Steve Hemingway

I spend too much time worrying about what Google thinks of my websites. It seems to have a mind of its own. I am usually disappointed in looking at my page rank, and general search engine performance, since I seem to further and further down the rankings.

Just recently this blog has mysteriously shot up. It seems to have coincided with my commenting on postings by Becker and Posner, a blog that I very much admire. They are always thought provoking, even if they can be rather ideological on occasions. You may think that This post is too Panglossian, for example.

What I didn't realise is that Movable Type is smart enough to parse the blog entry and fill in the trackbacks automatically. Previously I'd been carefully cutting and pasting the trackbacks into the relevant field on the posting screen.

I remain convinced that a modest level of link exchanging is beneficial to one's page rank. If you have a blog and you'd like to swap links, then please drop me a line. This means you, Neil!

I don't like to cut and paste whole articles from the web, but the FT's terrible website, and it's subscription policy for archives leaves me with no practical alternative. I'm sure the author won't mind!

Sir, Many investors have been taken by surprise by last week’s huge swings in the markets. But they shouldn’t have been. As Benoit Mandelbrot taught us long ago, and Nassim Taleb popularised in his recent book The Black Swan, extreme returns are far more likely and have a much larger impact on portfolios than most people usually think.

On Black Monday (October 17 1987), the Dow fell 22.6 per cent and more than erased the return earned since the beginning of the year (201 trading days). It then took the Dow another 320 days to get past the level reached the day before the crash. Although Black Monday is an extreme example, it is indeed the case that a few large daily swings can more than overturn the return obtained over a long period of time.

Between 1969 and 2006, a passive investor in the UK would have turned £100 into £1,854 (without accounting for dividends). However, an investor who missed the best 10 (20) days would have seen his terminal wealth reduced to just £979 (£596), and one who avoided the worst 10 (20) days would have seen his terminal wealth increased to £3,819 (£6,063). That is particularly shocking given that 10 (20) days are just 0.1 per cent (0.2 per cent) of the days considered.

This and other similar results have at least three important lessons for investors. First, long-term performance is largely determined by the impact of very few outliers, like those observed last week. Second, investors are very unlikely to time the market successfully and consistently. And third, much like going to Las Vegas, market timing may be exciting but is not a good way to make money.

So what are investors to do, when faced with swings like those observed last week? Nothing! They should just keep their eyes on the long term (and off the prices flashing in the computer screen), and stay the course. And if they feel adventurous enough and want to play Indiana Jones, they should even increase their exposure to the market.

After all, that is just what Warren Buffett and other savvy long-term investors do every time the market takes a big dive.

Javier Estrada,
IESE Business School,
08034 Barcelona, Spain

In passing, this shows why it's so hard to make money trading futures, and why the advice to put tight stops on all positions is absolute folly.

This article by John Gapper exposes the perverse incentives for traders in big banks and explains why Jérôme Kerviel was perfectly rational in his actions at Soc. Gen. This article requires an FT subscription, but someone has helpfully cloned it on the web here.

The perverse incentives of chief executives at large, publicly-quoted firms has led to the explosion of private equity, where the agency problem is solved by shooting the agent. Hedge funds may have some mechanisms to solve the trader's put problem. (The idea that the trader has a free option to 'sell' his position by just quitting or even being fired. This means that his incentives are asymmetrical: if his position makes a lot of money he gets a big reward whereas if they lose a lot of money his punishment is quite mild).

I have read Brearley and Myers. I have read a lot of books on enterprise and busines. I have read quite a bit of economics. In none of those places have I previously come across an analysis of what makes an optimal size of a firm.

I remember years ago reading something about the ease of communication and enforcing laws being a determinant of the size of countries or empires. Obviously there are problems with this when we look back on the Roman and British Empires, and think about the internet and modern communications.

On the face of it, with the market and prices being such perfect instruments for organising economic activity, it is not clear that firms are needed at all. Scott Adams of Dilbert fame has a large brand that has no employees, and I am fairly sure that Scott works at his PC in his dressing gown. How come the bosses of IBM and and Exxon do not do this?

The answer is to do with transaction costs: the price of using the price mechanism. It may be perfect, but it is not free! The argument is that the explicit arms-length contract that would have to be entered into to make someone a reasonable substitute for an employee is so complicated and costly that you really wouldn't want to bother unless the job was very simple (like operating the works canteen, or doing the cleaning).

I buy the general argument, but I'd like some numbers. I was reading a book, 'The Origin and Evolution of New Businesses' by Amar Bhidé. It simply observed that Oscar Mayer, the leading restaurant vendor of hot dogs in the US was a tiny fraction of the size of MacDonalds (and had a much smaller proportion of the market for hot dog vending market). This it put down to the influence of the founder, Ray Croc, suggesting at the very least, very slow convergence to equilibrium in these kind of markets.

This is one of those questions that business-school types seem to be uncurious about. Maybe it genuinely is a question that is not worth asking, but it would be nice for someone clearly to articulate why.

References

Wikipedia article on this topic, references Coase, who had the seminal insight.

Econtalk discussion of this with Mike Munger - highly recommended.

I don't think Economists think enough about software. I have never seen a professional economist discuss microeconomics of software production. Many businessmen fail to understand the nature of software, assuming that it can be produced in the same way that production line workers produce refrigerators, or building contractors produce tower blocks, or, possibly film producers produce films.

Two blog entries discuss the marginal cost of production of software (an new line of code?) here, and here, the second by the excellent geek Ben Laurie, the first reached through reading the comments on Ben's post.

I am not 100% sure I agree with each (which particularly look at the Open Source movement, rather than software development in general), but they are certainly not far from the correct analysis. As Baudel states, rather eloquently: "Software distinguishes itself from other works of the mind, such as music, in that its originality is by no means a part of its value or utility.".

What is certain is that to create software is to respond to a noble calling.

This post is rather worrying. It suggests that submitting links 'unnaturally quickly' or having an inbound link that looks 'suspiciously' like a paid-for link can result in a site being unindexed from Google altogether.

This would be a catastrophe for many ordinary businesses. Google accounts for the huge bulk of visits to my commercial sites. I suffered a severe loss of traffic moving from one host to another (and also switching domain names, temporarily) about a year ago. I have still not recovered.

I am a great fan of Google, but I am not unaware of the fact that it could crush me and not even notice.

Defra's Environmental Contract pages are a masterpiece of woolly-thinking nonsense. Take a look at this:

Who are the parties to the environmental contract?

All are welcome to take part but it is too late to wait for the unconvinced. Action must begin today and from this action it is hoped that others will be inspired to play their part in the process.

The contract a very over-extended analogy. The idea seems to be to avoid giving the impression that the government is forcing 'green' behaviour on individuals and firms, but is instead somehow entering into a contract with them, doing it's part in return for green behaviour on the part of them.

The problem is that the essential nature of a contract is that both sides enter into it willingly. But it is quite clear that the government will prosecute citizens who fail to carry out some (or possibly all) of their obligations under the 'contract'.

It beggars belief that Milliband when he was at Defra could have agreed this complete rubbish being published. One dispairs of the thought that his is not in charge of foreign policy for this country.

read Go here to read about this pile of utter rubbish.

The idea is that the local community is consulted about what development will take place in their district. The idea is, presumably, to allow local residents to decide how the district where they live will evolve in terms of development. The problem is that there is not the remotest chance that by asking a random unrepresentative sample of local residents questions like:

• Q 18 - What design features and characteristics would you like to see in the new neighbourhoods?
• Q 14 - Would you support building at densities higher than 30 dph [dwellings per hectare] in certain locations?
• Q 6 - should the release of employment land be phased? ['employment land presumably means areas zoned for commercial and industrial use']
• Q 3 - What features of the existing natural environment should be retained during and after the new growth takes place?

I could go on, and on, and on. But the reality is that this exercise serves only to create employment for consultants and council employees. Q3 is interesting. Most people would like some large mature trees in a residential neighbourhood, but they are virtually always removed, because insurers won't take the risk of root growth disrupting drains and foundations.

The Ford Motor Company doesn't send a questionnaire out to the population of the country asking them what they'd like to see in the next version of the Mondeo. They get an idea of what people are prepared to pay for. What people do, and what they say, are two very different things.

This letter by Tim Congdon is worth reading.

The key para is:

The second mistake is to assume that, whenever a sum of money is mentioned, an identical flow of resources is implied. In due course the allocation of money to a task does indeed often result in a flow of resources, but not always. Loans can be extended to acquire existing capital assets and repaid from the sale of those assets, and the only resources involved are the time and energies of a handful of bankers, lawyers, surveyors and so on.

Basically he's saying that replacing commercial loans with ones from the BoE and treasury is not a transfer of resources, and may not cost anything. This is clearly right as long as the assets are not that bad quality, as NR insists. I guess it is that any buyer like Olivant or VM are likely to make an offer based on a fairly pessimistic valuation of these assets. It stands to reason then, at least in my mind that the BoE might as well continue to provide capital to NR for at least a couple of years at which point the real quality of the assets should be much more apparent. To sell the bank in a panic now will surely get the wrong price. As long as the existing shares are trading the owners have the option of hanging on or selling out now and at least getting a little for their holding.

It is far from obvious to me why the 'do nothing more' option is not acceptable. There are mumblings about state aid, but a loan at a commercial rate, or a guarantee of of a loan from someone else, is not a subsidy, surely? Congdon says that the BoE loans are at a penal rate. I guess that the governments unseemly hurry to get shot of NR might mean that they know something that we don't - that the credit crunch is going to get much worse, and that we are still heading for that Minsky Moment that George Magnus keeps writing in the FT about.

I wonder if it would be better banks were required to buy deposit protection insurance commercially. I just feel that it would have been much less likely for NR to implode as it did if a commercial insurer was looking at the risks that it was running. Obviously insuring credit is a dangerous business as MBIA and Ambac have proved, but the political fallout would have been much less severe if it hadn't been the BoE / FSA / Treasury which had screwed up.

I famously don't like Flash. Hmm.

I may put this (smaller) in a sidebar somewhere, or put it on Mingwei.co.uk.

"Does Education Matter?" is the title of a book by Prof. Alison Wolf of Kings College, London. It is a wonderful book.

Oddly enough I just read this profile of Marcus Ospel, chairman and previously CEO of UBS. He left school at 17 and this didn't prevent him from rising to the top and hanging on there for a very long time.

A lot of the book is concerned with the business of vocational training in the UK and the baleful influence of the CBI on government policy. The internal contradictions in the system that lead to uncountable NVQs ('No Value Qualifications') the training courses of many of which were developed at large cost never to be gained by a single employer.

Alison Wolf what seems to be a unique combination of an economist's outlook and an education professional's deep understanding of how the education industry is structured. She points out the existence of tradeoffs that politicians seem compelled to turn a blind eye to, such as the impossibility of having a nationalised higher education industry with soviet tractor factory style targets which is nevertheless expected to deliver excellence.

Her survey of the international scene is very good, and even better is her analysis of why aspects of an education policy that is successful in one country cannot be easily imported into the UK. Not least is her explanation of why the German system of apprenticeships, which has been so successful, cannot be transferred successfully to the UK. As usual the point is that there is competition to get an apprenticeship in Germany, and therefore employers accept apprentices, not because of the skills they have acquired (e.g. BMW employs a lot of qualified bakers) but because the qualification has value as a positional good.

Unfortunately the book is not recent enough to talk about the Swedish system, the great white hope for UK primary and secondary schools. The book is eloquent in explaining why bureaucrats react to personal incentives, just like the rest of us, and not purely to achieve the goals of their organisations. I learned that there is a whole discipline dedicated to understanding this divergence (between public and private incentives) called public choice theory.

I have failed to do justice to this book. It is full of insights. You should read it, and not partial and distorted summaries, such as this.