• Extrmely low probability
• Extremely high impact
• Unimaginable a priori

Given this BSE, we have had a massive “pivot” from the health care fiasco in the making to focus on USA economy and jobs. The reason for this change is simply the one new Republican vote that can stop disastrous congressional economic policies.

OK, so how can this BSE save us? Bear with us for a bit.

We recently came upon this quote and find it quite descriptive:

“A democracy is always temporary in nature; it simply cannot exist as a permanent form of government. A democracy will continue to exist up until the time that voters discover that they can vote themselves generous gifts from the public treasury. From that moment on, the majority always votes for the candidates who promise the most benefits from the public treasury, with the result that every democracy will finally collapse due to loose fiscal policy…”

by Alexander Fraser Tytler, Scottish lawyer and writer, 1770.

Now, consider this fact:

~50% of USA workers pay $0 taxes, while the rest of the workers (the “rich”) pay all the taxes.

We think it fair to conclude:

Half the population has incentive to free-ride on the others and will cheerfully vote for increasing burdens on those “rich”.

Our country is in peril from financial catastrophes and very poor political decisions. Most pertinently, the Scott Brown BSE may enable the inevitable lunge by Democrats for more taxation and thus massive class warfare to be avoided.

Almost every page of the health care bill HR3200 from the House of Representatives has at least one statement that can alter your life. When those 1017 pages interact, they will produce effects not imagined by the bureaucrats and politicians who wrote this thing. The odds those unpredictable Black Swans are good for you are nil. They will hurt you.

As an example, consider this from the New York Times of 1 OCT 09 in regard to the current Medicare:

Medicare is putting in place a new policy that may sharply curtail the use of the cancer drug Avastin as a treatment for eye diseases.

But the way the bureaucratic gears mesh in this case, the move could end up costing Medicare itself hundreds of millions of dollars a year, and individual patients thousands of dollars.

What happened is that Medicare added a new reimbursement category for doctors to use for very small doses of an existing expensive drug. As the Times writes:

But Medicare has now introduced a special reimbursement code just for the smaller doses of Avastin. And starting Thursday, the reimbursement of Avastin dropped to about $7.20 for the dose typically used in the eye.

That would mean eye doctors — who purchase Avastin and then are reimbursed when using it on patients — would lose money administering the drug.

The new policy would give eye doctors a financial incentive to switch to Lucentis, for which they would be fully reimbursed even though that drug is significantly more expensive.

If doctors do shift to Lucentis, “this will have a huge economic impact on Medicare, in the range of hundreds of millions of dollars,” said Dr. David W. Parke II, chief executive of the American Academy of Ophthalmology. “Members view this as a bureaucratic decision that is maybe necessary, based on statutes, but highly short-sighted.”

This illustrates the obscenity the Congress is creating by rushing to a new, vast bureaucratic system with enormous perverse incentives and deep complexities that can only make life worse for everyone.

Read Full Article

Scenario Planning is an important component of strategic planning for any corporate or government organization that intends to prosper and succeed over time. It applies to individuals, too. Of course, it applies to investing as well.

Wired magazine published a clear, concise description of how to do Scenario Planning for yourself. The author, Peter Schwartz, is one of the pioneers in the field. He uses an example of an aerospace engineer planning for his career in quite uncertain times.

Read the Wired Magazine Article

In the first, The Economist lead editorial sets the stage:

What went wrong with economics

It says:

“In the wake of the biggest economic calamity in 80 years that reputation has taken a beating. In the public mind an arrogant profession has been humbled. Though economists are still at the centre of the policy debate—think of Ben Bernanke or Larry Summers in America or Mervyn King in Britain—their pronouncements are viewed with more scepticism than before. The profession itself is suffering from guilt and rancour. In a recent lecture, Paul Krugman, winner of the Nobel prize in economics in 2008, argued that much of the past 30 years of macroeconomics was “spectacularly useless at best, and positively harmful at worst.” Barry Eichengreen, a prominent American economic historian, says the crisis has “cast into doubt much of what we thought we knew about economics.” “

We almost always find Krugman’s assessment of anything remotely political off-base or wacky, but he definitely gets it right, here!

Two other articles analyze the failures of economists to detect or clearly recover from the calamity. These two focus on various aspects of economic theory itself.

The other-worldly philosophers

Efficiency and beyond

The latter article has a nice discussion of the famous Efficient Markets Hypothesis, which is obviously bogus. I love the EMH! It says. all information that could affect the price of a stock is already incorporated into the price, so over time, no one can profit from investing. Don’t you love it?

The EMH is the source of the old joke about two economist walking together down the street. One sees a $20 bill on the ground and reaches to pick it up. Then the other economist stops him, and says “Hey, don’t bother-if that was a REAL $20 bill, someone would already have picked it up!”

One of themes coursing through these articles is that economists have used some important simplifying assumptions, such as EMH, to build their models. These models have worked fairly well. But just as in engineering, one has to consider the “corner cases” before accepting a model. Clearly, economists failed to consider a variety of corner cases, any one of which would have set off alarms about calamity. (A corner case is a situation in which an assumption takes an extreme value. For example, an economic corner case: credit stops flowing completely.)

OK, here is our addition to the post-mortem about economists: Economists need to learn that just because model building is very hard, it’s not a reason to avoid numerous, dirty details. Engineers build elegant, and sometimes ugly, theories. They strive to be elegant and as simple as feasible. They like to avoid complexity. But the engineering mission is to design and build stuff that works according to spec and costs no more than spec. Thus, they do whatever it takes to handle the details of reality.

We acknowledge up front that in the real world, engineers get real feedback, so they know how well their models work. But they also know how to use computers for some of the most beastly models. Just consider the modeling required to predict tomorrow’s weather (Al Gore pay attention). Major mainframe-level facilities are commonly used. Same thing for understanding airflow over a wing design, and how to connect 2 billion transistors to make a speedy CPU.

So, the message to the economics profession is: Life is tough, deal with it! Make models of really messy reality. Just because some social systems can be much more difficult to understand than various physical systems is not an excuse to choose simplicity when brute force of simulation of ugly factors would give better results.

http://www.amazon.com/Demon-Our-Own-Design-Innovation/dp/0471227277

John Paulson, a hedge fund manager, shorted the bank stock index and made a $3B profit. Robert Shiller warned of the housing bubble about to burst. So the crisis was certainly not a Black Swan Event to these folks. But what about the rest of us? Were we surprised? Were we warned?

This video focuses on the psychological roots of some mental biases and how they can lead us to big mistakes. The video (2009-1-27)  takes 59 min, but in our humble opinion, it’s exceptionally stimulating.

Kahneman researched biases of human decision making and gained so many deep insights he was awarded the Nobel Prize in economics. Taleb popularized the idea of the Black Swan, and endlessly talks about the huge risks many people accept blindly, when they could know better.

Kahneman/Taleb Video Conversation

We have been wondering why this technical issue in portfolio management has seemed so hard to solve. As far we can understand, one only has to change the definition of risk in the standard portfolio optimization algorithms and you can account for the Black Swan Events. Pick any measure that seems reasonable. (It’s been clear that using the variance of returns in Modern Portfolio Theory doesn’t capture the really big bad events.) Then do the numerical math and programming. It takes some very straight forward rocket science (OK, we indulge) to produce a more realistic approach.

So we were amazed to discover this problem was in fact solved for the first time in 1987. Even more amazing, one can buy off the shelf software (see This) to perform all the math computations. This whole approach even has a name: “Post-Modern Portfolio Theory (PMPT).

It turns out the Pension Research Institute at San Francisco State University developed the mathematical algorithms of PMPT that are in use today. These methods provide a risk measure that directly accommodates investors’ preferences for upside uncertainty over downside uncertainty in their returns. Many papers and programs have been developed since. But it is supremely obvious that this approach requires much more work and analysis than the original MPT required. Business schools didn’t teach this either. Thus, generations of advisors had no clue that the high risk events everyone is so sensitive to post-catastrophe could be at least numerically handled in portfolio designs.

There was a Devil’s Pact by investors, whose innumeracy avoided discussing issues of risk definition and who wanted to avoid math explanations, and their enablers, those investment advisors who themselves do not understand the basics of quantified portfolio design, let alone an approach as computationally oriented as PMPT.

But armed with this knowledge, we can progress to now use PMPT.

Dr. Black Swan Urges Widespread, Systematic De-Leveraging, World Wide

He says hyperinflation is possible with the current government policies, which policies were unnecessary and driven by political fear.

Taleb is the promoter of the idea that “Black Swans”, or exceptionally rare, impactful and ex-ante unimaginable events must be dealt with in financial markets. Bernanke is chairman of the Federal Reserve Bank.

Taleb (L) and Bernanke (R)

Taleb (L) and Bernanke (R)

We speculate the intelligence organs as well as the commentariat in USA and elsewhere complacently assumed the Iranian elections would be rigged. After all, every candidate was pre-approved by the boss mullah. The fact that the proletariat in Iran rose up against what everyone assumed would occur is the Black Swan Event. A BSE has the definitional properties that it has very high impact, is exceptionally unlikely and can be explained only in hindsight.

The subtlety is this: Our BSE may not be yours. You may have special insight leading you to expect my BSE. An example: John Paulson saw the credit collapse coming and massively invested his hedge fund in shorting the bank stock index. He made billions of dollars for his fund and himself…while the rest of us were running for cover.

So now we ask: were our intelligence agencies expecting this BSE? We doubt it.

Mei Gechlik (JSD, MBA) is Lecturer in Law at Stanford Law School, where she also is Microsoft Rule of Law Fellow. She is fluent in Mandarin and knows the Chinese business scene. She has generously agreed to let us publish her analysis of the recent action by China. Here it is.

By Mei Gechlik

Stanford University

18 JUNE 09

Earlier this month, China’s Ministry of Industry and Information Technology (MIIT) made available a notice dated May 19 to require that from July 1, all personal computers (PCs) sold in China be preinstalled with a program that, according to the MIIT, filters harmful information.  The notice has drawn widespread criticisms that the Chinese government attempts to invade privacy and restrict freedoms in the name of creating a “healthy and harmonious Internet environment”.  Should PC producers rush to meet the requirement by July 1?  No.

First, the MIIT’s notice is, like many other Chinese rules, vague.  It does not specify that penalties will be imposed if the “Green Dam Youth Escort” (Green Dam) software is not preinstalled by July 1.  It only provides that any failure to meet the requirement should be corrected (改正, gai zheng).  Rushing to comply with such a poorly drafted and once secretive notice sends a wrong signal to the MIIT that PC producers do whatever it takes to increase their share in China’s PC market, which sold 40 million PCs last year and is the second largest in the world.  PC producers’ speedy compliance without any attempt to seek clarifications from the MIIT would encourage the MIIT and other ministries to take more drastic steps at their whim, leading to a more challenging business environment for local and foreign enterprises.

Second, the MIIT seems to have backed off because of growing pressure inside and outside of China.  In China, many netizens have questioned the MIIT’s ulterior motives of forcing every PC user to have a program that can, according to experts, turn every PC in China into a part of a botnet, a network of hijacked computers that the hijacker can manipulate.  Even people working for government-run institutions have openly expressed their concerns.

In particular, Li Fangping, a Beijing rights defense lawyer, has formally challenged the legality of the MIIT’s notice.  His main argument is that the notice concerns vital interests of the people and the failure of the ministry to hold a public hearing on the issue violates an October 2008 directive jointly issued by a few ministries including the MIIT and approved by the State Council, China’s highest executive organ.

Li further relies on China’s rules on open government information to demand the MIIT to, among other things, make public the “financial application and approval procedure” for spending RMB41.7 million of government funds to purchase the right to use Green Dam for one year.  At issue is that the MIIT entered into a contract with Jinhui Computer System Engineering Co., the developer of Green Dam that is linked to the People’s Liberation Army, China’s military, without going through any transparent bidding process.

Li also asks the MIIT to explain whether ordering all PC producers to install the software may have violated China’s Anti-Monopoly Law.  The law prohibits administrative authorities from abusing their power to eliminate or restrict competition.  Why is Green Dam, the effectiveness of which is challenged by experts, picked when the market offers other anti-virus software that can effectively block harmful information?

Pressure outside China takes the form of not only criticisms against the Chinese government’s Internet censorship but also lawsuits against Jinhui.  Solid Oak Software Inc., a California company, has alleged that Green Dam contains components stolen from its software and vowed to stop U.S. PC producers from shipping computers with Green Dam to China.

In an attempt to alleviate concerns, the MIIT spokesman has reportedly clarified that PC users can choose to uninstall Green Dam.  It remains unclear whether the MIIT will revoke its May 19 notice.

It is not unusual for the Chinese authorities to back off from their unreasonable stances after strong public opposition builds up through the Internet and the media.  In 2003, the State Council abolished the notorious “custody and repatriation” system to stop condemnations spreading rapidly across the country after a young migrant who failed to present ID documents was beaten by the police to death when he was locked up to be repatriated to his home town.  Earlier this week, a local court decided to set free a young woman who killed an official and wounded another to defend herself from a rape attack.  The woman was first arrested for murder.  Had the incident not been extensively covered by the media and the Internet, the court decision would have been different.

Given that the MIIT is subject to such enormous pressure, PC producers inside and outside of China should seize the opportunity to add their voices.  Apart from legal arguments, they should remind Chinese leaders that a highly-controlled Internet system is not conducive to the proliferation of ideas needed if China is serious about becoming an innovative country by 2020.
Twenty years after the 1989 crackdown of the student protest at the Tiananmen Square, Beijing has yet to review the crackdown and correct its own mistakes.  Instead, it continues to restrict freedoms in the name of creating a harmonious society.  Chinese leaders should know from history that China was the strongest when its society was tolerant, not when it was harmonious.