In my professional life I work in a financial institution on systems designed to measure financial risk. This last year --the last 3 months more-so-- has therefore been a very interesting one, as a lesson in the difference between theory and practice. Now, I should begin by saying that it is something of an open secret in the business that our risk models aren't very realistic. Almost everyone I've ever spoken to has an intuitive sense (if nothing more) that the real world doesn't work the way the model says it does. Not everyone is bothered by that fact, but almost everyone has some sense of it.
In finance, the risk on a portfolio of holdings (a mix of cash, stocks, bonds, derivatives) is measured by repricing it under different scenarios. Each scenario varies the price of some or all of the factors that affect the value of the various holdings. After a number of such scenarios have been priced, the range of results are ordered by the size of the gain or loss in value of the total portfolio. Somewhere toward the bottom of this list we say: Aha! This is our risk! Exactly how far down the list we go varies with the purpose of the measurement but the principle is always the same: the Nth worst result is what we consider to be our 'realistic' risk in the given context.
Several points worth commenting on emerge from this method. I'll stick to the most obvious: that the measurement cannot possibly be any better than the set of scenarios on which it is based. Because of this, coming up with a good scenario set is a huge part of the challenge of risk measurement. One relatively simple method of building scenarios is simply to replicate the variations in prices actually observed in the market place in the past, for a given 'window' period. A more complicated approach measures the relationships (or correlations) between all the various factors at work, and then spins a complex web of outcomes into a set of scenarios. Both these approaches rely on past observed relationships between factors, either implicitly (by replicating the results of these relationships) or explicitly by using them as input to the 'spinning machine' that creates the scenario set.
The problem with this is a variation on the old statistical saw that 'correlation is not causation'. Basically, the fact that two stock prices (for example) are correlated in a given period, doesn't mean that either of the two companies behind those stocks are necessarily dependent on the other, or that the observed correlation will hold up under duress. A fairly easy illustration is that in a strong bull market, stocks rise in a way that tends to create an observable, statistically significant positive correlation between many disparate stocks. The effect is stronger within an economic sector. When the economy sours, well, lets just say those correlations are quickly revealed to be overstated.
All this means that in times of stress, when financial risk is greatest, our risk models are at their most unreliable. Now how's that for an encouraging thought? You ask what can be done? The problem is that generating these scenarios is a fiendishly complex process as it is, with tens of thousands of variables. Adding more exponentially increases the complexity and quite possibly* doesn't substantially improve the predictive power of the models. So what is to be done? Perhaps we just need to pay a little more heed to that intuition I mentioned at the outset. Perhaps if all our reports contained that little line of boilerplate so common on other financial documents: "past results are no guarantee of future performance" we might not be in quite as bad a situation as we appear to be. Mea culpa.
_________________________
*I hope to continue this thought later.
2008/12/23
2008/12/16
No time for a band-aid
It might turn out that in a few months the ominous clouds we all seem to be seeing will turn out to have been just a nasty squall and the figurative sun will be warming our wallets just as the literal one begins to melt this winter into memory. Care to place a bet on that? Thought not.
There are two kinds of recessions. The common or business cycle recession caused by a simple imbalance of supply and demand that can be corrected by a few months of increasing unemployment and relatively minor pain. And then there's the structural recession, a much more nasty beast caused by more fundamental imbalances and often a change in the actual source of 'surplus value' that really drives wealth creation.
The proximate cause of the problems we face is the bursting of a financial bubble inflated by rotting loans and the gassy chemistry of derivative instruments designed to cover the bad smell of the former like a dose of Febreeze in a downmarket gym. On their own, bad loans, even in large numbers don't necessarily indicate structural problems, since some number of people and businesses can reliably get themselves into trouble in any business cycle. What seems to be behind this bubble though is a middle class struggle to maintain a set of expectations for themselves that the real economy can't support. Those people (FULL DISCLOSURE: I'm one of them) saw their incomes stagnate and even fall behind the level required by their own material expectations, and responded either by not saving at all or by using other people's money (loans) to keep up. This was okay in their (okay, our) minds because the assets they (yeh, we) did own were reliably increasing in value so their (our) equity (in housing, stocks, whatever) kept increasing, often at a rate that exceeded the increase in debt. I think most of us know that this kind of thing is inherently unsustainable, but we also think we're smart enough to cash out in time to avoid the inevitable crunch. (Is it surprising that this crisis is hitting just as the leading edge of the baby boom is turning 60?) So nearly everyone in the middle-aged middle class, raised to expect constantly rising expectations, raised their expectations just at the time retirement was raising it's enticing head, realized they didn't have enough, and tried to finesse the difference with a little harmless speculation. To be clear: many of us were not crazy or particularly foolish speculators. But we were placing bets on an unforseeable future with the capital we need to make it to that future.
Fair enough as far as it goes, but of course the issue driving all that behaviour is the erosion of economic supports for the middle class itself. That small problem of 20 or more years of little to no growth in real income in the bottom, middle and even upper-middle income slices of the population. This is partly explained by tax and other policy choices starting in the 1980s up to Dubya's tax cuts, which favour in extremis the top percent (or half-percent) of the population. But I don't think reversing those choices (sensible though that may be in lots of cases) would really address the crux of the problem.
My read on our situation at the moment is that the source of that surplus value I mentioned earlier has shifted in a way that is greatly disadvantageous to the middle class. In the early and middle part of the 20th century surplus value was created in the industrial processes of the great extraction & manufacturing companies. Surplus value came from successive refinements and efficiency improvements in those processes, and in the latter half of the 1900s the middle class benefitted thanks to the rise of organized labour, and later still the rise of the white-collar management and professional 'salarymen' who were increasingly needed to control the increasingly complex manufacturing systems.
Now, it seems that we have reached the end of the era in which wealth was created principally by improvements in industrial efficiency. Of course there are efficiencies to be found in industrial processes, many of which will be significant generators of wealth for some companies. The point is that these gains will be much more limited and not as likely to benefit the larger economy in the way the assembly line (the obvious example) did, spreading from its initial development to every corner of manufacturing as its principles were more and more widely applied, refined and improved upon. I think of it as manufacturing becoming a commodity; meaning, manufacturers have to work very very hard just to keep up with the competition. This is very similar to the plight faced by the small family farmer, circa 1930.
So the challenge we face is to reinvent the economic foundation for a large, stable middle class. I don't claim to have an answer (although I think Richard Florida and others like him are on the right track) but I think it's useful to see the challenge for what it is. Huge. Intimidating. Not band-aid sized.
More later.
There are two kinds of recessions. The common or business cycle recession caused by a simple imbalance of supply and demand that can be corrected by a few months of increasing unemployment and relatively minor pain. And then there's the structural recession, a much more nasty beast caused by more fundamental imbalances and often a change in the actual source of 'surplus value' that really drives wealth creation.
The proximate cause of the problems we face is the bursting of a financial bubble inflated by rotting loans and the gassy chemistry of derivative instruments designed to cover the bad smell of the former like a dose of Febreeze in a downmarket gym. On their own, bad loans, even in large numbers don't necessarily indicate structural problems, since some number of people and businesses can reliably get themselves into trouble in any business cycle. What seems to be behind this bubble though is a middle class struggle to maintain a set of expectations for themselves that the real economy can't support. Those people (FULL DISCLOSURE: I'm one of them) saw their incomes stagnate and even fall behind the level required by their own material expectations, and responded either by not saving at all or by using other people's money (loans) to keep up. This was okay in their (okay, our) minds because the assets they (yeh, we) did own were reliably increasing in value so their (our) equity (in housing, stocks, whatever) kept increasing, often at a rate that exceeded the increase in debt. I think most of us know that this kind of thing is inherently unsustainable, but we also think we're smart enough to cash out in time to avoid the inevitable crunch. (Is it surprising that this crisis is hitting just as the leading edge of the baby boom is turning 60?) So nearly everyone in the middle-aged middle class, raised to expect constantly rising expectations, raised their expectations just at the time retirement was raising it's enticing head, realized they didn't have enough, and tried to finesse the difference with a little harmless speculation. To be clear: many of us were not crazy or particularly foolish speculators. But we were placing bets on an unforseeable future with the capital we need to make it to that future.
Fair enough as far as it goes, but of course the issue driving all that behaviour is the erosion of economic supports for the middle class itself. That small problem of 20 or more years of little to no growth in real income in the bottom, middle and even upper-middle income slices of the population. This is partly explained by tax and other policy choices starting in the 1980s up to Dubya's tax cuts, which favour in extremis the top percent (or half-percent) of the population. But I don't think reversing those choices (sensible though that may be in lots of cases) would really address the crux of the problem.
My read on our situation at the moment is that the source of that surplus value I mentioned earlier has shifted in a way that is greatly disadvantageous to the middle class. In the early and middle part of the 20th century surplus value was created in the industrial processes of the great extraction & manufacturing companies. Surplus value came from successive refinements and efficiency improvements in those processes, and in the latter half of the 1900s the middle class benefitted thanks to the rise of organized labour, and later still the rise of the white-collar management and professional 'salarymen' who were increasingly needed to control the increasingly complex manufacturing systems.
Now, it seems that we have reached the end of the era in which wealth was created principally by improvements in industrial efficiency. Of course there are efficiencies to be found in industrial processes, many of which will be significant generators of wealth for some companies. The point is that these gains will be much more limited and not as likely to benefit the larger economy in the way the assembly line (the obvious example) did, spreading from its initial development to every corner of manufacturing as its principles were more and more widely applied, refined and improved upon. I think of it as manufacturing becoming a commodity; meaning, manufacturers have to work very very hard just to keep up with the competition. This is very similar to the plight faced by the small family farmer, circa 1930.
So the challenge we face is to reinvent the economic foundation for a large, stable middle class. I don't claim to have an answer (although I think Richard Florida and others like him are on the right track) but I think it's useful to see the challenge for what it is. Huge. Intimidating. Not band-aid sized.
More later.
Overheard on the TTC
I don't just beat on people man. I mean they gotta be hurtin' me first y'know. Or just buggin' me.
2008/12/11
What's a GG to do?
Media rhetoric notwithstanding, Canada's national political situation is not in a constitutional crisis as much as it is in the middle of an interesting lesson in how our system of government works. So far the system is functioning pretty much as it's supposed to, and showing how resilient and flexible it can be. I do hedge a bit in saying 'so far' because I recognize that we are much closer to a true constitutional crisis than we have been since the patriation of the constitution.
What would it take to turn the situation into a true constitutional crisis? Something would have to happen that challenges the ability of the system to respond in a way that is both legal and widely acceptable to Canadians. Since our constitution is an odd mix of written and unwritten (conventional) rules that date back hundreds of years in many cases, it is hard to imagine what that something might be. It really is a well tested old goat of a system. The only possibility of a true crisis, as it seems to me, is a failure of the second test: something happens that is widely unacceptable to the population or an important part of it. In simple terms, someone would really have to put their foot in it.
At the moment Michaelle Jean, the Governor General, has kept her boots clean. She made the correct decision in acceding to Stephen Harper's request to prorogue parliament. Personally I don't like it on the level of basic political justice --a Prime Minister ought not to be able to avoid a confidence motion simply by gathering up his marbles and going back to Sussex Drive-- but it was the right thing to do. Refusing a sitting Prime Minister's request would have been a surprise, and surprise is rarely the basis of sound policy. As a Liberal appointment with some slight taint (fair or, more likely not) of association with separatists such a course would have truly opened the door to crisis. There were good prudential reasons for granting the request also. Foremost is that the job of the Governor General really amounts to appointing a stable and functioning government, and little else. Granting this request not only gives Stephen Harper some breathing room, but also allows the coalition to prove itself as a stable alternative to the Conservatives. That is looking less and less to be the case.
So from here it now appears the most likely course is back to business-as-usual in a minority parliament. There is one bear trap out there as I see it though, and that would open up if the Prime Minister loses a confidence motion shortly after the house resumes in January, and then asks for a new election. In such a case she would have three options:
The second option is perhaps the riskiest. The opposition parties outnumber the Conservatives by 20 seats, but the two coalition partners together trail by 30. This isn't a good balance, and likely won't last the duration of the signed coalition agreement. It is also apparently viewed as illegitimate in large sections of the country. The longer the government can avoid defeat, the less the likelihood of this option being chosen.
The final option is the least likely without the Prime Minister's acquiescence, and carries with it a peculiar set of risks, but it's also, I think, the best possible outcome. It is clear to just about everyone that it is Stephen Harper much more than his party, that has lost the confidence of the house. Asking another member of his party perserves the results of the last general election, chastens the sitting PM, and spares the population in general the expense of another likely inconclusive general election. I suspect the opposition parties would (in private) welcome the outcome. The risks? Well they're related to my pet peeve.
- Grant a dissolution and call an election.
- Ask the opposition coalition to form a government.
- Ask another member of the governing party to form a government.
The second option is perhaps the riskiest. The opposition parties outnumber the Conservatives by 20 seats, but the two coalition partners together trail by 30. This isn't a good balance, and likely won't last the duration of the signed coalition agreement. It is also apparently viewed as illegitimate in large sections of the country. The longer the government can avoid defeat, the less the likelihood of this option being chosen.
The final option is the least likely without the Prime Minister's acquiescence, and carries with it a peculiar set of risks, but it's also, I think, the best possible outcome. It is clear to just about everyone that it is Stephen Harper much more than his party, that has lost the confidence of the house. Asking another member of his party perserves the results of the last general election, chastens the sitting PM, and spares the population in general the expense of another likely inconclusive general election. I suspect the opposition parties would (in private) welcome the outcome. The risks? Well they're related to my pet peeve.
Wouldn't it be nice if the Prime Minster could be easily and cleanly replaced by someone chosen from and by his caucus? Instead, 143 duly elected Conservative members are helplessly tied to Harper whether they want to be or not. And Canadians face the prospect of an unnecessary and expensive election not many of them want. So who does this system serve?
2008/12/09
Party Democracy: Oxymoron
So Bob Rae is going to step aside and allow Michael Ignatieff to become undisputed leader of the Liberal Party of Canada. Rae may be doing nothing more than reading the writing on the wall, or he may be motivated by a genuine sense of the kind of duty and honour that motivates true statesmen; either way, he did the right thing giving Canada a shot at something like an organized and effective opposition come January 26th.
Well done Bob!
But Bob, in doing the right thing (and earlier while resisting doing it) did you have to haul out and swear fealty to that hoary old Canadian tradition of 'Party Democracy'? I'm referring to the practice of having the Party membership select its parliamentary leader entirely outside of parliament. And lest anyone think I'm picking on the Liberals, it should be pointed out that this practice is (to the best of my knowledge) universal in Canada. (In fact, most Canadians seem to think there isn't any alternative). The Liberals are actually somewhat archaic and hold conventions to select leaders. Other parties have a one-member, one-vote policy, conducting leadership elections by phone or over the internet. The Liberal method at least ensures that elected members have a stronger (although far from sufficient) voice in the process.
"But that's democratic," you say. Is it? That's certainly what the parties want you to think. But let me ask: who do you, a Canadian voter actually vote for? You vote for someone to occupy a seat in Parliament and represent your views to the government. As a fair-minded person, you expect that person to be more aware of the complexities of the issues of the day than you have time or perhaps inclination to be. You expect her to be sensitive to the needs of your riding and mediate those needs with the needs of other groups, regions, or interests (don't laugh). What you probably don't want is a seat-warming, ready-aye-ready ignoramus simply toting and spouting the party line at every opportunity and jumping up to vote as told by The Party. Sound like anyone you know? That is what this system encourages.
You see, the elected MP enters Parliament hobbled. The Leader is all powerful and cannot be removed by the people he actually leads, only by a shadowy backroom (as it appears in the case of the Liberals) or by a vast and diffuse mass of The Membership. Our thoughtful representative can't apply much real pressure on the leader in this situation (yes, she can argue her positions in caucus). If the leadership, which answers only to the party, isn't inclined to listen, it won't.
Now I admit that much of the time this doesn't make a whole lot of difference. Most members know and support the party that nominates them to office. Once in office they support most of the policies their leadership proposes and where they aren't comfortable with any of those policies they make peace with them as part of the essential give-and-take compromise of real governing. But lest anyone think it never matters, I have two words for them: Stephane Dion. Here's a guy who was elected leader of the so-called natural governing party of Canada with almost no support from the then more numerous party caucus. How's that working out guys?
By all accounts most of the current caucus wants Michael Ignatieff. I bet that works out much better for them in the next election.
Well done Bob!
But Bob, in doing the right thing (and earlier while resisting doing it) did you have to haul out and swear fealty to that hoary old Canadian tradition of 'Party Democracy'? I'm referring to the practice of having the Party membership select its parliamentary leader entirely outside of parliament. And lest anyone think I'm picking on the Liberals, it should be pointed out that this practice is (to the best of my knowledge) universal in Canada. (In fact, most Canadians seem to think there isn't any alternative). The Liberals are actually somewhat archaic and hold conventions to select leaders. Other parties have a one-member, one-vote policy, conducting leadership elections by phone or over the internet. The Liberal method at least ensures that elected members have a stronger (although far from sufficient) voice in the process.
"But that's democratic," you say. Is it? That's certainly what the parties want you to think. But let me ask: who do you, a Canadian voter actually vote for? You vote for someone to occupy a seat in Parliament and represent your views to the government. As a fair-minded person, you expect that person to be more aware of the complexities of the issues of the day than you have time or perhaps inclination to be. You expect her to be sensitive to the needs of your riding and mediate those needs with the needs of other groups, regions, or interests (don't laugh). What you probably don't want is a seat-warming, ready-aye-ready ignoramus simply toting and spouting the party line at every opportunity and jumping up to vote as told by The Party. Sound like anyone you know? That is what this system encourages.
You see, the elected MP enters Parliament hobbled. The Leader is all powerful and cannot be removed by the people he actually leads, only by a shadowy backroom (as it appears in the case of the Liberals) or by a vast and diffuse mass of The Membership. Our thoughtful representative can't apply much real pressure on the leader in this situation (yes, she can argue her positions in caucus). If the leadership, which answers only to the party, isn't inclined to listen, it won't.
Now I admit that much of the time this doesn't make a whole lot of difference. Most members know and support the party that nominates them to office. Once in office they support most of the policies their leadership proposes and where they aren't comfortable with any of those policies they make peace with them as part of the essential give-and-take compromise of real governing. But lest anyone think it never matters, I have two words for them: Stephane Dion. Here's a guy who was elected leader of the so-called natural governing party of Canada with almost no support from the then more numerous party caucus. How's that working out guys?
By all accounts most of the current caucus wants Michael Ignatieff. I bet that works out much better for them in the next election.
2008/11/11
Blog slogging
I put the cart before the horse in publishing my piece on party democracy yesterday. No introductory "Why I'm writing this blog" piece to start things off and justify why exactly the world needs yet another blog, this blog, now.
The problem is of course, that it doesn't now, and it likely won't in the future.
When I sat down to start this blog some now embarrassingly large number of weeks ago, I was caught between my own inner urge to write, and the horrible realization that I didn't exactly know what I was planning to write about. A blog should have a theme, a cause, oh come on, a pet peeve surely? Simply everyone on the web has one!
Of course I realize that what I really want is to be relevant and important. And the desire to be relevant and important is a colossal bit of vanity on my part, but there it is. Paralysis ensues and nothing gets written because others are saying all the Important & Relevant things, and I can't possibly hope to have a bigger insight or say it better than them, so why bother?
Still don't have an answer to that one. I suppose I have Bob Rae to thank for getting me started and revealing I do own at least one pet peeve. I expect to elaborate on it in the future, but it won't by any means be an obsession. I have many interests, and I've noticed in now over 40 years that these interests are cyclical. They wax and wane with the phases of the moon, the seasons, the sunspot cycle --there's a veritable astrology of my little obsessions-- and I'm sure this blog will chronicle their ascendency more accurately than I could chart them independently.
Writing is cathartic. Especially when done for publication I find it clarifies and improves thought. It helps one work through ideas and their consequences. In this way (I expect) writing a blog is a process more than a product, and so the readership (if it materializes) is in a certain way secondary for the blogger. Ideally the readership becomes a vital and important partner in that process --especially in keeping yours truly here firmly anchored and down-to-earth.
I do hope (and fear) that this blog will be read and commented upon by someone outside my immediate circle of family, friends, and acquaintances. But what Bob helped me see is that the only thing that matters truly is that it be of some small importance to me.
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