the real problem with Nate Silver's election prediction model

note: I've got an extended preamble here about the debate regarding modeling in general.  If you want to get straight to my particular issues with the FiveThirtyEight prediction model, scroll down to the bolded text.

Just before the Alberta provincial election in April I left for China, and a couple weeks ago I arrived back in Edmonton, in time for another election south of the border.

In the last week before Tuesday's vote, it seems that one of North America's most popular pastimes is poll watching.  This has created a significant, albeit temporary, demand for online one stop shops that aggregate the polls, and the most popular sites add value by assessing how each poll should be used to make a prediction. 

This means modeling.  You take the data, run it through the model, and out pops a prediction.

Most of these modelers are predicting a solid Obama victory (i.e. with several dozen electoral votes to spare).  Sam Wang's "Princeton Election Consortium", for example, is of the view that the "Bayesian Prediction" of Obama's re-election chance is 98.1%.  Now this particular site is partisan, so partisan, in fact,  that he's using his site to raise money for Democrat candidates.  The site that's getting the most attention, though is Nate Silver's FiveThirtyEight blog which is now hosted by the New York Times.  Silver is also an Obama supporter, but doesn't have the incumbent as quite such an overwhelming favourite, pegging Obama as a 3 to 1 favourite to win the popular vote and slightly more of a favourite to win the Electoral College (and thus the election).

After Josh Jordan wrote a piece titled "Nate Silver's Flawed Model" for the National Review (no link as NRO's servers are in NYC and are under water) the liberal economists Paul Krugman and Brad DeLong weighed in, with Krugman insisting that this challenge to Nate Silver's model be seen as part of a "War on Objectivity" assuring us that "if these people triumph, science — or any kind of scholarship — will become impossible."

I'll leave aside the irony of Krugman declaring "if it isn’t what the right wants to hear, the messenger is subjected to a smear campaign" while he smears the critic of Nate Silver's model without specifically taking issue with so much as a single word of the offending post, stating simply that the criticism amounts to a "disgraceful episode. And the fact that the National Review ran with this tells you all you need to know about the publication."

What stuns me is that these liberals riding in to defend the honour of Nate Silver and his modeling are the same crowd that insists Wall Street's wizards are the cause of America's ailments.  Now there are exceptions.  Dean Baker is another leftist economist and he's of the view that "We would be in pretty much the same place today even if the financial crisis had not happened."  That's a view I happen to agree with, after all, the fancy derivative products that overcompensated financial engineers came up with are just that, derivative, meaning they are dependent upon and derive their value from what's happening in the underlying "real" economy.  But that doesn't mean that these people didn't obscure the price signals in such a way as to aggravate the misallocation of the capital that was occurring in the real economy.  How did these hot shots get away with it?  Because people treated them like Krugman is demanding we treat Nate Silver, that's why!  Silver uses exponential smoothing with a decay factor and Monte Carlo simulation!  Do you plebes understand that stuff?  No?  Then sit down and show some respect!

This is, of course, why hedge fund managers are so grossly overpaid.  There is no clear need for a finance industry beyond various straightforward functions such as putting people with business ideas together with people with capital but we've got these great towers of High Finance because, well, it's fueled by flows of money that get directed at whoever appears to be the smartest, and that generally means whoever's got the most complicated sounding model.

The economic consequence of Krugman stepping up to praise Silver is that the market will conclude Silver deserves a million dollar salary.  Yet Krugman's "liberal conscience" will of course soon compel him to turn around and complain about income inequality!  Dean Baker has figured out how dumb this all is:

Progressives... have been losing not just because conservatives have so much more money and power, but also because they have accepted the conservatives’ framing of political debates. They have accepted a framing where conservatives want market outcomes whereas liberals want the government to intervene to bring about outcomes that they consider fair.
...
This "loser liberalism" is bad policy and horrible politics. Progressives would be better off fighting battles over the structure of markets so that they don't redistribute income upward.

Baker has noted that part of the reason U.S. doctors and lawyers make so much money is because they have monopolies.  More international competition (i.e. free trade in professional services) would lower prices for ordinary Americans, and the people hurt would be people who are doing very well already.  Trying to instead move the money around via the tax system buys into the argument that these service providers rightly own the fruits of their monopoly power.

I could go on here but this preamble is already quite lengthy so I'll turn to my particular objections to Silver's model.

I'm not going to take issue with Silver's prediction of who will win the electoral college except to note that a lot of people are wrongly interpreting the slide in Romney's probability of winning as Obama momentum.  This is in fact just a consequence of Silver's model having a time decay.  If the home team is down 3 to zero in the third inning, if they are still down three zip in the bottom of the ninth that doesn't mean the away team has scored any more runs, but it does mean that the behind team is running out of "at bats."  In Silver's line graph there is therefore a force that pushes in both directions away from the 50% line.  The fact Romney was able to move up closer to the centre line earlier in October was all the more impressive because it was pushing up against this time gravity.

What I will take issue with is Silver's prediction that the odds of Obama winning the electoral college and losing the national popular vote are just 5.1%.  A big driver of this is Silver's skepticism that Romney will win the popular vote, pegging as he does Romney's chances at that at 24.3%, little better than Romney's 21% chance of winning the electoral college.

How can they be less than 25% when Rasmussen's national poll has Romney ahead by two points and Gallup has Romney up by five?  There are other national polls, of course, but almost all of them have Romney either tied, ahead of Obama (albeit by less), or at worst behind just 1 point.

Silver's response would be that there is other data out there.  There are state polls and these can be used to supplement the national polls for a more accurate prediction of the national popular vote.  Now this is perfectly sound in theory but how exactly does he do this?  Silver went into detail on this back in July.  One of Silver's critical beliefs here is that "the relative order of the states [i.e. how they line up relative to the national trend in terms of "redness" or "blueness"] is extremely consistent from year to year."  Now right there you have the weakness of most models: the assumption that the future will continue to be like the past.  It is not irrelevant to note that a split between the popular vote and the electoral college verdict has been historically rare, but it should be tested against various narratives that might explain why this time it's different.  

The fact is that Silver makes some adjustments based on considerations unique to each cycle anyway, so the "extreme consistency" is limited even in his own eyes.  An example of this is his "adjustment for home state effects."  "On average, a presidential candidate gets a seven-point push in his home state," he observes, and he therefore has the model push Massachusetts somewhat redder in "the relative order of the states" because Romney's from there.  Now this is where you need to start asking yourself if Massachusetts is really going to go redder this year.  Sometimes familiarity breeds contempt, no?  Don't "identity politics" apply in other aspects as well?  One has to stop somewhere, of course, and that's my point: Silver stopped too early when it comes to considering what's different about 2012.

According to Silver's "FiveThirtyEight Presidential Voting Index - 2012" Pennsylvania is seven states bluer than Ohio in the state order.  If Obama is ahead in Ohio by 2, then he should be up in Pennsylvania by more than 8 points.  Wisconsin is even bluer; Obama should be ahead in Wisconsin by 9.5% if he's up in Ohio by 2%.  If Obama is just 2 points back in North Carolina, then Obama should have an 9.6% lead in Pennsylvania and have a full 11% lead in Wisconsin.  Thus spake the model.  But this doesn't square with what we are seeing on the ground.  David Axelrod may have promised to shave his mustache if Obama loses any of Minnesota, Michigan, or Pennsylvania, but that doesn't change the fact that the Obama campaign is committing resources to these states.  The liberal leaning Pittsburgh Post-Gazette says that Pennsylvania is being "flooded with television ads."  Now maybe Romney and his allies have decided to go after Pennsylvania because they've been banging their heads against the wall in Ohio for a long time with little progress and so now they're making the Hail Mary pass next door.  But that doesn't explain why the Obama campaign is spending money to counter this; - after all, didn't Nate Silver say that "the relative order of the states is extremely consistent from year to year," meaning that the "battleground" states don't change?  If we turn to Michigan, there are no less than 14 states between Michigan and North Carolina in Silver's rank index.  If we check against the current polling, we see that Realclearpolitics (RCP) has Romney just 3 points behind while Silver's index says that if Obama is 2 points behind in North Carolina  (which is how Silver currently rates the situation in NC) Obama should be a whopping 13.9% ahead in Michigan.  If we turn to Wisconsin, we see that instead of that 11% lead for Obama in this state that I noted above, RCP's polling average says Romney is just 4% back.  Despite these underestimates of Romney's support when using the "battleground states" of NC and OH to predict the not-so-battleground states of Pennsylvania, Michigan, and Wisconsin "we can use this index to calculate an implied national popular vote," Silver insists.  

Silver addressed some of these concerns Wednesday (October 31):  

Michigan is probably not as close as two or three points right now: most polls released after the first debate in Denver suggested a lead for Mr. Obama in the mid-to-high single digits. Usually, states do not shift all that much relative to others in their region. The fact that Mr. Obama’s polling has held up reasonably well in Ohio and Iowa, for example, is reason to suspect that some of the movement in the poll represents statistical noise, even if it comes from a good polling company.

Does anyone else see the circular reasoning here?  Michigan can't be that close because "states do not shift all that much relative to others in their region."  In other words, Michigan can't be that close because my model says it can't be that close!

Now it should be acknowledged here that Silver doesn't just use the "battleground" states to predict the national vote.  He does use the other states.  So wouldn't that balance things out?  It could, if weighted by expected 2012 turnout and we had good up-to-date polling of those other states.  But Silver doesn't do that.  Take Utah, for example.  Silver gives it a weight of 0.05, while Florida gets a weight of 1.58.  Florida thus gets more than 30 times the weight of Utah.  But Florida's population is less than 7 times Utah's.  Utah has only been polled twice since June, but both of these Utah polls were from mid-October and they've got Romney ahead by 51% and 53% for an average of 52%.  That's 14.7% ahead of where Silver's "index" says Romney should be, and that's relative to the United States (meaning Romney is even farther ahead in Utah of where he should be relative relative to NC or OH).  While Romney's Utah support gets underweighted (and this doesn't even go beyond the relative population difference to note that people who lean Republican turn out more frequently than people who lean Democrat), Obama's Florida support gets overweighted, where Romney is running 3.6% behind where Silver's index says Romney should be.  I could make the same point here using Michigan instead of Utah and North Carolina instead of Florida.

Silver calls this weighting a "wrinkle" that is not "that important."  He says that he cannot weight just by turnout because the "quantity and quality of polling" varies from state to state.  As Silver put it in July, "So — although technically it determines an implied national popular vote for South Carolina — the South Carolina value receives very little weight in the overall calculation since the only poll there was conducted months ago."  In response to this, allow me to quote from this article titled, "Why Scientific Studies Are So Often Wrong: The Streetlight Effect": 

The fundamental error here is summed up in an old joke scientists love to tell. Late at night, a police officer finds a drunk man crawling around on his hands and knees under a streetlight. The drunk man tells the officer he’s looking for his wallet. When the officer asks if he’s sure this is where he dropped the wallet, the man replies that he thinks he more likely dropped it across the street. Then why are you looking over here? the befuddled officer asks. Because the light’s better here, explains the drunk man.

So in order to predict the national vote, Silver upweights "battleground" states like Ohio because the "light's better there."

Can anybody guess why Romney might be doing better in Utah than your typical Republican in the past?  I'm sure you can come up with a theory there.  Why might he being doing worse in Ohio?  Perhaps the "Not one of us" ads that Obama swamped the state with all summer in order to paint Romney as hostile to the working man brought Romney's support in blue collar Ohio lower without hurting Romney's support in the rest of the country (where the ads weren't aired) in the same proportion.

I'll make one final note here.  In his October 31 post Silver pointed at some other modelers and noted that they generally agreed with him.  As someone who works in finance I feel compelled to note that this is why so many supposedly brilliant hedge fund managers have their funds go bust.  They build these impressive appearing models that attract capital by virtue of their impressiveness without much consideration for the fact that the other hedgies are doing the same thing.  So when there is a market shock of some sort, these guys all end up trying to go in the same direction because their models are similar, and then they can't get out of their positions because there isn't anybody to take the other side of the trade!

Wildrose AGM review Part 4 - Alberta Constitution, financial regulation, gun rights

One of the first policy planks to come up for a vote called for an Alberta Constitution. A lawyer (or law student?) helpfully pointed out this could well end up playing a similar role to that of the Charter of Rights and Freedoms. As such, it would serve to limit the discretion of the elected legislature. The membership ended up voting for this measure, but later on voted for a philosophically opposite measure by deleting a clause that called for a referendum before invoking section 33 of the Charter (the Notwithstanding Clause), thereby handing discretion for whether to "opt out" of applying a provision of the Charter within Alberta back to the legislature. A sponsor of the measure to delete the requirement for a referendum when using s. 33 claimed that there would otherwise have to be a referendum every 5 years, but in fact that is only true under an unreasonable interpretation of the Wildrose policy clause. There is nothing in Canadian law which would preclude a provincial legislature from holding a referendum once, and the legislature interpreting that as supporting, say, a 50 year mandate instead of 5, and accordingly renewing sans referendum the use of s. 33 ten times over that 50 year period (every 5 years as is required by Canadian law).

I supported the use of section 33 without holding a referendum and voted against bringing in an Alberta Constitution primarily because I am a conservative as opposed to a libertarian. At the heart of our current problems is not too little reference to rights but too little reference to responsibilities. An Alberta Constitution, like all forms of legislation that are intended to be superior to the legislation produced by a legislature, would restrict the power of the majority (presumably) in the name of protecting the minority. The net result of this is provide a means of legal redress against the coercive power of norms. If the norm is to not engage in a certain behaviour, by enshrining a constitutional right to engage in the behaviour, deviants can sue to preserve their right to deviate. That's all well and good in theory, but in practice norms are what hold society together and minimize the development of anomie. The Charter of Rights and Freedoms only works in a liberal / libertarian direction opposed to conservatism because of its fundamental nature: it is not a "Charter of Responsibilities". While I grant that an Alberta Constitution could include rights that conservatives would normally support as part of an alliance with libertarians, like property rights, having experienced life in 80-odd countries and studied law and society for several years I am convinced that what ultimately protects a "right" is a society's norms, not what is written in its law books. Whatever a country's constitution might say, it is going to be interpreted in a way that is consistent with the prevailing culture of that country and the mentality of its people. North Korea is formally known as the Democratic People's Republic of Korea but in reality it is one of the least democratic jurisdictions in the world. An Alberta Constitution could ultimately make it more difficult to take necessary collective actions like creating budget surpluses, since it could create negative rights to not be taxed, positive rights to government services, or both. You might believe that the less collective action the better, but note that collective action is not necessarily government action. Whatever one's opinion on gay rights, for example, it is difficult to deny that the primary objective for those who used the Charter to advance gay rights was the erosion of the social norm than found same sex relations deviant. Government's role was really just incidental, since there was nothing stopping same sex couples from solemnizing their relationships before friends, family, and/or clergy. "Official" government recognition was important not for the piece of paper it involved but the message that was sent to the general public. Acceptance by society, as opposed to some formal government institution, was the most important goal.

Now it is true that an Alberta Constitution could enshrine things like "a marriage consists of one husband and one wife" but enshrining norms in legislation that is superior to elected legislatures is an abuse of power. Enshrining (true) rights at least has a rationale revolving around limiting majoritarianism. Enshrining whatever happens to be supported by the majority at a particular point in time (as reflected by the opinion of an elected legislature) as unchangeable for future majorities is to engage in unjustified exceptionalism. What is so special about today's norms that some of them should receive constitutional status? There has to be some sort of timelessness argument, and it is because I believe very very little is truly timeless than I oppose charters and lengthy, wide-ranging constitutions. Actually, I should correct that saying that I believe there are a number of timeless transcendent values but I am not inclined to force others to accept them by accepting my view of a constitution over theirs. Leave it to democracy. Choose conservative humility about what constitutes social justice over liberal arrogance. Constitutions and Charters take power away from democracies and hand that power to the framers of constitutions and charters. If an Alberta Constitution took power away from the federal government, I would interested in supporting it but, of course, an Alberta Constitution could control only the Alberta Legislature, not the Canadian Parliament.

Three policy proposals that came up later arose in a sequence and I ended up approaching the microphone to speak to all three. Two concerned labour and one concerned securities regulation. I'll address the labour matters in a subsequent post since otherwise this blogpost will be absurdly long. I spoke out against the proposal titled "Securities Act" because it just added clutter to the policy book. The policy planks should bind elected MLAs (and the party executive / leadership?) and this proposal didn't limit discretion at all. Gut securities regulation? Arguably OK because the proposed clause said the party supports greater protection for sellers of securities (against whom if not the buyers of securities, who would only have a positive action against the sellers if the law gave them one?). Increase the level of securities regulation? Just as defensible because the clause also called for greater protection of buyers of securities. A speaker in favour of adopting the policy plank made reference to the financial crisis, but I would refer readers to what the Economist wrote about the financial crisis just within the last day: "Though the financial crisis was global, it originated in America’s uniquely fragmented financial system, overseen by a patchwork of federal and state regulators." If the USA has a "patchwork of federal and state regulators" what does Canada have? Yet continuing or even increasing the "patchiness" of regulation in Canada seems to be exactly what the Wildrose leadership / caucus has in mind when it so intensely opposes a single national regulator. The Alberta Securities Act and Regulations is something like 3 inches think. It was my fattest statute book when I was in law school. Now times that by 13 for 10 provinces and 3 territories and call me when you are done reading, because only then have you mastered securities regulation throughout Canada, which represents, at most, 3% of global capital markets.

Were the party to adopt a plank like,

The Wildrose Alliance will use Alberta's influence over a national securities regulator to attempt to ensure that only financial derivatives listed on public exchanges may be traded in Canada

one might actually have something that got at what caused the crisis and helped prevent a future one. As that same Economist article notes, "[under the Dodd-Frank Wall Street Reform and Consumer Protection Act] Most derivatives that now trade dealer-to-dealer will be traded on public exchanges. That will lessen the risk that one dealer’s failure brings down others." Why is the risk reduced? For two main reasons. The first and most direct is that exchanged traded products are marked to market, usually daily, such that if one's counterparty defaults, the default is on just one day's worth of margin, whereas if the product were off-exchange, days, months, and perhaps even years' worth of a position going against the counterparty could have built up, leading to a massive credit overhang. The second is more structural, and goes to the transparency of the system. As the Globe and Mail reported on June 30 in a story titled, "Ignorance of derivatives spurred AIG fall",

As markets slid toward chaos, [AIG and Goldman Sachs] quarrelled bitterly over what obscure derivatives were worth, current and former executives testified Wednesday.
Their testimony casts light on what has long been one of the murkiest episodes in the broader meltdown.

Most Wildrosers support free markets primarily because they are free. As an economist, I primarily support free markets because it is generally the case that free markets make fundamental price values more transparent (government bureaucracy obscures the state of true demand and supply). But in the case of derivatives, which, as their name suggests, derive their prices from more fundamental prices, they make the fundamental economic signals more obscure. An off-exchange derivative is especially obscure because it is a tailored, non-standardized product requiring a unique valuation.

At the end of the day, neither of these policy planks, the Alberta Constitution nor this "Securities Act" plank, were especially consequential in and of themselves. With respect to the Constitution, what will matter is what is in it, not whether it exists or not. And the Securities Act plank didn't say anything. One could argue that the proposal to add a clause after "a Wildrose government will entrench individual property rights" stating "ownership of firearms is a form of property rights" would have been consequential (had it passed) but I don't think it would have been of great import in any case aside from optics (meaning voting just on one's view of the optics was entirely appropriate). It really just said what should be obvious: if one owns a gun one owns a gun. Governments violate individual property rights all the time by taxing individuals; it is just a question how much property the individual is left with after the tax man departs. What would matter was how the proposed policy plank was interpreted, and on that count I voted against it because the context seemed to be that of raising the right to own a gun to the level of, say, the right to due process, i.e. beyond mere property right. The debate on the subject helped turn votes against the proposal, I suspect, since the respected Link Byfield spoke out against and speakers in favour used implausible and/or extreme rhetoric, e.g. "a man without a gun is a slave (a man with a gun is a citizen)." As it was, a Firearms section which contained a lot of pro-firearms language was added to the policy book later, and the presumptive reason why that passed and this first proposal didn't was because the later proposal was in a context that was more appropriate to gun rights being on the level of presumptively respected but practically regulated property rights than on the level of inalienable and absolute personal rights.

So what did really matter, in my view? The provisions that were union-related, for reasons I will explain in my my next post.

"cap and cut"?

Today's Calgary Herald editorial calls for "cap and cut". Let's be clear here: "cap and cut" is not a policy, it's a tagline created by a politician. Saskatchewan Premier Brad Wall's new slogan makes little economic sense because if the government caps the emissions of two large emitters, say X and Y, and X could cut emissions at a cost of $10 per tonne and Y for no less than $20 per tonne, the government is making emissions abatement unnecessarily costly if Y cannot "trade" with X such that Y pays X $15 per tonne to reduce on Y's behalf. Y saves $5 per tonne in costs and X finds a new profit source in reducing emissions and selling the credits thereby earned.

The skeptics suspect that if a market for carbon emissions credits were actually set up, X would be an out-of-jurisdiction enterprise that would indeed find a new profit source in selling credits (to within-jurisdiction emitters) but without actually doing any real emissions reductions. I share this skepticism to sufficient extent that I am not a supporter of cap and trade relative to a carbon tax. But that's because the particular nature of the thing to be traded here. The Herald seems to object to the "trade" part of "cap and trade" on the general grounds that it would be, well, trade: to wit, "moving money around". As such, Calgary's paper of record feeds the presumption, perhaps unwittingly, that market systems in general just "move money around" and enrich financial sharks without creating any economic value.

In general, markets function well in setting the price signals that determine production. But the critical issue for markets is how to deal with information asymmetry.

A review of the financial crisis is instructive here. Although the flood of capital into the US (partly a consequence of the 1997 Asian crisis, in the wake of which many countries decided to protect against future runs on their currency by accumulating USD denominated assets) increased the risk that a sector of the US economy would have too much financing available to it, a bubble (which is a market failure, never mind the efforts of the EMH proponents to argue otherwise) was not strictly inevitable. The root of the 2008 financial crisis was rather a moral hazard: US mortgage originators were insulated from risk (or, more precisely, thought they were) because they spun the risk out to third parties via the financial system. Although financial markets perform a valuable function by redistributing risk, a tradeoff occurs (diminishing the social value of seeing the market trade occur) when the buyer of risk has less information than the seller. Had mortgage originators remained fully exposed to the risk of default by carrying the mortgages on their own books, they would have been fully incentivized to play a more active monitoring role with respect to their more doubtful clients. Although market discipline could have theoretically ensured that the originators remained vigilant, this discipline presumes that players all the way down the securitization chain could have been insightfully informed of the situation "on the ground". Maintaining this is increasingly difficult the more abstract the securitized products get. It is thus not just the quantity of information transmitted through layers of market players that matters but its complexity. More exacting disclosure regulations could not have helped avert the crisis when the problem was that it was too difficult to interpret the available information and when the people who could interpret the information had incentives to not share what insight they had. Finally, there was also an element of plain old dishonesty in that people filled out forms claiming that they had high incomes when in fact they didn't even have jobs. The bottom line is that the picture became too obscured for the pricing mechanism to ensure the efficient allocation of capital (although the US practice of allowing the tax deductibility of interest paid on residential mortgages was distortionary despite its transparency). Too few financial actors were engaged in the price discovery that sends signals to real production (they were instead creating and trading derivative products, which are effectively parasites on the price discovery process).

"Cap and trade" has problems of incentives and pricing complexity in spades. To take but a couple of examples, who is going to discipline the jurisdiction that sets easy caps on emitters in its territory in order to poach industry and keep employment up? Multilateral agreements could be made, but how is one going to detect and discipline cheaters? How economically useful is it going to be to stimulate the growth of a lobbying industry dedicated to convincing politicians to raise or lower the caps? An unworkable international emissions credits market (a purely local market defeating the whole point of a market) nonetheless does NOT mean that markets in general do not work. Economists are in almost universal agreement as to the value of free trade in goods and services. The consensus is also clear with respect to the free movement of capital provided it is genuine capital and not financial derivatives thereof which may or may not accurately represent changes in underlying capital. The problem with "cap and trade" comes down to the fact that the emission credits to be traded, which need to be fungible across jurisdictions, might not represent real emissions reductions. But that's a specific problem, not a general one.

crisis for capitalism = renaissance for left?

I have not written much on the financial crisis since I have been on the road and still am (currently in Chile). But I have a few moments today...

I do suspect there will be a serious revisiting of the idea of freedom of contract. But I do not think that it will be the leftist critique that cuts much ice. The left has often opposed freedom of contract on the grounds that contracting power is not equal. Unions, for example, may operate just like cartels in that they try to act as a monopoly supplier for their good or service (in this case, labour), but anti-competitive behaviour is OK if the victim is a corporate producer instead of an individual consumer (I could note the fact that, at the end of the day, it is still individual consumers who pay for the dead weight loss but that's another column). But at the root of the current crisis is credit being extended to poor individuals on terms that no one can say was too favourable to the corporate creditor. In fact, the terms were not favourable enough to those corporate creditors. Government policy that encouraged this flow of credit (including, but not limited to, mortgage deductibility) for no other discernible reason than creating more home owners (something that has no necessary relation with raising living standards) exacerbated the problem.

People can, and are, wagging the finger at the bankers. But the leftist critique has a hard time explaining how the bankers are to blame when it is the banks that are taking the hit and the borrowers who are washing their hands of unpaid debts. Sure, some banking executives made out like bandits, perversely, but in all of these cases it is not the borrower that was left holding the big but other capitalists, like the high rollers who put money into exposed hedge funds. The borrower is really only suffering because of the grief of the capitalists has "trickled down".

One can speak of "regulation", which is popularly conceived of as opposed to freedom of contract and therefore something on the "left" agenda, but in fact regulation is not necessarily left but anti-libertarian. Conservativism, as distinct from libertarianism, has always been suspicious of free wheeling capitalism. What conservatives approve of is competitiveness, something the left generally opposes (see my observations about labour supply cartels). A competitive character is a strong character. It is something in the blood. Freedom of contract, on the other hand, is an abstraction. And make no mistake, excessive abstraction is the root cause of the current crisis, when viewing from the most philosophical level.

A lot of regulations serve the leftist agenda of protecting favoured groups from competition. We do not need any more of that. But we could use more regulation that protects people from themselves. People have an inordinate capacity to create layers of abstraction that while theoretically designed to raise one's perspective from the concrete and immediate, often end up looping back to themselves in obscure ways such that one's perception is clouded by a false confidence. I have often preferred literature to formal philosophy because the former is more rooted (as an aside, I do not think the fact the Anglosphere is fertile ground to both analytical philosophy and exotic financial derivatives a coincidence). As novelist Joseph Conrad, very much a cultural conservative in temperament, wrote

Hang ideas! They are tramps, vagabonds, knocking at the back-door of your mind, each taking a little of your substance, each carrying away some crumb of that belief in a few simple notions you must cling to if you want to live decently and would like to die easy!

But it took two to tango here. Whereas the financiers blinded themselves via too much modeling and too little sense, the borrowers freely contracted with the bankers in order to satisfy their own consumption interests.

If I am getting too metaphysical here, it is because the continual search for an economic (or "abstract") explanation and/or solution is itself not going to be very satisfying if abstract models are themselves part of the problem. Economics does have a model for freedom of contract problems, namely, externalities (and externalities call for anti-libertarian policies). But this was not really a problem like a consumer and a producer freely contracting to dump the pollution associated with production on a third party. The categories are not so rigid. To a large degree, the third party here was the financiers themselves. It was the layers of abstraction that facilitated the inability (or unwillingness) to see that the music could stop and that it was themselves who could be left without a chair.

more on the origins of the financial crisis

Tony Frost, an International Business prof at Ivey (Western's B-school), writes one of the best summaries I've seen on this topic. I note that it echoes some of the themes I touched on back in November. Part of the reason I believe Frost has a better grasp of the factors than many experts is because he's coming from a biz school environment instead of an economics department. It's still academia, but it's a step closer to industry than economics departments.

That doesn't mean that I think Frost's account is complete. A complete account would expand on the relevance of the abstract concepts I raised last year like information asymmetry, moral hazard, and adverse selection.

"I just hope they know what they're doing."

It's just a gigantic scale.... It's the entire economic consensus in this country, including the academic economists, the Treasury people.... We're just taking such big moves. As I say, I just hope they know what they're doing.
- David Brooks, The Newshour with Jim Lehrer, November 28

I also hope they know what they're doing.

And I have major doubts that they do.

Let's start with the contradictions. "The entire economic consensus" used to be that cutting consumption taxes, like Canada's GST, which was just cut another 1% earlier this year, was the worst possible tax cut. Yet Britain cuts its VAT 2.5% and "Jonathan Loynes, chief UK economist at Capital Economics, said: 'This would be a bold, high-impact way of putting money straight into consumers’ pockets.'" Another source says that "[Britain's] economists seem united by a single opinion over the Government's immediate move to slash VAT from 17.5% to 15%. ... The move was, broadly, welcomed, and [even] criticised as not on its own being enough..."

So what was formerly out of fashion, to put it charitably, is now "bold" and "high impact"?

Auto sector bailout? Joseph Stiglitz is opposed, which wouldn't be especially surprising were it not for the fact that Stiglitz has been the most prominent economist to repeatedly jab an accusing finger at the Washington Consensus and free markets generally. Apparently Stiglitz doesn't think the decisions of private finance re the allocation of capital should be second-guessed... except when they should.

The incongruities increase: Germany's Social Democratic finance minister, Peer Steinbrück, said:

All this will do is raise Britain's debt to a level that will take a whole generation to work off. The same people who would never touch deficit spending are now tossing around billions. The switch from decades of supply-side politics all the way to a crass Keynesianism is breathtaking. When I ask about the origins of the crisis, economists I respect tell me it is the credit-financed growth of recent years and decades. Isn’t this the same mistake everyone is suddenly making again, under all the public pressure?

A supposedly left wing politician, and a Continental one at that, is the voice speaking out against a deficit-financed government spending spree? I'm reminded of when the NDP criticized Alberta's "Conservative" government for its spending. Considering the source, perhaps they have a point?

It is true that there are economists like Greg Mankiw who consider themselves stimulus skeptics, but Mankiw is (1) apparently very much in the minority ("Only one outside economist contacted by Obama aides, Harvard's Greg Mankiw, voiced skepticism") and (2) Mankiw is careful to call himself a skeptic and not an opposer.

There was a time when I put a lot of stock in what academics hold as true with respect to finance and economics. But my experience of the real world of finance disabused me of notions that are still considered gospel for professors, like market efficiency. Markets are not efficient with respect to pricing; they are inevitably subject to manias, panics, and crashes (unless (and even then this is just a theoretical unless) there is total transparency and simplicity with respect to how to determine fundamental values). Indeed, this is at the very core of what got us into this mess: the idea that market-determined prices reflect economic fundamentals. Financial engineers were given free reign to innovate ever more exotic financial products that worked AGAINST efficiency instead of for it by reducing transparency and simplicity. You didn't get better capital pricing with more financial market development, you got worse. Things got further and further away from fundamentals because the trial of bread crumbs became so long and convoluted nobody could understand it.

Now, as an aside, when I speak of market development I speak of the number and complexity of financial instruments (in particular second and third order instruments, aka derivatives) as opposed to liquidity. If I were pointing the finger at liquidity or trading levels, I'd be pointing the finger at capitalism itself.

These academics, in conjunction with the Wall Street veterans who have a conflict of interest with respect to bringing the sort of transparency to capital pricing that would allow non-Ivy League MBAs to figure out what was going on, are supposed to be now be deferred to with respect to a gi-normous dump of future generation financed government spending?

Germany's social democrats are questioning the wisdom of a massive expansion of government, while the Anglo-Saxon world is gung-ho. May you live in interesting times.