A lot of people, reading the reporting on the current financial
disaster, have been writing me to ask what people mean when they talk
about incentives. The traders, the bankers, the fund managers, and all
of the other folks involved in this giant cluster-fuck aren’t
stupid. So naturaly, the question keeps coming up, why would they go
along with it? And the answer that we keep hearing is something along
the lines of “perverse incentives”.
The basic idea is that the way that the people in the industry got paid,
it was actually in their interest do do things that they knew would
eventually cause a disaster. How could that work?
Watching news reports about President Obama’s proposed tax changes,
I’ve seen a number of variations on a very annoying theme, which involves
a very stupid math error.
A typical example is this story on ABC news, which contains a non-correction
President Barack Obama’s tax proposal — which promises to increase taxes for those families with incomes of $250,000 or more — has some Americans brainstorming ways to decrease their pay in an attempt to avoid paying higher taxes on every dollar they earn over the quarter million dollar mark.
A 63-year-old attorney based in Lafayette, La., who asked not to be named, told ABCNews.com that she plans to cut back on her business to get her annual income under the quarter million mark should the Obama tax plan be passed by Congress and become law.
“We are going to try to figure out how to make our income $249,999.00,”
“We have to find a way out where we can make just what we need to just under the line so we can benefit from Obama’s tax plan,” she added. “Why kill yourself working if you’re going to give it all away to people who aren’t working as hard?”
The original version of this article continued to follow this basic theme. The
updated article pretends to correct it, while still basically mantaining the
The idea behind this, and similar stories, is that raising the income tax
rate on people earning over $250,000 per year creates a threshold, where earning more than that threshold will result in your taking home less
after-taxes pay than if you earned less.
I wasn’t going to write about this, because I really don’t have much to add. But people keep mailing it to me, so in order to shut you all up, I’ll chip in.
As everyone knows by now, we’re in the midst of a really horrible
financial disaster. I’ve argued in the past on this blog that the root cause of the entire disaster is pure, simple stupidity on the part of people in the financial business. People gave out mortgages that any
sane rational person would have considered ridiculous. And then they built huge, elaborate financial structures on top of those mortgages, pretending that by somehow piling layer upon layer, loan upon loan, that
they were somehow creating something that could be considered real wealth.
They gave themselves bonuses that boggled the mind. Even after the whole ridiculous system came tumbling down, they continue to give themselves ridiculous bonuses. Insane bonuses. They’ve been writing themselves checks for millions of dollars to continue to operate their
businesses – even after taking billions of dollars in loans from the government to prevent them from going out of business. I consider
this to be downright criminal. But even if it’s not criminal, it’s
incredibly stupid. The very people who ran those firms right to the edge of bankruptcy, who nearly took down our entire financial system
are being rewarded. Not only are they being allowed to continue
to rut the businesses that they pretty much destroyed, but they’ve
been paying themselves an astonishing amount of money to do it. And now they’re complaining bitterly about the fact that the government
wants to limit them to a paltry half-million dollars of salary per year.
They argue that they must be allowed to earn more than that. Because after all, the people who run those businesses are special. They’re “the best and the brightest”. They’re
extra-smart. No one else could possibly run those businesses. We can’t rely on anyone who’d accept a puny half-mil – they won’t be smart enough. They don’t have the special knowledge of the business that these people do.
There’s one minor problem with that argument: it doesn’t work. A couple of weeks ago, some idiot at JP Morgan circulated a chart that was supposed to summarize just how bad the financial disaster has been. The chart circulated for a couple of weeks – bounced from mailbox to mailbox, sent from one financial genius to another.
Only the chart was blatantly, obviously, trivially wrong, and anyone who had the slightest damned clue of the assets those businesses managed – i.e., the kind of thing that the idiot who drew the chart was supposed to know – should have been able to tell at a glance how wrong it was. But they didn’t. In fact, the damned thing didn’t stop circulating until (of all people) Bob Cringely
flamed it. Go look at the chart – it’s up at the top of this post.
I’m behind the curve a bit here, but I’ve seen and heard a bunch of
people making really sleazy arguments about the current financial stimulus
package working its way through congress, and those arguments are a perfect
example of one of the classic ways of abusing statistics. I keep mentioning metric errors – this is another kind of metric error. The difference between this and some of the other examples that I’ve shown is that this is deliberately dishonest – that is, instead of accidentally using the wrong metric to get a wrong answer, in this case, we’ve got someone deliberately taking one metric, and pretending that it’s an entirely different metric in order to produce a desired result.
As I said, this case involves the current financial stimulus package that’s working its way through congress. I want to put politics aside here: when it comes to things like this financial stimulus, there’s plenty of room for disagreement.
Economic crises like the one we’re dealing with right now are really uncharted territory – they’re very rare, and the ones that we have records of have each had enough unique properties that we don’t have a very good collection of evidence
to use to draw solid conclusions about recoveries from them work. This isn’t like
physics, where we tend to have tons and tons of data from repeatable experiments; we’re looking at a realm where there are a lot of reasonable theories, and there isn’t enough evidence to say, conclusively, which (if any) of them is correct. There are multiple good-faith arguments that propose vastly different ways of trying
to dig us out of this disastrous hole that we’re currently stuck in.
Of course, it’s also possible to argue in bad faith, by
creating phony arguments. And that’s the subject of this post: a bad-faith
argument that presents real statistics in misleading ways.
And now for a short gripe from the other side of the political spectrum.
Normally, I like Media Matters. I personally think that the whole “left-wing media” thing
is a crock. The media has become so sensitive to the accusation of left-wing bias that they actually shy away from even dreaming of criticizing a conservative, and attack liberals with great fervor as a way of showing that they’re not being unfairly nice to them. In general,
I find Media Matters does a good job of showing how the modern press really works.
But the fact is, they are a biased organization, and you need to be very careful
to look at the details of what they write. Just like right-wing media-watch organizations,
they do look for interpretations of facts that support their bias, even if it requires
significant abuse of those facts to make the interpretation fit.
This morning, they provided an excellent demonstration of that. President Bush gave his final press conference this morning. The people at the conference showed a lot of deference to him, and let him get away with a lot. But one thing that Media Matters focused on
touches on math, and it’s bad.
Naturally, since this friday was the first time that the SB server has really been down since I start blogging (planned downtime, as it happens, for a major system upgrade), there
was spectacularly bad math in the local news here in NYC friday afternoon.
I’m not sure how long this has been the case, but Mayors of NYC have a radio show. It’s a mixture of them spouting off about whatever they feel like babbling about, and call-in questions. I don’t generally listen, but once in a while, if the mayor says something either particularly interesting or particularly insane, I’ll hear the segment repeated on the local NPR station.
In this friday’s show, he sprung a really shockingly stupid line. The supposed
topic was Bernard Madoff and his pyramid scheme. Bloomberg responded by saying
that “Madoff’s isn’t the biggest ponzi scheme ever. If you really want to see the
worlds biggest ponzi scheme, just look at social security.” He continued along
those lines for a few minutes.
This is, to put it mildly, bullshit. Incredibly, stupid, rampant, bullshit.
So, the financial questions keep coming. I’m avoiding a lot of them, because
(A) they bore me, and (B) I’m really not the right person to ask. I try to stay
out of this stuff unless I have some clue of what I’m talking about. Rest assured, I’m not spending all of my blogging time on this; I’ve got a post on cryptographic modes of operation in progress, which I hope to have time to finish after work this evening.
But there’s one question that keeps coming in, involving the nature of things
like so-called “Credit Default Swaps”, which I thought I’d explained, but
apparently my explanation wasn’t particularly clear. So I thought I should fill
in that gap, and strengthen the main weakness in my earlier explanations.
The basic question is: “What’s a credit default swap?”; I think what people
really want to know is both what, specifically, a credit default swap is, and how
the system surrounding credit default swaps and related monstrosities work.
Credit default swaps are interesting – in the same way that a Rube Goldberg
device is interesting. They are in a fundamental sense very simple, but the
structure that’s built up around them is so bizarre, so ridiculous on the face of
it, that when you look at it in retrospect, it’s hard to believe that anyone
actually thought that it was a good idea, or that it could ever work.
It purports to compare how the economy does under democratic versus
republican administrations. They claim that they’re computing the returns
on a 10,000 dollar stock investment under 40 years of republican
administrations and 40 years of democratic administrations, in the 80 years
Ok, another batch of questions have come in, all variants on
the same theme.
The question is, if mortgages are at the root of the current economic disaster, how can it possibly result in close to a trillion dollars worth of losses?
It definitely seems strange, on two different levels. On an absolute scale, it’s hard to see how mortgage losses could add up to a trillion dollars. And on a relative scale, it’s hard to see how the foreclosures could really overwhelm the lenders when even an extremely high foreclosure rate represents a fairly modest loss considered as a percentage.
There is at least a little bit of interesting bath math
to learn from in the whole financial mess going on now. A couple
of commenters beat me to it, but I’ll go ahead and write about
One of the big questions that comes up again and again is: how did they get away with this? How could they find any way of
taking things that were worthless, and turn them into something that could be represented as safe?