Thursday, 21 November 2013

What Borgen reveals to me about the philosophy of science

I watched episode two of the third series of Borgen after spending some time thinking about Viviana Zelizer's Economic Lives and the essays in Paul Zak's Moral Markets. This is all in the context of my general project to see if Pragmatic Philosophy has anything to offer with regard to mitigating financial crises.

 The link between Borgen/Zelizer and Zak are the law and race. The Borgen episode was entitled "The land is built on law" and has as a sub-theme the (fictional) Danish government’s attitudes to race. Zelizer writes about how culture drives economics and is related to aspects of Institutional Economics, particularly as put forward by John R Commons, that argue legal structures have a profound effect on economic activity.

 As a graduate in physics from Imperial College I have been trained to be dubious of the intellectual worth of any other discipline from any other institution. For a long time I took the view that "Lawyers start with a case and then gather the evidence, physicists start with the evidence and then build a case", i.e. lawyers are intellectual charlatans and it is an affront to Natural Law that they should, generally, wield more authority than physicists. This, for me, is essentially the same case as put forward by Britain's favourite physicist, Brian Cox, last December. I am an apostate.

What strikes me these days are the historic links between jurisprudence and science. Francis Bacon and Leibnitz were trained lawyers, while as many of the other giants that executed the scientific revolution were theologians or financiers. Scientific vocabulary borrows many legal terms, "proof", "evidence", judgement by "peers" and of particular interest to me, "probability". Mathematicians such as Bernoulli, Condorcet and Poisson, not to mention al-Khwarizmi, all placed legal issues at the centre of their research.

 Zak has put together a series of essays on the biological origins of morals, that is there are certain ethical concepts that are genetically wired into us. I am not a big fan of these biologically inspired arguments, they are a bit too deterministic for me, but I am enjoying the scholarship of the essays.

 What is often in my mind is the Pragmatic concern with the veracity of what physical scientists take to be "Natural Law".. Brian Cox responded to my criticism of his New Statesman article with the tweet:
Recently I read Richard Bernstein's The Pragmatic Turn and learnt about Alain Locke, an African-American philosopher who graduated from Harvard in 1910 when it was under the influence of William James. Locke was (one of the first) people to deny that race was a biological feature, rather it was cultural. Apparently this is the contemporary conventional view: an African American and a Somalian might be classed together racially, but there is a significant chance that the African-American is closer genetically to his white neighbours. Recently there was a lot of amusement when a white supremacist found out he was 14% "black".

Locke' s attitude to race brings to my mind the view, attributed to Stephen Jay Gould, that there is no such ting, biologically, as a fish. The basis of this statement is that genetically, "a salmon is more related to a camel than a hagfish". Gould was a strident opponent of "sociobiology", the view that genes drive human behaviour, and opposed the reductionist views of Richard Dawkins and Steven Pinker.

 My conclusion? I don't think I'm going to be convinced by Zak's collection of essays on the biological origins of ethics. Secondly, something that is apparently as "natural" as the existence of the biological class "fish"; my five year old son would probably group a salmon and hagfish separately from a camel, is actually a very slippery notion. In the end, medieval Danes and contemporary sociologists are probably right: "The land is built on law" or knowledge is built on culture, not "truth" or Nature.

Tuesday, 12 November 2013

Are bankers wasting a good crisis

This post is concerned whether banking culture will change as a consequence of recent financial crises/scandals and offers some material that could help change banker's culture.

There is a group of political scientists and mathematicians at UCL who argue that you should never waste a good crisis, crises which can be used to force structures to re-configure themselves and evolve.  I think they are right, and I often wonder if the fact that Riemann was in Berlin during the 1848 (failed) revolution had an impact on his way of seeing things that enabled him to, so successfully, re-configure geometry in 1853.

I have been thinking about the opportunities that crises present since I received a marketing e-mail from Deloitte at the weekend
Half a decade after the onset of the financial crisis, governments, regulators and senior bankers are pausing to reflect on the causes and how to avoid a repetition. Last year, The Deloitte Bank Survey tackled the subject of deleveraging. ...

The focus of debate has shifted from leverage to standards, values and culture. Many - both inside and outside the industry - now accept that many aspects of the industry’s culture were problematic and senior figures within the industry have acknowledged the need for change.

Deloitte UK has interviewed 41 senior bankers at financial institutions around the world to understand their views on the following questions: 
  1. What were the causes of these cultural problems that manifested themselves during and after the financial crisis
  2. To what extent do cultural problems still exist?
  3. And what can banks do about them?
You can (try to) read the report here.  What grabbed my attention is the emphasis Deloitte places on "culture", and so I read on.

The first finding is that 65% of the sample believe there is a problem, but only half of these see an issue at their own institution.  Three quarters think that compensation was a significant factor in creating the problems, but only a quarter felt their own institution was at fault.

At first sight these results seem wrong, there is agreement on the issue but most people are not taking responsibility.  With a bit of thought though, the results are coherent, if a third of the respondents worked at problem banks it is not unreasonable that two thirds of respondents recognise the fact.  However given the breadth of problems in UK banking - from leverage based speculation, through LIBOR/FX fixing, money laundering at overseas branches,  to retail mis-selling - I think the lay observer of UK banking has a right to raise their eyebrows at the results.

When asked to identify "What went wrong" bankers identified the main causes as poor leadership and incentives, both issues that are within banks' abilities to control and Deloitte sees these issues as being cultural.  Externally, bankers identified issues with light touch regulation but accepted that it was difficult for the regulator to retain the right skills to challenge the banks.

I don't disagree with these observations but I do think they highlight a significant issue.  The system appears to be based on carrots and sticks: rational utility maximisers will attempt to break the system and so have to be constrained by rules and sanctions.  I believe this carrot-stick dynamic is fundamentally unstable, not least because the people chasing the carrots are often faster than those wielding the sticks (the issue of the regulators competencies in complex, dynamic markets).

Deloitte identify the primary solution to the problems that bankers have identified as better performance management, i.e. optimally choosing the right size of carrot to dangle in front of the utility maximising miscreants to ensure that they don't escape the stick.  In conjunction miscreants should be punished, i.e. the stick should hurt them.  Somewhat schizophrenically, bankers  think stronger regulation will be more of a hindrance than a help and that change should come from the top.  This appears schizophrenic because bankers have identified problems with light touch regulation and expect sanctions to hurt, but they don't think the regulators powers should be extended. The resolution might be in keeping the regulations narrow but deep: focusing on specific issues with severe punishments, rather than broad and shallow: principles that cannot be enforced.  Similarly, suggesting change should come from the top has different implications if the respondents see themselves as being part of the 'top', or if they think of themselves as following someone else's lead, in which case they are abrogating responsibility.

Reading the main body of the report what struck me was how little it actually had to say about culture.  It is there but the emphasis is on processes: metrics to drive remuneration and behaviours; remuneration structures (cash or equity, immediate or deferred); communication, the ability for whistle-blowers to alert management and the need for management to "walk -the-talk".  I think the final comment was the most relevant
Leadership training for senior managers was ranked the most important tool to help banks embark on cultural change process, being chosen by 58% of respondents.
I have been thinking a lot about this since meeting with the Charted Institute of Banking: Professional Standards Board in the summer: how do you teach ethics? The word "ethics" comes from the Greek for "habituation", and then became to mean the science of morals (reference), that is, ethics develop in practice and so are a difficult skill to teach in the classroom.  Ethics emerges out of culture "The distinctive ideas, customs, social behaviour, products, or way of life of a particular nation, society, people, or period" (OED 7a) or "The philosophy, practices, and attitudes of an institution, business, or other organization. " (OED 7c) and so to teach ethics you must immerse the student in the right culture.  But this means a culture needs to be created.

As an educator I am troubled with the question of "teaching culture". This is because I know I can train students in the rules of calculus or probability, but my task is much harder; to have the student "internalise" the nature of calculus and probability.  This is difficult even with something as mechanical as calculus, but I would be really interested to understand how people would go about "training" for culture and ethics.  My sense from what Deloitte say is that they believe/hope that by creating the right structures - remuneration and communication - the right culture will grow naturally on the structures.  I am not so convinced of this.

My own view is not that revolutionary: it is the role of the liberal arts.  The dominant theme (in film for example) associated with modern commerce is rapracious greed - Glengarry Glen Ross, Wall Street, Boiler Room, Enron, Margin Call.  Whether we like it or not, Gordon Gekko, like Darth Vader (my son is going through a Star Wars phase), can be an enchanting character but unlike Vader, has a real prototype in Ivan Boesky. While Michael Lewis and Satyajit Das are explicitly critical of the excesses of trading floors, they never the less paint an attractive picture to people who have gone through school and university believing in the moral imperative of winning, whether by coming top of the class, leading the group, sporting success or being taught that the aim of finance is profit maximisation.

More subtle, and more controversial, is the culture of scientism that that I believe has become widespread as the industry has employed more and more science, engineering and mathematics graduates.  These graduates, certainly if they have an narrow English education (like myself), are emerging out of a culture that struggles to appreciate the role of culture in the science they do.  It depresses me how few of my undergraduate and post-graduate students trouble themselves with the nature of commerce and the 'soul' of money.  All to prevalent is the view that commerce is a machine, its agents are like 'atoms', homogeneous and unconscious, and the role of the machine is to optimise the distribution of scarce resources - implicitly assuming there is no radical uncertainty.  Removing these strong assumptions will divorce the practice of commerce from the culture of positivism that science graduates emerge out of.

I think if banks really want to change their cultures they need to fight fire with fire, they need to encourage their employees to absorb books and films that present an alternative view of commerce to the dominant themes they are more likely to come across.  To this end I am building a library of works I think would help science trained financiers develop a stronger culture, and would be interested to know of any others.

  • The Name of the Rose - this was written by Italy's most famous Pragmatic philosopher, Umberto Eco.  As a Pragmatist, Eco endorses scientific thinking while challenging the assumptions of scientism and one of the key messages (for me) is that it is the process, not the results, of enquiry that is important.
  • Decalogue 1 - this is a TV film made by Poland's most famous director Krzysztof KieĊ›lowski, who is noted for making moral parables.  The story is a tragic one of a father and son who place to much faith on computer modelling.
  • Parade's End - this is a quartet of books written by Ford Maddox Ford in the 1920s, though I think only the first two books are relevant and formed the basis of the BBC/HBO dramatisation.  I think the hero of the books, Christopher Tietjens, personifies the virtues of statisticians, emphasising his faithfulness to what he believes is true over what is expedient (in contrast to the adultery of his wife and the ambition of MacMaster).
  • The Merchant of Venice - one of Shakespeare's most famous plays and notoroiously enigmatic.  When I did the play for my 'O-levels' (exams taken at 16) the focus was on the anti-Semitism and the possibilities of a homosexual relationship between Antonio and Bassanio.  Alternative readings on the play focus on the themes of Justice and Love.  ‘Antonio, a merchant of Venice’  characterises Charity, or agape, though his sacrifices for his young friend Bassanio. The view that Antonio and Bassanio were physical lovers is a modern interpretation that does not distinguish storge (familial love, personified by Portia's obidence to her dead father, the deficit between Jessica and her father Shylock), philia (friendship, Portia/Nerissa, Lorenzo/Bassanio, etc), eros (physical love, Portia/Bassanio, Lorenzo/Jessica) and agape (spiritual love, Antonio/Bassanio, Shylock’s deficit), clear themes running through the play. Justice is a constant theme focussed on Portia and the play culminates in a famous court scence that rests on the idea that Shylock will take more than what was contracted to.  Chance also plays a pivotal role in the casket game.
  • The Baroque Cycle - this is a contemporary trilogy written by the 'science fiction' writer Neal Stephenson.  I stumbled across the books but think they are great for intervening topics in science and finance in an entertaining way.  They are less obviously morality tales than the other works but they place an important emphasis on the nature of money and the relationships between scientific and commercial cultures (in the Enlightenment).  They open up the possibilities of exploring the doux-commerce thesis.
  • Athena - my avater is taken from a mosaic representing Minerva (Athena) in the Library of Congress
There are various dimensions for thinking about Athena: her role in the Pandora Myth; as mother to Erichthonius who was regarded as the inventor of money and father of Tyche (Fortuna) -  both stories involve Hephaestus, the god of technology.

Friday, 8 November 2013

The Dark Side of Mathematics

This post starts by discussing the problem of alienation/estrangement of financial counter-parties, and goes on to discuss the role that mathematics has played in this estrangement.

Is default moral?  Noah Smith brought my attention to a post by his colleague Guan Yang reviewing the question of whether default is ethical.  I suspect Noah was prompted to pass this on to me because I had observed that it must be embarrassing for the radical anarchist David Graeber that his argument that "we do not all have to pay our debts" was (almost) being enacted by his ideological opposites associated with the Tea Party advocating US default.

Guan Yang [I assume that Yang has fairly interpreted the sources which I have not read]  lists the main points of the argument, starting with the Deontological point that contracts can be broken, subjects to a payment of compensatory damages: as such default is licit.  Yang suggests this approach is favoured by liberal types as it appears to alleviate misery, however since compensation is due, I cannot see how default can alleviate misery since it does not absolve the borrower from repayment of some sort.   I won't accept an argument that inequality is unjust and so should be corrected by "strategic default" by borrowers, as my mother said and I tell my children: two wrongs don't make a right.

What does absolve the borrower from repaying is if the 'contract' was void, this will be the case if one of the parties (typically the borrower) is not 'competent'.  This is a significant issue in the UK where in 1989 interest rate swaps held by the London Borough of Hammersmith and Fulham were declared ultra vires (beyond the powers) of local government and voided.  UK banks are still hobbled by having to pay compensation for mis-selling insurance products and there are more cases involving small businesses in swaps.  I am not aware of similar cases in the US, whether this is because US banking practice is more conscious of the competence test of US courts expect consumers to be more discerning, I do not know.

The Consequentialist argument is that since default will raise the interest rate across the board, and so an individual's default will damage society as a whole.  Yang summarises the argument as one of social contract, the individual gives up their right to default in exchange for the common benefit of lower borrowing costs.  He associates this approach with Conservatives and libertarians, which is remarkable because it would imply they should adopt similar arguments in other areas, i.e. social insurance, such as Obamacare.  One suspects that Conservatives and libertarians believe rational self-interest dominates coherence here: we can assume wealthy Conservatives suffer when others default, so employ social contract in this case, while contributing to a poor person's healthcare has a similar negative impact on their wealth and so in their rational self-interest they reject social contract arguments.  I believe this sort of muddle is an inevitable consequence of Consequentialist Ethics.

I adopt a Pragmatic/Virtuous approach to solving these sorts of ethical problems.  Virtue Ethics argues that Justice is central to economic performance and so a debt must be repaid, otherwise it is unfair, there is no equality between what was given and what was returned.   But virtues must be Tempered (mixed), and Justice needs to be Tempered with Charity (or benevolence), in particular the lender needs to have a genuine concern for the welfare of the borrower.

This argument is not simply Virtuous, it is Pragmatic, in that it emerges out of practice (in fact the word ethic derives from the Greek for 'habituation').  If you are not convinced of the implicit relevance of Justice and Charity in commerce I suggest you watch The Merchant of Venice as a study of the four natures of love (friendship, family, erotic, benevolent/philia, storge, eros, agape), with Antonio, the Merchant of Venice, personifying Charity/agape and spot the interplay between concepts of love and Justice.

Less abstract is the Quaker attitude to banking.  In the eighteenth and early nineteenth century it was, in the main, Quaker bankers who funded the British Industrial Revolution.  The Quaker approach to lending is captured in the proverb
“Well, Friend”, said the Quaker Banker, “Tell me the answers to these questions so that I may help you in your projects, for you have opportunities: Firstly, how much do you seek to borrow? For how long? And how will you repay the loan plus its interest?" These are the issues all good bankers must explore.
Essential to the process of banking is the question "how will you repay the loan": the lender must understand the borrower.   I would argue that without asking this question the lender cannot establish the competence of the borrower to enter into the loan contract, and so if the lender has not endeavoured to establish this competence, the loan is void.  The question relevant to US policy is how were sub-prime borrowers going to repay the loan and interest? I would argue that it is usurious (i.e. illicit) to see these sub-prime borrowers as profit opportunities if you do not genuinely believe they can re-pay the loan.

I am particularly interested in this idea of enticing people into contracts in order to make profits having just read Jonathan Levy's Freaks of Fortune, a hard to read but fascinating account of the role of life insurance in nineteenth century US society.

In the first half of the book an experience of the abolitionist actuary Elizur Wright in 1844, when he was forty, is described.  Wright was visiting London researching actuarial life tables when he witnessed men standing on an auction block as their life insurance policies were sold.  The men could not afford to keep up the premiums and so would sell the policy to the highest bidder who could afford to pay the premiums until the seller of the policy died, the more destitute the seller of the policy, the higher the price as the buyer would expect not to pay too many premiums until payout.  Wright was shocked to see free-born Englishmen standing on an auction block, as slaves did in the USA, and resolved to legislate that life policies had a surrender value, a price at which the holder could sell the policy back to the insurer if they could not maintain the premium payments.  Calculating the surrender value was not trivial, since premiums were level and did not change through the life of the policy, they were higher than the fair value when the policy holder was young, but lower when they were old.

The mathematics of actuarial science provided objectivity and fairness in calculating the correct premiums and surrender values and helped transform life insurance from speculation on God's will to moral prudence in the face of uncertainty.  In the immediate aftermath of the Civil War (1861-1865), life insurance exploded in the US.  In 1865, life insurers held $85 million in assets, in 1875 (after the disastrous 'Panic of 1873') the figure had quintupled to $435 million (16% per annum growth), reaching  $1,886 million in 1900 (8.8% growth over 35 years).

What caught my interest was that along side this mathematically based industry a 'fraternal' 'counter-movement' emerged.  Insurance is based on the policy holder paying premiums into a fund managed by the insurer, and out of this fund benefits are paid.  The fraternal movement, initiated and exemplified by the Ancient Order of United Workmen, worked on a very different principle.  People would become members of the fraternity on the payment of $1, in the event of a members death the other 1999 members of a fraternal lodge would be 'assessed' for a $1 each, and a $2,000 death benefit would be paid to the dependants of the dead member.

Being a member of a fraternity involved participating in rituals and the fraternal movement was vigorous in preventing any notion of a contractual relationship emerging between member and lodge or the application of actuarial methodologies in the management of the benefit funds.  This was  a popular feature in the aftermath of the Panic and a series of insurance failures of the 1870s.  The aim of the fraternal societies was to replace the corporate insurance principle with a social bond.  Levy explains that the "fraternal society was a decommodified risk community".

When the insurance industry was hauled in front of legislators to defend their actions in  1877, Henry Hyde, the president of the Equitable of New York cast a veil over the industry
There are certain fundamental rules ... which can only be understood by actuaries, and it is impossible for me to go into here
As Levy observes, "Ultimately the certainty was in the science".  Levy also notes that at the time life insurance was seen as being indicative of a progression from society based on "status" to one based on contract.  While scientifically based life insurance provided "certain sums", fraternities only offered "indefinite promises" and a "revolt against multiplication tables".  These arguments seem to ignore the mutual basis of fraternities and the various failures of insures.

While life insurance business was growing rapidly, the 'big three' New York insurers, the Mutual Life, New York Life and the Equitable, introduced tontine policies.  A member of a tontine pays into the fund which has a fixed maturity.  If the member dies before the funds maturity, their share is redistibuted to other members.  Effectively buying a tontine is a bet on your longevity.  It was marketed as a form of financial speculation that offered a benefit to the investor, not just their heirs, but should be hedged with a conventional policy.

Tontines were attractive to insurers because there were fewer restrictions on how the funds in the tontine could be invested-the actuaries could speculate in risky assets. Tontines were dubious, they are fundamentally speculative and explicitly gamble on 'God's providence'.  In 1885 the New York legislators investigated their legality - the response was that  "the only moral/legal obligations that existed were those between two contracting parties" and criticism was unscientific "emotion" that defied actuarial science.

The insurance corporations were becoming behmoth's.  If an insurance policy lapsed (the member stopped paying the premium) the funds became available to the insurer to do as they will.  In 1905 statistics showed that more than half of life policies were lapsing and that the legislated surrender values were essentially worthless.  These funds gave the insurers power on Wall Street and influence with legislators.  Between 1895 and 1905, the Equitable alone provided its Albany (New York state's capital) lobbyist $1.3 million and the impact of this influence was being seen in legislation, such as a New York law that prohibited policyholders demanding an accounting of their tontine funds.

The 1890s also saw a concerted attack on the fraternities.  As early as 1878 the weakness of the fraternal system was exposed when a yellow-fever epidemic menat that the fraternal promises could not be kept in some southern States, but when northern States were asked to support their southern brothers, they refused.  This prompted the creation of a "reserve" fund for the fraternities in the 1880s, which in turn exposed the fraternities to investigation for being un-regulated insurers, how can you have a reserve fund that is not actuarially managed?

My interpretation of the process that Levy describes is that by not holding a reserve fund the fraternities did not become rich on the basis of lapsed policy holders and so could not challenge the legislative power of the insurance companies.  A constellation of forces, the primacy of contract over relationship, profit over benevolence and the authority of mathematics forced the fraternities to morph into insurance corporations. As Levy observes,
the assessment system alone did not mean the societies were benevolent, charitable, institutions, rather than insurance companies.
I am not convinced that this change was a "natural" evolutionary process, survival of the fittest social system.   I believe it came about because the large insurers were able to become powerful by exploiting their policy holders who lapsed their policies, and mathematics was not a neutral player in this process.

I don't think this whole story is of purely historical interest.  Today we are observing the growing phenomenon of peer-to-peer lending and crowdfunding, both phenomena are subject to increasing regulatory scrutiny.  The questions the tale of the fraternal movement raises in my mind is who, exactly, is the regulator protecting? I believe the regulators assume that financial actors must be profit maximisers and therefore need restraining by ex catherdra rules, rather than seeing financial agents as attempting to build a mechanism for communicative action that carries credit in an uncertain environment. In taking this position, incumbents are protected and disruptive initiatives hindered.