Risk Markets And Politics

Saturday, June 25, 2005

Kelo: What, Me Worry?

On Thursday the Supreme Court upheld a local government's authority to take ordinary, non-blighted homes for redevelopment, not just for "public use" as is traditionally the case with eminent domain. Now a municipality can seize property even if they just think they can generate higher tax revenue by doing so.

A lot of people are very disturbed by this outcome, which they say points towards a dissolution of all property rights. I am a bit more sanguine. Any municipality (or government for that matter) that abuses this power will see their housing prices fall as people migrate to places where their property rights are more secure. It will be more difficult for abusive cities to justify higher property taxes, and in the long run they should see these tax receipts decline. They will almost definitely see residential property tax income decline in the long run, even if it is bolstered in the short-term by incoming workers. Taking advantage of this ruling will be a serious gamble for any city to undertake. Essentially, they will be wagering that the new commercial taxes will offset the eventual decline in residential tax income, and what happens when nearby cities announce that they won't be taking advantage of the ruling?

Now I doubt this will be the case, but it would be interesting and instructive if we someday look back on all of this and find that this ruling was the straw that broke the back of the housing market. It's easy to underestimate the effect of such a marginal change because, as Robert Shiller and Charles Manski point-out in different ways, people tend to overestimate the probability of small risks.

Friday, June 24, 2005

Why I Don't Believe In Ayn Rand

I have heard Objectivists proudly cite that Atlas Shrugged ranks second only to the bible in book sales. Rand’s accessible fiction may be evangelically useful in promoting ideas about free markets and capitalism, and I would probably agree with her position on almost any specific issue, but nonetheless something has always bothered me about her writing. Her philosophy has always been uncomfortably fundamentalist for my tastes – if not dogmatic, then darn close, and so I have never found her to be, shall we say, pantheon-worthy.

Rand is fundamentalist insofar as she thinks in terms of absolutes, which is often. Given her views on the use of force, this isn’t inexcusable in itself, but dogma isn’t typically a hallmark of great thinking. It is easy to grow tired of the callow confidence that proclaims everything, when “properly understood”, to be absolute, black-and-white, and completely objective. “A is A” – but this is only true insofar as it is a symbolic tautology! Anything that exists in reality is going to exist in time, and time is something that Rand never sufficiently addresses. Rand had to repress her own thought about time because of her desire for absolute foundations, and this is where I can offer a positive alternative. The Austrian mistrust of mathematical economics partly has to do with the fact that the models are instantaneous, and deal only in re-writing symbols, thereby expressing differences as identities. In contrast, Austrian praxeology addresses time and causality. As an example where Rand neglects these aspects of reality, why does she see subjectivity as a negation of reality if thought, however divergent from current reality, can have objective consequences in time? Additionally, Von Mises held a subjectivist theory of value, recognizing that the realm of the rational is always subject to the non-rational, i.e. ends aren’t necessarily rational. This is in contrast to Rand’s philosophy which largely consists of various combinations of the words “absolute”, “reality” and “reason.” I can understand how Rand’s writing is a somewhat independent reaction to the milieu of subjectivity that dominated 19th and 20th century philosophy, but just because something isn’t absolutely correct does not mean that its absolute opposite is valid! (Rand truly excels at straw-man and slippery slope arguments, occasionally in combination.) Randians may claim that the ideas of Von Mises and Hayek are too “free-floating” and then, quite earnestly offer Objectivism as a base. No thanks, guys.

Rand would have you believe that having no absolute standards means that you have absolutely no standards. (“The Age of Envy”) Given her background, we can excuse her allergies to anything “social”, but in a society people have different perspectives and it is in fact possible for there to be meaningful values without there being one absolute, universal, fundamental value. Values can be intransitive; they may exist in a rock-scissors-paper structure. We know by Arrow’s theorem that this is true for a group of people. Rand believes that, “nothing can be learned about man by studying society” (“What is Capitalism?”) but it is possible to imagine that this can also be true for one person over a span of time without having to say that they lack values. That person’s values were never absolute, but at no point in time could they be said to be lacking values absolutely. The fact that at any point in time they may have seemed absolute is irrelevant.

The Austrian subjectivist theory of value starkly highlights an important contradiction in the logic of Rand’s work. With one hand she pounds the table regarding absolute rationality and the like, while feeling for a nebulous “sense of life” (an “emotional atomosphere”) with the other. What else is the “sense of life” but the irrational underpinning of rational values? We can guess why Rand is haunted by this theme especially in her later work. It is clear that rationality alone cannot explain Rand’s romanticism, her exaltations of skyscrapers and rockets, for instance. (The former aren’t cost-effective beyond a certain height and the practical applications of the latter are always suspect) I am not criticizing her specific sense of life, but insofar as she had one, it wasn’t completely dictated by reason, nor is anyone’s. Rand’s “sense of life” is one of those seemingly marginal aspects of a work that, when carefully scrutinized, threaten to collapse the whole in contradiction. This is just a case of not reading what one writes – that the rational ought to cause the emotional, and speaking of writing…

The “absolutism of reality” is a typical Randian phrase. The first question is one of basic word usage: why “absolutism”? Is reality only exhibiting a tendency towards or style of the absolute? If it’s only a tendency, then reality is not actually absolute. However, one can never assume that Rand is employing basic philosophical terms correctly. Case in point: Rand misuses “existential” to mean existing or being. (e.g., in "The Objectivist Ethics" and "Faith and Force") While it is fine to appropriate words, Rand has not in my opinion distinguished herself sufficiently to color outside the lines in this way. One might be tempted to think that she is simply adding syllables to simple, accurate words to make them sound more philosophical. Most glaring of all is her chronically laughable use of “metaphysical”. It is not used to mean “ontological” nor “transcendental” nor "totalizing". Sometimes it is simply used instead of "physical." Mostly it is used as literally "beyond the physical", but insofar as this is the case, it adds no information and is devoid of explanatory force. With Rand, “metaphysical” is often an almost-meaningless gesture, meant to signal, “this is a philosophical sentence.”

People want to believe in Ayn Rand for various reasons. They want to believe in an American Philosopher, a Woman Philosopher, a Capitalist Philosopher, etc. These have existed and will continue to do so with or without Rand. Again, I would probably agree with her on almost any specific political issue, but whenever I see some kind of idol made in her image, I reach for a sledgehammer.

Friday, June 17, 2005

Hedgers vs. Bettors

Commentary in a recent FT claims that New York is falling behind London "in an arena of financial innovation that is rapidly converging with other forms of trading and investment", "gaming and betting sites." The article implies that America's relatively puritanical sense of morality is hampering the development of new markets.

What are the root causes, the genealogy of, the moral imperative against gambling? Perhaps Onanism, wasting otherwise productive resources and time? Likewise, gambling is seen as a stepping stone to other indulgent behaviors, not in alignment with "family values." But will moralist concerns actually threaten the development of online markets in the US? If so, the question becomes: "what is the clear line between hedging and betting?"

The article goes on to suggest a dilemma:
"It is easy to imagine, for example, home-owners or lenders placing bets on the future level of a house price index in order to protect themselves against potential loss. Would that be betting or financial hedging?"

At first, the answer seems clear. It is hedging so long as the home-owner sells the price index. If he buys the index, or if someone with no prior interest in real estate buys or sells it, that is betting. It comes down to pushing-away risk vs. taking it on, or decreasing the expected variance in your future wealth vs. increasing the volatility of expected well-being. The market will necessarily contain a mix of these types of actors and actions, but this is no different from any other mature financial market.

Now, some markets will by nature contain a higher percentage of bettors, in some cases nearly 100%. Sports gambling falls into this category. I suppose that some gamblers bet against their favorite team and this could very tenuously be considered as a hedge, though immaterial. There is also the entertainment value of participating in the market, and I dare say this is also no different from any other mature financial market! When market participation has some kind of immaterial "use" value, this does in fact blur the distinction between hedging and betting, but not critically so I think. Markets that allow participants to hedge pre-existing material risks should have no moralist legislative risk in any case.

Thursday, June 16, 2005


On the one hand, the word "speculator" is associated with the far-sighted sage, who prudently stores goods in times of plenty to later rescue society during crises and famines, concomitantly, buying low to sell high. The archetypical speculator of this kind is Joseph, who foresaw seven years of plenty followed by seven years of famine and advised the Pharaoh to store food accordingly.

More often though, speculation is synonymous with bad speculation, especially with the reckless buying that occurs in bubbles. This speculator, who buys high to sell still higher, is seen as short-sighted and liable to introduce volatility, as opposed to the noble speculator who instead buffers instability by taking more contrarian, independent, positions. This second type of speculator is, at best, naive, perhaps a "mere" gambler, and possibly downright malicious. An argument could be made for the philosopher Thales of Miletus being put into this category. If the story can be believed, Thales, through his skills in predicting the weather, anticipated a particularly large crop of wine grapes and went about accumulating (cornering?) wine-presses early in the year, thereby aggravating their shortage relative to grapes.

You see, Thales didn't "need" so many wine presses, and likewise, speculating is sometimes opposed to using. For example, in real estate, "flippers" are speculators, whereas the couple buying a home to raise their family would be considered users. Of course there is nothing preventing individuals or specific decisions falling under both categories to one degree or another, especially over time. Bertrand Roehner has proposed the "speculative ratio" metric, which is the number of speculators divided by the total number of market participants (speculators + users, or the ratio could be calculated on a capitalization basis). He notes that real estate markets typically contain 20% speculators, and that the speculative ratio of a stock market is 100%. It is in fact very high but not 100% as Roehner claims; this forgets the voting rights which are sometimes critical!

Users are like hedgers. The hedger has a risk that he wants to insure against, and the speculator buys this risk. This sense of speculator most closely corresponds to the one I have used below. Once again, this distinction is often unclear as hedgers often speculate and vice-versa, but this doesn't mean that the concept is useless, and perhaps it can be re-cast in a more precise way. Specifically, by "hedger" I mean someone for whom the market activity is secondary to some other activity (often in another market or business), and by "speculator", someone whose activity is primarily an activity in that specific market. The distinction is therefore relative; the speculator's activity is, of course, most probably secondary to some other activity or goal in his life, but in any given trade, one party is the relative speculator and the other the relative hedger.

The point (yes there is one!) is that speculators tend to prefer markets not dominated by other speculators. In most cases, larger dispersions in needs, perspectives and time-frames of market participants cause larger inefficiencies and more opportunities for profit.

Thursday, June 09, 2005


Right now people are hungry for yield and several investment markets and strategies exhibit overcrowding. Speculators thrive on market inefficiencies, but when speculators are successful and/or numerous, these inefficiencies tend to dissipate, driving their profits down. Speculators are thus always on-the-search for new markets, ideally where they can transfer a tested methodology to a hopefully naive arena. Falling yields can indicate a demand for new markets.

Strategy overcrowding is less apparent in non-zero-sum markets, and markets undergoing reflexive buying/selling episodes ("bubbles"). The reflexive buying and price-multiplier effects that accompany bubbles are however only a secondary cause. The primary cause of bubbles has more to do with the markets themselves becoming overcrowded. Unlike strategy overcrowding, this tends to increase average profits in non-zero-sum markets. The prices predicted by fundamental valuation models are sometimes inadequate when trumped by supply/demand factors extrinsic to the models. Fundamental valuation often assumes the form of yield, but yield can be pushed arbitrarily low by market forces of demand for the underlying security or property. Whether it be interest paid on bonds, or earning- and dividend-yields on stocks, or rent yields in real estate, yields can be pushed to seemingly irrational levels by extrinsic factors often relating to demographics, market structure (including globalization), and, commonly, developments in other markets.

For example, since the equity market is non-zero-sum and skewed sharply to the long side (most people own stocks as opposed to "being short" stocks), option implied-volatilities, which determine the value of options, exhibit their familiar pattern of relatively high put prices, as there is relatively more demand by hedgers (puts allow you to profit from the market going down.) Likewise, in online prediction and sports gambling markets, longshots tend to be overvalued, and favorites undervalued due to the reluctance of sellers and buyers of risk, respectively, at severely unfavorable risk/reward ratios. In both of these cases, structural factors external to the assumed exclusive content of the valuation models (which are interpretations of the markets specifying an implied probability or volatility) cause the models to malfunction and produce incorrect results, in the short run at least.

The housing market is another example where valuations are driven by factors extrinsic to yield-based valuation models, and I would like to stress the demographic aspects of the current trend. The housing market is doubly and perhaps triply driven by demographics. First, there are the oft-cited combined effects of the baby boom and increased life expectancy. Secondly, and this is an Austrian interpretation, the fact that the average age in the US is increasing at about 0.1 year per year currently should put a downward pressure on yields, especially on yields more than several years out. This is intuitive, as older folks tend to want their money more immediately. Lower yields of course help housing prices, but as people begin to retire "later" this effect will be mitigated. Perhaps the outcome of the housing market and other conundrums will be resolved around the same time as the social security debate, when the average retirement age will probably move sharply higher.

Sunday, June 05, 2005

Risk Markets and Prediction Markets

I use the term "risk markets" instead of "prediction markets", not as a result of Manski's paper, but because I think the risk-sharing capacities of markets are at least as important as any predictive properties they may have. I'm thinking of markets formally resembling the current online prediction markets, but with more substantially useful content, specifically, forms of insurance, risk-sharing, and hedging, much along the lines of Robert Shiller's work. Hedgestreet definitely has the right idea, offering contracts on market-specific real-estate prices, and gasoline, but I'm most intrigued right now by Tradesport's Social Security contract:

Passage of US law that allows taxpayers to divert SS taxes to managed private accounts by Jun 30, 06

This is where the "politics" really starts to come-in. Of course, the critical problem faced by any new market is attracting enough participants and liquidity, but I think this is where things are going.

Thursday, June 02, 2005

Drugs and Risk Markets

Why not let markets take-over some of the functions of the FDA? As long as drug manufacturers publish accurate tables of known risks involved with drugs, why not let the market specify prices for these drugs in accordance with these risk premia? Part of the reason is political and has to do with, as Victor Niederhoffer points-out, "what is seen and what is not seen", i.e. in the media one hears of the 100s of cases of people killed by some side-effect, but what is not seen are the 1000s of individuals dying from known conditions while potential life-saving drugs linger in the pipelines of drug companies. The other main obstacle is the focused liability that drug makers will take-on after publishing quantified risk tables. The possibility that a risk factor published as being, for example, a 4 standard-deviation side-effect, is actually only 3 SDs because a subset of the population with certain risk-factors was not included in the trials must be insured against so that the manufacturer is not unduly crippled by such an incident. Of course, the insurance would be void if the probabilities were knowingly published at fraudulently low levels. Exactly who is to act as this underwriter will be a topic of subsequent posts here. Some of the most interesting current political problems involve risk-sharing structures such as healthcare and social security.

The public nature of information is central to other aspects of healthcare, such as the illegality of genetic screening in providing healthcare insurance. Which personal details, from genetic predispositions to behavoural risk-factors such as unhealthy eating habits should be kept private from insurers? In any case, this freedom of individual privacy becomes, at least implicitly, a social risk-sharing arrangement. The situation need not remain binary though; life insurance prices can be broken-down by cause of mortality e.g. (20% heart disease, 10% cancer X, 5%, cancer Y, 1% accident, etc), so if an individual has a likelihood of contracting a certain form of cancer at 200% the average rate, their insurance premium will increase by 2 * the weight of that risk factor. It would be inefficient to deny them coverage entirely, and eople who are less likely than average to suffer that cancer will see their premia decline, and not be compelled to take-on someone else's specific risk. Like drug-makers insuring their risk tables, insurance companies could re-insure their risk tables, although this is the information insurers would like to keep private!

Likewise, regarding illegal drugs, legalization will have to wait until risk, especially health insurance, markets mature. Almost inevitably, the increased availability and reduced price of legalized drugs would lead to wider and greater usage. While there are valid debates concerning whether or not the current legal order accurately ranks the deleterious effects of legal and illegal drugs, it is indisputable that drugs such as alcohol or anything that involves smoking pose serious risk-factors. Therefore, health problems and healthcare costs will tend to escalate if there is significant drug legalization. This would be mitigated by a reduction in the implicit social risk-sharing of health insurance caused by an increase of public information. Unhealthy activities would then have a discouraging, additional "tax" put on them.

Gold and the Dollar

The resiliency of gold while dollars rallied Monday through Wednesday, along with the recent inflation fears receding, suggest that the metal's negative correlation to the dollar is softening. France's rejection of economic liberalism in favor of progressive liberalism has ended the Euro's bid to become the world's reserve currency of choice, a move which began in earnest in mid-2002 when it became clear that the U.S. intended to invade Iraq. While many had correctly predicted the result of the vote (Tradesports put the odds of a yes vote at 27% on the Friday before the referendum), the depth of Europe's aversion to Anglo-American capitalism was not fully priced-into the foreign exchange markets. Predictably, today was a day of profit-taking strength in the Euro while the markets await tomorrow's US payroll number. I would expect another leg down for the Euro some time after the release of the number. The number may however appear weak following April's strong growth and spark a short-lived squeeze.