The Colonial System & Its Impact – Part 1

Under the present system of management, therefore, Great Britain derives nothing but loss from the dominion which she assumes over her colonies. (Wealth of Nations, Book IV, Chapter 7, paragraph 151)

 

             Adam Smith in his seminal work on economic theory, The Wealth of Nations, wrote the above in the 1770’s. He was referring to the cost of nations supporting colonies in general and the American Colonies costs to Great Britain specifically. So why was the British government willing to support the American colonies in such a situation? Colonial expansion traditionally has three things to offer the state (as Smith calls the home country) first, raw land and what it could produce. Second, animal production which he distinguishes from vegetable production but could still in some sense be considered supported from the land. And third, mineral production.

             Smith discusses this three legged stool for supporting colonization in his review of Columbus’s discovery of the new world. He suggests that Columbus entertained the notion that he had discovered the lands of Marco Polo’s travels and all the rich trade long after it became evident that was not the case. Columbus needed to show that his discovery of the America’s, if not the vast hoped for lands did have some considerable value. Columbus could not show vegetable or animal produce that was exceptional at the time so he flattered himself that he had found exception mineral wealth, namely gold and silver. Smith suggests that in consequence of this representation “the Castile determined to take possession of countries of which the inhabitant were plainly incapable of defending themselves. The pious purpose of converting them to Christianity sanctified the injustice of the project. But the hope of finding treasures of gold [or silver] there, was the sole motive which prompted to undertake it.” (Wealth of Nations, chapter VII, prt 1, page 72)

Spain and Portugal scoured most the lands of the Western Hemisphere looking for the mineral wealth and in most cases initially ignored possible land wealth. There were some that were interested in non-mineral opportunities and these people saw early the potential of land. This allowed an opportunity to get something that was not available in populated Europe or Great Britain where serfdom and lifelong servitude with little chance for improvement was much more normal. But land with its possibilities was available in the new colonies of America, especially for British subjects. Smith suggests that agriculture is the proper business of all new colonies because the cheapness of the land gives strong advantages. Cheap land allows the production and sale of cheap produce which, because of the cheapness makes it possible to export. The colonies need manufactured goods which can be imported. So why Smith’s opening statement? He suggests that granted monopolies were a significant problem and one that lead to problems of cost and eventually revolution.
             The shopkeepers and other traders of England wanted to control the power of providing all manufactured and other goods to the colonies so as to capture what they saw as the wealth being generated. If the colonists could only spend their money on England’s goods then all the benefit would flow to England. Further, they enacted that the colonies could only sell their produce to England except in certain rare cases where they had to sell it to faraway lands that British merchants didn’t care about. Thus began early price control. Smith states that the maintenance of this monopoly was perhaps the sole purpose of the control by Great Britain over the colonies. He further suggests that any cost paid to maintain this control has been to maintain the monopoly for British shopkeepers and manufacturing.  To support the monopoly, Smith states that the state was willing to cover the costs of 20 regiments of soldiers and the expense of food, pay and military provisions, the cost of maintaining a naval force sufficient to discourage smuggling along the entire American and West Indies coasts.

Additionally, there was the cost of various conflicts with other nations including the Spanish war of 1739 which should also be included in the tab charged to colonial protection. So, Smith argues that all these costs are not offset by the benefits of monopolized trade gathered from the colonies and including any taxes collected. That is why Smith suggests that the colonies are a loss to Great Britain.
             In following papers I will explore Smith’s comments on alternatives to keeping colonies (and the benefits possible) and the motives of politicians. I think you will find them interesting and provocative.

Government Statistics and Raising A Child – How Not to Read the Data

             We got the call we have been hoping for from our daughter the other day. She said, dad, we have a foster child. Our daughter and son-in-law have passed all the tests and done all the preparation to be foster parents. They have been looking forward to the opportunity with excitement and some concern. Our daughter could have said, dad we have a foster child, now what do we do? But they didn’t. It is a little interesting because they were expecting an older child and instead have an 18 month old. A little different than they were expecting but we are all pleased and so are they. I have been thinking about raising five children (really Margie raised five children and I tried to be helpful and not cause too many problems) and the attendant questions and thoughts I had when first starting out. We are now looking at being empty nesters in just a couple of years.

             So, how did we afford to raise five children? Well, it wasn’t by reading the USDA reports on the cost of raising a child, even back when we started the process. A CNNMoney article titled “Average Cost to Raise a Kid: $241,080” as quoted by Melanie Hicken, August 14, 2013 on money.cnn.com states “From day care to the monthly grocery bill, the cost of raising a child is climbing at a rate that many families can’t keep you with.” The article says that a U.S. Department of Agriculture report released Wednesday (August 14, 2013) says the cost of raising a child from birth to 18 is up 3% from 2011, not including college to as much as $441,100 ($24,505.56/yr). The average cost is $241,080 ($13,393/yr). If we assume each child cost that much (the article doesn’t differentiate between one and several children) then Margie and I would not have been able to afford 5 children during the early years we had all of them at home on my salary.

             The problem with this kind of data and other related and interesting ideas is discussed in a new book I recently picked up by Charles Wheelan titled Naked Statistics Stripping the Dread From the Data. I find his writing informative, entertaining and thought provoking. It sort of reminds me of a book from several years ago titled How to Lie with Statistics by Darrell Huff. The premise of Wheelan’s book is that we need to use statistics correctly and if we do we can gain some important insights into our daily lives and what is happening to us. On the other hand he suggests that there are some statistics that if used incorrectly lead us to very erroneous conclusions or can even kill us. The above article is one of those cases that can lead to some very poor choices. One of Wheelan’s chapters is titled The Importance of Data: “Garbage in, garbage out”, another chapter is titled, Deceptive Description: “He’s got a great personality!” and other true but grossly misleading statements. I think you can see where I am going with these chapters from Wheelan. We need to be particularly careful in just reading the news headlines or even the actual article because the information may very well not give us what we need.

             So, for example, in the above article the discussion didn’t include anything about economies of scale, meaning the 2^nd child doesn’t need all new cloths or need a new bedroom for himself. Both “facts” the government study didn’t seem to take into account. In our case Margie was good at making the money fit the needs. For the record, you don’t need to spend $13,000 / year / child (the average). One article I found more helpful (“Cost to raise a child can be much less than USDA estimate” by Sarah Gilbert, June 14, 2010) suggests costs may be as low as $2,500 / year / child (for 3 children in this article). I think the actual total for each of us may be somewhere in-between. Which also makes sense as all of us do things differently. Again, the above statistics can give us an average but that may not be very helpful. If you are familiar with the Phantom Tollbooth by Norman Juster, in one of his encounters the hero meets the fractional child from the average family. This is kind of like that, the average cost of raising a child is not likely to really give you much helpful or useful information.   

Mark Twain famously remarked that there are three kinds of lies: lies, damned lies, and statistics. I think we could also say something like that about data. There are three types of data: data, damned data, and statistics. That is important to remember whenever you are presented with the “facts”.

Playing in the Sand Pile – Observations About Sand in Your Shoes – Part II

             I really am more organized than I sometimes seem. I had an outline of the topic I wanted to write about tonight. I started about four hours ago thinking I would be done in an hour or so. Well, it isn’t an hour later (as my previous sentence suggests) and I deviated quite a bit from the original outline. However, I feel that I need to lay this groundwork tonight. I cannot over emphasize the importance of being wary of economic and financial models or money schemes or the best investment you could ever make. Regardless of what Ben Bernanke (of the Fed) or Tim Geithner (of the Treasury Department) or leading economists (with lots of letters and abbreviations behind their names) or your neighbor (it is such a hot tip) or your best friend or a member of your religious congregation or your financial planner, tells you - be suspicious (in a nice way if you think you need to).     

             Previously we touched on the idea of the sand pile effect in nature and modeling. It includes such  concepts as nonlinearity and the critical state, is often known as complexity theory and sometimes called chaos theory. These ideas and concepts are discussed by Mark Buchanan in his book Ubiquity Why Catastrophes Happen, who we looked at briefly last blog and Nassim Nicholas Taleb in Fooled by Randomness who we have discussed several times.

             Let’s illustrate nonlinearity. Suppose we are enjoying a day at the beach with nothing better to do than build a sand tower as high as we can. As the tower increases with each bit of sand we add there comes a point that one more bit of sand causes the entire tower to collapse and slide down. This illustrates a nonlinear effect resulting from a linear force exerted on an object. Our tower suffered a disproportionate collapse from a very small additional input, namely a little bit of additional sand. It the sand pile would have reacted in a linear fashion we would have expected the small bit of sand to have a small impact. There are some idioms that incorporate this idea, the straw that broke the camel’s back or the last straw, or the drop that caused the water to spill. I can remember my father saying something like “that was the last straw” as he explained to me why I was being punished for what I thought was a fairly minor infraction and not worthy of the severity of the particular punishment I was receiving.

Taleb suggests that the nonlinear dynamics has what he calls the bookstore name of Chaos Theory. Taleb further suggests this is a misnomer because the theory has nothing to do with chaos or randomness instead, chaos theory does concern itself mainly with functions in which a small input can lead to a disproportionate response. A little bit of sand generates a massive sand slide. Buchanan suggests a slightly different but similar definition in his comment on what he calls the critical state. He says it represents “…a special kind of organization characterized by a tendency toward sudden and tumultuous changes, an organization that seems to arise naturally under diverse conditions when a system gets pushed away from equilibrium.” Buchanan says this is the first landmark discovery in the emerging science of nonequilibrium physics. Remember he is science writer and has a Ph.D. in theoretical physics.

             Look at the sand pile example again. Suppose you were to apply the nonlinearity principle to your commute home. A trip could take from a few seconds to months. Or suppose you are coming to the corner of the street. What is the likely height of the next person to come around the corner towards you. If we are in the sand pile the person could be from inches to miles high. Yet we have examples that follow this nonlinearity. Why is Bill Gates so rich. Is it because he is an intellectual giant compared to the rest of humanity. Or perhaps he is so much more intelligent than the rest of us. He may very well be of above average intelligence and superior work ethics and have high personal standards. But is he so much better as to deserve to be so wealthy. An element of nonlinearity or luck would better account for it. Economies, markets and social arenas tend to be nonlinear.  There really isn’t a mathematical model that can successfully model this type of activity. The model has to have a random element. Having said that, there are many who try to model parts and bits of things but the full, rich experience which makes up the world around us is difficult and complex. Think of weather models, how successful are we in predicting how much rain will fall on our backyard tomorrow, then one month later. If weather was linear we should be able to predict both time periods with great accuracy. Taleb suggests that one reason we get in trouble with economic and financial models is that some “…intelligent people who felt compelled to use mathematics just to tell themselves that they were being rigorous in their thinking, [and] In the great rush [to develop models] decided to introduce mathematical modeling techniques… without considering the fact that either the class of mathematics they were using was too restrictive for the class of problems they were dealing with, or that perhaps… the precision of the language of mathematics could lead people to believe that they had solutions when there were none.“  The purveyors of economic and financial models may try to convince us that their models do include enough “mathematics” to describe the particular situation but from our examples of tonight it seems very unlikely that the models will stand any test of time or uncertainty.

Playing in the Sand Pile of History – Part I

             A problem in modern economics has been the unpredictability of things. A cacophony of voices have tried from the beginnings of civilization to predict the next big thing. Just imagine the problem an Egyptian stone mason had trying to figure out the next big pyramid job. How was he going to know what and when to order stone so the competition didn’t get the jump on the big contract. Mark Buchanan in his book Ubiquity Why Catastrophes Happen tackles the problem head on and in my mind with that single mindedness of the scientist convinced that there is a mathematical equation somewhere that will hold the answer to life, the universe and everything. Those who model these chaotic systems talk about complexity and the greater problem some call upheavability. Buchanan suggests that chaos is limited in its ability to explain extreme events (I would say Black Swans – you recognize that term) because many models do not generate upheavals.

             Buchanan is good enough to suggest that predicting the long-term future of any chaotic system is practically impossible. I will suggest that it is presently quite unlikely that current models and modeling techniques will successfully model financial and economic systems with any degree of success or accuracy. Further, what little successes we may have is inversely proportional to model time horizon and the complexity of the system.  We will tend to have limited modeling success in the short term with simplistic systems. However, Buchanan does have some interesting suggestions for looking at complex systems which I think may help in understanding both the complexity and the pitfalls inherent in economic and financial modeling. He uses the term critical state to suggest  a special kind of organization characterized by a tendency toward sudden changes, maybe radical changes. Using his physics background he suggests that instead of trying to find mathematical equations to describe these complex systems that an alternative is to use mathematical games, much simpler equations, to understand specific portions of complex systems. We are going to explore one of these modeling technique, the sand pile, in later blogs. Today we need to set some parameters.

             We need to look at some basic principles regarding modeling and models. I want to start with what Emanuel Derman and Paul Wilcott, financial quantitative analysts, term the Modelers’ Hippocratic Oath. Derman and Wilcott are considered part of the elite group of financial modelers and have been in the financial industry before, during and after the great recession of 2008. Many feel that quants as the financial modelers are known are responsible for the severity and length of the recession and its attendant losses. In many respects this is accurate. Derman and Wilcott’s Oath shows some of the problems inherent in trying to model complex financial systems that many people seem to forget. Models are tools – blunt, limited, and easily breakable.

 Modelers’ Hippocratic Oath

·       I will remember that I didn’t make the world, and it doesn’t satisfy my equations.
·       Though I will use models boldly to estimate value, I will not be overly impressed by mathematics.
·       I will never sacrifice reality for elegance without explaining why I have done so.
·       Nor will I give the people who use my model false comfort about its accuracy. Instead, I will make explicit its assumptions and oversights.
·       I understand that my work may have enormous effects on society and the economy, many of them beyond my comprehension.
 

             I have a copy of this hanging by my desk. Any time I encounter a financial or economic model or a discussion of one I look at the oath and attempt to see if the author / originator has applied all the points to his model and the information I have about it. If there is any part of the oath that I suspect the author did not consider or incorporate in his model I am immediately suspect of the model, its conclusions and most of all its recommendations. All financial and economic models are suspect, period. Always assume there are errors in the model. Errors in logic, in assumptions, in data points included and excluded, in the equations, and in conclusions. Once you have looked at a model in this light it can be reviewed and analyzed to see if there are portions that may have some value. If you get the sense that models are potential death traps to your financial health and to the forecasting of economic conditions, that is accurate. One doesn’t have to be able to break down models to their component parts but one does need to realize that every model has problems, many of them significant problems. What is a person to do, be very skeptical of the output of any financial or economic model and run away from anyone who says, “trust me, you don’t need to know what is in the ‘black box’ “. If the person can’t or won’t explain the black box (for example, a new financial product guaranteed to get you 25% return in today’s environment) you don’t want to be involved, ever. Remember the old adage, if it’s too good to be true it probably is.

             Next time, how to look at a sand pile –  what can we learn and how can we use it.

The Black Swan – Story Possibilities (Part IV)

             We have spent a few posts looking at Black Swans in economics and politics. Look at them as possible story lines or back story items. This can be either in world building or single situations. Can the reader see it if seen from the correct angle? For example, one can see a Black Swan if one is the Thanksgiving turkey (see Part I – Are We Unknowingly the Turkey) but there really isn’t any Black Swan from the farmers standpoint. The turkey is dumbfounded but the farmer is full and satisfied. Is the reader the turkey or the farmer?

             L.E. Modesitt, Jr.’s series titled The Ecolitan Matter consists of four books; The Ecolitan Operation, The Ecologic Secession, The Ecologic Envoy and The Ecolitan Enigma. These books explore economic, political and ecologic ideas and concepts. I highly recommend all four as a good example of economic and political ideas. The books were written from 1986 through 1997, during a time of several stock market crashes (1987, 1992 and 1997), political upheaval and a renewed concern for the environment. I will admit it is not hard to write books during times of stock market crashes since they tend to happen every four to eight years. Modesitt does a masterful job of including economic and political problems into his stories. I find Modesitt’s use of economic and political principles very well done and very true to form. Notice how he leaves much of the material as back story or world building materials but enough is in the stories to make it easy to follow and enjoy. He doesn’t burden the reader with too much detail.

             Remember, economics and social sciences are full of Black Swans. It is their very nature to be uncertain and unpredictable. Review The Black Swan’s Mask (Part II) to see how we rationalize our incorrect or missed predictions. Can a story be developed from looking backwards through our missed prediction to a situation (reverse the process by creating an outcome and looking backwards through a false prediction to the original situation- which may be incorrect). Remember every world is full of floods that happen only once in a 1,000 years. In The Black Swan – but I saw that Coming (Part III) we looked at the outlier and the uncertain or unknown nature of such.  Again, the most important point is that economics and political science are not true sciences in the way we think of science as being measurable and predictable. Both are full of Black Swans, the unknown and unknowable. Use that to your advantage.

The Black Swan – But I Saw That Coming (Part III)

           We have spent a couple of posts looking at the problem of the Black Swan – the impact of the highly improbable. We have discussed the turkey and the Thanksgiving feast in part 1 of this set. One doesn’t want to be a surprised turkey. We have looked at the problem of induction or inductive knowledge which includes how can we logically go from specific instances to reach general conclusions. According to Nassim Taleb there are traps built into any kind of knowledge gained from observation. He also suggests that those who believe in the unconditional benefits of past experience cannot project into the future. Remember back to our turkey example, was the farmer surprised by the outcome?

           Having made the above observation, I will say there are some situations where we can use past experiences to draw conclusions about future observations. Suppose you are asked to find the average height of the all men in the United States. You could take a sample of say 10,000 men and draw some fairly detailed conclusions. You would be able to take that data and make some conclusions regarding height of men in general. Now if you were to measure one more man from the population in general your estimate of his height would likely be within the parameters you had established. The same would be true for weight. Another way to state this is, one more observation will not significantly impact the predicted results. Now suppose you sample people who are worth more than $10 million. Let’s suppose that your sample does not include Bill Gates. Your sample size may be quite large, relatively speaking, but if it doesn’t include Bill Gates then as soon as Bill Gates is included in the analysis we have a Black Swan situation. A deviation so large that it blows up the study. So, you decide that Bill Gates must be an aberration… (sorry, let me be specific, in the data only), and toss that data point out. Then the next data point you sample includes Steve Job’s estate. The difference between sampling height and let’s say millionaires is one set of data follows a bell curve (predictable or regular) or a variation of such things and one doesn’t. Many who have studied this feel that economics and social sciences cannot be defined by bell curves and its like. Many in econometrics feel that the world can be defined by regular occurring events or activities. Taleb suggests that “a nerd is someone who thinks exceedingly inside the box” or is blind to Black Swans.

           Some other themes arise from our blindness to the Black Swan. Again I turn to Taleb and his book, The Black Swan the Impact of the Highly Improbable. He suggests the following ideas. We tend to focus on preselected segments of the seen and generalize from it to the unseen. We fool ourselves with stories that cater to our thirst for distinct patterns. We behave as if the Black Swan does not exist, human nature is not programmed for Black Swans. What we see is not necessarily all that is there. History hides Black Swans from us and gives us a mistaken idea about the odds of these events. We “tunnel”, that is we focus on a few well-defined sources of uncertainty at the expense of the others that do not easily come to mind.

           As you listen to the news and look at economic projections remember that economists and their associates are working in a world full of Black Swans or full of Bill Gates type situations. It is important to realize that studies done on how successful economists have been in their predictions have shown economists have an exceptionally poor track record of being able to predict things. Just because an economist is able to show past data to support his position may have little or no relationship to future events. It all depends on where the Black Swans are.

The passing of my father

Two weeks ago tomorrow our family laid my father to rest. He was buried with full military honors in Logan, Utah. He was 86 years old, a good age and had lived a good life. I have spent the last two weeks thinking about and reviewing his life and my own. It will be some time before the heartache of his loss subsides. I suspect it will never go away but will fade and will, in time, become just a dull pain. I am grateful for him, his teachings, his life and his example. I know many are also feeling his loss acutely. We can take comfort in knowing that God loves us and that families are in fact eternal. Life is good. My father knew this and I know it too.

My regular blogs will continue tomorrow. Thank you.

The Black Swan’s Mask (problems in induction) Part II

           The marvels (for me anyway) of technology and the benefits of a good internet connection make it possible for me to be in Arizona visiting my grandchildren and their parents. We spent the afternoon at Pima Air Museum where I listened to a marvelous docent, Mr. Miller, tell stories and share experiences from his time in the air service and relating stories of others from earlier times. I marvel again at the willingness of our service people to lay their lives on the line for our great country. I am grateful for their service and sacrifice. I was thinking how it must have felt to live during 1937 – 1939 and watch the world unfold. From our standpoint now in history we know that Germany was going to war, Italy and Japan were gearing up for war and the world was set for an awful time to come. I remember reading that the correspondent William L. Shirer who wrote what is considered by many to be one of the definitive works on Germany’s Third Reich, The Rise and Fall of the Third Reich, was living in Germany during much of the 1930s. If I remember correctly he said that even for those living during that time in Germany and who had a grasp of world events such as a print journalist like himself, didn’t fully grasp what was happening. He and his associates didn’t predict war any better than the others in government, economics or any other branch of science or social science. History tends to look back and say, how could you have missed that. All the signs were there?

           I experienced the lead up and the effects of the recession of 2007 – 2009 from a unique standpoint. I am directly involved in investment banking and many feel that this industry is a big part of the problems that caused that recession. I think the sentiment has some validity. However, most of the leaders or men of knowledge in economics and investment banking never saw it coming. Again, there are some who did see something and made a lot of money on the fact that they felt something was out of alignment in the economy. Again, if one looks at much of the literature on this recession we see individuals drawing conclusions and wondering how we could have missed it. I was in the thick of the information so to speak and I didn’t see it coming. Government leaders, economists, most investment bankers and Wall Street types didn’t see it. We now have Frank-Dodd legislation which runs into hundreds of thousands of words and is so convoluted that we as a people will never fully understand what it does nor do the writers of the legislation really understand its workings or impact. This is supposed to guarantee that we won’t have another financial situation like this happen again. Trust me on this one, it will happen again

           Let’s look at how we rationalize our incorrect prediction (or missed predictions). This is how we protect our self-esteem according to Taleb in his book The Black Swan, where he suggests four methods of rationalization. (1) Tell yourself that you were playing a different game. It is not your skills that are to blame. There is some hidden information or element that if you had known you would have been right. (2) You invoke the outlier. (This is what is generally used by the economists and math guys to explain the recession of 2007 – 2009.) Something happened that was outside the system. Given that it was not predictable you are not responsible. Hey, it was a 1,000 year flood, of course I couldn’t predict it. (3) The “almost right” defense. By looking backwards we assign values after the fact to ideas or events thus applying more or less importance to things, activities, happenings or events. After the fact we say this piece of information is important and this is not. (4) The hedgehog and the fox from Isaiah Berlin and Aesop’s Fables. The hedgehog knows only one thing and tends to exclude all other thoughts and ideas. It may be a single consequential but improbable event. This helps make us susceptible to Black Swans. The fox knows many things and is not married to one idea or course of action. The fox has an open mind (not empty but open) and tends not to get married to one idea. The fox knows history will be full of improbable events but just don’t know what the events will be.

           So, be a fox with an open mind.

Are We Unknowingly the Turkey (the problem of induction) - Part I

           The next couple of posts will explore the idea of how to learn from the turkey or the problem of induction or inductive knowledge as discussed by Nassim Nicholas Taleb in his book, The Black Swan The Impact of the Highly Improbable. I have referred to this book before as it has what I consider some highly insightful and provocative concepts, thoughts, and commentary relating directly to economics and finance. This problem also directly relates to the Black Swan phenomena as discussed by Taleb in his book mentioned above.

           The problem  of the turkey can be seen in the following story. Suppose you are a turkey and today the farmer comes to your pen and feeds you. Initially you think to yourself, this is interesting I wonder what is going to happen tomorrow? By the 14^th day of feeding you are thinking this is pretty good. By the 50^th day of the same activity you think this feeding thing is really great. I am going to brag to my friends about the farmer. By the 250^th day you have forgotten that you ever worried about food. By the 350^th day you feel you are entitled to being feed. You can look back on a long history of consistent feedings, it has always happened. No change, no difference. You expect tomorrow to be just the same as every other day, why wouldn’t it be? Tomorrow comes. The farmer has an ax- it is the day before Thanksgiving. You were not expecting that! The consequences of underestimating the impact is significant for you (the turkey). This is the problem of induction. Do past experiences or histories allow us to predict future events and activities? How do we know that what has been observed will be sufficient to enable us to figure out the properties of what we have been observing? Taleb poses several questions including; one, “how can we know the future, given knowledge of the past; or, more generally, how can we figure out properties of the unknown based on the known?”, two, “how can we logically go from specific instances to reach general conclusions?” and three, “How do we know what we know?”

           As I write this I am listening to the song “Russians” by Sting from Dream of the Blue Turtles album. The lyrics discuss the problem of believing what the Russians and President Regan say regarding the atomic bomb. At the time this was released in 1985 nuclear annihilation was a great concern. Both governments had the ability to destroy all humanity several times over. I remember being in school in the late 60’s and having air raid drills where we got under our desks. However, just four years after the song was released in 1989 the Berlin Wall was breached and by 1990 was torn down. By 1991, Mikhail Gorbachev had overseen the dissolution of the Soviet Union. Who predicted from past Soviet actions culminating in 1985 that six years later there would no longer be a Soviet Union, as such? No one. In 1973 I was studying military tactics in ROTC which included the most effective ways of destroying Russian tanks. In 2003 my son Daniel served an LDS church mission in Rostov, Russia, the place where they built the tanks I learned how to destroy in 1973. I never imagined in my wildest dreams in 1973 that one of my children would be in Russia on a religious assignment teaching the peaceable elements of Christianity in a former Communist country. This is a positive induction problem.

           Let’s further consider the problem of the turkey. Was the farmer suffering from a problem of induction? No, of course not. He knew exactly what was happening. Such problems can be very one-sided and it is critical which side we are on. In the following posts we will look at some specific examples of the problem of induction relating to recent financial and economic problems and some ideas for handling the problems. Additionally, I think there are some applications for world building that I hope will be interesting and helpful.

The bad dreams spawned by thinking about taxes and tax filing

I realized I haven’t done my taxes yet. Usually I have them done by now; the refund deposited and much of it spent. The reason for my procrastination is that I may owe something this year. I don’t know that but the thought makes me ill.I hate it with a passion reserved for few other things. I don’t think I would feel so strongly if I thought the Federal government would or even could use the funds wisely but having watched the latest shenanigans in Congress (even at our own state level) I just don’t have much confidence. We seem to lurch from one crisis to the next like a drunken sailor. Congress seems to careen from one short-term “solution” to the next, apologizing with a drunken smile at each injustice and injury but never thinking that the real solution might be to get sober. There is a good horror story here but I like horror stories to be fiction not true.

A new favorite author I have been enjoying is Nassim Nicholas Taleb. He writes The Black Swan, Fooled by Randomness and his new book, Antifragile. I have referred to some of his thoughts in previous blogs and will continue to do so in future blogs and comments. He has many comments on politicians and their actions. My own thinking tends to lean towards the thought that about the only way a politician seems to be able to justify his existence is by either spending money, creating a new program, increasing the welfare rolls, or creating a new regulation. One of my favorite examples is the TSA and airport security. A multi-billion dollar agency has been created to make a visible statement that something is being done. It doesn’t matter if the activity is helpful or hurtful, just that there is activity. What constitutes success here? The number of people embarrassed, the length of lines, the amount of money spent, the number of new Federal employees, the number of laptops stolen from the screening areas? The real hero here is the person who came up with the reinforced steel door for cockpits and the rule that pilots stay in the cockpit in any emergency situation. That person deserves a medal but will probably never be recognized and may not even be known. Dad tells a story that happened fairly soon after we had moved to Logan. Several of the neighbors thought it would be good to have street lights on our block. The families along to block got together, did the research to find what needed to be done and raised the money for the streetlights. The city people offered to install the lights because they had all the right equipment needed to do it correctly. When the job was done the local newspaper found out that a citizens group had improved their neighbor. As I remember the story a little ceremony was scheduled and who should show up but the local politician to be photographed and included in the story. He wasn’t involved in any other activity than the picture and story.

So in your writing, make your politicians believable. Whether that means a good guy or a bad guy depends on what you need. However, in my current frame of mind you are really going to have to work at making me believe a story with a good politician. Now, if you wanted to include one that didn’t do any work and only shows up for the ribbon cutting I have just the reference materials to help you.

A busy week but well worth it

Have had a great past week but boy am I behind on regular things. I was able to spend 3 days at LTUE last Thursday through Saturday. My daughter Emily and I had a presentation on Friday that I thought went particularly well. Emily is really amazing. Go check out her website/blog. I have a link on this blog. I will start a new economics/finance topic here next week. However, I have to now get caught up on work and regular projects I let slip as I was preparing for and enjoying LTUE .

What is your risk level (part 4)

Government is designed not to lose & Risk summary

             Now think about a typical government department or function. How is success measured for government functions? What constitutes doing a good job? How does one do a great job? What is likely to happen if an individual tries something new and fails? As you think about government functions are they graded on how much money is made or is it on how much money is not lost. I believe that for government functions the goal is not to make money but to not lose it. A typical government function is not graded on succeeding but on not failing. It tends to not matter how many things go right but how many things go wrong. One failure can wipe out a multitude of successes. Think of government as a defensive function not an offensive innovation. If one is trying to win a battle are all the soldiers given shields (government) or are they given swords (private sector)? The army with swords may lose some men but will likely win the battle. The army with shields will not have the ability to win, only possibly not to lose. In government there will not likely be innovation, improvement, or  profit motivations. There will be support for status quo, minimization of failures, and entrenchment (defensive positions). I believe governmental officials tend not to be rewarded for taking risks (swords) but for not failing (shields).

             This underlying philosophy has serious implications. In general, innovation, new products and wealth generation come from the private sector not from government. Why, because innovation generally involves risk taking and the very nature of government is to avoid risks.

             As a general review, we discussed risk averse and risk tolerance and some ideas that show that the magnitude of the impact of an outcome can affect or view of the results. Many small impacts may not bother us as much as a few large impacts, especially negative changes. We looked at some evidence which supports the observed phenomena of the diminished capacity of the adolescent male brain as it approaches the 12 to 13 age range (which seems to reverse itself in most cases by the early 20s). The risk  that one does not know they don’t know can have significant ramifications. We looked at some examples of risk as it applies to specific outcomes and risk as it applies to ranges of activities or outcomes. We observed the distinction between private sector and public sector (governmental) risk taking and its possible impact.

            It was suggested that risk tolerance or avoidance could be used in character and story line development. Probability, the risks of uncertainty and of the unknown unknown could also apply to character and story line plots but may also be applied to world building and back story development. Such risks can be used to shape societies, cultures and even species or races. Can societies change their risk perception? Does a society by its nature lock in risk levels or understandings so that the individual must struggle to break free of norms expected behavior? Are risk traits inherited or learned, by an individual,  group or race. Does environment effect risk perception and action?

             Let me know your thoughts and ideas.

What is your risk level (part 3) update

There are different types of winning …. and losing

              Let us start with a quick review of how we perceive risk from part 1 and expand on the concept. Risk can be related to volatility. High risk can imply great or high volatility in relation to expected outcomes or solutions. Suppose a desired outcome is winning exactly $5,000, what is the likelihood of getting our desired outcome if the possible range of outcomes could be from $10,000 to -$10,000 with an equal chance of any integer on a single draw. Low risk suggests predictability or stability in the expected outcomes or solutions i.e. if our desired outcome is 1, what is the likelihood of drawing 1 (on a single draw) if the values available are between 2 and 0. In our first example, if we need to get $5,000 we will be very disappointed because the risk is so great that we will not get $5,000 (the odds are 1 in 20,000). However our upside potential (risk of getting equal to or more than $5,000) is much better. Our odds have improved to 5,000 in 20,000 or 1 in 4. We may be disappointed with the selection but not unhappy with the outcome.

             Risk can also relate to a specific outcome and the probability of that outcome. Assume option 1 has a 25% probability (1 in 4 chance) of making $1,000 and a 75% probability (3 in 4 chance) of making $0. Assume it costs $250 to participate. Remember, in business, finance and especially in investing there is always a cost to participate, if someone tells you there is no cost keep looking until you find it (I will get off my soapbox now). Option 2 has the same cost to participate but the probabilities are reversed. Now it is a 75% probability of making $1,000 and only 25% probability of making $0. Option 1 is substantially more risky than option 2. The risk is not in earning an amount different than the desired outcome ($1,000) but the likelihood of realizing or getting the desired outcome.

             Many business risks deal with a range of possible outcomes from very successful to significant lose. However, the payout or benefit of a successful outcome may be so great that the risk may be considered acceptable. Conversely, the cost of failure may be relatively small so that any lose is not particularly damaging. A business may be able to sustain a number of relatively small losses if the occasional success is great enough. In that case a risky venture, meaning a venture with significant volatility, may be not only acceptable but quite profitable. If one is accurate in predicting the probability (likelihood) of the possible outcomes then the risk of the unknown happening is greatly reduced. If one is uncertain of the possible outcomes then the exposure to risk can become enormous.

             We generally see that in order to generate the maximum possible wealth a certain amount of risk is usually involved. The very definition of increased risk as we discussed earlier, that results vary significantly from expected outcomes, suggests that there is likely a large element of the unknown or even unknowable in such situations. By 1985 Steve Jobs was cofounder, chairman and CEO of  Apple Inc. However in that year he was booted from the company. Many at the time may have thought that Jobs was done or finished. But by 1997 he was de facto chief of Apple Inc. again. In between 1985 and 1997 he had started another firm, NeXT, and acquired the computer graphics division of Lucasfilm which he spun off as Pixar. After returning to Apple in 1996 he is credited with helping engineer the turnaround of Apple and creating new products and innovations that made it the most valuable publicly traded company in 2011. Jobs must have been exposed to an innumerable number of risks. Many of them were likely negative but several were positive or upside risks.

          Next we will look at government and risk perception and some final thoughts.

What is your risk level (part 2)

Is your gut leading you astray or is it your salvation

             In this part we will look a little further at risk as it relates to making decisions and at some thoughts on the perception of risk. Risk can have an empirical basis, originating in or based on observation and testing or it can have what I will call a theoretical basis, based on guess work or perception. Assume you are an adult Scout leader out camping and want to build a fire. You know that the closer you get to the fire the warmer you get and if you stand in it there is a strong likelihood of being burned. You decide to sit near the fire but not in it and enjoy the warmth and light and also minimize the risk of falling in and getting burned. Now assume you are 20 years younger, a Boy Scout and with other scouts. Your scoutmaster has just told you not to play around the fire because you may get burned. You immediately reason with yourself that you have never fallen into a fire, been burned nor seen your friends suffer burns from a fire. Therefore you conclude that while it may get warmer as you get closer to the fire you will not get burned. So you and several of your fellow scouts decide to play a game of tag around the fire because there is plenty of light and it is easy to see one another plus as an added enjoyment it’s fun to jump over the flames as you try to catch your companions. The scoutmaster visibly ages and suggests that tag should be played somewhere else, not around the fire. It just doesn’t make any sense to you as a scout, why would you want to play anywhere else other than around the fire. Everything is completely under control. What is your risk level as an adult leader and as a Scout? How does your perception of risk change with additional observations, experience or more data?


RMS Titanic

         An additional factor relating to empirical risk relates to a false sense of security from limited observations or results. Although at the time, the observations or results may have seemed complete and conclusive. Nassim Nicholas Taleb in his book, The Black Swan – The Impact of the Highly Improbable has the following quote on page 42, “But in all my experience, I have never been in any accident… of any sort worth speaking about. I have seen but one vessel in distress in all my years at sea. I never saw a wreck and never have been wrecked nor was I ever  in any predicament that threatened to end in disaster of any sort.” E.J. Smith, 1907 Captain, RMS Titanic. Risk can be hidden, missed or not understood but that does not mean it is any less real. What we perceive as the level of risk may or may not be all inclusive or even sufficient to allow for a reasonable analysis. Look back to the financial crisis of 2008 and the collapse of home prices. Most thought that home prices would not only keep increasing but more importantly would not fall. Many individuals planned for the risk of home prices not increasing. The hidden risk was in not fully weighing the impact of the possibility of decreased prices. Or like our good Captain, the risk of an iceberg that could pierce several watertight compartments on a ship.
             Risk then has many facets. Are you comfortable with not only what you may know but that you likely don't know something important.

What is your risk level (part 1) update

             Let’s try a thought experiment. Suppose you have an opportunity to make $1,000 by investing in a pool. However it costs $250 to participate in the opportunity. Let’s further suppose that the likelihood of making $1,000 is one-in-four times that you participate. Each time you participate you will lose your  initial participation fee of $250. Would you participate in this investment opportunity? If you knew that once in every four times you participate you will make $1,000 would you try. What if you thought that you might be successful on one of the first three times you participate? You may be from $250 to $750  ahead. You could then stop investing and take your increase. From a statistical perspective you would be indifferent on your chances of recouping your costs. You know that regardless of what happens, you can recoup your funds if you participate four times, assuming that the investment opportunity is really as you are told.  However how would you react if you had an investment opportunity that would return $5,000 one in every four times you participate but the participation fee is now $3,000. How do you feel about participating now? If you are not successful  the first time you invest you will lose $3,000 but if you invest again and the investment is successful you will have only lost $1,000 ($3,000 cost x 2 less $5,000 payout). But if you are unsuccessful you will have lost $6,000. Do you take your $3,000 loss or try to reduce your lose by investing in the pool the second time. Of course if your investment is successful on the first investment you have $2,000 in net funds over your initial cost.
              Now assume that instead of $1,000 as the potential investment earnings it is $1,000,000 and the cost of investing is $250,000. How do you feel about your investment earnings? Do you feel a bit more reluctance? Realize that the actual statistical odds have not changed but you may not feel as comfortable about this investment because you can’t afford to have to pay the cost more than once. Risk can relate to financial, economic, emotional, physical or mental situations. At what point are you uncomfortable with the level of risk in a particular situation? Or in other words, what is your risk level, are you risk adverse or risk tolerant?

             In the financial world advisors will suggest that you invest your money in a mixture of stocks and bonds. This is to spread your financial risk. You don’t suffer a devastating loss as the stock market falls but you don’t get the full benefit as it climbs. You hope that you get some positive benefit but it will be less than the possible maximum. There are ways to potentially blunt the impact of market gyrations. As in all situations, solutions can be complex or simple, wildly profitable or financially devastating or even breakeven (and you have potentially been on an emotional rollercoaster for no real benefit).
             In world building, the development of backstories, or story lines there is an opportunity to add depth to characters, groups, societies or races by developing and incorporating risk tolerance (or lack of tolerance) or risk reaction components. Characters or groups don’t usually weigh the odds of an action with a mathematical formula but they could subconsciously be influenced about how they perceive risk. The level of risk a character may be willing to assume will affect their reaction to situations. Is a character a rogue with a devil may care attitude (risk taker) or are they cautious and unwilling to expose themselves to danger (risk adverse). Will a risk adverse character get trapped by their failure to act or saved by their caution. As you consider character development consider the risk reactions for that character. How will they react based on their risk aversion or risk tolerance? How might they stay consistent, what would cause them to change their willingness to assume or shun risk. How or why might their risk reaction change. You can ask similar questions of groups, societies and races.

 

Hello & Introduction

This is the start of something I hope will continue for some time. I am going to try to write a short piece every week or two on a financial or economic principal. My hope is to give some ideas or concepts regarding these principles that could be used in story lines to give background data or story ideas. My training, background and work experience is in finance and economics. I have spent more than 20 years in public finance and an additional 13 years in utility or government settings.

I enjoy reading science and fantasy fiction and am very interested in the cultures and societies authors develop to support, add depth and create story lines in their books. I find that a story is much more interesting to me if the culture and society support and flow naturally within the story line. I think it adds real depth and color as well as points of potential conflict and action. It is not necessary to have extensive passages detailing this information but it is important for it to be consistent and plausible. I consider some of the finer authors in this area to be Frank Herbert and Dune, Issac Asimov and Foundation Trilogy, Larry Niven and Jerry Pournelle and The Mote in God's Eye or Ringworld series, L.E. Modesitt Jr. and The Saga of Recluse series, The Imager Portfolio series or Empress of Eternity (just one of several of his stand-alone science fiction books) or Brandon Sanderson and Mistborn series (again one of several examples). As always this list is not meant to be exhaustive but just a sampling of some older and some newer.

I believe that Dune represents a minimalist approach to a society while L.E. Modesitt Jr. and The Saga of Recluse is an example of a consistent richness in society as story lines are woven through its several volumes. In my mind Frank Herbert has one of the most successful societies that is not detailed. Herbert is able to give just enough clues that we as readers fill in the unwritten information and give it a richness far beyond its words. Herbert gives us the direction but we supply the color, smells and sounds. How many of you have practiced walking on sand or can smell the spice or the sietch with your mind's eye or senses. I think we can see a similar phenomenon in J.R.R. Tolkien's works. Again, it isn't necessarily what is described in detail but what is implied or hinted. As readers we are drawn into not only the story but the society and cultures. I think L.E. Modesitt Jr. uses a a little different approach in his series. The Saga of Recluse series have both society and culture richly developed. Here Modesitt weaves all the aspects of several societies and their interaction with one another. He weaves the conflicts and opportunities as cultural borders touch and interact. He maintains the various societies and cultures throughout the series as the stories flow through generations and times. It you want to know about different forms of government and how they may interact follow the societies in Modesitt's volumes. As an economist myself I find Modesitt's treatments fasinating and insightful.

My desire is to attempt to provide some background materials on financial and economic theories, hypothesies, ideas and concepts that may be useful in story lines, plots and background development. We will have to see if I am sucessful.