The Value of Extremist Economics

An article by Justin Fox in the June 1, 2009, issue of Time called my attention to the economic commentary and libertarian views of Peter Schiff, president of brokerage firm Euro Pacific Capital. (Justin Fox writes the column “The Curious Capitalist” for Time. The article I’m referring to was called “Excluding the Extremist” in the print magazine but is called “Why We Should Listen to Peter Schiff’s Bad News” in the online version.)

While most other economic commentators were trying to prop up the smiley-face view of the economic prospects during 2006 and 2007, Schiff was warning that the economy was heading into a serious recession because of too much debt and a broken banking system, and that the stock market was due for a crash.

Commenting as part of a panel for Fox News on 18 Aug. 2007, Schiff said the following:

The worst is yet to come, the fundamentals are not sound, they’re awful. If the fundamentals were sound we wouldn’t be having these problems.

This to the derisive laughter of the other Fox panel members. In the following video you can see fascinating clips of Schiff during that period going up against the prevailing optimistic wisdom of the time:

Even now in 2009, says Fox, Schiff has not changed his tune:

He thinks the “phony economy” of the U.S. is headed for even harder times. He believes that the crisis-fighting measures coming out of Washington are merely delaying the inevitable, debasing the dollar and loading future taxpayers with huge debts.

Doomsday prophecies aside, though, one of the most interesting aspects of Fox’s column is what he has to say about the value of diversity of opinion, even extremist views. Fox refers to the work of University of Michigan Professor Scott E. Page, an expert in complex systems, political science, and economics.

Including a diversity of views in a set of people working on a problem, writes Page in his book The Difference, increases the possibility that a crucial “savant” will be included in the group and that that is the person who will contribute the nugget that solves the problem:

If we sample widely, we’re more likely to find the one person who can solve the problem or who can make the key breakthough. We did not get the theory of relativity from a crowd. We got it from a diverse, novel thinker in a patent office.

Page’s book explains the research that backs up this assertion.

Some of our research at the Institute for Innovation in Large Organizations (ILO) jibes with what Page is saying. In our 2007 report “Effective Cross-Functional Innovation Groups,” we cited research by Harvard business professor Lee Fleming, who studied 17,000 patents. Fleming encountered an interesting tendency when studying the diversity of innovation teams:

The financial value of the innovations resulting from such cross-pollination is lower, on average, than the value of those that come out of more conventional, siloed approaches. In other words, as the distance between the team members’ fields or disciplines increases, the overall quality of the innovations falls.
However, he adds a big but:
But my research also suggests that the breakthroughs that do arise from such multidisciplinary work, though extremely rare, are frequently of unusually high value—superior to the best innovations achieved by conventional approaches.

The financial value of the innovations resulting from such cross-pollination is lower, on average, than the value of those that come out of more conventional, siloed approaches. In other words, as the distance between the team members’ fields or disciplines increases, the overall quality of the innovations falls.

However, he adds a big “but”:

But my research also suggests that the breakthroughs that do arise from such multidisciplinary work, though extremely rare, are frequently of unusually high value — superior to the best innovations achieved by conventional approaches.

We wrote:

Fleming comments that “when members of a team are cut from the same cloth,” as with a group of all marketing professionals, “you don’t see many failures, but you don’t see many extraordinary breakthroughs either.”

As an example, Fleming says that economists and physicists seem to be able to “team up and innovate efficiently and produce many moderate-value innovations, because their fields are fairly well aligned,” sharing “the common foundational tools of mathematics.”

However, as team members’ fields begin to vary, “the average value of the team’s innovations falls while the variation in value around that average increases. You see more failures, but you also see occasional breakthroughs of unusually high value.”

To me, this emphasizes the value of giving more extreme views a place at the table when tackling complex problems, rather than just laughing them off.

AB — 1 June 2009


Author of ‘Life Inc.’ Bashes Corporatism, Points to a New Way

Recently I’ve learned about a new book, Life Inc., by Douglas Rushkoff, scheduled for release June 2, 2009.

In a recent video, Rushkoff says he believes humanity is at a crucial point, not just a crisis but an opportunity. He thinks this is “probably the first moment in the last couple of hundred years that we’ve had to rebuild our society and our economy on principles that serve humanity instead of killing life.”

Rushkoff says he doesn’t believe banks should be rescued — but that we should let them die “so that we can get on with business.” What he means by that is new forms of business and investment that focus on local communities.

In his new book and in the video talk, Rushkoff advocates ways people can “start investing in one another and with one another and make their towns better, actually earn returns that you’re not going to get from your Smith Barney broker – I promise you that – and see the return of your investment in the place you actually live. That’s not hard to do.”

In the Life Inc. book, and in the video in a briefer form, Rushkoff traces the history of the current economic predicament. He points to the Renaissance as a crucial starting point. During that period, he proposes, the world economy changed fundamentally when monarchs, to stem their loss of power, ceded monopolies to corporations:

The renaissance was not a golden age. It was the end of a golden age. The renaissance was the moment in history when kings decided they were going to monopolize all of the value that people were creating throughout western Europe.

Instead of letting people make stuff and trade stuff, they created chartered corporations ….

 They picked individual businesses to charter and in return for the exclusive control over an industry or over a region, that company would then give the king shares of stock.

People would have to work for corporations. Instead of letting people in different towns make their own money, everyone would have to use coin of the realm. Instead of people creating and trading and selling art, now you would have to have a sponsor, a patron, who would then bring you to court and let you be an artist.

This centralization of economic power has continued as the model up to our time, says Rushkoff, and has resulted in a worldwide “dehumanizing trend,” in which humans are disconnected “from their own labor, from their own consumption, from their own pleasure”:

The society that we built for the industrial age was built to mythologize the mass-produced object, because we needed to create a society of consumers who thought that buying all of this stuff would somehow make them happier.

Here is the entire video talk:

AB — 11 May 2009

Did “animal spirits” mess up the economy?

Could “animal spirits” explain the unpredictability of economies and the emergence of economic bubbles? Economists George A. Akerlof and Robert J. Shiller believe so, as they explain in their recent book Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism.

Their use of the term “animal spirits” does not derive from animism or from its cousin sociobiology, but from a statement by John Maynard Keynes in his 1973 book The General Theory of Employment, Interest and Money (pp. 161-2, boldface mine):

Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits — a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.

In an excerpt from their Animal Spirits book in The McKinsey Quarterly, Akerlof and Shiller describe these animal spirits as irrational forces that can cause volatile market fluctuations, often contrary to the rationality that should guide markets under classical economic thinking.

While acknowledging that markets are indeed influenced by people’s rational self-interested behavior, Akerlof and Shiller maintain that

they are also guided by noneconomic motives—“animal spirits”—which Adam Smith and his followers largely ignore. Sometimes people are irrational, wrong, shortsighted, or evil; sometimes they act for action’s sake; and sometimes they uphold noneconomic values like fairness, honor, or righteousness.

In the excerpt, they lay out five aspects of animal spirits that affect the economy:

  1. confidence and the feedback mechanisms that amplify disturbances
  2. the setting of wages and prices, which depend largely on attitudes about fairness
  3. the temptation toward corrupt and antisocial behavior
  4. the “money illusion,” or confusion between the nominal and real level of prices (so that people, for example, often miss the fact that conservative investments may be risky in times of inflation)
  5. the story of each person’s life and the lives of others—stories that in the aggregate, as a national or international story, play an important economic role

The authors believe a new regulatory regime is needed that takes into account the animal spirits that drive markets. New regulations could help prevent volatility and collapse of markets, as well as the need for crippling public bailouts.

But interestingly, they also highlight the need for a new “story” about the economy:

For decades, the dominant story about the economy maintained that all the fluctuations described previously had a rational basis. During the bubble years, the story also held that any risk arising from assets such as houses and subprime mortgages could be managed through complex financial devices like securitization and derivatives, which were largely unregulated.

Then the story changed. The new one suggested that all this complexity was just a novel way of selling snake oil. As the new story about Wall Street and its products took hold, the life drained out of financial markets. Housing prices sank, the demand for exotic products collapsed, and the credit crunch began.

Now, they stress, “there must be a new story about markets — a story that doesn’t always predict sunshine.” This story acknowledges “that animal spirits play a significant and largely destabilizing role.”

Although regulation takes place at the level of government, stories or narratives play out in the public forum and in the media — as well as in people’s own minds and their interactions with others. The need for a new story has implications about how people set personal goals and what they strive for in life.

AB — 20 April 2009

Do happy faces cause dumb investments?

Could an investor be prompted to make a more risky financial decision when exposed to positive, optimistic stimuli, such as a smile on the face of someone recommending or selling an investment?

That’s the implication of research by Julie L. Hall, a doctoral student in personality and social psychology in the Cognitive Science & Cognitive Neuroscience Program at the University of Michigan.

Hall and colleagues studied investment decisions made by 24 research subjects during a market simulation game. Some choices were high-risk and some were low-risk. Participants were shown pictures of happy, angry, or neutral faces before they carried out investment decison-making tasks.

Researchers also used fMRI (functional magnetic resonance imaging) during the tasks to see which areas of the brain “lit up” while participants were deciding which investments to follow.

Writing for New Scientist, Peter Aldhous describes how the game was set up (“Cheery Traders May Encourage Risk Taking,” April 7, 2009):

For every round of the game, the bond paid out $3. One of the stocks paid out $5 half of the time, while the other lost $5 at the same rate. At the start of the game, the players were told the rules but didn’t know which of the stocks was good and which was bad: that only emerged as the game unfolded. As with real-world investments, the good stock became bad at certain points during the game, and vice versa.

As Hall and colleagues anticipated, the positive stimuli caused increased activity in areas of the brain associated with anticipation of a reward and correlated with risky decision-making.

In introductory material to her March 23, 2009, presentation at the annual meeting of the Cognitive Neuroscience Society (“Put Your Money Where Your Heart Is: An fMRI Investigation of Affective Influences on Financial Investment Decisions,” Julie L. Hall, Richard Gonzalez, Oliver C. Schultheiss, Cognitive Neuroscience Society Annual Meeting Program 2009):

As predicted, participants showed greater NAcc activation and were more likely to make risky investment decisions after happy versus neutral face primes in both the subliminal and supraliminal presentation conditions. In addition, participants also showed greater anterior insula activation and made slightly less risky investment decisions after angry versus neutral face primes during supraliminal presentation conditions.

Hall concludes that

… facial expressions of emotion, even when they are not consciously perceived, can influence investment decisions and suggest that the inclusion of affect may lead to more accurate models of economic decision making, which better explain irrational financial behavior. They also suggest that affective states during pre-choice stages of the decision making process may alter the perception of benefits relative to costs, leading to changes in financial risk taking depending on whether the affective state is positive or negative.

Brian Knutson, a psychologist at Stanford University, has done similar research. He acknowledges, writes Aldhous, that “it is hard to determine the extent to which real financial markets are driven by similar emotional factors.”

However, Knutson has found that “the nucleus accumbens,” the brain area associated with risky investment decisions, “is activated when we are anticipating a reward.” For example, “showing men erotic pictures leads to similarly risky investment decisions.”

This fits with the Bubbleconomics proposition that infectious optimism contributes to economic bubbles and to the disastrous results.

Hall tells Adhous,

When risk-taking is a good thing, it’s good to be in a positive mood. When risk-taking is a bad thing, it’s not good.

AB — 7 April 2009

Attributed Value: How much is stuff really worth?

Today the term “attributed value” occurred to me as a way to modify the concept of value in the light of subjective opinion.

How much is something really worth? The traditional common sense answer is that something is worth whatever someone else will pay for it.

In other words, the value attributed by the best available buyer — the attributed value.

Conventional economics probably already has a term for this concept, but I thought I would pin it down while it’s on my mind.

During my career, I have had two businesses for sale. One I sold successfully. The other I was not able to sell at all. From my point of view, both businesses had value, but the one I was not able to sell had no attributed value.

At the time, I consulted a business broker who tried listing the business for me for awhile. We also discussed pricing strategies. One rule of thumb he mentioned is that some people price a business based on two years’ worth of profits. But what it really comes down to in the end, he told me, is the market reality: “This business is worth whatever somebody is willing to pay you for it.”

Wikipedia has an article related to this topic: “Subjective theory of value.”

This idea of attributed value has relevance to Bubbleconomics in that economic bubbles appear to be partly sustained by attributed values that are unnaturally high and thus unsustainable.

The concept of attributed value also has relevance to the question of the Big Bubble. Wikipedia’s article on “Market capitalization” says,

The total market capitalization of all publicly traded companies in the world was US$51.2 trillion in January 2007 and rose as high as US$57.5 trillion in May 2008 before dropping below US$50 trillion in August 2008 and slightly above US$40 trillion in September 2008.

Yet did the real value of all the stuff represented by those market capitalization figures actually change that much over those time periods? Or did the Big Bubble just deflate because of falling attributed value?

AB — 20 March 2009

Disaster myopia in the economy

In an article yesterday in the Financial Times“Error-laden machine,” John Plender in part blames a phenomenon called “disaster myopia.”

Plender defines disaster myopia as “the tendency to underestimate the probability of disastrous outcomes, especially for low frequency events last experienced in the distant past.”

This sounds like a good term to describe the reason people live next to volcanos or in Los Angeles, as well as the thinking of many 23-year-olds who brag, “Don’t preach to me. I’ve been driving this way all my life, and I haven’t had an accident yet!”

But according to Plender, it also explains investor behavior over the past several years:

The risk of falling victim to this syndrome was particularly acute in the recent period of unusual economic stability known as the “great moderation”. Investors were confronted by falling yields against a background of declining volatility in markets. Many concluded that a new era of low risk and high returns had dawned. Their response was to search for yield in riskier areas of the market and then try to enhance returns through leverage, or borrowings.

Equally popular were trading strategies such as carry trades, which involved borrowing at low interest rates and investing at higher rates, especially via the currency markets. Favourite trades included borrowing in Japanese yen to invest in Australia or New Zealand, and borrowing in Swiss francs to invest in Icelandic assets.

This was dangerous because the interest rate spread could be wiped out in short order by volatile currency movements. Yet because volatility remained low for so long, disaster myopia prevailed. Carry traders were lulled into a false sense of security, while more sceptical competitors joined in for fear of underperforming.

Plender says disaster myopia is a term used by academics, which got me curious. Along with other references, I found that disaster myopia is covered in Asset Price Bubbles, edited by William C. Hunter, George G. Kaufman, and Michael Pomerleano.

AB — 4 March 2009