Friday, April 18, 2014

Are Markets Better Described as Robust than Efficient?

Something that I think all of us with private sector jobs experience in our day to day lives is just how incompetent a large number of private businesses are. These may be our customers, suppliers, or another division. Yet, somehow, these businesses thrive despite not really having a good grasp of basic administrative procedures, financing, or sometimes even customer service.

Despite this, we often write and speak of private sector actors as if they are brilliant and efficient individually, despite the experiences of our everyday lives.* We simply assume as a result of mere market success that a business or individual has ability and competence. This isn't surprising, the just world hypothesis is a powerful cognitive bias which leads us to believe that the system as a whole must be more just than what our individual experiences would lead us to conclude. However, there is no property of the market system which should lead to this belief.

What's more notable is how little this impacts how we think about the market system as a whole. After all, given an immortal, perfectly rational, and omniscient central planner even the worst designed communist system would work beautifully. What's remarkable about the market system is that it should lead to ever increasing levels of productivity and efficiency even if the individual actors are all completely incompetent. Competition and creative destruction should lead businesses to be ever better even if they only differ due to random variation alone.

Yet, somehow this doesn't seem to impact how we think and write about markets and how they reward people much at all. Instead we often read in the popular press views about how market success means that an individual or business possesses unusual ability or competence despite the dearth of well established causal links between market success and any particular ability or trait. Creative destruction works as more of an evolutionary system, simple selection will lead to new forms to suit the environment they're in without the need for any conscious planning.**

An example may help illustrate this. The need for a common computing platform caused the market to require that a single operating system would predominate. In the early years of innovation in the personal computer market a wide variety of operating systems developed, all with a business plan that was more or less plausible. It was inevitable, however, that only one of these would dominate the industry due to the structure of the market. Someone was going to make billions, and did, but the need for a common platform meant that this would have happened whether or not any of the competing platforms exhibited even the barest level of competence. In addition, once established the need for interoperability mean that structural factors dominate any actual characteristics of the competition.***

This makes me think that markets might be better described as robust rather than efficient. The incredible thing about markets is that even if all the individual actors are morons the systemic factors will still lead to good outcomes, unlike other forms of human organization. But somehow this doesn't break into popular discussions of markets at all, much less into discussions about how our market system is distributing the fruits of our labors. I'm not sufficiently well versed in economic literature to know whether or not someone has done work on this, but I'm very curious if anyone has tried.

Tuesday, April 1, 2014

Overhead Allocation vs. Theft

I was reading Dean Baker's excellent post today on high speed trading. My initial reaction was that this was simply theft, high frequency traders supply absolutely no value to anyone but reduce the gains made by legitimate traders.

The first comment, however, made me think. SteveB asks "I don't understand how the tax solves the problem. Wouldn't it just increase the spread between buy and sell prices, and make the exchange even less efficient?" This would be an instance where the government and private thieves are doing almost exactly the same thing. So why are they different?

An easy way to answer this is to compare what the government does to overhead. While the private thieves are simply skimming other peoples money a new government tax is more like a business adjusting how it applies overhead across its various business units. The new tax assigns more of society's cost to the trading sector while allocating the costs away from other productive activities.

While perhaps not the best way to describe government's role, the overhead analogy does bear a certain appeal for communicating government's role to the business minded. As organizations grow larger and more complex their direct costs tend to decline while overhead increases. A local mechanic shop is likely to have very high direct costs and low overhead compared to a company like Ford, yet Ford will be far more efficient despite so much of its costs accruing to overhead.

Something similar is happening as government's role expands. Modern society is vastly larger and more complicated than it was a few centuries ago. Modern businesses require employees with a much larger capital investment, does anyone think the graduates of a one room schoolhouse would be qualified for a Wall Street trading job? Modern capital markets are vastly more complex and trust between corporations requires a much more active oversight role today than it did in the past. I could go on ad nauseam, but the basic point is that modern businesses exist today only as a result of a large supply of social and institutional capital. Without this capital many would still exist but in a much smaller and less productive form.

So while a financial tax would result in a roughly similar decrease in profits accruing to the parties to the transaction this money would be going to indirectly support the activities of the traders. Resistance to these kinds of taxes are ultimately akin to a business unit arguing against the allocation of overhead assigned to it. While this can increase the book profitability of the unit, this often makes the enterprise as a whole less efficient since the individual unit is unlikely to have a full appreciation of the overall costs of the organization. This makes the organization as a whole less productive since costs are misallocated.

At an extreme, anti-tax fervor can be compared to a dirty salesman who asks for his project to be costed at "true"* cost and then goes ahead and sells at near list price, driving his margins and commissions way up by robbing the organization as a whole of the portion of cost allocated to overhead (many organizations have a sufficient level of control to prevent this from being done too blatantly, I don't think the 113th Congress is one of them).

Another point is that as more of our productivity results in overhead rather than direct cost it becomes increasingly easy for the egotistical and/or unscrupulous to argue that the increased productivity is the result of their efforts rather than from efficiencies stemming from an organization as a whole. This happens at both the national level and within organizations, with direct costs so low it also becomes more difficult to assign the overall productivity of an organization to individual members. Since Americans tend to be so individualistically oriented we are rarely satisfied with assigning results to the system, instead preferring to allocate costs and production to individual people; even when this is conceptually incomprehensible.

*I've run into a few organizations where the salesmen assume that the marginal product cost is the true cost. It can be very hard to make these folks understand that overhead really matters.

Friday, March 14, 2014

Stockholders are Fungible, Employees are Not

This has been on my mind after reading some review's of Piketty's "Capital in the 21st Century" (which I really need to make time to read). Paul Krugman's recent post on it made a major point gel for me when he observes that:

How relevant is this story to what has happened so far? In the United States, as Piketty himself stresses, soaring inequality has to date been largely been driven by labor income – by “supermanagers” (I prefer superexecutives.)

Something that I've been considering as I take management classes is that it seems that a well managed firm should end up developing a strong espirit de corps and a great deal of management loyalty in the company. Companies should end up with long term employees and management that will oppose stockholder efforts to extract revenue from the company instead of using it to serve employees. Psychological characteristics and organizational behavior should be leading companies to have an in group of employees opposed to the out group of stockholders.

Yet, instead, we've seen labor share of income decline and record breaking profits. Despite the performance advantages of developing strong employee morale and loyalty companies seem prone to emphasizing staffing cuts and biased towards hiring more aggressive, less loyal employees to the expense of a strong corporate culture.

A possible explanation is that stockholders recognize that strong employee cultures can be against their interests. This forces them to compensate top management extravagantly in order to encourage them to identify with stockholders instead of the corporation they run and to engage in business practices which weaken the corporation in the long run in favor of higher profits now.

This tension ultimately results from the fact that there is no reason why the corporate entity should have any preference for what sort of capital funds it or who is providing it while there is a strong mutual identification amongst the employees of an organization. In turn, providers of capital have no reason to have a preference over which corporate entity receives their funds, with only some minor restrictions they can quickly and easily trade their stock for that of other corporations. Overcoming this difference in commitment requires capital to pay large bribes if it wants to extract wealth from companies. This also helps explain how common restructurings are despite a poor record of giving expected returns as well as a tendency for boards to hire in outsiders despite insiders with better knowledge of the company.

Examples of this would be a number of managers that have been hired to break strong, successful corporate cultures which led to market dominance and stable performance but relatively weak returns to shareholders. HP and Carly Fiorina being the textbook example from my classes.

[Cross-posted at Angry Bear]

Monday, March 10, 2014

Failing to Distinguish the Public and Private Self

Something that I find consistently frustrating about the American right's worldview is that they seem to always be defending powerful individual's rights to keep their public selves private while ignoring very real intrusions into individual's private selves. These particular thoughts are spurred by reading Rod Dreher and Ramesh Ponnuru's posts on religious freedom in the context of the veto of an Arizona bill touching on these topics by Governor Jan Brewer.

The problem is that the right keeps trying to expand the individual to encompass businesses they own. The problem with this is that a business is not a dirty old pair of sneakers, it is instead a web of contracts with other human beings and organizations. It is essentially public in nature in a way that personal property is not.

This should be obvious but for some reason it is lost on many people. Ponnuru mentions the Religious Freedom Restoration Act (RFRA), which from what I can tell is perfectly intact and doesn't really have anything to do with how businesses interact with their customers. He makes clear, however, that the Arizona bill tries to make the bill apply to businesses as well as individuals, so it's not really clear why he brings up the RFRA at all.

I don't see how this is in any way OK. The right has been trying to push this for far too long with far too little opposition. The interests of the owners of Hobby Lobby or Chik Fil A are not the same as the interests of Hobby Lobby or Chik Fil A. Well functioning markets require that these distinctions remain intact, the owners of these companies should not have any rights to impose their beliefs on their employees, their employees enter into contracts with the organization and identify with the organization's goals, which are not the goals of their owners (even if they pencil it into a values statement, anyone with any experience with a business plan knows that values and missions are linked to what the company actually does, fluffing it up is just distracting and does nothing to change how the business is run).

Whenever an individual forms a business as a separate entity they give up the right to treat their efforts as purely private in exchange for the rights and protections granted to a business entity and take upon themselves a public identity and its accompanying rights and obligations. There is no public interest, or philosophical justification, in further blurring these roles. We have already gone way to far in this direction in the United States and it should be opposed at every turn.

What we should be concerned about is the power that we have granted these powerful organizations to invade the privacy of individual's private selves. While business owners are doing an excellent job obscuring their public selves from private view, for example individual tax returns have not been publicly viewable since 1926 (critical if we are going to really on individuals negotiating wages rather than unions, I feel this is a non-trivial element in modern income inequality), donor's identities to political campaigns are often obscured, and owners can hide their involvement in their company's lobbying efforts, they simultaneously have been incredibly successful in gaining access to information on individual's private lives the first two that come to mind are routine drug testing (this is such an incredibly demeaning practice that I continue to be shocked that it is still legal, where is the outrage?) and credit checks for potential employees (another outrageous practice that there is no good argument for, how can we possibly consider ourselves at liberty when we often have to give up this information to get a job?).

Sunday, March 2, 2014

American's Woke Up and Realized They are Getting Screwed. Envy Isn't the Emotion They're Expressing.

Arthur Brooks has a column in today's NY Times that I take a bit of exception to. In it, he makes the claim that envy is on the rise in America and that this is a problem.

My central issue with this is that I believe that over the past 30 years institutional and cultural shifts have resulted in an increasing exploitation of the majority of society by those at the very top of the income scale. There is no other credible explanation for why these trends are so pronounced in the Anglo-Saxon countries, with the US an outlier among this group, and so much weaker in the rest of the developed world. While there is a small shift towards inequality that is occurring across all developed nations, probably largely the result of the vast increase in labor supply caused by the development of the third world, this international component is far smaller than the country specific shifts we have observed in the U.S., Canada, and Great Britain.

However, Brooks mentions none of this, instead trying to frame it as if there is a cultural shift towards envy being caused by politicians "fomenting bitterness" and reduced mobility resulting from regulations, taxes, and a lack of school choice (never mind that this agenda doesn't well describe the policies of countries with greater mobility than us). He summarizes Alexis de Tocqueville, stating that:

Alexis de Tocqueville phrased it a little differently, but his classic 19th-century text contains the same observation. Visiting from France, he marveled at Americans’ ability to keep envy at bay, and to see others’ successes as portents of good times for all.
It's been a long time since I've read de Tocqueville, but from what I remember of it his main explanation for American's attitude is that rich and poor alike share in all aspects of life. They meet and discuss the issues of the day at each other's homes and public entertainments, they recognize the mutual equality of each in politics, they live amongst each other and interact continuously in life's daily commerce, and the benefits and burdens of living in a civilized society are shared according to each individual's means and talents.

This is not descriptive of modern America. Our rich do not brush up against their inferiors in every day life. Today, they have separate stores, separate clubs, and a diverse array of high brow entertainments unavailable to the working poor. Their children attend separate schools, they live in separate, wealthy suburbs, and network amongst each other, not their less affluent fellow citizens. Furthermore, they pour money into influencing their favored political candidates, violating the original Americans' compact amongst each other to have equal voice in the political sphere even when of unequal means.

It isn't envy to realize that this is not de Tocqueville's America. If the rich want to maintain their wealth while dispelling envy the onus is on them to return to these roots. Live in Detroit instead of Grosse Pointe, send their kids to public schools instead of private schools, and shop at Walmart. Talk to the grocery store clerk about the most recent episode of Teen Mom and commiserate about the pot holes and bad public transit that each takes along the same commuting route. In short, live life amongst those of lesser means.

Sunday, February 23, 2014

Heritability of Personal Characteristics Does Not Imply Heritability of Social Characteristics

Gregory Clark has a very interesting article in the NY Times regarding research he has conducted tracking surnames and high status occupations. I recommend reading it.

However, while the data presented is fascinating I find the conclusions he draws highly questionable.

For example he writes that:

The notion of genetic transmission of “social competence” — some mysterious mix of drive and ability — may unsettle us. But studies of adoption, in some ways the most dramatic of social interventions, support this view. A number of studies of adopted children in the United States and Nordic countries show convincingly that their life chances are more strongly predicted from their biological parents than their adoptive families. In America, for example, the I.Q. of adopted children correlates with their adoptive parents’ when they are young, but the correlation is close to zero by adulthood. There is a low correlation between the incomes and educational attainment of adopted children and those of their adoptive parents.
Then goes on to say that:

These studies, along with studies of correlations across various types of siblings (identical twins, fraternal twins, half siblings) suggest that genetics is the main carrier of social status.
If we are right that nature predominates over nurture, and explains the low rate of social mobility, is that inherently a tragedy? It depends on your point of view.
I have to confess that I'm not as familiar with studies showing correlations between children's incomes and their adoptive parents, what little I have read does seem to indicate the correlation is much stronger than it is with IQ making this assertion questionable.

The real problem, however, has to do with the vastly different timing of reversion to the mean in IQ and social status. Dr. Clark is writing about reversion to the mean taking 15 or more generations. However, reversion to the mean with IQ only takes a couple of generations. I found this blog post by  Steve Sailer illustrating this, I'm not really familiar with the blog so can't vouch for the source but it is consistent with what I know from more formal reading:

The speed of the regression to the mean.
If one starts with two parents whose IQs are 160 and looks at the average IQs across generations the speed of the regression to the mean is quite fast.

Parents 160, 160
Children average 136 (assume these mate with a 136)
Grandchildren average 122 (assume these mate with a 122)
Greatgrandchildren average 113 (assume these mate with a 113)
How can genetic reversion to the mean explain the very slow social reversion to the mean? There is almost an order of magnitude difference in speed (2 generations vs 10 - 15).

Furthermore, while IQ studies tend to show high correlations between IQ and job performance the correlation between IQ and social status or income is much lower. The data certainly hint that social outcomes are the result of something other than merit and it stands to reason that something other than genetic heritability of merit is at work. Of course, there could be a strong genetic component that is not linked with ability, it is pretty well established that people tend to like and hire people more like themselves so it may be that non-performance related characteristics are being selected for and leading to unequal social outcomes. But the implications of this are very different than if elite selection is based on performance related personal characteristics.


Tuesday, February 18, 2014

Why Not Help Those Not Willing to Work for It Out of the Labor Force?

I was reading a wonk blog post that mentioned this statement by President Obama, "He’s said he wants to create 'more chances for folks to earn their way into the middle class as long as they’re willing to work for it.'"

The obvious corollary to this should be helping those who are not willing to work to get into the middle class to not have to. A major problem for many employers of lower wage workers is that they have issues finding employees who can do basic things like show up to work on time and spend their shift working rather than goofing off. This understandably makes them reluctant to take chances on lower wage workers more generally by giving them opportunities for greater responsibility and instead instills an attitude that low wage workers are dispensable.

This raises the question in my mind of why we consider it a good thing to make everyone work? Someone that doesn't want to work and is content living in a rat's nest of an apartment eating Cheetos, getting stoned, and playing video games isn't going to be anyone's idea of a model worker. Why is it a good idea to make someone willing to work to get ahead to have to compete with losers in the job market? Most businesses have crude measures for recruiting low wage workers, its hard to distinguish Mr. Cheetos from someone that has worked hard at multiple low wage employers with high turnover. Most small businesses won't bother trying.

Yet we constantly hear of policies that are designed primarily to punish Mr. Cheetos until he is willing to go out and get a job. This makes no sense, Mr. Cheetos is a terrible worker no one wants. Why not pursue policies to keep Mr. Cheetos on the couch so employers only have Mr. Willing To Work to choose from?

Wouldn't everyone be better off in this scenario?

Of course, if you believe in labor exploitation it makes a lot of sense to get Mr. Cheetos off the couch because this produces more labor supply and makes it easier to exploit Mr. Willing to Work but this isn't a theory often mentioned in polite company.