FX update

According to BIS figures published this week global central bank currency reserve diversification has been larger and faster than previously thought. Stories of central banks divesting their dollar holdings have been common in the past two years. However, hard evidence is difficult to come by as official data is only available on a sporadic basis in the form of the BIS and IMF annual report. The latest BIS annual report published this week, therefore, provides an important benchmark to the extent and pace of diversification. In a break from the past, this year the BIS published a series of the dollar’s share of global FX reserves in constant (2003) exchange rates. This controls for the variations in exchange rates that can depress or exaggerate a currency’s share in reserves. For example the weakness of the US dollar in the past three years would tend to deflate the dollar’s share of reserves even if the actual holdings of dollar reserves were constant.

Surprisingly, the BIS numbers are somewhat different to those published in the IMF annual report in September 2004. At the end of June 2004, the BIS estimate that 65.5% of reserves were held in US dollars. While this is not significantly different from the IMF reading of 63.8% at the end of 2003, the pace of reduction in dollar holdings is far quicker in the BIS data set. The share has fallen from 77% in 2001 (see chart for more details). The BIS also shows that the euro has been the main beneficiary of this change, with the share of euro reserves more than doubling since 1999 to 23.6%. (Source: State Street, via our correspondent)





At present the main currencies are not far from their post BW I averages in real effective terms. The NZD, GBP, TWD, SEK and SGD were the only currencies that were more than 15% off their respective averages:

Google payments

Rumors have been around for some time that Google will roll out a payment system. Company representatives have said it won't be a person to person payment system like PayPal. I suspect it will be a micropayment system that lets users pay for content out of their Google Wallet. This is a crucial component of the Internet ecosystem that has been needed for some time, and Google is one of the few entities with enough clout, eyeballs and technical capability to roll it out. It will enable Web publishers large and small to sell content, going beyond the current Google AdWords model which allows ad sales. This would allow publishers ranging from the very big (Slate, Salon, New Yorker, Time, etc.) to the very small (individual bloggers) to monetize both new and old content.

In a related development, Google is readying a platform that allows people to upload video and make it available for distribution. A natural step will be for video auteurs to charge a fee for each viewing, or for Google to split fees with content providers for footage from news, sports, movies, etc. Google has already reportedly made a lot of progress in video search.

While I'm impressed with Google's string of innovations (images, Gmail, maps, etc.) I still think the stock is overpriced at $300 :-)

AI update

Two tidbits from the inexorable advance of artificial intelligence.

1) Two amateurs from New Hampshire (a database administrator and a soccer coach) won a recent international "freestyle" chess tournament, which included several grandmasters. Freestyle chess is team competition, including both humans and computers. The winning team (ZackS, anonymous throughout the tournament) used ordinary PCs and commercial chess software. Nevertheless, their play was so spectacular that many suspected the presence of Gary Kasparov!

The other untitled team, ZackS, is a dark horse. The identity of the people behind this team, and the method they are using, will be revealed after the tournament is over. Everybody assumes that there are one or more GMs working together with the team captain. The rumour was that Garry Kasparov was producing the extraordinary chess displayed by ZackS, but we can confirm that on the weekend of the quarter-finals Kasparov was most certainly otherwise engaged.

The standard of play is very high, possibly the highest ever seen in chess at these time controls. One would scarcely expect a human player, even the best in the world, to be able to face the precision and the strategic depth of some of the participants in this event.

2) An AI program has matched the average human performance on the verbal analogies portion of the SAT. (You know, "fish is to sea as monkey is to ...?") This is far short of passing the Turing test, but still an impressive feat of extracting relations from computer analysis of a terabyte of text. The program was written by Peter D. Turney's Interactive Information Group, Institute for Information Technology of the National Research Council Canada.

How you got here

Below are the top keyword searches that led people to this blog in the past 24 hours. Apparently my post on the time travel movie Primer is popular. Other topics of interest: China, hedge funds, globalization, financial bubbles and the occasional wormhole...

Num Perc. Search Term
10 25.00% primer movie
3 7.50% china climbing
2 5.00% single-digit millionaires
2 5.00% why not hyperinflation
2 5.00% primer/movie
1 2.50% emerging markets debt processing
1 2.50% analyzing hedge fund returns
1 2.50% information processing in brain
1 2.50% advantages and disadvantages of globalization
1 2.50% ltcm today
1 2.50% horvitz cleveland
1 2.50% daniel kahneman and amos tversky
1 2.50% jeremy grantham 2005 interview
1 2.50% john d gartner the hypomanic hedge
1 2.50% cds implied volatility
1 2.50% asness bubble logic
1 2.50% tennessee candidate issues
1 2.50% china-japan relations
1 2.50% all about wormholes
1 2.50% cdx index
1 2.50% china explaining high savings
1 2.50% price to rent ratios
1 2.50% sony vs samsung tv
1 2.50% global real interest rates
1 2.50% why long bonds
1 2.50% price to rent ratio

Greetings from startup land

Sorry for the lack of posts recently. I'm in the bay area right now, setting up our new offices. Commercial real estate is still a bargain here - we looked at a number of places at around $1 per sq ft, full service. For example, I happened to see a nice 2000 sq ft live-work loft near the Berkeley-Oakland border for only $2k per month. Why buy an $800k house when you can rent a nice space like that? Certainly says something about price to rent ratios here :-)

We ended up renting a place between downtown Oakland and lake Merritt (not far from Chinatown). It's an up and coming area with lots of interesting restaurants. We've filled our 2000 sq ft offices with IKEA office furniture and Dell computers (very happy to be rid of that horrible U-Haul truck). My office here is now nicer than at the university or at home... The last tenants left us a closet filled with switches and some old servers, so they were pretty sophisticated themselves. I guess every small business these days has some network plumbing in the walls.

We're pretty happy with the team we've hired. We found the majority of our guys via Stanford and Berkeley, but struck out this time at Caltech, my alma mater!

Now it's into stealth mode... look for our beta release near the end of the year :-)

Economist on global housing bubble

Informed readers are already familiar with the situation, but the Economist as usual does a wonderful job of summarizing. In the first figure, note the oscillation of price/rent about the long-term average. In the second figure, you see a possible decades-long unwinding of the bubble, as in Japan.

Robert Shiller (quoted in the article) has called this the biggest bubble of all time, and the Economist agrees. In addition, his research shows only a tiny (.4% per year) real return on US house prices over the last century, contrary to conventional wisdom.

The most compelling evidence that home prices are over-valued in many countries is the diverging relationship between house prices and rents. The ratio of prices to rents is a sort of price/earnings ratio for the housing market. Just as the price of a share should equal the discounted present value of future dividends, so the price of a house should reflect the future benefits of ownership, either as rental income for an investor or the rent saved by an owner-occupier.

Calculations by The Economist show that house prices have hit record levels in relation to rents in America, Britain, Australia, New Zealand, France, Spain, the Netherlands, Ireland and Belgium. This suggests that homes are even more over-valued than at previous peaks, from which prices typically fell in real terms. House prices are also at record levels in relation to incomes in these nine countries.

...To bring the ratio of prices to rents back to some sort of fair value, either rents must rise sharply or prices must fall. After many previous house-price booms most of the adjustment came through inflation pushing up rents and incomes, while home prices stayed broadly flat. But today, with inflation much lower, a similar process would take years. For example, if rents rise by an annual 2.5%, house prices would need to remain flat for 12 years to bring America's ratio of house prices to rents back to its long-term norm. Elsewhere it would take even longer. It seems more likely, then, that prices will fall.

A common objection to this analysis is that low interest rates make buying a home cheaper and so justify higher prices in relation to rents. But this argument is incorrectly based on nominal, not real, interest rates and so ignores the impact of inflation in eroding the real burden of mortgage debt. If real interest rates are permanently lower, this could indeed justify higher prices in relation to rents or income. For example, real rates in Ireland and Spain were reduced significantly by these countries' membership of Europe's single currency—though not by enough to explain all of the surge in house prices. But in America and Britain, real after-tax interest rates are not especially low by historical standards.

...Another mantra of housing bulls in America is that national average house prices have never fallen for a full year since modern statistics began. Yet outside America, many countries have at some time experienced a drop in average house prices, such as Britain and Sweden in the early 1990s and Japan over the past decade. So why should America be immune? Alan Greenspan, chairman of America's Federal Reserve, accepts that there are some local bubbles, but dismisses the idea of a national housing bubble that could harm the whole economy if it bursts. America has in the past seen sharp regional price declines, for example in Boston, Manhattan and San Francisco in the early 1990s. This time, with prices looking overvalued in more states than ever in the past, average American prices may well fall for the first time since the Great Depression.

But even if prices in America do dip, insist the optimists, they will quickly resume their rising trend, because real house prices always rise strongly in the long term. Robert Shiller, a Yale economist, who has just updated his book “Irrational Exuberance” (first published on the eve of the stockmarket collapse in 2000), disagrees. He estimates that house prices in America rose by an annual average of only 0.4% in real terms between 1890 and 2004. And if the current boom is stripped out of the figures, along with the period after the second world war when the government offered subsidies for returning soldiers, artificially inflating prices, real house prices have been flat or falling most of the time. Another sobering warning is that after British house prices fell in the early 1990s, it took at least a decade before they returned to their previous peak, after adjusting for inflation.

Asian-Americans hurt by affirmative action

From Gene Expression, results of a new Princeton study showing that if affirmative action were eliminated at elite universities, 80% of the previously reserved slots would go to Asian Americans. I predict little or no protest from model-minority Asians over this. The paper can be found here, but you need a subscription to Social Science Quarterly to read it.

The researchers' results seem to be in agreement with what happened at Berkeley after UC was forced to drop affirmative action - the main effect was a drop in the numbers of black and hispanic students, a big increase in the number of Asians and little effect on the white population.

Why wouldn't white and Asian-American applicants benefit equally if admission were purely by merit? It sounds suspiciously like the quota system imposed on Jews early in the 20th century. Previous research by these authors showed that being Asian was statistically equivalent to a penalty of 50 points on SAT score. (Probably due to preference awarded to "legacies", who are predominantly white.)

Disregarding race in college admissions would cause sharp drops in the number of black and Hispanic students at elite institutions, according to a new study by two researchers at Princeton University. The study, described in an article published in the June issue of Social Science Quarterly, also found that eliminating affirmative action would significantly raise the number of Asian-American students, while having little effect on white students.

If affirmative action were eliminated, the acceptance rates for black applicants would fall to 12.2 percent from 33.7 percent, while the acceptance rates for Hispanic applicants would drop to 12.9 percent from 26.8 percent, according to the study. Asian-American students would fill nearly 80 percent of the spaces not taken by black and Hispanic students, the researchers found, while the acceptance rate for white students would increase by less than 1 percent.

The researchers who conducted the study -- Thomas J. Espenshade, a professor of sociology, and Chang Y. Chung, a statistical programmer at Princeton's Office of Population Research -- looked at the race, sex, SAT scores, and legacy status, among other characteristics, of more than 124,000 applicants to elite colleges.

US High-Tech Economy Slipping

Here are some specific data on US high-tech competitiveness from Physics Today. (See related post here.)

Education
* Undergraduate science and engineering degrees are being awarded in the US at a lower rate than in other countries. The ratio of college undergraduate degrees in the natural sciences is only 5.7 per 100 college students in the US, while Finland, France, Ireland, Spain, Sweden, and the UK award between 8 and 13 degrees per 100 students. In Asia, Japan awards 8 per 100, and Taiwan and South Korea each award about 11 per 100.
* The US has a smaller share of the worldwide total of science and engineering doctoral degrees awarded each year than either Asia or Europe. In 2000, about 89 000 of the 114 000 doctoral degrees given in science and engineering were earned outside the US.

Workforce
* From 1994 to 1998, the number of Chinese, South Korean, and Taiwanese students who chose to pursue PhDs in their own countries nearly doubled. By contrast, over that same period, the number of students from those countries pursuing PhDs at US universities dropped 19%, from 4982 to 4029.
* Since 1980, the number of science and engineering positions in the US has grown at almost five times the rate of the US civilian workforce as a whole.

Knowledge creation
* The US share of science and engineering papers worldwide declined from 38% in 1988 to 31% in 2001. Europe and Asia are responsible for the bulk of the growth in scientific papers in recent years.
* From 1988 to 2001, the US increased its number of published science and engineering articles by only 13%, while Western Europe increased its article output by 59%, Japan by 67%, and East Asia by 492%. Though both Japan and East Asia started from a far smaller base in 1988 and still do not publish as many articles as the US, their dramatic growth rates are striking.

R&D investment
* From 1995 through 2001, China, South Korea, and Taiwan collectively increased their gross R&D investments by about 140%, while the US increased its by 34%.
* US federal funding of basic research in engineering and physical sciences has experienced little to no growth over the last 30 years. As a percentage of gross domestic product, funding for physical sciences has been in a 30-year decline.

High-technology economy
* From 1980 to 2001, the US share of worldwide high-tech exports fell from 31% to 18%. At the same time, the global share for China, South Korea, and other emerging Asian economies increased from 7% to 25%.
* During the 1990s, the US maintained a trade surplus for high-tech products even as the trade balance for other goods plummeted. But since 2001, even the trade balance for high-tech goods has fallen into deficit.

The benchmarks note that even in nanotechnology, a heavily supported US research priority, Japan and China may have already surpassed the US. While the US is "supplying 25% of the global federal funding for nanotechnology," the benchmarks say, "Japan makes certain that its national nanotechnology initiative meets or exceeds the funding levels approved in the US. The European community is doing the same."

Financial Times on global savings glut

A strong endorsement of Bernanke's views. This article is long, but gives a fairly accurate picture of where we are and how we got here.

The paradox of thrift

Financial Times, Monday, June 13, 2005

Strange things are happening in the world economy: falling interest rates on long-term securities, declining spreads between returns on safe and riskier assets, large fiscal deficits and huge global current account "imbalances" should not, in normal circumstances, coincide. So what is going on?

Alan Greenspan, chairman of the Federal Reserve, admits that he is puzzled. He has referred to the decline in interest rates on long-term bonds at a time of rising short-term rates as a "conundrum". He returned to the issue last week when he remarked that "the unusual behaviour ofl ong-term rates first became apparent almost a year ago." Markets tried to push long-term rates up early last summer and again in March this year, but in both cases "forces came into play to make those increases short-lived. But what," continued Mr Greenspan, "are those forces? Clearly, they are not operating solely in the United States."

Mr Greenspan is correct. The changes are global. So, then, must be the forces at work. What are they? The answer, in a nutshell, is a global excess of desired savings against the background of weak investment, low inflation and ever more integrated economies.

Mr Greenspan's former colleague, Ben Bernanke, has already referred directly to excessive savings in explaining the explosive growth in the US current account deficit. In doing so, he took issue "with the common view that the recent deterioration in the US current account primarily reflects economic policies and other economic developments within the United States itself". Instead, hed eveloped what he called an "unconventional" perspective that seeks the explanation in the emergence of a "global savings glut". He was right to do so.

To understand the present we need to go back to the 1930s. The "paradox of thrift" was the most counterintuitive and, to the classically trained economist, morally, theoretically and practically objectionable idea in John MaynardK eynes' General Theory of Employment, Interest and Money, published in 1936, in response to the Great Depression. It is possible, he argued, for the private sector to want to save more than it wishes to invest. That is the paradox: what is good for individuals can be bad for an economy.T oday, at the beginning of a new millennium, Keynes' warning is again apposite.

Unfortunately, in certain circumstances, even lower interest rates may fail to clear the market for investible funds. This is particularly likely if inflation is low - and still more likely if it is negative, as has been the case in Japan for many years. Large fiscal deficits may then be needed to mop up the excess savings, as has also been the case in Japan. Otherwise, the economy may fall into a slump.

We are living once again in such a Keynesian world. How then does the argument work? What is the evidence to support it? What are the consequent dangers for the world economy? And what needs to be done?

Let us start with the economic argument. One likely outcome of a world of excessd esired private sector savings will be high fiscal deficits. These emerge partly in response to cyclical weaknesses and partly to "kick start" sluggish economies. In these circumstances, however, fiscal deficits will not crowd out private spending, but rather crowd it in, by sustaining current income and expenditures.

Another likely outcome will be "reaching for yield". High desired savings will lower real rates of interest, and so real return on capital, below "normal" levels. In response investors are likely to move towards riskiera ssets. If the riskiness of previously high-risk investments is also believed to be lower, perhaps because of success in stabilising inflation at low levels this tendency will be strengthened.

Again, if high desired private sector savings are not offset by monetary or fiscal policy action, current account surpluses will emerge in some economies. Attempts to keep the exchange rate down will support this outcome. These are, in the language of the 1930s, Some trading partners will then need to tolerate offsetting deficits. In effect, deficit countries act as spenders of last resort in the world economy.

Now turn to our second big question: how well does the evidence fit the story? Remarkably well, is the answer.

We can identify only realised, rather than desired, savings. Yet we can note that the global savings rate ran at the exceptionally high level of 25 per cent of global output last year. The striking features are the extraordinarily high, and rising, savings rate of the emerging market economies and the low, and falling, savings rates of the US (and the UK).

The private sectors of the eurozone and Japan, which generate one-third of world gross domestic product at market prices between them (22 per cent from the eurozone and 11 per cent from Japan), are running substantial surpluses of income over expenditure.

In both, the principal offset to high private sector financial surpluses has been government deficits. Japan's fiscal deficit absorbed just over 60 per cent of the country's private sector surplus in 2004 (with the rest going into the current account), while the eurozone's fiscal deficits absorbed over 80 per cent of the private sector surplus.

Despite the fiscal deficits, rough and ready estimates suggest that real long-term interest rates are below 2 per cent in Japan and Germany. But real interest rates are low worldwide. According to the International Monetary Fund's latest World Economic Outlook, they have not been this low since the 1970s . Then, real interest rates were low because of unexpected inflation. This time, however, low real interest rates are expected: US and UK government index-linked government bonds are yielding only 1½ per cent, which is less than half their level prior to the late 1990s. Moreover, inflation risk premiums have fallen since the late 1990s in both the US and UK.

Default risk premiums on emerging market and riskier corporate debt have also declined. Since October 2002, spreads over US treasuries of emerging market debt have fallen by 600 basis points, according to the JPMorgan index. This reflects not only the reaching for yield, but also an understandable perception of greater stability in thesee conomies: inflation is down, balance of payments positions are stronger, as we shall see, and the last worldwide emerging market financial crisis ended some six years ago.

Finally, there are those notorious external imbalances. As Maurice Obstfeld of the University of California at Berkeley and Kenneth Rogoff of Harvard point out, "incredibly, the US current account deficit is currently soaking up about 75 per cent of the combined current account surpluses of Germany, Japan, China and all the world's surplus countries". Meanwhile, the rest of the world is running a surplus of savings over domestic investment of around one-eighth of its gross savings.

...Particularly striking has been the shift for the emerging market economies as a group. Prior to 1997, they ran sizeable current account deficits, financed by private capital inflows. Since then they have moved into enormous current account surpluses, combined with huge private capital inflows.

Why has this turnround happened? The most important explanation was the financial crises of the late 1990s, which made everyone more cautious. Two-thirds of the Asian emerging market economies' swing from current account deficits to huge surplus occurred between 1996 and 1998 alone. Thec rises have cast long shadows. Also significant, however, have been the recent oil price rises: the Middle East's current account surplus jumped from $29bn in 2002 to $113bn in 2004.

The US has been accommodating the excess savings of the rest of the world, while attempting to run its economy in line with potential. One way of thinking about this is that in a global economy with no global government, the most important regional power - the US - has been following the Keynesian recommendation by offsetting excess desired savingse lsewhere. The US authorities did not intend to do that. But that is what they have had to do to generate a decent recovery at home.

Foreign governments have, more over, played a huge part in sustaining their domestic excess savings. According to statistics on the US balance of payments, 42 per cent of the net funding of the US currenta ccount deficits between 2002 and 2004 came from official sources. But these flows are the result of official intervention, combined with sufficiently tight monetary and fiscal policies - and direct intervention in credit markets - to sustain the domestic savings that are the counterpart of the official flows. In other words, the excess savings are in part a policy choice, except in Japan, where they are happening more naturally.

Yet another way of seeing the same thing is in accumulations of foreign currency reserves. In just the three years from 2002 to 2004, foreign currency reserves rose by $1,680bn to reach a total of $3,730bn.

...It cannot make sense for these relatively poor countries to devolve the task of borrowing and spending on to the vastly richer US. If the people of emerging economies are to lend on a vast scale to any governments, it should surely be to their own governments, which should be able to find better use for the funds now being poured into foreign currency reserves. As the rest of the world starts to shrink its excess savings, the US should expand its savings as well, largely by reducing the structural fiscal deficit.

...Large exchange rate changes will also be needed, to facilitate the adjustment process. All academic analyses of global balance of payments adjustment conclude that this will require large changes in relative prices or, to put it morep recisely, in real exchange rates. Under plausible assumptions, the required adjustment is two times larger than the real depreciation of the dollar that has occurred so far. Some estimates are much larger still. Precisely how much of a depreciation will be needed depends on how large a US current account deficit and net liability position proves sustainable.

Monkey money

Steve Levitt (my former colleague in the Society of Fellows at Harvard, now a famous economist and author of the bestseller Freakonomics) writes on Yale professor Keith Chen's research on monkey economics (Times magazine). Apparently capuchins can be taught to use metal slugs as a unit of exchange. Chen has already observed theft, prostitution and loss aversion among the little fellows. Perhaps Chen can stimulate an investment bubble in grapes by lowering interest rates? :-)

See here for video and pictures of Chen, his Yale capuchins (they understand money), and Harvard tamarins (they play prisoner's dilemma).

"It is sometimes unclear, even to Chen himself, exactly what he is working on. When he and Santos, his psychologist collaborator, began to teach the Yale capuchins to use money, he had no pressing research theme. The essential idea was to give a monkey a dollar and see what it did with it. The currency Chen settled on was a silver disc, one inch in diameter, with a hole in the middle -- ''kind of like Chinese money,'' he says. It took several months of rudimentary repetition to teach the monkeys that these tokens were valuable as a means of exchange for a treat and would be similarly valuable the next day. Having gained that understanding, a capuchin would then be presented with 12 tokens on a tray and have to decide how many to surrender for, say, Jell-O cubes versus grapes. This first step allowed each capuchin to reveal its preferences and to grasp the concept of budgeting.

...But these facts remain: When taught to use money, a group of capuchin monkeys responded quite rationally to simple incentives; responded irrationally to risky gambles; failed to save; stole when they could; used money for food and, on occasion, sex. In other words, they behaved a good bit like the creature that most of Chen's more traditional colleagues study: Homo sapiens."

Thought police slipping...

I was amazed to find this Economist article, discussing a possible evolutionary explanation of high intelligence (and high incidence of genetic diseases) in the Ashkenazi Jewish population. The Times also covered the story (although not as well), and the research paper is available here. See here for lengthy discussion, including comments by the authors of the paper, and here for a critique of the paper from a historical perspective.

We can easily count the number of violations of political correctness in the article:
0) the authors assume the existence of a general human characteristic called "intelligence"
1) the authors assume intelligence is (at least somewhat) heritable
2) the authors assume IQ tests have something to do with intelligence
3) the authors discuss a particular ethnic group and the distribution of genes in that population
4) the authors assume that variation in the environment in which natural selection takes place might lead to different distributions of genes in different ethnic groups.

Let's put aside the contentious issue of whether the theory is correct in what it says about Ashkenzim (it does make testable predictions, so we can wait and see). One interesting thing I learned from background reading on this subject is that there are specific genes that are known to correlate with above-average IQ. How long until we start "overclocking" humans via genetic or chemical engineering for higher intelligence?

Portrait of a quant

Here is a nice profile (NYT Sunday magazine) of hedge fund manager Cliff Asness. Some time ago, we discussed his research on a modified Fed model for equity valuation. Asness has a PhD from Chicago, and a quantitative style of investing. The article does a good job of explaining how hedge funds caught on with university endowments as alternative investment classes with (potentially) low correlation to the overall market, and good risk-return characteristics. Schools like Yale and Harvard led the way, with spectacular results.

Of being super rich, Asness says "Well, it doesn't suck." For a description of how the Bush tax policies favor the super rich, see here. (Those earning more than $10 million a year now pay a smaller share of their income in taxes than those making $100,000 to $200,000. So much for progressive taxation!)

Working class heroes

The Times Sunday magazine has a nice article on the plight of the millionaire serial entrepreneur in Silicon Valley...

NYTimes:

Every community has its haves and its have-nots, but in Silicon Valley, it's the additional deep divisions and steep hierarchies among the haves that is unique: the haves and the have-everythings. It is this subtle class system among the haves that delights industry veterans like Avram Miller, a former Intel executive who is now semiretired and lives on an estate in the Northern California wine country. Miller, who has the gray, steel-wool locks of a mad scientist, casts single-digit millionaires as the working class of Silicon Valley, working stiffs lucky enough to have been part of a successful company in the 1990's but still putting in grueling hours, cranking out code, crunching numbers, devising marketing plans. They are the ones most likely to drive a car sporting the bumper sticker you occasionally see on the streets of Palo Alto or Mountain View: ''Please God, Just One More Bubble.''

Double-digit millionaires make up the area's middle class, financially independent but still striving to keep pace. They live comfortably but not ostentatiously, at least by local standards. Keeping up with the Joneses takes on a whole new meaning when your next-door neighbor drives a 660-horsepower Ferrari that starts at $643,000 and the guy down the street owns a $38 million Gulfstream V. Even a used Cessna Citation X private jet costs in the neighborhood of $12 million, plus more than half a million a year for upkeep. And the price for a modest vineyard in Napa County? If you have to ask. . .

Finally, there are the true have-everythings, the area's centimillionaires. ''To feel truly rich in Silicon Valley,'' Miller says, ''you have to be worth in the three-digit millions.''

Greying of the professoriate

This Chronicle of Higher Ed article discusses the advancing average age of the professoriate. I can't say that I haven't noticed this trend in my own department, but at least we are doing better than the NC State econ department described in the article, which has only one professor under 40 and two thirds over 55!

"In the 16-campus University of North Carolina system, the proportion of tenured and tenure-track faculty members age 50 or older jumped from about a third in 1984 to more than half in 2001. In 1984 there were only two tenured faculty members over the age of 69. By 2001 the system had 90 such professors.

Other colleges face a similar demographic shift. A decade ago, at the University of Arizona, less than 17 percent of the tenured and tenure-track faculty members were 60 or older. Now, almost one in four professors is that old. At Wichita State University, 29 percent of the faculty were 55 or older a decade ago, and 41 percent are that old now. Nearly one out of 10 professors there is 65 or older. At private colleges, experts say, the situation is compounded: The type of pension plans that most private institutions offer tend to reward professors for working longer.

While the national population is aging as a whole, factors specific to academe magnify the trend. Ten years have passed since Congress ended mandatory retirement, a policy that had allowed colleges to require faculty members to retire at age 70. Many professors hired during the great expansion of academe in the 1960s and 70s are now reaching their golden years. And, because many people are living longer -- and need financial resources to do so comfortably -- more and more professors are delaying retirement, some of them indefinitely."

Short the real estate bubble!

Blogger Mark Kleiman, who lives in LA, did. What if you don't have a house in a bubble market? Well, now you can buy and sell derivative contracts based on median sales prices of existing single-family homes, as released each quarter by the National Association of Realtors (NAR). Available markets include NYC, Chicago, SF, LA, SD and Miami.

The problem is, it's the smart money (short interest) looking at these new derivatives. The dumb money is out there flipping houses with no-interest mortgages! In addition, it may take a few years or more for this bubble to deflate...

Price to rent ratios II

This San Francisco Federal Reserve report shows data going back to 1982. The current period is clearly anomalous (it recalls P/E ratios during the tech bubble 1995-2000). I expect to see a repeat of the bump seen earlier in the late 1980s to early 1990s; note the inevitable reversion to the mean. It won't be pretty given new phenomena like zero-interest and sub-prime mortgages, and home equity loans. (Compare to Japan's 20 year housing bubble, discussed in an earlier post. Ours may take another decade to unwind as well.)



Below is some data recently published in the Times. Note the nationwide uniformity of price-rent ratios in 2000, as opposed to today. The bay area leads the nation with a ratio that has almost tripled in the last 5 years.

It is possible that replacing home price by monthly mortgage payment in the numerator would account for most of the 2000-2005 increase in national average price-rent (from 11.6 to 17.1), but this doesn't come close to explaining the frothier regions on the coasts.

"Three billion new surfers on the wave of globalization"

Clyde Prestowitz's new book Three Billion New Capitalists: The Great Shift of Wealth and Power to the East is a more thoughtful, less breathless, version of Tom Friedman's The World is Flat.

Prestowitz discusses at length the advantages and disadvantages of globalization and free trade. His is the first popular book I know of to cite the work of Baumol and Gomory on problems with the usual Ricardian arguments of comparative advantage (see also this article by Samuelson). Prestowitz draws on his background as a trade negotiator in the Reagan administration to find real world examples which deviate drastically from the usual efficient market assumptions, including cases involving Japanese companies dumping their products in the US, and later raising prices once American competitors are eliminated.

Prestowitz advocates government support of R&D, as well as occasional intervention in markets. However, he doesn't seem to understand that while government intervention can lead to better outcomes, it may not on average do better than the market left to its own devices. See Samuelson for a nice discussion of this point.

Wormholes, NEC and all that

The BBC and New Scientist articles seem to have generated a lot of interest in this topic. Odd how my colleagues can hear me loudly discussing this stuff for six months with my postdoc and grad student, but only after the BBC decides to write about it do they want to know more :-)

The original papers are listed below. Both have been revised since posting on arxiv.org - if you want a more up to date version please contact me.

http://arxiv.org/abs/hep-th/0504003 (wormholes)
http://arxiv.org/abs/hep-th/0502203 (instability and NEC)

There is a longer version of the instability analysis forthcoming, by Buniy, Hsu and Murray.

Let me make some comments here for physics readers:

1) Our original interest was in dark energy. The observational data suggest (although not strongly - see comments) that w = p/rho < -1, which violates various energy conditions. We wanted to understand how easy or hard it is to build models with w < -1. With some collaborators at Caltech, I had obtained a result in classical scalar models that w < -1 implies instability. We wanted to generalize this result.

2) Our strongest results are in the contexts of classical field theory (including both gauge and scalar fields) and perfect fluids. There is a quantum loophole involving renormalization that allows for small violations of the NEC (well-known examples are the Casimir effect and black hole spacetimes).

3) When applying this to wormholes, we are considering the exotic (NEC-violating) matter necessary to stabilize the wormhole. This matter must have large energy-momentum tensor T_mn. We focus on wormholes which have nearly-classical spacetimes (the other type is less useful for Sci Fi). We show that this condition is strong enough to require that the exotic matter evolves semi-classically - i.e., it is subject to our results in classical field theory.

4) Some readers (esp. from the relativity community) have misinterpreted our results as claiming that the Casimir or black hole vacuum is unstable, but this is not the case (see point (2) above). In the wormhole case, the key point is that semi-classical wormholes cannot result from exotic matter which violates the NEC via quantum effects.

BBC on wormholes

We get a mention in this nice BBC article. Here is the latest version (PDF) of the talk Roman Buniy will give on Tuesday at a conference at Vanderbilt.

Wormhole 'no use' for time travel
By Paul Rincon
BBC News science reporter

Artist's impression of a wormhole Image: SPL
Wormholes contort the fabric of the Universe
For budding time travellers, the future (or should that be the past?) is starting to look bleak.

Hypothetical tunnels called wormholes once looked like the best bet for constructing a real time machine.

These cosmic shortcuts, which link one point in the Universe to another, are favoured by science fiction writers as a means both of explaining time travel and of circumventing the limitations imposed by the speed of light.

The concept of wormholes will be familiar to anyone who has watched the TV programmes Farscape, Stargate SG1 and Star Trek: Deep Space Nine.

The opening sequence of the BBC's new Doctor Who series shows the Tardis hurtling through a "vortex" that suspiciously resembles a wormhole - although the Doctor's preferred method of travel is not explained in detail.

But the idea of building these so-called traversable wormholes is looking increasingly shaky, according to two new scientific analyses.

Remote connection

A common analogy used to visualise these phenomena involves marking two holes at opposite ends of a sheet of paper, to represent distant points in the Universe. One can then bend the paper over so that the two remote points are positioned on top of each other.

[The wormholes] you would like to build - the predictable ones where you can say Mr Spock will land in New York at 2pm on this day - those look like they will fall apart
Stephen Hsu, University of Oregon
If it were possible to contort space-time in this way, a person might step through a wormhole and emerge at a remote time or distant location.

The person would pass through a region of the wormhole called the throat, which flares out on either side.

According to one idea, a wormhole could be kept open by filling its throat, or the region around it, with an ingredient called exotic matter.

This is strange stuff indeed, and explaining it requires scientists to look beyond the laws of classical physics to the world of quantum mechanics.

Exotic matter is repelled, rather than attracted, by gravity and is said to have negative energy - meaning it has even less than empty space.

Law breaker

But according to a new study by Stephen Hsu and Roman Buniy, of the University of Oregon, US, this method of building a traversable wormhole may be fatally flawed. In a paper published on the arXiv pre-print server, the authors looked at a kind of wormhole in which the space-time "tube" shows only weak deviations from the laws of classical physics.

These "semi-classical" wormholes are the most desirable type for time travel because they potentially allow travellers to predict where and when they would emerge.

The Tardis (BBC)
The concept is a favourite of science fiction writers
Wormholes entirely governed by the laws of quantum mechanics, on the other hand, would likely transport their payloads to an undesired time and place.

Calculations by the Oregon researchers show a wormhole that combines exotic matter with semi-classical space-time would be fundamentally unstable.

This result relies in part on a previous paper in which Hsu and Buniy argued that systems which violate a physical principle known as the null energy condition become unstable.

"We aren't saying you can't build a wormhole. But the ones you would like to build - the predictable ones where you can say Mr Spock will land in New York at 2pm on this day - those look like they will fall apart," Dr Hsu said.

Tight squeeze

A separate study by Chris Fewster, of the University of York, UK, and Thomas Roman, of Central Connecticut State University, US, takes a different approach to tackling the question of wormholes.

Amongst other things, their analysis deals with the proposal that wormhole throats could be kept open using arbitrarily small amounts of exotic matter.

Fewster and Roman calculated that, even if it were possible to build such a wormhole, its throat would probably be too small for time travel.

It might - in theory - be possible to carefully fine-tune the geometry of the wormhole so that the wormhole throat became big enough for a person to fit through, says Fewster.

But building a wormhole with a throat radius big enough to just fit a proton would require fine-tuning to within one part in 10 to the power of 30. A human-sized wormhole would require fine-tuning to within one part in 10 to the power of 60.

"Frankly no engineer is going to be able to do that," said the York researcher.

The authors are currently preparing a manuscript for publication.

Supporting view

However, there is still support for the idea of traversable wormholes in the scientific community. One physicist told BBC News they could see problems with Hsu's and Buniy's conclusions.

"Violations of the null energy condition are known to occur in a number of situations. And their argument would prohibit any violation of it," they commented.

"If that's true, then don't worry about Hawking radiation from a black hole; the entire black hole vacuum becomes unstable."

The underlying physics was not in doubt, the researcher argued. The real challenge was in explaining how to engineer wormholes big enough to be of practical use.

Cambridge astrophysicist Stephen Hawking is amongst those researchers who have pondered the question of wormholes.

In the 1980s, he argued that something fundamental in the laws of physics would prevent wormholes being used for time travel. This idea forms the basis of Hawking's Chronology Protection Conjecture.

PIMCO bullish on long bonds?

In his latest commentary, Bill Gross of PIMCO (perhaps the most influential bond trader in the world) comes very close to sounding bullish on long bonds. This is a rather amazing turnaround, since over the last couple of years he has been warning repeatedly about an interest rate meltdown.

Gross now seems convinced that our Bretton Woods II currency regime will survive another 3-5 years, and that the dominant trend is deflation exported from China. He reasons that several years of nearly zero (real) interest rates have failed to produce significant inflation in the US economy. Thus, once the stimulative effect of low interest rates goes away, we are in for a period of deflation, which will be kind to bonds - he is bold enough to predict 10 year yield as low as 3%!

Gross: "Future finance-based consumption, however, is limited by our ability to keep pumping lower and lower yields, which in the past have led to higher and higher TIPS, home, stock, and associated asset prices. Let me do the TIPS math for you and then you can draw the implications for other asset classes. The 14% 5-year TIPS capital gain over the past few years that Alan Greenspan has been able to manufacture probably can only go up by 5 more points, because a 0% real yield for a 5-year maturity TIPS serves as a practical limit that investors will tolerate during deflationary, and most low inflationary environments. A 5-year TIPS moving lower in yield from 1% to 0% goes up 5 points. Even if the Fed continues to “Pump,” then, we are ¾ of the way complete in terms of the Fed’s ability to continue to stimulate asset prices, because its 21st century journey started at 4%, we are now at 1%, and 0% is the practical limit. That doesn’t mean that the housing “bubble” can’t keep going because it likely will if the Fed “Pumps” real yields closer to 0%. But there are limits, and we are heading down the home stretch of this U.S. race towards prosperity based on asset price appreciation.

Our point on the “Pump” then, is to suggest that in combination with a globalized free trade-based economy exhibiting a surfeit of cheap Asian labor, it will be difficult to generate U.S. inflation higher than our current 3% even if interest rates fall further. If 3% inflation is all we can get from the past 5-years’ asset inflation, it’s hard to believe that we get more from what’s left. The potential to reflate via interest rates is nearly over. We draw the same conclusion for Euroland and Japan. Japan, of course, is the primary example of how 0% nominal yields can fail to generate any inflation whatsoever, is it not? Continued disinflation not reflation, then, will rule our fragile future kingdom, with the potential for 1-2% CPI prints in most years between 2006 and 2010 throughout much of the global economy. Readers may remember our past few years’ Secular Forum descriptions of the tug-of-war between disinflation and reflationary forces. We have proclaimed a winner based on our observation of massive fiscal and monetary global stimulation described above, the limited inflationary response, and the lack of further ammunition. Long live our disinflationary King.

If we had to forecast (and we do), we believe a range of 3 - 4½% for 10-year nominal Treasuries will prevail during most of our secular timeframe..."

Cloning has arrived...

While the US sleeps, leading-edge stem cell research is being done at Seoul National University. (Well, at least California has woken up and is trying to counter the Bush administration's lack of support for stem cell research by using state funds.)

The Korean lab can produce one clone per 17 donor eggs. That means the cost per clone is similar to that of an IVF cycle - or less than $5k. I imagine in a decade wealthy people (perhaps everyone?) will have access to a supply of their own stem cells. Also, women who are past reproductive age could choose to have a clone child, using their own or a relative or friend's genetic material.

Of course, some US religious fundamentalists (like our president) will fight these developments. Are we ready for the coming clone war?

NYT: "In what scientists say is a stunning leap forward, a team of South Korean researchers has developed a highly efficient recipe for producing human embryos by cloning and then extracting their stem cells.

Writing today in the journal Science, they report that they used their method to produce 11 human stem cells lines that are genetic matches of 11 patients aged 2 to 56.

Previously, the same group, led by Dr. Woo Suk Hwang and Dr. Shin Yong Moon of Seoul National University, produced a single stem cell line from a cloned embryo, but the process was so onerous that scientists said it was not worth trying to repeat it, and some doubted the South Koreans' report was even correct.

Now things have changed.

"It is a tremendous advance," said Dr. Leonard Zon, a stem cell researcher at Harvard Medical School and president of the International Society for Stem Cell Research, who was not involved in the research.

The method, called therapeutic cloning, is one of the great hopes of the stem cell field. It produces stem cells, universal cells that are extracted from embryos, killing the embryos in the process, and, in theory, can be directed to grow into any of the body's cell types. And since the stem cells come from embryos that are clones of individuals, they should be exact genetic matches. Scientists want to obtain such stem cells from patients to study the origin of diseases and to develop replacement cells that would be identical to ones a patient has lost.

...But this time, with a handful of technical improvements that mostly involved such things as methods for growing cells and breaking open embryos, they used an average of 17 eggs per stem cell line and could almost guarantee success with a single woman's eggs obtained in a single month. And it did not matter if the patient whose cells were being cloned was young or middle aged, male or female, sick or well - the process worked.

"You almost have no reason not to do it," said Dr. Davor Solter, the director of the Max Planck Institute for Immunobiology in Freiberg, Germany.

In fact, Dr. Solter added, it now looks like it is much more efficient to clone and obtain human stem cells than it is to do the same experiment in animals."

Bubble reaches Eugene

The other day I discovered a new development of big (3-4,000 sq ft.), expensive ($500-800k) houses in the SW hills of Eugene. Apparently there are others like it around the outskirts of our urban growth boundary. Five years ago you could have bought a house of that size for $300-400k. I was kind of surprised, as neither population nor income growth have been very large here in the last few years. Home prices were pretty flat here around 2000, and only recently accelerated. A realtor told me that "the market here is just so strong... it has nowhere to go but up!"

But, later she said "My husband and I worked our whole lives, and we can't afford any of these houses... Where do people get the money?"

Well, here's how:



WSJ: "More and more Americans are turning to debt to pay for lifestyles their current incomes can't support. They are determined to live better than their parents, seduced by TV shows like "The O.C." and "Desperate Housewives," which take upper-class life for granted, and bombarded with advertisements for expensive automobiles and big-screen TVs. Financial firms have turned credit for the masses into a huge business, aided by better technology for analyzing credit risks. For Americans who aren't getting a big boost from workplace raises, easy credit offers a way to get ahead, at least for the moment...

Utah vividly illustrates the changes credit has wrought in the U.S. Last year, 28 of every 1,000 Utah households filed for bankruptcy, twice the national average and nearly triple Utah's rate a decade earlier, according to Economy.com, a West Chester, Pa., consulting firm. Utahns often get married early and have the largest families in the nation on average. That makes for a lot of young parents with modest incomes looking for big homes and cars. The median monthly mortgage payment in Utah equaled 45.3% of a worker's average monthly income in 2002, the fourth-highest level in the nation, according to the Utah Foundation, a Salt Lake City think tank."

Credit derivatives and volatility

Longtime readers of this blog know I have been puzzled over low implied volatility in equity markets over the last year or so. Recently we've had a spike in volatility (see the VIX index which tracks implied vol on the SP500), and this recent PIMCO report on credit derivatives suggests one explanation for recent behavior (CDS = credit default swaps; credit derivatives are valued by assuming a link between the volatility of the stock (e.g. GM) and the probability of default on the corporate debt (credit risk), hence the correlation trade strategy B described below):

"Interestingly, hedge funds are the largest users of credit derivatives and CDS. Several of the largest Wall Street firms estimate that 50-60% of their current trading volume in CDS is with hedge funds. These leveraged funds use CDX index products to gain a diversified exposure to credit, thus earning positive carry. Two trades, which have been popular with hedge funds, are long CDX index products/short individual CDS names (Strategy A) and long CDX index products/short equity calls (Strategy B).

...Strategy B is an income generation strategy (which is also being implemented by $10 billion closed-end income generation funds started in the past year). This strategy seeks to produce income via long exposure to spread product, yet gives up any large equity upside by selling calls. Both hedge funds and closed-end funds have been aggressive sellers of equity call options over the past year, suppressing implied equity volatility. This created an illusion of calm waters. However, as soon as equities fell and volatility spiked, these calm waters got surprisingly rough in a short amount of time as investors shifted into "risk reduction" mode and unwound long credit positions, bought equity put options and bought protection on CDX index products. This leveraged unwind trade caused credit spreads to widen sharply, put downward pressure on stocks and caused implied volatility on CDX options to spike."

Are we getting smarter? Why?

It is well known that raw scores on IQ tests have been increasing at a rate of what would be about 3 IQ points per decade (the so-called Flynn effect). This means that, were the result of the test not rescaled so that the average is 100 by definition, the average IQ would have risen to 130 over the last century - i.e., the average person today scores better than all but 2 percent or so of the population in 1900. Malcolm Gladwell discusses this effect and its possible causes in this week's New Yorker, reviewing a new book claiming that modern society, with its fast-paced multimedia entertainment (including video games, computers, TV, etc.) actually improves our cognitive skills.

Gladwell: "Twenty years ago, a political philosopher named James Flynn uncovered a curious fact. Americans—at least, as measured by I.Q. tests—were getting smarter. This fact had been obscured for years, because the people who give I.Q. tests continually recalibrate the scoring system to keep the average at 100. But if you took out the recalibration, Flynn found, I.Q. scores showed a steady upward trajectory, rising by about three points per decade, which means that a person whose I.Q. placed him in the top ten per cent of the American population in 1920 would today fall in the bottom third. Some of that effect, no doubt, is a simple by-product of economic progress: in the surge of prosperity during the middle part of the last century, people in the West became better fed, better educated, and more familiar with things like I.Q. tests. But, even as that wave of change has subsided, test scores have continued to rise—not just in America but all over the developed world. What’s more, the increases have not been confined to children who go to enriched day-care centers and private schools. The middle part of the curve—the people who have supposedly been suffering from a deteriorating public-school system and a steady diet of lowest-common-denominator television and mindless pop music—has increased just as much. What on earth is happening? In the wonderfully entertaining “Everything Bad Is Good for You” (Riverhead; $23.95), Steven Johnson proposes that what is making us smarter is precisely what we thought was making us dumber: popular culture.

...As Johnson points out, television is very different now from what it was thirty years ago. It’s harder. A typical episode of “Starsky and Hutch,” in the nineteen-seventies, followed an essentially linear path: two characters, engaged in a single story line, moving toward a decisive conclusion. To watch an episode of “Dallas” today is to be stunned by its glacial pace—by the arduous attempts to establish social relationships, by the excruciating simplicity of the plotline, by how obvious it was. A single episode of “The Sopranos,” by contrast, might follow five narrative threads, involving a dozen characters who weave in and out of the plot. Modern television also requires the viewer to do a lot of what Johnson calls “filling in,” as in a “Seinfeld” episode that subtly parodies the Kennedy assassination conspiracists, or a typical “Simpsons” episode, which may contain numerous allusions to politics or cinema or pop culture. The extraordinary amount of money now being made in the television aftermarket—DVD sales and syndication—means that the creators of television shows now have an incentive to make programming that can sustain two or three or four viewings.

...It doesn’t seem right, of course, that watching “24” or playing a video game could be as important cognitively as reading a book. Isn’t the extraordinary success of the “Harry Potter” novels better news for the culture than the equivalent success of “Grand Theft Auto III”? Johnson’s response is to imagine what cultural critics might have said had video games been invented hundreds of years ago, and only recently had something called the book been marketed aggressively to children: (Johnson) Reading books chronically understimulates the senses. Unlike the longstanding tradition of gameplaying—which engages the child in a vivid, three-dimensional world filled with moving images and musical sound-scapes, navigated and controlled with complex muscular movements—books are simply a barren string of words on the page. . . .

Books are also tragically isolating. While games have for many years engaged the young in complex social relationships with their peers, building and exploring worlds together, books force the child to sequester him or herself in a quiet space, shut off from interaction with other children. . . .

But perhaps the most dangerous property of these books is the fact that they follow a fixed linear path. You can’t control their narratives in any fashion—you simply sit back and have the story dictated to you. . . . This risks instilling a general passivity in our children, making them feel as though they’re powerless to change their circumstances. Reading is not an active, participatory process; it’s a submissive one.

He’s joking, of course, but only in part. The point is that books and video games represent two very different kinds of learning. When you read a biology textbook, the content of what you read is what matters. Reading is a form of explicit learning. When you play a video game, the value is in how it makes you think. Video games are an example of collateral learning, which is no less important."

US math-science education

We often hear about the miserable (or at best mediocre) performance of US students on international tests of science and mathematics. Certainly there is a lot of room for improvement, but it is important to note that differences in average test scores are largely due to America's struggle to deal with a social underclass.

Consider the Trends in International Mathematics and Science Study eighth-grade science test, for instance, and the scores achieved by Colorado, Connecticut, Iowa, Maine, Massachusetts, Minnesota, Montana, Nebraska North Dakota, Oregon, Utah, Vermont, Wisconsin and Wyoming. Had these states -- none of which has a substantial underclass -- been treated as separate nations, each of them would have been outscored only by Singapore. The significant variation in averages by state should be no surprise to anyone who has looked at average SAT scores.

Take a minute to consider this -- eighth graders from Oregon outscored their counterparts in countries like Japan, Korea, Netherlands, Hungary, etc. Who would have believed it?

I doubt that American high school seniors would have performed as well compared to their counterparts, as our high school curricula are particularly lacking in rigorous science and math. Nevertheless, these results show that our K-12 system isn't completely dysfunctional.