Risk-adjusted return

Investors are familiar with the concept of risk-adjusted return. A fund which takes large risks to obtain higher returns might be judged inferior to another fund with lower risk and return. We should apply the same kind of thinking to the economic status of families in the US. While incomes have risen in recent decades, so has volatility in income. Families earn more on average than in the past, but also suffer larger swings in income (most likely due to layoffs and unemployement).

The personal risk-adjusted performance of our economy is not nearly as impressive as the simple GDP numbers. The 3-part LA Times series covering this is available here (their internal name for it is appropriately "new deal over").

I discussed this issue previously here.

LTCM (and the *real* smart guys)

When Genius Failed : The Rise and Fall of Long-Term Capital Management
by ROGER LOWENSTEIN

Inventing Money : The Story of Long-Term Capital Management and the Legends Behind It
by NICHOLAS DUNBAR

Long Term Capital Management was the hedge fund founded (1994) by legendary Salomon bond trader John Meriwether together with Robert Merton and Myron Scholes, the Nobel prize-winning academics behind options pricing theory. Meriwether was one of the first on Wall St. to see the value of quants, building a talented team which he took to LTCM. After several years of superb returns (over 40% in one year), the fund blew up in the wake of the Russian debt default and had to be bailed out by a consortium of banks organized by the Fed (1998).

If you are interested in the details of the LTCM story, the two books listed above are the place to start. (There was also a lengthy article in RISK magazine years ago, but you'll have to dig that out of your library.) Lowenstein is a business writer (formerly of the WSJ), who has also written a nice biography of Warren Buffet. His treatment is more readable for the average person, although frustratingly short on the details necessary to understand LTCM's actual trades and positions. Dunbar was a grad student at Harvard in applied physics, so understands the technical details better. He even gives a nice history of derivatives and option pricing.

Central Bank of Volatility: One of LTCM's big trades was a bet that future realized vol would resemble historical vol. They did so much business that London equity derivatives traders nicknamed them the Central Bank of Volatility. Historical vol was about 15% for European markets, but in 1997 the implied vol was 23%. LTCM was willing to sell vol (long dated options) at that price. Even larger positions in fixed income and mortgage-backed securities were also based on the assumption that markets would approach equilibrium. The question, as always: how long before mean reversion? Can you stay solvent longer than the market can stay "irrational"?

In their case, the answer was no, but the consortium of banks that bailed them out (buying out their portfolio) eventually made money. There was an issue of LTCM's counterparties front-running them on trades, but I don't think this was the main reason for their demise, and ultimately their positions came back.

LTCM got all the press, but few people know that the single most successful investment fund in recent history is Renaissance Technologies, founded in 1988 by mathematician Jim Simons. (Physics readers may be familiar with so-called Chern-Simons theory (Simons was Chern's PhD student at Berkeley) and wonder "whatever happened to Simons?"). Renaissance has averaged annual returns over 35% since its inception, and employs mostly former physics and math PhDs (MBAs need not apply). If I recall correctly, they now have over $10B under management and one of the most aggressive fee structures in the business (5/44 instead of 2/20!?!).

Simons: "The advantage scientists bring into the game is less their mathematical or computational skills than their ability to think scientifically. They are less likely to accept an apparent winning strategy that might be a mere statistical fluke."

Housing and Inflation

Economist: Housing costs comprise 30% of the core inflation indicator (CPI) used by the Fed. Because the recent run-up in home prices is not reflected in increased rental costs, you get very different results for the core CPI if you use home prices (cost to purchase a home) instead of rental cost in the calculation. You could argue this means that US inflation is much higher than previously thought. I prefer to see it as yet another indication of a housing asset bubble.

The shadow of LTCM

WSJ: "The watchmen are back. And they're watching the hedge funds again, among other points of concern.

The group, which wields the weighty title Counterparty Risk Management Policy Group II, was established to monitor risks to the world-wide financial system in the wake of the 1998 implosion of hedge fund Long-Term Capital Management.

E. Gerald Corrigan, past president of the Federal Reserve Bank of New York and now a managing director at Goldman Sachs Group Inc., is serving as chairman of the revived 15-member group, which includes representatives from major brokerage firms, banks and one insurer as well as the hedge funds with which they often trade. It will hold its first formal meeting next month.

The group's revival comes with the quiet backing of the New York Fed, which appears to have grown more concerned about potential market disruptions. For example, in a speech in November, New York Fed President Timothy Geithner noted "hedge funds -- and financial leverage more generally -- still present a source of potential risk to the financial system" and went on to cite a relaxation in credit terms and other risks."

Sounds like a good idea to me. But will they really be able to do anything about systemic risk? Someday this global liquidity bubble will come to an end. Hopefully in an orderly manner, but if not, look for a lot of hedge funds to blow up. LTCM would be a medium-sized fund these days, although the amount of leverage they used would still be considered high.

Null energy condition

New paper! A bit too technical to discuss here. But for Sci-Fi fans, the following tidbit: wormholes and time machines generally require violation of the null energy condition. Our paper shows, among other things, that none of the particles or fields of the type generally considered in particle physics will allow construction of a (stable) wormhole or time machine.

For those familiar with the Einstein equations, they are of the form:

{Curvature tensor R, fn of spacetime geometry} = {matter energy-momentum tensor T}

The set of possible spacetime geometries (could there be wormholes? loops in time?) satisfying the Einstein equations is unconstrained without some information about the right hand side of the equation. Traditionally in general relativity, one assumes that the matter fields satisfy certain energy conditions, for example the null energy condition, which requires that the tensor T, when contracted with any null (lightlike) four-vector n, is positive: Tnn > 0. We show that when this condition is violated, the system is necessarily unstable to small perturbations.


Instabilities and the null energy condition
Authors: Roman V. Buniy, Stephen D.H. Hsu

We show that violation of the null energy condition implies instability in a broad class of models, including all gauge theories with scalar and fermionic matter as well as any perfect fluid. When applied to the dark energy, our results imply that $w = p / \rho$ is unlikely to be less than -1.

http://arxiv.org/abs/hep-th/0502203

Smart money reaches $1 trillion

The Economist reports that hedge fund assets under management have reached $1 trillion, even while returns have diminished. Only qualified investors (an SEC classification) are eligible to invest - the requirement is $1M in net worth or $300K per year of family income. I guess most physics profs are stuck with mutual funds, which might not be so bad given the 2/20 fee structure charged by hedge funds ;-)

If your kid is mathematically gifted, I suggest pointing him (or her :-) to the nearest "relative value arbitrage" fund, rather than grad school in physics :-) With the glut of money heading into hedge funds, I've been told that the number one shortage is in investment ideas! You can see this in the graph below - the variation in returns is going down as more and more funds pile onto similar strategies.

Institutional Investor's obsessively read list of most-highly-paid hedge-fund managers starts with familiar names (George Soros: $750m), but 16 others made at least $100m in 2003... Successful managers become rich, possibly too rich to care about work, in just a few years.

I've discussed the role these funds are playing in the bond market, plying the carry or curve-flattening trades: sell the short end and buy the long end of the yield curve. Hedge funds are the third largest holders of US Treasury debt after Japan and China.

First FX domino?

Just as predicted by game theory critics of Bretton Woods II, Korea may be the first to defect from the currency regime, seeking to protect the value of its reserves by diversifying into a basket of currencies. Note, however, that BoK has merely floated this as a proposal to parliament. Korean companies may have something to say about whether the won should be allowed to rise against the dollar. Not long ago at the ASEAN meeting Korean President Roh expressed concern about the rising won and declared pan-Asian currency solidarity. Can the Koreans take the pain necessary to move to a basket?

Bloomberg: "The dollar fell the most in more than four months against the yen and dropped versus the euro, Korean won and at least 30 other currencies after the Bank of Korea said it plans to increase its non-dollar reserves.

South Korea's central bank, which has a total of $200 billion in reserves, said in a Feb. 18 report to a parliamentary committee it will increase investments in assets denominated in currencies such as the Australian and Canadian dollars. The country's reserves are the world's fourth biggest, behind Japan, China and Taiwan, according to data compiled by Bloomberg."

Brad Setser caught this as well.

UPDATE: From Bloomberg this evening, South Korea's central bank, which holds the world's fourth-largest foreign currency reserves, said it has no plan to sell dollars from those holdings and no plan to change the current portfolio of currencies in its reserves.

"The Bank of Korea will not change the portfolio of currencies in its reserves due to short-term market factors," the central bank's said in a press release e-mailed to all media this morning after the Korean won rose past 1,000 against the dollar for the first time since November 1997.

But not before the dollar plunged and US equity markets tanked...

"Easy Al" Greenspan

From Barrons: "The accompanying chart, which comes to us by grace of Trey Reik, of Clapboard Hill Partners, a New York-based investment outfit, shows one of the singular effects of Mr. Greenspan's eagerly accommodating reign at the Fed. It tells the story of credit in this fair land from 1916 through the present. Keeping in mind that Mr. G took over in 1987, you can readily see the trajectory picks up altitude abruptly from then until now.

Mr. Reik observes that for the past 100 years, the nation's credit-market debt has averaged between 140% and 160% of gross domestic product. The principal exceptions came in 1929, when the stock market went bananas, and in 1933, during the traumatized period that followed the Great Crash, when four years of the Depression (GDP shrank by an awesome 45%) hoisted the ratio to 287%, prompting a devaluation of the dollar. That was the all-time peak, never approached again until the remarkable rise that began in the 1980s and has resolutely continued ever since, lifting the ratio to today's astonishing 304%."

Finance for beginners

I recently discovered the Web site of John Norstad. According to his fascinating bio, John was an Iowa boy like me, who had a little too much interest in math when growing up. He now works in software development at Northwestern University, but has taken time out recently to write a number of expository papers on topics in modern finance, ranging from portfolio theory to options pricing.

Particularly nice is his note on "two-state options," a kind of toy-model world that helps develop intuition. One thing that always used to bother me was how the price of an option could really be independent of the assumed "drift term" in the Black-Scholes model (you can find this debated by real practitioners here). An explicit model in which one can replicate the derivative using cash and shares of the underlying security makes this more transparent. The deep insight is that all expectations about future returns on the underlying are contained in the instantaneous price. This also clarifies the observation that derivatives can be priced in a risk-neutral way, as I mentioned in my post on path integrals.

I haven't looked at all of his papers, but they seem just right for someone with a background in math or physics who wants a clear, concise, but theoretically sophisticated introduction to this subject. I usually tell people to read John Hull's introductory textbook, but I think a stop at Norstad's site might be very worthwhile.

Out on the tail

Lev Landau, a Nobelist and one of the fathers of the great Soviet physics system, had a logarithmic scale for ranking theorists, from 1 to 5. A physicist in the first class had ten times the impact of someone in the second class, and so on. He modestly ranked himself as 2.5 until late in life, when he became a 2. In the first class were Heisenberg, Bohr, Dirac and some others; Einstein was a 0.5! (For reminiscences of great physicists in that generation, see From a Life in Physics.)

My friends in the humanities, or other areas of science like biology, are astonished and disturbed that we physicists think in this essentially hierarchical way. Apparently, differences in ability are not manifested so clearly in those fields. Personally, I find Landau's scheme appropriate. There are many physicists whose contributions I cannot imagine having made. James Gleick, in his insightful biography of Feynman, devotes an entire chapter to these issues and the elusive subject of genius.

I once asked a famous theorist what fraction of the population was capable of doing good work in our field. He had already thought about this question (as later became clear), and immediately answered: 1 in 100,000. Whether his answer is correct is debatable, but surely the fraction is a small number. Even taking 1E-05 as the answer, there are many such people on the planet, most of them in developing countries (20,000 in China and India combined!). Do they have access to educations commensurate with their abilities? Won't the world benefit more and more from their talents as globalization continues? The US has benefited enormously from the brain drain that brings such people to our country.

[Note added (2009): In About Science, Myself and Others, Nobelist V.L. Ginzburg notes that Landau had ranked Feynman in the 1 category (so, higher than Landau himself). Ginzburg describes many similarities between Landau and Feynman, although unfortunately the two never met in person. p.281]

Summers firing

OK, you can read the entire transcript of Larry Summers' controversial remarks here (NBER Conference on Diversifying the Science & Engineering Workforce). Remember, he was invited to be a provocateur and explicitly stated he wasn't speaking as Harvard President, but as an economist. Do these remarks warrant his removal as president of Harvard? (The issue is that a small gender-related difference in standard deviation leads to huge asymmetries in the tails of the ability distribution - many more really dumb men than women and many more math genius men than women. Who knows whether it's true, but does it justify his firing?)

"...I'm focusing on something that would seek to answer the question of why is the pattern different in science and engineering, and why is the representation even lower and more problematic in science and engineering than it is in other fields. And here, you can get a fair distance, it seems to me, looking at a relatively simple hypothesis. It does appear that on many, many different human attributes-height, weight, propensity for criminality, overall IQ, mathematical ability, scientific ability-there is relatively clear evidence that whatever the difference in means-which can be debated-there is a difference in the standard deviation, and variability of a male and a female population. And that is true with respect to attributes that are and are not plausibly, culturally determined.

If one supposes, as I think is reasonable, that if one is talking about physicists at a top twenty-five research university, one is not talking about people who are two standard deviations above the mean. And perhaps it's not even talking about somebody who is three standard deviations above the mean. But it's talking about people who are three and a half, four standard deviations above the mean in the one in 5,000, one in 10,000 class. Even small differences in the standard deviation will translate into very large differences in the available pool substantially out.

I did a very crude calculation, which I'm sure was wrong and certainly was unsubtle, twenty different ways. I looked at the Xie and Shauman paper-looked at the book, rather-looked at the evidence on the sex ratios in the top 5% of twelfth graders. If you look at those-they're all over the map, depends on which test, whether it's math, or science, and so forth-but 50% women, one woman for every two men, would be a high-end estimate from their estimates. From that, you can back out a difference in the implied standard deviations that works out to be about 20%. And from that, you can work out the difference out several standard deviations. If you do that calculation-and I have no reason to think that it couldn't be refined in a hundred ways-you get five to one, at the high end.

Now, it's pointed out by one of the papers at this conference that these tests are not a very good measure and are not highly predictive with respect to people's ability to do that. And that's absolutely right. But I don't think that resolves the issue at all. Because if my reading of the data is right-it's something people can argue about-that there are some systematic differences in variability in different populations, then whatever the set of attributes are that are precisely defined to correlate with being an aeronautical engineer at MIT or being a chemist at Berkeley, those are probably different in their standard deviations as well. So my sense is that the unfortunate truth-I would far prefer to believe something else, because it would be easier to address what is surely a serious social problem if something else were true-is that the combination of the high-powered job hypothesis and the differing variances probably explains a fair amount of this problem."

Q: You know, in the spirit of speaking truth to power, I'm not an expert in this area but a lot of people in the room are, and they've written a lot of papers in here that address ....

LHS: I've read a lot of them.

Q: And, you know, a lot of us would disagree with your hypotheses and your premises...

LHS: Fair enough.

Q: So it's not so clear.

LHS: It's not clear at all. I think I said it wasn't clear. I was giving you my best guess but I hope we could argue on the basis of as much evidence as we can marshal.

Q: It's here. (Referring to papers?)

LHS: No, no, no. Let me say. I have actually read that and I'm not saying there aren't rooms to debate this in, but if somebody, but with the greatest respect-I think there's an enormous amount one can learn from the papers in this conference and from those two books-but if somebody thinks that there is proof in these two books, that these phenomenon are caused by something else, I guess I would very respectfully have to disagree very very strongly with that. I don't presume to have proved any view that I expressed here, but if you think there is proof for an alternative theory, I'd want you to be hesitant about that."

Asperger watch

Add Harvard President Larry Summers to the list of usual Asperger suspects. Summers, from a family of famous economists, is the nephew of Nobelist Paul Samuelson and nephew in-law of Nobelist Kenneth Arrow. (Summers' father, an econ prof at Penn, changed the family name to avoid anti-semitism.) Summers started as a math major at MIT, but switched to econ after seeing the competition.

From the Times review of a new book on Harvard and its president:

Although Mr. Bradley is convinced that he has written an institutional portrait, the book is a remarkably personal. Alongside numerous critiques of Mr. Summer's table manners - Mr. Bradley judges him a "sloppy eater" - the author speculates early on in the book that the Harvard president may have Asperger's syndrome, a condition that renders him socially autistic.

"I'm neutral on it," he said. "I'm not a doctor. I don't feel qualified to say. I do think the explanation has 'explanatory power,' as one of my Harvard professors used to say."

The article suggests that there will be a forthcoming vote of no-confidence in Summers from the Harvard faculty. I've avoided talking about the flap over Summers' comments on gender differences in science and math ability (it's a no-win subject, as Summers has found), but here is a good summary page.

I discussed Asperger's syndrome here and here.

Book recommendation

Since we got onto the subject of biology, let me recommend the following

The Genome War: How Craig Venter Tried to Capture the Code of Life and Save the World
by JAMES SHREEVE

as the best book I've found yet on the race to sequence the human genome. Shreeve had unlimited access to Celera and Craig Venter's team during their race with the government-funded Human Genome Project. The reporting is very good on a wide range of matters, from the human issues (Venter is an amazing character, as are a number of the other figures like Francis Collins, Eric Lander, etc.) to the science (whole-genome shotgun sequencing; bioinformatics) to the business and strategy issues. It also exposes how far from complete the sequencing was when both parties agreed to a truce and made their triumphant announcement from the Clinton White House.

Eric Lander (Whitehead Institute/MIT) is perhaps the most impressive figure in the book, although he plays a minor role compared to Venter. (Princeton valedictorian, Oxford PhD in math, briefly taught finance at Harvard Business School, then switched to biology.) At one point a prominent biologist says "Eric's mind is simply overwhelming - he could squash me like a bug." Although the whole-genome shotgun technique that Celera used is based partly on his work, he emerges as their fiercest critic by the end - claiming that they would have gotten nowhere without using the HGP data, which, unlike Celera's, was in the public domain. (I would really like to know whether this issue is resolved now - was whole-genome shotgun a success?)

Evolutionary timescales

One of my colleagues complained today that my blog has been "all about money" lately, and needed a dose of science :-)

Below is a comment I posted to biophysicist Carson Chow's blog recently:

"The process of evolution has been experimentally verified without question. But has anyone shown that humans could have evolved from complex molecules in the time allowed? (e.g., age of the universe = 10 Gyr?) I think the best claim a creationist (or "intelligent design" enthusiast or whatever) could make is that, sure, evolution works, but without a hidden push every now and then there has not been enough time to achieve the observed complexity of the biological world. Since we can't really estimate the necessary timescales from what we currently know, we can't rule out this possibility.

I once asked a well-known evolutionary biologist at Harvard about this, and was stunned to realize he didn't understand my question. He gave me a BS answer about the observed mutation rate being fast enough to explain the observed complexity of life, but I don't see how anyone could justify that.

Of course Occam's razor suggests that evolution alone is capable of producing humans in the allotted time, but that is not yet verifiable scientifically."

Does anyone want to make a counter-claim? What scientific progress will be necessary for us to be very confident in a quantitative sense that genetic drift + natural selection are enough to explain the incredibly optimized eyes, brains, leaves, tendrils, web-spinners, etc. in the natural world? How about to conclude that 10^{100} years is more than enough time? (Remember, we have to start with molecules and understand the timescales required to get to simple cells (but with genetic coding), then to multicellular beasts, and eventually to Angelina Jolie :-)

Housing revisited

Coincidentally, I was referred to two housing bubble reports today. This one is from FDIC, and these are slides from a talk by NY Fed VP Richard Peach. The latter is remarkably sanguine - it seems to say that price to rent and price to median income indexes are off because they don't adjust for improving quality of units sold (for instance, increased median square footages, etc. - sounds to me like the "hedonic" adjustments in the CPI that Bill Gross is suspicious about). Once that adjustment is made the housing market doesn't look overpriced, at least nationally. The Fed report also claims that while many buyers are motivated by low interest rates, few are buying in anticipation of near term price increases (classic sign of a bubble).

I guess I'm skeptical, and in any case there is a big difference between a national housing bubble and one in selected markets like CA, Boston, DC, etc. You can read the reports and decide for yourself...

Place your bets...

Steve Roach at Morgan Stanley:
Dr. Zhou Xiaochuan, Governor of the People's Bank of China and the one of the nation's leading macro thinkers, has put the Chinese currency issue to rest for the time being. “Now is not the time,” he said in an interview on the eve of the 5 February G-7 meeting in London when queried about China’s plans to adopt a more flexible foreign exchange regime. That puts an end to speculation of an imminent move and even draws into question my view that China is actively preparing to modify the decade-long peg between the renminbi and the dollar (see my 31 January dispatch, “An Unprepared World”). Governor Zhou qualified the concept of preparation for full RMB convertibility as one that “may take years to achieve.”

Roubini and Setser's new paper on Bretton Woods II and renminbi revaluation is summarized here, and an interesting dissenting view here.

Roubini and Setser have (kind of) gone out on a limb predicting things will become intolerable for the PRC government within 2 years. Others think things could continue as they are for another 5 years or more. That's the great thing about academia - (1) the amount of skin you have in the game is limited (no one will fire you for getting things wrong, and you won't have lost an investor or (shudder) your own account billions of dollars) and (2) you can waffle a bit in your predictions. This should not be taken as a criticism - predicting macro or FX movements is extremely hard, and the detailed analysis lays out all the assumptions for you to see. But, there is something very nice about being able to look at a trader's P/L (bottom line) to see if he really got it right or wrong! ;-)

An interesting factual question is raised by these analyses. To what extent are the BOJ and PBOC actually sterilizing currency flows? I suppose the BOJ can have it either way, since they are (a) facing deflation and (b) have such low domestic interest rates. The latest inflation report from China was rather benign, so if they are not sterilizing, and hence not building up unbalanced yuan obligations vs dollar assets, they should be able to continue for some time.

My previous thoughts are here, as well as elsewhere on this blog.

Liquidity feedback

Economist: "It is not just America that feels the effect of low American interest rates. America has flooded the whole world with liquidity. Its loose monetary policy has been exported to other central banks through the fall in the dollar. For example, to offset the impact of a stronger euro on growth, the European Central Bank has been forced to hold the euro area's real interest rates negative for longer than might otherwise have been prudent. Mortgage lending in the single-currency zone is rising at an annual rate of 10%. In many countries, notably France and Spain, house prices are booming.

America's easy money has also spilled beyond its borders in a second way. When central banks buy American Treasury bonds, adding to their foreign-exchange reserves, to try to hold down their currencies against the dollar, they print local money. This amplifies the Fed's lax stance. Last year, the global supply of dollars (the sum of America's monetary base plus global foreign-exchange reserves) rose by a whopping 25%. After adjusting for inflation, this is close to the fastest pace in the past three decades.

Worse still, the effects of greater global liquidity then flow back into America's economy. By buying huge amounts of American securities to prevent their currencies rising, Asian central banks depress American bond yields, lowering borrowing costs for home buyers and companies. By some estimates, Asian purchases of American bonds have reduced yields by between half and one percentage-point."



Are foreign central banks essentially printing money to buy Treasuries? (That would indeed be inflationary.) Or, are they issuing local-currency denominated bonds to raise money with which they buy US bonds ("sterilizing")? In the latter case there is no inflationary effect but there is an FX mismatch between assets and liabilities of the central bank that will hurt them if the dollar falls in value.

Fed symposium on China exchange rate

Coverage from Bloomberg here.

"At a symposium at the San Francisco Federal Reserve Bank last week, more than 30 economists, mostly from universities and international institutions, tackled the issue of China's currency peg. Most of them argued that the Chinese would be forced to adopt a more flexible exchange rate regime, and some said that would come no later than next year.

On the other hand, the symposium -- which was titled, "The Revived Bretton Woods System; A New Paradigm for Asian Development?'' -- was called to discuss a series of papers by economists who maintain that the Chinese have such an overriding interest in strong growth that the peg will last at least for another five years.

National Bureau of Economic Research Working Paper published last July, Direct Investment, Rising Real Wages and the Absorption of Excess Labor in the Periphery: "If the price to be paid for this (industrialization) strategy includes financing a large U.S. current account deficit, governments in the periphery will see it in their interest to provide financing even in circumstances where private international investors would not.

"The catastrophic losses and abrupt price breaks forecast by the conventional wisdom of international macroeconomics arise from a model of very naive government behavior. In that model, periphery governments stubbornly maintain a distorted exchange rate until it is overwhelmed by speculative capital flows. In our view a more sensible political economy guides governments in Asia. The objectives are the rapid mobilization of underemployed Asian labor and the accumulation of a capital stock that will remain efficient even after the system ends.''

I discussed a number of these issues in a previous post.

A tale of two geeks

I have two young friends who are postdocs in theoretical physics. One is an American kid named Joe. The other, named Sanjay (or Sergei or Song) is from a foreign country whose GDP per capita is a small fraction of ours. Both Joe and Sanjay are brilliant - Sanjay scored in the top 20 in all of India (or China or Russia) on the IIT entrance exam, represented his country on the Math Olympiad team and managed to get admitted to a top American graduate program. Ditto for Joe, except that he went to school in the US and his parents paid a lot of money for Stanford tuition when he was an undergrad.

Joe notices that in his field there are many Sanjays, Sergeis and Songs for every American-born kid, but he realizes that this is just a consequence of the large populations and good (elite) educational systems of their home countries. He also notices that these other guys are really determined to stay in the US, because their job prospects at home are pretty poor in comparison.

Joe is a bit confused, because most of his (American) friends from Stanford went right into finance, law or medical school after college. They, and even his little brother who is a year younger, are all well on their way to being established by their 30's. This bothers Joe a lot, because he was always a much stronger student than his little brother or any of his friends from school - in fact, he was one of the brightest students in his entire class at Stanford! Joe, though, is just trying to land another postdoc, and, in a few years, perhaps a faculty job. He knows that only about 1 in 4 graduates from his top tier PhD program manage to do so. [Actual statistics here.]

I, the tenured professor, am chairing a job search for a theoretical physicist. Our files contain applications from over a hundred Joes, Sanjays, Sergeis and Songs. Despite the fact that the talent in our postdoc pool is tremendous - one could staff numerous derivatives trading desks, chip design teams and software startups with these young people - the successful applicant will be offered a princely salary not very different from that of a police officer or public school teacher. Once hired, he or she will have to slave for another 6 years to gain tenure. (A ridiculously long time - meaning a total of over 10 years of focused post-PhD research before the tenure decision - far more than in other fields where there are no postdoc positions and PhDs can go directly into faculty jobs.)

Homework questions:

1) Do the presence of Sanjay, Sergei and Song affect Joe's compensation or quality of working conditions? Think about what a university has to pay to "buy" a good physicist from the pool. If Joe doesn't like the offer or working conditions, won't he be easily replaced? Is the job market for police officers and high school teachers similarly impacted?

2) Is it paradoxical that the presence of Sanjay and friends is good for both the US economy and US universities, but bad for Joe?

3) Did Joe make good career choices? Do not assume that his utility function is a delta function peaked on "I looove science!"

Additional reading.

Path integrals

I've finished lecturing on renormalization of QED, and am now covering path integrals. Feynman, following an earlier observation of Dirac, showed that the quantum amplitude for a particle to propagate from A to B is given by the sum over all possible paths connecting A to B, weighted by i times the classical action of each path:

Amplitude = Sum e^{i S[path]}

This yields a very intuitive formulation of quantum mechanics and quantum field theory. Mathematicians don't like the Feynman path integral (merely a heuristic used by physicists!). Due to its highly oscillatory integrand, little has been rigorously established about its properties or even its existence. Under better control is the related Wiener integral (an imaginary time Feynman integral or Euclidean path integral), which takes the form (S is real):

Sum e^{- S}

It didn't take long for physicists on Wall St. to realize that options pricing theory can be completely recast in path integral language. The Euclidean path integral for a free particle describes Brownian motion (a random walk). Interpret the location of the particle (in 1 spatial dimension - cake!) as the log of the price of a security, and you are off to the races! In the path integral language we value a derivative contract as the payoff averaged over all future paths. (We can only do this if the derivative can be perfectly hedged at all times, so risk preferences do not enter, but that is a subtlety.)

I derived a closed form expression using the free particle propagator and delta function potentials for the value of any possible exotic path-dependent option. At the time, this was quite novel, as such contracts were usually priced using Monte Carlo simulations. (If you look hard enough you can find an MIT Sloan school report with all the details :-) Soon after, I was offered a job in the equity derivatives group at Morgan Stanley. Being young and idealistic (dumb and naive), I decided it was better to be a postdoc at Harvard than a future multi-millionaire (although now that I think about it I did have a faculty offer at Yale by that time). A reporter from CNBC interviewed me as one of the rare "rocket scientists" who turned down Wall St. (They had no shortage of interviews with the other type :-) The camera man even shot some footage of me walking into Lyman Lab with my crummy backpack full of physics books.

Carly Fiorina no longer HP CEO

It's official - Carly Fiorina is no longer HP CEO. I remember being at an HP Labs conference when the Compaq merger closed. The HP engineers and scientists were all crying. No one thought it was a good move. Since then, HP has gone downhill. I'm not sure what they are still doing in the commodity PC business - they should focus on imaging and printers. HP's market cap is up $7B today on the news!

Carly is a tremendously effective speaker and communicator. She isn't dumb, either. But, she is in no way a technologist. The job requirements for the CEO position in a public technology company are tremendous. The set of people who can do the job well is very, very small. Having said this, I believe that CEOs are overpaid these days - in no way should someone who merely takes over control of an existing successful enterprise be paid $100M - that should be reserved for someone (an entrepreneur) who actually creates such an enterprise.

A modern CEO has to have the following qualities:
1) Must communicate well with financial markets
2) Must communicate well within the company, to engineers as well as marketers
3) Must be able to get by on 4 hours of sleep and endure 14 hour work days for years on end
4) Must understand technical issues well enough to have strategic vision
5) Must be decisive - cannot lose sleep over hard decisions
6) Must inspire confidence and exhibit leadership, both at the small team and enterprise level

I would say Carly only fell short in quality (4). But that was enough for a disaster! If I had to pick an ideal CEO, I would have to go with Steve Jobs. No one has his innate feel for both technology and marketing, and no one is as willing to take bet-the-farm risks (OS X, iPod, Mac Mini...).

See here for reaction from tech geeks and HP employees.

Household debt

Household debt as a fraction of disposable income is up uniformly from 10 years ago. But, I think this just reflects rational behavior - since interest rates are so low I bet debt payments as a fraction of income are actually flat or down. (Certainly the case with mortgage debt, although perhaps not with credit cards.) If you trace all the way back, the responsibility for this consumption bubble goes to Greenspan and complicit Asian central bankers (who have elbowed the bond vigilantes of the 90's off the stage).

I was amazed this week that treasuries and the dollar rallied on the basis of Greenspan's G7 comments and Bush's non-credible budget. This may be an opportune window to exchange some dollars for hard currency, before the FX traders decide there is no chance that the US current account or budget deficits will improve in the near term.

Science funding

I noticed that Bush's new budget cuts both the DOE and NSF budgets (the former in nominal dollars, the latter in real dollars).

If I were a billionaire I would set up a foundation whose main mission is to increase Federal spending on science and engineering research - a kind of sci-tech PAC.

Existing organizations, like the Sloan or Packard Foundations, already fund promising individual scientists, or support popular science programs like NOVA. But, we might get bigger bang for our non-profit buck from making Congress more aware of the positive return on research (i.e., direct lobbying), and supporting those politicians that are most pro-science. A few billion allocated to science PACs could produce a lot of good for society in the long run. Supporters of science have to face the reality of how our government works, and how the levers of power are manipulated. If the NRA or anti-abortion lobby can hold the majority of Americans hostage over fringe issues, why not a pro-science PAC that operates in the long-term interest of America?

This foundation could also produce economic policy papers documenting the return on government investment in research, and publish a list of the 50 least supportive representatives and senators each year. In the current environment, a dollar spent on lobbying for federal resources may have a greater return for science than a dollar spent directly on research.

Editorial from Chemical and Engineering News: "U.S. leadership in science and technology used to be a foregone conclusion. No longer. The European Union, China, Japan, India, Russia, and other nations are rapidly building scientific capabilities that rival ours--as evidenced by more U.S. companies moving science and engineering jobs and facilities offshore and by fewer international students applying for U.S. graduate programs in science and engineering.

Is our technological leadership slipping? If so, how will that affect our ability to generate future breakthroughs and high-wage jobs? These questions are not being asked often enough in Washington, D.C. Instead, the President's budget request cuts basic research at the Departments of Energy and of Defense, and the House of Representatives recently slashed National Science Foundation research. Because these agencies dominate federal investments in nonmedical research, our elected leaders are running a very risky national experiment at a pivotal time in U.S. history.

Like a thoroughbred in a race without a finish line, science runs nonstop for the American people. Our military supremacy, industrial strength, and quality of life depend heavily on it. However, if we leave critical areas unexplored, we will fall back in science and create a void other nations are certain to fill. To keep pace, we must make sustained and smart investments in basic research.

The trend toward flat research budgets is troubling because basic research supported by NSF and other agencies ensures a steady stream of scientific discoveries that can transform entire industries and even create new ones. While the nation's sluggish job growth is gaining much attention, too little attention is being paid to America's long-standing reliance on innovative new industries to create high-wage jobs. No one knows which next big innovation will produce a wave of new jobs, although biotechnology, nanotechnology, and renewable energy are strong contenders. But we do know that major job-producing innovations stem from strong basic research investments.

The American public believes in job growth through innovation. In fact, in a recent poll, more than 70% of Americans said the nation spends too little on basic research. If the U.S. is to continue to lead the way in the creation of new technologies and jobs, we can't afford to put federal research on hold. Today, federal research investment is less than 1% of GDP--less than half the rate of the 1960s. In other nations, the rate is much higher."

China-Japan relations

The Times had a nice Week in Review article on China-Japan relations. Although China recently became Japan's number one trading partner, political relations are still tense between the two nations. The real source of these tensions is of course WWII, which Japan has never adequately apologized for. While young Germans are acutely aware of their country's role in the war, and in the holocaust, most young Japanese know almost nothing about Japan's wartime atrocities or imperial aspirations. When traveling abroad in Asia they are often shocked at the anti-Japanese sentiment which persists to this day.

Younger Asians are more likely to have a positive view of Japan, perhaps due to the widespread appeal Japanese pop culture (a form of "soft-power"). China is the exception, where, amazingly, young people tend to have stronger anti-Japanese feelings than older people with more direct ties to the war. The PRC government deliberately uses nationalism as an outlet for political tensions, and this is yet another area in which that policy may backfire.

NYT: Over the long term, the economic trajectories of the two countries are clear. Barring catastrophes, "China will become the sole leader in Asia, with Japan as an important subordinate," Toyoo Gyohten, a Japanese business leader, warned in a speech last fall.

Mr. Gyohten questioned the wisdom of antagonizing China out of pique over Chinese harping on World War II. "Many Japanese believe they have already apologized," he said. "But I, for one, believe that we should apologize as many times as possible."

But for Mr. Koizumi, Mr. Ishihara and their generation, there is a statute of limitations on contrition. As Jeffrey Kingston, director of Asian Studies at Temple University Japan, said in an interview: "This is a Japan that doesn't flinch any more."

Cosmic accounting

A couple of people have asked me about a new discovery by Chandra (orbiting x-ray observatory) of lots of mass in distant gas clouds (NASA release).

What has been discovered is more baryons (ordinary stuff, like protons and neutrons), not the exotic dark matter. There are strong limits from nucleosynthesis (synthesis of light nuclei early in the hot big bang) that constrain the baryon fraction of the total energy density to be about 5%. The dark matter (non-baryonic matter of unknown type clumped around galaxies or clusters of galaxies) is about 25% of the total and dark energy (weird stuff with negative pressure) is the remaining 70% or so.

About half of the expected 5% baryon fraction had been accounted for in galaxies, and these huge gas clouds may be the rest of it. We're still in the dark about dark energy and dark matter, though.

One mystery puzzling theorists is why there are roughly (within an order of magnitude or so) equal amounts of these 3 types of stuff. As the universe expands, the energy density of dark energy changes very slowly compared to baryons or dark matter. Unless we are living at a very special epoch, one would expect the densities of these things to differ by many orders of magnitude. (For example, when the universe was 10 times younger the DE fraction was tiny, and when it is ten times older the DE fraction will be nearly 100%.)

The myth of fingerprints

Fingerprint scanning is one of several biometric technologies under development. Sounds pretty good - just put your thumb on the sensor and it identifies you. Several supermarket chains are already trying it out.

Unfortunately, clever hackers have already learned how to defeat fingerprint scanners using gummy bears and other methods. For a step-by-step guide to stealing and using someone else's fingerprints, see here. Thank goodness it doesn't involve cutting off anyone's thumb. Actually, the stealing part will be easy since the fingerprints will be stored as digital files somewhere. Once one of these databases is compromised the bad guys will have millions of fingerprints to play with.

This technology looks DOA to me unless combined with other methods of authentication (in which case, it becomes just another multi-factor method). A particularly bad aspect of fingerprint scanning is that it is very hard to repudiate your own fingerprint once it has been stolen. A stolen credit card number is easily replaced, but not a fingerprint.

Retinal scans may suffer the same fate if contact lenses can be developed to mimic retinal patterns, although I don't know whether this is possible.

Coming soon: the $4K car from China

This is the Chery QQ, which sells in China for $3,600. It's apparently a copy of the GM-Daewoo Spark, introduced in China in 2003. Chery sold about 50K of these last year in China and is planning to begin exporting cars to the US by 2007. Of course, the low price may be partly due to the, umm, borrowed intellectual property in the product. Nevertheless, it seems obvious that China is exporting deflation to the US - the $30 DVD player is only the beginning.

Actually, it looks pretty cool - just the thing to get me from home to office in Eugene when it's raining too hard to bike! (Something funny going on, though. My former students are driving Mercedes and I am looking at this thing :-)

Housing bubble

I mentioned the bay area housing bubble in the last post, and was asked to elaborate. Coincidentally, the Economist just posted this survey on property worldwide.

I can't claim to be an expert on this topic, but here goes...

I think there is clear evidence for a bubble in places like the bay area, Boston, NYC, LA and some other cities. The metric I find most compelling is price to rent (P/R) ratio, which is analogous to price to earnings (P/E) for equities. This is at an all time high in many cities, although not nationwide. The other metric which is very inflated in certain markets is price to average (family) income. Some of this data is available at the Case-Shiller-Weiss (CSW) Web site. (That's Robert Shiller, of "irrational exuberance" fame.) The bay area is particularly hard to understand, since something like 250K jobs were lost since the peak of the tech bubble in 2000, and there has actually been net migration out of the area. Rents have actually dropped slightly, but property values continue to increase.

On the behavioral front, I think a lot of people jumped into real estate thinking it was one of the few "safe" investments after the stock bubble burst a few years ago. One sure sign of a bubble is that people buy with the expectation of near-term price increases. I keep reading that units in developments in places like Florida and LA are often unoccupied - the owners have purchased them as investments with the intention of flipping. These speculators are going to get burned when interest rates rise, but until then they get to brag to their friends about their big gains. (Sound familiar?)

I mentioned in a previous post that bubbles can persist for surprisingly long periods of time, even after a fairly wide consensus has emerged that things are overpriced. I claim this has a lot to do with the timescales and effectiveness of arbitrage in a particular market. See here for related discussion in the Economist, and here for derivatives related to real estate prices.

Finally, let me note that I must not be very smart, since I thought the bay area was already overpriced 10 years ago, and should have bought something back then...

Virtual meetings overdue

I was in silicon valley again the last few days. Although it's only an hour flight from Eugene, there is still a noticeable toll, both mental and physical, from all the schlepping.

Years ago I was optimistic that we would soon be conducting most of our meetings over the Internet. A number of companies and technologies were and are in pursuit of this goal. But at this point there is still no substitute for face to face interaction - the richness of cues from facial expressions, body language, etc. are surprisingly important and still not replicated by current technology. We may reach the threshold with gigabit pipes and holographic projectors, but for the time being business travel is an unpleasant fact of life.

On the bright side, I was able to enjoy a warm Sunday afternoon in Berkeley, roaming from Espresso Roma to Cody's to lower college avenue. What used to be grungy college co-ops have often become perfectly groomed residences of affluent families. A casual glance at the realty listings shows modest homes going for >$400 per square foot. Perhaps it's a bubble, but where else can you enjoy a view of the bay on a warm sunny day in January, just a short drive from the Pixar, Chiron and UCB Campuses, Lawrence Berkeley National Lab and the Mathematical Sciences Research Institute?