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June 2009

Mathematical Models in Finance and Economics

"In Modeling Risk, The Human Factor was Left Out." (New York Times, November 4, 2008) This article argues that, while the financial crisis has been blamed on the mathematical models of financial engineering, "the larger failure, [experts] say, was human - in how the risk models were applied, understood and managed." There is a good analysis of the role credit-default swaps played in the current situation, and a brief mention of the computer credit-scoring models that replaced human judgment in approving mortgages.

One of the people quoted also touches upon the difficulty in quantifying factors like "complexity, transparency, liquidity and leverage." In addition, a report by the Fed suggests Wall Street analysts "correctly predicted that a drop in real estate prices of 10 or 20 percent would imperil the market for subprime mortgage-backed securities", but severely underestimated the probability of this happening. (By now, errors in estimating probabilities are nothing new.) The article has many more nuggets of wisdom, which I will let you discover for yourself, but I'll end with this excellent quote by Columbia University Emanuel Derman: "To confuse the model with the world is to embrace a future disaster driven by the belief that humans obey mathematical rules."

"Bernanke's Models, and Their Limits." (New York Times, October 30, 2005) This article states that Bernanke, who was at the time the nominee to replace Alan Greenspan at the Fed, "has focused on the use of mathematical models to set monetary policy" and "has written repeatedly about ways of using mathematical models of a dauntingly complex economy to set monetary policy." His philosophy, according to the article, is "that the central bank should use a model, not just hunches, to decide about interest rates and the money supply."

A late economist at MIT, assessing one of Bernanke's models published in the literature, commented that "the interesting issue is not the gentle part of the trip but rather when it crashes;" the model apparently did not account for the fact that credit and liquidity could dry up. (And this was 2005.) But another professor, this time from Berkeley, supported Bernanke: "He of course understands that even in normal times, the best model is just a guide."

"The Anti-Macroeconomics Roar Grows Louder." (New York Times, June 3, 2009) Steven Levitt, of Freakonomics fame, argues that macroeconomics isn't about "writing down fancy mathematical models." Part of the problem, he says, is a lack of macro data, which makes it hard to measure the skills a good macroeconomist is supposed to have. He writes: "The single easiest way to make a mark in a modern macro paper is to solve a problem that is really, really hard mathematically. Even if it is not that relevant to anything, it is seen as a sign that the author has “impressive skills,” which is enough to get a job — and even tenure sometimes — at top universities."

While mathematical models are hopefully more relevant in real life than Levitt implies, he voices a valid concern, which is also illustrated in the chasm in my field between "hard operations research" (which is mathematics-driven) and "soft operations research" (which is non-mathematical). You can read more about that in OR/MS Today, especially "Taming Hard Problems with Soft O.R." (April 2009), "The Case for Soft O.R." (April 2009) and "Who's SORiors now?" (June 2009) The battle goes on.


Car windshields and Styrofoam cups

Diandra Leslie-Pelecky, guest blogger at Cocktail Party physics, has an interesting post, complete with equations and back-of-the-envelope estimates, on whether a Styrofoam cup can break a windshield. Her instinctive answer is: of course not. It's a Styrofoam cup! Then she saw the pictures - she was asked the question by a local reporter after someone in a car discarded a cup of soda through his or her window, cup that then smashed the windshield of a poor woman who happened to drive by in the opposite direction.

For those of you who can't get over the fact that all this damage was caused by a Styrofoam cup, the key isn't the cup (very light), but the soda that was in it (much heavier). As Leslie-Pelecky writes, "We know it was a cup of soda because, in addition to poor Marilyn [the innocent driver] getting wet, there is sticky dried cola-colored liquid all over the inside of the car.  The police pulled part of the cup out of the windshield (which is how we know it came from Sonic) and found a shredded straw inside the car." (The driver was lucky to be wearing glasses,which "were pitted from where pieces of windshield glass hit them.")

Leslie-Pelecky proceeds to estimate the force with which the cup full of soda hit the windshield, coming up with a range of 24-120 pounds because of the lack of data on the angle at which the cup hit the car and other parameters. It's a fun article to read for people who like science; Leslie-Pelecky points out that more kids might become interested in physics if high school exercises were more relevant to real life. But when it comes to throwing your cup of soda out of your moving car, the moral of the story is that it's a big no.


Manufacturing and America's Competitiveness

The July/August issue of Harvard Business Review has an excellent article on "Restoring American Competitiveness" by Gary Pisano and Willy Shih (pp.114-125). The authors object to the commonly held view that outsourcing low-tech manufacturing has had no impact on the American ability to compete; on the contrary, they argue that "decades of outsourcing manufacturing has left US industry without the means to invent the next generation of high-tech products that are key to rebuilding its economy."

The statistics they provide certainly give pause. For instance, the authors point out that the US trade balance in high-tech products has steadily declined, from a surplus in 1999 and 2000 to a deficit from 2002 onwards; the deficit now reaches 53.6 billion dollars. (See Figure 6-19 in the National Science Board report, "Science and Engineering Indicators 2008".) Furthermore, "average real weekly wages have essentially remained flat since 1980, meaning that the US economy has been unable to provide a rising standard of living for the majority of its people."

One of the authors' central claims is the importance to high-tech innovation of what they call "the industrial commons", i.e., "R&D know-how, advanced process development and engineering skills, and manufacturing competencies related to a specific technology." Such a commons is often rooted geographically; for instance, US biotech firms have clustered in Boston, San Diego and San Francisco, while Germany is known for its mechanical engineering commons due to its automobile and machine tool industries. This is why, in the authors' eyes, the world is not flat at all. (Sorry, Thomas Friedman.) Instead, "innovation in one business can spawn whole new industries," which makes it difficult, for companies that have outsourced the manufacturing of mature products, to compete in more cutting-edge areas based on similar technologies. (See the example of the solar panel industry p.118.)

An example p.119 also shows the erosion of the US industrial commons in the personal computer industry; I was surprised to learn that "[n]early every US brand of notebook computers, except Apple, is now designed in Asia, and the same is true for most cell phones and many other handheld electronic devices." (p.116 - italics mine)

A couple of additional quotes:

  • "One [myth] is the popular belief that an advanced economy like the United States no longer needs to manufacture and can thrive exclusively as a hub for high-value-added design and innovation. In reality, there are relatively few high-tech industries where the manufacturing process is not a factor in developing new - especially, radically new - products." (p.119)
  • "[The prevailing view that the migration of mature manufacturing industries away from developed countries like the United States is just part of a healthy, natural process of economic evolution] ignores the fact that new cutting-edge high-tech products often depend in some critical way on the commons of a mature industry" (p.120)

For other great insights, including (1) a sidebar on "why Amazon's Kindle 2 can't be made in the US", (2) a discussion on the role of government, especially in funding basic vs applied research ("Government funding for applied research has declined even more sharply [than for basic research]... [But] Creating the internet involved little or no new basic science. It did, however, require significant investments in applied research," p.122), and (3) words of advice to companies ("Create technology-savvy boards of directors," p.125), head for the closest newsstand while the HBR issue is in stores!

For the opposite view, check out "Innovation in America: A Gathering Storm" from the November 20, 2008 edition of the Economist, which refers heavily to Amar Bhide's "The Venturesome Economy," a 2008 Best Business Book of the Year. The book argues that the US doesn't really need more PhDs in science and engineering: innovation happening abroad will find its way to the States due to the appeal of the large American customer base (so companies will want to market their products in the US), and bringing high-tech innovation to consumers requires good business skills rather than advanced scientific skills. From the Economist: "For America to retain this sort of edge, then, what the country needs is better MBAs, not more PhDs."

Bhide "argues that the obsession with the number of doctorates and technical graduates is misplaced because the “high-level” inventions and ideas such boffins come up with travel easily across national borders." This assumes that all the inventions that aren't discovered in the US can be discovered elsewhere at about the same time. I disagree with the idea that geographic location doesn't matter. The Academic Rankings of World Universities are consistently dominated by American institutions; US-based professors have often spent decades developing cutting-edge expertise, which cannot easily be acquired in a short period of time by others. Of course, some non-US universities, such as the University of Utrecht in the Netherlands and Sapienza University of Rome in Italy, rightfully enjoy worldwide fame, but making it more difficult for US-based professors to supervise students due to the lack of funding impedes their ability to make discoveries and pass along their knowledge; it also hurts the students who are unable to realize their full potential. This, in turn, delays innovation. Hoping research is "background-independent" and will simply be performed in another country before finding its way to the States is naive, at least for now.

The comments at the bottom of the Economist article widely slam the position that the US doesn't need more PhDs. I wouldn't throw away the HBR article just yet.


First Book

Many charities have seen the amount of their donations decrease this year and, as the end of their fiscal year draws near, are making last-minute pleas for help before the June 30 deadline. So I thought I'd make a quick plug for my favorite charity, First Book, an organization that gives new books to children in need. Every ten dollars donated provides five new books to kids of low-income families; in addition, First Book has a four-star "exceptional" rating from Charity Navigator, which means the money donated really goes toward buying books for the kids, and not, say, toward paying the staff's salary. (First Book extensively relies on volunteers to fulfill its mission.)

Fighting illiteracy is a cause dear to my heart, because - as the people who have been reading this blog for a while know - education helped my family get out of poverty many years ago. My grandmother was a genocide survivor who arrived in France with only the clothes on her back; my grandfather (her future husband) was a blue-collar worker who painted cars before there were robots to do that, and before people knew they should wear masks to protect their lungs from the paint fumes. He died in the hospital from respiratory problems. There is a similar story on the other side of the family. I wish my grandmother, who outlived her husband by two decades, had lived long enough to learn that I had been admitted to MIT - she missed the big news by a matter of months. For her, the school cook who hadn't graduated from high school, that would have been like her granddaughter being elected President. Anyway, my parents got where they are by studying very hard in school, and making sure their children studied very hard too. If kids don't know how to read, though, they will never get a chance to improve their life. High levels of literacy help give disadvantaged children and their family the tools to take control of their situation and fight for themselves.

So I donate to First Book every year, and I hope you'll make a donation too. The minimum amount is just five dollars.


Universities' Cost Savings Measures

The June 18 edition of the New York Times has an article about universities' original ways to save money ("For Colleges, Small Cuts Add Up to Big Savings") One of these measures sounded oddly familiar... Others seemed overdue - for instance, why should students get free ESPN and HBO? Who in this day and age prefers using the antiquated phones in the dorm rooms rather than one's own cell phone or email system? Eliminating free printing in libraries and labs is a more sensitive topic; I would rather let the "average" users print for free and only make students pay when they have exceeded a quota. In any case, it would be useful to track everyone's consumption and let people know how they measure up with respect to their peers.

Some of the measures surprised me - "Cafeterias, too, are saving money, cutting food waste and reducing hot-water and detergent costs by eliminating trays." This measure has supposedly saved Whittier College in California about $30,000 a semester. But others simply shift the burden of the economic crisis off-campus: "Rhodes College in Memphis economizes — and gives students work experience — by hiring students in 25 professional staff positions, saving $725,000 a year." That means 25 more people in Memphis have lost their job. Similarly, shifting from a daily trash-collecting schedule to a weekly one "eliminated three custodian jobs" at Carleton College in Minnesota.

Other universities have taken bigger steps toward reducing costs, and have sometimes created controversy in the process. Brandeis University in Massachusetts, in particular, has been sharply criticized for its decision to close its Rose Art Museum, which owns works by world-famous artists such as Roy Lichtenstein and Andy Warhol. (See "Brandeis to sell school's art collection", Boston Globe and "In the Closing of Brandeis Museum, a Stark Statement of Priorities", New York Times)

Selling a few paintings is a far better solution than laying off employees; closing the whole museum, though, suggests a complete disinterest for art and a belief that visual displays of innovation, creativity, and original thinking bring little to student education. Brandeis's decision is particularly controversial because, in the NYT's words, the museum "supports itself, raises its own funds and has consistently planned wisely for its own future without leaning on the university. The trustees treated it nonetheless as a disposable asset." 

Overall,though, many universities have resorted to traditional cost-cutting measures, which are reviewed in this news release from Temple University college by college. North Carolina State has published a detailed memo on its approach, which involves flexible furloughs, layoffs and salary reductions. Harvard University has unveiled a voluntary early-retirement program.

I was struck by a sentence in the Harvard Magazine article: "What did it matter if the endowment were reduced in size to the 2005 level?" That is an excellent question - 2005 was only four years ago. Here is the answer: "In the succeeding years [...], the faculty had grown by 63 additional professorial slots; FAS [Faculty of Arts and Sciences]’s buildings had grown by a million square feet of new space, for which it now bears debt-service and operations-and-maintenance expenses (which are especially high for laboratories, the bulk of the new space); and undergraduate financial aid had risen $55 million annually, from $81 million in fiscal year 2005 to $136 million now (reflecting increases in aid for students from lower- and middle-income families)." It is incredible that sustaining such changes, which happened over a relatively short period of time, now requires drastic measures such as early-retirement packages.

In response to the crisis, three young Harvard alumni have created a website matching "alumni lenders and cash-strapped [Harvard] students, who post photographs and biographical information and can request up to $2,000", in the New York Times's words ("I'm Going to Harvard, Will You Sponsor Me?"). The loans are "interest-free and payable within five years of graduation." While the sums involved remain modest ("So far, the alumni have lent about $4,500 to the eight students who have uploaded profiles"), the website offers an interesting new way to directly match alumni donors and students from the same university; alumni are promised three updates a year from their students in exchange for a relatively small amount of money (compared to the usual headline-making gifts). This brings small donors into a limelight they are unused to, and must certainly appreciate. Maybe it's time for universities to put the same ardor in collecting small gifts that they are showing in creating small cuts.


Jobless in Montana, and Elsewhere

Government officials in the city of Bozeman, Montana, unleashed a storm of criticism this week when it was revealed they had asked applicants for city jobs to "list any and all current personal or business Web sites, web pages, or memberships on any Internet-based chat rooms, social clubs, or forums, to include, but not limited to: Facebook, Google, Yahoo, YouTube.com, MySpace, etc".

Applicants were apparently requested to turn over their usernames and passwords, which violates Facebook's terms of service and possibly those of other social sites. The outcry prompted the city of Bozeman to suspend its practice yesterday. While the city's backing down was not surprising, its unusual policy represents only the latest attempt by employers, who face unprecedented numbers of applications for each job opening, to learn more about the candidates as they attempt to find the best fit for the position.

The Wall Street Journal printed a fascinating article about two weeks ago: "What won't you do for a job?" (June 2, 2009) It describes the "unconventional hurdles" candidates are subjected to. For instance, "[A jobless] executive and seven fellow candidates were ushered into a crowded boardroom [at a West Coast bank], where officials gave them each five minutes to interview the applicant next to them and offer a presentation on "why that person would be the best person for the job," [the executive] recalls." Another company offered an "unpaid tryout" to a jobless analyst. The WSJ comment section contains interesting remarks on companies using (ultimately not hired) applicants to perform unpaid consulting work for them; see for instance the one starting with "As a professional Heathcare Recruiter..." 

But the WSJ article also cites good practices, such as having candidates perform case studies and simulated work tasks. The days where one could ace an interview by only "talking" and not "doing" might be over.


"Influence" by Robert Cialdini, Part 2

Here is the second part of my post on "Influence: The Psychology of Persuasion" by Robert Cialdini. (Part 1, about the first hundred pages, is here.) Below are highlights from the remaining chapters. The book is packed with extraordinarily useful information and there is much more to gain from reading it in its entirety.

  • Still in Chapter 3 - Commitment and Consistency - Cialdini describes a technique used by car salesmen, which he calls the lowball on p.98 of the Collins Business Essentials paperback edition. The dealer quotes a really good price for a car, but in fact "never intends [the deal] to go through"; the offer's "only purpose is to cause a prospect to decide to buy a car." Then people's need for consistency takes over and "customers automatically develop a range of new reasons to support the choice they have now made." When the salesman comes up with excuses why he has to increase the car price after all, people's initial commitment to the car often prevents them from stepping back and realize what is happening. Interestingly, this technique can also be used for the greater good- see a study p.101.
  • In Chapter 4, Social Proof, Cialdini analyzes starting on p.129 why people didn't come to the aid of an assault victim who was terrorized on the street for half an hour and ultimately murdered while thirty-eight witnesses did nothing to help. He argues that "in an ambiguous situation [with many other witnesses], the tendency for everyone to be looking to see what everyone else is doing can lead to [...] the failure of entire groups of bystanders to aid victims in agonizing need of help." Along the same lines, he recommends on p.138 that victims of car accidents (having been one himself and witnessed social proof in action) dissipate any ambiguity and put specific people in charge - "Isolate one individual from the crowd: Stare, speak and point directly at that person and no one else." In his experience, people about to drive by without stopping then become very willing to pull over and help.
  • Chapter 5, on Liking, offers an amazing story about how "an innocent association with either bad things or good things will influence how people feel about us." (p.189) An insert on that page describes how television weather forecasters are sometimes held responsible for bad weather, and subjected to threats from irate citizens. A forecaster from Arkansas recalls that a burly, drunk farmer came up to him in a bar one day and said: "You're the one that sent that tornado and tore my house up... I'm going to take your head off." The forecaster, who wanted to ask the bouncer for help but could not spot him, came up with the following answer: "That's right about the tornado, and I'll tell you something else, I'll send another one if you don't back off." I'm not kidding. The quote is on p.190.
  • Chapter 6, about Authority, stunned me with its account of a scientific study addressing the question: "When it is their job, how much suffering will ordinary people be willing to inflict on an entirely innocent other person?" (p.211) The study involved groups of two participants, one in a Learner role and one in a Teacher role. The Teacher served as the researcher's assistant and administered progressively more painful electrical shocks when the Learner answered questions incorrectly. (The Learner volunteer was in fact an actor and there were no electrical shock involved, but the Teacher volunteer did not know that and did not realize his behavior was the true subject of the study.) It turns out that "the typical [Teacher participant] was willing to deliver as much pain as was available to give," although the Learner begged him to stop, convulsed in pain, screamed, and did everything he could to convince the Teacher to stop. So why didn't the Teacher agree? Because the researcher - his boss - told him to keep going. On p.215: "It is the extreme willingness of adults to go to almost any lengths on the command of an authority that constitutes the chief finding of the study."
  • Chapter 7, on Scarcity, describes a study about jurors' reaction to evidence being declared inadmissible at a trial (p.254). "Thirty [experimental] juries heard the case of a woman who was injured by a car driven by a careless male defendant." The jurors awarded the woman $37,000 when the driver said he had liability insurance and $30,000 when he said he had not, but what's truly fascinating is that "if the driver said he was insured and the judge ruled that evidence as inadmissible [...] the instruction to disregard had a boomerang effect, causing an average award of $46,000." Cialdini concludes: "We react to information restriction [in a courtroom] by valuing the banned information more than ever."

This is one of the best business books I have read in a while and I highly recommend it.


Trouble at the Boston Globe

The Boston Globe has been making the news instead of reporting it this week - on June 8, the paper's largest union "narrowly rejected $10 million in wage and benefit cuts," which led its parent company, the New York Times, to impose a 23% pay cut on union members (Boston Globe, Globe union votes no, June 9, 2009.) As of today, management and union are still negotiating; a hearing on the unfair labor charge, which the Guild union filed about the 23% cut, has been postponed to give both parties a chance to reach an agreement (Globe management and guild resume talks, June 16, 2009).

The Globe is projected to lose $85 million this year if no savings are made, and the Times has hired the investment firm Goldman Sachs for help in possibly selling the paper (Christian Science Monitor, Any buyers for the Boston Globe? June 11, 2009). Read also: New York Times Seeks Buyer For Boston Globe, Washington Post, June 11, 2009. According to the Post, the Times bought the Globe for $1.1 billion in 1993, and an expert now puts the Globe's value at $200 million, in part because of - or thanks to - its real estate.

Some people question whether a cost-focused approach is the right way to go. For instance, Jeff Jarvis writes at his Buzzmachine blog: "Rather than nickel-and-diming-and-dollaring their way to survival through cutbacks (though I wonder how saving $20 million when you’re losing $85 million can possibly do the job; it’s a Band-Aid on a gushing artery) the Globe should find its alternate future not as a newspaper but as a journalistic service online." Stephen Baker raises a similar question on his BusinessWeek blog. The fact that the proposed cuts represent less than 25% of the projected losses has been largely ignored in the mainstream articles I've read. The New York Times doesn't seem to have a plan to tackle the remaining $65 million losses, except by selling the paper and making it someone else's problem. More information on potential bidders is available in the Boston Globe's article: Papers' bidders may join forces, June 16, 2009)

 Finally, Bloggingheads.tv has an interesting "dialog video blog" (dubbed diavlog) about Journalism 2.0, "Brand You" and the broader presence that will be required of journalists-bloggers if they want to remain professional reporters - as in: paid ones - and make a living out of their vocation in a world where journalism is increasingly blog-based.


Academia's Petty Fights

Someone once said that academic politics are so vicious because the stakes are so low. The quote, under various forms, is routinely attributed to former Harvard professor and Secretary of State Henry Kissinger, but others have said it is also due to Wallace Sayre, a former Columbia professor (see in particular the Wikipedia page for Sayre's Law.) According to Wikipedia, similar statements have been repeated by various people over the years, from Woodrow Wilson to Laurence Peter to Richard Neustadt, which suggests the quote struck a chord with many. (Still according to Wikipedia, Kissinger couldn't help but add in a speech in 1997: "And I promise you at Harvard, [the fights] are passionately intense and the subjects are extremely unimportant.")

In its May 28th edition, The Economist provides another example of Sayre's Law, which is stated on the Wikipedia page as (in a formulation attributed to Charles Issawi): "In any dispute the intensity of feeling is inversely proportional to the value of the stakes at issue... That is why academic politics are so bitter." The article, entitled "Natural selection - academic squabbles really are the bitterest", describes the infighting for "Oxford University’s professorial seat in poetry, paying just £6,901 ($11,000) a year" but offering a lot of prestige. It is quite enlightening - I'll let you read for yourselves because it is hard to give a good account of the squabbles without quoting the whole article. The best part is at the end - "This year, out of more than 4,000 academic staff and 150,000 graduates, only 477 people bothered to vote." Such a big fight for such a small audience.