaying behavior X, the more confident we become in the assumption that in the next instant it will continue to display behavior X, but if we know that behavior X becomes increasingly improbable over time, then our confidence in the predictive powers of past behavior will progressively diminish".

Now lets apply the insect watching ideas to the housing market. Shiller states that something external is needed to start a housing bubble - well, I'd re-phrase that as something external can start a housing bubble, but it can also start all by itself just by random fluctuations. Consider a small town in which every year a certain number of people move out and a certain number of people move in. Let us imagine that on average these numbers are approximately equal, but simply according to the law of random numbers, in one particular year the numbers may be quite different. Imagine that as a one-in-100-year event, there was a significant predominance of new people moving in, and not only that they were on average wealthier than the average of the people living there already. This entirely random event would cause house prices to rise significantly in this town over the year.... now the spider has started to move from left to right... the people watching house prices in the town have no idea that this was a special one off rare event that will not be repeated. Instead they start to predict that house prices in the area will continue to move upwards. Estate agents will start writing in their brochures that this is an up and coming town and purchases here would be a great investment. These "truthful" statements will make the purchase of properties in this town more attractive... the ball has started rolling and you can imagine what happens next. The spider is making a steady march from left to right. The higher prices in the town will cause the prices in the suburbs rise, then neighboring towns and so on and so on.

I'd like to nit pick with Shiller again at this point. Shiller states that the "hype" and "newspaper" stories are what is driving the rise. Where as I would state that its to a large degree, the rise that is driving the rise! The newspapers are just helping the process along. Like a second spider observer telling you "Hey, did you see that! The spider is going from left to right!". You could see that already yourself - but of course the confirmation from the second observer will support or intensify your belief (that you would of had anyway) that the spider will continue in that direction.

Now lets consider the bubble bursting. Shiller appears to think the turning point is beyond analysis. I however, feel it is an entirely logical process. Remember my earlier statement: "...but if we know that behavior X becomes increasingly improbable over time, then our confidence in the predictive powers of past behavior will progressively diminish". This could be re-phrased for the housing market as "In a rising market, the more improbably stupid house prices become, the less likely we are to believe that the current rising pattern will continue." The bubble will burst when the price rise non-believers start to outweigh the believers. I don't know if surveys have been done but I would hazard a guess that in any asset price bubbles one could a detect an increase in the proportion of "non believers" before the bursting point.

It should be noted that the point at which non-believers start to outnumber the believers may be helped along by some external event. Something which makes rising prices less probable. And the further the price rises had drifted in to the realms of the improbable, the smaller the external event that would be required to trigger the reversal in the direction of prices. Now there will always be people around who will point to this trigger and claim that this was the true reason prices reversed - but it is very likely that this was simply the straw that broke the camels back and if that event hadn't happened then something else, or even nothing at all other then the inevitable rise in the fraction of non-believers, would have shortly afterwards.

P.S. In response to a comment about this blog entry, I will add a little extra detail:

When I mention looking at the proportion of "non-believers", I don't mean the proportion of politicians/journalists/economists who say "This bubble has got to burst sometime". And I don't mean that we should listen to how vociferously they are proclaiming this. We all know people who were saying "this can't go on forever" (some were saying it many years in advance). Instead I mean simply monitor the fraction of ordinary potential house buyers who say "I'm NOT going to buy a house right now because I think that its value will not rise or may even fall by the time I want to sell it". They are the people who will stop the bubble. And the greater the preponderance of them, the sooner the bubble will burst.

Friday, 1 May 2009

My first ever investment

After years of not having invested in anything, I finally have decided that it is probably less risky to make an investment than not! As detailed in several posts I believe that there is a risk of the pound going through a period of very high inflation and so taking a serious nosedive on international markets.

So here's my investment of choice: ETFS All Commodities, as I understand it (and please tell me if you think I've got it wrong!) this is an investment which tracks the price of a basket of commodities like gold,copper,oil,assorted agricultural produce etc. Now its important to note that its tracking the price of the stuff itself, not the success of companies that make it.

There are many reasons I've chosen this:
  1. Its diverse.
  2. Commodities can never go out of fashion, nobody is ever going to say "Oh that copper junk, who needs that!" and this will be true for decades to come.
  3. Unlike companies, commodities can never "go bust".
  4. Many commodities, like oil, are running out and/or getting more expensive to extract (see this if you need persuading).
  5. The worlds population is expanding, creating ever more demand.
  6. It seems to me that the cost of commodities, in the very long term, should increase at least in line with world average (erm, maybe total) earnings.
  7. After a big crash (like now) is probably a reasonable time to buy in.
  8. I wouldn't matter if the UK (where I'm from) had some economic catastrophe as long as most of the rest of the world was doing ok and could hold up commodities prices.
  9. Relatively cheap to invest - through Interactive Investor its £10 to buy in and £10 to sell regardless of the quantity. Then 0.49% P.A. management. No "stamp duty".
  10. Buy or sell at any instant.
The only thing that worries me about this investment is that I haven't fully understood the mechanics of exactly how it is arranged "under the hood" and I don't fully understand the insurance that backs it up.

I would very much like your opinions on my investment.