Yield curve inverts

The 5 yr yield was briefly below the 2 yr yield today. Is the market predicting a recession? I guess historically the Fed always overtightens...

Imagine you want to model interest rate fluctuations. You have to have a decent model for fluctuations at all maturities. Are there any reasonable constraints? How far can the curve invert? How likely is that? What are the self-consistency constraints? How do we incorporate current option prices into the analysis? A well-known practitioner once told me that modeling the yield curve is to modeling equity prices as quantum field theory is to ordinary quantum mechanics!

See here for Derman's explanation of the BDT (Black, Derman, Toy) yield curve model. I discussed a nice bio of Fischer Black here, and Derman's book here.

Ben Stein on globalization

Ben Stein is most likely familiar to you as a comedian in movies and on TV. Earlier in life he attended Yale Law School and worked in the Nixon White House as a speechwriter. Below he gives the positive spin on globalization. However, at the very end he addresses the winners and losers issue, and his description of losers sounds a lot more like the average american than his description of winners!

China: Friend or Foe?
Wednesday, November 23, 2005

A few nights ago, I had the pleasure of speaking to and MC'ing the annual dinner of the Semiconductor Industry Association (SIA). Attending were the major players in the chip world, the Texas Instruments, AMDs, National Semiconductors, and -- well, you get the picture. Very successful, super smart men and women filled the room -- real geniuses who did things like create programs that read and check immense software codes written in India, only do it in real time over the internet. These are people who started and run incredibly complex and productive businesses.

You might have thought it would be a rollicking good time, but it was not at all.

The three main speakers -- George Scalise, head of the SIA; Charlene Barshefsky, formerly Clinton's Special Trade Representative; and Byron Wien, a major power at Morgan Stanley -- were deeply worried about Far Eastern competition in the chip world. It is simple enough: China, Taiwan, Thailand, and India have far lower labor costs than we do. They have up-to-date machinery and a highly trained, well motivated labor force. They can make chips for less, and they are starting to become players in a big way -- not just in chip manufacturing (or "fabbing," as they say) but in design, which was formerly an American fiefdom.

Trees Do Not Grow to the Sky

The three main speakers showed charts and graphs pointing out Asian inroads and the declining U.S. share of production and design. And one speaker expressed doubt that we would see our kids live as well as we do because of Asian competition.

This prompted several thoughts in my wooly head.

First of all, we start out very far ahead of China in wealth and income. The per capita GDP of the U.S., depending on how you measure it, is as much as 40 times Chinese per capita GDP and not less than 12 times by any measurement.

Yes, China is growing much faster than we are, at roughly 10 percent per year. If current trends last, China will overtake the U.S. in per capita GDP sometime this century. But current rates for China are extremely high. No nation has ever been able to sustain the rates China is experiencing for very long. History argues that China will not be able to do so either. Put simply, trees do not grow to the sky.

However, the Chinese are an amazing, intelligent, hard working, well disciplined people. Possibly they will be able to enjoy super high growth rates for a prolonged period. It would be a historical anomaly, but maybe it will happen.

Is What's Good for China Good for the U.S.?

Even if China became much richer than it is now though, that would not necessarily make us poorer. China is a prodigious buyer of foods and resources, and we have a lot of both. Chinese industry will be partly owned by U.S. investors, and Chinese prosperity will (if no fraud is involved) make them much richer. The fact that a very large nation like China becomes rich makes individual American workers who compete with China worse off, but it does not make America as a nation worse off.

Next, is it not interesting that China, in a state of brutal totalitarian rule, was really not a threat to us except in fiction? But under capitalism, China is making us all run around screaming in fear. I am really not sure what we have to fear from China. The country is our partner in prosperity, not our enemy. The earlier we work out a durable framework of respect and cooperation in trade and policy, the better off everyone will be.

But the main thing I want to express, as I did to the SIA, is that China is getting rich because its people are getting well educated, because they are working hard, because they are saving, and because they are investing. These are exactly the same things that made America rich. And these are exactly the same things that are allowing Hispanic and Asian immigrants to America to move up the economic ladder.

Who Wins, Who Loses?

Young Americans who study hard, learn serious subjects, do not lose themselves in computer games, avoid doomed industries, learn good work habits, save prudently, and invest sensibly will be well off no matter what happens in China or Taiwan or India.

Americans who are slothful, do not pay attention to economic trends, learn no useful skills, do not save, and do not invest wisely will roll downhill fast.

But for the disciplined among us who learn from the Chinese the keys to wealth as the Chinese learned from us and we learned from all of history, the future is bright.

China book reviews

From The NY Review of Books. I briefly mentioned both of these books in earlier posts here and here.

Three Billion New Capitalists: The Great Shift of Wealth and Power to the East
by Clyde Prestowitz
Basic Books, 321 pp., $26.95

China, Inc.: How the Rise of the Next Superpower Challenges America and the World
by Ted C. Fishman
Scribner, 342 pp., $26.00

The "rise" of China has suddenly become the all-absorbing topic for those professionally concerned with the future of the planet. Will the twenty-first century be the Chinese century, and, if so, in what sense? Will China's rise be peaceful or violent? And how will this affect the United States, the current "hyperpower"? In fact, China has been "rising" for some time (after several hundred years of "fall"), but for many years its claim to notice was obscured by more exciting events. Attention in the 1990s concentrated on the fall of Soviet communism, "globalization," the spread of democracy, and the high-tech revolution. These developments, which left America as the world's sole economic and political superpower, seemed to belie Paul Kennedy's prediction in 1987 of relative US decline and "more of a multipolar system."[1]

The attack on the World Trade Center in 2001, together with the concurrent collapse of the high-tech bubble, exposed America's fragility, but this was masked by the hyperactivity of the Bush administration. The "war on terror" planted American armies in Afghanistan and Iraq; the Clinton surpluses were succeeded by the Bush deficits to shore up the economy and finance the military operations. However, as the Iraq escapade foundered and the deficits ballooned, the sense of relative decline reasserted itself. Unlike in 1987, there was now a clear candidate for the succession: China. This was especially so as the US economy became dependent on China's bankrolling its huge trade deficit. The dream of an "American century" receded, to be replaced by the nightmare of a "Chinese century."

Focus on China is overdue. For the last quarter of a century its economy has been growing by over 9 percent a year, increasing eightfold. However, it is not just this long-sustained hyper-growth rate that amazes and alarms the observer. It is the size of the economy which is growing. China's population is officially estimated at 1.3 billion, but is probably larger—one fifth of all the people in the world. This makes its rise much more important than that, say, of Japan in the 1960s. From the economic point of view its cheap labor is much more abundant, so its cost advantage will not quickly be eliminated. The size of an economy obviously matters, too, in measuring power. The Chinese economy, in terms of the purchasing power of the Chinese people, is about two thirds the size of the US economy.[2] If it continues to grow at 9 percent a year, it will overtake the US by 2014. Lee Kwan Yu of Singapore believes that the rise of China will shift the balance of power back to the East for the first time since Portuguese caravels arrived there in the sixteenth century.

China's growth, simply because of its size, is bound to create problems both for itself and others. From the Chinese leadership's point of view, the main problem is how to maintain social cohesion amid the vast socio-economic upheavals going on. Apart from the environmental degradation and rampant corruption, China's pell-mell, and largely uncontrolled, economic growth is disturbing its domestic stability in a profound way: there is a huge floating population without settled jobs or abodes, and a development and income gap between the coastal and inland areas which is as big as between the United States and North Africa. According to one estimate, 30 percent of China's urban workforce, or 200 million people, is currently unemployed or underemployed. The livelihood of another 100 million agricultural workers is threatened as World Trade Organization rules increase China's dependence on foreign food supplies. The specter of chaos frightens the rulers in Beijing.

In international relations, the issue is whether China' impact on the world will be peaceful or violent. Th debate here follows disciplinary lines. "Those who focus on economics tend to see partnership, cooperation and reasons for optimism despite tensions, while security experts are more pessimistic and anticipate strategic conflict as the likely future for two political systems that are so different," writes one commentator [3]. Both views can claim some evidence in their favor...

Google click to call

This is the next step in Internet advertising. Among the text ads that come with your search results you might see a little telephone icon. If you click it and enter your phone number, Google will connect a representative from the advertiser to you via VOIP. (Your phone will ring, and voila, you can discuss how the refrigerator gets delivered or whether the plasma screen is glare resistant. Guess what part of the world the call center rep will be working from :-) This sort of thing is already out there using IM-type clients, but here the user only needs an ordinary phone. Google does not tell the advertiser your phone number, so your anonymity is protected. Very nice!

I'm very envious of the Google people because they actually have the opportunity to implement all of these nifty ideas.

Simons, Thorp and Shannon

Nice article on Jim Simons and Renaissance in Saturday's Times. Part of me wants to get into the new fund (fees are pretty reasonable compared to Medallion), but then again they are embarking on something new, so it's no sure thing. See earlier posts here and here. Most impressive about Medallion is their consistency -- no down years since 1988 and only a single down month in the last 5 years!

BTW, I've received my copy of Fortune's Formula and it's quite good. I learned a number of tidbits about Thorp (the mathematician who wrote Beat the Dealer and invented a system for counting cards in blackjack), Shannon (the father of information theory) and others from this book. Apparently, Thorp and Shannon's investment returns (Thorp ran an early hedge fund called Princeton-Newport, while Shannon invested his own account) rivalled those of the best managers like Buffet and Soros. Buffet and Thorp actually knew each other early on, and had very high opinions of each other. The stories of Thorp testing his card counting system in Nevada are hilarious -- the level of detail after all these years suggests a phenomenal memory!

The bit about optimizing geometric vs arithmetic returns (a subject of controversy between math/physics guys like Kelly, Shannon, Thorp and economists such as Samuelson, and the origin of the title of the book) seems not so interesting to me, as the answer depends on what one wants to achieve. On the subject of hedge funds, it appears everyone is starting one, including information theorist Thomas Cover and former physicist turned AI researcher Eric Baum (author of What is Thought?, the best book I've read on AI).

NYTimes: $100 Billion in the Hands of a Computer

By JOSEPH NOCERA
PEOPLE ask me all the time: What's your secret?" James Simons said. We were sitting in an office in Manhattan that Mr. Simons uses when he's not at the Long Island offices of Renaissance Technologies, the money management firm he founded in 1982. He was wearing an elegant shirt and tie, and loafers with no socks. He took a drag from a cigarette, the second of three he would smoke in the course of a long interview.

I had indeed come to ask him what his secret was. In the hedge fund world, that's what everybody wants to know.

Mr. Simons, 67, who rarely talks to journalists, is hardly a household name like Warren E. Buffett. But Mr. Simons, who got into the hedge fund business after abandoning a stellar career in mathematics, has a track record that is jaw-dropping. This summer, word leaked out that he was starting a new fund - people took to calling it the "$100 billion fund" because its marketing materials say that it could conceivably grow to that enormous size. Not surprisingly, that has caused Wall Street types to be even more curious about him.

Here are Mr. Simons's numbers: from 1990 to 2004, Renaissance's primary hedge fund, called Medallion, has delivered annualized returns of 33.21 percent. (The Standard & Poor's 500-stock index has returned, on average, 10.98 percent during those same years.) Since the end of 2002, the fund, which has $5 billion under management, has disbursed $4.9 billion to its investors - with another $1.5 billion to be delivered at the end of this year.

And these returns are after Medallion's 5 percent management fee and 44 percent share of the profits - surely the highest hedge fund fees in the land. Medallion's returns, and its fees, have helped make Mr. Simons a very wealthy man, with a net worth that Forbes estimates at $2.7 billion.

When I showed Mr. Simons's returns to a hedge fund friend, he looked startled. "Nobody has numbers like those," he said. But here's the real eye-opener: no one outside the firm's 200 or so employees has a clue how he does it.

Medallion, you see, is a quantitative fund. In quant funds, trading activity is generated by complex computer models rather than human judgment. Most quants are secretive about the algorithms that drive their models; after all, that's their investing edge. But of the handful of big-time "black box" investors, as they're often called, Mr. Simons's box may well be the blackest.

HERE'S what we do know. Medallion's portfolio contains literally thousands of stocks and other financial instruments that it trades in rapid-fire fashion. The firm's scientists are constantly searching for repeatable patterns, and other signals, in the enormous amounts of data they compile. The computer models they devise tell them when to make trades based on those signals.

As Mr. Simons put it - and this is about as specific as he would get - "Certain price patterns are nonrandom and will lead to a predictive effect." He also told me that Medallion sticks with highly liquid securities that trade in public markets around the world. Why? "Because there is a lot of data on such instruments, and we're very statistically oriented," he said. He stays away from exotic derivatives.

Not even Mr. Simons's investors know much more than I've just described. "We trust Jim and we think he's smart," said one longtime Medallion investor. "So we stopped caring what the computer was doing." When this investor began describing Mr. Simons's investing approach, he admitted he was guessing.

Mr. Simons shrugged when I suggested to him that his firm's lack of "transparency," as they say in the business, was bound to make people nervous. Humans fail in the market all the time, but somehow we are willing to keep giving our money to human beings to manage because we understand investing based on human judgment. Or at least we think we do. But black box investing feels different. It feels scary somehow, precisely because it is not something most of us can understand.

"How any great investor does it isn't in the least obvious," Mr. Simons responded. "How we do it isn't any more mysterious than how a great fundamental investor does it. In some ways it is less mysterious because what we do can be programmed." Then he stopped, took another drag from his cigarette, and let out a small chuckle. "Well," he conceded, "it's less mysterious to us."

Mr. Simons wasn't always a quant. A former crypt analyst - a code breaker, that is - he did important work in mathematics that helped lay the foundation for string theory. When he began managing money in the 1970's, he did it the same way most investors did: he used his own judgment. "At first," he said, "I didn't think about investing in a scientific fashion. But I was trading currencies, and it gradually occurred to me that there might be some way to create models that would allow you to predict currency movements."

Although Mr. Simons and a partner made an absolute killing in the currency markets the old-fashioned way - they made huge bets that turned out to be right - he began surrounding himself with scientists who developed models for all sorts of tradeable securities. "By the end of the 1980's," he said, "I was a model man, and didn't want to do fundamental analysis." One advantage, he said, is that "models can lower your risk." Another, though, is that "it reduces the daily aggravation." With old-fashioned stock picking, he said: "One day you feel like a hero. The next day you feel like a goat. Either way, most of the time it's just luck."

Indeed, trading the way he does, making thousands of small trades aimed at capturing small price movements, doesn't generate the kind of "10 bagger" that investors love. But when done well, quant investing is less likely to have the kind of disaster that is always the danger when one bets big on a stock.

To those who point to Long-Term Capital Management as an example of the dangers of black box investing, Mr. Simons's defenders point out that his fund has far less leverage than Long-Term Capital, and that in any case, while Long-Term Capital had several Nobel laureates on board, human bets were what caused it to go awry.

Clifford Asness, another well-known quant hedge fund manager, said that while he knew no more about Mr. Simons's methods than anyone else, "It's hard to believe that there isn't a measure of safety in Jim's approach.

"Presumably, he's got a highly diversified portfolio, high turnover, and he's capturing small inefficiencies. It's hard to lose a ton of money doing that. It is always possible that someday his models might stop working. But that's different from 'blowing up.' "

"You know," Mr. Asness added, "human beings have a black box, too. It's called the brain."
As for the new "$100 billion fund," Mr. Simons was even more constrained than usual, thanks to regulatory restrictions that limit what he can say publicly while the fund is raising money. People are buzzing about it nonetheless, for it seems to be a major departure from Medallion. Medallion's investors were almost all wealthy individuals; the new fund, called the Renaissance Institutional Equities Fund, has a $20 million minimum investment and is aimed at institutions. It has a much lower fee structure. It will invest in - or sell short - only publicly traded equities. Instead of making rapid-fire trades, it will be much closer to a buy-and-hold portfolio. And so on.

In one critical way, though, it is similar to Medallion. As the marketing document, which I obtained from a person unconnected to Mr. Simons, put it: "The company's risk control, variance and covariance estimation, execution techniques, slippage models, and predictive signals are all derived from those employed by the managing member in trading the Medallion Funds."

In other words, Mr. Simons believes that computer models similar to those that have worked for Medallion will also work for a fund that can hold $100 billion worth of stocks over long periods of time. It is absolutely audacious.

What interested me most of all was: why? At an age when most men are contemplating retirement, with more money than he can count, why was Mr. Simons still at it? "I enjoy the challenge," he replied.

He then began describing a demonstration he saw recently of a new nuclear accelerator at the Brookhaven National Laboratory, where he is on the board. Two atoms hurtled toward each other, colliding with great force. "A huge number of particles are thrown out," he said, "and the job is to analyze everything that results from the collision."

"Watching the spray of particles on the screen made me think of the stock market," he continued. Every trade, even of a hundred shares of a company, affects every other trade. And every day there are thousands upon thousands of such trades, all of them affecting the rest of the market. His work, as he sees it, is to analyze that incredibly complex mosaic and try to figure out how it all fits together.

"The subject may not be the most important in the world," he concluded, "but the dynamics of the market are really interesting. It's a serious question."

I suddenly understood the motivation behind Mr. Simons's new fund. He's doing it because he wants to see if it can be done. Once a scientist, always a scientist.

The new white flight

Instead of white students fleeing academically weak school districts dominated by disadvantaged blacks and hispanics, in Silicon Valley white students are fleeing overly strong school districts dominated by Asians. Who needs all that math and science anyway?

See related post on Asians and affirmative action here.

WSJ: CUPERTINO, Calif. -- By most measures, Monta Vista High here and Lynbrook High, in nearby San Jose, are among the nation's top public high schools. Both boast stellar test scores, an array of advanced-placement classes and a track record of sending graduates from the affluent suburbs of Silicon Valley to prestigious colleges.

But locally, they're also known for something else: white flight. Over the past 10 years, the proportion of white students at Lynbrook has fallen by nearly half, to 25% of the student body. At Monta Vista, white students make up less than one-third of the population, down from 45% -- this in a town that's half white. Some white Cupertino parents are instead sending their children to private schools or moving them to other, whiter public schools. More commonly, young white families in Silicon Valley say they are avoiding Cupertino altogether.

Whites aren't quitting the schools because the schools are failing academically. Quite the contrary: Many white parents say they're leaving because the schools are too academically driven and too narrowly invested in subjects such as math and science at the expense of liberal arts and extracurriculars like sports and other personal interests.

...In the 1960s, the term "white flight" emerged to describe the rapid exodus of whites from big cities into the suburbs, a process that often resulted in the economic degradation of the remaining community. Back then, the phenomenon was mostly believed to be sparked by the growth in the population of African-Americans, and to a lesser degree Hispanics, in some major cities.

But this modern incarnation is different. Across the country, Asian-Americans have by and large been successful and accepted into middle- and upper-class communities. Silicon Valley has kept Cupertino's economy stable, and the town is almost indistinguishable from many of the suburbs around it. The shrinking number of white students hasn't hurt the academic standards of Cupertino's schools -- in fact the opposite is true.

...white students represented 20% of [Monta Vista's] 29 National Merit Semifinalists this year.

...At Cupertino's top schools, administrators, parents and students say white students end up in the stereotyped role often applied to other minority groups: the underachievers. In one 9th-grade algebra class, Lynbrook's lowest-level math class, the students are an eclectic mix of whites, Asians and other racial and ethnic groups.

"Take a good look," whispered Steve Rowley, superintendent of the Fremont Union High School District, which covers the city of Cupertino as well as portions of other neighboring cities. "This doesn't look like the other classes we're going to."

On the second floor, in advanced-placement chemistry, only a couple of the 32 students are white and the rest are Asian. Some white parents, and even some students, say they suspect teachers don't take white kids as seriously as Asians.

Outsourcing at Conexant

The handwriting is on the wall...

NYT: Dwight Decker, Conexant's chief executive, said that half the semiconductor design and other high-tech engineering work is now done at Conexant India, the division in Hyderabad.

The operation there employs 700 engineers, nearly as many as headquarters does. That is up from 10 percent of such work last year, and Mr. Decker says that figure will jump to 65 percent by the end of 2006, leaving just one-third of the work to be done by the engineers in the United States.

"We are placing a very large bet on our ability to shift a significant part of our development to Asia," Mr. Decker said. "We are doing that more aggressively than any semiconductor company." He emphasizes that no layoffs are planned for Newport Beach, where engineers will work on the "innovation and architecture" of the firm's semiconductor systems.

Conexant's step is enormous, proportionate to its middling size. Giants like General Electric and 3M routinely assign high-tech research to laboratories they own in India and China. And the sprinkling of such work among their global systems is increasing. But most of their research remains in the United States.

Conexant is a fraction of their size, with only 2,400 employees and $900 million in sales of computer and communications equipment last year. Yet it is a technological powerhouse - the inventor 50 years ago of the computer modem - and a major investor in research and development.

Conexant will spend about $250 million this year on research and development because it must keep coming up with new microelectronic wonders for demanding customers like Samsung Electronics, DirecTV and others that are striving to bring movies, music, medical diagnoses and every conceivable service via Internet television to the digital home. Conexant is a strong and rising competitor in the electronics that make possible broadband Internet reception through D.S.L. telephone lines.

In 1955, as a division of North American Aviation, Conexant developed the transistor modem for communicating data over telephone lines, under a contract from the Defense Department. In the early 1980's, as part of Rockwell International, it brought out high-speed fax modems, and in 1996, it introduced high-speed Internet connectivity.

"We have adapted time and again," said Mr. Decker, who has led Conexant since it was spun off from Rockwell in 1999. "And we will continue to adapt and play our part in an expanding world market as long as we innovate." Conexant is putting emphasis on India to keep ahead of it main competitors, the Broadcom Company and the Swiss-based giant, ST Microelectronics Group, said Mr. Decker, a physicist and mathematician with degrees from McGill University in Montreal and a doctorate in math from the California Institute of Technology.

Mr. Decker said that besides financial reasons the export of research jobs is motivated by a looming dearth of engineering talent in the United States. Engineers in India earn one fourth of the pay of their American counterparts, roughly $25,000 a year in salary and benefits, compared with $100,000.

"If we can get two-thirds of our product development at one-fourth the cost, we come close to cutting our overall costs in half," Mr. Decker said. In the first year of large-scale work in India, he said, Conexant reduced costs by $36 million.

Conexant may be a harbinger of developments at corporate research departments across America. "There is a lot more research work being done in India these days," said Shivbir Grewal, a lawyer in Irvine, Calif., who works with companies in America and India.

The attraction is "the huge pool of talent" from the Indian Institutes of Technology - seven major institutions established over the last 54 years - and regional engineering colleges, Mr. Grewal said. But "visas to the United States have been extremely restricted since 9/11," Mr. Grewal said, "so the graduates are staying home and finding work in India." The increase in research overseas is arousing concerns in the United States. The fear is that good jobs will migrate to India and China and that the innovative wellspring of new technology will slowly dry up in the United States.

Terry Opdendyk, a venture capitalist, disagrees with the second concern, but concedes the first.

"It is extremely difficult to achieve and manage innovation in collaborations across oceans and time zones," said Mr. Opdendyk, who has backed more than 100 start-ups as head of Onset Ventures, a Silicon Valley firm he founded in 1984. "But I worry because we're educating too few engineers in America and I don't see us pursuing change-the-world ideas as we used to," Mr. Opdendyk said.

Mr. Decker agrees that at fewer than 60,000 new engineers a year, the United States may not have enough skilled people to handle all the work to be done. However, he said, the United States still leads in information technology, and "we can sustain our world leadership if we continue to innovate."

Fortune's formula

Fortune's Formula: The Untold Story of the Scientific Betting System that Beat the Casinos and Wall Street, by William Poundstone

I just ordered this book from Amazon -- apparently it is in vogue among some of the big institutional investors :-)

The optimization problem described is interesting from an academic point of view, and also as a good rough guide for investors, but of course it assumes that certain quantities, such as correct probabilities of future outcomes, are knowable. That may be the case in casino gambling, but in investing one can only make rough guesses based on past performance. I recall being puzzled at a section on portfolio optimization in the information theory book by Cover and Thomas, but now I see the connection.

BTW, on the topic of finance books, I highly recommend this biography of Fischer Black, which I should have reviewed here long ago. Fischer was yet another outsider (his background was in theoretical physics) to finance who made an important contribution. Unlike Kelly, he was accorded mainstream recognition (professorship at Chicago and partnership at Goldman) during his career. The most impressive thing about Black was his ability to think deeply and independently -- beyond the conventional wisdom. There are some very intriguing passages in the book about his views on money and banking which are, I think, quite unconventional to mainstream economics.

See here for an interesting review of Fortune's Formula by Berkeley math professor E. Berlekamp -- himself a former manager of Jim Simon's Medallion Fund and a collaborator of Claude Shannon!

In a paper published in 1956, John L. Kelly of Bell Labs formulated the asset-allocation problem in terms of an idealized model for which he derived some quantitative results. He used colorful racetrack terminology reminiscent of the classic Damon Runyon movie Guys and Dolls: Suppose that one goes to the racetrack with an available bankroll, B. Suppose further that one knows for each horse the correct probability that it will win the next race. Suppose further that the betting odds are at least slightly inconsistent with this information. And finally, suppose that each race is merely one of a very long sequence of betting opportunities. Kelly found criteria for deciding how much one should then bet on each horse in each race.

Kelly observed that, under similar idealized assumptions, the same formulation could also be applied to investments. In the idealized model, the portfolio manager has an accurate probability distribution on the future performance of each asset in the universe of potential investments. Kelly's methodology then provides a quantitative specification of how big a position to take in each of the candidate assets. Not surprisingly, the fraction of one's portfolio to be invested in any asset that has a negative expected rate of return will be zero. Most assets with positive expected rates of return will merit the investment of some positive fraction of the portfolio. Among assets with similar expected rates of return, those whose returns are relatively stable will be weighted more heavily than those whose future returns have significant risks of substantial losses, even when these risky investments also have some chance of large gains. All of these qualitative features of Kelly's performance criteria concur with conventional wisdom. What distinguishes Kelly's work from that of his predecessors is his quantitative specificity and the fact that he succeeded in proving that, under his assumptions, in the very long run the bankroll of an investor who followed his criteria would eventually surpass the bankroll of anyone following any other strategy.

Kelly also derived a formula for the rate at which this bankroll would grow. This formula is related to a fundamental information-theoretic notion that Claude Shannon (now widely considered to be the father of the information age) had introduced in 1948. Shannon had shown that noise on a communication channel need not impose any bound on the reliability with which information can be communicated across it, because the probability of transmitting a very long file inaccurately can be made arbitrarily small by using sufficiently sophisticated coding techniques, subject to a constraint that the ratio of the length of the source file to the length of the encoded file must be less than a number called the channel capacity. Kelly showed that the asymptotically optimum asset allocation could be determined by solving a system of equations that maximized the log of one's capital. In his horse-track jargon, Kelly also showed that the resulting optimal compound growth rate could be viewed as the capacity of a hypothetical noisy channel over which the bettor was getting the information that distinguished his odds from those of the track. Kelly's betting system, expressed mathematically, is known as the Kelly criterion.

The title of Kelly's paper, "A New Interpretation of the Information Rate," highlighted his discovery of a situation in which Shannon's celebrated capacity theorem applied even though no coding was contemplated. The paper, which appeared in the Bell System Technical Journal, initially attracted a modest audience among information theorists but went unnoticed by economists and professors of finance courses in business schools. Perhaps it would have received more attention if it had had another title. "Information Theory and Gambling" was the title that Kelly himself used for an earlier draft of his paper, but that title was rejected by AT&T executives.

Israeli startups

The Economist discusses the disproportionate impact of Israeli startups in the tech industry. Israelis are especially prominent in computer security, often due to their training in the military. One of the public companies that almost acquired my last startup (since merged/acquired by Juniper) had an extremely bright Israeli CTO who had come aboard from a previous acquisition. Like many other Israeli technologists, he was an alumnus of the IDF (Israel Defense Forces) signal corps training program, which takes in the brightest recruits for intensive IT training. Membership in that unit is sort of equivalent to having a Caltech or MIT degree. At least, the screening process is pretty tough. Of course, there might be other reasons for Israeli success in high tech :-)

Red Herring: Talpiot is a special army training program that puts the best high school graduates through a rigorous curriculum of computer science, physics, and math, then places them in key assignments in, say, intelligence units.

...The selection process for Israel's army-trained technology elite starts when teenagers apply to programs, usually in their last two years of high school. Only volunteers are eligible to be chosen for the army's training programs. The most selective program, Talpiot, accepts only 30 applicants, or 1 in 10, a year. Officers say the army doesn't look for fuzzy traits like creativity and leadership; it focuses on measurable qualities. Extremely high aptitude in math and science, along with success in rigorous exams, are the key qualifications.

REBOOT CAMP

Talpiot's M.O. is total immersion, whether the subject is software coding or the Arabic language. The programming course is just six months long, but classes run from 8 a.m. to 10 p.m., five and a half days a week. Although many soldiers say that the program's immersion approach is an effective way to learn, Col. Tregar says it's simply the only way to cram a lot of information into a very short period of time. There's little time to spend on theory and skills that won't directly relate to the students' army postings later on. "In an academic setting, you'll learn about models for parallel processors and the structure of compilers -- those kinds of things," Col. Tregar says. "It's true it gives you a much broader understanding, but on a practical level, you won't have to deal with them in your first job. People with academic degrees that come to the IDF need to undergo considerable training before being put into practical assignments."

Economist: In 2003, 55% of Israel's exports were high technology, compared with the OECD average of 26%. Tech giants such as IBM, Motorola and Cisco have research centres in Israel, which is also where Intel developed its Centrino chip. Not bad for a country with a population of 6.9m.

Why is Israel—sometimes called the “second Silicon Valley”—so strong in technology? For several reasons, says Mr Mlavsky. First, the pump was primed by government grants in the 1970s, by the BIRD Foundation (a joint American-Israeli initiative that supported many start-ups before VC money was widely available), and by government schemes to encourage Russian immigrants who arrived after the collapse of the Soviet Union.

The second big factor is the army. “The army gets hold of everybody at age 18, and if they have a glimmer of potential, it catalyses their transformation into engineers or scientists,” says Mr Mlavsky. The technically minded are given projects to develop and run, and are allowed to keep any intellectual property that they develop, which results in many spin-outs. It also means that once they get to university, trainee engineers already have practical experience and a problem-solving mentality. Israel has 135 engineers per 10,000 employees, compared with 70 in America, 65 in Japan, and 28 in Britain (see chart).

The small size of Israel's home market is also, paradoxically, an advantage. While a British start-up, say, will look to its home market to get started, Israeli firms cannot. Accordingly, they look to America for customers, so that Israeli start-ups function as “mini-multinationals” from the off—and are instantly exposed to the world's most competitive high-tech market. Similarly, Israel's relative lack of land and resources serves to steer entrepreneurs towards high technology instead.

Naturally, cultural factors play a part too. Around 5% of start-ups in America are headed by repeat entrepreneurs, says Mr Mlavsky, compared with around 30% in Israel. “The whole culture, we're like junkies, and the real kick is success, not the fruits of success, so we want to do it again,” he argues. Israeli entrepreneurs are often workaholics who tend not to change their lifestyles much after becoming successful, he says. Gil Shwed, the boss of Check Point and one of Israel's richest men, still has a regular DJ slot at a Tel Aviv restaurant on Wednesday nights, for example.

The bad news for other countries that wish to encourage the development of their technology industries is that few of these factors can be replicated. Singapore's attempt to establish itself as a biotechnology centre faces the challenge of encouraging risk-taking and entrepreneurialism in a highly conformist society. And Britain is hardly likely to introduce conscription in order to boost the fortunes of the technology cluster around Cambridge University. In technology, as in so many other ways, Israel is a special case.

Chalabi, Hitchens tragicomedy

I don't know whether to laugh or cry. As you may know, Chalabi is the former Iraqi exile (and Chicago math PhD) who conned the neocons with all kinds of crappy pre-war WMD "intelligence," as well as the notion that our troops would be welcomed with flowers (who would you have believed on this, Chalabi or Army Chief of Staff Shinseki?). Rather than being the subject of an FBI/CIA investigation, he is being feted in Washington by Condi and others, and giving a lecture at AEI, apparently attended by Iraq war apologist and self-important blowhard Christopher Hitchens. The little nugget below comes via TalkingPointsMemo.com (see here for more).

Hitchens then turned the subject back to Chalabi, his good friend. I asked him if he thought Chalabi had been passing American intelligence to the Iranians. "No," he insisted. "It's possible that with his training, you know, at [The University of] Chicago that with his own ability he was able to crack the codes. He is a mathematical genius. His expertise is cryptology. It is possible that he broke the codes himself." (This is a paraphrase since I was walking down M Street and crossing Connecticut Avenue all while being amazed that I was having an actual conversation with Christopher Hitchens at the time). Now, I don't believe this for one second. Why would Chalabi be trying to break American codes in his spare time anyway? Who does that if they are friendly to us? Suspicious, I say.

Well, Chalabi's expertise is not cryptography, and no, he didn't single handedly break any Iranian ciphers. What he did was pass on some important intel to the Iranians (that the US had broken their ciphers) that should occasion yet another investigation into neocons leaking classified information.

What makes me most sad is that someone (Hitchens) so ignorant and un-careful in thinking and speaking about topics about which they know nothing could be a public intellectual. But then again in our culture knowledge of basic mathematics or physics is considered geek esoterica whereas an educated person is expected to have read all of Shakespeare.

Baby boom

Invaders: 2, Adults: 0.

The invaders have overwhelmed us! Communications may be interrupted for some time...

VCs, Greenspan and globalization

NYTimes on Silicon Valley VCs and China investments. Note the final paragraph.

WHEN Joe Schoendorf, a Silicon Valley venture capitalist, was in Shanghai a few years ago to hear a pitch from a Chinese start-up company, he sensed something familiar. He interrupted the meeting, walked to the window and pulled back the curtains.

"What are you looking for?" he remembers the would-be entrepreneurs asking.

"I just wanted to make sure I was in China and not back in Palo Alto," he responded.

China's high-technology community, with its brains and competitive spirit, is probably more like its counterpart in Silicon Valley than any other in the world.

Yet Silicon Valley's views of investment in China have tended to swing between wild optimism and deep anxiety - with the anxiety going beyond a fear of losing money. Some worry about helping Chinese start-ups move up the technology food chain.

These days, the Valley venture capitalists are sharply divided in two camps: one rushing into China and one holding back.

...The dominant perspective is that China is a vast sea of opportunity, from its low-cost skilled labor pool to its enormous consumer market that is more than one billion strong.

In fact, it is now routine for venture investors to demand that their start-up firms place the bulk of software development and manufacturing efforts in China or India. (A supply chain problem at a manufacturing arm in China, however, can easily ruin financial results in any given quarter.)

For China skeptics, the concern is that American investment will help energize a formidable competitor, which could come to dominate both markets and technologies.

The fear is based in the Valley's complex relationship with China as supplier, partner, customer and competitor. Most venture capitalists say this evolving relationship will define the future of the Valley and maybe even technology development in the United States.

The Ningbo Bird Company is one case in point. It went from being a contract manufacturing supplier for Motorola to being a serious rival in the Chinese handset market in a matter of a few years.

Still, last year, most of the Valley seemed to throw caution aside as venture firms invested nearly $1.3 billion in China, up nearly 30 percent from 2003, according to Zero2IPO, a venture capital research and consulting company based in Beijing.

But in the first half of this year, investment slowed drastically after several changes in Chinese securities regulations. Those new rules caused "a decline of 50 percent in the first two quarters," said Dixon Doll, managing director of Doll Capital Management, based in Menlo Park, Calif.

The lull is ending, though, in part because of the high-profile success of the initial public offering of Baidu, a Chinese search engine company that was able to raise $86.6 million in August, and a securities rule change in October. In September, Sequoia Capital, a major backer of Google, was reported to be planning a $200 million fund and hiring several employees in China.

That announcement followed an earlier joint agreement this summer by Accel Partners, a leading Silicon Valley firm, and the International Data Group to set up a $250 million fund.

There have even been reports recently that Kleiner Perkins Caufield & Byers, the Valley's highest-profile venture firm, was creating its own China fund, though people briefed on the firm's plans said that was not true. While Kleiner has recently added Colin L. Powell as a partner to serve as a "rainmaker" in Asia, it remains concerned about changes in Chinese security laws that could complicate the return of investment funds to the United States.

Mr. Schoendorf, who is an Accel partner, sees benefits in helping China to become a fierce new competitor. He likens this moment of anxiety and promise to the 1970's, when Japan began to compete successfully with the United States.

"The Chinese graduate more engineers than we do," he said. "They're smart, they work hard, and so the only way to compete with them is to remain more innovative."

WSJ: Greenspan comments on globalization of labor markets. (Holding down inflation is the same as diminished returns to labor...) The bond market reacted negatively to these comments, as Greenspan said the effect would eventually go away. But I think that was a mistake: only the leading edge of those 2 billion workers have been integrated into the world economy -- a distinct minority. It will take decades before that deflationary effect wanes. Not to say that there aren't other inflationary forces at play, like oil and commodity scarcity, but the labor component is deflationary as far as the eye can see. Not only do low-skill workers have little pricing power, but even engineers and service professionals are under pressure from abroad.

The integration of China, India and the former Soviet bloc into the world trading system is helping to hold down inflation but at some point, that effect will fade, Federal Reserve Chairman Alan Greenspan said.

...Mr. Greenspan said the addition of more than 100 million educated workers from former Soviet countries, large segments of China's 750-million strong work force, and workers from India "would approximately double the overall supply of labor once all these workers become fully engaged in competitive world markets," a development that "has restrained the rise of unit labor costs in much of the world and hence has helped to contain inflation."

But while these forces "may well persist for some time," he said, the process and its contribution to inflation control will wane and that "will need to be monitored carefully by the world's central banks."

Black holes for financiers

No, that's not a typo: it's black holes, not Black Scholes :-) I posted the following comment on Brad Setser's blog (mostly read by finance and econ types). He was fascinated by this Times article on a measurement of the size of the supermassive black hole at the center of our galaxy.

It's now widely believed that many galaxies have at their centers supermassive black holes with masses larger than a million solar masses. (The existence of these supermassive holes is a plausible consequence of how galaxies are formed through non-linear growth of density perturbations in the early universe, but that is another story.) Because black holes are dense, even these supermassive black holes are not that large. The one at the center of our galaxy appears to have diameter roughly that of the earth-sun distance (= 93 million miles; the galaxy is 10^9 times larger), and a mass of 4 million solar masses.

It is easy for astronomers to find objects which are so dense that, theoretically, they must be black holes. The thing at the center of our galaxy is one example; there are many more that are remnants of stellar evolution (very large stars that run out of fuel and collapse to form black holes -- these are only a few orders of magnitude more massive than our sun). To estimate the density astronomers need to measure the mass (based on the gravitational pull exerted on nearby objects such as stars) and size of the object.

The recently reported findings have to do with radio astronomers looking at the black spot caused by absorption of radio waves coming from behind the black hole. They can measure the radius of the black spot to estimate the size of the black hole.

What is most interesting about black holes is the general relativistic effects associated with their "horizon" -- particles, even photons, which pass the horizon can never escape and are doomed to eventually fall into the "singularity" inside the black hole where (according to general relativity) known physics must break down. Unfortunately, based on what I just said, outside observers will never know what happens at the singularity since the object falling in cannot send a signal back out once it has passed the horizon!

To establish the properties of the horizon predicted by general relativity would require probes which signal back to us as they fall in. (They would go dark just as they hit the horizon -- their signal would be "infinitely redshifted.") Astronomical observations are not really enough (although these radio observations are a step in the right direction) since in principle a very dense object which isn't necessarily a black hole might absorb photons (radio waves) to yield a black spot. The identification of an object as a black hole simply based on its density relies on general relativity in a domain in which the theory has not been tested experimentally.

Economist on intellectual property

The Economist has a nice survey on patents and IP. As I mentioned in an earlier post, the US patent system (esp. for software) is pretty broken right now. The Economist looks forward to a day when ideas themselves can be bought and sold like any other product. In such a world, some firms might specialize solely in innovation, leaving other tasks like manufacturing, marketing and distribution to others. Of course, this assumes a smoothly functioning IP system, which seems very far off. At the moment, the legal costs of resolving a patent dispute are sufficiently high that startups (which produce a disproportionate amount of innovation) often cannot afford any confrontation with a public company. Given that many big companies are aggressively pursuing a patent-hoarding strategy (hiring more patent attorneys, but perhaps not more scientists!), this may have a negative effect on innovation. See here for leading patent recipients in 2004.

It can take years of hard work, and millions of dollars, for VCs, inventors and entrepreneurs (all of whom have "skin in the game") to determine the worth of an idea. (In this process, the original idea is almost always revised in important ways.) Thus, even if a liquid market for patented ideas existed, valuation would be a very difficult problem. It is true that large companies often sign bulk cross-licensing agreements (for example, Sony and Samsung have cross-licensed a huge number of patents), but I have a hard time imagining a future where I can list a clever idea on EBay and sit back to consider bids from around the world.

The new predominance of intellectual property in technology industries is fed by a number of broader industry trends. First, IT and telecoms have become so complex that there is a greater willingness to accept the innovations of others. Gone are the days when vertically integrated firms handled every step of a product, from initial design to final sale. Now, a small army of specialist firms focus on narrow portions of technology, using intellectual-property rights to protect their inventions when they are licensed out.

Second, as many new technologies quickly turn into commodities, firms increasingly rely on innovation to remain competitive. Yet the return on investment in R&D is short-lived because more people innovate at a far faster pace than before. That means margins have shrivelled, explains Ragu Gurumurthy of Adventis, an IT and telecoms consultancy. “How to recoup the cost of innovation? By licensing the technology,” he says.

Third, customers are demanding “interoperability” and common standards rather than proprietary systems, which means different firms' technologies must work together smoothly. This often requires pooling patents or cross-licensing agreements.

Fourth, generating intellectual property is less capital-intensive than other aspects of the IT businesses because it relies mainly on people rather than bricks, mortar and machinery. That makes it attractive to many start-up firms. Venture capitalists often demand that firms patent technology, both to block rivals and to have assets to sell in case the firm flounders. This was particularly apparent during the internet boom in 2000. “In addition to the dotcom bubble, we had a patent bubble,” says Mark Webbink of Red Hat, a firm that sells Linux, an open-source operating system.

Companies cannot simply turn their back on what is happening in intellectual property. Even if they refuse to play the game, they may be unwittingly infringing someone else's patents because there are so many more of them around. Unless firms have patents of their own to assert so they can reach a cross-licensing agreement (often with money changing hands too), they will be in trouble. Thus many companies are acquiring large numbers of patents for purely defensive reasons, for use only to keep others' patent threats at bay.

...But when talking to executives in the technology firms themselves, the language you hear most often is that of “the arms race” and “mutually assured destruction”. Companies amass patents as much to defend themselves against attacks by their competitors as to protect their inventions. Many technology companies have recently championed reform of the patent system to deal with spuriously awarded patents, licensing extortion and massive lawsuits. “There is a broad recognition in the US that the patent system, if not reformed, will...begin to impede American competitiveness around the world,” says Bruce Sewell, general counsel of Intel, the world's biggest chipmaker.

This survey will argue that, despite such adjustment problems, the huge changes in intellectual property currently taking place in the IT sector will in time produce more efficient markets. But what do the IT firms themselves make of it all?

See also this article in the survey on IP in China and India.

The rise of China and India has mainly been underwritten by foreign companies, not indigenous ones, though this is starting to change. Both countries have been good at persuading firms setting up operations there to invest in training locals. Today, nearly all the large IT firms have big research centres in both countries, and local companies understand the need to develop their own intellectual property. Local people who went to Silicon Valley to find fortune are now starting up their own businesses in their home countries. Foreign venture capital is pouring in.

Without home-grown technology, India and China have to depend on foreign firms, and they do not like it. China, in particular, has seen a surge in the royalties it is paying to foreign firms, and is trying to stem the flow. When Qualcomm's boss went to China in 2001 to negotiate royalty payments for his company's third-generation mobile-phone standard, he agreed to accept less than what he charges others. Within a year, China was working on developing its own 3G wireless standard. If it succeeds, Qualcomm will see its royalties shrink further.

China and India have more to offer than just low costs, although these are clearly important. They are also able to deploy huge numbers of people to work on a project. Being able to throw bodies at a problem is vital in IT. It allows firms to do things such as speed up development cycles or explore alternative approaches that would not be possible with a smaller labour force.

In short, China and India are not simply taking over western IT jobs, they are changing the very process of IT development. It is not about doing the same thing cheaper, but about doing things that simply could not be done before. In that endeavour, intellectual property is becoming increasingly important.

There are limits to the optimism about India and China. Both countries have a culture of keeping technology to themselves. The western concept of patents is fairly new to them, and has proved controversial for countries at their stage of development. Also, both nations have huge institutional and infrastructure obstacles to overcome. Capital markets are embryonic. Big companies are coddled by the state. India's government bureaucracy is stifling; China's is opaque and corrupt. The legal system is uneven in India and consistently inadequate in China. Both countries badly need more experienced managers.

American technology executives with some experience of India and China are worried that the two are about to eat the rich world's lunch, but locals with deep knowledge of both countries think it will take at least a decade. Still, the overall trend is clear: the rise of China and India as centres of innovation will radically shake up the technology industry that is today based mainly in rich countries.

...Take Huawei Technologies, a big vendor of communications equipment, with revenues of $5.6 billion in 2004. This year, revenue from abroad is expected to surpass that from domestic customers for the first time. Around half of its 34,000 employees do R&D work, claims the company. Its patent filings almost doubled each year during the 1990s, though they have recently started to slow somewhat: the number this year will be around 2,400, and from next year it is expected to settle at around 3,000 a year. In 1995 the company created a special department to work on patents, which currently has 100 people on the payroll but will expand to twice that number next year.

“If you didn't have patents, you would be in a very disadvantaged position relative to your competitors,” explains Liuping Song, the head of Huawei's intellectual-property department, at the firm's headquarters in Shenzen. “Other companies approach you and charge you for using their patents.” So is the firm chasing after patents simply because other companies are doing the same thing? Mr Song laughs and says, “That is a difficult question to answer.” Then he adds: “We have to play by the rules of the game.”

Google ads

Nice article in the NYTimes describing Google's main revenue source: advertising. As a veteran of this era, I witnessed advertising as a revenue model go from very successful (circa 1999, mainly due to cost-per-view purchases by huge dotcoms willing to pay to aggregate eyeballs) to horrible (circa 2002, as supply outstripped demand and cost-per-view became cost-per-click, and then cost-per-action), and finally to success again, with auction models and a shortage(!) of prime ad space. It was one of the wildest swings in value of a commodity (Internet advertising) ever witnessed -- probably a swing on the order of a factor of 100 within a few years. (For veterans, from CPM of $10 to complete inability to sell CPMs at all, and an implied CPM value using click-through or action rates of less than 5 cents or so...)

Very few people know that it wasn't Google that pioneered the ultimately successful auction model (now used by Yahoo, Google and MSN). It was Bill Gross' Goto.com, which became Overture, which was acquired for billions by Yahoo. The Times article does a good job of clarifying exactly how innovation proceeded. Note how young (and smart!) the people involved were (are). Gross is a Caltech grad, Brin and Page were Stanford PhD students, Schmidt is a Berkeley PhD and Kamangar is a Stanford grad. It's yet another case of the non-linear value of brainpower in this century...

In early 2002, a Google employee, Salar Kamangar, now 28, convinced Mr. Schmidt and the founders to switch to an auction-based system like the one set up by Bill Gross, the head of IdeaLab. Mr. Gross had created Goto.com, a search engine made up entirely of ads, where advertisers paid only if their ad was clicked on, and the advertiser who bid the most per click was listed first. (Goto was later renamed Overture Services and then bought by Yahoo, an early Google backer that has become its fiercest rival.)

Mr. Kamangar, though, had an important improvement on the model. Rather than giving priority to the advertisers that bid the most per click, as Goto did, he realized that it was better to save the front of the line for ads that brought in the most money - a combination of the bid and the number of clicks on the ad. This was not only more profitable, but it also linked readers to ads that were more relevant to them. He also figured out that the system should use what is called a Vickrey auction - that is, to charge the winner only one cent more than the second-highest bidder. That gives advertisers an incentive to bid high, knowing that they will not be penalized if they are far higher than the rest of the market.

Mr. Page and Mr. Brin were suspicious of any system that put high-bidding advertisers at the top, Mr. Kamangar said. "They thought if someone was willing to pay more it was a negative," he recalled. But he was able to convince them that the site could be improved by incorporating how often users clicked on an ad.

Mr. Schmidt, who was still new as chief executive, was worried more that moving to an entirely auction-based system - amid a recession in online advertising - could be financially disastrous. "I said to Salar, 'Promise me the revenue won't go down,' " Mr. Schmidt said. "I was afraid people would realize these ads were worthless." In fact, revenue quickly increased tenfold.

As Google's audience took off, advertisers came running - many thousands of smaller ones at first, but soon large companies as well. Among Google's largest advertisers is eBay, which has long bought keywords for nearly every sort of merchandise it sells.

"The smartest thing that Google did was getting smaller advertisers to buy in," said Ellen Siminoff, the chief executive of Efficient Frontier, an agency that helps advertisers manage their campaigns on search engines. She estimates that Google has two to three times as many advertisers as Yahoo does, largely because Yahoo has a 10-cent minimum bid. This lets Google earn money on more obscure search terms for which rivals have no ads.

This growing advertising business gave Google the confidence to expand its audience. Most significantly, in 2002, America Online brought in Google to replace Overture, which provided both search and search ads; that deal enshrined Google as the premier search engine and ad network. Google won the deal by guaranteeing AOL a substantial sum, which it would not disclose. Google was willing to make that bid only because of its confidence in its advertising sales prowess. "If we were wrong," Mr. Kordestani said, "there were some scenarios that would bankrupt the company."

But by that point, Google had figured out that the same sort of computing and engineering skill that it used to find Web pages could also be used to improve the quality and, ultimately, the profitability of advertising. "Initially, we didn't understand how fundamental the computer science was in advertising," Mr. Schmidt said. "We didn't have enough staffing or focus on this area. I managed to fix that."

GOOGLE introduced its current system for determining which ad to show on which page late last year. It is a wonder of technology that rivals its search engine in complexity. For every page that Google shows, more than 100 computers evaluate more than a million variables to choose the advertisements in its database to display - and they do it in milliseconds. The computers look at the amount bid and the budget of the advertiser, but they also consider the user - such as his or her location, which they try to infer by analyzing the user's Internet connections - as well as the time of day and myriad other factors Google has tracked and analyzed from its experience with advertisements.

"If someone is coming from a particular location, a certain ad may be more popular there," explained Jeff Huber, Google's vice president for engineering. "The system can use all the signals available, and the system itself learns the correlations between them."

Babies arrived

Sorry for the lack of posts. I've been a bit busy with some new additions to the family :-)

One year anniversary

Wow! My blog is one year old now. The first post was 10/24/04, on revealed preferences and college rankings, and there have been 319 posts since then.

Some recurring topics?

globalization: China, India, US competitiveness, Bretton Woods II

finance: derivatives, volatility, equity risk premium, CDOs, bounded cognition, hedge funds, housing bubble

startups and Silicon Valley
my research in theoretical physics
science as a (bad) career choice
artificial intelligence
race and genetics
internet security

You can find posts on each topic using Google and the additional search term site:infoproc.blogspot.com. For example, here are all the places on my blog where the term singularity appears.

A list of pages that link to this blog.

Book of the month

We already have a favorite prescient cartoon, now for our favorite prescient book. (See here for the latest developments. Has Fitz flipped Libby?)

Worse Than Watergate: The Secret Presidency of George W. Bush by John Dean.

For those who don't recall the name, John Dean was Nixon's White House counsel (not to be confused with Harriet Miers), who turned witness for the prosecution and pled guilty to obstruction of justice. It takes one to know one. You can't con a con man. Don't kid a kidder, etc., etc.

From the reviews:

John Dean goes further back, seeing in Bush all the secrecy and scandal of Dean's former boss, the notorious Richard Nixon. The difference, as the title of Dean's book indicates, is that Bush is a heck of a lot worse. While the book provides insightful snippets of the way Nixon used to do business, it offers them to shed light on the practices of Bush. In Dean's estimation, the secrecy with which Bush and Dick Cheney govern is not merely a preferred system of management but an obsessive strategy meant to conceal a deeply troubling agenda of corporate favoritism and a dramatic growth in unchecked power for the executive branch that put at risk the lives of American citizens, civil liberties, and the Constitution.

...For a convicted felon, John Dean is an exceptional author. I remember reading his own recollections of the Watergate affair and his own association with the subsequent events that led both to his own denouement and the resignation of Richard Nixon in disgrace in "Blind Ambition" in the mid 1970s. Once again he weighs in impressively by building a very strong circumstantial case for the investigation and possible prosecution of President George W. Bush for criminal actions that Dean terms to be indeed, "worst than those of Watergate". Culling from public records and the recollections of other eye-witnesses, Dean shows how Mr. Bush has systematically exaggerated, embellished, and engineered a series of preverifications and outright lies to the American public in an effort to convince us of the need for military intervention in Iraq.

Google print

For anyone who hasn't played with this new tool, I highly recommend it. It is a shame that publishers are suing to prevent the further scanning of books into Google's database.

Try the following search:

"ellsberg plumbers"

Which brings up (third result) The Columbia Guide to America in the 1960s, edited by David R Farber, Beth L Bailey:

The first major episode in what came to be called the Watergate scandals occurred in July 1971. At Nixon's orders, White House aides had formed a secret group called the Plumbers, to plug all leaks of secret information from the executive branch.

The Plumbers' first target was Daniel Ellsberg. A former Pentagon consultant, Ellsberg had inspired Nixon's wrath by leaking a secret government report on the Vietnam war, dubbed the "Pentagon Papers," to the New York Times. These documents revealed that the U.S. government had continuously misled Congress and the American people about the course of the war... in hopes of destroying Ellsberg's credibility, the Plumbers broke into his psychiatrist's office, looking for embarassing personal records.

Next, I recommend the key words "perjury obstruction conspiracy watergate".

Finally, search using "ecclesiastes new sun" to find that there is nothing new under the sun :-)

The fire this time

I'm sure current defenders of Bushco would have been just as quick to defend Ehrlichman and co-conspirators back in 1973, until admitting belatedly, 10 years later, that they were indeed criminals whose activities threatened to undermine our Republic. Let's see what current Bush supporters will have to say 10 years from now.

Note the parallels between Nixon's cronies trying to silence or discredit Daniel Ellsberg's criticism of the Vietnam war, and Bushco's attack on Joe and Valerie Wilson.

From the discussion of this blog post, analyzing how Judith Miller was caught in a perjury trap by Fitzgerald (resolving the mystery of how she "found" her lost notebook and why she had to testify twice). Apparently, Secret Service records showed her meeting Libby at the White House on June 23.

While I cannot know which of the convicted felons involved in the Watergate crimes was Buchanan's "good friend," it is certainly true that some people went to prison for telling a grand jury, "I can't recall" when that was false.

For example, White House domestic policy assistant John Erlichman was indicted on September 4, 1973. Count 4 of the indictments issued by the a grand jury against John Erlichman and others (CR 74-116, United States District Court for the District of Columbia) charged that Erlichman violated Title 18, United States Code, Section 1623, which makes "False declarations before grand jury or court" . His crime occurred in this exchange:

Q. Just so that the Grand Jury and we are clear on this, prior to receiving information about the break-in, you had no information, direct or indirect, that a psychological profile of Dr. Ellsberg was being drawn up?
A. I can't recall hearing of a psychological profile until after I had heard or the break-in.

5. The underscored [boldfaced] portions of the material Declarations quoted in paragraph 4, made by JOHN D. EHRLICHMAN, the DEFENDANT, were material to the said investigation and, as he then
and there well knew, were false. (Title 18, United States Code, Section 1623.)

http://www.watergate.info/judici...ciary/ APPII.PDF at pages 19-21 (indictment starts at page 12).

Erlichman was found guilty of this count and 2 other counts. http://www.watergate.info judici...ciary/ APPII.PDF at page 9. He was sentenced to serve a prison term of 20 months to 5 years for conviction on 3 counts.

Egil Krogh avoided conviction on a similar count of falsely declaring when he said that he was not aware of certain travel. He avoided that conviction because instead he entered a guilty plea on another matter in a plea agreement with the prosecution. Pages 29-31 of same.

Krogh made a statement to the court upon entering his guilty plea, to the effect that the actions of retaliation against a critique of the war in Vietnam were an invasion of the rights of Dr. Ellsberg. He stated:

"But however national security is defined, I now see that none of the potential uses of the sought information could justify the invasion of the rights of the individuals that the break-in necessitated. The understanding I have come to is that these rights are the definition of our nation. To invade them unlawfully in the name of national security is to work a destructive force upon the nation, not to take a protective measure." (http://www.watergate.info/judiciary/APPII.PDF at page 61)

Of course, it's not only Judith Miller who "could not recall" some things, but some of the principals in the White House. Those supposed lapses in memory could be the basis for indictments if Fitzgerald has evidence that a claim of lapsed memory is bogus.

From that well-known liberal newspaper, the WSJ:

Yesterday, one former administration official said Karl Rove, the deputy White House chief of staff, had discussed former diplomat Joseph Wilson and the role of his wife, Ms. Plame, with White House staffers in 2003. That buttresses the possibility that Mr. Fitzgerald is investigating charges related to leaking classified information.

The former official said Mr. Rove had these discussions after Mr. Wilson went public with claims that the Bush administration had twisted intelligence to build support for the Iraq war. Mr. Rove discussed discrediting Mr. Wilson, the former official said, adding that Mr. Rove didn't necessarily name Ms. Plame or make her a key talking point in conversations with other White House officials.

Hard rain's gonna fall

In an unguarded moment during the last campaign, John Kerry said (not knowing a microphone was on): "These guys are the biggest bunch of crooks you've ever seen."

Chris Matthews:

If there are indictments, they're going to be probably in the vice president's office, they're probably going to come next week and they are going to blow this White House apart.

It's going to be unbelievable.

I think the people watching right now who are voters better start paying attention to this issue. It's not just about whether somebody's name was leaked, it's about whether we went to war under false pretenses or not, whether people knew about that or not, and what they did when they were charged against that kind of offense against the United States.

It's serious business.

and from Pat Buchanan:

During Watergate, a good friend went to prison for saying twice before a grand jury, "I can't recall." That was about a picayune matter compared to Judy Miller's "I can't recall" to the question, "Who gave you this name, 'Valerie Flame'?"

So, my guess is that there are multiple indictments coming, for lying to investigators, perjury, obstruction of justice, and disclosure of national security secrets for political purposes. And maybe conspiracy....

Though this case may be narrowly about whether Libby or Rove lied to investigators or the grand jury, it could also become about whether we were lied into a war General Odom calls the "greatest strategic disaster in the history of the United States."

There is simply no good news here for Bush & Co., unless Patrick Fitzgerald declines to indict anyone. If, however, Fitzgerald comes down with no indictments, some journalists will have to be put on suicide watch, so heavy is their psychological and emotional investment in this case.

From DailyKos. Also, see our favorite prescient cartoon.

Plamegate indictments?

Will Cheney be indicted? Will there be a conspiracy charge against members of the White House Iraq Group (WHIG)? Did Fitzgerald flip one or more White House staffers? Will Karl Rove be frog-marched out of the White House in handcuffs? It's either the calm before the storm, or an anticlimactic end to this long running investigation. See here for obsessive sleuthing and analysis, including comments like the following. Are they living in an alternate universe, or is the Watergate scandal of our generation about to unfold?

Perhaps it is a bit premature to say so, as the indictments haven't been handed down yet - but it seems to me that the Republic has in essence been saved through the efforts of one lone tenacious prosecutor. He is the Bernstein and Woodward of our day.

...and because the disgraceful MSM hasn't done their job in reporting on this story to the public, it will come as quite a surprise to many people when the VP and half the neo-cons who have been in control of this country go down in the next week or 10 days.

Also, see our favorite prescient cartoon.

Equilibration can hurt

More on Delphi's bankruptcy from the WSJ. For those who don't follow globalization, Delphi (a huge auto-parts supplier spun out of GM) provides one of the clearest examples of the economic handwriting which has been on the wall for many years now. Previous posts here and here.

First, from an interview with Delphi CEO Steve Miller:

Mr. Miller: Globalization is a fact of life these days. What has been brought into sharp relief is the differing value the global market places on knowledge workers versus basic manufacturing workers. I was struck by what I saw when I visited our Delphi operations in Mexico last week. Our average hourly worker makes about $7,000 a year, while the average salaried worker makes about $35,000 a year. A spread of five times. The same spread, or wider, exists in all low-cost countries. The implications for America are enormous, and it boils down to this. If you want your kids to enjoy the great American dream, get them a good education. The days when manual unskilled labor can deliver a $65-per-hour wage are disappearing.

...

WSJ: Last year, your predecessors negotiated a two-tier wage deal that lowered wages for new hires to the $12-to-$16-an-hour range. Your most recent proposal, according to the UAW, was $10 an hour in wages with a total package of $20. What is a competitive wage package for you?

Mr. Miller: You've got to think of two kinds of components. There are things that are labor intensive, very small. You can put a thousand of them in a box and ship them across the ocean. Those things are going to be made in low-cost countries. They're not going to be made in America. Not for $10 an hour or $5 an hour. They are going to be made for $2.

There are other components like manifold covers for engines that are huge assemblies with all kinds of sophisticated electronic parts and fuel-feeding parts. Those are high value and logistically so hard to handle they have to be made next to the customer, close to the final assembly plant. Those will be made in America. But they will be made by people who have competitive, American industrial wages. And a competitive American industrial wage is, all in, about $20 an hour, in round numbers.

And to get $20 an hour all in, and have a health-care plan, pay the workers' comp bill, which is high in the states we are in like New York, Ohio and Michigan, then wage, retirement, then, bang, at a $10 wage you are already hovering around $20.

Now, the UAW has organized workers that are in the $20-a-hour all-in range and they are suppliers and they compete with us. So this isn't about breaking a union. This is about simply transforming our workplace to be competitive with other U.S.-based suppliers for components that can be made in this country.

Second, an interview with Delphi's VP for Asia-Pacific operations.

Delphi Corp., which is preparing for a painful reorganization to pull through bankruptcy protection, pays its U.S. unionized workers $27 an hour. Throw in health and retirement benefits, and the cost is more like $65.

In China, Delphi pays its workers roughly $3 an hour, about a third of which goes to medical and pension benefits. Delphi also throws in a bus ride to work each day and free lunch in the factory canteen.

The huge difference in labor costs helps explain why Delphi's Asian division is profitable, and thus exempted from the company's bankruptcy filings. It also explains why the Asian division is hiring even more workers as it expands across the region, supplying not just General Motors Corp., but Toyota Motor Corp., Hyundai Motor Co., Nissan Motor Co., Honda Motor Co., Volkswagen AG and a slew of coming Chinese makers.

As a result, Delphi's Asian division is playing a major role in one of the world's largest hypergrowth markets, with customers from China to India to Southeast Asia buying their first automobiles along with their entry into the middle class.

Delphi is in trouble because "the U.S. is losing money, but we are not," says Choon T. Chon, Delphi's vice president in charge of Asian-Pacific operations. "Asia is our future."

Asia is still a small part of Delphi's overall annual sales of $28.6 billion. But its $1.1 billion in Asian sales of auto components is more than double what the company made in Asia five years ago and has been growing more than 15% a year. Indeed, Delphi's 35 ventures in plants and technology-development centers in Asia are providing a key growth engine that is likely to help drive the company through its current crisis.

The 58-year-old Mr. Chon, who has been head of Delphi's Asia operations since 2000, is charged with the important task of keeping the region's operations humming. The Korean-born Mr. Chon, an industry veteran who has worked for GM, Ford and Chrysler, isn't an executive who minces words. He has been explaining the bankruptcy filing of the U.S. operations to his staff and customers by likening Delphi's Asian operations to the children of a sick American mother.

"Our mother has a tumor. This tumor is the UAW," he says, referring to the powerful union that represents 25,000 of Delphi's employees in North America and 10,000 retirees. Still, he is careful to remain optimistic. "We know that she's going to come out of the hospital very well," he says, referring to the U.S. company's Chapter 11 bankruptcy-protection status.

The UAW has equally critical words for Delphi's management, saying it is "unfair that the law allows Delphi to put its U.S. operations into bankruptcy, while leaving its foreign operations untouched," according to a union statement. Benefits in China are far less expensive than those provided to UAW members in the U.S. Roughly $1 of every $3 Delphi pays for hourly labor in China goes toward housing subsidies, medical and employment insurance, and a modest pension scheme that few believe is big enough to provide a significant source of retirement income.

...Delphi, which has roughly 135,000 employees outside the U.S., has poured $500 million in investments in China since 1993, making a slew of auto parts -- sparkplugs, battery cables, brakes, radiators -- not only to supply the booming China market, but also to export from China to markets elsewhere. It is building similar operations in other countries with ambitions of developing their own auto industry, like Thailand and Indonesia. It is also building advanced technical-development centers in South Korea and Japan to work with the region's powerhouses like Toyota and Hyundai.

Like other U.S. companies, Delphi sees immense export possibilities from China. But for now the company is preoccupied with trying to keep up with demand in the domestic Chinese market. Two years ago, Delphi broke ground for a $40 million, 200,000 square foot car electronics-parts plant in the coastal city of Suzhou, employing 600 people. The original plan was to produce electronic gadgets for export, but China is growing so fast that managers changed the focus to supplying domestic customers.

Mr. Chon says the key to success in China is training local managers. A crucial job for the dozens of U.S. expatriates across the region is to train local staff to take over local operations. "I have told all my expats, 'When you leave, there are no more Americans coming.' "

El-Erian to run Harvard endowment

I guess I should reevaluate my investment in PIMCO's emerging markets bond fund, made mostly based on El-Erian's reputation :-)

I can't imagine El-Erian will make much less than Meyer did, which will probably continue to irritate certain alumni. See earlier post.

Harvard Hires Pimco's El-Erian to Run $25.9 Billion Endowment
2005-10-14 10:25 (New York)

By Brian K. Sullivan and Matthew Keenan
Oct. 14 (Bloomberg) -- Harvard University is hiring Mohamed El-Erian, who oversees emerging-market debt investments at Pacific Investment Management Co., to run its endowment.

El-Erian, 47, will be chief executive officer and president of Harvard Management Co., which manages the $25.9 billion fund for the Cambridge, Massachusetts, university, replacing Jack Meyer who resigned to start a hedge fund, Harvard said in a statement today.

El-Erian has been a managing director at Newport Beach, California-based Pacific Investment Management, known as Pimco, since 1999. He oversees more than $28 billion, making him the world's biggest buyer of emerging market debt.

Harvard's endowment under Meyer was consistently a top performer. Its investments returned 19.2 percent in the year ended June 30, almost triple those of U.S. stocks and bonds. Even so, Harvard Management has been criticized for paying its
managers too much, a factor in Meyer's decision to leave.

El-Erian's flagship $2.9 billion Emerging Markets Bond Fund has a five-year annualized return of 19 percent, ranking ahead of 90 percent of competitors, according to data compiled by Bloomberg. In the past year, the fund has gained 10 percent, trailing 69 percent of rivals. He also manages Pimco's Floating Income and Dividend Income funds.

El-Erian spent 14 years at the International Monetary Fund, where he rose through the ranks to become deputy director. He left in 1997 and was a managing director at Salomon Smith Barney before joining Pimco, a unit of Munich-based insurer Allianz AG. He earned his undergraduate degree in economics at Cambridge
University and a master's and doctorate at Oxford University.

Endowment Returns

El-Erian spent much of his youth in Egypt and Europe, becoming fluent in Arabic, English and French. His father, Abdallah, was a lawyer and diplomat who represented Egypt at the United Nations in New York and was ambassador to France and
Switzerland.

His appointment was reported earlier today by the Boston Globe.

Harvard has been one of a few U.S. universities that relies on in-house managers to invest its endowment fund. Under Meyer, the proportion of money managed by outsiders has increased to 50 percent from 15 percent, with the university parceling out billions to companies formed by departed Harvard Management employees.

Harvard had named Peter Nadosy, former president of Morgan Stanley Asset Management, to fill in for Meyer, 60, until a permanent replacement was hired. Meyer, who said in January he planned to start a hedge fund, will take about 30 Harvard Management employees with him. His firm, Convexity Capital Management LP, will manage about $500 million for the college.

Under Meyer, the endowment had grown from $4.7 billion over 15 years. The fund had a 16.1 percent average annual gain in the 10 years through June, compared with an 11.8 percent increase of the university's internal benchmark.

Message from Linde

Andre Linde (Stanford) sends some interesting comments on our paper Message in the Sky. He points to an earlier paper of his, and a nice interview in Slate, where he discusses the idea of creating a universe in the lab. In the comments section of the previous post I mentioned that one of the reasons I had been thinking about this topic is the work of Farhi and Guth (MIT) on the behavior of a false vacuum bubble created in the lab. I hadn't known that Andrei had also worked out the solution (although I should have). A false vacuum bubble can expand in a non-Euclidean way, so that the observer in the lab sees the bubble shrink while an observer inside sees it expand (inflate).

Andrei also had the idea that the creator of the bubble universe might like to send a message to its future inhabitants. He discusses tuning the fundamental parameters so that physicists in the bubble universe would understand that their physical laws had been adjusted just-so. Our proposal allows a bit more information to be encoded (or rather, read out), but the idea is similar. The problem with having special values of the constants is that some nutty physicists might come up with anthropic reasons explaining those values, and not figure out it was done intentionally ;-)

But why bother making a universe if it's going to run away from you? Wouldn't you want to have some power over how your creation unfolded, some way of making sure the beings that evolved in it turned out well? Linde's picture was as unsatisfying as Voltaire's idea of a creator who established our universe but then took no further interest in it or its creatures.

"You've got a point," Linde said. "At first I imagined that the creator might be able to send information into the new universe—to teach its creatures how to behave, to help them discover what the laws of nature are, and so forth. Then I started thinking. The inflation theory says that a baby universe blows up very quickly, like a balloon, in the tiniest fraction of a second. Suppose the creator tried to write something on it surface, like 'Please remember I created you.' The inflationary expansion would make this message exponentially huge. The creatures in the new universe, living in a little corner of one letter, would never be able to read the whole thing."

But then Linde thought of another channel of communication between creator and creation—the only one possible, as far as he could tell. The creator, by manipulating the cosmic seed in the right way, has the power to ordain certain physical parameters of the universe he ushers into being. So says the theory. He can determine, for example, what the numerical ratio of the electron's mass to the proton's will be. Such ratios, called constants of nature, look like arbitrary numbers to us: There is no obvious reason they should take one value rather than another. (Why, for instance, is the strength of gravity in our universe determined by a number with the digits 6673?) But the creator, by fixing certain values for these dozens of constants, could write a subtle message into the very structure of the universe. And, as Linde hastened to point out, such a message would be legible only to physicists.

"You might take this all as a joke," he said, "but perhaps it is not entirely absurd. It may be the explanation for why the world we live in is so weird. On the evidence, our universe was created not by a divine being, but by a physicist hacker."

Linde's theory gives scientific muscle to the notion of a universe created by an intelligent being. It might be congenial to Gnostics, who believe that the material world was fashioned not by a benevolent supreme being but by an evil demiurge. More orthodox believers, on the other hand, will seek refuge in the question, "But who created the physicist hacker?" Let's hope it's not hackers all the way up.