Magic, maths and money Fri, 12 Sep 2014 09:02:00 GMT language
I spent the first part of the week at the eco**2 meeting, sponsored by the British Ecological Society and the LSE's Systemic Risk Centre and exploring the relationship between economics and ecology. I attended because I am in the early stages of a research programme to explore if distinctive financial network topologies emerge out of different commercial cultures, and whether the distinctive topologies are more/less efficient in distributing funds and resilient (robust) in responding to shocks; essentially how financial systems evolve and how the commercial environment influences the financial organisms- the ecology. It was useful as I met for the first time Thomas Lux and Steffano Battiston.
I have a strange connection with ecologists; before becoming an academic I worked for a US oil company in London. In the late 1990s, in response to over a decade of failed exploration, the firm invited John Krebs and Alex Kacelnik to review its approach to exploration based on their experience of optimal foraging strategies of animals. I was the internal project manager. The research was cancelled before the project finished (part of a change in senior staff and a "re-focus") and the two tangible consequences are Oxford Risk and that I list Alex as one of my inspirations to leave industry for academia (along with a choice between a nice redundancy package and PhD in maths or a career in Houston).
One thing that Alex taught me is the sub-optimality of risk-aversion. Some birds need to eat up to 40% of their body weight in a British winter to survive the night, and so their very existence depends on making the right decisions about looking for food. Let's say a bird has 6 hours to find 9 berries and it has two choices:
- [Play it Safe] The bird stays where it is, where it knows there are berries in the hope of finding a few. The chance of finding one or two berries in the hour is 50:50.
- [Take a Risk] The bird flies off, in the hope of finding berry-bonanza but with a high chance of only finding enough to replace the energy lost in flying. The energy cost of flying is one berry and the chance of only finding the one berry in the new field is 5 in 6, but there is a 1 in 6 chance of finding 10 worms (and getting an excess of 9).
Notice that the expectation of both strategies is the same, one-and-a-half berries in an hour and so the bird can expect to get the nine berries in the six hours. However the second approach is riskier (for any concave utility function the expected utility of the second strategy is less than the first).
Alex explained that if the bird has only found five berries after five hours, it is certain to die if it does not switch to the risky strategy, where it has a small chance of finding the 10 berries that will ensure survival. A similar argument applies if the bird has found more than 8 berries after 5 hours - it can afford to take a risk.
The financial interpretation is that only the middle class should be risk averse the rich can afford to gamble, the poor have nothing (substantially) to lose by gambling but there is the small chance they become rich. This is an explanation as to why the poor defy economic 'rationality' in buying lottery tickets, it is actually practically reasonable.
Apart from presenting my own work, my first contribution came in the second plenary when Thomas Lux and Michel Loreau discussed "Important Models in Economics/Ecology". Michel discussed Malthusian catastrophes (possibly in response to a question) and positively contrasted Malthus with Condorcet. This becomes interesting to me, given Condorcet is associated with maths and finance. The moderator asked the audience of mixed "economists" and ecologists if any economist took Malthus seriously, I don't think anyone raised their hand. I felt this left the ecologists with the impression that economists were a bit short sighted. My contribution was the following: Malthus was a Tory cleric worried about the effects of the political changes -the collapse in social hierarchy- in France, where as Condorcet was committed to French Revolutionary principles of equality, brotherhood and freedom. I suggested the reticence of economists to follow Malthus was that his ideas legitimated the liberal policies of the British government during the Irish famine. Restricting growth on the basis of Malthus requires we address the problem of (global) inequality; I question the morality of people with stuff telling people without stuff that they can't have any more stuff. Lord May commented that Malthus was right but the time scale was wrong, I think this is a peculiar view of an empirical scientist: I can point to the problems of the Malthusian catastrophe theory, the theory has yet to be shown to be true. I think the consensus is that famine and pestilence is not an issue of availability of resources but the distribution of resources, what I think economists call the co-ordination problem.
At the end of the day Doyne Farmer captivated his audience by describing his success as a hedge fund quant in the 1990s. I though it a bit odd that the previous evening Lord May had been critical of the type of activities Doyne had been involved with, yet 24 hours later the audience seemed to see the sense of it all. Doyne's story was essentially that he did not believe in the Efficient Markets Hypothesis, and as a skilled mathematician he could go below the economic theory of "first order efficiency" and mine riskless profits in identifying "second order inefficiency". He produced a series of convincing plots, which all seemed to end around 1998. Let's be straight- a priori I am sceptical about Farmer's claims given he claims he built the first wearable computer in the 1970s, where as I believe it was Claude Shannon and Ed Thorpe in the early 1960s. At the end of his presentation a young ecologist asked the question "If you were making money out of these inefficiencies, who was losing money". Farmer skirted round the question, first stating that economics is not a zero-sum game (that is true, but finance IS a zero-sum game) and that the activities of arbitrageurs made markets more efficient (again that is true). What he did not answer was who was losing money.
I then asked Prof Farmer "Is making riskless profits ethical?" My reasons were three-fold.
- I felt he had not been sincere in answering the ecologist's question.
- I have argued that the Efficient Markets Hypothesis can bee seen not a statement of fact but one of values: it is a contemporary version of the Scholastic injunction on making riskless profits. Farmer's criticism of the EMH, in my mind, is a criticism of this moral injunction.
- Both the US and UK legislators (in the Financial Crisis Inquiry Commission report of 2011 and the Changing Banking for Good report of 2013) stress the degradation of commercial ethics as a cause of financial crises since 2007.
This might seem academic and irrelevant, the practical usefulness is that it enables me to identify why practices described by Farmer might be unethical, rather than relying on an instinct that speculation in complex financial instruments just can't be right (where as geo-engineering, genetic modification or nuclear weapons are OK). I aim to show in my research, that such markets can offer growth without creating the inequality that Michel Loreau objected to, but I feel is a consequence of the aim at efficiency that a 'Darwinian' economics demands.
A popular tweet from the meeting was
Farmer ends on 'ecological approaches could play important role, but requires abandoning some fundamental assumptions in economics'
— Eco Squared 2014 (@e2c2o2) September 9, 2014
My object in this chapter is to shew that there is no fundamental difference between man and the higher mammals in their mental faculties.
The great break in the organic chain between man and his nearest allies, which cannot be bridged over by any extinct or living species, has often been advanced as a grave objection to the belief that man is descended from some lower form; ... At some future period, not very distant as measured by centuries, the civilised races of man will almost certainly exterminate, and replace, the savage races throughout the world. At the same time the anthropomorphous apes, as Professor Schaaffhausen has remarked, will no doubt be exterminated. The break between man and his nearest allies will then be wider, for it will intervene between man in a more civilised state, as we may hope, even than the Caucasian, and some ape as low as a baboon, instead of as now between the negro or Australian and the gorilla.
In contrast to Darwin, in An Inquiry into the Nature and Causes of the Wealth of Nations Adam Smith argues that humans are distinctive from other animals in the degree to which they are co-operative
Two greyhounds, in running down the same hare, have sometimes the appearance of acting in some sort of concert. Each turns her towards his companion, or endeavours to intercept her when his companion turns her towards himself. This, however, is not the effect of any contract, but of the accidental concurrence of their passions in the same object at that particular time
Humans are different to animals in that they exhibit
the propensity to truck, barter, and exchange one thing for another.
Markets are not simply a technical tool to facilitate life, but they capture a key distinction between humans and other animals. I am not convinced that it is progressive to lose the 'civilised' aspect of humanity.