Friday 12 September 2014

Economics, Ecology and Ethics

I spent the first part of the week at the eco**2 meeting, sponsored by the British Ecological Society and the LSE's Systemic Risk Centre and exploring the relationship between economics and ecology. I attended because I am in the early stages of a research programme to explore if distinctive financial network topologies emerge out of different commercial cultures, and whether the distinctive topologies are more/less efficient in distributing funds and resilient (robust) in responding to shocks; essentially how financial systems evolve and how the commercial environment influences the financial organisms- the ecology.  It was useful as I met for the first time Thomas Lux and Steffano Battiston.

I have a strange connection with ecologists; before becoming an academic I worked for a US oil company in London.  In the late 1990s, in response to over a decade of failed exploration, the firm invited John Krebs and Alex Kacelnik to review its approach to exploration based on their experience of optimal foraging strategies of animals. I was the internal project manager.  The research was cancelled before the project finished (part of a change in senior staff and a "re-focus") and the two tangible consequences are Oxford Risk and that I list Alex as one of my inspirations to leave industry for academia (along with a choice between a nice redundancy package and PhD in maths or a career in Houston).

One thing that Alex taught me is the sub-optimality of risk-aversion.  Some birds need to eat up to 40% of their body weight in a British winter to survive the night,  and so their very existence depends on making the right decisions about looking for food.  Let's say a bird has 6 hours to find 9 berries and it has two choices:
  • [Play it Safe] The bird stays where it is, where it knows there are berries in the hope of finding a few.  The chance of finding one or two berries in the hour is 50:50.
  • [Take a Risk] The bird flies off, in the hope of finding berry-bonanza but with a high chance of only finding enough to replace the energy lost in flying.  The energy cost of flying is one berry and the chance of only finding the one berry in the new field is 5 in 6, but there  is a 1 in 6 chance of finding 10 worms (and getting an excess of 9).
Notice that the expectation of both strategies is the same, one-and-a-half berries in an hour and so the bird can expect to get the nine berries in the six hours.  However the second approach is riskier (for any concave utility function the expected utility of the second strategy is less than the first).

Alex explained that if the bird has only found five berries after five hours, it is certain to die if it does not switch to the risky strategy, where it has a small chance of finding the 10 berries that will ensure survival.  A similar argument applies if the bird has found more than 8 berries after 5 hours - it can afford to take a risk.

The financial interpretation is that only the middle class should be risk averse the rich can afford to gamble, the poor have nothing (substantially) to lose by gambling but there is the small chance they become rich.  This is an explanation as to why the poor defy economic 'rationality' in buying lottery tickets, it is actually practically reasonable.

Apart from presenting my own work, my first contribution came in the second plenary when Thomas Lux and Michel Loreau discussed "Important Models in Economics/Ecology".  Michel discussed Malthusian catastrophes (possibly in response to a question) and positively contrasted Malthus with Condorcet.  This becomes interesting to me, given Condorcet is associated with maths and finance.  The moderator asked the audience of mixed "economists" and ecologists if any economist took Malthus seriously, I don't think anyone raised their hand.  I felt this left the ecologists with the impression that economists were a bit short sighted.  My contribution was the following: Malthus was a Tory cleric worried about the effects of the political changes -the collapse in social hierarchy- in France, where as Condorcet was committed to French Revolutionary principles of equality, brotherhood and freedom.  I suggested the reticence of economists to follow Malthus was that his ideas legitimated the liberal policies of the British government during the Irish famine.  Restricting growth on the basis of Malthus requires we address the problem of (global) inequality; I question the morality of people with stuff telling people without stuff that they can't have any more stuff. Lord May commented that Malthus was right but the time scale was wrong, I think this is a peculiar view of an empirical scientist: I can point to the problems of the Malthusian catastrophe theory, the theory has yet to be shown to be true. I think the consensus is that famine and pestilence is not an issue of availability of resources but the distribution of resources, what I think economists call the co-ordination problem.

At the end of the day Doyne Farmer captivated his audience by describing his success as a hedge fund quant in the 1990s.  I though it a bit odd that the previous evening Lord May had been critical of the type of activities Doyne had been involved with, yet 24 hours later the audience seemed to see the sense of it all.  Doyne's story was essentially that he did not believe in the Efficient Markets Hypothesis, and as a skilled mathematician he could go below the economic theory of "first order efficiency" and mine riskless profits in identifying "second order inefficiency".  He produced a series of convincing plots, which all seemed to end around 1998.  Let's be straight- a priori I am sceptical about Farmer's claims given he claims he built the first wearable computer in the 1970s, where as I believe it was Claude Shannon and Ed Thorpe in the early 1960s.  At the end of his presentation a young ecologist asked the question "If you were making money out of these inefficiencies, who was losing money".  Farmer skirted round the question, first stating that economics is not a zero-sum game (that is true, but finance IS a zero-sum game) and that the activities of arbitrageurs made markets more efficient (again that is true).  What he did not answer was who was losing money.

I then asked Prof Farmer  "Is making riskless  profits ethical?" My reasons were three-fold.
  1. I felt he had not been sincere in answering the ecologist's question.
  2. I have argued that the Efficient Markets Hypothesis can bee seen not a statement of fact but one of values: it is a contemporary version of the Scholastic injunction on making riskless profits.  Farmer's criticism of the EMH, in my mind, is a criticism of this moral injunction.
  3. Both the US and UK legislators (in the Financial Crisis Inquiry Commission report  of 2011 and the Changing Banking for Good report of 2013) stress the degradation of commercial ethics as a cause of financial crises since 2007.
I do not think I am alone in thinking Doyne did not really understand the question when it was asked. I  do not think he really understood what riskless profits means, as opposed to high probability profits, but I also feel he had never considered the ethics of his mathematical modelling (the Professional Standards Board of the Chartered Institute of Banking are interested in my work because they have found it virtually impossible to get the ethics agenda into the "quant" world).  I believe the moral vacuum in finance is not endogenous to commerce but has entered the discipline from academia, that is dominated by a strict fact/values dichotomy.  Doyne's response was a suggestion that I was evoking some sort of Protestant shaming.  I pointed out usury prohibitions were Catholic, the Protestants removed them. But in a sense I was; the previous night Lord May had called for a "professionalisation" of banking, so that those who bought the profession into disrepute could be expelled.  The legal, accounting, actuarial, and banking professions all emerged in Presbyterian Scotland, with a tradition of shaming, before Episcopal England.  One of the features of contemporary finance is that it is impenetrable for public scrutiny, every thing happens behind closed doors, and so it is difficult to "shame" bankers into probity.  If no one asks you if you are behaving ethically, because they cannot see what you are doing, you do not have to worry aebout behaving ethically.  Mauss made the point that the difference between science and magic is science is a public activity (like religion) where as magic is purposefully secret.

After the session closed I went to the pub with a couple of ecologists and explained that I asked the question because before the nineteenth century commerce was seen as a civilising (as in supporting civil society) force, not the destructive force we think of today.  Shakespeare personified the virtue of charity in Antonio, The Merchant of  Venice, something that is inconceivable today.  The origins of actuarial science are in the Scottish Ministers' Widows' Fund, a synthesis of Faith, Hope and Charity.  Later I was asked "What changed", I took a breath and answered "Darwin".

Starting with Malthus the cooperation metaphor - a key theme in eighteenth century economics, including in Adam Smith - is replaced by the competition metaphor.  The economic system shifts from one designed to co-ordinate (equitable) supply and demand to one designed to winnow out the weak and inefficient.  I have argued that this reflects society replacing a fear of the uncertain with a concern for scarcity (recall that there were a series of famines in Europe in the second quarter of the nineteenth century), enabled by Laplacian probability reducing distributions to expectations.  I do not suggest Darwin was responsible for this shift, but he does personify a general trend that included Mill, Spencer, Galton, Huxley et al., all now seen as pre-eminent figures of English nineteenth century thought.  I think the demotion of humans to be "just" another class of animal was a key feature of this period (and this is the opinion of a firm atheist) and was a central result of the nineteenth century biologists.

Something I had not thought of occurred to me on the final day of the workshop. At some point someone had asked if there was the concept of redundancy in economics.  I think I answered, but it might only have been in my head, that  there is not in economics but there is in finance, where, since the Scottish Ministers' Widows' Fund, at the latest, there has been the issue of reserves.  Listening to some of the ecologists I noted that there  were repeated references to optimising energy use as a key feature of ecological thought.  Similarly a key tool in the physical sciences is minimising energy or maximising entropy.  This thought was followed by the thought that physicists often try and see a conceptual relationship between money and energy which seems to completely mis-represent the nature of money.

Sitting in Heathrow's Terminal 5 I thought that the terminal was a masterpiece of efficiency but probably the most inhuman place I had ever been, worse than a nuclear power plant or production line.  Waiting for my flight I wondered if the relationship between ecology and economics was more profound that I had ever appreciated, and that the striving for efficiency in economics is in some sense the application of ecological principles.  Alfred Marshall is known for both improving the mathematical rigour of economics and advocating the adoption of biological techniques: “the Mecca of the economist lies in economic biology rather than in economic dynamics [i.e. mechanics].”  The problems of finance are that a financier's tendency to hold reserves in a stochastic market are challenged by the economist's desire to use capital efficiently, as an animal uses energy efficiently.  This is feasible because a Lapacian can reduce a distribution to an expectation and possible because a scientist separates facts and values and sees man as beastly, not virtuous.

I have come to conceive of markets as centres of communicative action reliant on the norms of reciprocity, sincerity and charity.  In this formulation mathematics is not used to determine (predict) the truth but as a language to facilitate discourse.  I believe, based on sociological studies of the markets,  that when market makers offer a price they can be seen as making a claim, which can be challenged by speculators and arbitrageurs, who either accept the claim/price and let it pass, or challenge it by taking the price or offering their own.  In this sense mathematical models are used to justify claims, furthermore I believe this practice of using mathematics in justifying claims in finance was adapted in both politics, to deliver democracy, and science: I do not believe in stochastic systems models can be used to predict, only to justify in a discursive process.

This might seem academic and irrelevant, the practical usefulness is that it enables me to identify why practices described by Farmer might be unethical, rather than relying on an instinct that speculation in complex financial instruments just can't be right (where as geo-engineering, genetic modification or nuclear weapons are OK).   I aim to show in my research, that such markets can offer growth without creating the inequality that Michel Loreau objected to, but I feel is a consequence of the aim at efficiency that a 'Darwinian' economics demands.

A popular tweet from the meeting was
and I ask myself: is this a good thing?  Has society been served well by efficiency replacing redundancy in finance and competition metaphors replacing cooperation metaphors in economics?  Before ecologists invite economists to abandon some of their fundamental assumptions I would like them to explain how their approaches differ from Darwin's argument articulated in The Descent of Man
 My object in this chapter is to shew that there is no fundamental difference between man and the higher mammals in their mental faculties.
and that
 The great break in the organic chain between man and his nearest allies, which cannot be bridged over by any extinct or living species, has often been advanced as a grave objection to the belief that man is descended from some lower form; ...  At some future period, not very distant as measured by centuries, the civilised races of man will almost certainly exterminate, and replace, the savage races throughout the world. At the same time the anthropomorphous apes, as Professor Schaaffhausen has remarked, will no doubt be exterminated. The break between man and his nearest allies will then be wider, for it will intervene between man in a more civilised state, as we may hope, even than the Caucasian, and some ape as low as a baboon, instead of as now between the negro or Australian and the gorilla.
In contrast to Darwin, in An Inquiry into the Nature and Causes of the Wealth of Nations Adam Smith argues that humans are distinctive from other animals in the degree to which they are co-operative
Two greyhounds, in running down the same hare, have sometimes the appearance of acting in some sort of concert. Each turns her towards his companion, or endeavours to intercept her when his companion turns her towards himself. This, however, is not the effect of any contract, but of the accidental concurrence of their passions in the same object at that particular time
Humans are different to animals in that they exhibit
 the propensity to truck, barter, and exchange one thing for another.
Markets are not simply a technical tool to facilitate life, but they capture a key distinction between humans and  other animals.  I am not convinced that it is progressive to lose the 'civilised' aspect of humanity.

Pragmatism requires me to consider the practical implications of my aim.   Someone asked a BBC radio news program what would be the relationship between an independent Scotland and the BBC.  As with everything no one knows what will  happen post independence (because the nationalists have told us what they want not what they might be able to deliver).  The news was not positive for the lover of BBC's Radio 4.  It then struck me that much of the independence debate is focused on the unionists pointing out to people who "have"what they might lose in an independent Scotland: jobs, low mortgage rates, large research grants, a stable currency and the BBC.  Of course, if you have no job, no mortgage, no money and watch Sky but pay for the BBC, you have nothing to lose but the chance of winning in the nationalist vision of a wealthy and fair society.  For me the independence referendum, and the potential for a FN victory in France and the rise of UKIP are the consequences of basing markets on the theory of competition, that accepts the inevitability of extinction of those who can't keep up, rather than social cohesion.

3 comments:

  1. I do not believe Prediction were actually making risk less profits, I think they were engaged in statistical arbitrage, i.e. high probability profits this is why the graphs finished in 1998 when LTCM and other hedge funds failed. I don't have an issue with risky profits.

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  2. Great post you've made here. Ethics will always be part of anything that's related to economy, lest every person will be affected with slight changes. client experience programs

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