The Wisdom of Crowds and the Federal Reserve

At 11:38 am on January 28, 1986, the space shuttle Challenger lifted off from its launch pad at Cape Canaveral. Seventy-four seconds later, it was ten miles high and rising. Then it blew up. The launch was televised, so news of the accident spread quickly. Eight minutes after the explosion, the first story hit the Dow Jones News Wire.

The stock market did not pause to mourn. Within minutes, investors started dumping the stocks of the four major contractors who had participated in the Challenger launch: Rockwell International, which built the shuttle and its main engines; Lockheed, which managed ground support; Martin Marietta, which manufactured the ship's external fuel tank; and Morton Thiokol, which built the solid-fuel booster rocket. Twenty-one minutes after the explosion, Lockheed's stock was down 5 percent, Martin Marietta's was down 3 percent, and Rockwell was down 6 percent.

Morton Thiokol's stock was hit hardest of all. As the finance professors Michael T. Maloney and J. Harold Mulherin report in their fascinating study of the market's reaction to the Challenger disaster, so many investors were trying to sell Thiokol stock and so few people were interested in buying it that a trading halt was called almost immediately. When the stock started trading again, almost an hour after the explosion, it was down 6 percent. By the end of the day, its decline had almost doubled, so that at market close, Thiokol's stock was down nearly 12 percent. By contrast, the stocks of the three other firms started to creep back up, and by the end of the day their value had fallen only around 3 percent.

What this means is that the stock market had, almost immediately, labeled Morton Thiokol as the company that was responsible for the Challenger disaster. Six months after the explosion, the Presidential Commission on the Challenger revealed that the O-ring seals on the booster rockets made by Thiokol--seals that were supposed to prevent hot exhaust gases from escaping--became less resilient in cold weather, creating gaps that allowed the gases to leak out. Thiokol was held liable for the accident. The other companies were exonerated.

In other words, within a half hour of the shuttle blowing up, the stock market knew what company was responsible. How did they get it right? Said Cornell economist Maureen O'Hara, "While markets appear to work in practice, we are not sure how they work in theory." From The Wisdom of Crowds by James Surowiecki

The theory of the "wisdom of crowds" is based on the idea that a large enough group of people acting as separate individuals will come up with a conclusion, once their differing opinions are aggregated, that is better than the opinion of those same people meeting as an expert committee (You can read more here: http://experimentgarden.blogspot.com/2009/12/critical-analysis-wisdom-of-crowds-by.html or in the book). Researchers at the University of Iowa have actually developed a futures marketplace that allows individuals to place "bets" of up to $500 on future events. It is most heavily used for political elections, and its "crowd-based" predictions outperform the "experts" (www.intrade.com)

This brings us to Fed Chairman Bernanke and his belief that "printing" $600 billion will help our economy. Where can we find signals to evaluate his bet against the wisdom of crowds? Remember, the individuals in the crowd must act independently and must have real money at stake. Here are some described by Alan Reynolds in the WSJ today (http://online.wsj.com/article/SB10001424052702303467004575574610003111250.html?mod=WSJ_hp_LEFTTopStories#articleTabs%3Dcomments):
1. Gap between regular Treasury bonds and inflation-protected bonds (TIPS): widened by 60 basis points since August (bet is against bernanke)
2. US dollar: dropping against non-Western currencies (bet is against)
3. ETF ProShares: This fund bets against long term interest rates falling. If Bernanke's gambit was to work (ie by decreasing interest rates), the Proshares should drop. So far, it has not (bet is against).

The point here is not so much that Bernanke is "clueless", because he is not. The point is how one best makes a difficult judgement: by trusting experts and committees or by trusting Hayek's marketplace. Free markets out perform top-down marketplaces over time, because they rely on the latter. If you think you can identify an undiscovered predictor from the crowd, you could also make a lot of money.

How many reported on this?

In a report to Congress on Oct. 26, 2010, Neil Barovsky, the special inspector general overseeing the Troubled Asset Relief Program, which funds HAMP (The Dem's program to help homeowners avoid mortgage bankruptcy), had this to say. The high profile mortgage-restructuring program "has undoubtedly put people into foreclosure". "It's a parade of documentation horrors." Many borrowers might end up "worse off than before they participated." More than half of the 1.4 million borrowers who have been approved for temporary decrease in their mortgage payments under the plan will fall out and have to repay the modified difference to the bank.
As Reagan said, "the scariest words in the English language are, "I'm from the Government and I'm here to help...""

http://online.wsj.com/article/SB10001424052748704805204575594453938527666.html?KEYWORDS=foreclosure+crisis

the New Deal and today's recession

Jason Zwieg is an economics reporter I've long respected. In the WSJ today (http://online.wsj.com/article/SB10001424052748704405704575596382345085258.html?KEYWORDS=zweig), he discusses an economist from the FDR era, Melchior Palyi who had insights into the New Deal that are as true today as then:
1. Banking Act of 1933, which said that banks could not hold securities that weren't rated "investment grade" by two ratings firms. Noting that in the 1920's these bonds often went under, even in the same year they were rated, he predicted that a bank following the new rules could have 1/3 of its bond portfoloio go bankrupt. Rating agencies are so unreliable, he wrote, that it would be "more responsible to stop the publications of ratings altogether". He felt that the banks had replaced liquidity as a way to handle this risk, with "shiftability" to others that would some day "be magnified into catastrophic dimensions".
2. government push for universal home ownership (1938) would "make the population fixed to the ground" by 'overburdening them with housing costs". Limited mobility of workers in this housing collapse is thought to be a major factor in our current persistently high unemployment rate.
3. "quantitative easing" by the Federal Reserve is "a sort of Santa Claus to the economic system" that can lead to "runaway inflation" and too muchpower in too few hands.
La plus ca change...

Where do your tax dollars go?

I have written about understanding income taxes before, using the "tax receipt" idea from Third Wave. Here is another good example from the WSJ 11/6/10 (http://online.wsj.com/article/SB10001424052748704506404575592900454547226.html?KEYWORDS=laura+saunders). As we discussed last Thursday, all of the expenditures below SS, Medicare/Medicaid, interest on debt, and the military (called "non-military discretionary spending) only account for 17% of spending. If you cancellled them all, you would barely cover 1/2 of this year's deficit.
This is a good place to note that there are 7 different ways that income is taxed at the federal level: income from work (to which 3 different tax schemes are applied: federal income tax, Social Security, and Medicare), income from interest, income from dividends, income from investments and then all of these combined under another tax scheme, the Alternate Minimum Tax.

Wall Street Journal Op-Ed with a few more examples of Gov. complicity in reducing competition

Mr. Reich, It's Not the Tea Partiers Who Are Out of Touch 

In "Why Business Should Fear the Tea Party" (op-ed, Oct. 29), Robert Reich fails to state that the largest U.S. companies have played both sides of the political fence for years. The result is ethanol, windmills, the elimination of the incandescent light bulb, ridiculous car safety and gas mileage standards, the elimination of top-loading washing machines and other laws that have reduced competitiveness and established a government-business alliance that is part of our spending problem. This has resulted in a tax code that carves out special tax breaks for certain businesses. We in the tea party would like business to be competitive and not part of the ever-increasing crowd suckling on the government teat. So yes, some businesses should be nervous.

Davies Wakefield

Green Bay, Wis.

Energy: natural gas, the Marcellus shale and fracking

We were discussing the importance of natural gas as a transition energy source to carbon-free energy production. The US has vast natural reserves, most noteworthy in the Marcellus shale of the Appalachians. This has become commercial in the past twenty years due to technical advances in horizontal drilling and hydraulic extraction, called "fracking". There is real controversy as to the environmental hazards of fracking. It is quite an emotional topic, so make up your own mind, but beware of using secondary sources. Here is a starting reading list:

1. http://www.scientificamerican.com/article.cfm?id=shale-gas-and-hydraulic-fracturing#comments
2. http://en.wikipedia.org/wiki/Hydraulic_fracturing
3. http://gaslandthemovie.com/
4. http://climateprogress.org/2010/03/03/natural-gas-fracking/
5. http://blogs.forbes.com/christopherhelman/2010/08/08/can-gas-fracking-pollute-groundwater-unlikely/
6. http://online.wsj.com/article/SB10001424052748703399204574507440795971268.html
7. http://www.washingtonexaminer.com/opinion/blogs/beltway-confidential/environmental-defense-fund-admits-propaganda-effort-against-natural-gas-exploration-is-bunk-105903083.html

Cost of public school in New Hampshire

We discussed the cost of schooling in tonight's meeting. In New Hampshire public schools, it is $12,144 / pupil /year. Here is the reference:
http://www.seacoastonline.com/articles/20101010-NEWS-10100341