This makes some sense to me, theoretically. But here’s what’s weird, something I’ve been wondering at myself for quite a while:

American is the only country in the world where “liberal arts education” is widespread, actually pretty much ubiquitous in higher ed. Every other country has a much more voc-tech model: even at Cambridge and Oxford (and certainly in France or China), when you get to college you declare your major immediately, pursue that major, then get a job in that major.

America also has, far and away (by everyone’s measure, here and abroad), the most, best universities in the world — maybe even equivalent to its military dominance. America is the number-one magnet location for students from across the globe. And countries across the globe are soliciting American universities to set up satellite shops — with their liberal arts models — in their countries.

How to explain this? The standard, loosy-goosey nostrums about developing critical thinking skills, flexibility of mind, adaptability in a fast-changing work world, etc. seem so vague and wooly up against hard-eyed, nuts-and-bolts preparation for the world of work. But on a national and global level they seem to be born out, in spades.

It’s worth noting that those university rankings give a lot of weight to the strength of graduate schools — which are, essentially, voc-techs at a high level. But (almost) all the people in those graduate schools came up through the liberal arts undergraduate system.

It’s possible, of course, that we have the best universities in spite of the liberal arts model, not because of it. Perhaps if we were more utilitarian we’d be even more profoundly dominant in higher education. But I’m thinking that that imagined counterfactual conjecture has the burden of proof on it, up against the existing evidence.

This reminds me of the comment I read a while back from history professor. His students would ask him what they could do with a history degree. He said (paraphrasing from memory here), “Unless you’re going to teach, nothing. But that’s the wrong question. The right question is ‘What do people with history degrees do?’ The answer is — everything.”

Me, I got my B.A. in Literature, Theory and Criticism, and went on to be an equity partner and/or principal in a whole string of startups, with combined values totaling tens of millions of dollars. Did that degree help me do that? I have absolutely no idea. I do know that it’s what I wanted to do at that time — what I’d work at day and night because I was fascinated by the subject. (Even though I had absolutely no intention, at any time in my life, of becoming a teacher or a professor.)

And that interest has continued, greatly enriching my life ever since. Viz. (Competing for the most-life-enriching prize is what I call my pre-graduate degree, which I took in downhill skiing — paid for by loading chairlifts in Very Cold Weather for two winters at low wages, and by the opportunity cost of not doing something more remunerative and/or career-enhancing.)

I don’t call myself representative — I’m somewhat smarter than the average bear, and I had a lot of other advantages of birth. Certainly some people will enhance their lives far more by studying something more practical.

But on a national level, I like to think about one of my kids’ friends, who is currently at the Annapolis Naval Academy, majoring in … literature.

Wacky? Maybe so. But when I look at the world around me, the balance of the evidence tells me that our country and our world are better off because he has the freedom and opportunity to do that. It’s another aspect of the freedom that our country provides — cultural, institutional, intellectual, psychological — which is among the main reasons — maybe the main reason — that we’re such a remarkably successful country.

Related posts:

1. Consumption Inequality Revisited: Uh…Hello??
2. Republicans Create Opportunity? Yeah, Right.
3. Women Rule! So Why Do They Tart Themselves Up?

A lot of people — maybe even most Americans — think that making government smaller will make it better.

But that reminds of the time when I a little kid that I got in trouble for pouring water out of a glass down a heat register in our house.

Why down a heat register? I can only say that it seemed like a good idea at the time.

Why was I pouring water out of a glass? Because the water was warm, and I wanted cold water. I figured I could pour the hot part out. What can I say? The logic of children.

With the experience, wisdom, and sagacity of age, I’ve realized why that wouldn’t work. It’s like blood-letting, right? If you drain off the bad blood, you’ll get better!

For the last thirty years, the Republicans have been engaged in the political (and intellectual) equivalent of blood-letting.

Contrary to what the sainted President Reagan said, government is not the problem. Bad government is the problem.

The solution to bad government is not small government, but good government.

Pass it on.

Related posts:

1. Government: BAD? — Part 1 of a Series
2. Milton Friedman Caused The Great Depression
3. McCain: Rebel Without a Brand?

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1. Guantanamo Chief Prosecutor on Guantanamo
2. Pubs: You Had a Blank Piece of Paper for Eight Years

For many data series, it’s very easy (as demonstrated here) to cherry-pick periods that seem to “prove” a given thesis. Far better to look at a whole bunch of periods of different lengths and see if there’s any pattern.

In this case, there doesn’t seem to be:

Think of each number representing a scatter plot with a trend line, like the graph in the previous post. Negative correlations mean higher taxes/slower growth; positive correlations are the opposite.) I’ve used percentage here because I think they’re easier to grasp at a glance. 20%, for instance, means a correlation usually represented by .20.

Averages:
All periods: -.18%
Periods >9 years: -2%
Periods >19 years: 4%

Averaging may not be terribly valid, but it is a quick way to do what you were doing anyway: looking at the chart and trying to eyeball the average.

These are vanishingly small correlations; don’t even need to calculate a p function to know they’re deep within the range of randomness, chance.

Counts:
All periods: 42% of 78 periods show positive correlation.
Periods >9 years: 42% of 36 periods show positive correlation.
Periods >19 years: 66% of 6 periods show positive correlation.

Draw your own conclusions.

Related posts:

1. Are Progressive States More or Less Prosperous? Not Really
2. Do Lower-Taxing States Grow Faster? No.
3. Small Government Spurs Growth? Economists Say No.

You have millions, maybe tens of millions, in the bank.

You live in a big, gorgeous house on the water on Mercer Island, with sunset views and your sailboat and powerboat out front.

You and your family are actively involved in the community — arts, sports, non-profits, civic groups, and assorted commercial ventures.

Quite possibly, most of your family is here, and maybe has lived here for generations.

You have a large circle of long-time friends here that you love.

If you have school-age kids, they’re in schools that they love. (If the public schools don’t cut it where you are, they’re in great private schools.)

You have everything you want.

So…you’re obviously going to move your family to to Alaska or Wyoming to save $5,000 a year in taxes — for you, mere pocket change. (Note: if you’re only making a measly $400,001 a year, your extra taxes would be … five cents. And that’s not even considering the $4,000 a year your business[es] will save in B&O taxes.)

Yes, you could pretend that your legal residence is elsewhere. But if you’re like most of the people described above — I know, have known, lots of them, so I’m here to tell you — you’re also not willing to lie and cheat to save $5,000 a year.

While you’re thinking about it, check out Sightline Daily’s takedown of The Seattle Times‘ deceptive math.

Related posts:

1. Mankiw’s Right: Money’s Not the Incentive
2. Washington State Income Tax (Initiative 1098): Who’s Affected?
3. Most Regressive Taxes? My Home State :-(

The simple fact is, this building is private property, and the owners have a right to use the building as a house of worship, and the government has no right whatsoever to deny that right. And if it were tried, the courts would almost certainly strike it down as a violation of the U.S. Constitution.

Should government attempt to deny private citizens the right to build a house of worship on private property based on their particular religion? That may happen in other countries, but we should never allow it to happen here.

I would add:

1. The moderate muslim community, which uniformly disowns and decries terrorism in the name of Islam as despicable and contrary to their religion, is the most powerful voice there is against those terrorists. There are few more effective things we can do that empower, embrace, and encourage that voice.

2. The voices against the mosque are raised not in prospect of any future good, but in angry reaction to past evils. Vengeance, revenge, should never serve as the spur to our actions, because the urge for vengeance — no matter how innate and irresistible it is to the human character — is always about looking backward, never forward.

Retribution — rooted in cold, clear, calculated reasoning and intended to prevent future evils — is often essential and inescapable. But vengeance-driven actions are almost inevitably counterproductive.

That’s what I think, anyway.

Related posts:

1. Religious “Indoctrination”?
2. Fareed Zakaria for President
3. Is Altruism Inevitable?

Again I used median household income, because it’s a good measure of widespread prosperity, a.k.a. The American Dream.

Here’s the story:

In aggregate, there’s no discernible difference between growth rates for low- and high-taxing states, despite quite large differences in taxation levels. The correlation is -.03. That yields a two-tailed p value of .85, meaning that there’s 85-in-100 odds that the (tiny) correlation is just random chance.

As usual, this is just one slice of the data, analyzed in one way. It’s only worth paying attention to because it sings exactly the same song as dozens of other slices, analyzed dozens of other ways.

Update 8/16: To see the correlations for many more periods, click here.

Related posts:

1. Are Low-Taxing States More Prosperous? No. QTC.
2. Are Progressive States More or Less Prosperous? Not Really
3. An Open Letter to Robert Barro

But what about states? Are low-taxing states more prosperous?

I decided to take a look at tax burdens compared to median (read: middle-class) household income. It’s a good measure of widespread prosperity, which is what The American Dream is all about. Here are the results:

Higher taxes, more (widespread) prosperity. The correlation is .22.

Is this statistically significant? The two-tailed p-value is .12, meaning there’s an 88% chance that something is causing this correlation. There’s only a 12% chance it would happen by chance.

Does this mean that higher taxes create greater prosperity? That would be quite a leap. But nothing here contradicts that possiblity.

We can say this, though: the numbers we’re looking at here give absolutely no evidence that lower taxes results in greater prosperity.

If anything, the opposite is true.

(While I’m here I can’t resist pointing out the one big outlier: Sarah Palin’s Socialist Utopia of Alaska up there in the northwest — thanks to its redistribution of oil revenues.)

median income: http://www.census.gov/prod/2009pubs/acsbr08-2.pdf

taxes: http://www.taxfoundation.org/files/f&f_booklet-20100325.xls, tab 2

Here’s the spreadsheet: http://www.asymptosis.com/wp-content/uploads/2010/08/state-median-income.xls

Related posts:

1. Do Lower-Taxing States Grow Faster? No.
2. Are Progressive States More or Less Prosperous? Not Really
3. Taxes: Equity versus Efficiency? Not so Much

I can’t resist quoting this:

I suspect brain damaged partisans of the left suffer from somewhat different cognitive deficits than brain damaged partisans of the right.

I would add that the brain damaged partisans of the left (there are plenty of them) don’t control the Democratic party. Contrary to what the brain damaged partisans on the right might believe (you know: the whole Republican/tea party gang, top to bottom), they’re mostly prattling over at Daily Kos.

Stockman: How the GOP Destroyed the U.S. Economy | The Big Picture.
By Barry Ritholtz

Related posts:

1. Tea Partiers: Old, White, Rich, Educated Men
2. Dang Those Bush Tax Cuts Really Worked!
3. Pubs and Dems: Brands and Beliefs

There’s been some debate going back and forth recently on how many Washington State taxpayers will be affected by the proposed income tax. The two sides have done a good job of providing the source data (you can follow their links), but the debate’s been inconclusive because:

1. Single filers would pay the tax above $200K in adjusted gross income, and married filers pay above $400K in AGI.

2. We (I) don’t really know how many filers make more than $400k

Curious as always, I decided to run the numbers assuming that 30% of >$200K filers make more than $400K (probably a generous assumption). I’m also using the percentages provided by EOI in the debate: 85% of >$200K filers file joint returns.

Here’s the arithmetic that results (and here’s the spreadsheet [XLS]):

So, with the property-tax and business excise-tax reductions in 1098:

59% of >$200K filers with business income will have lower taxes.

80% of >$200K filers will have lower taxes or no change. (Anyone care to break this out?)

95.8% of  filers with business income will have lower taxes or no change.

99.35% of  filers will have lower taxes or no change.

Update: It turns out my 30% estimate was remarkably accurate — but not generous as I suggested. The actual number is closer to 33%. I’ve updated the spreadsheet, including the source link (XLS) for these calcs.

57% of >$200K filers with business income will have lower taxes.

79% of >$200K filers will have lower taxes or no change. (Anyone care to break this out?)

95.5% of  filers with business income will have lower taxes or no change.

99.31% of  filers will have lower taxes or no change.

The state Office of Financial Management estimates that 38,400 filers will be affected by the income tax — significantly higher than the 22,000 I estimated.

But still: 99% of Washington’s 3.4 million filers will see lower taxes or no effect under this initiative. The lower taxes will be primarily on small businesses.

Related posts:

1. Washington 1098: Will the Wealthy Leave the State?
2. Tax the Rich! And make us all richer?
3. Government: BAD? — Part 3: Taxes and GDP Growth

Source.

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1. Stockman: How the GOP Destroyed the U.S. Economy | The Big Picture
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3. Recessions Make Americans Lazy!

When I consider arguments in favor of climate legislation, Manzi’s thinking is what I measure those arguments against. Here’s his argument in small (my emphasis for easy skimming):

• “the cost of policies designed to limit the rise in atmospheric carbon dioxide to 450 parts per million (ppm) average a little over 6 percent of global GDP by 2100 (with a very wide range of estimates). That is, we would start paying a cost today that would rise to about 6 percent of world output by 2100 in order to only partially avoid a problem that would have expected costs of about 3 percent of world output sometime later than 2100.”

• “hedging your bets and keeping your options open is almost always the right strategy. Money and technology are our raw materials for options. … the loss of economic and technological development that would be required to eliminate all theorized climate change risk (or all risk from genetic technologies or, for that matter, all risk from killer asteroids) would cripple our ability to deal with virtually every other foreseeable and unforeseeable risk.”

Yes, he addresses the uncertainty/risk/probability issues of global warming — notably those from Harvard’s Martin Weitzman.

It’s a compelling argument: given the risk scenario painted by the IPCC in 2007 — and its uncertainty — our best response is to promote economic and technological growth and development, so we have the resources to address problems in the future, when we have a clearer picture of what the problems are.

But the counterarguments are also very strong. If Manzi incorporated them into his thinking, I think he would come to very different conclusions. Respondents at The New Republic have offered several of them; I will steal from them unabashedly, and add a few of my own.

• The 2007 IPCC report is getting long in the tooth — it’s based on the best research from four to six years ago. Recent research is (almost uniformly) far more alarming. Two examples: 1. “The area of summer sea ice remaining during 2007-2009 was about 40% less than the average projection from the 2007 IPCC Fourth Assessment Report.” 2. One report posits a circa 5% chance that large portions of the planet will be rendered uninhabitable — including the eastern U.S..

• The 2007 report specifically did not make projections for sea-level rise. The modeling of ice-sheet behavior was considered too difficult at the time. The economic costs from rising seas could dwarf all others combined. A cost-benefit analysis that doesn’t include those costs doesn’t tell us much.

A 6%-of-GDP insurance policy against those eventualities starts to sound more reasonable. But even the 6% estimate has serious problems.

• Manzi assumes that carbon taxes will add to, not replace, other taxes. Economists agree that consumption taxes and “Pigovian” taxes — taxing negative externalities — are more economically efficient (they result in greater economic growth and prosperity) than many of our current taxes, like those on income, corporate profits, etc. A carbon tax is a Pigovian consumption tax. If our tax base shifts in that direction, the result is more economic efficiency, yielding the very result — faster growth and development — that Manzi champions.

• He assumes the need for a global taxing regime, ignoring the benefits to the U.S. of a unilaterally imposed carbon tax. The long-term savings in national defense and security from reduced fossil-fuel consumption are darned hard to predict, but even most righties will acknowledge that we wouldn’t have invaded Iraq if there was no oil over there. That war will cost us trillions, all told — somewhere north of 25% of U.S. GDP for a year. And that’s before even considering the fuel that it poured on the fire of global jihad. That was one damned expensive insurance policy to ensure future oil supplies.

• He ignores the threat that global warming poses to U.S. national security, as detailed by those left-wing nut jobs at the Pentagon in their Quadrennial Defense Review for 2010 (PDF): ”climate change could have significant geopolitical impacts around the world, contributing to poverty, environmental degradation, and the further weakening of fragile governments. Climate change will contribute to food and water scarcity, will increase the spread of disease, and may spur or exacerbate mass migration.While climate change alone does not cause conflict, it may act as an accelerant of instability or conflict, placing a burden to respond on civilian institutions and militaries around the world.”

• He ignores the truly horrific, potentially even apocalyptic human impact of global warming, and a “mere” 3% decline in GDP, especially outside the developed world. (Quite resoundingly demonstrating Jonathan Haidt’s findings about libertarians’ lack of compassion.) As Nate Silver has pointed out (H/T Bradford Plumer) we could eliminate 43% of the world’s people and only reduce world GDP by 5%.

As I said, I greatly admire Jim Manzi’s thinking. But I have to say that his failure to include these points in that thinking gives the strong impression of confirmation bias.

Related posts:

1. Global Warming Caused by Sex!
2. Fiscal Stimulus: $336,000 Per Job. But…
3. Businesses Constrained by Lack of Investment? Oh, Maybe Not.

The austerity principle is finally taking hold — just when the opposite should be true.

The basics of fiscal and monetary policy aren’t really rocket science: you loosen, spend, and cut taxes in the bad times to stimulate the economy, and tighten up when the economy’s going strong.

But now — thanks as usual to the deranged “theorists” on the right (they don’t care much for facts and empirics) — the whole world seems to be doing the opposite (with misguided encouragement from the IMF).

After three decades of almost nonstop Keynesian stimulus, in good times and bad — by the very people who supposedly abhor said stimulus — it’s up to the Democrats, once again (viz: Clinton), to clean up the mess that Red-Ink Republicans have left us with.

Obama’s got us on track to flatten the curve. Can he reverse those thirty years and pull it back down?

He has not succeeded in his first year and a half in office. Obviously a failed presidency.

Related posts:

1. Government is Not the Problem. Bad Government is the Problem.
2. Is Fiscal Stimulus Just Stupid?
3. David Stockman on Starving the Beast: “It doesn’t work. Game over.”

Hidden in the fine print, you’ll find proof positive that trickle-down works: middle-class incomes have risen by 1% a year since 1979! And poor people’s incomes have gone up by 0.4% a year.

How can you argue with that kind of rampant, precipitous prosperity growth?

(Note that these are post-tax, post-transfer incomes.)

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1. Tax the Rich! And make us all richer?
2. Investing: Government Knows Better
3. Government: BAD? — Part 1 of a Series

It’ll all trickle down, right?

I’ve struggled with my thinking on this a lot; there are obviously lots of problems with the trickle-down idea (some of which I’ve discussed many times), but it’s hard to argue with the phenomenal prosperity (or at least profits) that the Apple model delivers.

Andy Grove’s new Bloomberg article does a lot to help me sort out that thinking, and adds another nail to the coffin to which “trickle down” is increasingly (finally!) being relegated.

His central point, cutting the Gordian knot: as the manufacturing ecosystem disappears in America — along with the jobs — we lose the ability to innovate. I think of the decades-long culture in my home town, Seattle, which has its roots in generations of Boeing machinists and engineers bringing up machinists and engineers. It’s a self-perpetuating culture from which innovation springs.

Grove’s article is brief and concise (and well worth reading in full), so rather than summarizing it I’ll just pull some choice morsels for you. All emphasis is mine.

… our own misplaced faith in the power of startups to create U.S. jobs. …

Startups … cannot by themselves increase tech employment. Equally important is what comes after that mythical moment of creation in the garage, as technology goes from prototype to mass production. …

The scaling process is no longer happening in the U.S. And as long as that’s the case, plowing capital into young companies that build their factories elsewhere will continue to yield a bad return in terms of American jobs. …

American companies discovered they could have their manufacturing and even their engineering done cheaper overseas. When they did so, margins improved. Management was happy, and so were stockholders. Growth continued, even more profitably. But the job machine began sputtering. …

what kind of a society are we going to have if it consists of highly paid people doing high-value-added work — and masses of unemployed? …

Simply put, the U.S. has become wildly inefficient at creating American tech jobs. …

…the cost of creating U.S. jobs grew from a few thousand dollars per position in the early years to $100,000 today. …

Whoever made batteries then gained the exposure and relationships needed … U.S. companies didn’t participate in the first phase and consequently weren’t in the running for all that followed. I doubt they will ever catch up. …

a general undervaluing of manufacturing — the idea that as long as “knowledge work” stays in the U.S., it doesn’t matter what happens to factory jobs. …

we broke the chain of experience that is so important in technological evolution. …

Our fundamental economic beliefs, which we have elevated from a conviction based on observation to an unquestioned truism, is that the free market is the best economic system …  we stick with this belief, largely oblivious to emerging evidence that while free markets beat planned economies, there may be room for a modification that is even better.

Such evidence stares at us from the performance of several Asian countries … These countries seem to understand that job creation must be the No. 1 objective of state economic policy. …

these economies turned in precedent-shattering economic performances over the 1970s and 1980s in large part because of the effective involvement of the government in targeting the growth of manufacturing industries. …

Long term, we need a job-centric economic theory — and job-centric political leadership — to guide our plans and actions….

… our pursuit of our individual businesses … has hindered our ability to bring innovations to scale at home. …

Losing the ability to scale will ultimately damage our capacity to innovate. …

The first task is to rebuild our industrial commons. … Levy an extra tax on the product of offshored labor. … Deposit it in the coffers of what we might call the Scaling Bank of the U.S. and make these sums available to companies that will scale their American operations.

I fled Hungary as a young man in 1956 to come to the U.S. … I witnessed first-hand the perils of both government overreach … there was a time in this country when tanks and cavalry were massed on Pennsylvania Avenue to chase away the unemployed. It was 1932; thousands of jobless veterans were demonstrating outside the White House. Soldiers with fixed bayonets and live ammunition moved in on them, and herded them away from the White House. In America! Unemployment is corrosive. …

If we want to remain a leading economy, we change on our own, or change will continue to be forced upon us.

Grove understands what the rabid Norquistista free-marketers seem incapable of comprehending or acknowledging:  there is an invisible hand, but there is also a tragedy of the commons.

He only makes one real policy proposal: taxing offshore work and using the money to encourage onshore employment. There are many others (Robert Frank had some great suggestions in last Sunday’s Times), all rooted in central economic planning by the federal government. I’ll just mention my favorite once again, without further discussion: greatly expanding the Earned Income Tax Credit, and increasing its “salience” by delivering it on weekly paychecks.

And then there’s infrastructure, of course. I just rode the TGV from Paris to Avignon and back — at 200 mph. A great experience, and the prosperity it’s delivered to southern France is incalculable.

China is currently building 42 high-speed rail lines. We have one that we’re sort of, kind of, working on.

I’m sure this is because China is foolishly engaged in centralized economic planning.

And we — obviously far more clever than they — are not.

Related posts:

1. Fiscal Stimulus: $336,000 Per Job. But…
2. Does Unemployment Insurance Make People Lazy?
3. Does the Liberal Arts Model Deliver Life Success? National Success?

I’ve mentioned this a few times before…

The Sky Is Falling! Business Lending Down 1.2 Percent!

Related posts:

1. Should the Financial Sector Shrink?
2. The Sky Is Falling! Business Lending Down 1.2 Percent!
3. Mankiw: Do Equity Analysts Create Prosperity?

McLellan. MacArthur. McChrystal.

Makes me think of this post.

As Sen. Jim Webb, D-Va., argues in his 2004 book, “Born Fighting: How the Scots-Irish Shaped America,” the Scots-Irish are a particularly pugnacious people, self-reliant and hyper-individualistic, who place honor above profit.

…

Once Democrats, Webb says the Scots-Irish created the “core culture around which Red State America has gathered and thrived.”

And in that context, don’t forget: McCain.

Related posts:

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3. Hillary: The “one-woman solution to the Republican’s problems”

No, nobody is suggesting a Maoist cultural revolution, forcing executives and professors to muck shit on collective farms.

But I feel compelled to share the results from my latest, comparing income inequality to prosperity and prosperity growth in the fifty states.

Contrary to the supply-sider narrative, income inequality appears to have almost no correlation with prosperity growth (.05). What correlation it does show is the opposite of what the supply-siders would have you believe.

This suggests — also contrary to all-too-commonly received wisdom — that there is not in fact an inevitable trade-off between equity and efficiency. That it’s a false choice. That we can in fact have more of both.

Related posts:

1. Taxes: Equity versus Efficiency? Not so Much
2. Does Inequality Result in Prosperity?
3. Politicians Should Resist Equality and Prosperity!

Marginal Revolution: The Dark Magic of Structured Finance.

I’ll let you read it yourself, but here’s the takeaway. If the chance of underlying mortgages’ defaulting goes from 5% to 6% (a 20% increase),

the probability of default in the 10 tranche[s] jumps from p=.0282 to p=.0775, a 175% increase.  Moreover, the probability of default of the CDO jumps from p=.0005 to p=.247, a 45,000% increase!

These securities don’t just leverage the risk; they massively leverage the risk of risk.

Related posts:

1. Regulating the Ratings Agencies: Low-Hanging Fruit?
2. How to Avoid Regulation: Smart Regulation
3. Should the Financial Sector Shrink?

In a recent post I cited the 1987 Long-Term Capital Management hedge-fund fiasco, which occurred because they were assuming a normal distribution bell curve for financial events. “A one-in-five-hundred-year event on a normal bell curve was a one-in-five-year event in the actual distribution of market movements.”

Now the New York Times (from Reuters) reports that even 20 years after the 1987 LTCM meltdown, Wall Street risk mangers were still using that la-la land distribution. August, 2007:

“We were seeing things that were 25 standard deviation moves, several days in a row.”
–David Viniar, chief financial officer, Goldman Sachs

25 standard deviations means about one chance “in the lifetime of a billion universes.” Think it might be time to take another look at that model?

And even today, after the 08/09 catastrophe — at least according to this article — many still use the “normal” or “Gaussian” distribution — what you get if you throw a bunch of pennies on the ground, measure all their distances from the center, and plot those distances on a histogram.

Why do they assume that the penny distribution is the same as the distribution of financial events encompassing hundreds of trillions of dollars and millions of (presumably, sort of) intelligent agents? No reason that I can discern. And I can’t find anyone who has attempted to plot the actual distribution of market events. (Pointers to the contrary from my gentle readers much appreciated.)

The closest, cited in the article, was the mathematician Benoit Mandelbrot (of fractal fame, among others). In 1962 he looked at a hundred years of cotton prices, and plotted a bell-curve for that actual emprical data.

So here’s the tiny detail: the shape of a bell curve is determined by a single simple number — the exponential rate of decay. The normal, gaussian distribution has an ERD of 2. Flatter bell curves with fatter tails — more unusual events — have lower numbers. Mandelbrot came up with 1.7 for the distribution of cotton-market events. According to Reuters, with some exceptions the normal, gaussian distribution is still “the one that is actually used.”

I recommend giving it a read for more details. It’s quite short.

Related posts:

1. Is Altruism Inevitable?
2. Mankiw: Do Equity Analysts Create Prosperity?
3. Nature: Good?