When do markets work?

In some situations the free market seems to work reasonably well - the equity markets in ordinary conditions for the largest companies, for instance. In others, the unfettered market (at least as currently set up) does not seem to be as efficient: the internal market in the NHS might be one example, the monopolistic behaviour of some corporations is another. So when does the market work well?

Some thoughts about things which help:

• There are a lot of items which are broadly the same, and these are transacted often. A market price only means something if price discovery is useful to other market participants. Thus the market price of a stock (and the near certainty of liquidity at that price) is useful information to other owners of that stock. The market price of the only sculpture ever made by a particular artist is of lesser interest to other market participants as it gives almost no information about transactions they might be able to make.
  


• There are a variety of different independent willing buyers and willing sellers of the same (or very similar) item. Because otherwise the price can be distorted by the operation of monopolies on one or both sides. This is not necessarily to disadvantage of the buyers, but it does mean that the free market model may not be appropriate.


• The costs of providing a market are not too high. It may be that there are situations where transaction, marketing or other costs are so high that having a range of providers does not make sense. I suggest this might well be the case for something like railways: a single system is better than a choice between competing alternatives.


• A public marketplace is acceptable to most market participants. In some markets it may well be that the advantages of a visible price are outweighed by the disadvantages of being seen to transact. Market participants may value privacy highly.


• There is not an unacceptable level of moral hazard or information asymmetry in participating in the market. Thus for instance buyers are comfortable that sellers are not selling because they know something bad about the item which the buyer cannot easily discover.


• The market is not thought to be easily manipulable. Market participants tend to shun markets that are seen as unfair.


• The market is not illegal and actively policed. Although arguably the market for certain drugs is a counterexample.

Tories are heirs to Blair

From The Guardian:

The shadow chancellor, George Osborne, will say today that the Conservative party is the heir to Tony Blair's reforms of hospitals and schools, not Gordon Brown.

(A rather better monument than Tony is likely to get from his heirs, taken in a church in Milan.)

First reaction: yes, Tony's policies are not policies of the left. Second reaction: in saying that, does he imply that being Tony's heir is a good thing? I just wish I believed El Gordo agreed with this statement too...

Levels of abstraction

A review by Jerry Fodor in the LRB (of Consciousness and Its Place in Nature by Galen Strawson) brings to mind an issue I've been meaning to write about for ages: the importance of a tall tower of abstraction for some kinds of emergent behaviours.

Fodor says:

The third of Strawson’s leading theses is a good deal more tendentious than the first two; namely, that emergence isn’t possible. ‘For any feature Y of anything that is correctly considered to be emergent from X, there must be something about X and X alone in virtue of which Y emerges, and which is sufficient for Y.’

Assuming for a moment this is a correct account of Strawson's views (I haven't read the book), this is an error, and a common one for people who have not studied systems that have a lot of different levels. Let me try to explain.

How many different levels are there in thinking about reading this post? There's the level of your hardware: transistors and gates. There's the level of hardware design: functional modules and so on. In fact (and I'll skim this part as this isn't the hardware blog) there are three or four levels here, roughly going from thinking about groups of 10-20 transistors to thinking about blocks of hundreds of thousands. Microcode runs on this, so now we are at the hardware/software boundary. Beyond this is the microcode interpreter, instruction optimisation, pipelining and so on. Then up to true machine code, as spit out by a compiler. From there we move up to programming languages. Finally there's your browser and it's internal architecture.

No one understands all of this in detail. A good hardware designer might span the five or six levels of abstraction needed to design a working chip, but most working within one or two levels with some knowledge of the ones above and below. A good software designer might occasionally be willing and able to delve into the compiler output -- very occasionally. But it's just too hard to understand all of the ten or more levels involved in something as simple as a web browswer running on a modern PC. Its behaviour might be determined by its code which in turn relies on an implementation in machine code running on a pipeline processor implemented using... but it might as well be emergent as far as any single person knows.

Now suppose that there are a lot more levels of abstraction involved in a brain than in a PC. We have no idea whether this is true or not, but certainly there is a big gap between the detailed hardware as revealed by neurophysiology and the architecture conjectured by cognitive psychology. It could be that in order to understand that gap we need not one or two levels of abstraction but twenty. Consciousness could be a feature of a program X running on Y running on Z running on A and so on down a long, long way. Just because you can't see how a bunch of transistors is able to grant you access to www.hornyyoungphilosophers.com (register this now if it hasn't gone already - it has to be a money spinner) doesn't mean they can't - just that it is too hard for any single person to understand all the steps necessary for it to happen.

Fodor's article is excellent and it really makes me want to read Strawson's book. But he posits something that seems at least unnecessary (although it may well be true): a law of emergence. Perhaps we don't need it simply because emergence can be like a good joke -- it takes a lot of setting up, and all the pieces are needed to make it work, but once you have all those pieces, the punch line is pretty much inevitable.

About to be antiquated

There is a picture in the new Tate How We Are: Photographing Britain show of bear baiting in an English village, dating from 1910. It looks much older: we can hardly believe less than a hundred years ago that was going on in England.

Here's something that will seem equally odd soon. It is a picture of Sunday's Monaco Grand Prix in Monte Carlo.
I predict that in thirty or forty years it will be hard to believe that a 'sport' which celebrates the egregious consumption of natural resources (and incidentally doesn't seem to me to be very sporting) will seem as out of date as bear baiting. By then, though, Monte Carlo won't be the same kind of place: rising sea levels will have turned a lot of the current centre into a diver's paradise. Underwater roulette anyone?

Let me end with a uncharacteristically sensible (if rather purple) piece of prose from George Monbiot today:

Motorised transport is a form of time travel. We mine the compressed time of other eras - the infinitesimal rain of plankton on the ocean floor, the settlement of trees in anoxic swamps - and use it to accelerate through our own. Every tank of fuel contains thousands of years of accretions. Our future depends on the expectation that the past will never be exhausted.

Am me up, Pa

There is a lovely post today on the often insightful Calculated Risk on reverse mortgages. Here's the issue. Older people, particularly retired people, might have a valuable house but a low income. If they sell the house they take the risk that the funds raised run out before they die. What they need is an annuity like stream of income.

A reverse mortgage involves a bank making regularly monthly payments to a borrower as long as they live in exchange for a first lien on their property. The bank takes a combination of house price risk and mortality risk: if house prices go down then the eventual sale of the collateral will be lower than the value of the cash advanced; similarly if the borrower lives a long time then the interest payments create a substantial loss for the bank. Typically these products are structured as true mortgages so any excess of the eventual sale price over the amount needed to repay the loan belongs to the borrower's estate: the bank has the downside of higher longevity but not the upside of lower. Usually the notional principal of the loan is a fraction of the assessed value of the property so if mortality is high then the product is fairly safe. A combination of low mortality (increasing the duration of the loan) and falling house prices (decreasing the collateral value) can however be dangerous. There is also mortality dependent interest rate risk as you don't know how long to hedge rates for.

Note that combined asset price and longevity risk is one of the things that is causing problems in life insurance companies who have written annuities (or worst guaranteed return annuities) based on outdated actuarial tables and dud assumptions about asset returns. They too assumed that prices wouldn't go down and that people wouldn't live too much longer. Still, there's nothing like losing money in exactly the same way as the last guy, is there?
As Keynes put it:

A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way along with his fellows, so that no one can really blame him.

What does safe mean?

It is an interesting question. Nothing is safe, 100% robust under any set of circumstances. If a two hundred foot high sea monster climbs out of the Thames and starts munching on Canary Wharf a few disaster recovery plans would doubtless be found wanting.

There are at least two issues. The first is to encourage people to be skeptical about the performance of any construction, mechanical, electronic or intellectual: there are some events that will screw up any design.

But then we come to the problem of how to estimate how unlikely these testing circumstances are. Typical operational risk events involve a concatenation of errors, of individually improbable circumstances. Sadly it seems that sometimes these events are not independent so that the joint probability of a screw up is much bigger than one might think. For that matter, the equity, credit, FX and interest rate markets often have low return correlations: but they can all move together in a crisis, as LTCM found out. It isn't that a plausible worst case is bad -- we knew that -- it is that the worst case can be much more likely than it appears.

Going nuclear

Tony and Gordon have bottled energy conservation and renewables, and instead see a new generation of nuclear power stations as key to meeting our energy needs. As we already knew over a year ago they would. Just one question. Can we afford them?



After all, despite the expert's protests, we know that nuclear power stations over their life subtract value from the economy: they cost more to build, run and (crucially) decommission than the power they generate is worth. This might change, of course, but buying an out of the money option is a gamble on the underlying going up, and the government doesn't have a hedge.

What I really worry about, though, is the ongoing costs and risks of dealing with the waste. U235 has a half life of 700 000 000 years. For U238 it's 4 billion years, or roughly the age of the earth. The most permanent structure man has made has lasted less than 10,000 years, yet we are taking on liabilities 700,000 times longer. We are going to produce tonnes, perhaps hundreds of tonnes, of material so toxic that ingesting a microgram is likely to be fatal, and it will remain dangerous for billions of years. Put that way is there anyone who honestly believes it's a sensible idea?

Update. The house of Lords clearly have concerns too.

What particularly troubles me about all of this is that fusion research has slowly been making progress and with more funding, goodness knows how quickly we could get there. In the context of the sums at risk from climate change, a few tens of billions on fusion research would be infinitesimal. Yet this is an order of magnitude less than we are spending. That seems like a bad strategy to me.

The short gamma of short gamma

Very roughly, a short gamma trading strategy is one that profits from not much happening and loses a lot of money if there are big moves, whereas a long gamma strategy loses a little money every day there isn't a big more, but makes a lot if there is.

Short gamma traders (in the widest sense) are trend followers or people who believe things will be normal. Long gamma traders want something unusual to happen.

Now here's the thing. At the moment there is a lot of talk about a market crash being imminent. For instance, Calculated Risk is doing a good job of recording the woes of the US housing market, Nassim Taleb's new book on long gamma has been getting a lot of publicity, and Anthony Bolton is predicting a crash. But if everyone is expecting a crash, surely this is the orthodoxy. And true long gamma traders pay to get a position that will profit if the orthodoxy does not prevail. So shouldn't they go short gamma? And vice versa of course.

Believing the worst

Shamelessly stolen from Overcoming Bias:

In 1983, NASA was planning to bring back Martian soil samples to Earth. Contaminating the Earth with alien organisms was an issue, but engineers at Jet Propulsion Laboratories had devised a "safe" capsule re-entry system to avoid that risk. However, Carl Sagan was opposed to the idea and explained to JPL engineers that if they were so certain [...] then why not put living Anthrax germs inside it, launch it into space, then [crash the capsule back to earth] exactly like the Mars Sample Return capsule would.

The engineers helpfully responded by labeling Sagan an alarmist and extremist. But why were they so unwilling to do the test, if they were so sure of their system? The answer is probably they feared that if the test failed, their careers would be over and they would have caused a catastrophe. But an out of control Martian virus, no matter how unlikely, would have been equally a catastrophe. However, that vague threat didn't concentrate their minds like the specific example of anthrax.

Imagine for a moment that those engineers had been forced to do Sagan’s test. Fear of specific disaster would have erased their overconfidence, and they would have moved from 'being sure that things will go right' to 'imagining all the ways things could go wrong' – and preventing them. The more dangerous the test, the more the engineers would have worked to overcome every contingency.

The Folly of Choice

Folly care of the Sham Castle, Bath.

Mark Ravenhill makes an interesting point today:

What I want is a nice politician who'll say: "I'll offer you one school, one hospital, one justice system - and it'll be well-funded and well-run. And we'll fund the service by cutting all that admin bollocks it takes to offer you choice."

He's quite right of course. Ask a group of people if they would rather have a choice or not have a choice, most of them will say they prefer choice. But if you ask the more relevant question, from the perspective of the Blairite public services agenda, of whether you would prefer one good alternative or the choice between three or four or five inadequate ones, not many people will say 'Yes Mr. Tony, we choose choice'. And choice costs. It costs in administration, in duplication, in measuring the alternatives so you can provide statistics to guide the choice, in marketing, in all sorts of crap that is totally irrelevant to actually providing health care or education or a legal system. I wonder how much it costs, and how much better the system could be without that spending?

The problem with a lack of choice is that things can sometimes go wrong. If you offered a choice, it was the chooser's fault they picked a surgeon who didn't know their pancreas from their prick, or a school run by a group of 13 year old hooligans, or a lawyer who thinks Tort is a kind of Austrian cake. Nothing is ever the government's fault. That is why Mr. Tony liked it: no accountability. But that does not make it a good idea. Next time some idealogue from the left or right offers you a choice, ask how much offering it costs.

The death of the dirty vehicle?

So Ken is to impose a £200 a day charge on high pollution lorries in London? Just when you are really starting to dislike him again he comes up with an excellent idea like this. Well done Livingstone - unlike that spineless and strategy free road lobby toady Ladyman, he is actually doing something to improve matters.