Mathematicians and the Prevention of Recessions

I don't find this at all convincing

It seems to me to be weak support for the claim "if top tier math/physics talent went into finance, they could plausibly make billions, since fourth tier talent make millions." (Fourth tier meant in the sense of this comment, but third tier might be more appropriate.)

There are also famous high-profile failures, though, such as Scholes at LTCM. (He did only win the Nobel prize in Econ, though, which is not a particularly strong predictor of math ability.)

I know very little about finance

You're a PhD in math with no specialist knowledge of finance. Do you think that you personally could do better financial analysis than, say, a Business major with a CFA and a decade or two of industry experience? If no, why do you think mathematicians are the way forward for the field?

The problem is that a put strategy bleeds money on option costs, whereas a short doesn't. (Shorts bleed on dividends, but in a lot of industries that's cheaper). Also, long-term puts deeply out of the money(which you want, to minimize costs and maximize leverage) are an incredibly thin market, which tends to make trading difficult and expensive.

I'm not sure; I can ask the next time I talk to him (which will be over a month from now).

Actually, as soon as I posted this I thought about how MIRI does exactly this! But this is just one group, and we would need more data.

There's no problem with suggesting a hypothesis based on a limited data set, but that's not how the post reads. It sounds like it is making a definitive claim, but does not present the evidence to back this up.

I don't believe DH7 really applies here, because the status quo is the steelman of your proposal for change. We already have open-source financial analysis and financial models, and mathematicians do work in the industry. I'm unclear on what concrete changes you're actually proposing here that haven't already been implemented decades ago.

1) I suspect this is the reason why Simons is so unusual, and one of the main stumbling blocks to your plan. Getting to high levels of mathematical skill and achievement takes years, and spending more years learning finance is naturally going to be unappealing. Surely they won't all make $10B, and trying to get folks who've spent their lives getting the famously conservative institution of tenure to give it up for the famously chaotic world of Wall Street seems like a serious challenge.

2) I would agree with this - mathematics is a frame of mind as much as anything, and a pretty useful one. While finance has some elements of the same effect, "anything can be traded" is far less transferrable, and the more specific knowledge base lacks the out-of-field utility of math.

3) True, but then that's true of most fields where people want to do a good job.

4) I'm not convinced of that. One of the good things about finance is how incredibly well incentives are aligned(modulo Congress) - someone who guesses right makes billions, someone who guesses wrong loses billions. Having managers share information and analysis destroys that accountability. It also would tend to encourage groupthink - 20 separate paths of analysis will inherently vary more than one collective pool of analysis. Given that groupthink is a major contributor to bubbles, this seems a real danger.

5) Granted.

6) The primary cost is going to be reduced tax receipts and increased welfare costs, plus the stimulus. The bank bailout actually made a small profit, the auto bailout would probably have happened either way by now, but the damage to the economy(especially the top strata that pays a disproportionate amount of the taxes) really did hurt the government's finances. Also, for ease of data collection, I'm limiting my numbers to the US. Most developed economies will have a similar money lost:GDP ratio(Canada and Japan less, PIIGS more, but it's assumed to work out in the end). All numbers from this wonderful document: http://www.gpo.gov/fdsys/pkg/BUDGET-2014-TAB/pdf/BUDGET-2014-TAB.pdf

Tax receipts: We'll measure these peak-to-peak, so 2000-2007, and use that to establish a trend line. In 2000, the USG took in $2025B, in 2007 it took in $2568B, for an average growth of 3.45%. We'll assume that inflation and population growth are constant over the time period, so the trend will stay flat.
Year Trend Actual Loss
2007 2,568 2,568 0
2008 2,657 2,524 133
2009 2,748 2,105 643
2010 2,843 2,163 680
2011 2,941 2,303 638
2012 3,043 2,450 593
That's a cumulative loss of $2687 billion in tax receipts thus far.

Social spending: It's hard to define "social spending" precisely. Social Security, for example, should remain basically stable during economic change, while food stamps will vary wildly. I'm going to use the "Income Security" function and "Health" function(which is primarily Medicaid - Medicare is separate) to approximate this. There's some stray charges in there(federal employee pensions, occupational health and safety, etc.), but those should be fairly stable modulo recession, and I don't know enough about what precisely is in the categories to get too fine in my distinctions. I'm using the same 3.45% growth assumption.
Year Trend Actual Loss
2007 632 632 0
2008 654 712 -58
2009 677 868 -191
2010 700 991 -291
2011 724 970 -246
2012 749 888 -139
This yields a total of $924 billion in added welfare costs.

Stimulus: The ARRA was estimated at $831B of total costs, though a significant fraction of that has been counted above - $288B was tax cuts, $155B was health spending, and $82B was welfare of various sorts. The remainder is $306 billion on education, infrastructure, and research.

The sum of the above categories is $3917 billion, to the end of FY 2012. However, we also need to factor in the effect of lower interest rates - we're spending less on debt interest today than we were in 2006, despite a 137% increase in the size of the debt. This works out to a $228B savings versus trend(again, assuming 3.45% YOY growth). Throw in a few miscellaneous billions for uncounted programs, we can estimate the cost to date at $3.7 trillion. Final cost will likely be some $6-8 trillion, depending how long this mess continues for.

It's worth noting, though, that if you phrase it in terms of cost to taxpayers, the loss of receipts shouldn't really be counted - after all, it doesn't lose me money to have my taxes go down. Actual new spending as a result of the recession is only about a trillion thus far, the remainder is simply deferred taxes.

(Yes, these numbers are a bit ham-fisted in places. I'm not the CBO, I don't intend to get too far into the details for the sake of an internet discussion. It's a good enough estimate to work with)

According to Wikipedia:

As of December 31, 2012, the Treasury had received over $405 billion in total cash back on Troubled Assets Relief Program investments, equaling nearly 97 percent of the $418 billion disbursed under the program.

But TARP was just a small part of the whole picture. What concerns me is that there seem to have been somewhere between $1.2 trillion and $16 trillion in secret loans from the Fed to big financial institutions and other corporations. Even if they've been repaid, the low interest rates might represent a big transfer of wealth from the poor to the wealthy. And the fact that I'm seeing figures that differ by more than an order of magnitude is far from reassuring, too! The GAO report seems to be worth digging into. If not mathematicians, at least accountants could be helpful for things like this!

Well from 2009-2013, the US government spent $18.3 trillion in total. Do you really think that half of that went to banks, instead of old people and soldiers?

Saying the bailouts cost $9T is like saying that the derivative market is measured in trillions of trade a day - yes, that's the face value, but it's not the actual amount of cash trading hands, any more than the travel insurance I bought today with $10M of coverage is a $10M contract.

True, but you don't always need everyone. How many "greater fools" do you actually need to have an asset price bubble?

Subissue 1: You can find lots of financial analyses around, some available for free, some not. Why should this one be given any more weight than others, when you can find someone else with good credentials saying the exact opposite? And accurately assessing the quality of an analysis is almost as hard as doing the analysis yourself; it's very easy to be fooled by bullshit.
Subissue 2: When you have the appearance of equal and opposite experts, many people are going to end up believing what they want to believe, and acting accordingly.

The people in a position of influence in the housing market were primarily the homebuyers. Needless to say, they didn't want to believe that the value of their biggest asset was about to go up in smoke.

Which, FWIW, is what happened. The question is, "why didn't it happen sooner?" with perhaps a follow-up of "what's the soonest we can reasonably expect these things to happen?"

I'll admit that I'm tragically under-read on the NGDP thesis, but it seems like a restatement of the old Phillips Curve nonsense that caused so much of the wreckage of the 1970s. It basically amounts to "inflate when times are bad to spike employment", which does work in the short-term, but the long-term second-order effect of increased inflation expectations saps all the value out of it quickly.

Is there something I'm missing here, or is this just failed policy from 50 years ago with a new label on it?

When NGDP/NGDI, the total amount of money the economy spends, goes down below trend, so does RGDP. If the Fed had e.g. bought government bonds, the amount of circulating money could have been prevented from going down (without any need for "fiscal stimulus", by the way) without making loans to any particular trading companies (no need for bailouts! let them go bust!), and the bonds wouldn't be monetized, they would be sold again as velocity picked up. I recommend http://themoneyillusion.com/ - your viewpoint here is too distant from sane macroeconomics, and too close to crazy populist economics, for me to tackle all the individual problems. But what you're saying is more or less literally, exactly what people were saying about banks needing to take their medicine just before the Great Depression. Seriously, look it up, that was what made people realize that monetary velocity slowdowns needed to be made up by (temporary) monetary supply increases.

Didn't we already have a long debate about this? Didn't I mostly convince you that NGDP stabilization was a good idea?

I think you're actually just not understanding Krugman right. He often writes misleadingly, so that's understandable. The Fed's normal tools perhaps can't be used to do that (but they probably can), but the Fed's normal tools are stupid and it's easy to produce inflation with slightly different tools (negative interest rates on reserves, level targeting, targeting the forecast etc., credible promise to keep interest rates low). This isn't some new theory, Krugman has a famous paper about how the Japanese Central Bank could do exactly that.

Having a target and achieving the target are definitely different things, but achieving an NGDP target is not difficult because central banks have approximately infinite control over a single future nominal variable (e.g. NGDP, nominal interest rate or price level).

One of the big lessons from central banks response to this recession is that interest rates and inflation are a very misleading and confusing ways to talk about monetary policy.

It's much easier under these circumstances to do the same thing with fiscal policy rather than monetary policy: have the government borrow and spend to put idle resources to work directly, increasing NGDP by increasing real GDP. (This is how World War II caused the end of the Great Depression.)

This is likely an incorrect understanding.

If I'm understanding my Sumner right, Krugman is just plain wrong about this. Central banks can decrease interest rates, promise to keep future interest rates low, engage in quantitative easing, charge negative interest on reserves, and print physical money and drop it out of helicopters. "There is no zero bound" is a market monetarist slogan and I have to say it sounds a tad plausible from over here.

The problem isn't that the Fed can't reach (from low to hit) NGDP targets; the problem is that anyone can scheme to raise NGDP by conducting dummy transactions that nevertheless go on record in economic accounting as higher NGDP. At which point NGDP loses its evidential and causal power through Lucas/Goodhart effects.

What if underlying structural issues put you into a very long term recession which only bubbles give the temporary appearance of rising out of...

Certainly it is common for bubbles to lead to recessions, but with good monetary policy, it does not need to.

Seems plausible, but that doesn't tell me whether I should study math for its own sake or not.

Thanks for your thoughts.

You have the same problem with getting mathematician into finance the way JonahSinick proposes. Someone who's completely motivated by money probably won't.

On the other hand being the head of a good open source financial simulation is probably a good way to get tenure as an economics professor.

Once you have a computer model that's useful, academic publications are going to use it and cite it.

There's also open source software that gets developed by companies that make good money. You could sell consulting to fit the software to particular business needs. There are a lot of companies besides Hedge funds and big banks that would profit from having access to good financial analysis tools.

If you customize your tool to help Walmart with their planning needs Walmart doesn't have a particular problem with the tool being open source and other companies also profiting from the tool.

And yet other people looking at the ratings didn't immediately notice there was a problem. I think it was a combination of evil and stupid with a lot more of the latter, specifically people did some cooking of their books but took everybody else's numbers at face value.