tag:blogger.com,1999:blog-40394342024-03-13T06:03:28.872-04:00Rajiv Sethithoughts on economics, finance, crime and identity...Rajivhttp://www.blogger.com/profile/13667685126282705505noreply@blogger.comBlogger175125tag:blogger.com,1999:blog-4039434.post-71930369463295291172021-11-01T10:30:00.003-04:002021-11-01T10:30:41.075-04:00Moved to Substack<p>This post is long overdue. </p><p>About a year ago, I copied over all posts from here to Substack, and have been publishing occasional posts there ever since. Although Substack is being used by many writers as a subscription-based service, it can also be used as an old-fashioned blog that can be read by all without charge. And that's how I plan to use it. You can subscribe (for free) if you like, or just vist the page from time to time: </p><p><a href="https://rajivsethi.substack.com/">https://rajivsethi.substack.com/</a> </p><p>The older posts on substack will link back to this blog, so I'll leave this up indefinitely.
Here are a couple of recent posts:
</p><p><a href="https://rajivsethi.substack.com/p/notes-on-a-remarkable-finding-from">Notes on a Remarkable Finding from Finland</a> </p><p><a href="https://rajivsethi.substack.com/p/kidney-donor-chains">Kidney Donor Chains and the Bad Art Friend</a> </p><p><a href="https://rajivsethi.substack.com/p/prediction-markets-in-a-polarized">Prediction Markets in a Polarized Society </a><br /></p><p>Hope to see (and hear from) you at the new site. </p><p>Rajiv <br /></p><p> </p>Rajivhttp://www.blogger.com/profile/13667685126282705505noreply@blogger.com0tag:blogger.com,1999:blog-4039434.post-32986407207587020922020-03-18T10:15:00.001-04:002020-03-18T10:15:56.324-04:00Time for Individual Accounts at the Fed<div style="text-align: justify;">
As the COVID-19 virus tears through our bodies and our economy, policy makers are struggling to come up with a response that is bold enough to meet the challenge.<br />
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Public health officials have urged us to adopt social distancing and other preventive measures, and to self-quarantine once exposed. Airlines have suspended routes, sports leagues have cancelled seasons, universities have moved classes online, and mayors and governors have mandated closures and cancellations.</div>
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All of this will inflict extraordinary hardship on millions of people, especially on those who fall ill, those who care for them, and those who face layoffs or lost hours. Many businesses small and large face bankruptcy. The S&P 500 index has lost a quarter of its value in a month. People close to retirement age face not just the risk of debilitating illness, but also a sharp loss in the value of their savings.</div>
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In response to the impending calamity, the Federal Reserve made an <a href="https://www.nytimes.com/2020/03/15/business/economy/federal-reserve-coronavirus.html">emergency cut</a> to a key interest rate on Sunday, taking it close to the lower bound of zero, and initiated a large-scale program of asset purchases. Instead of taking comfort in these measures, the stock market <a href="https://www.nytimes.com/2020/03/16/business/stock-market-drops-recap.html">dropped</a> a further dozen percent on Monday, treating the measures as a signal of more bad news to come. </div>
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On Monday Senator Mitt Romney announced a <a href="https://www.romney.senate.gov/romney-calls-urgent-action-additional-coronavirus-response-measureshttps:/www.romney.senate.gov/romney-calls-urgent-action-additional-coronavirus-response-measures">proposal</a> for a monthly income of $1000 for each American adult, “to help ensure families and workers can meet their short-term obligations and increase spending in the economy.” A day later Representative Adam Schiff <a href="https://twitter.com/RepAdamSchiff/status/1239653798425120776?s=20">echoed</a> this proposal and added another $500 per child. Representatives Ro Khanna and Tim Ryan <a href="https://khanna.house.gov/media/press-releases/release-reps-ryan-khanna-propose-cash-infusion-between-1000-6000-help-working">proposed</a> payments as large at $6000 for those below an income threshold. And Treasury Secretary Mnuchin <a href="https://www.washingtonpost.com/us-policy/2020/03/17/trump-coronavirus-stimulus-package/">asserted</a> that the administration was “looking at sending checks to Americans immediately.”</div>
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But sending checks to individuals, who must then cash or deposit them in their commercial bank accounts, is not the best way to implement such policies, especially if they are going to be in place indefinitely. While the post office remains operational and banks remain open for the moment, there may come a time when these services are also disrupted. Furthermore, there are people in relative isolation at locations other than those to which their checks would be mailed. </div>
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One alternative is to have people enter their bank account information on a federal website, as many already do to pay taxes or receive refunds. But a far better system—one that would continue to yield benefits long after this particular calamity is behind us—would involve the creation of an account at the Federal Reserve for every American adult. These accounts could then be credited whenever the need for large-scale transfers of this kind arises. And if we as a society were ever to permanently adopt a universal basic income this would be the ideal mechanism for implementation. </div>
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One of the most significant and enduring benefits of individual accounts at the Fed would be their <a href="http://rajivsethi.blogspot.com/2013/11/the-payments-system-and-monetary.html">absolute safety</a>—unlike accounts at commercial banks, there would be no need to provide deposit insurance to prevent bank runs. Furthermore, the payments system would not be in jeopardy when the next financial crisis arrives, and there would be no need to bail out the banking system simply to ensure that economic transactions are not interrupted. Commercial banks could continue to accept deposits, but much like money market mutual funds today, these would not come with a federal guarantee. And banks could continue to engage in proprietary trading, but would not be able to do so with the help of insured deposits, making the so-called <a href="https://www.nytimes.com/2011/10/22/business/volcker-rule-grows-from-simple-to-complex.html">Volcker Rule</a> superfluous. </div>
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There are also sound reasons to maintain a <a href="https://internationalbanker.com/finance/social-support-financial-architecture-proposal-reform/">universal basic income</a> even after the current crisis has passed.</div>
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International trade allows us to consume goods of greater variety and quality, and at lower cost, than could be produced domestically. But it also results in severe and geographically concentrated disruption. Small towns dependent on one or two large employers can be economically and socially devastated, even as major metropolitan areas thrive. In a study examining the impact of trade with China, David Autor, David Dorn, and Gordon Hanson have <a href="https://www.annualreviews.org/doi/abs/10.1146/annurev-economics-080315-015041">reported</a> that "adjustment to trade shocks is stunningly slow, with local labor-force participation rates remaining depressed and local unemployment rates remaining elevated for a full decade or more after a shock commences." </div>
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The consequences of such disruptions on health and social cohesion can be dire. In their new book <a href="https://press.princeton.edu/books/hardcover/9780691190785/deaths-of-despair-and-the-future-of-capitalism">Deaths of Despair and the Future of Capitalism</a>, Anne Case and Angus Deaton have documented increasing rates of suicide, drug and alcohol poisoning, and chronic diseases in affected communities, together accounting for an increase in midlife mortality. </div>
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The incessant march of technology can have similar effects. Revolutionary advances in natural-language processing, robotics, and autonomous transport have the potential to deliver greater prosperity and improve lives on average, but can also <a href="https://medium.com/basic-income/deep-learning-is-going-to-teach-us-all-the-lesson-of-our-lives-jobs-are-for-machines-7c6442e37a49">throw multitudes out of work</a> in short order. </div>
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As the COVID-19 virus permeates and devastates our communities, it also forces upon us the realization that we are all deeply interconnected and commonly vulnerable. Perhaps this can create conditions for radical change in our economic and financial arrangements. Programs such as Social Security and Medicare have widespread support today in part because they are universal. A basic income and access to our central bank are likewise universal policies that send a message of equal dignity, and this may be exactly the right time to implement them.
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Rajivhttp://www.blogger.com/profile/13667685126282705505noreply@blogger.com0tag:blogger.com,1999:blog-4039434.post-77040907061712301492019-11-03T14:40:00.002-05:002019-11-04T03:16:32.391-05:00Deadly Force: Then and Now<div style="text-align: justify;">
On Wednesday, October 30 there was an extraordinary <a href="https://ssrc-myrdal.s3.amazonaws.com/3d525cfb4bda4dce949ab6a94acfc9d0.pdf">conference</a> at the <a href="https://www.nypl.org/locations/schomburg">Schomburg Center</a>, marking the 75th anniversary of Gunnar Myrdal's American Dilemma. The conference was conceived and organized by <a href="http://www.alondranelson.com/">Alondra Nelson</a> and <a href="https://econ.columbia.edu/econpeople/brendan-oflaherty/">Dan O'Flaherty</a>, and video of the entire event is available in two parts <a href="https://anamericandilemma21c.org/beyond-the-book">here</a> (click on the landing page to see a menu). A companion <a href="https://anamericandilemma21c.org/">digital platform</a> brings to a much wider audience research memoranda written by the many exceptional scholars who worked alongside Myrdal, but who remain largely "hidden figures" to this day. </div>
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Speakers at the conference were limited to ten minutes. My own remarks were based on Chapter 8 of my <a href="https://books.google.com/books?id=scyJDwAAQBAJ">recent book</a> with Dan, which draws on material from the Schomburg archives. The text is reproduced below with a few minor edits and links added (the full session is in the <a href="https://livestream.com/accounts/7326672/events/8866611/videos/198406420">Part 2 recording</a> starting at around 2:50:00):</div>
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I’m so immensely grateful to the organizers for the opportunity to speak on this occasion, with this amazing group of panelists. <br />
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I’d like to speak mostly about crime and policing, which is the topic of my recent book with Dan, and how this work led us to the archives of the Schomburg Center in search of information on the history of police-community relations, and data on the historical use of deadly force. <br />
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As many other panelists have pointed out, American Dilemma was built on the work of dozens of researchers, who painstakingly assembled vast amounts information. Only part of that knowledge made it into print, much of the rest remains largely hidden from view.<br />
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I’ll talk about what Dan and I found in the Schomburg archives in just a few minutes, but let me begin by saying a few words about what we know about police-related homicides today. <br />
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One thing we know is that we don’t know much—there’s still no complete and reliable source of official data on the use of deadly force by police in the United States. <br />
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As Paul Butler has written in his book <a href="https://books.google.com/books?id=5ZpeDwAAQBAJ">Chokehold</a>, the “information about itself that a society collects—and does not collect—is always revealing about the values of that society. We know, as we should, exactly how many police officers are killed in the line of duty. But we do not know, as we should, exactly how many civilians are killed by the police.”<br />
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Even James Comey, when he was FBI Director in 2015, <a href="https://www.washingtonpost.com/national/fbi-director-calls-lack-of-data-on-police-shootings-ridiculous-embarrassing/2015/10/07/c0ebaf7a-6d16-11e5-b31c-d80d62b53e28_story.html">described</a> the absence of official statistics on police homicides as embarrassing, ridiculous, and unacceptable. <br />
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But over the past few years, unofficial statistics have started to be compiled, some by traditional media organizations like the <a href="https://www.theguardian.com/us-news/series/counted-us-police-killings">Guardian</a> and the <a href="https://www.washingtonpost.com/graphics/2019/national/police-shootings-2019/">Washington Post</a>, and others by relatively new online sources like <a href="https://mappingpoliceviolence.org/">Mapping Police Violence</a> and <a href="https://fatalencounters.org/">Fatal Encounters</a>. <br />
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These data only go back a few years, but we can already see a few patterns that I’d like to bring to your attention. </blockquote>
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First, the scale of police killing in the United States far exceeds that in other comparable countries. According to the Guardian data, police kill about 1,100 civilians a year. In contrast, German police kill about 8 and British police about 2. The US population is about three times as large as these countries combined, but the rate of deadly force is more than a hundred times as great. </blockquote>
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Second, there are significant racial and ethnic disparities in exposure to deadly force. The most highly exposed groups are African Americans and Native Americans, followed by Latinos, and the least exposed are whites and Asians. In the Guardian data for example, African Americans are about two and half times as likely to be victims of lethal force relative to white civilians. But these racial and ethnic disparities vary widely by location: in the five largest cities, the ratio of black to white exposure to lethal force ranges from four in Houston to eighteen in Chicago. </blockquote>
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Third, there are staggering differences across states in the incidence of lethal force. The deadliest states have about eight times the rate of lethal force as the safest. Police homicides occur most often in Western states and parts of the South. The eight states with the highest incidence in the Guardian data are New Mexico, Oklahoma, Alaska, Arizona, Wyoming, West Virginia, Colorado, and Nevada. Six of these are in the West, the other two in the South. By contrast, the safest states are in the Northeast. </blockquote>
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Fourth, extremely large differences also exist among the largest cities. New York and Los Angeles are both large, diverse, coastal, and liberal cities with strict gun laws, but every demographic group is much safer in New York than in Los Angeles today. White civilians in Los Angeles are almost four times as likely to be killed by police as those in New York. Latinos in Los Angeles are more than eight times as likely to be killed as those in New York. And Houston is even deadlier for white civilians than Los Angeles. In fact, the differences in overall rates is so great that white residents of Houston are more likely to be killed by police than African Americans in New York City. </blockquote>
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Fifth, and this came as a surprise to us, many states in the South, including the secessionist states of the former confederacy, have smaller racial disparities in exposure to lethal force than states elsewhere. Many of these Southern states have approximate parity between rates of lethal force faced by black and white civilians in the Guardian data. This is true of Mississippi, Alabama, South Carolina, Georgia, Arkansas, and Tennessee for example. <br />
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Bear in mind that these data are very recent and possibly incomplete, so these patterns may not hold up as better data become available. But we can make some tentative comparisons with the 1930s, based on information in the Schomburg archives. <br />
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Among the researchers who did the groundwork for American Dilemma was the sociologist Arthur Raper, who surveyed a large number of police departments by mail about police-related homicides in the five years ending in 1940. A total of 228 departments responded. These departments represented about 13 percent of the national population, and about 20 percent of the national black population at the time. <br />
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According to Raper’s data, police killed roughly four times as many African Americans as lynch mobs did in the 1930s. In fact, police accounted for more African American deaths than all other white Americans combined. This remains approximately true even today. <br />
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Many cities had much higher rates of killing in the 1930s than they do now. Denver, Covington KY, and Jacksonville had rates over fifty per million in the Raper data, and Atlanta, Nashville, Kansas City, and Chattanooga had rates above forty per million. In the Guardian data, only two cities—Miami and Stockton, CA—had rates in this range.<br />
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There are fifty-two cities in Raper’s data that had over 50,000 people in 1940. In this group of cities, the rate at which African Americans were killed by police fell from about twenty per million in 1935–1940 to about ten in 2015–2016. So at least in the South, the incidence of lethal force faced by black civilians has declined, although from an extremely high level. <br />
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One of the points that Dan and I have explored in our book is that fearsomeness and fearfulness are two sides of the same coin. Murder is the only major crime that can be motivated by pure preemption—people sometimes kill simply to avoid being killed first. This makes fearful people dangerous, and fearsome people afraid. When people can be killed with impunity, these effects are amplified and very high rates of killing can arise in a climate of fear. <br />
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In the 1930s fear was rampant—both fear of police and fear by police. Drawing on prior work by H. C. Brearley, Raper observed that between 1920 and 1932, more than half of interracial homicides in which the killer’s identity was known were either slayings of black civilians by white police officers or slayings of white officers by black civilians. Along similar lines, Khalil Muhammad has observed in his pioneering book <a href="https://books.google.com/books?id=N8ypCwAAQBAJ">The Condemnation of Blackness</a> that according to “dozens of letters written by black suspects and convicts to the NAACP in the 1920s, self-defense was one of the most frequently cited causes of interracial homicide of white male citizens and police officers by black men.”<br />
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In fact, one of Raper’s most striking findings is the extremely high rate at which officers in the South were killed in the 1930s when compared with today. Among Raper’s respondents, 1.3 police officers were killed per year per million population, while current rates are between 0.1 and 0.2 per year per million. It seems that officers have become much safer from civilians than civilians have become from officers. <br />
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Since American Dilemma was largely a study of the South, we don’t have comparable historical data for other parts of the country. What we do know, though, is that variations in the use of lethal force across law enforcement agencies are immense. And these differences persist even when one takes into account such factors as gun prevalence, crime intensity, police-civilian contact, arrest rates, and the degree of danger faced by officers themselves. <br />
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It seems that selection, training, leadership, and organizational culture matter a great deal. Put differently, high rates of deadly force arise not from bad apples, but from bad orchards. Certain soils are fertile environments for the growth of practices that result in high rates of killing. We don’t yet have a good understanding of what makes them so. But we do understand that the painstaking work of a team of talented researchers three generations ago, and the efforts to preserve the fruits of their labor right here at the Schomburg Center, will be of enormous help to us as we grapple with these questions.</blockquote>
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An additional and very valuable source of historical information on the use of deadly force in the United States is the Kerner Commission report of 1968. The report is discussed at length in the book, and some of the key lessons are described in an <a href="https://www.themarshallproject.org/2019/05/01/can-understanding-fear-mitigate-police-violence">article</a> that Dan and I wrote for the Marshall Project a few months ago. An <a href="https://www.abc.net.au/radionational/programs/latenightlive/how-stereotyping-affects-crime-and-justice/11055838">interview</a> with Phillip Adams of Late Night Live on ABC (Australia) and a more recent <a href="https://www.wbur.org/hereandnow/2019/10/16/racial-stereotypes-fear-police-excessive-force">conversation</a> with Tonya Mosley on NPR's Here and Now also covers some of this ground. </div>
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The book is about much more than deadly force though; it deals with how stereotypes condition and contaminate all sorts of interactions related to crime and the justice system, including interactions between victims and offenders, officers and suspects, prosecutors and witnesses, judges and defendants, and so on. If you have an hour to spare, this detailed, probing <a href="http://sfnewmexican.libsyn.com/shadows-of-doubt-stereotyping-and-prejudice-in-the-us">conversation</a> with Mary-Charlotte Domandi of the Radio Café podcast covers the essentials and broader implications of the argument. </div>
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And if you happen to be in New York on November 14 and would like to attend a panel on the book, featuring <a href="http://www.columbia.edu/cu/psychology/vpvaughns/vpv-bio.html">Valerie Purdie Greenaway</a>, <a href="https://www.gc.cuny.edu/faculty/core-bios/carla-shedd">Carla Shedd</a>, and <a href="https://sipa.columbia.edu/faculty-research/faculty-directory/suresh-naidu">Suresh Naidu</a>, please stop by, details <a href="http://heymancenter.org/events/celebrating-recent-work-by-brendan-oflaherty-and-rajiv-sethi/">here</a>, no registration required. </div>
Rajivhttp://www.blogger.com/profile/13667685126282705505noreply@blogger.com0tag:blogger.com,1999:blog-4039434.post-39131152156237493462017-09-03T03:05:00.001-04:002017-09-03T03:27:03.569-04:00Innovation in Economics Pedagogy and Publishing<div style="text-align: justify;">
Well, it's Labor Day weekend, which means that Barnard and Columbia students are back on campus and classes are about to begin. This semester I'm teaching a <a href="https://www.dropbox.com/s/2v634z8st5xkrt7/Seminar_Syllabus.pdf">seminar</a> based on a book I'm writing with Dan O'Flaherty, and... Introduction to Economic Reasoning.</div>
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It's my first time teaching an introductory course in well over a decade and, to be honest, I never thought I'd ever do so willingly again. But this time I volunteered, and am excited to start. It's the culmination of an extraordinary journey that began almost five years ago, when Wendy Carlin of UCL contacted me about joining an initiative that eventually led to the <a href="http://www.core-econ.org/">CORE Project</a>. Our first major accomplishment is a new book, <a href="https://fireandlion.com/portfolio/core/">The Economy</a>, produced simultaneously for digital and print:</div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEixgEWzgXmYv19PgMN-zNme4TzEU8VOxutztUDBIZhMvMtjaaqW5t4HdPp5DyDVVK971w0yPtDRCRJWR8sX6Pb6rk9aN2Tdlh4fuL658E2o-x7k1Z2w21kuyZcdHWX1zpQb0IUrhQ/s1600/core-feature.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="553" data-original-width="810" height="271" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEixgEWzgXmYv19PgMN-zNme4TzEU8VOxutztUDBIZhMvMtjaaqW5t4HdPp5DyDVVK971w0yPtDRCRJWR8sX6Pb6rk9aN2Tdlh4fuL658E2o-x7k1Z2w21kuyZcdHWX1zpQb0IUrhQ/s400/core-feature.jpg" width="400" /></a></div>
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The digital version is available free of charge worldwide, released under a Creative Commons license, while the <a href="https://global.oup.com/academic/product/the-economy-9780198810247?cc=us&lang=en">print version</a> sold by Oxford University Press retails for under fifty dollars in the United States, about a sixth of the price of a standard textbook.</div>
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And it's a <i>lot</i> more interesting and fun to read than a standard text. We started from scratch in producing it, incorporating a lot of economic history, data, experiments, and interesting theory – including social preferences, strategic interaction, incomplete information, incomplete contracts, disequilibrium dynamics, and more.</div>
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But the content innovation is just part of the story. Above all, it was an incredible <i>process</i> innovation, involving authorship by <a href="http://www.core-econ.org/the-economy/book/text/0-6-contributors.html#producing-theeconomy">more than twenty scholars</a> scattered across the world, some making contributions to just a couple of units while others (Wendy Carlin, Sam Bowles, and Margaret Stevens) contributed to just about everything and ensured continuity and coherence. My own substantive contributions were to units 11 and 12, on market dynamics and market breakdowns, and to the profiles of some great economists of the past. But we all chipped in here and there, reading and offering minor suggestions wherever our own particular expertise turned out to be an asset.</div>
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And then there's the publishing innovation, which Arthur Attwell describes very nicely <a href="https://fireandlion.com/thinking/2017/08/29/producing-the-economy-with-the-ebw-case-study/">here</a>: </div>
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I’m a book-maker, which, for the most part, means I turn Word
documents and Powerpoint slides into books. These days, my team and I
also turn them into websites and ebooks. To do it well, we draw on 500
years of book-making craft. And very rarely we get to try to add
something to that craft.<br />
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The CORE project – specifically, the production of their textbook <i>The Economy</i>
– has enabled us to do really exciting, perhaps pioneering, book-making
work...<br />
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For over fifteen years, book-makers like me have been pulled in two
directions: you’re a print person or you’re a digital person. This is
largely a practical matter: the skills and tools for each have been
completely different. Which meant the workflows for creating each format
were completely different, as were their distribution channels... the practical matter of skills has framed the evolution of
publishing as ‘print vs digital’, when of course the conversation should
be about print <i>and</i> digital. Not just because we’re stuck with a
multiformat world whether we like it or not, but because print and
digital formats are symbiotic. In ambitious book projects, especially
where we want a book to have a social impact, neither can be successful
without the other.</blockquote>
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Print books generate instant credibility. They carry a sense of permanence and authority that digital formats cannot muster... But print does not scale, and it’s locked into a funding model where the end-user pays for every copy.</blockquote>
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Digital formats, and websites in particular, are the opposite. Web
publications struggle to muster the authority of a printed book, but
they scale instantly and allow for a range of funding models... Books as websites can be
public goods in a way that printed books cannot, especially for the
poor. </blockquote>
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So, when a book needs to make an impact, it simply must be in print
and digital formats. It cannot have impact without the authority of
print. And it cannot have impact without the scale of the web...<br />
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For most book-makers like me, who make print and digital
publications, this has meant creating two versions: the print edition
and the digital edition. The print edition is usually the master, and
the digital version a laborious, post-production conversion. </blockquote>
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This is an expensive process, often done by teams of glorified
copy-pasters. And since most books need to be corrected and updated
after a short time, everything must be done twice, and version control
between the formats is error-prone. </blockquote>
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Clearly the holy grail for book-production workflows is to produce
all formats from one source simultaneously. Many teams have tackled this
challenge. Big incumbents like Adobe have tried valiantly to extend
their print-production tools to produce ready-to-use digital formats,
but their roots in page design are too deep to make this simple or
scalable. And, given the nature of the web and the high costs of
developing software, digital workflows based on proprietary software
don’t spread or become standards. </blockquote>
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For print-and-digital book production to grow we need open-source
tools that produce high-end, print-ready files and sensible websites.
With the CORE project, we are right at the frontier.</blockquote>
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And the production quality has to be seen to believed. The book loads almost instantaneously in a browser, and renders beautifully on a mobile device. And it contains features that make the use of supplementary slides unnecessary. Take a look, for instance, at <a href="http://www.core-econ.org/the-economy/book/text/01.html#figure-1-2">Figure 1.2</a>. You'll notice six slides in the sidebar; click through each of these in turn. You'll see global inequality along three dimensions: within and between countries, and across time. Watch the movement of the entire income distribution in China from 1980 to the present day, as it leapfrogs one set of countries after another. There's no need for ancillary resources, just project the book itself on a screen and talk through it. As Arthur says, we are at the frontier. </div>
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Finally, there's the innovation in outreach, in building a community of adopters, and getting graduate students excited about teaching again. Last month we launched <a href="http://www.core-econ.org/core-usa/">CORE-USA</a>, with a <a href="https://sites.google.com/core-econ.org/workshop-schedule/">workshop</a> involving about twenty graduate students and thirty faculty, funded by a generous grant from the Teagle Foundation. This is the first of several such workshops, one of the primary goals of which is to identify graduate students with strong potential in <i>both</i> teaching and scholarship, and provide them with exposure to the our materials and community. </div>
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These students will be designated CORE-Teagle Fellows, which we hope will provide a strong, positive signal as they enter the academic job market in a year or two. If you're hiring, look out for these pioneers, and if you're a graduate student, consider applying for next year's workshop. And if you'd like to support this initiative, just buy the print version of <a href="https://global.oup.com/academic/product/the-economy-9780198810247?cc=us&lang=en">The Economy</a>. You'll enjoy it, and a small portion of the proceeds will flow to the non-profit that produced it.</div>
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There's some serious disruption going on in economics pedagogy and textbook publishing right now, and it's exciting to be in the thick of things. </div>
Rajivhttp://www.blogger.com/profile/13667685126282705505noreply@blogger.com3tag:blogger.com,1999:blog-4039434.post-32711840140002964602017-03-07T15:02:00.000-05:002017-03-07T21:19:05.774-05:00The Teaching of Economics<div style="text-align: justify;">
In 2013, with funding from the Institute for New Economic Thinking, University College London, Friends Provident Foundation, Azim Premji University (Bangalore) and Sciences Po (Paris), a group of concerned economists created <a href="http://www.core-econ.org/">CORE</a>, the Curriculum Open-Access Resources for Economics. Wendy Carlin from University College London led the initiative, and I was fortunate enough to have been <a href="http://rajivsethi.blogspot.com/2014/09/the-core-project.html">involved</a> from the outset. The group soon grew to encompass a couple of dozen <a href="http://www.core-econ.org/contributors/">members</a> from a broad range of countries including France, Chile, Colombia, Turkey, and India. <br />
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CORE’s vision is that economics should be an inquiry into the fundamental problems facing humanity today and the ways that economic reasoning can address them, not just a training in abstract problem solving. We sought to directly address the problem of a lack of good teaching resources consistent with this vision, and the attendant issues, including limited incentives for faculty and their teaching teams to make use of what is available. <br />
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Since its launch, CORE has successfully begun to produce high-quality resources for the teaching of economics through this global collaboration of scholars, and to distribute these resources free of charge worldwide under a Creative Commons license. Our e-book <a href="http://www.core-econ.org/">The Economy</a>, currently in beta, is being taught as the required introductory course at University College London (UCL), the Toulouse School of Economics, Humboldt University (Berlin), and other top economics departments in Europe. It is also being taught at the Lahore University of Management Sciences, Azim Premji University (Bangalore), the University of Sydney, and Universidad de los Andes (Bogota). More than 2,300 verified instructors have been cleared for access to CORE’s full range of supplementary teaching materials, and over thirty thousand students spread across 78 different countries have registered for access to the e-book. </div>
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As part of its strategy to improve the teaching of economics CORE is now seeking to expand its outreach and impact in the United States. It will do so in collaboration with Barnard College, which has just received a <a href="http://www.teaglefoundation.org/Grants-Initiatives/Grants-Database/Grants/Graduate-Student-Teaching-in-the-Arts-and-Sciences/Transforming-the-Teaching-of-Economics">major award</a> from the Teagle Foundation for exactly this purpose. My department colleagues Homa Zarghamee and Belinda Archibong will join me in directing this effort. <br />
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At the heart of the initiative is a series of workshops involving faculty and graduate students, who will be selected through a competitive application process and provided with stipends and partial reimbursement of travel costs. These workshops will be designed to bring together instructors who already have experience with implementing CORE, and a larger group of potential adopters. The first workshop will be held at Barnard on August 17-19, 2017. We will post a call for applications soon, and are currently in the process of hiring a project manager.<br />
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Among our goals is the creation of a cadre of confident, networked, new PhDs excited about making teaching a fulfilling and central part of their career in economics. Graduate students who complete a workshop will be certified as <i>CORE-Teagle Fellows</i>, a designation that we hope will become a credible signal of commitment to quality teaching among employers, especially liberal arts colleges and public policy schools. We would also like this to be a signal of <i>scholarship</i> potential, and will accordingly screen applicants for exceptional promise in both research and teaching. <br />
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Over the longer term, we also want to identify a set of institutional partners with shared goals for the improvement of economics education and a commitment to the development and use of high quality, open access instructional content. To further these goals, we will launch the <i>CORE Consortium</i>, a membership program for institutions willing to enter into a long-term, multi-year commitment to support faculty and graduate students using CORE, and host workshops on a rotating basis. By the end of the 36-month period covered by the Teagle grant, we hope to have at least half a dozen institutions on board as members, as well as a leadership team and an administrative structure.<br />
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We are enormously grateful to the Teagle Foundation for funding this exciting new initiative. Further updates will follow once a project manager is in place.</div>
Rajivhttp://www.blogger.com/profile/13667685126282705505noreply@blogger.com1tag:blogger.com,1999:blog-4039434.post-38757947932478997502017-03-01T04:10:00.000-05:002017-03-01T05:39:11.331-05:00Reigns of Error<div style="text-align: justify;">
The death of <a href="https://www.nytimes.com/2017/02/21/business/economy/kenneth-arrow-dead-nobel-laureate-in-economics.html?_r=1">Kenneth Arrow</a> has led lots of people to swap stories about their interactions with him. Larry Blume has posted several of these on facebook, including the following response to my own <a href="http://rajivsethi.blogspot.com/2017/02/arrow-edgeworth-and-millicent-garrett.html">contribution</a> (quoted with permission):</div>
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This story is not at all surprising; Ken read everything. I think I mentioned elsewhere that my last conversation with Ken, this past June, concerned <i>The Theory of Moral Sentiments</i>. He and Amartya Sen were taking turns quoting from it, from memory... I could recognize the quotes, but not respond in kind. Once in a conversation about Nash equilibrium and rational expectations, Ken wondered if I had read Merton on expectations - not Robert Jr.: <a href="https://www.jstor.org/stable/4609267">https://www.jstor.org/stable/4609267</a>. He also had a good stock of Shakespeare to call on.</blockquote>
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The link is to a 1948 paper by the great sociologist Robert K. Merton (father of the Nobel-winning economist). Reading anything at all by Merton is an excellent use of one's time, so I went through this paper. It's extraordinary. Not only does Merton provide a very clear account of equilibrium beliefs, but goes on to point out that even when these beliefs are correct in a narrow sense, they can hold in place an incorrect understanding of the social world. To translate this into the contemporary language of economics, Merton points out that the play of equilibrium strategies can go hand in hand with a deeply erroneous understanding of the game. </div>
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Merton begins with an account of a Depression-era bank run that perfectly captures the multiple equilibrium logic he has in mind:</div>
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It is the year 1932. The Last National Bank is a flourishing institution. A large part of its resources is liquid without being watered. Cartwright Millingville has ample reason to be proud of the banking institution over which he presides. Until Black Wednesday. As he enters his bank, he notices that business is unusually brisk. A little odd, that, since the men at the A.M.O.K. steel plant and the K.O.M.A. mattress factory are not usually paid until Saturday. Yet here are two dozen men, obviously from the factories, queued up in front of the tellers' cages. As he turns into his private office, the president muses rather compassionately: "Hope they haven't been laid off in midweek. They should be in the shop at this hour."</blockquote>
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But speculations of this sort have never made for a thriving bank, and Millingville turns to the pile of documents upon his desk. His precise signature is affixed to fewer than a score of papers when he is disturbed by the absence of something familiar and the intrusion of something alien. The low discreet hum of bank business has given way to a strange and annoying stridency of many voices. A situation has been defined as real. And that is the beginning of what ends as Black Wednesday -- the last Wednesday, it might be noted, of the Last National Bank.</blockquote>
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You can see why Arrow saw in this a precursor to the concept of Nash equilibrium, the existence of which would be <a href="http://www.pnas.org/content/36/1/48.full">established</a> just two years later. There are also echoes here of the <a href="http://www.journals.uchicago.edu/doi/abs/10.1086/261155">Diamond and Dybvig</a> model of bank runs, in which the multiple equilibrium nature of the problem finds formal expression. </div>
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But Merton doesn't stop there, he considers how the people expressing the described behavior <i>interpret</i> the situation they are in. And here he observes an important disparity between the manner in which the situation is viewed by the the participants themselves, as compared with its interpretation from the analytical viewpoint of the social scientist:</div>
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The self-fulfilling prophecy is, in the beginning, a <i>false</i> definition of the situation evoking a new behavior which makes the originally false conception come <i>true</i>. The specious validity of the self-fulfilling prophecy perpetuates a reign of error. For the prophet will cite the actual course of events as proof that he was right from the very beginning. (Yet we know that Millingville's bank was solvent, that it would have survived for many years had not the misleading rumor <i>created</i> the very conditions of its own fulfillment.) Such are the perversities of social logic.</blockquote>
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So beliefs are correct in one sense, but at sharp variance with reality in another. Such "reigns of error" are not something we economists pay much attention to, with one very notable exception. </div>
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In his book <a href="https://books.google.com/books?hl=en&lr=&id=jFh33xr7OFAC">The Anatomy of Racial Inequality</a> Glenn Loury discusses the manner in which negative stereotypes about a group can become self-fulfilling through the incentive effects that the stereotypes themselves create. This is the phenomenon of <a href="https://en.wikipedia.org/wiki/Statistical_discrimination_(economics)">statistical discrimination</a>, introduced into the economics literature by none other than Kenneth Arrow. Like Merton, however, Loury is not content to simply identify the kinds of behaviors consistent with equilibrium beliefs. He wants to know how people with these beliefs will interpret the behaviors. And here he deploys the idea of <i>biased social cognition</i>, which can give rise to <i>essentialist causal misattributions</i>.</div>
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That is, behavior arising in equilibrium through the operation of incentives can be interpreted by casual observers as being a consequence of deep differences in character. And this has enormous consequences, since <a href="https://books.google.com/books?lr=&id=jFh33xr7OFAC&q=du+bois#v=snippet&q=%22biased%20social%20cognitions%22&f=false">biased social cognitions</a> can "cause some situations to appear anomalous, disquieting, contrary to expectation, worthy of further investigation, inconsistent with the natural order of things---while other situations appear normal, about right, in keeping with what one might expect, consistent with the social world as we know it."</div>
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Loury has <a href="https://books.google.com/books?hl=en&lr=&id=XpB0DBXhZ0IC">argued</a> elsewhere that the level of mass incarceration currently prevailing in the United States could not possibly be sustained were it not for its racial character. As long as essentialist interpretations of incentive-driven actions continue to be widespread, such high levels of confinement will not be seen as anomalous or disquieting, and will not give rise to urgent calls for action. </div>
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The economic method, for all its flaws, has one very important virtue: it shines a bright light on interests and incentives, and in doing so can challenge essentialist interpretations of social reality. But if this potential is to be realized, it is important to focus not just on the characterization of equilibrium behavior, but also on the reigns of error that distort our mental models of the underlying game.</div>
Rajivhttp://www.blogger.com/profile/13667685126282705505noreply@blogger.com1tag:blogger.com,1999:blog-4039434.post-25984821604889233092017-02-25T21:58:00.000-05:002017-02-25T23:21:08.726-05:00Arrow, Edgeworth, and Millicent Garrett Fawcett<div style="text-align: justify;">
There's not much one can say about <a href="https://www.nytimes.com/2017/02/21/business/economy/kenneth-arrow-dead-nobel-laureate-in-economics.html?_r=0">Kenneth Arrow</a> that hasn't already been said, but there's one personal story that I can add to all the tributes and remembrances. </div>
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I met Arrow just once, at a Stanford <a href="https://dl.dropboxusercontent.com/u/2615082/Blog/Social%20Economics%20Workshop%20Stanford%202008%20Agenda.pdf">conference</a> in April 2008 that he and Matt Jackson jointly organized. While everyone else was seated around the outside of a large ring of tables, Arrow was on the inside, directly in front of the speaker. He was 86 at the time. </div>
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I was first up, presenting an early version of a <a href="http://onlinelibrary.wiley.com/doi/10.1111/jeea.12037/abstract">paper</a> with Sam Bowles and Glenn Loury on group inequality. Arrow interrupted me within the first couple of minutes – not aggressively at all, just seeking clarification about the information structure. Then, during a coffee break after the talk, he asked if I’d read a piece by Millicent Fawcett on gender wage inequality, published in the Economic Journal in 1892. That’s not a typo – he really meant 1892. I confessed that I hadn't. <br />
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Arrow said that Fawcett’s work was extensively discussed in a 1922 <a href="http://www.jstor.org/stable/2223426?seq=1#page_scan_tab_contents">presidential address</a> by Francis Edgeworth, but while many were familiar with the Edgeworth lecture, few had bothered to read Fawcett herself. </div>
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It’s true. Edgeworth mentioned “Mrs. Fawcett” seven times in his address, and cited three separate pieces by her. His lecture was on “Equal Pay to Men and Women for Equal Work,” and one of papers he referenced was “Equal Pay for Equal Work,” <a href="http://www.jstor.org/stable/2222105?seq=1#page_scan_tab_contents">published</a> by Fawcett in 1918. Here’s how the latter begins:</div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhM_0Fbzzt0WCqdVnBaL9G8JEQeLaZ5kXGLW2Qcsft8kAGQ_-1WRnr1U5VQUYzGpBUnsLwstJc7kDuqy7mSUwpg3mEuD79NtdDaJVxVcMCOL3HWnQehJXH4tfQm_tfRBxoW51weQA/s1600/Fawcett+1918.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="312" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhM_0Fbzzt0WCqdVnBaL9G8JEQeLaZ5kXGLW2Qcsft8kAGQ_-1WRnr1U5VQUYzGpBUnsLwstJc7kDuqy7mSUwpg3mEuD79NtdDaJVxVcMCOL3HWnQehJXH4tfQm_tfRBxoW51weQA/s400/Fawcett+1918.png" width="400" /></a></div>
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I didn’t realize it at the time, but <a href="https://en.wikipedia.org/wiki/Millicent_Fawcett">Dame Millicent Garrett Fawcett</a> was every bit as remarkable as Edgeworth and Arrow, and economics was the least of her accomplishments. I imagine that Arrow saw in her a kindred spirit. Rajivhttp://www.blogger.com/profile/13667685126282705505noreply@blogger.com0tag:blogger.com,1999:blog-4039434.post-43702808980314836232016-12-14T17:24:00.001-05:002016-12-15T08:59:25.284-05:00Thomas Schelling, Methodological Subversive<div style="text-align: justify;">
Thomas Schelling <a href="http://www.nytimes.com/2016/12/13/business/economy/thomas-schelling-dead-nobel-laureate.html">died</a> at the age of 95 yesterday.</div>
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At a time when economic theory was becoming virtually synonymous with applied mathematics, he managed to generate deep insights into a broad range of phenomena using only close observation, precise reasoning, and simple models that were easily described but had complex and surprising properties.</div>
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This much, I think, is widely appreciated. But what also characterized his work was a lack of concern with professional methodological norms. This allowed him to generate new knowledge with great freedom, and to make innovations in method that may end up being even more significant than his specific insights into economic and social life. </div>
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Consider, for instance, his famous "checkerboard" model of self-forming neighborhoods, first introduced in a <a href="https://dl.dropboxusercontent.com/u/2615082/Blog/Schelling%201969.pdf">memorandum</a> in 1969, with versions published in a 1971 <a href="http://www.tandfonline.com/doi/abs/10.1080/0022250X.1971.9989794">article</a> and in his 1978 book <a href="https://books.google.co.in/books?id=DenWKRgqzWMC">Micromotives and Macrobehavior</a>. This model is simple enough to be described verbally in a couple of paragraphs, but has properties that are extremely difficult to deduce analytically. It is also among the very earliest <a href="http://rajivsethi.blogspot.in/2010/02/case-for-agent-based-models-in.html">agent-based computational models</a>, reveals some limitations of the equilibrium approach in economic theory, and continues to guide <a href="http://www.jstor.org/stable/25098897?seq=1#page_scan_tab_contents">empirical</a> <a href="http://www.sciencedirect.com/science/article/pii/S0094119014000436">research</a> on residential segregation. </div>
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Here's the model. There is a set of individuals partitioned into two groups; let's call them pennies and dimes. Each individual occupies a square on a checkerboard, and has preferences over the group composition of its neighborhood. The <a href="https://en.wikipedia.org/wiki/Moore_neighborhood">neighborhood</a> here is composed of the (at most) eight adjacent squares. Each person is content to be in a minority in their neighborhood, as long as minority status is not too extreme. Specifically, each wants strictly more than one-third of their neighbors to belong to their own group. </div>
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Initially suppose that there are 60 individuals, arrayed in a perfectly integrated pattern on the board, with the four corners unoccupied. Then each individual in a central location has exactly half their neighbors belonging to their own group, and is therefore satisfied. Those on the edges are in a slightly different situation, but even here each individual has a neighborhood in which at least two-fifths of residents are of their own type. So they too are satisfied. </div>
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Now suppose that we remove twenty individuals at random, and replace five of these, placing them in unoccupied locations, also at random. This perturbation will leave some individuals dissatisfied. Now choose any one of these unhappy folks, and move them to a location at which they would be content. Notice that this affects two types of other individuals: those who were previously neighbors of the party that moved, and those who now become neighbors. Some will be unaffected by the move, others may become happy as a result, and still others may become unhappy. </div>
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As long as there are any unhappy people on the board, repeat the process just described: pick one at random, and move them to a spot where they are content. What does the board look like when nobody wants to move?</div>
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Schelling found that no matter how often this experiment was repeated, the result was a highly segregated residential pattern. Even though perfect integration is clearly a potential terminal state of the dynamic process just described, it appeared to be unreachable once the system had been perturbed. The assumed preferences are tolerant enough to be consistent with integration, but decentralized, uncoordinated choices by individuals appear to make integration fragile, and segregation extremely stable. Here's how Schelling <a href="https://books.google.co.in/books?id=DenWKRgqzWMC">summarized</a> the insight:</div>
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People who have to choose between polarized extremes... will often choose in a way that reinforces the polarization. Doing so is no evidence that they prefer segregation, only that, if segregation exists and they have to choose between exclusive association, people elect like rather than unlike environments.</blockquote>
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One can <a href="https://ccl.northwestern.edu/netlogo/models/Segregation">tune the parameters</a> of the model: the population size and density, or the preferences over neighborhood composition, and see that this key insight is robust. And for reasons discussed in <a href="https://dl.dropboxusercontent.com/u/2615082/Blog/Book%20Chapter%20SFR19_02%20Kirman%20and%20Sethi.pdf">this essay</a>, equilibrium reasoning alone cannot be used to uncover it. </div>
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A very different kind of contribution, but also one with important methodological implications, may be found in Schelling's 1960 classic <a href="https://books.google.co.in/books?id=pS1wCwAAQBAJ">The Strategy of Conflict</a>. Here he considers the adaptive value of pretending to be irrational, in order to make threats or promises credible (emphasis added):</div>
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How can one commit himself in advance to an act that he would in fact prefer not to carry out in the event, in order that his commitment may deter the other party? One can of course bluff, to persuade the other falsely that the costs or damages to the threatener would be minor or negative. More interesting, the one making the threat may pretend that he himself erroneously believes his own costs to be small, and therefore would mistakenly go ahead and fulfill the threat. Or perhaps he can pretend a revenge motivation so strong as to overcome the prospect of self-damage; <i>but this option is probably most readily available to the truly revengeful</i>. </blockquote>
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Similarly, in bargaining situations, "the sophisticated negotiator may find it difficult to seem as obstinate as a truly obstinate man." And when faced with a threat, it may be profitable to be known to possess "<i>genuine</i> ignorance, obstinacy or simple disbelief, since it may be more convincing to the prospective threatener."</div>
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Starting with <a href="http://www.sciencedirect.com/science/article/pii/0022053182900291">three</a> <a href="http://www.sciencedirect.com/science/article/pii/0022053182900308">classic</a> <a href="http://www.sciencedirect.com/science/article/pii/002205318290031X">papers</a> in the same 1982 issue of the <i>Journal of Economic Theory</i>, a large literature in economics has dealt with the implications for rational behavior of interacting
with parties who, with small likelihood, may not be rational. While this work has focused on characterizing rational responses to irrationality, Schelling's point speaks also to <i>payoffs</i>, and raises the possibility that departures from rationality may have <i>adaptive value</i>. </div>
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The methodological implications of this are profound, because the idea calls into question the normal justification for assuming that economic agents are in fact fully rational. Jack Hirshleifer explored the implications of this in a <a href="https://scholar.google.co.in/scholar?cluster=15212629481770293245&hl=en">wonderful paper</a> on the adaptive value of emotions, and Robert Frank wrote an <a href="https://books.google.co.in/books?id=xXtrQgAACAAJ&dq=passions+within+reason&hl=en">entire book</a> about the topic. But the idea is right there, hidden in plain sight, in Schelling's parenthetical comments. </div>
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Finally, consider Schelling's burglar paradox, also described in <i>The Strategy of Conflict</i>:</div>
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If I go downstairs to investigate a noise at night, with a gun in my hand, and find myself face to face with a burglar who has a gun in his hand, there is a danger of an outcome that neither of us desires. Even if he prefers to just leave quietly, and I wish him to, there is danger that he may think I want to shoot, and shoot first. Worse, there is danger that he may think that I think he wants to shoot. Or he may think that I think he thinks I want to shoot. And so on. "Self-Defense" is ambiguous, when one is only trying to preclude being shot in self-defense.</blockquote>
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Sandeep Baliga and Tomas Sjöström have <a href="http://restud.oxfordjournals.org/content/71/2/351.short">shown</a> exactly how such reciprocal fear can lead to a fatal unraveling, and explored the enormous consequences of allowing for pre-play communication in the form of cheap talk. And I have <a href="http://rajivsethi.blogspot.in/2012/06/reciprocal-fear-and-castle-doctrine.html">previously discussed</a>
the importance of this reasoning in accounting for variations in
homicide rates across time and space, as well as the effects of
Stand-your-Ground laws. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
There are a handful of social scientists whose impact on my own work is so profound that I can't imagine what I'd be writing if I hadn't come across their work. Among them are <a href="http://bloggingheads.tv/videos/30467">Glenn Loury</a>, <a href="http://www.booksandideas.net/Elinor-Ostrom-Fighting-the-Tragedy-of-the-Commons.html">Elinor Ostrom</a>, and Thomas Schelling. I can think of at least five papers: on <a href="http://www.jstor.org/stable/10.1086/424742">segregation</a>, on variations in homicide across <a href="http://www.nber.org/chapters/c11847.pdf">regions</a> and <a href="http://www.sciencedirect.com/science/article/pii/S0094119010000343">communities</a>, on <a href="http://www.sciencedirect.com/science/article/pii/S0899825603000290">reputation</a> in bargaining, and on <a href="http://www.sciencedirect.com/science/article/pii/0167268195000534">social norms</a>, that flow directly from Schelling's thought. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
It may surprise some to know that Glenn Loury's <a href="https://books.google.co.in/books?id=jFh33xr7OFAC">Du Bois lectures</a> are dedicated to Schelling, but it makes perfect sense to me. Here's how Glenn explains his choice in the preface:</div>
<div style="text-align: justify;">
<blockquote class="tr_bq">
Shortly after arriving at Harvard in 1982 as a newly appointed Professor of Economics and of Afro-American Studies, I begin to despair of the possibility that I could successfully integrate my love of economic science with my passion for thinking broadly and writing usefully about the issue of race in contemporary America. How, I wondered, could one do <i>rigorous</i> theoretical work in economics while remaining relevant to an issue that seems so fraught with political, cultural and psychological dimensions? Tom Schelling not only convinced me that this was possible; he took me by the hand and showed the way. The intellectual style reflected in this book developed under his tutelage. My first insights into the problem of "racial classification" emerged in lecture halls at Harvard's Kennedy School of Government, where, for several years in the 1980s, Tom and I co-taught a course we called "Public Policies in Divided Societies." Tom Schelling's creative and playful mind, his incredible breadth of interests, and his unparalleled mastery of strategic analysis opened up a new world of intellectual possibilities for me. I will always be grateful to him.</blockquote>
</div>
<div style="text-align: justify;">
As, indeed, will I. </div>
Rajivhttp://www.blogger.com/profile/13667685126282705505noreply@blogger.com0tag:blogger.com,1999:blog-4039434.post-91579290252156206912016-11-02T02:13:00.000-04:002016-11-02T03:24:05.745-04:00The Prediction Market Paradox<div style="text-align: justify;">
There’s a reason why campaigns are eager to publicize polls that show them ahead, while downplaying those in which they happen to be trailing. The perception that a candidate is losing can depress donations and volunteer effort, and lower morale and turnout among supporters. Hence polls that show tightening of a race are <a href="http://www.tandfonline.com/doi/abs/10.1080/10584609.1994.9963048">often advertised</a> as indicators of momentum by the trailing party, and as outliers by the leader. The actual likelihood of victory is not independent of beliefs about this likelihood. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
This gives rise to what might be called a prediction market paradox. If prices are widely believed to accurately reflect underlying probabilities, then there is an incentive for <a href="http://rajivsethi.blogspot.in/2013/09/the-romney-whale.html">deep-pocketed partisans</a> to try and manipulate these prices at the margin. But if the possibility of manipulation is salient and prices are treated with skepticism, then incentives to manipulate are weakened and prices will in fact be quite accurate reflections of underlying beliefs.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
An interesting illustration of this phenomenon is the recent decision by PredictIt to post an <a href="https://www.predictit.org/Home/Election2016">electoral college map</a>, updated by the minute, that aggregates probabilities derived from all its state level markets. Here's what the map looks like at the moment:</div>
<div style="text-align: center;">
<br /></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgbD4KGKeewrLU-IMPTCFL-4Ns9B97zmaAVuxsfgncFxG1ArMWrTjnXHcczUMugp0FI4veuGDUsTaSpezn1-VIDQuJUJerLvc3BOuJuomJGM28XoCIXaOPMsQ7RogBB_OTrCkA-mg/s1600/Screen+Shot+2016-11-02+at+10.00.03+AM.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="301" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgbD4KGKeewrLU-IMPTCFL-4Ns9B97zmaAVuxsfgncFxG1ArMWrTjnXHcczUMugp0FI4veuGDUsTaSpezn1-VIDQuJUJerLvc3BOuJuomJGM28XoCIXaOPMsQ7RogBB_OTrCkA-mg/s400/Screen+Shot+2016-11-02+at+10.00.03+AM.png" width="400" /></a></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
There are seven categories: the safe, likely, and leaning states for each candidate and one toss-up category. States shift across categories as prediction market prices cross the relevant thresholds. This way, a broad range of probability assessments is mapped onto a much coarser set that is easy to visualize and process. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
But this creates the possibility that small changes in price, of the order of one cent, can lead to reassignments across categories that generate a very different picture. The incentives to manipulate prices is amplified whenever such categorical switches are feasible.</div>
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<br /></div>
<div style="text-align: justify;">
Of course these incentives apply to both sides of the market, with some traders wishing to shift states to the left while others are pushing to the right. As a result, an unusually large number of states may be expected to bounce back and forth across boundaries, and to remain within a narrow band of prices close to those selected (somewhat arbitrarily) by the exchange as thresholds.</div>
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<br /></div>
<div style="text-align: justify;">
This seems to be what we are seeing. The boundary between the lean and likely Clinton states is determined by a 75% threshold, and we see four states (Wisconsin, Michigan, Colorado, and Pennsylvania) all within a point or two of this. Here are those above the threshold:</div>
<div style="text-align: center;">
<br /></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjExZMgVNjjNg9RWDMGUEqBpMM9cXUvfieJtS15fucdoen_A-6Z0KhZTfiebBPHMBSMbApOqKiTGtWsQkYTKmxV-r8u-U0ZrKJI4EHMhBHJknB_Die621VfQO43FEQbPGuiR6DDNw/s1600/Screen+Shot+2016-11-02+at+9.59.41+AM.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="200" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjExZMgVNjjNg9RWDMGUEqBpMM9cXUvfieJtS15fucdoen_A-6Z0KhZTfiebBPHMBSMbApOqKiTGtWsQkYTKmxV-r8u-U0ZrKJI4EHMhBHJknB_Die621VfQO43FEQbPGuiR6DDNw/s200/Screen+Shot+2016-11-02+at+9.59.41+AM.png" width="191" /></a></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
And those below:</div>
<div style="text-align: justify;">
<br /></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhMQPoFNXO8OE_nah5Chtx3NrDlgytX6yO36nlOhJUuO6vm6Kn0CRhk11fx65f-Gu61U3DPX_JXWW43hkfd3QBmeQZQ6GQ8qbZwbVc282NdSroI6xzLLVzYVVdgMbJH3eFf0vU1Vw/s1600/Screen+Shot+2016-11-02+at+9.59.31+AM.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="120" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhMQPoFNXO8OE_nah5Chtx3NrDlgytX6yO36nlOhJUuO6vm6Kn0CRhk11fx65f-Gu61U3DPX_JXWW43hkfd3QBmeQZQ6GQ8qbZwbVc282NdSroI6xzLLVzYVVdgMbJH3eFf0vU1Vw/s200/Screen+Shot+2016-11-02+at+9.59.31+AM.png" width="200" /></a></div>
<div style="text-align: center;">
<br /></div>
<div style="text-align: justify;">
New Hampshire is not far from the boundary either. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
All this could be just coincidence, but if one looks at probabilistic forecasts from other sources, there is no such pattern. The New York Times <a href="http://www.nytimes.com/interactive/2016/upshot/presidential-polls-forecast.html?_r=0">conveniently collects</a> six probabilistic forecasts including it's own, with the current picture looking like this:</div>
<div style="text-align: center;">
<br /></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgKObicqKvmVDPe7WZKdGK-r62G_954GwiGbidy-PzgYycJiaJKC8_-0nDzu7zp0NRzfTLfsrRE-ktlUxMwdtdW2dplpV3xmlaU3nox9arvyKGpAWyy_jDeCB9ATJxA6s41bUubQg/s1600/Screen+Shot+2016-11-02+at+11.06.51+AM.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="160" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgKObicqKvmVDPe7WZKdGK-r62G_954GwiGbidy-PzgYycJiaJKC8_-0nDzu7zp0NRzfTLfsrRE-ktlUxMwdtdW2dplpV3xmlaU3nox9arvyKGpAWyy_jDeCB9ATJxA6s41bUubQg/s400/Screen+Shot+2016-11-02+at+11.06.51+AM.png" width="400" /></a></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
These forecasts (from the Times, FiveThirtyEight, Huffington Post, Predictwise, Princeton Election Consortium and Daily Kos respectively) don't appear to be clustered around the PredictIt thresholds at all.<br />
<br />
Still, the evidence is anecdotal at best, and a proper analysis would have to look for a discontinuity in prices around the time that the map was created, with a clustering of prices around boundary points that could not be accounted for by random chance alone. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Meanwhile, some caution is probably warranted in interpreting prediction market data. This is a case in which the ease of visualization, aggregation and dissemination of data can have an impact on the underlying measurements themselves, and indeed on the objective probabilities that the measures are intended to reflect.</div>
Rajivhttp://www.blogger.com/profile/13667685126282705505noreply@blogger.com1tag:blogger.com,1999:blog-4039434.post-49906624145788284172016-09-23T02:53:00.002-04:002016-09-23T10:05:33.232-04:00Thine Every Flaw<div style="text-align: justify;">
There’s a verse in <a href="https://en.wikipedia.org/wiki/America_the_Beautiful#Lyrics">America the Beautiful</a> that I absolutely adore; it represents for me the very best traditions of my adopted country:</div>
<div style="text-align: justify;">
<blockquote class="tr_bq">
America! America!<br />
God mend thine ev’ry flaw,<br />
Confirm thy soul in self-control,<br />
Thy liberty in law.</blockquote>
</div>
<div style="text-align: justify;">
I’ve been thinking about these words a lot over the past year or so, as the election season has revealed just how divided and how lacking in common purpose we are as a nation. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
It's glaringly obvious that international trade, migration, and technological progress have brought enormous benefits to many of us. Our handheld devices are more powerful than the computers that launched our first satellites into orbit. Our system of higher education remains a magnet for eager students from every corner of the world, in part because we have attracted and retained the finest research talent. We are on the verge of a revolution in transportation and urban form as driverless cars make their presence felt. Our cultural products—movies and music among them—continue to attract strong global demand. And our Olympic medal winners encompass many different identities, religions, and countries of origin.</div>
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<br /></div>
<div style="text-align: justify;">
But globalization and technological progress have also left in their wake economic devastation and social disintegration across large swathes of the country that were previously prosperous and stable. The kind of deprivation once confined to inner cities—and tolerated for decades by the rest of society—is now pervasive in once-thriving industrial areas. In his recent and acclaimed <a href="https://books.google.co.in/books?id=bKmpCgAAQBAJ">memoir</a>, JD Vance laments the decline of Middletown, Ohio from a proud and bustling steel town to "a relic of American industrial glory," with abandoned shops and broken windows, derelict homes, druggies and dealers, and places to be avoided after dark.</div>
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<br /></div>
<div style="text-align: justify;">
Anne Case and Angus Deaton have <a href="http://www.pnas.org/content/112/49/15078.abstract">reported</a> a startling increase in midlife mortality among white Americans without a college degree, "largely accounted for by increasing death rates from drug and alcohol poisonings, suicide, and chronic liver diseases and cirrhosis." Stratification by sex <a href="http://www.pnas.org/content/113/7/E816.full">reveals</a> that this phenomenon has hit white working class women especially hard. Trends in criminal justice tell a similar story: the <a href="https://sanukriti.wordpress.com/2016/08/10/female-prisoners-in-the-united-states/">incarceration rate</a> for white women has risen by a staggering fifty percent since 2000, while that for black women has fallen more than 30%. Similar, but much less striking trends are in evidence for males. </div>
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<br /></div>
<div style="text-align: justify;">
All this has led to what Dani Rodrik calls the <a href="https://www.socialeurope.eu/2016/03/the-politics-of-anger/">politics of anger</a>. In its American incarnation, this anger has lifted to the helm of a major political party a man who has apparent contempt for the greatest of our traditions: due process even for those accused of the most heinous crimes, the prohibition of cruel and unusual punishment, and freedom from discrimination on the basis of religion or race. He lacks the self-control for which the verse above pleads, and his appeal to liberty and law is opportunistic and entirely self-serving.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
This has been too much for some in his own party to stomach. Meg Whitman, a Republican candidate for Governor of California as recently as 2010, has been <a href="http://www.nytimes.com/2016/08/03/us/politics/meg-whitman-hillary-clinton.html">actively campaigning</a> for Hillary Clinton. And if <a href="http://www.nytimes.com/2016/09/21/us/politics/elder-bush-plans-to-vote-for-hillary-clinton-a-kennedy-says.html">unconfirmed reports</a> are to be believed, former president George H.W. Bush intends to vote for her too. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
But even if we manage to dodge this bullet in November, the conditions that have fueled Trump's rise will remain in place, and the anger will intensify rather than abate. Something has got to be done to prevent our social fabric from fraying further. But what?</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Perhaps protectionist and exclusionary policies can provide some measure of short term relief, but much of the dislocation that results from globalization is also a consequence of technological progress, and giving up on the latter is a recipe for economic suicide. Targeted interventions that support retraining and transition to growing sectors of the economy have to be part of the solution, but these are piecemeal efforts with varying effectiveness and the potential for bureaucratic mismanagement.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
An alternative approach is to target inequality and poverty directly, through cash transfer schemes such as a universal basic income or a negative income tax. But payments such as these are not contingent on the performance of the economy as a whole, and therefore provide no incentives for people to support policies that are beneficial in the aggregate but impose costs on them as individuals. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
What we need is a distributive mechanism that allows for all to
benefit when the country benefits. Debraj Ray has recently proposed something along these lines, a <a href="http://debrajray.blogspot.in/2016/07/the-universal-basic-share.html">universal basic share</a>. This is simply a share of nominal GDP, the value of which will ebb and flow with the nation's aggregate income. Aside from some obvious advantages relative to a basic income, such as the absence of any need for indexation, this would give all citizens a stake in the prosperity of the country as a whole.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
How might such a scheme be implemented? I have <a href="http://rajivsethi.blogspot.in/2013/11/the-payments-system-and-monetary.html">previously proposed</a> the creation of individual accounts at the Federal Reserve for every citizen, including minors, which could be credited with the profits of open market operations. These profits are currently transferred to the Treasury. Any shortfall relative to the basic income share would then have to be made up by transfers from the Treasury to the Fed. One considerable benefit of such accounts is that they would do away with the need for deposit insurance, and would remove at a stroke the implicit subsidy that such insurance provides for proprietary trading at commercial banks. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Policies of this kind already exist. For instance, the <a href="http://www.apfc.org/home/Content/aboutFund/aboutPermFund.cfm">Alaska Permanent Fund</a> collects and invests a portion of the revenue from mineral leases, and periodically distributes dividends to all qualified residents of the state.</div>
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<br /></div>
<div style="text-align: justify;">
The hope is that an initiative such as this can distribute more evenly the benefits from policies that raise aggregate incomes, whether through trade, migration, or technological progress. This ought to mitigate the political obstacles to the implementation of such policies. And perhaps the sense of common ownership will help bridge some of the deep divisions that have become so salient during this electoral season. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Through his rhetoric, Donald Trump has
emboldened and empowered some of the most virulently racist and
anti-Semitic elements in our society. Just take a look, for instance, at
the <a href="https://storify.com/dsallentess/trumpsupporters">messages received</a> on twitter by the political theorist Danielle Allen, in response to her concerns about a Trump nomination. They are disheartening in the extreme. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
But Trump has the support of about 40% of registered voters, which in <a href="https://twitter.com/rajivatbarnard/status/774552623139655680">my estimation</a> is about 88 million people or 36% of the adult population. While many of them may hold views on some matters that are immensely distasteful and deeply hurtful to others, I think that JD Vance is <a href="http://www.nytimes.com/2016/09/22/opinion/when-it-comes-to-baskets-were-all-deplorable.html">right</a> to point out that it is "difficult in the abstract to appreciate that those with morally objectionable viewpoints can still be good people." </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
I have been an American for just six years, and it is far too soon for me write off so substantial a fraction of my fellow citizens. Call it the naive optimism of the newly naturalized if you like, but I really do think that we can get past this. With or without divine intervention, we can mend our individual and collective flaws.</div>
Rajivhttp://www.blogger.com/profile/13667685126282705505noreply@blogger.com6tag:blogger.com,1999:blog-4039434.post-79074317771283482632016-07-21T08:54:00.000-04:002016-07-21T10:32:00.606-04:00A Fallacy of Composition<div style="text-align: justify;">
Peter Moskos is a sociologist by training, a professor at John Jay College of Criminal Justice, and a former Baltimore City police officer. In <a href="http://www.copinthehood.com/2016/07/philando-castile.html">responding</a> to the shooting of Philando Castile, he had this to say:</div>
<div style="text-align: justify;">
<blockquote class="tr_bq">
Honestly, in this shooting, with this cop, in this locale, I don't think there's a chance in hell Castile would have been shot had he been white. </blockquote>
</div>
<div style="text-align: justify;">
Nor did he think this was an entirely isolated incident; it reminded him of the (non-fatal) <a href="https://youtu.be/RBUUO_VFYMs">shooting</a> of Levar Jones by Sean Groubert at a traffic stop in South Carolina. I had exactly the <a href="http://rajivsethi.blogspot.com/2016/07/deadly-stereotypes.html">same reaction</a> when I saw the Castile video, as did <a href="http://talkingpointsmemo.com/edblog/how-does-this-happen">others</a>. Even the Governor of Minnesota <a href="http://www.nytimes.com/video/us/100000004518473/governor-vows-justice-in-castile-death.html">conceded</a> that the shooting "probably would not have happened if he were white."</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
And yet, Moskos was <a href="http://www.copinthehood.com/2016/07/reducing-police-involved-shooting.html">unsurprised</a> by Roland Fryer's <a href="http://www.nytimes.com/2016/07/12/upshot/surprising-new-evidence-shows-bias-in-police-use-of-force-but-not-in-shootings.html?smid=tw-upshotnyt&smtyp=cur&_r=0">recent claims</a> of an absence of racial bias in police shootings:</div>
<div style="text-align: justify;">
<blockquote class="tr_bq">
I was not surprised by Fryer's conclusions... if one wishes to reduce police-involved shootings... there are good liberal reasons to de-emphasize the significance of race in policing.<br />
<br />
Jonathan Ayers, Andrew Thomas, Diaz Zerifino, James Boyd, Bobby Canipe, Dylan Noble, Dillon Taylor, Michael Parker, Loren Simpson, Dion Damen, James Scott, Brandon Stanley, Daniel Shaver, and Gil Collar were all killed by police in questionable to bad circumstances... What they have in common is none were black and very few people seemed to know or care when they were killed. </blockquote>
</div>
<div style="text-align: justify;">
Moskos is not arguing here that the police can do no wrong; he is arguing instead that in the aggregate, whites and blacks are about equally likely to be victims of bad shootings. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
How can these two views be reconciled? If there is bias in individual incidents, ought it not to show up in aggregate data? Doesn't the congruence between the racial composition of arrestees nationwide and the racial composition of victims of police killings indicate an absence of bias, as Sendhil Mullainathan <a href="http://www.nytimes.com/2015/10/18/upshot/police-killings-of-blacks-what-the-data-says.html">claimed</a> a few months ago?</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
I have <a href="http://rajivsethi.blogspot.com/2015/10/threats-perceived-when-there-are-none.html">argued previously</a> that it does not, because of systematic differences in the qualitative nature of encounters. If police initiate more encounters with blacks that are not objectively threatening (but may in some cases be subjectively perceived to be threatening) then parity in killings per encounter can indicate the presence rather than absence of bias. As Andrew Gelman put it at the time, it's <a href="http://andrewgelman.com/2015/10/21/its-all-about-the-denominator-and-rajiv-sethi-and-sendhil-mullainathan-in-a-statistical-debate-on-racial-bias-in-police-killings/">all about the denominator</a>. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
But Moskos offers another, quite different reason why bias in individual incidents might not be detected in aggregate data: large <i>regional variations</i> in the use of lethal force. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
To see the argument, consider a simple example of two cities that I'll call Eastville and Westchester. In each of the cities there are 500 police-citizen encounters annually, but the racial composition differs: 40% of Eastville encounters and 20% of Westchester encounters involve blacks. There are also large regional differences in the use of lethal force: in Eastville 1% of encounters result in a police killing while the corresponding percentage in Westchester is 5%. That's a total of 30 killings, 5 in one city and 25 in the other. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Now suppose that there is racial bias in police use of lethal force in <i>both</i> cities. In Eastville, 60% of those killed are black (instead of the 40% we would see in the absence of bias). And in Westchester the corresponding proportion is 24% (instead of the no-bias benchmark of 20%). Then we would see 3 blacks killed in one city and 6 in the other. That's a total of 9 black victims out of 30. The black share of those killed is 30%, which is precisely the black share of total encounters. Looking at the aggregate data, we see no bias. And yet, by construction, the rate of killing per encounter reflects bias in both cities. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
This is just a simple example to make a logical point. Does it have empirical relevance? Are regional variations in killings large enough to have such an effect? Here is Moskos <a href="http://www.copinthehood.com/2016/07/reducing-police-involved-shooting.html">again</a>:</div>
<div style="text-align: justify;">
<blockquote class="tr_bq">
Last year in California, police shot and killed 188 people. That's a rate of 4.8 per million. New York, Michigan, and Pennsylvania collectively have 3.4 million more people than California (and 3.85 million more African Americans). In these three states, police shot and killed... 53 people. That's a rate of 1.2 per million. That's a big difference.<br />
<br />
Were police in California able to lower their rate of lethal force to the level of New York, Michigan, and Pennsylvania... 139 fewer people would be killed by police. And this is just in California... If we could bring the national rate of people shot and killed by police (3 per million) down to the level found in, say, New York City... we'd reduce the total number of people killed by police 77 percent, from 990 to 231! </blockquote>
</div>
<div style="text-align: justify;">
This is a staggeringly large effect. </div>
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<br /></div>
<div style="text-align: justify;">
Additional evidence for large regional variations comes from a recent <a href="http://policingequity.org/research/1687-2/">report</a> by the Center for Policing Equity. The analysis there is based on data provided voluntarily by a dozen (unnamed) departments. Take a close look at Table 6 in that document, which reports use of force rates per thousand arrests. The medians for lethal force are 0.29 and 0.18 for blacks and whites respectively, but the largest recorded rates are much higher: 1.35 for blacks and 3.91 for whites. There is at least one law enforcement agency that is killing whites at a rate more than 20 times greater than that of the median agency.</div>
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<br /></div>
<div style="text-align: justify;">
On the reasons for these disparities, one can only <a href="http://www.copinthehood.com/2016/07/reducing-police-involved-shooting.html">speculate</a>:</div>
<div style="text-align: justify;">
<blockquote class="tr_bq">
I really don't know what some departments and states are doing right and
others wrong. But it's hard for me to believe that the residents of
California are so much more violent and threatening to cops than the
good people of New York or Pennsylvania. I suspect lower rates of lethal
force has a lot to do with recruitment, training, verbal skills,
deescalation techniques, not policing alone, and more restrictive gun
laws. </blockquote>
Moskos expands on these points in a recent <a href="http://bloggingheads.tv/videos/42759">conversation</a> with Glenn Loury.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
All of this must be interpreted with caution, since the information we have available is so patchy and deficient. As I wrote in a recent <a href="http://thehill.com/blogs/congress-blog/judicial/288204-police-brutality-drivers-impossible-to-uncover-without-accurate">opinion piece</a> with Willemien Kets, there is a desperate need for better data, collected and distributed in a comprehensive and uniform manner. Without this we are just groping in the dark. </div>
Rajivhttp://www.blogger.com/profile/13667685126282705505noreply@blogger.com0tag:blogger.com,1999:blog-4039434.post-51538323011205787602016-07-14T04:15:00.000-04:002016-07-14T14:18:47.447-04:00On Arrest Filters and Empirical Inferences<div style="text-align: justify;">
I've been thinking a bit more about Roland Fryer's <a href="http://www.nber.org/papers/w22399">working paper</a> on police use of force, prompted by <a href="https://twitter.com/europile/status/753280134665347073">this thread</a> by Europile and excellent posts by <a href="https://scatter.wordpress.com/2016/07/11/yes-there-is-racial-bias-in-police-shootings/">Michelle Phelps</a> and <a href="http://www.mtv.com/news/2903957/why-its-so-hard-to-measure-racial-bias-in-police-shootings/">Ezekeil Kweku</a>. </div>
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<br /></div>
<div style="text-align: justify;">
The Europile thread contains a quick, precise, and insightful summary of the empirical exercise conducted by Fryer to look for racial bias in police shootings. There are two distinct pools of observations: an arrest pool and a shooting pool. The arrest pool is composed of "a random sample of police-civilian interactions from
the Houston police department from arrests codes in which lethal force is more likely to be justified:
attempted capital murder of a public safety officer, aggravated assault on a public safety officer,
resisting arrest, evading arrest, and interfering in arrest." The shooting pool is a sample of interactions that resulted in the discharge of a firearm by an officer, also in Houston. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Importantly, the latter pool is not a subset of the former, or even a subset of the set of arrests from which the former pool is drawn. Put another way, had the interactions in the shooting pool been resolved without incident, many of them would never have made it into the arrest pool. Think of the <a href="http://www.nytimes.com/video/us/100000004517374/deadly-police-shooting-in-minnesota.html">Castile traffic stop</a>: had this resulted in a traffic violation or a warning or nothing at all, it would not have been recorded in arrest data of this kind. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
The analysis in the paper is based on a comparison between the two pools. The arrest pool is 58% black while the shooting pool is 52% black, which is the basis for Fryer's claim that blacks are <i>less</i> likely to be shot by whites in the raw data. He understands, of course, that there may be differences in behavioral and contextual factors that make the black subset of the arrest pool different from the white, and attempts to correct for this using regression analysis. He reports that doing so "does not significantly alter the raw racial differences."</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
This analysis is useful, as far as it goes. But does this really imply that the video evidence that has animated the black lives matter movement is highly selective and deeply misleading, as <a href="http://www.nytimes.com/2016/07/12/upshot/surprising-new-evidence-shows-bias-in-police-use-of-force-but-not-in-shootings.html?smid=tw-upshotnyt&smtyp=cur&_r=0">initial reports</a> on the paper suggested? </div>
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<br /></div>
<div style="text-align: justify;">
Not at all. The protests are about the <i>killing of innocents</i>, not about the treatment of those whose actions would legitimately plant them in the serious arrest pool. What Fryer's paper suggests (if one takes the incident categorization by police at face value) is that at least in Houston, those who would assault or attempt to kill a public safety officer are treated in much the same way, regardless of race. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
But think of the cases that animate the protest movement, for instance the list of eleven compiled <a href="http://www.nytimes.com/interactive/2016/07/12/us/looking-for-accountability-in-police-involved-deaths-of-blacks.html">here</a>. Families of six of the eleven have already received large settlements (without admission of fault). Six led to civil rights investigations by the justice department. With one or two possible exceptions, it doesn't appear to me that these interactions would have made it past Fryer's arrest filter had they been handled more professionally. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
The point is this: if there is little or no racial bias in the way police handle genuinely dangerous suspects, but there is bias that leads some <a href="http://rajivsethi.blogspot.com/2015/10/threats-perceived-when-there-are-none.html">mundane interactions</a> to turn potentially deadly, then the kind of analysis conducted by Fryer would not be helpful in detecting it. Which in turn means that the breathless manner in which the paper was initially reported was really quite irresponsible. </div>
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<div style="text-align: justify;">
For this the author bears some responsibility, having inserted the following into his discussion of the Houston findings:</div>
<div style="text-align: justify;">
<blockquote class="tr_bq">
Given the stream of video "evidence", which many take to be indicative of structural racism in
police departments across America, the ensuing and understandable outrage in black communities
across America, and the results from our previous analysis of non-lethal uses of force, the results
displayed in Table 5 are startling...
Blacks are 23.8 percent <i>less</i> likely to be shot by police, relative to whites. </blockquote>
</div>
<div style="text-align: justify;">
His <a href="http://www.nytimes.com/2016/07/12/upshot/surprising-new-evidence-shows-bias-in-police-use-of-force-but-not-in-shootings.html?smid=tw-upshotnyt&smtyp=cur">claim</a> that this was "the most surprising result of my career" was an invitation to misunderstand and misreport the findings, which are important but clearly limited in relevance and scope.<br />
<br />
<div style="text-align: center;">
---</div>
<br />
<u>Update</u>. If you follow the links at the start of this post, you'll see a case made that Fryer's own findings of bias in the use of non-lethal force suggest that the composition of the arrest pool will be altered by bias in the charging of innocents for resisting or evading arrest.<br />
<br />
It occurred to me that the same data used to examine use of non-lethal force (from the citizen's perspective) could also be used to get an estimate of this effect. This is the Bureau of Justice Statistics Police-Public Contact Survey. If anyone had done already this please let me know, I'd be interested to see the findings. </div>
Rajivhttp://www.blogger.com/profile/13667685126282705505noreply@blogger.com13tag:blogger.com,1999:blog-4039434.post-35928659796003316952016-07-11T15:14:00.000-04:002016-07-12T08:04:30.732-04:00Police Use of Force: Notes on a Study<div style="text-align: justify;">
A new <a href="http://www.nber.org/papers/w22399">empirical analysis</a> of police use of force by Harvard economist Roland Fryer is attracting <a href="http://www.nytimes.com/2016/07/12/upshot/surprising-new-evidence-shows-bias-in-police-use-of-force-but-not-in-shootings.html?smid=tw-upshotnyt&smtyp=cur">national attention</a>. The paper deals with both lethal and non-lethal force, using a variety of different data sets, some public and some painstakingly assembled by the author and his team. Given the <a href="http://www.nytimes.com/2016/07/09/us/dallas-attacks-what-we-know-baton-rouge-minnesota.html?_r=0">harrowing events</a> of the past week, it's likely that his results on shootings will attract the most attention, but it's worth carefully considering both sets of findings. </div>
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<div style="text-align: justify;">
Fryer provides evidence of significant racial disparities in the experience of non-lethal force at the hands of police, even in data that relies on self-reports by officers. Using official statistics from New York City’s Stop, Question and Frisk program, he
finds that blacks and Latinos are more likely to be held, pushed,
cuffed, sprayed or struck than whites who are stopped. This remains the
case even after controlling for a broad range of demographic,
behavioral, and environmental characteristics. And using data from a
nationally representative sample of civilians, which does not rely on
officer accounts, he finds evidence of even larger disparities in
treatment.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
But Fryer also reports an absence of racial bias in police shootings for a select group of jurisdictions. He recognizes that a proper analysis of police bias in the use of lethal force requires data not only on those incidents in which shootings occurred, but also those in which suspects were successfully pacified and disarmed. Data of this kind is extremely hard to come by, but he has managed to obtain incident reports on arrests in Houston that can be used for this purpose. </div>
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<div style="text-align: justify;">
The focus is on arrest categories that are more likely to involve incidents resulting in justified use of lethal force. It turns out that in this arrest data 58% of the population is black, while in the shooting data the corresponding share is 52%. This immediately implies that in the absence of controls for other features of the interaction, blacks in the arrest population are less likely to be shot than whites. He finds that controlling for other features of the interaction "does not significantly alter the raw racial differences." Here is how Fryer characterizes these findings:</div>
<div style="text-align: justify;">
<blockquote class="tr_bq">
Given the stream of video "evidence", which many take to be indicative of structural racism in
police departments across America, the ensuing and understandable outrage in black communities
across America, and the results from our previous analysis of non-lethal uses of force, the results
displayed in Table 5 are startling...
Blacks are 23.8 percent <i>less</i> likely to be shot by police, relative to whites. </blockquote>
</div>
<div style="text-align: justify;">
He <a href="http://www.nytimes.com/2016/07/12/upshot/surprising-new-evidence-shows-bias-in-police-use-of-force-but-not-in-shootings.html?smid=tw-upshotnyt&smtyp=cur">describes</a> this as "the most surprising result of my career."</div>
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<div style="text-align: justify;">
While it is entirely possible that the Houston Police Department doesn't exhibit systematic racial bias in the use of lethal force, I'm not sure such an emphatic conclusion is warranted. A close look at the arrest data (Table 1D) alongside the shooting data (Table 1C, column 2) reveals a number of puzzles that should be a cause for concern. In the arrest data only 5% of suspects were armed, and yet 56% of suspects "attacked or drew weapon." This would suggest that over half of suspects attacked without a weapon (firearms, knives and vehicles are all classified as weapons). Moreover, there are large differences across groups in behavior: two-thirds of whites and one-half of blacks attacked, a difference that is statistically significant (the reported <i>p-value</i> is 0.006). </div>
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<br /></div>
<div style="text-align: justify;">
What this means is that the pool of black arrestees and the pool of white arrestees are systematically different, at least as far as behavior is concerned. So the raw data comparison described as startling in the quote above is not really valid. (I made a <a href="http://rajivsethi.blogspot.com/2015/10/threats-perceived-when-there-are-none.html">similar point</a> in response to a <a href="http://www.nytimes.com/2015/10/18/upshot/police-killings-of-blacks-what-the-data-says.html">piece</a> by Sendhil Mullainathan a few months ago). Still, Fryer controls for these differences in behavioral and contextual characteristics and finds that the basic picture doesn't change. This has to be taken seriously. The key question, to my mind, is whether these controls are adequate. </div>
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<br /></div>
<div style="text-align: justify;">
I personally would be more convinced if the arrestee pool looked more like the shooting victim pool. For instance, 18% of arrestees, but only 4% of shooting victims are female. I suspect that many of the interactions in the arrestee pool are not threatening, even from the subjective perspective of the officers involved. And others are so obviously threatening---for instance those involving suicide-by-cop---that no discretion or judgement is really necessary. Pruning these from the data might give us a clearer picture of bias in the use of discretionary lethal force. </div>
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Despite these concerns, I think that there is a case to be made that there is no systematic bias against blacks in the lethal use of force within the Houston Police Department. What one ought not to conclude, however, is that this applies nationally. The analysis of other jurisdictions considered in the paper is restricted to encounters in which shootings actually occurred, and cannot therefore be used to answer the same kinds of questions that the Houston data allows. </div>
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<div style="text-align: justify;">
One last point about shootings: I'm not sure why there are quotation marks around the word "evidence" in the above quote. Video evidence, for all its flaws, is still very powerful evidence. It was video evidence that led to the <a href="https://www.washingtonpost.com/news/post-nation/wp/2015/06/08/police-officer-who-shot-walter-scott-indicted-for-murder/?tid=a_inl">indictment</a> of Micheal Slager on murder charges, and the <a href="http://www.scdps.gov/comm/nr2014/091914.html">conviction</a> of Sean Groubert for assault and battery. It is selective and cannot establish the presence of racial bias in individual cases, but surely it can't be dismissed out of hand. </div>
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<div style="text-align: justify;">
Finally, consider Fryer's analysis of non-lethal force, which is consistent with <a href="http://amstat.tandfonline.com/doi/abs/10.1198/016214506000001040">earlier findings</a>. Aside from being fundamentally unjust, disparities in the use of non-lethal force have some really important implications for crime rates. The harassment of entire groups based on racial or ethnic identity is a major obstacle to witness cooperation in serious cases, including homicide. In fact, given the importance of corroboration, a belief that other witnesses will not step forward can be <a href="http://www.jstor.org/stable/10.1086/649032?seq=1#page_scan_tab_contents">self-fulfilling</a>.<br />
<br />
With witnesses routinely unwilling to come forward in some neighborhoods, people can be killed with near impunity. And this significantly increases the incentives to kill preemptively, in a climate of <a href="http://rajivsethi.blogspot.com/2012/06/reciprocal-fear-and-castle-doctrine.html">reciprocal fear</a>. Low clearance rates for homicide are directly responsible for high rates of killing, and both of these are held in place by distrust of the criminal justice system by potential witnesses. The excessive and discriminatory use of non-lethal force by police thus ends up having indirect lethal effects.</div>
Rajivhttp://www.blogger.com/profile/13667685126282705505noreply@blogger.com26tag:blogger.com,1999:blog-4039434.post-82227722963915484052016-07-07T14:36:00.000-04:002016-07-08T15:04:24.393-04:00Deadly Stereotypes<div style="text-align: justify;">
This video is hard to watch but important to think about and learn from:</div>
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<div style="text-align: center;">
<iframe allowfullscreen="" frameborder="0" height="315" src="https://www.youtube.com/embed/6WkTURRuDZ0" width="420"></iframe>
</div>
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<div style="text-align: justify;">
Here's what <a href="http://www.nytimes.com/2016/07/08/us/philando-castile-falcon-heights-shooting.html">appears to have happened</a>. At around 9pm on July 6, Philando Castile was stopped for a broken taillight while driving in Falcon Heights, Minnesota. He was accompanied by his girlfriend, Lavisha Reynolds, and her young daughter. On being asked for his license and registration, Castile informed the officer that he had a firearm in the vehicle, and a concealed carry permit. He then reached for his wallet and was fatally shot. The video above captures the aftermath of the shooting, and was streamed live to a facebook account by Reynolds. </div>
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<br /></div>
<div style="text-align: justify;">
The incident immediately brought to mind the <a href="http://www.slate.com/blogs/the_slatest/2014/09/25/south_carolina_dashcam_shooting_sean_groubert_levar_jones_incident_on_video.html">shooting</a> of Levar Jones by Sean Groubert in September 2014, which was captured on the officer's dashcam video. Again, there was a traffic stop, a request for documents, and multiple shots fired as Jones reached for his wallet:</div>
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<iframe allowfullscreen="" frameborder="0" height="315" src="https://www.youtube.com/embed/RBUUO_VFYMs" width="420"></iframe>
</div>
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<div style="text-align: justify;">
Jones was hit but survived the shooting, and Groubert would later <a href="https://www.washingtonpost.com/news/post-nation/wp/2016/03/14/former-south-carolina-trooper-pleads-guilty-to-shooting-unarmed-driver-during-traffic-stop/?utm_term=.52f4d33197f4">plead guilty</a> to assault and battery. </div>
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<div style="text-align: justify;">
What ties these incidents together is that they seem to have been motivated primarily by <i>fear</i> rather than anger or malice. Moreover, this fear turned out to have been unwarranted: neither Jones nor Castile posed an objective threat to the respective officers. The same was true of <a href="https://en.wikipedia.org/wiki/Shooting_of_Amadou_Diallo">Amadou Diallo</a> back in 1999, and in the more recent cases of <a href="https://en.wikipedia.org/wiki/Shooting_of_Tamir_Rice">Tamir Rice</a> and <a href="https://en.wikipedia.org/wiki/Shooting_of_John_Crawford_III">John Crawford</a>.</div>
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<div style="text-align: justify;">
Whether or not the fear was reasonable under the individual circumstances of each case is harder to ascertain, and there is usually enough doubt to preclude criminal prosecution. Nevertheless, there are rare instances in which the unreasonableness of the fear is recognized: Groubert's employment with the South Carolina Department of Public Safety was <a href="http://www.scdps.gov/comm/nr2014/091914.html">terminated</a> on the explicit grounds that he "reacted to a perceived threat where there was none."</div>
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<div style="text-align: justify;">
A question of great moral and social importance is whether or not such fear is driven, in part, by exaggerated stereotypes of black male violence held by some subset of officers. The anecdotal evidence certainly suggests that such stereotypes matter on average, even if they are not implicated in every case. There is also some <a href="http://www.vox.com/2014/8/28/6051971/police-implicit-bias-michael-brown-ferguson-missouri">evidence</a> of implicit bias from video game simulations.</div>
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<div style="text-align: justify;">
Further evidence can be found in a <a href="http://www.theguardian.com/us-news/ng-interactive/2015/jun/01/the-counted-police-killings-us-database">dataset</a> assembled by The Guardian. According to this source, there were a total of 1,145 police
killings in 2015 alone, about half of which involved suspects armed with
a gun. A further 13% of those killed were armed with a knife. There is no question, therefore that police officers often face armed and dangerous suspects. However, 18% of whites killed by police in 2015 were
unarmed while 52% had a gun; the corresponding figures for blacks were
25% and 46%. This suggests that within the set of encounters that result
in police killings, those involving black suspects are less objectively
threatening to the officers involved. One possible explanation is that
any given encounter is more likely to be perceived by the officer as
threatening when the suspect happens to be black.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
In the Guardian data, slightly
more than half of those killed by police were white, 27% were black, and 17%
Latino. The proportion of those killed who were black is roughly the same as the proportion of total arrestees who are black, which has led some to <a href="http://www.nytimes.com/2015/10/18/upshot/police-killings-of-blacks-what-the-data-says.html?_r=0">argue</a> that "removing police racial bias will have little effect on the killing rate." But this claim depends on the questionable assumption that encounters involving black citizens are as likely to be objectively threatening to officers and encounters with white citizens. As I have <a href="http://rajivsethi.blogspot.com/2015/10/threats-perceived-when-there-are-none.html">argued previously</a>, there are reasons to believe that they are not. </div>
<div style="text-align: justify;">
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<div style="text-align: justify;">
The health of our society depends on an effective and trusted criminal justice system. In fact, the system cannot be effective if it isn't trusted. Distrust makes witnesses to crimes unwilling to come forward and depresses clearance rates. This allows serious crimes, including homicide, to be committed with impunity. Fear of homicide victimization raises incentives for preemptive killing, resulting in <a href="http://www.sciencedirect.com/science/article/pii/S0094119010000343">epidemics of violence</a>. At the heart of it all are stereotypes, affecting interactions between <a href="http://www.sciencedirect.com/science/article/pii/S0167268108001303">victims and offenders</a>, <a href="http://www.nber.org/chapters/c11847">parties to disputes</a>, <a href="http://www.jstor.org/stable/10.1086/649032?seq=1#page_scan_tab_contents">prosecutors and witnesses</a>, and officers and suspects. And the very same stereotypes also affect the urgency and concern with which the general public views <a href="https://books.google.com/books?id=XpB0DBXhZ0IC">mass incarceration</a>. </div>
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<div style="text-align: justify;">
What
can be done? The screening and training of officers has got to take
into account the possibility that stereotypes can be deadly.
Psychologists have found that <a href="http://onlinelibrary.wiley.com/doi/10.1111/spc3.12023/full">exposure to counterstereotypical exemplars</a>
can reduce implicit bias, and residency requirements can serve as a
screening device. Finally, the construction of a complete and consistent national
database of incidents remains imperative. Public action requires broad
engagement with the issue and some agreement on the nature of the
problem, and this will not be possible while arguments continue to rely
on anecdotal and indirect evidence. Such evidence is too quickly dismissed by skeptics and too easily filtered by stereotypes, no matter how shocking and heartbreaking and deeply persuasive a sympathetic observer finds it to be. </div>
Rajivhttp://www.blogger.com/profile/13667685126282705505noreply@blogger.com6tag:blogger.com,1999:blog-4039434.post-82690858473978146302016-04-10T12:27:00.001-04:002016-04-10T20:51:55.360-04:00Fee-Structure Distortions in Prediction Markets<div style="text-align: justify;">
Since the launch of the pioneering <a href="http://tippie.uiowa.edu/iem/">Iowa Electronic Markets</a> almost thirty years ago, prediction markets have grown to become a familiar fixture in the forecasting landscape. Among the most recent entrants is <a href="https://www.predictit.org/Browse/Featured">PredictIt</a>, which has been operating for about a year under a no-action letter from the CFTC.</div>
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Both IEM and PredictIt offer contracts structured as binary options: if the referenced event occurs, the buyer of the contract gets a fixed payment at the expense of the seller, and otherwise gets nothing. The price of the contract (relative to the winning payment) may then be <a href="http://www.nber.org/papers/w12200">interpreted</a> as a probability; an assessment by the "market" of the likelihood that the event will occur. These probabilities can be calibrated against actual outcomes over multiple events, and compared with survey and model based forecasts. Comparisons of this kind have generally found the <a href="http://www.sciencedirect.com/science/article/pii/S0169207008000320">forecasting</a> <a href="https://poq.oxfordjournals.org/content/73/5/895.abstract">performance</a> of markets to be superior on average to those based on more traditional methods. </div>
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But interpreting prices as probabilities requires, at a minimum, that the set of prices referencing mutually exclusive outcomes sum to at most one. This condition is routinely <a href="http://predictwise.com/blog/2016/01/a-modest-proposal-for-predictit/">violated</a> on PredictIt. For instance, in the market for the presidential election winner by party, we currently have:</div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjqsYx5SemSyFKLaCv6GBlmu7lRw9ghSnHHWW37fVZYvmKMjbCv0WdeKG3S7jEyB8dF7YHTQNRILlwh8LUjga0oD8piI_fwahpVi-iPRIkOHeA5s-u8l8_mXocjHYm4AJHrUTAb0w/s1600/Screen+Shot+2016-04-10+at+5.32.19+AM.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="137" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjqsYx5SemSyFKLaCv6GBlmu7lRw9ghSnHHWW37fVZYvmKMjbCv0WdeKG3S7jEyB8dF7YHTQNRILlwh8LUjga0oD8piI_fwahpVi-iPRIkOHeA5s-u8l8_mXocjHYm4AJHrUTAb0w/s400/Screen+Shot+2016-04-10+at+5.32.19+AM.png" width="400" /></a></div>
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Based on the prices at last trade, there is an absurd 108% likelihood that someone or other will be elected president. Furthermore, the price of betting against all three listed outcomes (by buying the corresponding no contracts) is $1.96, even though the payout from this bundle is sure to be $2.00. Since these contracts are <a href="http://rajivsethi.blogspot.com/2015/09/the-price-impact-of-margin-linked-shorts.html">margin-linked</a> (the exchange only requires a trader to post his or her worst-case loss) the cost of buying this bundle would be precisely zero in the absence of fees, and this would be as pure an opportunity for arbitrage as one is likely to find. </div>
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On IEM, or the now defunct Intrade, such a pattern of pricing would never be observed except perhaps for an instant. The discrepancy would be spotted by an algorithm and trades executed until the opportunity had been fully exploited. Profits would be small on any given trade, but would add up quickly: the most <a href="http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2322420">active account</a> on Intrade during the last presidential election cycle traded close to four million contracts for a profit of $62,000 with minimal risk and effort. This trader had a median holding period of <i>zero</i> milliseconds. That is, the trader typically sold multiple candidate contracts simultaneously (with the trades having identical timestamps) in a manner that could not possibly have been done manually. </div>
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Why don't we see this in PredictIt? The simple answer is the fee structure. Whenever a position is closed at a profit the exchange takes 10% of the gains; losing trades don't incur fees. Taking account of this fee structure, the worst-case outcome for a trader betting against all three outcomes in the example above would be a win by someone other than a major party nominee. In this case the trader would lose $0.95 and gain $0.99, incurring fees on the latter of around ten cents. The result would be a net loss rather than a gain, and hence no opportunity for arbitrage. Prices could remain at these levels indefinitely. </div>
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Still, algorithmic arbitrage can prevent prices from getting too far out of line with meaningful probabilities. The extent to which this happens depends on whether the events in question include some that are considered highly unlikely. In a market with only two possibilities (such as that <a href="https://www.predictit.org/Contract/2090/Will-the-Senate-confirm-the-next-SCOTUS-nominee-before-Obama-leaves-office#data">referencing</a> confirmation of Merrick Garland) price distortion will be lowest if both outcomes are considered equally likely. For instance, if the prices of the two contracts were each 53, betting against both would cost 94, and fees would be a shade above 5 no matter what happens. These prices could not be sustained, so the distortion would be at most 5%. </div>
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But in the same market, prices of 99 and 10 for the two outcomes could be sustained, for a distortion of 9%. The cost of betting against both would be 91 but if the less likely outcome occurs, the fee would wipe out all gains. Hence no opportunity for arbitrage, and no pressure on prices to change. </div>
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Given that PredictIt is operating as an <a href="http://rajivsethi.blogspot.com/2015/04/prediction-market-design.html">experimental research facility</a> with the purpose of generating useful data for academic research, this situation is unfortunate. It would be easy for the exchange to apply fees only to <i>net</i> profits in a given market, after taking account of all losses and gains, as suggested <a href="http://predictwise.com/blog/2016/01/a-modest-proposal-for-predictit/">here</a>. This does not require any change in the manner in which margin is calculated at contract purchase, only a refund once the market closes. If this is done, prices should snap into line and begin to represent meaningful probabilities. The decline in revenue would be partially offset by increased participation. And the transition itself would generate interesting data for researchers, consistent with the stated mission of the enterprise. </div>
Rajivhttp://www.blogger.com/profile/13667685126282705505noreply@blogger.com7tag:blogger.com,1999:blog-4039434.post-53811258194656007882016-03-19T09:57:00.001-04:002016-03-20T04:37:26.850-04:00Does Market Microstructure Matter?<div style="text-align: justify;">
The Securities and Exchange Commission has decided to <a href="https://next.ft.com/content/489bc832-ec75-11e5-bb79-2303682345c8" target="_blank">delay</a> for a second time ruling on the application by IEX to register as a national securities exchange. This time they did so without seeking or receiving permission from the applicant, on the grounds that a decision requires clarification of their own <a href="https://www.google.co.in/url?sa=t&rct=j&q=&esrc=s&source=web&cd=3&cad=rja&uact=8&ved=0ahUKEwjksPvO_czLAhWDjo4KHVbMDooQFggkMAI&url=https%3A%2F%2Fwww.sec.gov%2Frules%2Ffinal%2F34-51808.pdf&usg=AFQjCNGkh2uoyNo-0y1UEG7B84aRWyB8Dg&sig2=_-QiiepM-U5HUYwLwsmhtg">order protection rule</a>. Accordingly, they have posted a <a href="https://t.co/LPJ2KE1HXJ" target="_blank">notice of proposed interpretation</a> and invited the general public to submit comment letters. </div>
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The key passage in the notice is the following:</div>
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<blockquote class="tr_bq">
Specifically, the Commission preliminarily believes that, in the current market, delays of less than a millisecond in quotation response times may be at a <i>de minimis</i> level that would not impair a market participant’s ability to access a quote, consistent with the goals of Rule 611 and because such delays are within the geographic and technological latencies experienced by market participants today... permitting the quotations of trading centers with very small response time delays, such as those proposed by IEX, to be treated as automated quotations, and thereby benefit from trade-through protection under Rule 611, could encourage innovative ways to address market structure issues.<br />
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Accordingly, the Commission today is proposing to interpret “immediate” when determining whether a trading center maintains an “automated quotation” for purposes of Rule 611 of Regulation NMS to include response time delays at trading centers that are <i>de minimis</i>, whether intentional or not.</blockquote>
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If this proposed interpretation is sustained, it seems to me that the application would have to be approved. But perhaps I'm not being <a href="https://twitter.com/nanexllc/status/710976389990772736" target="_blank">cynical</a> enough. There will certainly be a flurry of comment letters from those whose current business models are threatened by the entry of IEX, and it's possible that the delay is intended to provide cover for a change in interpretation on the basis of which the application will eventually be rejected.</div>
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But one thing I find encouraging about the notice is that it seems to <a href="https://twitter.com/rajivatbarnard/status/710972210752528384">find persuasive</a> two excellent <a href="https://www.sec.gov/comments/10-222/10222-24.pdf" target="_blank">comment</a> <a href="https://www.sec.gov/comments/10-222/10222-398.pdf" target="_blank">letters</a> by RT Leuchtkafer (I <a href="https://twitter.com/rajivatbarnard/status/701889375974649857" target="_blank">flagged</a> the second when it was submitted but had missed the first). Among the many points made in these letters is the following: if an intentional delay in allowing traders access to quotes is a violation of Regulation NMS, then the entire system of co-location services, differential access speeds, and proprietary data feeds would need to end. Here's the <a href="https://www.sec.gov/comments/10-222/10222-24.pdf" target="_blank">logic</a> of the argument:</div>
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<blockquote class="tr_bq">
If deliberately slower access is an "intentional device that would delay the action taken with respect to a quotation," as the IEX Critics' reasoning certainly implies, the problem isn't just that all the major exchange groups use "delay coils" to equalize access within their data centers. The problem is that you have to pay to get into their data centers in the first place, and if you don't it sure looks like you are intentionally delayed compared to those who can and do pay.<br />
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It gets worse! Even within exchange data centers, exchanges charge fees depending on the speed of your connections. A 10gb connection is certainly delayed with an "intentional device" you know, routers, switches and the like relative to a much more expensive 40gb connection, especially when the faster connection is priced out of all proportion to its actual cost, especially when the public SIP feeds have average delays of 500 microseconds to one millisecond and the SEC's own statistics show that billions of quotes are stale before they are ever broadcast by the SIPs.<br />
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Where does this logic take us? I naturally started to wonder that if the IEX Critics are right, by their own reasoning the exchanges will have to dismantle their co-location facilities and stop offering tiered high-speed network facilities. They are selling faster access to their markets, and if you don't pay, aren't you slower than you could be, aren't you intentionally delayed?</blockquote>
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The critics might want to be careful what they wish for. </div>
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I am <a href="http://rajivsethi.blogspot.in/2016/01/the-order-protection-rule.html" target="_blank">on the record</a> in support of the IEX application, and hope that the interpretation proposed in the notice is indeed sustained. The IEX design <a href="https://www.sec.gov/comments/10-222/10222-285.pdf">prevents trading</a> based on information from an order that has
been partially filled but not fully processed. It therefore moves us closer to a true national market system, in the sense that orders are
processed in full in the sequence in which they make <i>first contact</i> with
market.</div>
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But does all this really matter, except to those whose interests are directly at stake? I believe it does, because the rules governing transactions in asset markets affect the relative profitability of different trading strategies, and this in turn has consequences for share price accuracy and volatility, the allocation of capital across competing uses, the costs of financial intermediation, and the returns to ordinary investors. </div>
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There is an extremely diverse set of participants in the secondary market for stocks, with significant differences in goals, investment horizons, and trading strategies. It is useful to group these into three broad categories: (a) long-term investors, who save during peak earning years and liquidate assets to finance consumption during retirement (b) information traders, who seek to profit from deviations between prices and their private estimates of fundamental values, and (c) high-frequency traders, who combine a market-making function with arbitrage and short-term speculation based on rapid responses to incoming market data.</div>
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There is clearly a lot of overlap between these categories. For instance, actively managed mutual funds and some hedge funds belong to the second category but often manage money for long-term investors, pension funds, or university endowments. </div>
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The traditional market making function involves the placement of passive orders that provide liquidity to the rest of the market. Such passive order placement is subject to <i>adverse selection</i>: if a posted offer to buy or sell is met by an information trader the market maker will suffer losses on average. In order for a market making strategy to be profitable, these losses have to be matched by gains elsewhere. Where do these gains come from? </div>
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In <a href="http://www.sciencedirect.com/science/article/pii/0304405X85900443" target="_blank">standard</a> <a href="http://www.jstor.org/stable/1913210" target="_blank">models</a> of market-making, the bid-ask spread is determined by a balance between losses from transactions with information traders and gains from transactions against those with price-insensitive demands. But this is not the balance that exists in markets today. Instead, high-frequency traders combine passive liquidity provision with aggressive liquidity-taking strategies based on the near instantaneous receipt, processing, and reaction to market data. The posting of bids and offers is motivated less by profiting from the spread than by fishing for information, which can then be used to take and quickly reverse directional positions. The relative weights on passive liquidity provision and aggressive short-term speculation varies considerably across firms, but there is <a href="http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2433118" target="_blank">evidence</a> that the most aggressive and profitable among these are able to effectively forecast price movements over very short horizons. </div>
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A transition to a truly national market system will affect the <a href="http://rajivsethi.blogspot.in/2010/05/blame-instructions-not-machines.html">competitive balance</a> between information traders and high-frequency traders. It is in the interests of the former to prevent information leakage so that they can build large positions with limited immediate price impact. It is in the interest of the latter to extract this information from market data and trade on it before it has been fully incorporated into prices. Other things equal, the ability to extract information from a partially filled order and trade ahead of it at other exchanges benefits high-frequency traders at the expense of information traders. A truly national market system would mitigate this advantage. </div>
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This means, of course, that high-frequency traders would be more vulnerable to adverse selection and would place a lower volume of passive orders to begin with. But the orders would be genuinely available, and not subject to widespread cancellation or poaching if one of them were to trade. Visible bid-ask spreads may widen but there would be no illusion of liquidity. </div>
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The shift in competitive balance between these trading strategies would have broader economic implications. The returns to investment in fundamental information would rise relative to the returns to investment in speed, which should result in greater <a href="http://scholarship.law.duke.edu/dlj/vol65/iss2/1/" target="_blank">share price accuracy</a>. Furthermore, there is a real possibility that the aggregate costs of financial intermediation would decline, as expenditures on co-location, rapid data processing and transmission, equipment, energy, and programming talent are scaled back. This would be a desirable outcome from the perspective of long-term investors. <a href="http://www.wsj.com/articles/SB117099466838903386" target="_blank">After all</a>:</div>
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<blockquote class="tr_bq">
It is the iron law of the markets, the undefiable rules of arithmetic: Gross return in the market, less the costs of financial intermediation, equals the net return actually delivered to market participants.</blockquote>
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Finally, extreme volatility events should arise less often. Algorithms making short-term price forecasts may predict well on average but they will sometimes mistake a random fluctuation for a large order imbalance. Such false positives can give rise to a hot potato effect, of the kind that is believed to have been in play during the <a href="http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1686004" target="_blank">flash crash</a>. Of course, such events can occur even in the absence of market fragmentation, and cannot be prevented entirely, but a transition to a true national market system should reduce their amplitude and frequency. </div>
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For these reasons and more, approval of the IEX application would be a modest but meaningful step in the right direction.</div>
Rajivhttp://www.blogger.com/profile/13667685126282705505noreply@blogger.com0tag:blogger.com,1999:blog-4039434.post-28241049563302614162016-03-07T22:26:00.001-05:002016-03-09T07:53:06.026-05:00Systematic Biases in Prediction Market Forecasts<div style="text-align: justify;">
On <a href="http://rajivsethi.blogspot.com/2016/03/super-tuesday.html" target="_blank">Super Tuesday</a>, and then again on <a href="http://rajivsethi.blogspot.com/2016/03/forecasting-elections.html" target="_blank">March 5</a>, there were systematic biases in prediction market forecasts. Specifically, Donald Trump lost four contests that he was predicted to win (Oklahoma, Alaska, Minnesota and Maine) and won no contests that he was predicted to lose (Texas and Kansas).</div>
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Another way to express this is as follows: if someone had bet that Trump would lose all eleven states on Super Tuesday at the prevailing prices, they would have secured a substantial positive return, approximately doubling their money, even though he actually won seven states. Each bundle of such bets, one for each state, would have cost about $2 and paid out $4 for a 100% return. On the other hand, if they had bet that Trump would win all eleven states they would have lost money, paying about $9 per bundle to get back $7. And there was enough liquidity available to scale up these bets quite substantially. </div>
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The pattern repeated itself on March 5: betting on Trump losses across the board would have made quite a bit of money, betting on him to win everything would have been a money-losing proposition. This was true even though he won two of four states, since betting on him to win was much costlier in the aggregate than betting on him to lose. </div>
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Yet another way to say this is that the markets were not terribly well-calibrated. But this ought to be a temporary phenomenon as wealth is transferred across accounts and traders update their beliefs after each outcome realization.</div>
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It's election day again tomorrow, which gives us an opportunity to see if such a correction has in fact occurred. Four states are in play on the Republican side, with Trump heavily favored to win Michigan and Mississippi:</div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjApPMxxD_G4jVM5VCPGZvxl5c__Gki8n6LrrVIPK5YfnAp6cFlFb40dT3N2gmNrIBk8SKXEkv2l3SNeLVnYQIzSSdaxwDh-ocxDw6b_2zY0TIOMtKv4QC761doTzQYRxUO6eeJ8A/s1600/Screen+Shot+2016-03-07+at+8.48.34+PM.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="121" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjApPMxxD_G4jVM5VCPGZvxl5c__Gki8n6LrrVIPK5YfnAp6cFlFb40dT3N2gmNrIBk8SKXEkv2l3SNeLVnYQIzSSdaxwDh-ocxDw6b_2zY0TIOMtKv4QC761doTzQYRxUO6eeJ8A/s200/Screen+Shot+2016-03-07+at+8.48.34+PM.png" width="200" /></a></div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi4rxmZcAOqsioa_2DP15bRs3ae0sOHII66rQf0ik_DcJNo68_X3IruCSf_uhgTkgtA5kKMNGpd7nx9smobXfpMF7RikC3t_363hVbvtV2OJb7KK7pAccdFO5OJzDivWoXm9R9dFA/s1600/Screen+Shot+2016-03-07+at+8.51.44+PM.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="123" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi4rxmZcAOqsioa_2DP15bRs3ae0sOHII66rQf0ik_DcJNo68_X3IruCSf_uhgTkgtA5kKMNGpd7nx9smobXfpMF7RikC3t_363hVbvtV2OJb7KK7pAccdFO5OJzDivWoXm9R9dFA/s200/Screen+Shot+2016-03-07+at+8.51.44+PM.png" width="200" /></a></div>
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If he fails to win either one of these states it would suggest to me that the biases previously evident have not yet been eliminated. </div>
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As far as the other two contests are concerned, Cruz is favored in Idaho, with Rubio (marginally) favored in Hawaii:</div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhwxICcrpiPXkFHkQ71tIFhAdUAT0W7Tp9b9q8JB9NpgzZFflo8vxaSm8uIyYagt4zvjphE_MKSTYtPlZ2XtKfsMpqrLmZfHlx1T2g3pTkoZZHGc_9G3Y8H24XScB7bi5thMA2C1Q/s1600/Screen+Shot+2016-03-07+at+9.27.15+PM.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="123" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhwxICcrpiPXkFHkQ71tIFhAdUAT0W7Tp9b9q8JB9NpgzZFflo8vxaSm8uIyYagt4zvjphE_MKSTYtPlZ2XtKfsMpqrLmZfHlx1T2g3pTkoZZHGc_9G3Y8H24XScB7bi5thMA2C1Q/s200/Screen+Shot+2016-03-07+at+9.27.15+PM.png" width="200" /></a></div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh9nLZYJG-Xr4Y1gqJyYLb7pwYPaXwsqcJEolZhSujlrEGYaLzLBAFuJS8fnSpthezUwbhQYvfKQ6y4vQ7PT4yGEokOID-1mbSbfYAkfYGVYnOtgN8VrY_y5WnWWKnJNOiWjnvGpg/s1600/Screen+Shot+2016-03-07+at+9.27.49+PM.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="123" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh9nLZYJG-Xr4Y1gqJyYLb7pwYPaXwsqcJEolZhSujlrEGYaLzLBAFuJS8fnSpthezUwbhQYvfKQ6y4vQ7PT4yGEokOID-1mbSbfYAkfYGVYnOtgN8VrY_y5WnWWKnJNOiWjnvGpg/s200/Screen+Shot+2016-03-07+at+9.27.49+PM.png" width="200" /></a></div>
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<br />
How do these predictions compare with more traditional
poll and model based forecasts? On the Republican side, all we have is a Michigan forecast from <a href="http://projects.fivethirtyeight.com/election-2016/primary-forecast/michigan-republican/" target="_blank">FiveThirtyEight</a>:</div>
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This is in substantial agreement with the prediction markets, so the outcome will not help adjudicate between the two approaches. Similarly, on the Democratic side, there is negligible difference in forecasts: the prediction markets and FiveThirtyEight both agree that Clinton is heavily favored to win Michigan and Mississippi. </div>
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One of the most striking facts that David Rothschild and I uncovered in our <a href="http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2322420" target="_blank">analysis</a> of Intrade data from the 2012 election was that the overwhelming majority of traders bet in only one direction. They could be partitioned into Obama enthusiasts and Romney enthusiasts, changing their exposure over time in response to news, but never switching entirely from one side to the other. (These categories are based only on beliefs about the eventual outcome, as represented in bets placed, and need not correspond to political preferences.) </div>
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If this pattern holds for the contests currently underway, then poorly calibrated forecasts could be a consequence of over-representation in the market of Trump enthusiasts, or a willingness of such individuals to place larger bets. Even so, the bias should be self-correcting over time, as the wealth of those making consistently losing bets is gradually depleted.<br />
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---</div>
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<div style="text-align: justify;">
Update (March 9). The <a href="http://www.nytimes.com/elections/results" target="_blank">results</a> are in and it's safe to say that there was no hint of bias in favor of Trump this time: he won Michigan and Mississippi handily and Hawaii became the first state that he won while being predicted to lose. The big surprise, of course, was on the Democratic side where Sanders prevailed over Clinton in <a href="http://www.nytimes.com/elections/results/michigan" target="_blank">Michigan</a>. This outcome was given a likelihood of less than one in ten by FiveThirtyEight and prediction markets, and was even mistakenly called for Clinton at 9pm ET last night:</div>
<div style="text-align: justify;">
<br /></div>
</div>
<div style="text-align: justify;">
<blockquote class="twitter-tweet" data-lang="en">
<div dir="ltr" lang="en">
We project that Hillary Clinton will defeat Bernie Sanders in Michigan.</div>
— Decision Desk HQ (@DecisionDeskHQ) <a href="https://twitter.com/DecisionDeskHQ/status/707385496826093569">March 9, 2016</a></blockquote>
</div>
<div style="text-align: justify;">
<br />
So we still have little to choose from when comparing markets to poll-based predictions, with Kansas being the only state called differently (correctly by markets and incorrectly by FiveThirtyEight). </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
The other big news of course was the failure of the Rubio campaign to secure even a single delegate (as of this writing), while Kasich managed to get 17. Even before polls opened on March 5, I <a href="http://rajivsethi.blogspot.com/2016/03/forecasting-elections.html" target="_blank">wrote</a>:</div>
<blockquote class="tr_bq">
<div style="text-align: justify;">
I suspect that there is a non-negligible probability that Rubio may exit
the race before Florida to avoid humiliation there, while Cruz and
Kasich survive to the convention. </div>
</blockquote>
<div style="text-align: justify;">
There's been a lot of chatter about this possibility over the past couple of days, and it seems increasingly likely to me. A Rubio exit before Florida could tip Ohio to Kasich and set up an interesting and unpredictable three-person race going forward. Ohio will also be critical for the continued viability of Sanders. It's a fascinating election cycle. </div>
Rajivhttp://www.blogger.com/profile/13667685126282705505noreply@blogger.com0tag:blogger.com,1999:blog-4039434.post-65637065783448547242016-03-05T01:44:00.001-05:002016-03-05T23:34:52.716-05:00Forecasting Elections<div style="text-align: justify;">
This wild and crazy election cycle is generating an enormous amount of data that social scientists will be pondering for years to come. We are learning about the beliefs, preferences, and loyalties of the American electorate, and possibly witnessing a political realignment of historic proportions. Several <a href="http://www.newsmax.com/Headline/Republicans-Non-Support-Trump/2016/03/03/id/717219/" target="_blank">prominent republicans</a> have vowed not to support their nominee if it it happens to be Trump, while a <a href="https://www.washingtonpost.com/news/post-politics/wp/2016/03/04/jim-webb-id-vote-for-trump-but-not-clinton/" target="_blank">recent candidate</a> for the Democratic nomination has declared a preference for Trump over his own party's likely nominee. Crossover voting will be rampant come November, but the flows will be in <a href="http://www.bostonherald.com/news/us_politics/2016/02/amid_trump_surge_nearly_20000_mass_voters_quit_democratic_party" target="_blank">both directions</a> and the outcome remains quite uncertain. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Among the issues that the emerging data will be called upon to address is the accuracy of prediction markets relative to more conventional poll and model based forecasts. Historically such markets have <a href="https://books.google.com/books?id=wAK_aKs3EPoC&pg=PA742&lpg=PA742&dq=Results+from+a+Dozen+Years+of+Election+Futures+Markets+Research&source=bl&ots=e9-W452f8i&sig=fHparf2dURSFHTz-aU9TQxjsCTw&hl=en&sa=X&ved=0ahUKEwjB6cOk8ajLAhVEpx4KHaqpCjUQ6AEIPTAE#v=onepage&q&f=false" target="_blank">performed well</a>, but they have also been subject to <a href="http://papers.ssrn.com/sol3/Papers.cfm?abstract_id=2322420" target="_blank">attempted manipulation</a>, and this particular election cycle hasn't really followed historical norms in any case. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
On Super Tuesday, the <a href="http://rajivsethi.blogspot.com/2016/03/super-tuesday.html" target="_blank">markets predicted</a> that Trump would prevail in ten of the eleven states in play, with the only exception being a Cruz victory in his home state of Texas. This turned out to be quite poorly calibrated, in the sense that all errors were in a single direction: the misses were Oklahoma and Alaska (which went to Cruz) and Minnesota (where Rubio secured his first victory). But the forecasters at <a href="http://fivethirtyeight.com/features/super-tuesday-preview-republican-presidential-election-2016/" target="_blank">FiveThirtyEight</a> also missed Oklahoma and were silent on the other two so no easy comparison is possible. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Today we have primaries in a few more states, and another opportunity for a comparison. I'll focus on the Republican side, where voting will occur in Kansas, Kentucky, Louisiana and Maine. Markets are currently predicting a Cruz victory in Kansas (though the odds are not overwhelming):</div>
<div style="text-align: center;">
<br /></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjRKHI-C_Qwa13jlZU1T87KbfDJsdr8qV4H7jXDiAXVNBoudeB2t3ox4JT_s-lbRo6WIlIiWpM0XfQkazd3QzIDUN7dWZE1WN5ecm7fhUAqNNo3Wwh3xAe3zMgsmgI7gnf2BTbC9Q/s1600/Screen+Shot+2016-03-05+at+1.16.40+AM.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="122" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjRKHI-C_Qwa13jlZU1T87KbfDJsdr8qV4H7jXDiAXVNBoudeB2t3ox4JT_s-lbRo6WIlIiWpM0XfQkazd3QzIDUN7dWZE1WN5ecm7fhUAqNNo3Wwh3xAe3zMgsmgI7gnf2BTbC9Q/s200/Screen+Shot+2016-03-05+at+1.16.40+AM.png" width="200" /></a></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
In contrast, FiveThirtyEight gives the edge to Trump, though again it's a close call:</div>
<div style="text-align: center;">
<br /></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjuL7YlVsnyqdl_KcLH4e0pAC6O9j4u6OW_Q1R3nZyR6PqBu1UOIv5Nr-MTMWmIf8yNMAT3id47GbJ-HibVaGOefaW_3d-j4Z41ObusbTYjAVuYvxPw0WEE5uSqbEo8hH7m6CFRJQ/s1600/Screen+Shot+2016-03-05+at+1.19.17+AM.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="201" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjuL7YlVsnyqdl_KcLH4e0pAC6O9j4u6OW_Q1R3nZyR6PqBu1UOIv5Nr-MTMWmIf8yNMAT3id47GbJ-HibVaGOefaW_3d-j4Z41ObusbTYjAVuYvxPw0WEE5uSqbEo8hH7m6CFRJQ/s400/Screen+Shot+2016-03-05+at+1.19.17+AM.png" width="400" /></a></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
The only other state for which we have predictions from both sources is Louisiana, but here there is negligible disagreement, with Trump heavily favored to win. Trump is also favored by markets to take Kentucky and Maine, for which we have limited polling data and no predictions from FiveThirtyEight. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
So one thing to keep an eye out for is whether Trump wins fewer than three of the four states. If so, the pattern of inflated odds on Super Tuesday will have repeated itself, and one might be witnessing a systematically biased market that has not yet been corrected by new entrants attracted by the profit opportunity. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
But if the market turns out to be well-calibrated, then it's hard to see how Rubio could possibly secure the nomination. Here's the Florida forecast as of now:</div>
<div style="text-align: center;">
<br /></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi51S77M8_zuU4S8_cT-VOJESqDKv6SpVH-PT8XEzecTEeXpsSHmrfDVcgK0TcaOdYiXVRaFp64sZg2Q2bmlKyABStkIGrVzcfk2MZ_0xGzRDlp36R90gg35fal9YLocntu155vog/s1600/Screen+Shot+2016-03-05+at+1.29.45+AM.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="120" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi51S77M8_zuU4S8_cT-VOJESqDKv6SpVH-PT8XEzecTEeXpsSHmrfDVcgK0TcaOdYiXVRaFp64sZg2Q2bmlKyABStkIGrVzcfk2MZ_0xGzRDlp36R90gg35fal9YLocntu155vog/s200/Screen+Shot+2016-03-05+at+1.29.45+AM.png" width="200" /></a></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
The odds of a Trump victory in Michigan are even higher, while Kasich is slightly favored in Ohio. Plenty of things can change over the next couple of weeks, but based on the current snapshot I suspect that there is a non-negligible probability that Rubio may exit the race before Florida to avoid humiliation there, while Cruz and Kasich survive to the convention. This is obviously not the conventional wisdom in the media, where Rubio continues to be perceived as the establishment favorite. But unless things change in a hurry, I just don't see how this narrative can be sustained.<br />
<br />
<div style="text-align: center;">
---</div>
<br />
Update (March 5). The <a href="http://www.nytimes.com/elections/results" target="_blank">results</a> are in, with Cruz taking Kansas and Maine and Trump holding on to Kentucky and Louisiana. The only missed call by the prediction markets was therefore Maine. Still, the significant margins of victory for Cruz in Kansas and Maine suggest to me that traders in the aggregate continue to have somewhat inflated expectations regarding Trump's prospects. And I'm even more confident than I was early this morning that Rubio faces a humbling and humiliating loss in his home state of Florida, though he may have no option now but to soldier on.</div>
Rajivhttp://www.blogger.com/profile/13667685126282705505noreply@blogger.com16tag:blogger.com,1999:blog-4039434.post-58680101857885716452016-03-01T15:45:00.000-05:002016-03-05T13:52:49.350-05:00Super Tuesday<div style="text-align: justify;">
It's Super Tuesday, and if the polls and prediction markets aren't completely off base, Donald J. Trump is heading for a significant and perhaps insurmountable delegate lead in the contest for the Republican nomination. According to <a href="https://www.predictit.org/Browse/Group/64/Super-Tuesday" target="_blank">PredictIt</a>, he is heavily favored to win all states except Texas, in which Cruz continues to have an edge. His likelihood of winning exceeds 90% in Virginia, Georgia, Oklahoma, Massachusetts, Vermont, Alabama, Tennessee and Alaska. He is also favored to win Arkansas and Minnesota, though there is somewhat less certainty about these.<br />
<br />
The forecasts at <a href="http://fivethirtyeight.com/features/super-tuesday-preview-republican-presidential-election-2016/" target="_blank">FiveThirtyEight</a>, based on polls and fundamentals, are a bit less skewed but tell a similar story. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
The conventional wisdom seems to be that this is good news for the Democrats. For example:</div>
<div style="text-align: center;">
<blockquote class="twitter-tweet" data-lang="en">
<div dir="ltr" lang="en">
Super Tuesday: Republicans widely expected to hand the White House over to Hillary Clinton today</div>
— Downtown Josh Brown (@ReformedBroker) <a href="https://twitter.com/ReformedBroker/status/704648457206816768">March 1, 2016</a></blockquote>
</div>
<div style="text-align: justify;">
<br />
This seems very premature, and is quite inconsistent with prediction market prices. Currently Trump is given an 83% chance of securing the nomination and a 38% chance
of winning it all:<br />
<br /></div>
<div style="text-align: center;">
<br /></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjkWvjelid3mUyNIMuYaFsL1xWikLpbC-bTlobZM2Pidfro2toFKmCBnnsUF7lQq9eWoJEejo_iZMVBVc5coe9hLrvbbgOOev0o6TX-L4X2U4Pkhp-n5FVSTphAG6GfRSrnasDwDw/s1600/Screen+Shot+2016-03-01+at+2.33.53+PM.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="120" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjkWvjelid3mUyNIMuYaFsL1xWikLpbC-bTlobZM2Pidfro2toFKmCBnnsUF7lQq9eWoJEejo_iZMVBVc5coe9hLrvbbgOOev0o6TX-L4X2U4Pkhp-n5FVSTphAG6GfRSrnasDwDw/s400/Screen+Shot+2016-03-01+at+2.33.53+PM.png" width="400" /></a></div>
<div style="text-align: center;">
<br /></div>
<div style="text-align: justify;">
<br />
His probability of winning conditional on being
nominated is accordingly not far below one-half.<br />
<br />
Are the markets completely wrong or are pundits and prognosticators missing something important?</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
It seems to me that a major political realignment is underway in America. The press has focused on prominent Republicans who could not support Trump under any circumstances, such as <a href="http://townhall.com/tipsheet/christinerousselle/2016/02/29/sen-ben-sasse-i-will-never-ever-vote-for-trump-n2126521" target="_blank">Senator Sasse</a> of Nebraska. Some of these will sit out the election or look for a third option; some may consider crossing over. But there will also be crossover votes in the <a href="http://www.bostonherald.com/news/us_politics/2016/02/amid_trump_surge_nearly_20000_mass_voters_quit_democratic_party" target="_blank">other direction</a>:</div>
<div style="text-align: justify;">
<blockquote class="tr_bq">
Nearly 20,000 Bay State Democrats have fled the party this winter, with thousands doing so to join the Republican ranks, according to the state’s top elections official. Secretary of State William Galvin said more than 16,300 Democrats have shed their party affiliation and become independent voters since Jan. 1, while nearly 3,500 more shifted to the MassGOP ahead of tomorrow’s “Super Tuesday” presidential primary... The primary reason? Galvin said his “guess” is simple: “The Trump phenomenon,” a reference to GOP frontrunner Donald Trump, who polls show enjoying a massive lead over rivals Marco Rubio, Ted Cruz and others among Massachusetts Republican voters.
</blockquote>
</div>
<div style="text-align: justify;">
This phenomenon is unlikely to change the outcome in Massachusetts come November, but it could be enough to affect New Jersey, Pennsylvania or Ohio. In any case, the traditional lines between red and blue states are going to become increasingly blurred, with highly unpredictable net effects. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Perhaps the prediction markets are wrong on this point, skewed and shifted by Trump enthusiasts. I would certainly prefer it if that were the case. But I suspect that the prediction market crowd is on to something, and there is peril in ignoring it.<br />
<br />
<div style="text-align: center;">
---</div>
<br />
Update (March 2). The results are <a href="http://www.nytimes.com/elections/2016/results/2016-03-01" target="_blank">in the books</a>, with Trump winning seven of the predicted ten, losing Oklahoma and Alaska to Cruz and Minnesota to Rubio. Cruz won his home state as predicted. Since the markets systematically overestimated Trump's performance, the results should have lowered his odds in both the nominee and the presidential winner markets. And indeed this is what happened:<br />
<div style="text-align: center;">
<br /></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiVT8A6X2zmFo1-f_6mI9P3d0_eo-Z1_dOAyMGYNU67wfzYt-bsi6VdnizXmpu8oZHOyaSQalmgVQE7oT9a8jD_onKLw1DfUkCPXdYqMBN6bMGd-CBiraVF-SeTz40F8EqqRMaI-w/s1600/Screen+Shot+2016-03-02+at+5.41.12+AM.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="123" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiVT8A6X2zmFo1-f_6mI9P3d0_eo-Z1_dOAyMGYNU67wfzYt-bsi6VdnizXmpu8oZHOyaSQalmgVQE7oT9a8jD_onKLw1DfUkCPXdYqMBN6bMGd-CBiraVF-SeTz40F8EqqRMaI-w/s400/Screen+Shot+2016-03-02+at+5.41.12+AM.png" width="400" /></a></div>
<br /></div>
But here's the thing. Trump's odds of winning the presidency conditional on being nominated did not decline, consistent with the argument I made above. And since he remains the <a href="http://www.centerforpolitics.org/crystalball/articles/tuesdays-super-for-trump-and-clinton/" target="_blank">overwhelming favorite</a> for the nomination, it's worth keeping this in mind. Rajivhttp://www.blogger.com/profile/13667685126282705505noreply@blogger.com4tag:blogger.com,1999:blog-4039434.post-71979801657044098952016-01-10T11:06:00.002-05:002016-01-10T17:55:53.505-05:00College Sports and Deadweight Loss<div style="text-align: justify;">
The amount of money generated by college sports is staggering: broadcast rights alone are worth over a billion dollars annually, and this doesn't include tickets sales for live events, revenue from merchandise, or fees from licensing. But the athletes on whose talent and effort the entire enterprise is built get very little in return. As Donald Yee points out in a <a href="https://www.washingtonpost.com/posteverything/wp/2016/01/08/college-sports-exploits-unpaid-black-athletes-but-they-could-force-a-change/" target="_blank">recent article</a>, these athletes are "making enormous sums of money for everyone but themselves." Even the educational benefits are limited, with "contrived majors" built around athletic schedules and terribly low graduation rates. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Since colleges cannot compete for athletes by bidding up salaries, they compete in absurd and enormously <a href="https://www.washingtonpost.com/posteverything/wp/2016/01/08/college-sports-exploits-unpaid-black-athletes-but-they-could-force-a-change/" target="_blank">wasteful ways</a>:</div>
<div style="text-align: justify;">
<blockquote class="tr_bq">
Clemson’s new football facility will have a miniature-golf course, a sand volleyball pit and laser tag, as well as a barber shop, a movie theater and bowling lanes. The University of Oregon had so much money to spend on its football facility that it resorted to sourcing exotic building materials from all over the world.</blockquote>
</div>
<div style="text-align: justify;">
The benefit that athletes (or anyone else for that matter) derives from exotic building materials used for this purpose are negligible in relation to the cost. Only slightly less wasteful are the bowling lanes and other frills at the Clemson facility. The intended beneficiaries would be much better off if they were to receive the amounts spent on these excesses in the form of direct cash payments. This squandering of resources is what economists refer to as deadweight loss.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
But are competitive salaries really the best alternative to the current system? I think it's worth thinking creatively about compensation schemes that could provide greater monetary benefits to athletes while also improving academic preparation more broadly. Here's an idea. Suppose that athletes are paid competitive salaries but (with the exception of an allowance to cover living expenses) these are held in escrow until successful graduation. Upon graduation the funds are divided, with one-half going to the athlete as taxable income, and the rest distributed on a pro-rata basis to each primary and secondary school attended by the athlete prior to college. A failure to graduate would result in no payments to schools, and a reduced payment to the athlete. </div>
<div style="text-align: justify;">
<br />
This would provide both resources and incentives to improve academic preparation as well as athletic development at schools. Those talented few who make it to the highest competitive levels in college sports would clearly benefit, since their compensation would be in cash rather than exotic building materials. But the benefits would extend to entire communities, and link academic and athletic performance in a manner both healthy and enduring. It's admittedly a more paternalistic approach than pure cash payments, but surely less paternalistic than the status quo.</div>
Rajivhttp://www.blogger.com/profile/13667685126282705505noreply@blogger.com18tag:blogger.com,1999:blog-4039434.post-28161477076577003472016-01-04T23:41:00.000-05:002016-01-05T14:47:03.605-05:00The Order Protection Rule<div style="text-align: justify;">
The following is a lightly edited version of my <a href="https://www.sec.gov/comments/10-222/10222-285.pdf" target="_blank">comment letter</a> to the SEC in reference to the application by <a href="http://www.iextrading.com/" target="_blank">IEX</a> to register as a national securities exchange. Related issues were discussed in a couple of <a href="http://rajivsethi.blogspot.com/2014/04/superfluous-financial-intermediation.html" target="_blank">earlier</a> <a href="http://rajivsethi.blogspot.com/2015/04/intermediation-in-fragmented-market.html" target="_blank">posts</a> on intermediation in fragmented markets and in <a href="http://www.nytimes.com/2015/04/28/opinion/the-trader-as-scapegoat.html" target="_blank">this piece</a> on spoofing in an algorithmic ecosystem. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: center;">
---</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
In 1975, Congress <a href="https://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=1&ved=0ahUKEwj_65_M8JHKAhVFxGMKHVamAYEQFggdMAA&url=https%3A%2F%2Fwww.sec.gov%2Frules%2Ffinal%2F34-51808.pdf&usg=AFQjCNGkh2uoyNo-0y1UEG7B84aRWyB8Dg&sig2=pvy238SnLWXbfOsh0TBREQ&cad=rja" target="_blank">directed the SEC</a>, “through
enactment of Section 11A of the Exchange Act, to facilitate the establishment
of a national market system to link together the multiple individual markets
that trade securities.” A primary goal was to assure investors that “that they are
participants in a system which maximizes the opportunities for the most willing
seller to meet the most willing buyer.”</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
To implement this directive the SEC instituted <a href="https://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=1&ved=0ahUKEwj_65_M8JHKAhVFxGMKHVamAYEQFggdMAA&url=https%3A%2F%2Fwww.sec.gov%2Frules%2Ffinal%2F34-51808.pdf&usg=AFQjCNGkh2uoyNo-0y1UEG7B84aRWyB8Dg&sig2=pvy238SnLWXbfOsh0TBREQ&cad=rja" target="_blank">Regulation NMS</a>, a centerpiece of which is the Order Protection Rule:
</div>
<div class="InsideAddress" style="text-align: justify;">
<blockquote class="tr_bq">
The Order Protection
Rule (Rule 611 under Regulation NMS) establishes intermarket protection against
trade-throughs for all NMS stocks. A trade-through occurs when one trading
center executes an order at a price that is inferior to the price of a
protected quotation, often representing an investor limit order, displayed by
another trading center…<sup>.</sup> strong intermarket price protection offers
greater assurance, on an order-by-order basis, that investors who submit market
orders will receive the best readily available prices for their trades. </blockquote>
To a layperson, the common sense meaning of a
National Market System and the Order Protection Rule is that an arriving
marketable order (say Order A) should be matched with the best readily available price in the market as
a whole, before any order that is placed after Order A has made first contact
with the market begins to be processed.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Given the large number of trading venues now
in operation and the speeds at which communication occurs, it is important to
be very clear about what these terms mean. If a marketable order arrives at an
exchange, is partially filled, and then routed to another exchange, there will
be a small gap in time before the second exchange receives what is left of the
order. It is technologically possible for a third party to observe the first
trade (either because they are a counterparty to it or have access to the data
generated by it) and to act upon this information by sending orders to other
exchanges. These may be orders to trade or to cancel, and may arrive at other
exchanges before the first order has been fully processed.
</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Should these new orders, placed after Order A
has made first contact with the market, be given priority over Order A in
interacting with resting orders at other exchanges? It seems to me that the
plain meaning of Congress’ directive and the order protection rule says that
they should not.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
IEX’s proposed design prevents this kind of
event from taking place by delaying the dissemination of information generated
by Order A’s first contact with the market until enough time has elapsed for
the order to be fully processed. This brings the market closer to the national
system envisaged by Congress, and indeed by the SEC itself.
</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
It appears that the following example in a <a href="https://www.sec.gov/comments/10-222/10222-33.pdf" target="_blank">comment letter</a> by Hudson River Associates, while submitted as an objection to
the IEX application, actually supports this interpretation:
</div>
<div style="text-align: justify;">
<blockquote class="tr_bq">
Example 3: IEX BD
Router – IEX bypasses the POP allowing it beat a member to another exchange<br />
<ul>
<li>Member C has an order to buy at 10.00 resting on IEX. </li>
<li>IEX has a routable sell order that fully executes Member C’s buy interest on IEX. </li>
<li>When executed, Member C decides to update its buy order prices on another exchange
from 10.00 to 9.99. </li>
<li>The POP would delay Member C’s execution information by 350 microseconds. As a
result, although Member C’s buy order on IEX has been executed, it does not
know this for at least 350 microseconds. </li>
<li>Before Member C is informed of its buy order execution, the IEX BD Router sends an
order to the other exchange to execute against Member C’s buy order at 10.00 on
the other exchange. </li>
<li>Since
Member C was not informed of its execution on IEX, its order at 10.00 on the
other exchange is executed by the IEX BD Router before Member C can update the
price to 9.99. </li>
</ul>
</blockquote>
</div>
<div style="text-align: justify;">
This example refers to cancellation, but there
is nothing to prevent Member C from placing marketable sell orders at 10.00
that trade ahead of the routable order. In either case, liquidity that was “readily
available” when the routable sell order made first contact with the market is
removed before this order has been fully processed.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
What the author of this letter appears to want
is that Member C should be able to place an order (to cancel or trade) after
the routable sell order has made first contact with the market, and to have
these orders interact with the market before the routable sell order has been
fully processed. This kind of activity is currently permitted by the SEC, but
to me seems to clearly violate the spirit if not the letter of Congress’ directive.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
The design proposed by IEX, by preventing
orders from trading out of sequence (measured with respect to first contact
with the market) would bring the system closer to that envisaged by Congress. In
a true national market system with multiple exchanges, each order would receive
a timestamp marking its first contact with the market, and no order would begin
to be executed until all orders with earlier timestamps had been fully
processed. In making a determination on the IEX application, I would urge the
commission to consider whether approval would bring the system closer to this
ideal. And indeed, to think further about what other changes to the rules
governing market microstructure would also achieve the same goal.
</div>
Rajivhttp://www.blogger.com/profile/13667685126282705505noreply@blogger.com1tag:blogger.com,1999:blog-4039434.post-26368371105680844372015-10-16T23:46:00.000-04:002015-10-21T15:16:34.437-04:00Threats Perceived When There Are None<div style="text-align: justify;">
Sendhil Mullainathan is one of the most thoughtful people in the economics profession, but he has a <a href="http://www.nytimes.com/2015/10/18/upshot/police-killings-of-blacks-what-the-data-says.html" target="_blank">recent piece</a> in the New York Times with which I really must take issue.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Citing data on the racial breakdown of arrests and deaths at the hands of law enforcement officers, he argues that "eliminating the biases of all police officers would do little to materially reduce the total number of African-American killings." Here's his reasoning:</div>
<div style="text-align: justify;">
<blockquote class="tr_bq">
<div>
According to the F.B.I.’s Supplementary Homicide Report, 31.8
percent of people shot by the police were African-American, a proportion
more than two and a half times the 13.2 percent of African-Americans in
the general population... But this data does not prove that biased police
officers are more likely to shoot blacks in any given encounter...<br />
<br />
Every police encounter contains a
risk: The officer might be poorly trained, might act with malice or
simply make a mistake, and civilians might do something that is
perceived as a threat. The omnipresence of guns exaggerates all these
risks. </div>
<br />
Such
risks exist for people of any race — after all, many people killed by
police officers were not black. But having more encounters with police
officers, even with officers entirely free of racial bias, can create a
greater risk of a fatal shooting.<br />
<br />
Arrest
data lets us measure this possibility. For the entire country, 28.9
percent of arrestees were African-American. This number is not very
different from the 31.8 percent of police-shooting victims who were
African-Americans. If police discrimination were a big factor in the
actual killings, we would have expected a larger gap between the arrest
rate and the police-killing rate.<br />
<br />
This
in turn suggests that removing police racial bias will have little
effect on the killing rate. </blockquote>
</div>
<div style="text-align: justify;">
A key assumption underlying this argument is that encounters involving genuine (as opposed to perceived) threats to officer safety arise with equal frequency across groups. To see why this is a questionable assumption, consider two types of encounters, which I will call <i>safe</i> and <i>risky</i>. A risky encounter is one in which the confronted individual poses a real threat to the officer; a safe encounter is one in which no such threat is present. But a safe encounter might well be perceived as risky, as the following <a href="http://www.slate.com/blogs/the_slatest/2014/09/25/south_carolina_dashcam_shooting_sean_groubert_levar_jones_incident_on_video.html" target="_blank">example</a> of a traffic stop for a seat belt violation in South Carolina vividly illustrates:</div>
<br />
<br />
<div style="text-align: center;">
<iframe allowfullscreen="" frameborder="0" height="315" src="https://www.youtube.com/embed/RBUUO_VFYMs" width="420"></iframe>
</div>
<div style="text-align: center;">
<br /></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Sendhil is implicitly assuming that a white motorist who behaved in exactly the same manner as Levar Jones did in the above video would have been treated in precisely the same manner by the officer in question, or that the incident shown here is too rare to have an impact on the aggregate data. Neither hypothesis seems plausible to me. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
How, then, can one account for the rough parity between arrest rates and the rate of shooting deaths at the hands of law enforcement? If officers frequently behave differently in encounters with black civilians, shouldn't one see a higher rate of killing per encounter? </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Not necessarily. To see why, think of the <a href="http://rajivsethi.blogspot.com/2009/11/leon-lashley-and-gates-arrest.html" target="_blank">encounter</a> involving Henry Louis Gates and Officer James Crowley back in 2009. This was a safe encounter as defined above, but may not have happened in the first place had Gates been white. If the very high incidence of encounters between police and black men is due, in part, to encounters that ought not to have occurred at all, then a disproportionate share of these will be safe, and one ought to expect <i>fewer</i> killings per encounter in the absence of bias. Observing parity would then be suggestive of bias, and eliminating bias would surely result in fewer killings. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
In justifying the termination of the officer in the video above, the director of the South Carolina Department of Public Safety <a href="http://www.scdps.gov/comm/nr2014/091914.html" target="_blank">stated</a> that he "reacted to a perceived threat where there was none." Fear is a powerful motivator, and even when there are strong incentives not to shoot, it is still a preferable option to being shot. This is why stand-your-ground laws have resulted in an <a href="http://rajivsethi.blogspot.com/2012/06/reciprocal-fear-and-castle-doctrine.html" target="_blank">increased incidence of homicide</a>, despite narrowing the very definition of homicide to exclude certain killings. It is also why homicide is so <a href="http://www.nber.org/chapters/c11847" target="_blank">volatile</a> across time and space, and why staggering <a href="http://www.sciencedirect.com/science/article/pii/S0094119010000343" target="_blank">racial disparities</a> in both victimization and offending persist. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
None of this should detract from the other points made in Sendhil's <a href="http://www.nytimes.com/2015/10/18/upshot/police-killings-of-blacks-what-the-data-says.html" target="_blank">piece</a>. There are indeed deep structural problems underlying the high rate of encounters, and these need urgent policy attention. But a careful reading of the data does not support the claim that "removing police racial bias will have little
effect on the killing rate." On the contrary, I expect that <a href="http://www.nydailynews.com/new-york/serpico-wedge-driven-police-society-article-1.2034651" target="_blank">improved screening</a> and better training, coupled with body and dashboard cameras, will result in fewer officers reacting to a perceived threat when there is none.</div>
<div style="text-align: justify;">
<br />
<div style="text-align: center;">
---</div>
<br />
<b>Update (10/18)</b>. I had a useful exchange of emails with Sendhil yesterday. I think that we both care deeply about the issue and are interested in getting to the truth, not in scoring points. But there's no convergence in positions yet. Here's an extract of my last to him (I'm posting it because it might help clarify the argument above):<br />
<blockquote class="tr_bq">
Definitely you can easily make sense of the data without bias. The
question is whether this is the right inference, given what we know
about the processes generating encounters.<br />
<br />
Suppose (for the sake of argument) that whites have encounters with
police only if they are engaging in some criminal activity, while
blacks sometimes have encounters with police when they are
completely innocent. This need not be due to police bias: it could
be because bystanders are more likely to think blacks are up to no
good for instance (Gates and Rice come to mind). <br />
<br />
Suppose further that those engaging in criminal activity are threats
to the police with some probability, and this is independent of
offender race. The innocents are never threats to the police. But
cops can't tell black innocents from black criminals, so end up
killing blacks and whites at the same rate per encounter. If they
could tell them apart, blacks would be killed at a lower rate per
encounter. What I mean by bias is really this inability to
distinguish; to see threats when none are present. <br />
<br />
I believe that black cops are less likely than white cops to
perceive an encounter with an innocent as threatening. If a suspect
looks like your cousin, or a guy you sit beside to watch football on
Sundays, you are less likely to see him as a threat when he is not.
That's why I asked you in Cambridge whether you had data on officer
race in killings - when the victim is innocent the officer seems
invariably to be white. So a first very rough test of bias would be
whether innocents are killed at the same rate by black and white
officers...<br />
<br />
I've found the twitter reaction to your post a bit depressing,
because better selection, training and video monitoring are really
urgent needs in my opinion, and the absence-of-bias narrative can
feed complacency about these. I know that was far from your
intention, and you are extremely sympathetic to victims of police
(and other) violence. You also have a responsibility to speak out on
the issue, given your close scrutiny of the data. But I do believe
that the inference you've made about the likely negligible effects
of eliminating police bias are not really supported by the evidence
presented. That, and the personal importance of the issue to me,
compelled me to write the response. </blockquote>
<div style="text-align: center;">
---</div>
<br />
<b>Update (10/19)</b>. This <a href="https://jwdink.shinyapps.io/police-deaths" target="_blank">post</a> by Jacob Dink is worth reading. Jacob shows that the likelihood of being shot by police conditional on being unarmed is twice as high for blacks relative to whites. The likelihood is also higher conditional on being armed, but the difference is smaller:<br />
<br />
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgF1o0yNDiTuOxl1_UDYS_fGrdgBLhm3BB3ePylBf1iyBtgPS7gpEWBxFtotmTYp8NV5ykuiNPaUgBaVAg9TdCII3YSh8q4MV_WuhM57e5mKXVn__U4qFk2_pJqbbhd_RU8wNd2rA/s1600/unnamed-chunk-6-1.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="285" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgF1o0yNDiTuOxl1_UDYS_fGrdgBLhm3BB3ePylBf1iyBtgPS7gpEWBxFtotmTYp8NV5ykuiNPaUgBaVAg9TdCII3YSh8q4MV_WuhM57e5mKXVn__U4qFk2_pJqbbhd_RU8wNd2rA/s400/unnamed-chunk-6-1.png" width="400" /></a></div>
<br />
This, together with the fact that rates of arrest and killing are roughly equal across groups, implies that blacks are less likely to be armed than whites, conditional on an encounter. In the absence of bias, therefore, the rate of killing per encounter should be <i>lower</i> for blacks, not equal across groups. So we can't conclude that "removing police racial bias will have little
effect on the killing rate." That was the point I was trying to make in this post. <br />
<br />
<div style="text-align: center;">
---</div>
<br />
<b>Update (10/21)</b>. Andrew Gelman <a href="http://andrewgelman.com/2015/10/21/its-all-about-the-denominator-and-rajiv-sethi-and-sendhil-mullainathan-in-a-statistical-debate-on-racial-bias-in-police-killings/" target="_blank">follows up</a>. The link above to Jacob Dink's post seems to be broken and I can't find a cached version. But there's a <a href="http://howardfrant.blogspot.com/2015/06/a-note-on-police-shootings.html" target="_blank">post</a> by Howard Frant from earlier this year that makes a similar point. </div>
Rajivhttp://www.blogger.com/profile/13667685126282705505noreply@blogger.com10tag:blogger.com,1999:blog-4039434.post-37284366211388386742015-09-29T20:42:00.002-04:002015-10-01T10:17:13.973-04:00The Price Impact of Margin-Linked Shorts<div style="text-align: justify;">
The real money peer-to-peer prediction market PredictIt just made a major <a href="http://www2.aristotle.com/webmail/55602/167835699/68d4401f6fdc1bcd1e5abdbac91c7308" target="_blank">announcement</a>: they plan to margin-link short positions. This will lead to an across-the board decline in the prices of many contracts, especially in the two nominee markets. Given that the prices in these markets are already being <a href="http://www.politico.com/story/2015/09/jeb-bush-2016-donors-republicans-214166" target="_blank">referenced</a> by the campaigns, this change could well have an impact on the race.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
What margin-linking short positions does is to make it substantially cheaper to bet simultaneously against multiple candidates. Instead of a trader's worst-case loss being computed separately for each position, it is computed based on the recognition that only one candidate can eventually win. So a bet against <i>both</i> Bush and Rubio ought to require less cash than a bet against just one of the two, since we know that a loss on one bet implies a win on the other.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
In an <a href="http://rajivsethi.blogspot.com/2015/04/prediction-market-design.html" target="_blank">earlier post</a> I argued that a failure to margin-link short positions was a design flaw that results in artificially inflated prices for all contracts in a given market, making the interpretation of these prices as probabilities untenable. The problem can be seen by looking at some of the current prices in the GOP nominee market:</div>
<div style="text-align: justify;">
<br /></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgH2YSApyIP3Jpn3fY7_s-K-7F8Vh5jaFO1CYUCTlYFzxeiqJuFSKDCrOYJp3SXU1cTynMWJ-MrgditIOE30JdxxS3lvrdGks-worZcqdjQLB8-Nhaji6lSatC15uwRBJs1GhtTWw/s1600/GOP+nominee.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="376" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgH2YSApyIP3Jpn3fY7_s-K-7F8Vh5jaFO1CYUCTlYFzxeiqJuFSKDCrOYJp3SXU1cTynMWJ-MrgditIOE30JdxxS3lvrdGks-worZcqdjQLB8-Nhaji6lSatC15uwRBJs1GhtTWw/s400/GOP+nominee.png" width="400" /></a></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
The "Buy No" column tells us the price per contract of betting against a candidate for the nomination, with each contract paying out a dollar if the named individual fails to secure the nomination. One could buy five of these contracts (Rubio, Bush, Trump, Fiorina, and Carson) for a total of $3.91, and even of one of these were to win, the payoff from the bet would be $4. If, on the other hand, Cruz or Kasich were to be nominated, the bet would pay $5. There is no risk of loss involved.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Margin-linking shorts recognizes this fact, and would make this basket of five bets collectively cost nothing at all. This would be about as pure an arbitrage opportunity as one is likely to find in real money markets. Aggressive bets would be placed on all contracts simultaneously, with consequent price declines.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
A useful effect of this change in design is that manipulating the market becomes much harder. Buying contracts to push up a price would be met by a wall of resistance as long as the sum of all contract prices yields an opportunity for arbitrage. To sustain manipulation would require a trader not only to put a floor on the favored contract, but a ceiling on all others. This <a href="http://rajivsethi.blogspot.com/2013/09/the-romney-whale.html" target="_blank">has been done</a> before, but would be considerably more costly than under the current market design.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
I'd be interested to see which prices are affected most as the transition occurs, and how much prices move in anticipation of the change. But no matter how the aggregate decline is distributed across contracts, this example illustrates one important fact about financial markets in general: prices depend not just on beliefs about the likelihood of future events, but also on detailed features of market design. Too uncritical an acceptance of the efficient markets hypothesis can lead us to overlook this somewhat obvious but quite important point. </div>
Rajivhttp://www.blogger.com/profile/13667685126282705505noreply@blogger.com17tag:blogger.com,1999:blog-4039434.post-42321285643946895692015-04-22T08:34:00.002-04:002015-04-23T08:55:14.678-04:00Spoofing in an Algorithmic Ecosystem<div style="text-align: justify;">
A London trader recently <a href="http://www.justice.gov/sites/default/files/opa/press-releases/attachments/2015/04/21/sarao_criminal_complaint.pdf" target="_blank">charged</a> with price manipulation appears to have been using a strategy designed to trigger high-frequency trading algorithms. Whether he used an algorithm himself is beside the point: he made money because the market is dominated by computer programs responding rapidly to incoming market data, and he understood the basic logic of their structure. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Specifically, Navinder Singh Sarao is accused of having <a href="http://www.ft.com/intl/cms/s/0/fc3a66a8-e84a-11e4-baf0-00144feab7de.html#axzz3Y1jCJty2" target="_blank">posted</a> large sell orders that created the impression of substantial fundamental supply in the S&P E-mini futures contract:</div>
<div style="text-align: justify;">
<blockquote class="tr_bq">
<div style="background-color: white; border: medium none; color: black; overflow: hidden; text-decoration: none;">
The
authorities said he used a variety of trading techniques designed to
push prices sharply in one direction and then profit from other
investors following the pattern or exiting the market.</div>
<br />
The DoJ said by allegedly placing multiple, simultaneous,
large-volume sell orders at different price points — a technique known
as “layering”— Mr Sarao created the appearance of substantial supply in
the market. </blockquote>
<blockquote class="tr_bq">
Layering is a type of spoofing, a strategy of entering bids or offers with the intent to cancel them before completion.</blockquote>
</div>
<div style="text-align: justify;">
Who are these "other investors" that followed the pattern or exited the market? Surely not the fundamental buyers and sellers placing orders based on an analysis of information about the companies of which the index is composed. Such investors would not generally be sensitive to the kind of order book details that Sarao was trying to manipulate (though they may buy or sell using algorithms sensitive to trading volume in order to limit market impact). Furthermore, as Andrei Kirilenko and his co-authors found in a transaction level analysis, fundamental buyers and sellers account for a very <a href="http://rajivsethi.blogspot.com/2011/02/market-ecology.html" target="_blank">small portion</a> of daily volume in this contract. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
As far as I can tell, the strategies that Sarao was trying to trigger were high-frequency trading programs that combine passive market making with aggressive order anticipation based on privileged access and rapid responses to incoming market data. Such strategies <a href="http://rajivsethi.blogspot.com/2012/12/risk-and-reward-in-high-frequency.html" target="_blank">correspond</a> to just one percent of accounts on this exchange, but are responsible for almost half of all trading volume and appear on one or both sides of almost three-quarters of traded contracts. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
The most sophisticated algorithms would have detected Sarao's spoofing and may even have tried to profit from it, but less nimble ones would have fallen prey. In this manner he was able to syphon off a modest portion of HFT profits, amounting to about <strike>four</strike> forty million dollars over four years. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
What is strange about this case is the fact that spoofing of this kind is, to quote one market observer, as <a href="https://twitter.com/nanexllc/status/590596274640027648" target="_blank">common as oxygen</a>. It is frequently used and defended against within the high frequency trading community. So why was Sarao singled out for prosecution? I suspect that it was because his was a relatively small account, using a simple and fairly transparent strategy. Larger firms that combine multiple strategies with continually evolving algorithms will not display so clear a signature. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
It's important to distinguish Sarao's strategy from the ecology within which it was able to thrive. A key feature of this ecology is the widespread use of <a href="http://rajivsethi.blogspot.com/2010/05/blame-instructions-not-machines.html" target="_blank">information extracting strategies</a>, the proliferation of which makes direct investments in the acquisition and analysis of fundamental information less profitable, and makes extreme events such as the flash crash practically inevitable. </div>
Rajivhttp://www.blogger.com/profile/13667685126282705505noreply@blogger.com4tag:blogger.com,1999:blog-4039434.post-48217801541309121542015-04-06T20:04:00.002-04:002015-04-07T07:13:29.295-04:00Intermediation in a Fragmented Market<div style="text-align: justify;">
There’s a <a href="http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2580002" target="_blank">recent paper</a> by Merritt Fox, Lawrence Glosten and Gabriel Rauterberg that anyone interested in the microstructure of contemporary asset markets would do well to read. It's one of the few papers to take a comprehensive and theoretically informed look at the welfare implications of high frequency trading, including effects on the incentives to invest in the acquisition and analysis of fundamental information, and ultimately on the allocation of capital and the distribution of risk. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Back in 1985, Glosten <a href="http://www.sciencedirect.com/science/article/pii/0304405X85900443" target="_blank">co-authored</a> what has become one of the most influential papers in the theory of market microstructure. That paper considered the question of how a market maker should set bid and ask prices in a continuous double auction in the presence of potentially better informed traders. The problem facing the market maker is one of <i>adverse selection</i>: a better informed counterparty will trade against a quote only if doing so is profitable, which necessarily means that all such transactions impose a loss on the market maker. To compensate there must be a steady flow of orders from uninformed parties, such as investors in index funds who are accumulating or liquidating assets to manage the timing of their consumption. The competitive bid-ask spread depends, among other things, on the size of this uninformed order flow as well as the precision of the signals received by informed traders.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
The Glosten-Milgrom model, together with a closely related <a href="http://www.jstor.org/stable/1913210?seq=1#page_scan_tab_contents" target="_blank">contribution</a> by Albert Kyle, provides the theoretical framework within which the new paper develops its arguments. This is a strength because the role of adverse selection is made crystal clear. In particular, any practice that defends a market maker against adverse selection (such as electronic front running, discussed further below) will tend to lower spreads under competitive conditions. This will benefit uninformed traders at the margin, but will hurt informed traders, reduce incentives to acquire and analyze fundamental information, and could result in lower share price accuracy. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Such trade-offs are inescapable, and the Glosten-Milgrom and Kyle models help to keep them in sharp focus. But this theoretical lens is also a limitation because the market makers in these models are passive liquidity providers who do not <i>build</i> directional exposure based on information gleaned from their trading activity. This may be a reasonable description of the specialists of old, but the new market makers combine passive liquidity provision with aggressive order anticipation, and respond to market data not simply by cancelling orders and closing out positions but by <a href="http://rajivsethi.blogspot.com/2012/12/risk-and-reward-in-high-frequency.html" target="_blank">speculating</a> on short term price movements. They would do so even in the absence of market fragmentation, and this has implications for price volatility and the likelihood of extreme events which I have discussed in <a href="http://rajivsethi.blogspot.com/2010/05/reflections-on-flash-crash.html" target="_blank">earlier</a> <a href="http://rajivsethi.blogspot.com/2011/02/market-ecology.html" target="_blank">posts</a>. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
But the focus of the paper is not on volatility, but rather on market fragmentation and differential access to information. The authors argue that three controversial practices---electronic front running, slow market arbitrage, and midpoint order exploitation---can all be traced to these two features of contemporary markets, and can all be made infeasible by a simple change in policy. It's worth considering these arguments in some detail.</div>
<div style="text-align: justify;">
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Electronic front running is the practice of using information acquired as a result of a trade at one venue to place or cancel orders at other venues while orders placed at earlier points in time are still in transit. The authors illustrate the practice with the following example: </div>
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For simplicity of exposition, just one HFT, Lightning, and two exchanges, BATS Y and the NYSE, are involved. Lightning has co-location facilities at the respective locations of the BATS Y and NYSE matching engines. These co-location facilities are connected with each other by a high-speed fiber optic cable. </blockquote>
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An actively managed institutional investor, Smartmoney, decides that Amgen’s future cash flows are going to be greater than its current price suggests. The NBO is $48.00, with 10,000 shares being offered at this price on BATS Y and 35,000 shares at this price on NYSE. Smartmoney decides to buy a substantial block of Amgen stock and sends a 10,000 share market buy order to BATS Y and a 35,000 share market buy order to NYSE. The 35,000 shares offered at $48.00 on NYSE are all from sell limit orders posted by Lightning. </blockquote>
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The order sent to BATS Y arrives at its destination first and executes. Lightning’s colocation facility there learns of the transaction very quickly. An algorithm infers from this information that an informed trader might be looking to buy a large number of Amgen shares and thus may have sent buy orders to other exchanges as well. Because of Lightning’s ultra-high speed connection, it has the ability to send a message from its BATS Y co-location facility to its co-location facility at NYSE, which in turn has the ability to cancel Lightning’s 35,000 share $48.00 limit sell order posted on NYSE. All this can happen so fast that the cancellation would occur before the arrival there of Smartmoney’s market buy order. If Lightning does cancel in this fashion, it has engaged in “electronic front running.” </blockquote>
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Note that if Smartmoney had simply sent an order to buy 45,000 shares to BATS Y, of which an unfilled portion of 35,000 was routed to NYSE, the same pattern of trades and cancellations would occur. But in this alternative version of the example, orders would not be processed in the sequence in which they make first contact with the market. In particular, the cancellation order would be processed before the original buy order had been processed in full. This seems to violate the spirit if not the letter of <a href="https://www.sec.gov/rules/final/34-51808.pdf" target="_blank">Regulation NMS</a>.</div>
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Furthermore, while the authors focus on order cancellation in response to the initial information, there is nothing to prevent Lightning from buying up shares on NYSE, building directional exposure, then posting offers at a slightly higher price. In fact, it <i>cannot</i> be optimal from the perspective of a firm with such a speed advantage to simply cancel orders in response to new information: there must arise situations in which the information is strong enough to warrant a speculative trade. In effect, the firm would mimic the behavior of an informed trader by <a href="http://rajivsethi.blogspot.com/2010/05/blame-instructions-not-machines.html" target="_blank">extracting</a> the information from market data, at a fraction of the cost of acquiring the information directly. </div>
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Electronic front running prevents informed traders from transacting against all resting orders that are available at the time they place an order. This defends high frequency traders against adverse selection, allowing them to post smaller spreads, which benefits uninformed traders. But it also lowers the returns to investing in the acquisition and analysis of information, potentially lowering share price accuracy. Given this, the authors consider the welfare effects of electronic front running to be ambiguous. </div>
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The other two practices, however, result in unambiguously negative welfare effects. First consider slow market arbitrage, defined and illustrated by the authors as follows:</div>
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Slow market arbitrage can occur when an HFT has posted a quote representing the NBO or NBB on one exchange, and subsequently someone else posts an even better quote on a second exchange, which the HFT learns of before it is reported by the national system. If, in the short time before the national report updates, a marketable order arrives at the first exchange, the order will transact against the HFT’s now stale quote. The HFT, using its speed, can then make a riskless profit by turning around and transacting against the better quote on the second exchange…<br />
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To understand the practice in more detail, let us return to our HFT Lightning. Suppose that Lightning has a limit sell order for 1000 shares of IBM at $161.15
posted on NYSE. This quote represents the NBO at the moment. Mr. Lowprice then posts a new 1000 share sell limit order for IBM on EDGE for $161.13.<br />
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The national reporting system is a bit slow, and so a short period of time elapses before it reports Lowprice’s new, better offer. Lightning’s co-location facility at EDGE very quickly learns of the new $161.13 offer, however, and an algorithm sends an ultra-fast message to Lightning’s co-location facility at NYSE informing it of the new offer. During the reporting gap, though, Lightning keeps posted its $161.15 offer. Next, Ms. Stumble sends a marketable buy order to NYSE for 1000 IBM shares. Lightning’s $161.15 offer remains the official NBO, and so Stumble’s order transacts against it. Lightning’s co-location facility at NYSE then sends an ultra-fast message to the one at EDGE instructing it to submit a 1000 share marketable buy order
there. This buy order transacts against Lowprice’s $161.13 offer. Thus, within the short period before the new $161.13 offer is publicly reported, Lightning has been able to sell 1000 IBM shares at $161.15 and purchase them at $161.13, for what appears to be a $20 profit. </blockquote>
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This practice hurts both informed and uninformed traders, and is a clear example of what I have elsewhere called <a href="http://rajivsethi.blogspot.com/2014/04/superfluous-financial-intermediation.html" target="_blank">superfluous financial intermediation</a>. According to the authors this practice would have negative welfare effects even if it did not require the investment of real resources.</div>
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In discussing wealth transfer, the authors argue that "Ms. Stumble... would have suffered the same fate if Lightning had not engaged in slow market arbitrage because that course of action would have also left the $161.15 offer posted on NYSE and so Stumble’s buy order would still have transacted against it." While this is true under existing order execution rules, note that it would not be true if orders were processed in the sequence in which they make first contact with the market. </div>
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Finally, consider mid-point order exploitation:</div>
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A trader will often submit to a dark pool a “mid-point” limit buy or sell order, the terms of which are that it will execute against the next marketable order with the opposite interest to arrive at the pool and will do so at a price equal to the mid-point between the best publicly reported bid and offer at the time of execution. Mid-point orders appear to have the advantage of allowing a buyer to buy at well below the best offer and sell well above the best bid. It has been noted for a number of years, however, that traders who post such orders are vulnerable to the activities of HFTs… Mid-point order exploitation again involves an HFT detecting an improvement in the best available bid or offer on one of the exchanges before the new quote is publicly reported. The HFT puts in an order to transact against the new improved quote, and then sends an order reversing the transaction to a
dark pool that contains mid-point limit orders with the opposite interest that transact at a price equal to the mid-point between the now stale best publicly reported bid and offer…<br />
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Let us bring back again our HFT, Lightning. Suppose that the NBO and NBB for IBM are $161.15 and $161.11, respectively, and each are for 1000 shares and are
posted on NYSE by HFTs other than Lightning. Then the $161.15 offer is cancelled and a new 1000 share offer is submitted at $161.12. Lightning, through its co-location facilities at NYSE, learns of these changes in advance of their being publicly reported. During the reporting gap, the official NBO remains $161.15.<br />
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Lightning knows that mid-point orders for IBM are often posted on Opaque, a well known dark pool, and Lightning programs its algorithms accordingly. Because Opaque does not disclose what is in its limit order book, Lightning cannot know, however, whether at this moment any such orders are posted on Opaque, and, if there are, whether they are buy orders or sell orders. Still there is the potential for making money.<br />
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Using an ultra-fast connection between the co-location facility at NYSE and Opaque, a sell limit order for 1000 shares at $161.13 is sent to Opaque with the condition attached that it cancel if it does not transact immediately (a so-called “IOC” order). This way, if there was one or more mid-point buy limit orders posted at Opaque for IBM, they will execute against Lightning’s order at $161.13, half way between the now stale, but still official, NBB of $161.11 and NBO of $161.15. If there are no such mid-point buy orders posted at Opaque, nothing is lost.<br />
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Assume that there are one or more such mid-point buy orders aggregating to at least 1000 shares and so Lightning’s sell order of 1000 shares transacts at $161.13. Lightning’s co-location facility at NYSE is informed of this fact through Lightning’s ultra-fast connection with Opaque. A marketable buy order for 1000 shares is sent almost instantaneously to NYSE, which transacts against the new $161.12 offer. Thus, within the short period before the new $161.12 offer on NYSE is publicly reported, Lightning has been able to execute against this offer, purchase 1000
IBM shares at $161.12, and sell them at $161.13, for what appears to be a $10.00 profit. </blockquote>
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As in the case of slow market arbitrage, this hurts informed and uninformed traders alike. </div>
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The three activities discussed above all stem from the fact that trading in the same securities occurs across multiple exchanges, and market data is available to some participants ahead of others. The authors argue that a simple regulatory change could make all three practices infeasible:</div>
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We think there is an approach to ending HFT information speed advantages that is
simpler both in terms of implementation and in terms of achieving the needed legal changes. None of these three practices would be possible if private data feeds did not make market quote and transaction data effectively available to some market participants before others. Thus, one potential regulatory response to the problem posed by HFT activity is to require that private dissemination of quote and trade information be delayed until the exclusive processor under the Reg. NMS scheme, referred to as the “SIP,” has publicly disseminated information from all
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Rule 603(a)(2) of Reg. NMS prohibits exchanges from “unreasonably discriminatory” distribution of market data… Sending the signal simultaneously to an HFT and to the SIP arguably is “unreasonably discriminatory” distribution of core data to the end users since it is predictable that some will consistently receive it faster than others… Interestingly, this focus on the time at which information reaches end users rather than the time of a public announcement is the approach the courts and the SEC have traditionally taken with respect to when, for purposes
of the regulation of insider trading, information is no longer non-public. Thus the SEC’s ability to alter its interpretation of Rule 603(a)(2) may be the path of least legislative or regulatory resistance to prohibiting electronic front-running. </blockquote>
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There’s an even simpler solution, however, and that is to process each order in full in the precise sequence in which it makes <i>first</i> contact with the market. That is, if two orders reach an exchange in quick succession, they should be processed not in the order in which they reach the exchange but rather the order in which they have reached <i>any</i> exchange. Failing this, I don't see how we can be said to have a "national market system" at all. </div>
Rajivhttp://www.blogger.com/profile/13667685126282705505noreply@blogger.com0