lukegilman.com : High on the Hog Blog
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The End of the Financial World as We Know It

One of the most accessible evaluations of the events leading up to the financial collapse I’ve seen: Michael Lewis and David Einhorn, The End of the Financial World as We Know It, New York Times, January 4, 2009

…consider the strange story of Harry Markopolos. Mr. Markopolos is the former investment officer with Rampart Investment Management in Boston who, for nine years, tried to explain to the Securities and Exchange Commission that Bernard L. Madoff couldn’t be anything other than a fraud. Mr. Madoff’s investment performance, given his stated strategy, was not merely improbable but mathematically impossible. And so, Mr. Markopolos reasoned, Bernard Madoff must be doing something other than what he said he was doing.

In his devastatingly persuasive 17-page letter to the S.E.C., Mr. Markopolos saw two possible scenarios. In the “Unlikely” scenario: Mr. Madoff, who acted as a broker as well as an investor, was “front-running” his brokerage customers. A customer might submit an order to Madoff Securities to buy shares in I.B.M. at a certain price, for example, and Madoff Securities instantly would buy I.B.M. shares for its own portfolio ahead of the customer order. If I.B.M.’s shares rose, Mr. Madoff kept them; if they fell he fobbed them off onto the poor customer.

In the “Highly Likely” scenario, wrote Mr. Markopolos, “Madoff Securities is the world’s largest Ponzi Scheme.” Which, as we now know, it was.

Harry Markopolos sent his report to the S.E.C. on Nov. 7, 2005 — more than three years before Mr. Madoff was finally exposed — but he had been trying to explain the fraud to them since 1999. He had no direct financial interest in exposing Mr. Madoff — he wasn’t an unhappy investor or a disgruntled employee. There was no way to short shares in Madoff Securities, and so Mr. Markopolos could not have made money directly from Mr. Madoff’s failure. To judge from his letter, Harry Markopolos anticipated mainly downsides for himself: he declined to put his name on it for fear of what might happen to him and his family if anyone found out he had written it. And yet the S.E.C.’s cursory investigation of Mr. Madoff pronounced him free of fraud.

What’s interesting about the Madoff scandal, in retrospect, is how little interest anyone inside the financial system had in exposing it. It wasn’t just Harry Markopolos who smelled a rat. As Mr. Markopolos explained in his letter, Goldman Sachs was refusing to do business with Mr. Madoff; many others doubted Mr. Madoff’s profits or assumed he was front-running his customers and steered clear of him. Between the lines, Mr. Markopolos hinted that even some of Mr. Madoff’s investors may have suspected that they were the beneficiaries of a scam. After all, it wasn’t all that hard to see that the profits were too good to be true. Some of Mr. Madoff’s investors may have reasoned that the worst that could happen to them, if the authorities put a stop to the front-running, was that a good thing would come to an end.

The Madoff scandal echoes a deeper absence inside our financial system, which has been undermined not merely by bad behavior but by the lack of checks and balances to discourage it. “Greed” doesn’t cut it as a satisfying explanation for the current financial crisis. Greed was necessary but insufficient; in any case, we are as likely to eliminate greed from our national character as we are lust and envy. The fixable problem isn’t the greed of the few but the misaligned interests of the many.

It continues with How to Repair a Broken Financial World

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An Interview with Psychologist Daniel Kahneman (video)

An interview with Princeton Psychology Professor and Nobel Laureate Daniel Kahneman.

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Charlie Rose Talks Hedge Funds with Bill Ackman (Video)

Bill Ackman is a major investor and hedge fund manager of Pershing Square Capital Management LP. He talks with Charlie Rose on the mortgage crisis and financial bail out.

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Ben Stein on the Economics of Love

AS my fine professor of economics at Columbia, C. Lowell Harriss (who just celebrated his 96th birthday) used to tell us, economics is the study of the allocation of scarce goods and services. What could be scarcer or more precious than love? It is rare, hard to come by and often fragile.

Ben Stein, Lessons in Love, by Way of Economics

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Economic Theory and Grand Theft Auto IV (or How I Got a Great Idea for a Graduate Thesis)

Sudhir Venkatesh is the is William B. Ransford Professor of Sociology at Columbia University. He is also the kind of guy that writes articles entitled Unjustifiable Carnage, Uneasy Alliances, and Lots of Self-Doubt: What Grand Theft Auto IV gets right about gangland and illegal economies and that is why I like him.

This may sound strange, but I found that Grand Theft Auto actually offered a less sensational portrait of gangland and ghetto streets than the one put out by most cops, politicians, policymakers, and even academics. There is nuance in the game that exceeds most of the conventional portraits of American cities;


GTA IV offers a screenshot of
the local gangland economy

This is no apologia for the glorification of violence in video games or a paean to the majesty of Rockstar’s RAGE gaming engine, but simply taking an observation where it lies, something at which Venkatesh seems to excel. I discovered him through Levitt and Freakonomics, which says something about his willingness to undertake unconventional methods to get at or promote new ideas, on display most fully to date in his work culminating in Off the Books: The Underground Economy of the Urban Poor (2006). Venkatesh recognizes in Grand Theft Auto the underlying sameness that belies the external differences that tempt us to dismiss it out of hand – it is after all, a video game, an unreality, inherently escapist. What could we possibly expect to learn from it? And yet -

The game’s success can be traced to a simple principle: Niko Bellic, the protagonist who roams around Liberty City, making his way in the world by building relationships. Even in a city dominated by warring gangs and unjustifiable carnage, people have to find ways to work together not only to commit crimes but to resolve disputes, respond to injustice, and otherwise fulfill their assigned missions. As you move the dashing Niko through beautifully rendered streets, you build up his network of friends and comrades. Of course, in the exploitative terrain of the black market, you can’t trust anyone for long; this is one of the key challenges that animate GTA IV. But the point is that a lone wolf can’t survive. Niko has to take a risk and trust somebody.

Even the criminals must follow this rule. …. In other words, free agents abound on Wall Street and ghetto streets. GTA IV’s Liberty City gets this fluidity of enmity and alliance exactly right. A friend can become a foe; a gang member can turn on you; an ally is never to be trusted for too long. You can’t do it alone, and the game forces you to make your bets.

Venkatesh recognizes in criminal activity the same invisible hand that moved Adam Smith’s merchant class, with the same potential for market failure and waste when incentives are misplaced or economic actors are simply shortsighted. One function of economics is to remove our social blinders, to see the reality of our situation and to take the longer view. I doubt many GTA aficionados take away the same lessons, but they could, and Venkatesh is there to point it out to any who listen.

And now I have some empirical research to conduct…

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Why I shop at Borders and buy on Amazon

and why when the time is right, I hope Amazon will buy them.

Borders is increasing the number of books that it displays with the cover facing out (rather than the spine facing out), even though this shelf-space-eating approach will require cutting inventory at each store up to 10%. Says one analyst: “Breakfast cereals are not stocked end-of-box out. […] It’s a little bizarre that it’s taken booksellers this long to realize that the point of self-service is to make the product as tempting as possible.”

Post hoc ergo propter hoc

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Bryan Caplan Asks Why Anyone Should Bother to Vote

He goes a bit further, in fact, and wonders why you bother to vote, and hopes you won’t actually. Caplan is an economist at George Mason University and co-author of Marginal Revolution, by far my favorite economics blog. In his new book The Myth of the Rational Voter: Why Democracies Choose Bad Policies (amazon), he makes himself a hamburger of our sacred cow, democracy. You are, dear reader, not smart enough to vote, and by “rocking” said vote, you harm not only yourself but your country. Please stop. Leave voting to the professionals; economists that is. As Louis Menand notes in a review in the New Yorker:

The average person, he says, has four biases about economics—four main areas in which he or she differs from the economic expert. The typical noneconomist does not understand or appreciate the way markets work (and thus favors regulation and is suspicious of the profit motive), dislikes foreigners (and thus tends to be protectionist), equates prosperity with employment rather than with production (and thus overvalues the preservation of existing jobs), and usually thinks that economic conditions are getting worse (and thus favors government intervention in the economy).

Louis Menand, New Yorker: Fractured Franchise. (Go buy Menand’s Metaphysical Club (amazon) while you’re at it)

The argument of his book, though, is that economists and political scientists have misunderstood the problem. They think that most voters are ignorant about political issues; Caplan thinks that most voters are wrong about the issues, which is a different matter, and that their wrong ideas lead to policies that make society as a whole worse off. We tend to assume that if the government enacts bad policies, it’s because the system isn’t working properly—and it isn’t working properly because voters are poorly informed, or they’re subject to demagoguery, or special interests thwart the public’s interest. Caplan thinks that these conditions are endemic to democracy. They are not distortions of the process; they are what you would expect to find in a system designed to serve the wishes of the people. “Democracy fails,” he says, “because it does what voters want.”

If you’re a bit shocked and appalled right now, well, that’s partly the point. Economics is the enfant terrible of academic thought and provocation is part of what a good economist does well. What goes mostly unanswered in Caplan’s analysis is what an irrational society is to do about this irrationality. In economics it’s customary to assume the rationality of our fellow man (despite ample evidence to the contrary) because the alternative is, well, not very useful. While I recognize that democracy’s flaws are nearly exactly what Caplan says they are, I’m not ready to write off democracy. I don’t think Caplan is either. Economic thought has made amazing leaps in permeating the public consciousness. I remain optimistic about the potential of society and the public debate to grow beyond the four economic biases Caplan points out. Economists have and will continue to have greater influence than we think. As Keynes noted, “Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.”

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Cowan on McGaw’s Schumpeter, Prophet of Innovation

Tyler Cowan of Marginal Revolution has given an glowing review of – Thomas McGaw’s Prophet of Innovation: Joseph Schumpeter and Creative Destruction – a book I’ll likely not have a chance to read in the near future. Law school means never having to say you don’t have anything to read. I’m still struggling to find time to put a dent in Sudhir Ventatesh’s excellent Off the Books.

NB: if you’re not subscribed to this econoblog’s RSS feed your news-reading habits suffering a diminishing rate of return.

The American: Schumpeter Revealed.

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A Reprieve… the tax man still cometh, but on the 17th

If you’ve had the sinking suspicion you’ve been forgetting something, fear not young tax delinquent, Tax Returns Are Due April 17 This Year. Just in case you don’t believe me, get it straight from the horse’s um… mouth.

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Reading: Sudhir Ventakesh, Off the Books

Sudhir Ventakesh

With a finite amount of time before Contracts starts, I decided my next read is going to be Sudhir Ventakesh‘s Off the Books: The Underground Economy of the Urban Poor. Ventakesh was a colleague of Steve Levitt‘s (Freakonomics) whom I’ve discussed here and here. Levitt and Dubner discussed Ventakesh’s work with Chicago gangs at length in Freakonomics, comparing the organization of a drug-selling gang to the franchising of McDonald’s. The gist of that research is available in a talk Levitt gave at the Technology Entertainment Design Conference (TED).

In Off the Books Ventakesh delves deeper into the Southside Chicago neighborhood to explore the economics of the everyday lives of its residents, who, often living on the edge of survival, struggle with “their desires to live a just life and their needs to make ends meet as best they can.”

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