naked capitalism

By Richard Alford, a former economist at the New York Fed. Since then, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side.

Apologies to both Clemenceau (Prime Minister of France 1917-1920) and General Jack D. Ripper (Dr. Strangelove 1964)

The recent crisis and continuing economic and financial dislocations has led many to question the usefulness of the current macroeconomic paradigm, if not economics more generally. Raghuram Rajan, whose paper, “Has Financial Development made the World Riskier,” was summarily dismissed at the Fed Jackson Hole Conference in 2005, has recently posted a piece titled “Why Did Economists Not Foresee the Crisis?” In this piece, Rajan rejects three popular explanations for the failure of economics and economic policy, i.e. the absence of “models that could account for the behavior”, “ideology”, and “corruption”. Rajan offers alternative explanation(s): “I (Rajan) would argue that three factors largely explain our (economists) collective failure: specialization, the difficulty of forecasting, and the disengagement of much of the profession from the real world.” The logical conclusion of Rajan’s explanation(s) is that to avoid future crises, the role of economists, or at least academic economists, in the policy formulation process should be reduced. More troubling yet for economists, including Rajan, is some recent work by Frydman and Goldberg which argues that current economic models are inherently flawed.

Rajan dismisses the argument that economics lacked relevant models. He cites the fact that academic economists have studied and modeled many of the factors that contributed to the crisis. Rajan does, however, cite the compartmentalization of economics which leaves macroeconomists ignorant of findings in other sub-disciplines of economics.

In Rajan’s view, the inability to forecast accurately reflects shortcomings in the current model. All models of the economy abstract from the complexities of the economy and financial system. Models are simplifications of realty. Hence the models are incorrect. (We will return to this point later.) The only questions are how large and costly will the model-driven errors be.

Observers should not be surprised by the fact that the models employed by economists contained simplifying assumptions. However, they should be disturbed by the recent performance of policymakers. They ought to ask the question: why did economists remain wedded to their model despite the growth of all the macro-economically important economic and financial imbalances and unsustainabilities that existed in the years prior to the crisis?

Rajan rejects the argument that it was an ideological commitment to market efficiency that led economists to undue faith in the model. Rajan cites the fact that both behavioral economists who reject market efficiency and progressive economists who reject free markets also failed to see the crisis coming.

However, economists and policymakers in the US dismissed evidence of numerous unsustainabilities, as well as rejected warnings by the likes of Rajan, Shiller, White, and ironically Kohn formerly of the Board of Governors. In an op-ed piece, Shiller blamed the failure to foresee the crisis on group think. (here) He cited as evidence his experience on an FRBNY advisory board. In a 2003 paper, Kohn cited potential risks in unsustainabilities in the housing market, consumer expenditures and the build-up of debt. However, judging by his response to Rajan at the 2005 Jackson Hole Conference, he didn’t see problems or risks despite the large and growing unsustainabilities in areas he had cited in 2003.

The narrow specialization of academic economists is consistent with this highly specialized group think dominated the policy perspective. This is also reflected in the job description offered by one former member of the Board of Governors, appointed during the run-up to the crisis. The appointee said something to the effect that his job on the Board was helping Bernanke implement inflation-only targeting. This reflects a narrow anti-intellectual mindset. This view of the job of a central banker implies that the appointee’s model of the economy had morphed from an engine of analysis (potentially one of many) in to a set of intellectual blinders complete with an disregard for a governor’s regulatory responsibilities. Hence It is probable that the imbalances and unsustainabilities were ignored because they were at variance with the group-think-endorsed model and were a)implicitly and without thought deemed to be unimportant, or b)if addressed would have ruined or delayed the proof the their model was the correct one.

Rajan rejects the argument that consulting contracts and other outside (outside of academia) money had corrupted economics. The view that economics had been corrupted became more popular when it became widely known that former Fed Governor Mishkin, while still an academic, had been paid for a review of developments in Iceland by Icelandic groups with an interest in promoting financial markets and institutions in Iceland. Two observations:

1) Did anybody ever think that he did it for free? (Do academics, economists, psychologists, sociologists, chemists, statisticians generally consult for free?); and
2) To suggest that this corrupted Mishkin is an insult to the Icelanders who hired him. Does anyone think that they did anything but search out someone with proper credentials and who was already predisposed to produce a favorable review?

Rajan points out that that the vast majority of economists who subscribed to the views held by Mishkin never got a dime from Iceland or any other outside source.

Rajan also cited the disengagement of much of the profession from the real world as a reason why economists failed to foresee the crisis:

The main advantage that academic economists have over professional forecasters may be their greater awareness of established relationships between factors. What is hardest to forecast, though, are turning points – when the old relationships break down. While there may be some factors that signal turning points – a run-up in short-term leverage and asset prices, for example, often presages a bust – they are not infallible predictors of trouble to come…

The danger is that disengagement from short-term developments leads academic economists to ignore medium-term trends that they can address. If so, the true reason why academics missed the crisis could be far more mundane than inadequate models, ideological blindness, or corruption, and thus far more worrisome; many simply were not paying attention.

Rajan’s explanation for the failure of the academic economics profession to foresee the crisis should be more disturbing to academic economists than the popular criticisms. The shortcomings mentioned in the popular explanations are more easily corrected. The vast majority of academic economists have not benefitted at all from lucrative outside consulting contracts. There exists a spectrum of opinions within the economics profession even if a narrow perspective dominated macroeconomics. Economists are already at work to alter the assumptions in their models that have been linked directly to the financial crisis. (This is no guarantee that altering these assumptions will prevent future crises.)

On the other hand, virtually all academic economists are “specialized” in one or another compartmentalized sub-discipline of economics. It would probably take a generation before academic programs produce and reward “Renaissance” academic economists. It will also take years (a generation?) for the degree of academic disengagement “from the real world” to be reduced significantly.

However, Rajan also ignores the fact that academic and professional economists (his distinction) share many of the same problems. “The difficulties of forecasting” exist for both academic and professional economists. This is important given the existence of lags in the policy process. In a book titled “Beyond Mechanical Markets: Asset Price Swings, Risk and the Role of the State”, Frydman and Goldberg address some of difficulties beyond those raised by acknowledging the short-comings of models that incorporate “rational expectations”. They address difficulties inherent in economic modeling and forecasting in general. Some of the salient findings have been cited in reviews and blog posts (see here and here). Quoting from one of the reviews:

Frydman and Goldberg’s thesis deals with more fundamental macroeconomic matters: To what extent can we predict the future? Is there a mechanical causal link that we can ever truly identify and quantify between past and future? They gather and deploy their intellectual confederates: Frank Knight, John Maynard Keynes, Friedrich Hayek, Karl Popper. They argue that rational expectations is one method, certainly a ubiquitous one, based on what they call a “fully predetermined model,” in which market players act as robots and markets operate as a kind of machine; another predetermined approach, they argue, is the New Keynesian school, that is the formalization into mathematical models of Keynes’ “General Theory” of 1936; a third includes some of the more mechanical tendencies of the behavioral school. “To portray individuals as robots and markets as machines,” they write, “contemporary economists must select one overarching rule that relates asset prices and risk to a set of fundamental factors such as corporate earnings, interest rates and overall economic activity, in all time periods. Only then can participants’ decision-making process ‘be put on a computer and run.

(The book) … marshals a powerful argument that’s bolstered by empirical reality: the eternal failures of mechanical forecasting; the sheer difficulty of beating the market with consistency; the unforeseeable ways that history unfolds. The belief in precise prediction resembles a kind of utopian project, a tower of economic Babel. … They quote Popper: “Quite apart from the fact that we do not know the future, the future is objectively not fixed. The future is open: objectively opened…

…. the insurrection Frydman and Goldberg argue for is far greater than just an overthrow of rational expectations; it’s an entire economic world view that claims the power to accurately predict, forecast and capture market reality …

The perspectives of Rajan and the F&G book have implications not only for financial markets, economics, and economic forecasting, but for economic policy beyond its interaction with asset prices. Model-driven financial and economic activities do not always produce the expected outcome. Firms will not always maximize profit streams and policymakers will fail to minimize the “misery index”. On the private side, think LTCM. On the policy side, policymakers did not plan or expect the inflation of the 1970s. The current set of policymakers did not expect the crisis or the great recession, but it is clear that policy through omission, commission or both contributed to this less than positive outcome.

The F&G perspective calls attention to the fact that there is risk attached to policy, especially during periods dominated by non-routine changes, e.g. globalization and rapid financial innovation. The inherent risks attached to policy, in turn, imply that while the Fed’s mandate to hit targets for inflation and unemployment makes wonderful sense politically, pursuing it will at times contribute to inferior outcomes. Notwithstanding all the false precision attached to forecasts and estimates e.g. the existence of the great moderation and the equivalence of $600B of QEII with exactly 75 basis points of reductions in the Fed funds rate.

The risks in policy and the possible costs associated with policy errors suggest that policymakers should not behave as if their model-driven decisions will invariably produce optimal outcomes. Policymakers should be more open than they have been to evidence that indicates that the chosen policy stance is inconsistent with sustainable growth and price stability. Given the specialization in the economics profession as well as evidence that economists or at least economists in macro-economic area are subject to “group think”, the policy process must include individuals who think outside the current box and can see when the reigning model omits non-routine developments which may play a crucial role in driving outcomes.

Economic policy is too important to be left economists who do not appreciate the limitations of economic models. If you think that being a professional economist is necessary to be a good policymaker ask yourself: Whom do you think history will look on more favorably the non-economist Volcker or one of the academic/professional economist Burns, Greenspan or Bernanke?

By Douglas K. Smith, author of On Value and Values: Thinking Differently About We In An Age Of Me

In “Economics In Crisis”, professor Brad DeLong notes:

The most interesting moment at a recent conference held in Bretton Woods … came when Financial Times columnist Martin Wolf (asked) Larry Summers, “[Doesn’t] what has happened in the past few years simply suggest that [academic] economists did not understand what was going on?”

DeLong agreed with Summers’ response: “the problem is that there is so much that is “distracting, confusing, and problem-denying in…the first year course in most PhD programs.” As a result, even though “economics knows a fair amount,” it “has forgotten a fair amount that is relevant, and it has been distracted by an enormous amount.” DeLong then goes on to call for serious change in what economics departments do and teach.

In Part 2 of this post, I’m going to address the realities of ‘serious change’; and, in that context, what is troubling for INET about Summers’ presence at the recent Bretton Woods gathering. I’ll do this from my experience in leading and guiding real change as well as by contrasting INET with another, smaller, and more nascent effort called Econ4.

For now, though, let’s put aside the serious lack of self-respect in paying any attention at all to a world historical failure like Summers (Why is this arrogant sophist even on anyone’s C list, let alone A list? Why isn’t Summers wearing sack cloth and rolling in ashes?). Instead, let’s respond to DeLong’s ‘fessing up to the crisis in economics:

I was shocked by how large a panic was produced by what seemed to me – and still does – relatively small losses (in terms of the size of the global economy) in subprime mortgages; by the weakness of risk controls at the major highly-leveraged banks; by how deep the decline in demand was; by how ineffective the market’s equilibrium-restoring forces have been at rebalancing labor-market supply and demand; and by how much core-country governments have been able to borrow to support demand without triggering any run-up in interest rates.

Stifle the Casablanca jokes. DeLong is no Captain Renault (“I am shocked, shocked that gambling is going on here.”). Renault was cynical; Delong is not. From what Yves and others tell me, DeLong, unlike Summers, has an open mind (see this for excellent description of what it takes to have a rational discussion). So, please, no personal attacks on DeLong (although go ahead and have at Summers).

Now, in the spirit of helping orthodox economics move beyond culturally induced ignorance, let’s pose some exam questions regarding what DeLong found so shocking. We’ll do this by looking at each shocking element; and, then, for extra credit, ask some ‘dog that didn’t bark’ as well as curricular and epistemological questions.

There’s no intention here of attacking DeLong personally. But these exam questions are specifically and clearly directed at him as well as other mainstream economists. Yes, tenured professors are more comfortable giving exams than submitting to them. Well, that’s one of the many things that must change if economics and economists are to emerge from this crisis with anything more than warmed-over excuses and rationalizations. Other professionals — lawyers, doctors, accountants — have faced up to requirements of staying current in fields that change rapidly. Economists must do so too. Any economics professor and/or professional who would purport to opine, teach and/or advise on any of the following topics ought to be required to demonstrate competence by answering these questions. And that includes DeLong.

Shocked at panic produced by relatively small losses in subprime:

Exam questions

:

How small or large were these losses? First, how small or large were the direct losses in the subprime market? What was the size of that market and it’s loss severity? Do you include Alt A with ‘subprime’? Anything else? If not, why not – where and why do you draw the line? Is ‘subprime’ best understood by the characteristics of the customer; or, the terms of the transaction? In light of your answers to that, how large was the “subprime-like” market and what was the loss severity? Based on all this, how small or large were/are the total losses — and why do you call them ‘relatively small’? Relative to what? Relative to the size, leverage and funding requirements of CDOs? How small or large were the CDO losses that were triggered by losses in subprime and ‘subprime-like’ (however you define that)? Were these losses concentrated? If so, with what institutions, and how connected were those institutions to one another? That is, what was the size of the full contagion– and please address that relative to the interconnectedness of the players in what has been called a massively tightly coupled system? Are these losses ‘relatively small’?

What had you learned, written on, spoken about, conferenced about, taught about at either the undergraduate or graduate level, or otherwise explored in the five years prior to 2007/2008 that had relevance to any of these questions?

Shocked by the weakness in risk controls at the major highly leveraged banks:

Exam questions:

Please describe for the major highly leveraged banks (both TBTF and shadow) what risks and whose risks were addressed by institutional risk controls? Also describe what risks and whose risks were not addressed by those controls. In addition, please describe the role and contribution of ratings agencies to the risk controls of major highly leveraged banks (both TBTF and shadow).

Please describe for the same organizations what were the reporting relationships over the past decade between those who take risks and those who design and implement risk controls? Please describe who had more power within these firms and why? What salary, bonus, stock option, career path and advancement tracks were in place for these respective groups; and, what were the effects of those things on the motivations of these people as well as the operational effectiveness of their interactions with one another?

What can behavioral economics and a census of executives/managers/traders et al in the highly leveraged banks (both TBTF and shadow) as well as those with key roles in ratings agencies tell us about the presence and effects of the following kinds of people in these institutions:

➢ People who are criminals? How many of these people work in these institutions and what effect did that have on risk controls?
➢ People like the famous Enron traders (“fuck California” link: http://www.cbsnews.com/stories/2004/06/01/eveningnews/main620626.shtml) are entirely unethical. How many of these people work in these institutions and what effect did that have on risk controls?
➢ People who claim to and even in some aspects of their lives comply with some basic ethical and/or rule-based behaviors but nonetheless are inclined to cheat and easily swayed to do so? How many of these people work in these institutions and what effect did that have on risk controls?
➢ People who attend to ethical and other rules but paint for themselves and others the most optimistic picture possible of their behavior and choices, especially when they’ll get rich by doing so? How many of these people work in these institutions and what effect did that have on risk controls?
➢ People who may not themselves fit any of the above categories and yet hierarchically report to people in the above categories and are disinclined to challenge authority? How many of these people work in these institutions and what effect did that have on risk controls?
➢ One last group: People who are ethical and abide by rules and quite willing to exert and/or challenge authority when they believe ‘the way we do things around’ here have serious shortcomings? By all means, please describe how many of these people work in these institutions and what effect did that have on risk controls?

What are the economics of control fraud? How do your responses to earlier exam questions in this section relate to those economics? For example, did the actual incentive structures, reporting relationships, job definitions, approach to risk controls and behavioral inclinations in the decade running up to 2008 contribute to control fraud? How often and why? Which of those elements – singly and in combination – have changed significantly as a consequence of Dodd Frank, Sarbanes Oxley, and other actions taken since 2008? Have these changes been significant enough to reduce the incidence of control fraud going forward?

What had you learned, written on, spoken about, conferenced about, taught about at either the undergraduate or graduate level, or otherwise explored in the five years prior to 2007/2008 that had relevance to any of these questions?

Shocked by how deep the decline in demand was:

(Here I’m assuming DeLong’s reference is to consumer and enterprise demand for goods and services and distribution thereof. He might, though, mean demand for securitization instruments, etc. But, let’s go with goods, services, etc.)

Exam questions:

Please describe the typical cash flow sources (e.g. jobs, salary/wages, non-wage related income, debt/borrowing, etc) and uses (e.g. expenditures of all sorts) picture for households in each five quintiles by income and wealth, and how that picture changed from the early 1970s to 2008. Next, please describe each quintile’s evolving balance sheet over the same years and how that balance sheet related to the evolving picture of cash flow sources and uses? In light of each evolving picture, please describe any shifts in consumption capacity and robustness/sustainability of that capacity for each quintile? What do those analyses tell you about what might have been expected regarding the depth/shallowness of decline in consumer demand by 2008? And, what does your response to the last question suggest about the profile of enterprise demand (i.e. B2B) for goods, services, and distribution?

What had you learned, written on, spoken about, conferenced about, taught about at either the undergraduate or graduate level, or otherwise explored in the five years prior to 2007/2008 that had relevance to any of these questions?

Shocked by how ineffective the market’s equilibrium-restoring forces have been at rebalancing labor market supply and demand:

Exam questions:

Please describe the sources of information best suited to understanding basic movements in the labor market’s supply and demand, and how and what you must do to make those sources of information intelligible? Next, list what you consider to be the three to five most important ‘market equilibrium-restoring forces’ relevant to labor market supply and demand. How do the following affect your understanding of these three to five forces on labor markets:

➢ Your answers to the exam questions about decline in demand
➢ The effect of ‘extend and pretend back door recapitilization with bonuses intact’ bail outs of TBTF banks and others on housing markets
➢ The relative importance of private sector, government sector and non-profit sector in job creation over the decade prior to 2008; and, within the private sector, how those sources for job creation varied by size of firm and number of years firms were in business
➢ Moves toward government austerity
➢ The cash positions of corporations
➢ The hurdle rates for investments in corporations and how they are designed and calculated
➢ Tax policy

Please describe what is meant by the ‘financialization of the economy’. Also describe what is meant by ‘turning the financial sector into a casino?” How does financialization of the economy and turning the financial sector into a casino relate to the equilibrium restoring-forces that rebalance labor market supply and demand? In answering this last question, please distinguish labor markets for those with high talents at engineering, math, marketing and sales versus others? Does financialization/casino/etc lead to any distortions and differences in the labor markets for jobs in financial firms versus the labor markets for jobs in other sectors?

With the functioning of labor markets in mind, please compare and contrast an economy whose policies and strategies are essentially focused on asset values and credit versus one whose focus is essentially on jobs and incomes. Considering that comparison, also please answer the following: Is financial activity socially useful? In what ways? Is financial activity ever socially useless and/or harmful? In what ways? Please describe the relationship, if any, between executive, trader, employee incentives and (i) financial activity that is useful; (ii) financial activity that is useless; and, (iii) financial activity that is harmful. As you consider these questions, please pay close attention to the effects of financialization and the ‘casino’ on income and wealth inequality; and, in turn, what effects that inequality has on families and communities? Human health and happiness? Democracy? Oligarchy? Crony capitalism?

What had you learned, written on, spoken about, conferenced about, taught about at either the undergraduate or graduate level, or otherwise explored in the five years prior to 2007/2008 that had relevance to any of these questions?

Shocked by how much core country governments have been able to borrow to support demand without triggering any run-up in interest rates:

Exam questions:

Please describe the ‘demand’ that has been supported by the borrowings of core country governments? That is, demand for what and by whom and in what proportions (e.g. demand for goods and services vs demand for off balance sheet financing and so on)?

Please describe the sources/reasons for the ‘run up in interest rates’ that you would have expected, and how your expectations are affected by (i) a Zero Interest Rate Policy of the Fed; (ii) availability of risk-free interest revenue to financial institutions from the Treasury through arbitrage (i.e. borrow at zero, lend at something); and, (iii) the deep decline in demand that was the subject of your earlier shock?

Please describe how the financial balances of the following sectors interact in ways that affect an economy’s growth? Distribution of income and wealth? Interest rates?

➢ C (Personal consumption expenditures);
➢ I (Gross private domestic investment);
➢ E (Net exports of goods and services); and,
➢ G (Government consumption expenditures and gross investment).

What had you learned, written on, spoken about, conferenced about, taught about at either the undergraduate or graduate level, or otherwise explored in the five years prior to 2007/2008 that had relevance to any of these questions?

Extra Credit I: The Dog That Didn’t Bark

Professor DeLong does not write that he experienced any shock at the combined effects of the deregulation of ‘free’ financial markets, the cognitive capture of agencies, and the evisceration of enforcement budgets and personnel. Let’s assume this was not an oversight; and, that he indeed was not shocked by the severity and depth of turmoil triggered by the gutting of government’s role (indeed, the reversing of that role into one of partnership with the financial sector).

For extra credit, then, please describe what the last 20 years have taught the economics profession about the likely course and character of an economy led by the financial sector when that sector operates ‘freely’ in the absence of any law, rules, regulations or ethics not to mention service to or link with the real economy? In particular, please describe what happens when the financial sector becomes a casino where Captain Renault would be quite welcome – in particular what happens when some of the casino players wake up one day needing an infusion of short-term cash, but none of the other players will lend it? Please describe to whom these casino players turn, and on what terms?

And, in light of your response to this, please review and, if necessary, revise your answers to all previous exam questions about just how shocked you were by the events and patterns of the past several years.

What had you learned, written on, spoken about, conferenced about, taught about at either the undergraduate or graduate level, or otherwise explored in the five years prior to 2007/2008 that had relevance to any of these questions?

Extra Credit II: What changes would you make to economics curriculum and epistemology?

What would you change in curriculum for graduate and/or undergraduate economics? Specifically, what content that is currently core to graduate and/or undergraduate curriculum would you drop entirely or significantly alter (and how would you alter it).

In addition, which of the following would you significantly feature in graduate and/or undergraduate curriculum — not just mention in a ‘drive by’ way, but actually make core to the degree itself?

➢ Economic history
➢ History of economic thought
➢ Actual/real study of institutions (versus, say, mathematized study of them)
➢ Behavioral economics
➢ Distribution economics
➢ Modern monetary theory
➢ Networks, systems and resiliency
➢ History/history of thought in general
➢ Ethics – both in general and as applied to economists and the work they do, for whom, and with what compensation and reward
➢ Gross Domestic Happiness and other alternatives to GDP
➢ Other?

What, if anything, would you change about the epistemology of economics? That is, the basis for the knowledge claims that economics and economists make? What role, if any, would fact gathering and empiricism play in the future of economics epistemology; and, how does that significantly differ from the past? What role does/should the scientific method play in the epistemology of economics; and, in that vein, what role should Popper’s falsification have? What role would assumptions such as rational beings and perfect and perfectly accessible information have, if any? What role would assuming away such things as instability, unemployment, and distributional and power inequalities play, if any? What effects (for example, regulatory and cognitive capture) do high concentrations of power and wealth in a market economy have on the conduct and knowledge claims of economics and economists? How would you characterize, if at all, any minimum threshold of ethics as a dimension to knowledge claims? In order to avoid tautologies, how carefully should economics compare and contrast the specific content of the assumptions it makes with the specific content of the conclusions it draws?

I’m pretty amazed that no one looked into the greenhouse gas impact of fracking until now. One of the big rationales for fracking, which is already controversial due to reports of damage to aquifers, is that it was abundant in North America and also produces comparatively little in the way of carbon emissions.

The problem, per a study soon to be published by Cornell University, is fracking results in the release of methane, one of the most potent greenhouse gases, apparently enough to undercut the claims that it is relatively “clean”. From NewsWise:

Extracting natural gas from the Marcellus Shale could do more to aggravate global warming than mining coal, according to a Cornell study published in the May issue of the peer-reviewed journal Climatic Change Letters.

While natural gas has been touted as a clean-burning fuel that produces less carbon dioxide than coal, ecologist Robert Howarth warns that we should be more concerned about methane leaking into the atmosphere during hydraulic fracturing.

Natural gas is mostly methane, which is a much more potent greenhouse gas, especially in the short term, with 105 times more warming impact, pound for pound, than carbon dioxide, Howarth said, adding that even small leaks make a big difference. He estimated that as much as 8 percent of the methane in shale gas leaks into the air during the lifetime of a hydraulic shale gas well – up to twice what escapes from conventional gas production.

“The take-home message of our study is that if you do an integration of 20 years following the development of the gas, shale gas is worse than conventional gas and is, in fact, worse than coal and worse than oil,” Howarth said. “We are not advocating for more coal or oil, but rather to move to a truly green, renewable future as quickly as possible. We need to look at the true environmental consequences of shale gas.”….

We are highlighting unconventional gas because it is a contemporary problem for us in upstate New York, and because there is a big difference between developing gas from an unconventional well and a conventional well, for the mere reason that unconventional wells are bigger,” Ingraffea said.

He noted that the hydraulic fracturing process lends itself to more leakage because it takes more time to drill the well, requires more venting and produces more flowback waste, he said.

“We do not intend for you to accept what we’ve reported on today as the definitive scientific study in regards to this question. It’s clearly not,” he added. “What we’re hoping to do with this study is to stimulate the science that should have been done before. In my opinion, corporate business plans superseded national energy strategy.”

From The Hill (hat tip reader Thomas R):

In essence, the Cornell study argues that methane emissions from these shale gas projects mean that shale gas ultimately brings climate consequences comparable to coal over a century, and worse than coal over two decades….

Obama has touted the potential of natural gas for use in vehicles, in addition to its role in power generation (natural gas currently produces around a fifth of U.S. electricity).

His proposed “clean energy standard,” which would require utilities to greatly expand the supply of power from low-carbon sources, includes partial credit for natural gas.

More broadly, many gas supporters see domestic reserves as a “bridge” fuel while alternative energy sources are brought into wider use.

Howarth’s study questions this idea.

“The large GHG footprint of shale gas undercuts the logic of its use as a bridging fuel over coming decades, if the goal is to reduce global warming,” the study states.

The report in the New York Times on the same study is understated even if factually accurate (note the title says “studies” but the second study depends on the Cornell research for some of its key data):

Natural gas, with its reputation as a linchpin in the effort to wean the nation off dirtier fossil fuels and reduce global warming, may not be as clean over all as its proponents say.

Even as natural gas production in the United States increases and Washington gives it a warm embrace as a crucial component of America’s energy future, two coming studies try to poke holes in the clean-and-green reputation of natural gas. They suggest that the rush to develop the nation’s vast, unconventional sources of natural gas is logistically impractical and likely to do more to heat up the planet than mining and burning coal.

The problem, the studies suggest, is that planet-warming methane, the chief component of natural gas, is escaping into the atmosphere in far larger quantities than previously thought, with as much as 7.9 percent of it puffing out from shale gas wells, intentionally vented or flared, or seeping from loose pipe fittings along gas distribution lines. This offsets natural gas’s most important advantage as an energy source: it burns cleaner than other fossil fuels and releases lower carbon dioxide emissions.

Obama had been planning to construct 9 to 12 nuclear reactors in addition to emphasizing shale gas as ways to reduce carbon emissions. Fukushima is going to make it harder if not impossible to get nuclear plants built, and fracking is looking less attractive the more scrutiny it gets. Looks like it’s time to develop Plan B.

One of the interesting features during the Fukushima reactor crisis were the fistfights that broke out in comments between the defenders of nuclear power and the opponents. The boosters argued that the worst case scenario problems were overblown, both in terms of estimation of the odds of occurrence and the likely consequences. The critics contended that nuclear power was not economical ex massive subsidies, that there was no “safe” method of waste disposal, and that nuclear plants were always subject to corners-cutting, both in design and operation, so the ongoing hazards were greater than they appeared.

Reader Crocodile Chuck passed along a story from the Bulletin of Atomic Scientists, “The Lessons of Fukushima“, by anthropologist Hugh Gusterson. Here is the key section:

And presumably there are other complicated technological scenarios that we have not foreseen, earthquake faults that are undetected or underestimated, and terrorists hatching plans for mayhem as yet unknown. Not to mention regulators who place too much trust in those they regulate.

Thus it is hard to resist the conclusion reached by sociologist Charles Perrow in his book Normal Accidents: Living with High-Risk Technologies: Nuclear reactors are such inherently complex, tightly coupled systems that, in rare, emergency situations, cascading interactions will unfold very rapidly in such a way that human operators will be unable to predict and master them. To this anthropologist, then, the lesson of Fukushima is not that we now know what we need to know to design the perfectly safe reactor, but that the perfectly safe reactor is always just around the corner. It is technoscientific hubris to think otherwise.

This leaves us with a choice between walking back from a technology that we decide is too dangerous or normalizing the risks of nuclear energy and accepting that an occasional Fukushima is the price we have to pay for a world with less carbon dioxide. It is wishful thinking to believe there is a third choice of nuclear energy without nuclear accidents.

Readers will correctly argue that other energy sources have considerable human and environmental costs. Coal fired electrical plants are major CO2 emitters, and the older ones also spew a lot of particulates. Many communities in the US are fighting fracking out of well warranted concerns about the damage it might do to underground water supplies. Others readers have contended that we need to get over our growth addiction and start adapting to less energy intensive lifestyles (which if we were really serious about it, means much more urbanization in the US).

Is nuclear power worth the risk? And if you argue against it, what energy/economic strategy do you recommend in its place?

Reader James S. highlighted a useful article at the MIT Technology Review, “Can the U.S. Rare-Earth Industry Rebound?” Our only quibble to this solid piece is its summary, which underplays some critical aspects of the article:

The U.S. has plenty of the metals that are critical to many green-energy technologies, but engineering and R&D expertise have moved overseas.

In fact, the while the article does discuss US versus foreign engineering expertise in rare earths mining, it describes in some detail how difficult rare earths mining is in general (more accurately, not the finding the materials part, but separating them out) and the considerable additional hurdles posed by doing it in a non-environmentally destructive manner. Thus the rub is not simply acquiring certain bits of technological know-how, but also breaking further ground in reducing environmental costs.

And this issue has frequently been mentioned in passing in accounts of why rare earth production moved to China in the first place. It’s nasty, and advanced economies weren’t keen to do the job. China was willing to take the environmental damage. For instance, the New York Times points out:

China feels entitled to call the shots because of a brutally simple environmental reckoning: It currently controls most of the globe’s rare earths supply not just because of geologic good fortune, although there is some of that, but because the country has been willing to do dirty, toxic and often radioactive work that the rest of the world has long shunned.

From the MIT Technology Review:

Getting from rocks to the pure metals and alloys required for manufacturing requires several steps that U.S. companies no longer have the infrastructure or the intellectual property to perform….

In the 1970s and 1980s, the Mountain Pass mine in California produced over 70 percent of the world’s supply. Yet in 2009, none were produced in the United States, and it will be difficult, costly, and time-consuming to ramp up again…

The two mines that will be stepping up production soonest are Mountain Pass, being developed by Molycorp, and the Mount Weld mine, which is being developed by Lynas, outside Perth, Australia. Mountain Pass has the edge of already having been established. But the company cannot use the processes used in the mine’s heyday: they’re both economically and environmentally unsustainable.

Several factors make purification of rare earths complicated. First, the 17 elements all tend to occur together in the same mineral deposits, and because they have similar properties, it’s difficult to separate them from one another. They also tend to occur in deposits with radioactive elements, particularly thorium and uranium. Those elements can become a threat if the “tailings,” the slushy waste product of the first step in separating rare earths from the rocks they’re found in, are not dealt with properly…

Mountain Pass went into decline in the 1990s when Chinese producers began to undercut the mine on price at the same time as it had safety issues with tailings. When the Mountain Pass mine was operating at full capacity, it produced 850 gallons of waste saltwater containing these radioactive elements every hour, every day of the year. The tailings were transported down an eleven-mile pipeline to evaporation ponds. In 1998, Mountain Pass, which was then owned by a subsidiary of oil company Unocal, had a problem with tailing leaks when the pipeline burst; four years later, the company’s permit for storing the tailings lapsed.

Meanwhile, throughout the 1990s, Chinese mines exploited their foothold in the rare-earth market. The Chinese began unearthing the elements as a byproduct of an iron-ore mine called Bayan Obo in the northern part of the country; getting both products from the same site helped keep prices low initially. And the country invested in R&D around rare-earth element processing, eventually opening several smaller mines, and then encouraging manufacturers that use these metals to set up facilities in the country.

Yves here. I’d be curious for input on this point from any informed readers. China has allegedly made R&D advances, but are these processes aimed at increased efficiency? If so, they’d give China a cost advantage, but not contend with environmental issues; indeed, it’s conceivable that the toll with these new processes is even worse. Back to the article:

By 2012, Molycorp expects to produce 20,000 tons a year, and under its current mining permits could double capacity to 40,000 tons. Sims also says the company will produce rare-earth products at half the cost of the Chinese in 2012. According to the company, these savings will be made possible by several changes, such as eliminating the production of waste saltwater. Molycorp will use a closed-loop system, converting the waste back into the acids and bases required for separation and eliminating the need to buy such chemicals. The company will also install a natural-gas power cogeneration facility onsite to cut energy costs.

But Ames Lab’s Geschneidner notes that one major source of cost in the separation process can’t be eliminated–the fact that it simply takes a long time. Milled rock is shaken again and again in a mixture of solvents to separate the elements by weight; depending on the ultimate purity that’s required, this must be done 10,000 to 100,000 times. The result is then sold as a concentrate or treated to produce rare-earth metal oxides.

Even if Molycorp does succeed in reducing the costs of separation by half, the next step in production may cause a hiccup. Rare-earth oxides and concentrates do have a market, for example as catalysts for the petroleum industry, but they can’t be made into magnets. To make magnets, rare-earth oxides must first be converted into pure metals, a process that produces caustic byproducts, and is done solely in China today. Sims says that Molycorp is investigating pathways that are environmentally friendly and aren’t covered under intellectual property owned by foreign companies. These metals must next be made into alloys suitable for the magnets, another capability that’s concentrated overseas, mostly in Japan and Germany.

The story is not quite as dire as one might conclude from this article, which focuses strictly on the US mining question. The US is not the only country looking to gear up its rare earth production. Rare earths can be extracted from used products, particularly cars. And some products can be designed to eliminate the use of rare earths, although the tradeoff is typically more bulk and weight. Nevertheless, it is clear that advanced economies will need to make a lot of adjustments, including more investments in R&D and product design, to contend with the challenge of rising demand versus constrained supplies of rare earths.

The birth of modern propaganda took place in World War I, where an extraordinarily well orchestrated campaign turned America from pacifist to ferociously anti-German in a mere eighteen months. When after the war, the public learned that its beliefs had been turned without their realizing it, some of the key actors. such as Eddie Bernays (often described as the father of the public relations industry) and journalist Walter Lippman defended this type of activity. Lippman, in his 1922 book Public Opinion, contended that most people did not have the time, inclination, or ability to take the time to analyze the relevant information and parse it. Thus, it was important for well informed people to take responsibility for this process, which Lippman called “the manufacture of consent.” This is, of course, an argument for the role of an elite, steering the masses who are less capable of coping with its complexities.

Americans in particular are leery of this sort of thinking; elitism has a very bad name here. Yet there has rarely been a time when the gap between the beliefs of those in the corridors of power and those of ordinary people has been so wide.

One of the reasons may be that the very needs of those at the top of the food chain to sell their messages is leading to distorted feedback. We saw a ham-handed effort earlier this year of a deliberate effort to generate “opinion” data that would support the agenda of a particular group, in this case, the Peterson Institute’s long-running campaign against Social Security and Medicare. But their “America Speaks” campaign backfired rather spectacularly.

An attentive reader pointed out a subtler and more widespread version of this problem, keying off a weekend article in Raw Story, “Poll: Vast majority opposes attack on Iran“:

Fewer than one in five Americans would support a US military strike on Iran if the Middle Eastern country continued to pursue its nuclear program in the face of international sanctions, a new poll indicates.

The poll, carried out in June for the Chicago Council on Global Affairs, finds 18 percent would support a strike on Iran if the country failed to stop its enrichment of uranium. Forty-one percent would urge further economic sanctions against the country, and 33 percent would support further diplomatic engagement.

When asked what the UN should do, the answers were similar: 21 percent support military action, while 45 percent want more sanctions and 26 percent want negotiations.

“Americans are gravely con cerned about Iran’s nuclear program. Yet they are also quite concerned about the possible negative impact of a military strike to try and stop it,” the survey’s authors state. “Only a small minority favors the use of military force now, and if all efforts to stop Iran from develop ing nuclear weapons fail, Americans are essentially evenly divided over whether to conduct a strike.”

The survey (PDF) also finds an electorate that is far less certain of its support of Israel than US political leaders would suggest. By a narrow margin — 50 percent to 47 percent — Americans would oppose the US militarily defending Israel if it were the victim of an unprovoked attack.

If the attack against Israel were retaliation for Israeli military action, even more — 56 percent — would oppose US military intervention, while 38 percent would support it.

Our correspondent’s remarks:

To hear any kind of mainstream discussion, and even most discourse in the blogosphere, it’s taken as a given that Americans: a) by a vast majority will back Israel all the way in anything, b) want Iran bombed if they don’t grovel, and c) despise ‘those Islamic upstarts.’ In fact, this substantive poll with a large sample shows those positions to be false insofar as the public is concerned. Those statements are true only _of the Beltway elite_. In short, those at the top of the pile are running these policies, together with collaborative mass media, in direct opposition to public sentiment; not something one hears reported, unsurprisingly.

There are pols which show more hostile attitudes by the American public yes, but that’s where the plot thickens. It’s not generally well understood the extent to which the polling industry is, largely knowingly, producing ‘results’ which significantly overstate right-wing biases. This is done by the phrasing of the questions and the framing of alternatives. The issue has been discussed among others by George Lakoff, a linguist with considerable expertise in ‘framing’ (who as a dyed-in-the-wool liberal sold himself completely to the Democrats and now, I rather thinks, regrets his credulity in that regard.) The country _sounds_ more right-wing because the right wing media frames the issues and right-leaning language in polls elicits more right-leaning answers than a neutral remark would. I’m not being paranoid on this: it’s a major issue in US political discourse which I’ve only seen a few scattered discussions of in recent years, even on radical websites (whose membership largely prefers conspiracy theories even beyond REAL conspiracies such s the Koch brothers’ dealings).

I haven’t looked at this systematically, but some of my early work was in survey research, and anyone who has had any exposure knows that the results of questionnaires are quite sensitive to the wording of the questions. And I have noticed more than occasionally signs of bias in polling (unnecessarily value-laden phrases, strange either-or pairings that exclude other choices, leading question sequences). I generally take opinion polls when called out of curiosity but I can recall at least a couple of time aborting the call because the questions were very leading. So my hunch is that there is more that a little truth in this argument, even though it would take a fair bit of effort to prove it in a rigorous manner.

Some readers have wondered why this blog from time to time runs posts on the US health care system. Aside from the fact that it’s a major public policy problem in America, it is also a prime example of bad incentives, information asymmetry, and corporate predatory behavior. It thus makes for an important object lesson.

Reader Francois T pointed to an example, a commentary on a paper presented by Donald Light at the annual meeting of the American Sociological Association, “Pharmaceuticals: A Two-Tiered Market for Producing ‘Lemons’ and Serious Harm.” It still appears to be embargoed, but Howard Brody provides an extensive summary on his blog.

Light uses George Akerlof “market for lemons” as a point of departure. For those not familiar with the famed Akerlof paper, a “market for lemons” can occur when consumers are unable to distinguish product quality. The used car market is the paradigm, since the dealer has a much better idea than the buyer of whether a particular car is any good. Unscrupulous operators can stick a lot of hapless chump customers with overpriced clunkers. However, as crooked vendors become more common, buyers wise up a tad and are not longer to pay as much for cars they cannot evaluate. So while the prices buyers are now willing to pay are probably still too high for rattletraps, they are too low for decent cars. People with good merchandise start to look for other channels. Akerlof posits that the market eventually falls apart.

Note that used cars dealers did not set out to create lemons; the cars were bad deals by being overpriced (presumably, if they had been presented, warts and all, they still would have found purchasers, presumably people who thought they could repair them and those who wanted them for parts and scrap). Light contends, by contrast, that major pharmaceutical companies create bad products:

[T]he pharmaceutical market for ‘lemons,’ differs from other markets for lemons in that companies develop and produce the lemons. Evidence in this paper indicates that the production of lemon-drugs with hidden dangers is widespread and results from the systematic exploitation of monopoly rights and the production of partial, biased information about the efficacy and safety of new drugs…Companies will design and run their clinical trials to minimize evidence that their drugs cause adverse reactions and maximize evidence that they are not inferior to or [are] better than a placebo for the target indication. And companies will also learn from the regulatory body how to game accelerated approvals and condition[al] approvals with post-market studies by cutting corners and submitting partial evidence in order to get drugs on the market faster and put the regulator under pressure to approve and not to later rescind.

Yves here. The reason we have an FDA was unsafe food, such as adulterated meat products and unsanitary slaughterhouses, and toxic medicines (such as radium drinks that produced some particularly horrid deaths). And the impetus for the FDA is being proven correct: producers, left to their own devices, value their own profits over their customers’ well being.

Pharma defender will contend this picture is distorted; the industry is highly innovative. Really? Its innovativeness of late is on par with Wall Street’s. The Financial Times reported that of the so-called “new drug applications” to the FDA, 88% were not in fact new drugs at all. They were either slightly different formulations (say, a time released version, so patients might need to take a pill only once a day rather than morning and evening), or were simply getting “off label”uses approved so that that the drug company could market that application (pharmaceuticals can be marketed only for uses approved by the FDA, but doctor are free to prescribe a drug as they see fit). Light has read a broad range of studies and has similar findings, that only 10% to 15% of the drugs approved by the FDA are new compounds. Thus, per Light, “[C]ompany R&D goes largely to a marketing strategy that does not meet societal needs or the needs of patients.”

Brody draws some implications from Light’s study:

Extrapolating from the best available figures, the US suffers about 111,000 deaths annually from adverse drug reactions (that is, drugs prescribed and administered correctly, and leaving aside deaths from medical errors), or more than twice as many fatalities as from auto accidents. This puts adverse drug reactions as the 4th leading cause of death, and besides, adverse reactions lead to about 1.5M hospitalizations per year (the total damage toll being underestimated because we lack good data for nonhospital settings).

If the industry produced drugs, many of which offer no real advantage over existing drugs, and then urged the maximum possible caution in their use, we could perhaps avoid some of this swath of death and destruction. But such, of course, would hardly suit the company bottom line; so instead we have what Light calls the “risk proliferation syndrome.” Company-sponsored research talks up the efficacy and the safety of the drug. Marketing then tries to get physicians to prescribe the drug to as many patients as possible, including those (such as the elderly) inherently at higher risk for adverse reactions, and those who have less and less chance of actually benefiting (because their disease is mild, or for whom nondrug therapy would work better, etc.) The industry does everything possible to speed up FDA approvals of new drugs and to slow down any threatened FDA action to remove an unsafe drug from the market or to restrict its use. The end result is that as many patients as possible are put at risk, while revenues go steadily up.

The financial power of the drug industry allows it to “colonize” medicine in the same way that it has effectively taken over the FDA. This means that more and more of medicine turns into a commercial enterprise placed at the service of industry profits. New diseases are “discovered” that require drugs to treat them. The medical literature becomes indistinguishable from the industry marketing juggernau

Yves here. In one sense, we do have evidence of a market for lemons: the rising popularity of alternative medicine. Some of its appeal is that certain treatments do work (for instance, acupuncture does reduce inflammation) and that alternative practitioners are interested in ailments often deemed as sub-clinical by MDs. one impetus is that some consumers are reluctant to take drugs. Light’s analysis says their concern is not unfounded.

Full disclosure: I’ve known Amar Bhide for roughly 25 years (we both worked on the Citibank account at McKinsey, albeit never on the same project) and although we correspond only occasionally, I continue to regard his as a particularly keen observer and original thinker. He was briefly a proprietary trader, then an associate professor at Harvard Business School (first in finance, later in enterpreneurship), then a professor at Columbia’s business school, and after taking a sabbatical to write a book (A Call for Judgment, due out in two weeks) is joining the Fletcher School of Law and Diplomacy in a newly-established chair.

Amar has an article at the Harvard Business Review which encapsulates some of the core arguments from his book. I’m providing a few extracts here because it appeals to my sensibilities and I therefore think NC readers will like it as well. The most interesting bit to me is the aspect that I highlight in the headline to this post: that the evolution of finance, particularly in its near universal adoption of standardized models in lending processes bears a troubling resemblance in its process and outcomes to a centrally planned economy (funny that people like to dump on the Fed for interest rate setting, and miss the other. widespread aspects of de facto centralization, via standardization and over-reliance on models). Some of his arguments overlap ones I’m made repeatedly here. For instance, I’ve decried the fact that shifting lending from loan officers in branches to standardized, score-based templates resulted in considerable loss of information: face to face assessment of the borrower (does he understand what he is getting into? Does he regard the loan as a serious commitment?) and knowledge of the community (How healthy is his employer? What is the outlook for the local economy?)

Bhide comes to similar conclusions to ones reached here and in ECONNED, and his framing may help finance skepticism get greater traction. From his HBR article:

Because natural laws and mathematical inferences cannot predict behavior, algorithms are built upon statistical models. But for all their econometric sophistication, statistical models are ultimately a simplified form of history, a terse numerical narrative of what happened in the past. (The simplifying assumptions of most statistical models are in fact so great that they can almost never be used successfully to reconstruct the very historical data used to construct the models.) They reveal broad tendencies and recurring patterns, but in a dynamic society shot through with willful and imaginative people making conscious choices, they cannot make reliable predictions….

This doesn’t mean statistical controls and data-mining programs are useless in human affairs. They can debunk false assumptions and stereotypes or suggest new rules of thumb. Faced with a large number of choices (as when thousands apply for one job), they can provide a quick, objective first-cut screen. But predictions of human activity based on statistical patterns are dangerous when used as a substitute for careful case-by-case judgment. They nonetheless continue to gain ascendency. Nowhere has this been more apparent—or more dangerous—than in the financial industry…..

The traditional lending model was built around case-by-case judgment. Home buyers would apply for loans from their local bank, with which they often had an existing relationship. A banker would review each application and make a judgment, taking into account what the banker knew about the applicant, the applicant’s employer, the property, and conditions in the local market. The banker would certainly consider history—what had happened to housing prices, and the track record of the borrower and other similarly situated individuals. But good practice also required forward-looking judgments—assessments of the degree to which the future would be like the past. Dialogue and relationships were also important: Bankers would talk to borrowers to ascertain their beliefs and intentions. And staying in touch after the loan was made facilitated judgments about adjusting terms when necessary….

Over the past several decades, centralized, mechanistic finance elbowed aside the traditional model. Loan officers made way for mortgage brokers. At the height of the housing boom, in 2004, some 53,000 mortgage brokerage companies, with an estimated 418,700 employees, originated 68% of all residential loans in the United States. In other words, fewer than a third of all loans were originated by an actual lender. The brokers’ role in the credit process is mainly to help applicants fill out forms. In fact, hardly anyone now makes case-by-case mortgage credit judgments. Mortgages are granted or denied (and new mortgage products like option ARMs are designed) using complex models that are conjured up by a small number of faraway rocket scientists and take little heed of the specific facts on the ground….

The buyers of securitized mortgages don’t make case-by-case credit decisions, either. For instance, buyers of Fannie Mae or Freddie Mac paper weren’t, and still aren’t, making judgments about the risk that homeowners would default on the underlying mortgages. Rather, they were buying government debt—and earning a higher return than they would from Treasury bonds. Even when securities weren’t guaranteed, buyers ignored the creditworthiness of individual mortgages. They relied instead on the models of the wizards who developed the underwriting standards, the dozen or so banks (the likes of Lehman, Goldman, and Citicorp) that securitized the mortgages, and the three rating agencies that vouched for the soundness of the securities.

Dispensing with judgment has also helped funnel the mass production of derivatives into a few mega-institutions, posing systemic risks that their top executives and regulators cannot control.

Little good has come of this robotization of finance. Reduced case-by-case scrutiny has led to the misallocation of resources in the real economy. In the recent housing bubble, lenders who, without much due diligence, extended mortgages to reckless borrowers helped make prices unaffordable for more prudent home buyers.

The replacement of ongoing relationships with securitized, arm’s-length contracting has fundamentally impaired the adaptability of financing terms. No contract can anticipate all contingencies. But securitized financing makes ongoing adaptations infeasible; because of the great difficulty of renegotiating terms, borrowers and lenders must adhere to the deal that was struck at the outset. Securitized mortgages are more likely than mortgages retained by banks to be foreclosed if borrowers fall behind on their payments, as recent research shows.

When decision making is centralized in the hands of a small number of bankers, financial institutions, or quantitative models, their mistakes imperil the well-being of individuals and businesses throughout the economy. Decentralized finance isn’t immune to systemic risk; individual financiers may follow the crowd in lowering down payments for home loans, for instance. But this behavior involves a social pathology. With centralized authority, the process requires no widespread mania—just a few errant lending models or a couple of CEOs who have a limited grasp of the risks taken by subordinates.

Yves here. This is a particularly succinct indictment of modern finance. It’s unlikely to get the traction it deserves because no new paradigm is waiting in the wings. As Thomas Kuhn argued in his Theory of Scientific Revolutions, scientific (and by implication, intellectual) frameworks persist even as evidence against them mounts, with ever-more patches and work arounds, until a new generation embraces a different paradigm.

But modern finance is a sort of lingua franca, computationally convenient, and most important, a lot of people have businesses deeply embedded in the current way of doing things. And the regulators are just as deeply invested. I found this section of a recent New York Fed paper on the shadow banking system simply astonishing (I’ve wanted to shred other significant elements of this article, but that is a serious undertaking that has to wait a bit). It listed the advantages of securitazation….without offering a list of disadvantages. To wit:

There are at least four different ways in which the securitization-based, shadow credit intermediation process can not only lower the cost and improve the availability of credit, but also reduce volatility of the financial system as a whole.

First, securitization involving real credit risk transfer is an important way for an issuer to limit concentrations to certain borrowers, loan types and geographies on its balance sheet.

Second, term asset-backed securitization (ABS) markets are valuable not only as a means for a lender to diversify its sources of funding, but also to raise long-term, maturity-matched funding to better manage its asset-liability mismatch than it could by funding term loans with short-term deposits.

Third, securitization permits lenders to realize economies of scale from their loan origination platforms, branches, call centers and servicing operations that are not possible when required to retain loans on balance sheet.

Fourth, securitization is a potentially promising way to involve the market in the supervision of banks, by providing third-party discipline and market pricing of assets that would be opaque if left on the banks’ balance sheets.

Yves here. Notice the Panglossian subtext: everything is for the best in this best of all possible worlds of securitization. Not only is there no consideration of the downside, such as the near-impossibilty of dealing with troubled borrowers on a case-by-case basis, but there is no acknowledgement that the same benefits could have been achieved by other, sometimes cheaper, means.

For instance, the first advantage, greater diversification, can be achieved by a less costly route, by selling loans. The second finesses the real problem with mortgages, that the US is pretty much alone among advanced economies in offering thirty year fixed rate mortgages on a large scale basis. Floating rates are the norm elsewhere.

A fixed rate mortgage made sense in a low interest rate volatility environment, but the product continues to exist when its effect is to shift interest rate risk on to banks, who in turn blow up on it periodically (first the savings and loan crisis) and leave taxpayers with losses. So ultimately, it isn’t banks that bear the interest rate risk, but the taxpayers who backstop banks. How sensible is this? What about a compromise, like floating rate mortgages with floor and ceilings (for example, if you got a 4.5% floater now, its floor might be 2.5% and its ceiling might be 6.5%). That way, borrower still can make sensible budgets, since their exposure is capped, but they bear a fair bit of the risk of interest rate movements.

Point three is about the cost savings from standardization and scale, when as anyone who has dealt with a servicer can tell you, it is often at the expense of service quality.

Point four, which is a naive recitation of the canard that investors can supervise banks, is refuted by Bhide’s piece. Supervision was not done in a decentralized way; instead, the greater complexity of structured credit products led investors to rely on expert opinion (ratings agencies) and models. From a related comment by Donald MacKenzie in today’s Financial Times:

The languages of today’s complex financial markets often consist not simply of words and numbers but also of technical systems. The credit crisis has shown the importance of their powers – and limits.

Although few outsiders have heard of it, the single most important language of mortgage-backed securities and similar products is a system called Intex. It includes a computer language for defining deals’ intricate cash flow rules, a graphics-based tool for designing deals, and a truly remarkable computerised “library” of the parameters of the underlying asset pools and the cash flow rules of more than 20,000 deals….

Intex’s power as a language is to make instruments such as mortgage-backed securities mentally tractable. I confess I’ve always found them daunting. The rules governing a deal can occupy hundreds of pages of impenetrable legal prose, and the economic value of the deal’s tranches depends on three complex characteristics of the underlying mortgage pool: the rate at which borrowers prepay (redeem their mortgages early), their propensity to default, and the loss severity (the proportion of the debt that cannot be recovered if a borrower defaults).

In July a friendly banker showed me Intex in action. He chose a particular mortgage-backed security, entered its price and a figure for each of prepayment speed, default rate, and loss severity. In less than 30 seconds, back came not just the yield of the security, but the month-by-month future interest payments and principal repayments, including whether and when shortfalls and losses would be incurred. The psychological effect was striking: for the first time, I felt I could understand mortgage-backed securities.

Of course, my new-found confidence was spurious. The reliability of Intex’s output depends entirely on the validity of the user’s assumptions about prepayment, default and severity. Nevertheless, it is interesting to speculate whether some of the pre-crisis vogue for mortgage-backed securities resulted from having a system that enabled neophytes such as myself to feel they understood them.

Yves here. It may seem churlish to point fingers at Intex (“Its’ a tool! You can have operator error with any device”), but pervasive use of models allows people to think all too superficially about situations. I noticed a marked decay in the understanding of businesses when PCs became widespread. Yes, doing projections and multiple scenarios became trivial. But in the stone ages of finance, bankers and analysts had to look at financial statements and go into footnotes to find details to put into spreadsheets, and they had to do any massaging to make the presentation comparable themselves. The grappling with the data produced a far greater appreciation of what the underlying reports actually contained, and also meant any scenarios were thought about before being analyzed and any not-pretty results were given more serious consideration. Now, it’s trivial to keep tweaking a model until it tells the story needed to support a sales pitch. The degree of abstraction has made it all to easy to airbrush risk out.

To return to Bhide, his piece provides further grist for thought, and I hope you will read it in full.

By Richard Alford, a former economist at the New York Fed. Since then, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side.

As far as the laws of mathematics refer to reality, they are not certain, and as far as they are certain, they do not refer to reality.

Albert Einstein

Some weeks ago, an economist at the Federal Reserve Bank of Richmond’s Research Department posted an open letter on the web titled “Economics is hard. Don’t let bloggers tell you otherwise.” It generated a tidal wave of criticism that swept the original post off of the web (Still available here.) The criticism is both understandable and justified, with much anger directed at the implicit hubris and its self-serving nature.

However, the criticisms were almost exclusively aimed at the conclusion and little if any attention was paid to the underlying premise or structure of the argument. This is most unfortunate. The argument is based on three assertions:

1. Economics is and ought to be treated as hard science; consequently
2. Macroeconomics is too hard for bloggers and other non-PhD commentators to offer clear conclusions with any degree of confidence, but
3. Macroeconomics is not so hard that PhD economists are unable to offer clear conclusions with high degrees of confidence.

In regard to the first assertion, there are numerous reasons that macroeconomics should not be treated as a hard science. Nonetheless, the author of the post is not alone in drawing parallels between macroeconomics and seismology. However, the choice of this particular hard science to serve as benchmark reflects a wrinkle. The charge had always been that economists had “physics envy,” in particular, “astrophysics envy,” and economists as a group embraced the comparison.

Why “astrophysics envy”? And why did economists embrace a comparison to astrophysics?

Astrophysics is widely accepted as a hard science. It has been very successful in making predictions. Furthermore, it is highly mathematical and model-based, with limited ability to do repeated-controlled laboratory experiments. Given the predictive power and the absence of the ability to do controlled laboratory experiments, economists desiring that economics be accepted as a hard science adopted astrophysics as a research role model/paradigm. (The replacement of astrophysics by seismology as the benchmark to which economics is to be compared may reflect the fact the forecasting record of economics has more in common with seismology than it has with astrophysics.)

There are two possible outcomes: If the result confirms the hypothesis, then you’ve made a measurement. If the result is contrary to the hypothesis, then you’ve made a discovery.

—Enrico Fermi

No amount of experimentation can ever prove me right; a single experiment can prove me wrong.

–Albert Einstein

To be scientific, a discipline must be based on gathering observable measurable evidence (data). On the basis of the observable data and past experience, researchers form a hypothesis. They use that hypothesis as a base to make a prediction or forecast a consequence. The hypothesis is then tested. If the predicted consequence does not come to pass, then the hypothesis has been falsified. One “failure” can prove a hypothesis false, but no number of “passes” can prove a hypothesis to be true. For example, one sighting of a black swan disproved the hypothesis that all swans are white, all the sightings of white swans notwithstanding.

How does contemporary macroeconomics fare when compared to the above description of the scientific method?

Contemporary macroeconomic theory generates policy frameworks/hypotheses predicated on non-observable variables, e.g., expected future values of explanatory variables and various “natural” rates. Furthermore, many variables are subject to significant measurement errors. If crucial variables cannot be observed and/or accurately measured, the hypotheses cannot be truly tested. No falsifiability, no science.

In addition, there are the problems posed by the Lucas Critique (the instability of aggregate macroeconomic relationships) and Goodhart’s Law (policymaker dependent reality).

The man who cannot occasionally imagine events and conditions of existence that are contrary to the causal principle as he knows it will never enrich his science by the addition of a new idea.

– Max Planck

Prior to the onset of the current travails, economists and Fed policymakers repeatedly cited inflation-only targeting as the reason for the “Great Moderation. They dismissed concerns about unsustainabilities in financial markets, asset prices, savings rates, and external imbalances. These variables were not part of their causal model-based policy framework.

We cannot solve our problems with the same thinking we used when we created them.

Albert Einstein

Inflation-only targeting, as reflected in the Taylor Rule, was predicted to result in stable inflation and trend growth. The decision to attach zero cost to the unsustainabilities and the failure to act when they grew, contributed to an economic outcome at variance with the forecast. However despite this failure, mainstream professional Ph.D. economists do not seem to have reduced the confidence they place in the Taylor Rule as a guide to policy.

A new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die and a new generation grows up that is familiar with it.

Max Planck

Or Planck’s short version:

Science advances funeral by funeral

In a similar fashion, criticism of the widely-used DSGE model has been limited. Proposed changes to the model have been limited to relatively minor (marginal) adjustments when compare to the near absence of a financial sector and a model that is inherently self-stabilizing.

However, even if economics is not a hard science, that does not imply that economics cannot be useful. Medicine is a mix of art and science. I believe that it is accurate to say that society places a greater value on the advancements in medicine than on all the increased understanding of the cosmos. The net benefit stream is more important than the relative purity of the science.

Economics might profit from replacing physics with medicine as its research role model. Adopting the research discipline of medicine as a role model would imply significant changes for economics.
Medicine acknowledges that risks are attached to virtually all courses of treatment. The medical profession also recognizes that not all treatments work or are as effective in all cases. It recognizes that in some cases negative side effects may preclude the use of a drug or treatment. It practices risk management by weighing the potential benefits against potential costs.

In many, it requires patients be periodically tested to confirm the absence of negative side effects. Evidence of any adverse outcomes not discovered during the trials can be cause to have them pulled or their use proscribed. There are processes and procedures in place to prevent researchers and pharmaceutical companies from ignoring negative side effects or carrying on while suggesting that possible side effects are someone else’s or some other specialty’s problem.

Furthermore, as a profession it is open to the possibility that both the benefits and costs may vary over time and across populations. Pharmaceuticals that were once effective, e.g., antibiotics, are acknowledged to have lost effectiveness. Pharmaceuticals with acceptable benefit/risk ratios in one section of the population may be inappropriate for use in another or because of the existence of another medical condition. It is recognized that a pharmaceutical can be beneficial at one dosage and fatal at another.

Contrast that with the behavior of the highly confident policymakers and macroeconomists.

They posit arguments based on the universality and time invariant quality of their models. Currently, pundits are debating the impact of possible tax changes. They express their conclusions with certainty, but history suggests that the link between changes and tax is mutable. The Kennedy tax cuts are credited with stimulating GDP growth. Clinton’s economic advisors and others have argued tax increases stimulated US GDP while at the same time argued that tax increases in Japan derailed a recovery there.

The link between financial aggregates and the economy has followed a similar path. Some Keynesians (but interestingly enough not Keynes) argued that money did not matter and that fiscal policy could be used to exploit a stable Phillips Curve (which it turned out wasn’t stable). In retrospect, the policy stances came to be viewed as contributing to the inflation of the 1970s. Monetarism was reborn and the back of the inflation was broken. However, high and volatile rates of interest induced a spate of financial innovation. Links between the monetary aggregates and GDP became unstable. Monetary targeting was dropped. With the rise of inflation-only targeting, policy makers chose to treat all financial measures, including debt and liquidity levels, but not interest rates, as devoid of any informational content and inappropriate targets for monetary policy. Post the housing bubble; however, liquidity became a focus of policy as the policymakers took action to prevent the deleveraging of the financial system, i.e., levels of liquidity, debt and leverage were important after all.

Prior to the current recession, policymakers dismissed all the policy supported unsustainabilities in the financial markets and the real economy (think negative side effects) during the run up to the crisis, then laid all the blame for the crisis and its aftermath on the failure of regulation.

Fed policymakers also failed to practice risk management when setting interest rate policy. In response to the slowing of the economy, the Fed eased dramatically starting in late 2000. The target for the Fed funds rate was reduced to 1.00%, where it stayed until mid-2004. The rate was then ratcheted up 25 basis points per FOMC meeting until mid-2006, when the Fed funds rate reached 5.25% and accommodation was deemed to have been removed. According to the CBO, the output gap (as a percentage of GDP) was -0.7, 0.0 and +0.2 for 2004, 2005 and-2006 respectively. In terms of the real economy, how much potential benefit/upside risk was there in accommodate monetary policy 2004-2006?

Economists and others had cited a list of growing economic and financial imbalances prior to and during the period 2004-2006, but the Fed chose to ignore the warnings. We now know with some certainty the minimum size of the downside risks associated with having interest rates too low for too long: an output gap at close to -7% of GDP, a sizable negative output gap that is expected to last for years, a ballooning of the fiscal deficit, the severe crippling of the financial system, etc.

Exposing the economy to those risks in turn for upside potential of less than 1% of GDP was a failure of risk management. The failure stemmed from policymakers’ misplaced confidence in their model and a resulting willingness to dismiss risks without so much as a thought. (If you doubt the veracity of this line of argument, then I suggest you Rajan’s speech and Kohn’s intellectually vacuous reply at the Jackson Hole Conference in 2005.)

In regard to the second and third assertions in the original post, I believe that no one, including PhD economists, has a sufficient understanding of either the real economy or financial markets to be able to forecast or recommend policy prescriptions with anything like the confidence expressed by any of the most widely-read, degree-holding pundits or policymakers. In short, I agree with the second assertion, but disagree with the third.

For all their differences pundits share a position. They all assert with great confidence that there is a riskless low-cost solution to the economic problems we face. They also assert that the solution could be put in place if only correct thinking policymakers are empowered. I differ. I do not think that the best solution will be riskless or will be low cost. However, economics can make a significant contribution to economic well-being, but only if it recognizes that it will never be able to make predictions (and propose policy) with anything like the confidence of a hard science.

However, to my mind the most objectionable and ironic aspect of the original post isn’t the claim that only professional economists can comment on economics and economic policy with confidence, but rather that the conclusion itself reflects really bad economics.

The original post cited a number of reasons that analysis performed by PhD economists has more merit and is more valuable than analysis or commentaries by both non-PhD economists and non-economists. They are

1. Ph.D economists are bright (although not the only bright people),
2. They have devoted years to study of economics, and
3. They have expended enormous efforts.

This is to say that economics done by professional Ph.D. economists embodies more human capital and is therefore superior to economics done by those who have not devoted the same amount of resources e.g. time and effort. This is ironic beyond belief. It is nothing more than a very crude labor (quality adjusted?) theory of value. A theory of value found to be wanting at least a hundred years ago by Jevons, Walras, Menger, Marshall et al.

It is of course possible that the author was aware of the failure to predict the worst recession and financial crisis since the Great Depression, but did not mention the failures in order not to undermine his own argument that economics is a hard science. While this explanation would explain the apparent retreat to a labor theory of value (totally ignoring the usefulness of the output, demand side), it only does so by emphasizing the profoundly unscientific and anti-intellectual aspects of the argument.

Economists have been rewarded all too well for fetishing numbers and mathematics. The self-conscious effort within the discipline to turn it into a science (a goal most real scientists would deem to be impossible, given the fickle nature of human behavior), which meant making it more mathematical, has resulted in economists being better paid than other social scientists and having a seat at the policy table.

The result is that this methodological bias (which we discuss at some length in ECONNED), has had the unfortunate effect of blinkering the discipline. Economists have exhibited a great disinclination towards considering the idea that markets and economies could be unstable, first, because the mathematics that can characterize instability are fairly daunting and second, economists would have much less to say about them (as in the range of possible outcomes quickly becomes large). And this love of quantification has been taken up with even more enthusiasm by businessmen, with equally questionable outcomes (some of the most important aspects of business performance may note be readily quantified, but the obsession with measurement means those behaviors will be overemphasiszed).

Some within the academy have started to question the biases that result from focusing on what can be easily measured versus richer, more nuanced appraisals. For instance, Joseph Stiglitz and Amartya Sen have argued that GDP is a poor metric of economic progress, and are working to develop better measures.

John Kay at the Financial Times has some musings along these lines. He offers a defense of the value of the arts (in a UK context, where it is often subsidized) which might strike some flat notes with US readers, but his underlying reasoning has merit.

From the Financial Times:

Many people underestimate the contribution disease makes to the economy. In Britain…. [i]llness contributes about 10 per cent of the UK’s economy: the government does not do enough to promote disease.

Such reasoning is identical to that of studies sitting on my desk that purport to measure the economic contribution of sport, tourism and the arts. These studies point to the number of jobs created, and the ancillary activities needed to make the activities possible. They add up the incomes that result….to persuade us….that they contribute to something called “the economy”.

The analogy illustrates the obvious fallacy. What the exercises measure is not the benefits of the activities they applaud, but their cost; and the value of an activity is not what it costs, but the amount by which its benefit exceeds its costs. The economic contribution of sport is in the pleasure participants and spectators derive, and the resulting gains in health and longevity…..Similarly, the economic value of the arts is in the commercial and cultural value of the performance, not the costs of cleaning the theatre… Good economics here, as so often, is a matter of giving precision to our common sense. Bad economics here, as so often, involves inventing bogus numbers to answer badly formulated questions.

But good economics is often harder to do than bad economics. It is difficult to measure the value of a Shakespeare play…..The relevant economic questions are whether the cultural and commercial value of the performance offsets these costs and whether these benefits can be translated into a combination of box office receipts, sponsorship and public subsidy. The appropriate economic criterion, everywhere and always, is the value of the output.

But bad economics has been allowed to drive out good. I am sympathetic to the well-intentioned people who commission studies of economic benefit, though not to those who take money for carrying them out. They are responding to a climate in which philistine businessmen assert that the private sector company that manufactures pills is a wealth creator, but the public sector doctor who prescribes them is not. Extolling the virtues of manufacturing, they value the popcorn sold in the interval, but not the performance of the play, arguing that the vendor of consumer goods creates resources, which the subsidised theatre uses up. People who work in the theatre, hospitals or education are often forced to listen to this nonsense. It should be no surprise that so many of them despise business and the values such business espouses. If these values were truly the values of business they would be right to despise them….

We need to put out of our minds this widely held notion that there is such a thing as “the economy”, a monster outside the door that needs to be fed and propitiated and whose values conflict with things – such as sports, tourism and the arts – that make our lives agreeable and worthwhile. Activities that are good in themselves are good for the economy, and activities that are bad in themselves are bad for the economy. The only intelligible meaning of “benefit to the economy” is the contribution – direct or indirect – the activity makes to the welfare of ordinary citizens.

Yves here. If you don’t like the arts example, consider childrearing. If you were to adopt a purely GDP perspective, unpaid child care (mothers staying at home to raise their kids) has no value (save maybe in a discounted NPV of child’s future earnings, but discounting cash flows that don’t begin for 20 more years produces a surprisingly low number).

This post first appeared on May 11, 2007

I am beginning to suspect that many are reacting to the overstimulation of the modern world – the accelerating pace of change, data overload, time pressure, work and relationship instability – by turning off their brains. The rise of fundamentalism and the “family values” push, both efforts to turn back the clock, is one set of responses.

Another is the rise of sound-biting, of using pithy communications to cut through the clutter of the daily information assault. But sound biting is inherently reductionist. It doesn’t permit nuanced argument, or pointing out fuzziness in data, or shades of grey. Sound bites are great for simple, emotional appeals, lousy for policy development (which is one reason why this country seems incapable of having an intelligent discussion on important topics like health care. The public has been trained out of having a long enough attention span to listen to alternatives).

Sound biting polarizes people, and makes it hard to find common ground (where can Bush go with Iran now that he has called them a member of the “axis of evil,” for instance?).

So I get worried when I see smart people embracing the logic of sound biting and seeing it as a more general prescription, particularly when they want to use it to run organizations, as opposed to sell shampoo or wars. Let’s look at this post by Brayden King at orgtheory.net:

Made to Stick is a book by Chip and Dan Heath that explores why some ideas grab our attention and others quickly fade from memory. The book has received a lot of attention in the consultant-y side of the blogosphere….

One of their main premises is that sticky ideas tend to be simple. By simple they don’t mean simplistic; rather they mean that each idea can be reduced to its essential, most important core. To communicate an idea clearly, you need to strip “an idea down to its most critical essence” (28). You need to “find the core.”

My immediate thought was that I need to do a better job in finding the core of some of my papers.* But “finding the core” also applies to organizations. Most organizations are based on some sort of core idea. They have an irreducible essence upon which the logic of the organizing, decision-making, and strategizing rests. Some organizations, of course, are better at communicating that core to their stakeholders. They’ve figured out how to make that idea central to decisions and to the daily life of the organization.

One example that the Heaths provide in the book is how Southwest Airlines used the idea that “We are THE low-fare airline” to guide important decisions. When Southwest has to decide whether they’re going to offer a new food item to be served on their flights, like chicken salad, they can go back to their core guiding principle to assess whether it would be a beneficial change. The answer is no. Providing chicken salad, as good as it might sound, does not fit with Southwest’s principle of being THE low-fare airline….

I think we need to develop better theories of decision-making in businesses and I think that the identity concept is a good place to start. Some theories of decision-making seem very weak in their ability to actually predict what kinds of decisions would be good for the organization (from the manager’s perspective). For example, the rather simplistic (not simple) idea that managers make decisions based on what they think will maximize shareholder value falls apart once you consider the hundreds of ways that a manager might try to maximize value at any given moment. Using the decision-making criterion of “our company maximizes value” is vacuous. Every business works under this principle, and so it gives the manager no guidance when attempting to make a decision that is unique to its organization. It begs more questions than it provides answers. Managers need more than a motive to maximize value….

The point of bringing up Heath and Heath and Whetten’s work on identity is that both readings seem to be saying the same thing. People or organizations need a core idea to motivate decision-making. We need a simple guiding principle. Whetten says that the core idea is the identity of the organization. If you can identify the central and distinctive character of the organization, you have found that which makes the organization unique from its peers. You know what works (the identity has at least gotten you this far), and you know what stakeholders expect (enough customers and employees like your identity to make the organization a worthwhile venture).

Thus, using the identity as a core principle to guide decision-making makes sense. When faced with a decision, managers put themselves in the place of the organization as if it were a real actor – what should an organization like this do? Sure, if you’re a business you assume that the end goal of any decision should be to maximize returns. But how you do it is contingent on the unique, core idea of the organization. As Whetten and Mackey (2002: 396) argue, identity is the “court of last resort.” When you reach that fork in the road, your identity pulls you down the eventual path.

Ooof. This all sounds great (particularly the bit debunking maximizing shareholder value) until you think about it a bit. Make It Stick argues that “simple ideas (when well expressed) are memorable.” Granted. It then goes on to see simple ideas as being virtuous. That is, if you can’t reduce your idea to simple idea, by implication, there is something wrong with it or with you.

No doubt writers should strive to be as clear as possible. But some of the most thought-provoking, and useful thing I have read (and they are very well written to boot) can’t be boiled down to a simple sentence or two because they are bigger than that.

For example, the best management book I have read in quite a while is Phil Rosenzweig’s The Halo Effect. It is a brilliant, important, yet accessible piece of work, it tells you that just about everything written about management is wrong, but it cannot be summarized in a sentence, or even two. Here is one reviewer’s stab at it:

Rosenzweig tells us that our beliefs about business success are largely, perhaps entirely, wrong, distorted by the halo effect — in this case, the idea that once we consider a company successful, we tend to see it as doing everything right.

That’s about as much as you can convey in one sentence, yet you are left wondering what the book is about, and it actually does take some explaining to grasp Rosenzweig’s thesis:

In World War I, psychologist Edward Thorndike asked commanding officers to rank their subordinates on a series of qualities. He found the answers to be highly correlated; in other words, the officers saw the soldiers in broad-brush positive or negative terms, as either all good or all bad….

To illustrate his point, Rosenzweig goes through case studies of Lego, Cisco, and ABB. For example, when its fortunes were rising, Cisco was praised for “extreme customer focus,” skill in acquisition and integration, and highly motivated employees. Yet when performance fell, critics saw many of these previously admirable attributes as causes of failure. Cisco’s problem wasn’t that it had ridden a bubble that collapsed — no, it had “a cavalier attitude toward customers.” Its deals had been haphazard, employees had been “too busy taking orders and cashing stock options to bother with efficiency, cost-cutting, or teamwork.” Academics joined the media in this reputational pump-and-dump. As the author explains: “No one was saying that Cisco had changed between 2000 and 2001. It was just that now, in retrospect, Cisco was described through a different lens — one of failing performance. . . . Placing these accounts together, the impression is nothing short of Orwellian — a rewriting of history that thrusts facts into the past, rearranging the record . . . reinterpreting the past to suit present needs.”

The implication is that books like In Search of Excellence and Good to Great are mere exercises in storytelling, because their main data sources, press reports and retrospective interviews, ar hopelessly tainted by the halo effect. And he goes on to prove analytically that their findings were incorrect.

Now Rosenzweig’s book has a very important message, but I challenge you to boil it down to even three sentences. As a consequence, (and Make It Stick is borne out here) it won’t have the impact it ought to. But by the Heaths’ logic, popularity is tantamount to merit. That just ain’t so. In fact, one could argue that one way to get ahead in a competitive world is to have an information advantage, and seek out more complicated constructs that are ignored in a dumbed-down world.

Let’s go on to their organizational argument, that companies should find a simple idea to guide all their decisions, which is even more dodgy. That premise holds if you have a strategy, like Southwest’s, that is distinctive and can be boiled down to a simple tag line.

I can too readily think of companies that have powerful cultures that are key to their success where no such tag line would or could exist. Let’s start with two: Goldman Sachs and Toyota. Each is unquestionably the dominant player in its arena. Each has a very strong culture. But if you were ask employees of either firm for a single principle, you wouldn’t get the simple actionable phrase that the Heaths idealize. At Goldman, they’d look at you like you were nuts. The firm has 14 guiding principles. Each is more than a sentence long. And the firm (at least historically) believes deeply in them and amazingly enough, operates from them.

A recent New York Times feature on Toyota describes a similar, multifaceted, yet cohesive culture. Toyota, unlike Goldman, does have an overarching ambition: “To enrich society through the building of cars and trucks.” That doesn’t provide the kind of decision guidance that the Heaths like, and the American writer has to explain what it means:

I lost count of how many times Toyota executives, during the course of my reporting, repeated it and how often I had to keep from recoiling at its hollow peculiarity. And yet, the catch phrase — to enrich and serve society — was not intended, at least originally, to function as a P.R. motto. Historically the idea has meant offering car customers reliability and mobility while investing profits in new plants, technologies and employees. It has also captured an obsessive obligation to build better cars, which reflects the Toyota belief in kaizen, or continuous improvement. Finally, the phrase carries with it the responsibility to plan for the long term — financially, technically, imaginatively. ”The company thinks in years and decades,” Michael Robinet, a vice president at CSM Worldwide, a consulting firm that focu

ses on the global auto industry, told me. ”They don’t think in months or quarters.”
The core mission is elucidated through other Toyota maxims, some of which make more sense to Westerners than others. And it also leads to behaviors that are alien to most companies. Toyota employees are obsessed with finding problems, be they with the cars, with marketing, with processes, because they see them as an opportunity for improvement. And to them, it is all part of “enriching and serving society by making cars and trucks.” But that message has all of the other ramifications because management has imbued that simple phrase with a great deal of meaning and many corollaries. The phrase is not what guides the culture. The phrase is much smaller than what it has come to mean at Toyota. The NYT author spent a long paragraph explicating it and still hadn’t distilled it.

The failing of the Heaths’ idea is due to another important construct, obliquity that isn’t summarized in a tag line. A Financial Times article explains:

If you want to go in one direction, the best route may involve going in the other. Paradoxical as it sounds, goals are more likely to be achieved when pursued indirectly. So the most profitable companies are not the most profit-oriented, and the happiest people are not those who make happiness their main aim. The name of this idea? Obliquity….

George W. Bush speaks mangled English rather than mangled French because James Wolfe captured Quebec in 1759 and made the British crown the dominant influence in Northern America. Eschewing obvious lines of attack, Wolfe’s men scaled the precipitous Heights of Abraham and took the city from the unprepared defenders. There are many such episodes in military history. The Germans defeated the Maginot Line by going round it, while Japanese invaders bicycled through the Malayan jungle to capture Singapore, whose guns faced out to sea. Oblique approaches are most effective in difficult terrain, or where outcomes depend on interactions with other people. Obliquity is the idea that goals are often best achieved when pursued indirectly.

Obliquity is characteristic of systems that are complex, imperfectly understood, and change their nature as we engage with them…..Obliquity is equally relevant to our businesses and our bodies, to the management of our lives and our national economies. We do not maximise shareholder value or the length of our lives, our happiness or the gross national product, for the simple but fundamental reason that we do not know how to and never will. No one will ever be buried with the epitaph “He maximised shareholder value”. Not just because it is a less than inspiring objective, but because even with hindsight there is no way of recognising whether the objective has been achieved…..

Most businesses operated in competitive environments far too complex for a terse phrase to be a useful guide to action. Yet a magic incantation, a talisman, a battle cry is terribly appealing. But those who can resist the temptation of relying on a simple playbook and face the complexity and uncertainty of their environment are likely to steer a better path. But understanding risk and adapting also demands far more courage that trusting simple ideas.

If only it was that easy.

First sentence: “Pick up a piece of text and start reading and it usually becomes clear pretty quickly whether you’re reading a nonfictional news story or a fictional novel.”

They lost me right there.

Hat tip to Alea.

Reader Francois T highlighted a story at Washington Monthly that I recommend highly to readers. It illustrates how the intersection of corporate pursuit of profit and regulatory backfires can produce tidy oligopolies that pursue rent-seeking behavior with impunity. From his e-mail:

A well-intentioned move by Congress in 1986, followed by another one in 1996 converted Group Purchases Organizations (non-profit collectives formed by medical facilities that hoped to keep a lid on prices by banding together to make bulk purchases of supplies and devices at a discount) in for profit quasi-monopolies that now has a near total stranglehold on the medical device market in the USA.

Needless to say that all the negative consequences of such a state of affairs (stifling of innovation, reduced competition, impossibility to access the hospital markets for smaller players, excessive prices paid by…us!, avoidable pain and mortality) has happened and is still happening, despite congressional inquiries and court cases.

It is a long, but very illuminating article about the inner workings of an oligopoly that is out there to stick it to all of us, make health care costs even more egregious than they are now, and harm patients by choking life-saving innovations. Of course, the fuckheads in Congress cannot be bothered to reverse their mistakes, since there is money for them too, in the form of this legalized bribery called campaign contributions.

An extract:

GPOs started to come under scrutiny. The New York Times ran an investigative series on their business practices in 2002, and Congress followed suit with a string of hearings. One of the first witnesses was California entrepreneur Joe Kiani, who had invented a machine to monitor blood-oxygen levels. Unlike other similar devices, Kiani’s worked even when patients moved around or had little blood flowing to their extremities, a crucial innovation for treating sickly, premature infants, who tend to squirm and need to be monitored constantly for oxygen saturation—too little and they suffocate, too much and they go blind. But most hospitals couldn’t buy Kiani’s product because his larger rival, Nellcor, had cut a deal with the GPOs.

You can find the story here.

Readers may know I have perilous little sympathy for Big Pharma. The industry too often wraps itself in the mantle of science, in particular, claiming its needs its high profits and hence high prices to support its research and development efforts. In fact, it spends more on marketing than on R&D (and perilous few industries sell products with fat enough margins to support the cost of frequent sales calls to small businesses, let alone prime time TV ads). And it is a given that it allocates as much overhead as its accountants will tolerate to its reported R&D levels.

A new and interesting line of attack has been opened against Big Pharma’s defense of its high US prices and its ongoing attacks on Europe and other countries that negotiate discounts. US drugmakers have contended that the rest of the world is effectively free-riding on US research, and that its inability to charge higher prices outside the US limits funding of R&D (ahem, have we forgotten the fact that most really big ailments already have treatments of some sort, making it much less likely that anyone will find a new blockbuster drug?).

But a more granular look at drug pricing within the US shows that drugmakers offer enough discounts here to undermine their attacks on non-US health schemes. And the foreign drug regimes at least assure that everyone in the population is on the same footing, while here, the highest prices fall on those either outside health care plans or in ones without favorable drug pricing, so the burden of higher prices falls disproportionately on lower income people.

From the Financial Times:

Claims by the US drugs industry that the US disproportionately funds research and development of new drugs by paying higher prices than Europe for its medicines have been undermined by a new study to be published soon.

Panos Kanavos and Sotiri Vandoros at the London School of Economics argue in their report that a rigorous like-for-like comparison shows that transatlantic differences in patented medicine prices are modest and declining over time.

In a forthcoming article in Health Economics, Policy and Law, the co-authors conclude that “public prices for branded prescription medicines in the US are comparable to those in key European and other OECD countries”.

Their findings are an embarrassment for the industry, and notably PhRMA, its powerful Washington, DC-based trade body. In the past PhRMA has argued that Europe’s ill-conceived public policies, including price controls and sluggish regulatory decision-making, have chilled innovation and raised doubts among private investors who help to underwrite research.

But the study confirms data released recently by several pharmaceutical groups, including AstraZeneca and GlaxoSmithKline. This data – confirmed informally by senior industry executives – suggests profits in the US are only marginally greater than in Europe.

Yves here. There is one area of difference:

His study concludes that Europe remains a relatively attractive market by volume and price, even though budget deficits have forced through aggressive price cuts in several EU states in recent weeks.

But Mr Kanavos demonstrates that manufacturers of branded drugs do not significantly cut prices to compete with lower cost generic rivals once patents expire. Governments typically have to ensure that prescribers switch to generic alternatives to save money.

Yves here. I am waiting for this study with baited breath. I wonder if they also adjusted for the differences in marketing costs.

By Wallace C. Turbrville, the former CEO of VMAC LLC who writes at New Deal 2.0

In the 1930s, a great many Southerners had no access to electricity. The Roosevelt administration perceived an enormous opportunity to restructure the region’s economy. By building facilities to bring power to the rural South, jobs would be created from thin air to mitigate the unemployment of the Great Depression. More importantly for the long run, commercially vibrant communities would replace subsistence farms. For the people directly affected, lives of toil and sweat would be a thing of the past; for the nation, large populations would be integrated into the economy for the first time, helping to assure sustainable and diverse growth in the post-depression era.

The political effects were dramatic. Robert Caro, in his epic biography of Lyndon Johnson, described the brutal life of West Texas before the creation of the Lower Colorado River Authority. He pointed out that the dramatic life-changing effect of rural electrification spawned a fierce loyalty to New Dealers like Johnson. This persisted throughout the South for three decades until, ironically, Johnson’s Civil Rights legislation snuffed it out.

For those 30 years, electrification and other tangible benefits of the New Deal drove political discourse in this country. For the next three decades (and still), the Civil Rights legislation animated politics. The issue morphed from overt racism to resentment of the federal government telling people what to do. We must remember to thank Rand Paul for reminding us of the connection between race and the radical right.

Today, the federal government is considering a second revolution in energy. The issues are more abstract than those of the 1930s. We no longer have insufficient energy infrastructure. We have the wrong infrastructure. Instead of a backwards region dragging on an economy already in dire straits, the concerns today are threats to our future well-being: climate change and dependence on foreign sources of fuel. A comparison of the 30s and today is like the difference between treatment of a bleeding artery and a wellness program. Both will save your life, but the wellness program can be started next week.

It will be necessary to overcome both parochial regional opposition and ideological opposition by the Republican right. The right has a general aversion to federal expenditures to secure a promised benefit in the future. The aversion is strongest in regions whose economies depend disproportionately on coal. Their upfront cost is disproportionately large and the anticipated benefits are spread over the whole society.

The key to success is to articulate an urgency to act on concerns that are somewhat intangible. Energy reform addresses two distinct concerns. Climate change constitutes a catastrophic threat while energy independence is a national security matter, a defense against economic tactics in the conflict with Islamic extremism. A portion of the public is susceptible to both concerns. However, on the extremes, representing the most politically active people, there is much less overlap. In particular, the people who are most attached to the national security rationale are unlikely to be motivated by environmental risks. For example, despite the tragedy of the BP oil spill, many on the right are resistant to a drilling moratorium. The winning strategy is to keep as many individuals from these two groups together as possible. This is a treacherous endeavor.

The task of the proponents for a new energy revolution can be framed by an analysis of the opponents’ strategy. The most direct strategy, obfuscation, was signaled by Lamar Alexander in his response to the President’s Oval Office speech on energy and the oil spill. He characterized the proposed Climate Change legislation as an “energy tax.” He proposed as an alternative simply replacing half of our vehicles with electric powered cars, trucks and buses.

For those who thought that the legislation was about the environment, this alternative proposal sounds like nonsense. The new vehicles will still require energy, just not gasoline as fuel. Transportation represents about 33% of total carbon emissions in the US. Power generation accounts for about 42%. Simple logic suggests that the 16.5% reduction in transportation sources would be transferred to power generation which would then constitute 58.5%. Almost certainly this is imprecise, but, as they say in Tennessee where Senator Alexander and I grew up, “it’s close enough for gov’ment work.”

Alexander’s proposal is not about the environment. It is designed to separate the national security advocates from the environmentalists. It is unlikely that Republicans view it as a realistic alternative. It echoes the tactics employed in the health care debate. In health care, they attempted to carve back the scope of the bill by advocating an incremental approach, knowing full well that the only way to benefit poorer people was comprehensive legislation. Their purpose was to separate middle income people interested in insurance reform from those also interested in the plight of the poor. The Democrats were tentative about advocating benefits of helping poor people and the opponents achieved significant success. If the same tentativeness is used regarding the environmental benefits of the Climate Change legislation, we can expect the same type of result or much worse.

The second strategy of the opponents is de-legitimization. The far right has turned this into a socio-political movement, encompassing everything from the Birthers to the Tea Party enthusiasts dressed in Revolutionary War costumes. They embrace the position that scientific proof of climate change caused by human activity is untrue. To explain these beliefs in the face of concrete evidence they resort to pseudo science and preposterous conspiracy theories. (This is a remarkable echo of the religious right’s reliance on literal readings of the Bible to counter scientific facts like evolution.)

Republican leaders have seized on this anti-intellectual movement. It is hard to believe that politicians who are able to ascend to positions of leadership and commentators able to construct and manage media empires are unpersuaded by the scientific consensus on climate change. The only alternative is that they are driven by cynical opportunism and venality. Their motives are known only to them. The practical problem is that the movement is a useful weapon for ideological opponents of Climate Change legislation.

Of the two opposition strategies, obfuscation will only be successful if de-legitimization works to undercut the threat of climate change. The message of de-legitimization is particularly powerful in America today. The American public is insecure and feels as if leadership of all kinds has failed it. Being normal humans, they are unlikely to blame themselves for bad decisions. It is easier to de-legitimize the people and institutions in which they formerly chose to believe. The President and other leaders must not allow themselves to be ridiculed and bullied by know-nothings.

If the climate debate becomes an argument over competing beliefs through de-legitimization of proponents, the cause is lost. Opponents would not advertise their real intent to kill the whole effort. They would offer easier incremental options designed to appeal to those most interested in national security, hoping to smother the environmental elements of the legislation.

The proponents cannot succeed by relying on compellingly logical proofs. The problem is not that people doubt the data and the algorithms; it’s that they doubt the messengers. The first step in bolstering legitimacy is to demonstrate sincerity of the messengers. Sincere people are more legitimate. The President is the dominant messenger in our system so it must start with him.

Climate change threatens future generations. It would be powerful if the President conveyed with sincerity that addressing climate change now is important to him because of concern for his family and that he shares this concern with all American parents. The threat to the future must made concrete and personal and that means families. Political agendas must be secondary to sincere and shared concern for future generations. If the public believes that the single leader elected by all of us sincerely is concerned for their children’s well-being, de-legitimization will lose its bite. Science can then make the case for prompt action.