# On the inverse relationship between likelihood and falsifiablity

Given our current knowledge of the world. We believe that the likelihood of a certain event is 50 percent. That is, we can’t really explain it very well, it just seems random.

Now say some new hypothesis comes along, call it the hypothesis A, this new hypothesis predicts that the event that we were curious about before actually occurs at a different rate. A says that if we condition on some parameters that it explicitly specifies then the probability that this event will happen is actually 90%.

Now let’s say that we take 5 observations and the event has only occurred once. The probability of this occurring with hypothesis A is p(1-p)^4=0.00009. Whilst the probability of it occurring with the original knowledge is 0.03125. So we should prefer the original hypothesis to this one.

In the example above, we used 5 observations to try and compare our two hypotheses. So what did we actually do? Well, we compared the difference between their probabilities and depending on whether the difference was positive or negative we chose one or the other. Now it should be easy to see that the larger is this difference, the more confident we can be in our rejection or corroboration (“temporarily accepting” in Popper’s language)of the new hypothesis.

So now assume that we have some other hypothesis, hypothesis B, and this hypothesis predicts that actually, this event will be occurring 50.1% of the time. Now it should be trivial to see the difference in probability between our current state of the world and this new hypothesis prediction will be very small indeed. In other words, this hypothesis will be much harder to falsify.

What this means is that the more likely something is given our current state of the world, the harder it is to falsify, and the harder it is to falsify, the less scientific it is. Once again, if a hypothesis is very likely given what we know, then this hypothesis NOT scientific. Indeed it is the opposite, the more unlikely it is, the more scientific it is. Why is this? Because we can test it.

# When do we need science?

I often get into arguments with people and invariably I end up invoking science in a way to present evidence. Often this invocation of mine is countered with an accusation of, ‘you must admit science isn’t perfect’, where I am forced to admit that this is indeed the case. What is quite frustrating is that I more often find myself arguing against the blind application of science rather than for it, so when this accusation is levied at me, I find that a gross misunderstanding has occurred. With this in mind, I wish to attempt to clarify when the application of science is or is not appropriate or necessary.

Science is NOT appropriate for living, intuition dominates daily life. We do not need science to tell us how much pressure to put on the pencil so the tip does not break, this will be learned by trial and error. Similarly like Nassim Nicholas Taleb likes to say, we do need to ‘lecture birds how to fly’, birds can fly without understanding aerodynamics and the complicated physical laws that accompany them. A snake does not need to understand the mechanics of friction or momentum to learn how to slither. In this very same way science will very often shed light on things that we can already perfectly navigate through without this formalized mumbo jumbo. Religion would also fall in the intuitive domain.

Even science that is ridiculously close to the truth can often be insufficient for taking action due to the Precautionary Principle (a previous topic). Just because we find that something is unlikely does not make it less important, acting upon a hypothesis cannot be weighted without taking into account the magnitude of its implications. It follows from this that  it is worthwhile to invest in preventative measures when the consequences of an event are devastating even if the event is highly unlikely. An application of this is that it could be worth overreacting(a misnomer) to disease contagions such as Ebola and NOT to airplane accidents because the former does have a higher propagation effect (the probability of Ebola killing a million people is much higher than the probability of an airplane accident killing a million people).

With these devastating critiques of science, one might think I’m as anti-science as they come. However, this conclusion would be blatantly false; science is the most systematic way for humanity to approach objective truth. This truth need not imply anything about how we structure society or our lives. Yes, it may be misused but so can every possible freedom afforded to society, indeed this is the very definition of freedom. We avoid restricting freedoms of the masses based on what some people may do , we do not quarantine every individual because some people may be murderers. Free inquiry is a fundamental principle of every open society, the goal of science is to attempt to codify our knowledge, not to tell us how to use it. The fact that each person may infer from it what he wills is the very basis of an individualist society and why we need robust Kantian moral imperatives. This principled stance is vital to the open society so that when an inconvenient truth emerges, we have no need to change our social behavior; This is because our behavior was not derived from scientific principles in the first place but from irrefutable morality.

Science is not perfect and many hypothesis we take as temporarily right (a hypothesis can never be proven) end up being false; however when we are dealing with ideology and things away from intuition, science is how we put our biases in check. Inherently when one discusses ideology based on hypothesis which are out of the intuition of daily life and are contradicted by many other individual experiences, science must be invoked. The very first step to the scientific method outlined by Popper, before ANY empirical work is conducted is to clean up your hypothesis. If your hypothesis predicts the same observations an existing hypothesis predicts then your theory isn’t precise enough to be meaningful, much in the same way the hypothesis of ‘shit happens’ is not a credible theory. Any theory that cannot be disproven is fundamentally flawed and must be discarded or at least not believed in until it can be fleshed out to make observable predictions.

Technical point: The production of evidence is often a function of a function. What this means is that we cannot ignore the bias or effort that goes through the production process. If for instance there are ten thousand ideologically biased researchers who are searching to prove hypothesis x, then by pure randomness we can conjecture that at the 99% level, then there will be 100 studies showing an effect when none exists.

Finally, often we can come up with numerous theories that fit the same observations; invariably this happens in every field, so how do we choose one? The most philosophically consistent position to adopt in such situations is to choose the hypothesis that makes the least assumptions. This is often called Occam’s razor and it is possibly one of the most important elements in the selection of any scientific theory.

# Big ideas: Design vs Evolution

This was supposed to be a single post but I don’t like talking about concepts I haven’t previously introduced on the blog so I’m making the first post about design and evolution and then following it up with a post on movies and series.

# Design

A design is an article/product/item of manufacture that is the result of an architect’s vision. The key in design is the presence of the final vision from the initial stages of the process. Likely to be the biggest achievement of design thinking is the wheel.

Intuitively, the wheel is uniquely the product of design thinking as half a wheel or a wheel with angles would be close to useless. Therefore, if we are calculating the marginal value of each design step and the steps are sufficiently small we would never come up with the wheel. This is because at most steps, the direction towards the wheel will never appear like an improvement. It is only when the wheel is completed (or close to it) that its value starts to emerge. Accordingly, it seems alternative improvements will always be chosen over those that will lead to the wheel.

When the wheel is only 20 or 30 percent completed and only a step or two ahead can be envisioned, it is unlikely that the design process would continue and lead to the final product.

Design thinking does however make the product highly fragile. Since in essence it relies on the synergy of the components and not their value in isolation, damaging a component creates a non-linear loss in value. For instance, adding a couple of angles to a wheel quickly deteriorates its value as it can no longer roll smoothly. This fragility does not have to pertain to the object itself, it can emerge from the environment for instance a wheel’s utility is fragile to not being on flat ground.

This same logic applies to buildings, they are a product of design thinking. You know a skyscraper is designed because knocking down a small proportion of the building causes it be useless (collapse). It is designed to lean on certain components more than others. (I might come back to this in the form of urban planning in some future post).

Overall the weakness of design is its fragility. It does have potential for unprecedented efficiency but it is very reliant on its designer. If the designer has no sense of history he may not incorporate proper systems into his design which fragilizes the whole endeavor.

# Evolution

Evolution is all about small steps, where you try different things in different directions and choose the one that better improve the outcome. There is a caveat of conscious versus unconscious evolution but it’s not important for my purposes.

Through evolution it is possible that the outcome be enormously complex. Perhaps one of the more famous examples is echolocation in bats or dolphins, which is an enormously complex process that is more efficient than most of what modern technology has pieced together. Perhaps a more intuitive example of evolutionary outcomes is in scheduling your calendar. Gradually adding routine things to your calendar (gym, dance, learning, etc) is an evolutionary process because you evaluate each addition separately.

Things that evolve through evolution are generally very robust to variation and damage. For instance in the scheduling example, if suddenly one activity gets cancelled, the value of the others is usually not suddenly damaged and you still have the value of the other activities and the free time you gained from the cancelling. Similarly half a lung is still very useful, though it will obviously be able to produce only a fraction of the full lung’s oxygen. In fact most (if not all) of the organs of the human body share this feature.

Technical note: When dealing with evolved entities its usually less misleading to rely on the Law of Large Numbers.

The thing about evolution that makes it robust is that it does not forget the past. It is conscious of history and has systems to incorporate the past into its future behavior.

# Putting it together

To me evolution vs design is an important question in almost all domains in life. Should one plan or play it by ear and deal with things as they come along?

The truth of the matter is that nature (which is almost fully a product of evolution) has a statistical validity that makes arguing against it a highly challenging endeavor. Whatever was not robust was ruled out by millennia of evolution. Therefore a proposal that is an alternative to nature, to be credible must have a significance level that can be juxtaposed to these millennia of evolution. I.E though taking a car (a designed object) to work may appear universally more efficient, but the lack of walking may lead to heart problems, unbalanced psychology, etc. The thing about evolution is that it feels no pressure to inform its user what the benefit of a certain heuristic/habit is, so great care must be taken when trying to replace such heuristics. Evolution may give us instincts to delay gratification but a design thinker may not accept such a delay because he/she does not see the benefit, and if you do not see it, then you cannot design around it.

Evolution doesn’t have to be uniquely genetic or cultural. For instance the heuristic to look left and right when crossing the street is probably both a cultural heuristic and a genetic tendency, it is a method of taking the past and using it in the future.

Similarly the economics debates which used to be in large part dominated by either evolution (pure capitalism) or design (communism), have now become dominated with a mixture.  Ideas of pure design have mostly been shut down, they have been replaced with arguments about the provision of platforms and are inherently of higher sophistication. Property rights and the rule of law are seen as such a platform and debates over the welfare state can be interpreted similarly.  It does seem however that there is quite a lot of emphasis on this kind of design thinking without much mention of fragility, and it’s obvious to me that with things like nukes, the internet, and even central banking(I find this one particularly interesting), we are quite a bit more fragile than we have ever been.

# Evidence vs proof. How to think about Global Warming and GMO’S.

This might be a bit of derivative post because I am just deciding to come back to blogging.

This topic has been resonating in my head over the last couple of weeks as I hear people saying the words “there is proof”. The difference between “proof” and evidence doesn’t appear to be an obvious one so let me try to clarify.

There are two kinds of proofs. Mathematical proofs, and legal proofs. Mathematical proofs are axioms which are internally coherent, there are many levels of sophistication in mathematics and some higher level proofs may not be deemed worthy of the title of “proof” by the purest of mathematicians. Legal proofs on the other hand are not nearly as related to internal coherence. It is merely the nature of the law to categorize things into binary states (guilty or not guilty), it is not meant to indicate a perfectly coherent internal structure but is meant to classify people so that decisions can be made.

The important thing to note here is that science and proofs are unrelated. Science is a negative endeavor, it never deals with saying anything is true, it works only in calling out untruths. When you read any paper that says “we show that there is a relationship between…” what they mean to say is “we cannot reject the fact that there is a relationship between these things…” You cannot show that something is true you can only show that it is untrue. If you do an experiment within a closed system a million times, it is STILL not proven.

You might think that all this means that the correct question is then: “at what point is the evidence strong enough so that we can lean on it to make decisions?” While the volume of evidence does matter, what could matter to a much greater degree is what it implies.

Let’s take global warming as an example. There is some correlational evidence but it is hardly convincing given that we know spurious correlations arise naturally. There are also some simulations but simulations can be made to show anything and always miss some real world nuances (given chaos theory, a half realistic simulation would take years to run on the best super computers). Though everyone treats human driven global warming as “fact” it is far from it. This however is irrelevant, the consequences of global warming, perhaps eventually making the planet uninhabitable to humans are so gargantuan that the standard of evidence we need is as low as it could be. In other words, the consequences of overreacting are comparatively minimal to the consequences of underreacting. Indeed when there is some probability, however small, that the world will end, the burden of proof falls to the other side.

The opposite example is GMO’s (Genetically modified organisms). The question is simple, should we genetically modify food on a mass scale? Well it is still unclear what such modification will do to humans and it could have strange long term interactions (which will almost never be fully controlled for in an experimental setting). Even if the evidence is unclear, this is grossly insufficient because the effects could take any form and if a large population of people were to be involved, the consequences could explode. The burden of proof quite obviously falls on the people pushing GMO’s. Ninety ninth percentile significance levels is not a metric that warrants application, if ninety nine percent of flights were safe, there would be over ten thousand people dying a day from plane accidents.

Technical note: When using Bayesian statistics it is easier to objectively apply this logic because we can just set extreme priors.

# Scottish independence! Yay or Nay?

Haven’t blogged in a while, mostly due to military engagements but I’m out now and in Scotland. So a topologically relevant topic seems appropriate, on September 18th Scotland will have a vote about whether or not to leave the UK: should they?

Who should be able to vote for such a thing? I think in philosophy the solution to the boundary problem (who can vote) is called “all-affected-interests-principle”. So it’s odd that I can vote even though this probably doesn’t affect me and UK citizens can’t even though they are to be affected in a number of ways, including Security Council status in the UN, military strength, and the economy.

## Weird legal issues:

Not in UK means not in EU which comes with not being an EU citizen. However it is likely that Scottish people will just remain UK citizens and also gain the Scottish citizenship, while not all UK citizens will get Scottish Citizenship, so Scots would get the rights of all UK citizens (including voting) and their own but UK citizens would now not have such easy access to Scotland, doesn’t sound too fair to me.

Now, Scotland would probably be allowed into the EU but “probably” is not certainly and there could be a significant lag time between independence and entering the EU, in the meantime Scotland might not have member state rights, including free trade. I don’t think I’ve read anything on what can possibly happen to their exports in such a scenario.

So when should an area try to be independent?

The US declaration of Independence puts it well: “Governments long established should not be changed for light and transient causes”. It’s reasonable to want independence if you are slaves of some sort, secondary citizens or governmental abuse. There doesn’t seem to be any freedom that a Scotsman doesn’t have, if they really want to I’m sure the UK would not mind the website suffix “.scot”.

## Even weirder finance issues:

As usual politicians throw around random figures, specifically some undeniably inaccurate statements about future projections of income for Scots conditional on independence.

So if Scotland becomes independent, what happens to its debt? Does the UK pass some its debt on to it? If so how much? Apparently if it pays its population share (aka total UK debt*proportion of UK citizens which are Scottish) then the only way to increase the wealth of Scotland is to get at least as much revenue from the optimistic projections(joke) of North sea Oil.

## Economics:

Finally to the good stuff, fairly obvious, asymmetric SHOCKS! Monetary policy is pretty good at dealing with shocks to the economy which are symmetric but not so good at dealing with asymmetric shocks, so the wider your government the more it can have fiscal stabilizers to dampen a crisis. Aka if a crisis hits Scotland only and not the rest of the UK, the UK government will be able to reallocate funds to dampen the Scottish shock and vice versa, setting independence achieves almost nothing but surely limits options.

There is also question of what currency Scotland will be using as the BOE won’t have them be using the pound. If this is done quickly and efficiently, which I deem as unlikely then currency might not be a problem but if Scotland temporarily has its own currency and does not set about the right expectations about joining the Euro or at least pegging, then there is room here for immense volatility which would also be catastrophic for trade.

## The truth:

As always the problem comes down to politicians, since they have the most to gain by separations. Alex Salmond claims that Scots will win a thousand pounds over the next 15 years if they vote yes, and the UK government has a counter-bribe of 1400 per person over the next 20 years. This is what democracy comes to, bribing the public with(in all likelihood) borrowed funds.

## Overall:

Accepting such a thing sets a precedent and others would want to join, including Catalona, Veneto, Basque country, Padania, Brittany, Corcisa and Transyvania.

Why should Edinburgh not be independent from the rest of Scotland, why should households not be independent from the rest of the world?

Data is scarce on this issue, so it should be natural to be risk averse and vote no. I would however think it worthwhile if independence implied a return to Scottish Banking! I am unsure as to if it could work when such a system is competing with neighbouring central banks but it’s worth a try.

# Tips on setting up Ipython on windows

Just a quick update, I’ve recently hit a bump while trying to start this online course on quantitative economics and they have a good guide on getting started. I read that other people have issues setting up Anaconda(a package with Ipython) too. Anyways here’s quick guide on what I did to overcome my bumps on setting it up with powershell. I’ve found the issue that Anaconda configures windows paths to a folder named Python27 which for me was in C.

I would recommend making sure your execution policy is set right, this guide here on how to do that.

Then type in this command into powershell:

`\$a = \$env:path; \$a.Split(";")`

When this is done you will get a list of paths from where powershell reads. You then have to make sure that one of those is anaconda, and in my case I had to rename it to python 27 because that’s where it reading from. You could also just change it in the system setting(there’s a link on that in the quantitative economics link above).

Also if you are completely new to using CMD type things, its probably useful to go thru some basic commands.

# Consequences of inflation phobia

updated: added the summation of the factors for a -1.5 deflation rate.

I’m sure most people have heard that increasing how much money is going around generally increases prices (and the opposite holds true). Economists have a formal method for explaining this phenomenon:

M * V = P * Y

The model’s variables are aggregates representing different aspects of the economy. M is how much money there is (though unclear as to what money is). V is Velocity which is s how quickly money is circulating, this variable can tell you quite a bit about the economy and confidence. P is the price level of the economy (Consumer price index is a proxy for consumer), and Y is the total output (Gross Domestic Product is a proxy).

You generally have to get it logged so you can work in growth rates which help tell you better where the economy is heading. So that gives:

m + v = p + y

To clarify, that means that if GDP grows by 10% then y would be 10%. Rearranging for the price level gives us:

m + v – y = p

Now it’s just a question of plugging the right numbers in to predict what inflation will be. Money velocity is expected to be dropping by about 2.5% because of broken financial institutions and lack of confidence in the economy. GDP growth rate in the Eurozone is up for debate but for the sake of argument let’s say its 2%. The ECB is unwilling to be expansionary (thanks to Germany’s hyperinflation phobia) so money growth seems to be about 3%.

3 – 2.5 – 2 = -1.5

So why is this bad? Because when people expect deflation, they end up waiting more (since they expect their money to buy more in the future). This means that economic activity decreases even further and sends the economy further down a depressionary spiral. This includes not only consumers but investors, since consumers won’t be spending, investors won’t find fruitful projects. This comes back in the form of less stuff and less employment. This is not to say that the marginal effect of a deflation movement from 1 to 0 is worse than one from 0 to -1, but generally speaking, the more deflation, the worse things will be.

Money velocity and GDP can be affected by fiscal stimulus that is, government spending more money. You can also affect velocity by increasing confidence in the markets which makes people not hoard cash as much. But both of these seem unrealistic in the Eurozone with its lack of political union where everyone seems to be obsessed with austerity. An easier solution would be for the ECB to say we are going to increase how much money there is in the economy by 10%, since money is something they directly control this is very easy to do, just print more money, but that won’t even be necessary, as long as they say it out loud, investors and consumers will all know to expect inflation and will invest or spend in the economy.

A note: the expansionary monetary policy would also allow government debt to become more sustainable which makes the other options easier to do.

# Understanding Currency Areas and the Eurocrisis

I’ve been quite perturbed that most analyses of the Eurocrisis is done by politicians and doomsayer journalists to the extent that most of the content out there centers on the least likely events and fails to capture the spirit of the intellectual debate. Nice thing about blogs is that you can make things as complicated as you like, though in this case I will restrict myself and not use formulas or graphs for the sake of clarity.

Devaluation is used as a mechanism to reduce real wages. The reason devaluation works is that workers fail to notice or respond to the inflation by raising their money wage demands. If wages were all tied to inflation(also known as indexation), as many multinationals do, the process would not work, and if some did and others didn’t, the process would disproportionately affect those without this adjustment. This power of devaluation is much more prominent the more the cost of living is reliant on the outside world and hence more likely to provoke a response from the labour force. From that point of view this makes the case for much larger currency areas since devaluation is possible without provoking a response. Devaluation can occur not only through monetary means but also by decreasing the cost of doing business which includes a decrease in taxation levels;

I would recommend reading my Unit of account post and Unit of Exchange post to fully understand the functions of money because they are directly relevant to this post.

The benefits of monetary union

These are microeconomic in nature and involve helping out small firms remain competitive as well as alleviating consumer burdens.

Transaction cost

The first benefit is a reduced transaction cost. Though fees on large currency transactions are quite small, currency turnover is extremely high, so cumulative costs can be higher than one might imagine. Although it’s easy to say that the transaction cost of a single currency is reduced, it is possible to overestimate the magnitude by which this is so. This mistake might be enabled by ignoring the fact that not all foreign currency loans are simply hedging exchange rate risk, indeed some of these are favourable because the foreign loans have a lower interest rate. Even so the reasons for this lower financing rate could not be related to the exchange rates whatsoever, an example of which is a multinational borrowing in the domestic market because its reputational capital can be leveraged into higher credit ratings. Additionally many of the potential perceived costs of foreign trade are simply rents extracted by financial institutions exploiting their economies of scale. This allocation of resources not only has an opportunity cost in terms of human labour but also causes inequality between industries by funneling money into finance.

As an example let’s consider a bid-ask spread (buying versus selling currency) of 0.05%. To the individual this might seem insignificant, but this is a very deceptive way of analysing the situation. Given that 600 billion in currency transactions take place in London, such a spread would represent 300million in costs per day. Even so, this element is frequently ignored by politicians because the savings might be negligible from the narrow view of an individual country, especially since a great proportion of the trading is done on behalf of foreign principals, this means that although monetary union would be a considerable savings cost, the UK perceives it as a booming export sector. Even so, the savings potential from a UK resident’s perspective of an EMU would be limited to transactions within the Eurozone. Academic estimates with all this taken into account estimate that the cost savings in transaction costs would be about 1% of EU income.

Accounting costs

Foreign flows being converted into a common currency for the consolidated balance sheet inherently introduce greater variability in forecasts of share prices and increases capital market volatility.

When evaluating risks of currency splitting we must be able to partition the arguments for what it does and doesn’t do. Any individual entrepreneur is likely to be less enthusiastic of any prospect if an additional risk of currency fluctuation is introduced. However when dealing with multinational firms this risk is not necessarily as large as it appears since a true multinational would have flows in both currencies and opportunities to finance from institutions in both currencies and so the risk is likely to be overstated if we just look at the variance of the exchange rate. If the company has accurate forecasts of these future cash flows it may even hedge, but this is a return to the previous point that this process funnels money into the financial industry. Perhaps most importantly we may overstate the cost of the currency risk because even if the foreign currency value does depreciate, this will be partially offset by the fact that the foreign production will become more competitive and in the process, increasing prospective cash flows. However these options are not present for smaller companies, which have to rely on financial institutions ability to mimic these advantages and generally are likely to reduce competitive forces within the economy since it offers more than just an economy of scale advantage to bigger firms.

Insulation from monetary disturbances and reduced political pressure

Given multiple currencies, it’s possible that the domestic prices are sticky (don’t adjust fast enough). This stickiness might lead to unnecessary and temporary fluctuations in the real exchange rate due to speculative bubbles.

Finally without the option of protectionist policies from myopic politicians, we reap the benefits from the most agreed upon economic policy of all: free trade.

Costs of monetary union

These are macroeconomic in nature (more about patterns of adjustment to disequilibrium) and would hence be up for rigorous debate. Some schools of thought, like the Austrian school of economics might even dismiss them completely and blame this thinking for the business cycle by enabling the allocating of resources to be done in a manner that does not reflect the preference of consumers, implying an inevitable crisis.

Monetary flexibility

This is perhaps the main cost being referred to. Currency union makes regions less able to respond to macroeconomic imbalances through specific monetary policy. This belief is mostly credible in the monetarist sphere of thought since fiscal stabilization is a very plausible alternative to most interventionists (and perhaps the only choice when interest rates hit the zero bound, ignoring of course the more unorthodox methods being suggested).

Monetary flexibility also includes financing government spending via inflation, by reducing the burden of public debt (e.g. if your currency is worth less, government bonds are worth less and easier to pay back). Though some would question such indirect measures of taxation as not being transparent it is an important option for extreme times such as wars. However EU wide tax and transfer systems reduce the need for this. Similarly seigniorage revenue in a common currency area (the ability of new money to buy goods and services) would need to split in very equitable ways.

Labour mobility is king

These arguments are all rendered irrelevant by one thing, a sufficiently high labour mobility (people willing to move across the currency zone).

To give an example lets imagine the price level dropped in a country by 10% and that foreign goods are responsible for 50% of the cost of living, so real wages have increased by 50*10%=5%(since you can now afford your previous lifestyle with less money). However given that the people can now buy more but their productivity has not changed this will make firms less competitive and apply downward pressure on the economy which will increase unemployment, bankruptcies and so forth. With sufficient labour mobility, employment will be restored without transitional unemployment because people will fleet to the new high wage country until the supply of people brings wages back to equilibrium.

The question as to how the existence of labour mobility comes about is of course a different one. Although Economists usually perceive it as a requirement for an optimal currency area, it is likely that action must first be taken to increase the labour mobility. Indeed since the Euro was introduced an increase of labour mobility has occurred within the Eurozone and the crisis has further fuelled this trend.

However it is obviously still insufficient and more could be done to encourage this trend, reforms to this end would include: a single language being used in business, transferable pensions, lower transportation costs(from country to country), standardized unemployment benefits, common legal systems…etc; This encouragement is not only important for Europe but also for the US where empirical estimates show that about six years are required for labour mobility to substitute the failure of wage levels to fall. From this point of view you could argue that even the US should be a candidate for monetary disintegration. I would also add that policies that encourage home ownership, which are taken by most governments are likely to reduce labour mobility.

Of course there is also the matter that entering a common currency usually leaves countries open to speculative attacks by investors. Though this has already been experienced by the EU in the early 1990s and paying any attention to this now is merely a sunk cost fallacy.

Expectations and Politics

Fixed exchange rates could theoretically offer many of the benefits of union without the costs. Though the assumption here is that the countries can keep this indefinitely, and if it would have been done indefinitely they would have just joined the monetary union. So in practice fixed exchange rates have a problem of credibility, how long will they keep doing this? In some cases the market will use immense capital to attack these fixed exchange rates and break down the regime.

Although this analysis is economic, it is impossible to ignore the effects of political framing on the markets. From the very outset the framing of North versus South has had an enormous influence on the markets and has greatly impeded the ability of governments to take action. When it was presented that the crisis is a result of Greek fraudulence and profligacy, it becomes difficult to aid them from a political point of view. If the crisis was framed in terms of economic interdependence and not of morality aka, helping the lazy Greek (some economists disagree with that stereotype) it is likely that bond spreads within the EU would not be as high as they are now and more credibility could have been given to weaker governments, as it is now stronger governments are able to retain market confidence. The more these benefits are spread out, the more consumers of these advantaged countries will lose out in terms of an increase in cost of living.

The idea that monetary union requires fiscal union has been spouted enough but it doesn’t go far enough. In addition to the measures that would encourage labour mobility, common deposit insurance, financial regulation, true lender of last resort abilities from the ECB and a federal constitution that overrides state power would all go a long way to unifying Europe.

Of course in ordinary times it is true that countries are able to borrow more than they would have otherwise due to the credibility of their neighbours, creating an incentive for governments to be unsustainable. In turn this increased spending creates inflation and boosts real wages (and hence, standard of living) to levels that don’t reflect the competitiveness of the country.

However, in another light all this talk about restricting countries from defaulting and requiring German taxpayers to bail out other sovereigns is nonsense. US states and local governments have defaulted in the past as John H. Cochrane’s puts it: “A currency is simply a unit of value, as meters are units of length. If the Greeks had skimped on the olive oil in a litter bottle, that wouldn’t threaten the metric system.” Too much is done to enable bailouts either in more direct manners (ECB buying government bonds in the secondary markets) or indirectly (ECB lending to banks that lend money to the governments), which is not helping sustainability and will require hoards of EU taxes to fix or the Euro will be inflated away.

Governments and the ECB have been pressuring banks to keep buying their debts, the ECB is more of culprit since it gives conditional liquidity injections. These banks become more and more dangerous as this effect continues, Cyprus’s recent bank troubles are but a demonstration of this instability.

Possible endings

We could possibly kick the can down the road with just more bailouts but eventually wishful thinking will end and the true choices will emerge.

One of these is fiscal and monetary union, federal government issuing controls on government budgets and allowing for some of the above frictions for labour mobility to be eliminated.

The other is monetary union only, this would mean governments need to be able to default like companies, and banks would be allowed to treat sovereign debt like any other debt (something BASEL 3 doesn’t help with).

And the most costly option is the breakup, probably after a crisis and inflation. This would be seriously debilitating to all contracts that would have to be converted to a currency that doesn’t exist and would lead to immense capital flight and economic damage. Once again in the words of Cochrane: “The euro, like the meter, is a great idea. Throwing it away would be a real and needless tragedy.”

# Should we abolish government? What is a libertarian?

I’ve been noticing that libertarianism has been gaining quite a bit of traction, Ron Paul is probably the first Libertarian I’ve seen get so far in politics, yet I am astounded as to the number of people who don’t properly understand what it means, I plan on making reference to libertarians in a future post so I thought a quick and simple(and visual) definition for my readers who are not familiar with the term was in order:

First of all watch this 2min video:

Libertarians believe that society should only have one law and that is to protect people from externalities, also known as tragedy of the commons. Many things can be viewed as externalities have a look at this video for a brief introduction:

The majority of our legal system today would not exist under a libertarian’s wet dream. Government would only have the roles of running courts, the army, and probably the police. My previous post on patents and IP would probably be agreeable to libertarians.

In many ways a libertarian society is a true democratic one, since the output of society is reflected on what most people want to do. A politician will claim he owns the majority of the vote, yet even among the people who did vote for him it is likely that most people disagree with him on at least some point, the only person who can represent you, is yourself.

It’s impossible to please everybody with one size fits all policies, and yet everybody is paying for it with their tax dollars. Under a libertarian society, the majority can no longer sway the other 49% to do as they are told, this might sound controversial but a moment’s reflection would probably result in the conclusion that this is as true as democracy can ever get. For instance the 51% can no longer force the 49% to pay foreign aid; any individual who wants to give money to a charity practicing foreign aid, can do so at his own expense.

What occurs in non-libertarian societies is that some guy, has a view, and believes his view is absolute and whoever doesn’t follow it should be punished. So if Obama decides to rescue the automakers and you disagree with it, so you don’t pay your taxes that year, the IRS will pick you up and throw you in jail.

As far as I’m concerned a libertarian society is as immune to the public choice dilemma as we can get without falling into anarchy, here’s another video explaining the problem of public choice:

As a hint to why I wanted this term clarified I would pinpoint to the fact that libertarians only wish to limit the role of government not its scope.

# What’s the potential of on-line education?

The hip term in academia for online education is MOOC (massively open online courses). MOOC’s medium (the internet) isn’t really a new thing, however what is new is the fact that it is free, and that top universities have started to roll out this free content on the internet.  These courses generally have very large cohorts of students, and although the completion rate is fairly low, it is still significantly large in aggregate terms. This logically implies that the average quality of teachers on the web is much higher than the average teacher (assuming the internet picks the best teachers). As MOOCs expand, they offer terrific possibilities for developing countries, the only requirement for this free knowledge is access to internet. A 16 year old Indian who has never been to school could potentially know more math than an MIT graduate. The only real advantage offline courses offer is direct contact with the teacher though this is not necessarily as important as it may first appear; it could be that the forums created will become extensive enough to answer every possible question a student might have (especially with some advanced algorithms we can produce today) but in terms of thesis feedback and supervision, there would be complications, and there are also some limitations on more practical subjects being mastered online.

# Economic theories of education

Before discussing online education we must first lay down the ground work for why people get educated.

The first theory is the theory of human capital, which basically says that people go to school or university to improve their skills or knowledge. Improving themselves makes them more valuable to companies, and as long as your value capacity is higher than what the employer has to pay you then you should be able to get a job.

A second theory is signalling, here people don’t go to university or school to get better, they merely go there so that they can prove to employers that they have certain skills. For instance, getting a degree might signal that you are more intelligent or that you work hard, which are traits the employers desire. This theory could imply a limited capability for social mobility since signalling accreditation is not accessible to all.

Finally the third main theory is the status theory; this is people going to Universities because of cultural or societal ranking purposes. This is not very different from attending a church, though this model could imply a networking effect which boosts earnings.

The literature I am familiar with seems to indicate signalling is the more prominent one. The specific measurements seem to indicate that depth of education is secondary to selection criteria and brand value of the university, which both lean towards signalling.

edit: An example of how researchers try to separate human capital from selection is by looking at those who got accepted into top universities but did not attend, some studies .

Generally my ball park estimate for the value found from attending University is something like 80% signalling and a close match between the other two, human capital is probably slightly more important than good status.  This split isn’t the same in all degree types of course, humanities rely more on signalling; technical skills could be more reliant on human capital and MBA programs more reliant on status.

# Application to online education

Under all three theories, online education has a place, however its potency differs. Under signalling dominating there is likely to be a wage premium for attending regular Universities since a large portion of their value is their selection criteria which are diluted when there is an online system. However if a shift should occur and human capital becomes more important, that is, people attending Universities to improve their skills, then that spells a bust for traditional universities.

Making online education also appeal to signalling will require a way to make testing credible by being exempt from plagiarism, it might seem plausible to just have screen sharing settings on or webcam active at all times during testing but it’s very hard to say who would watch these, it is perhaps better if an automated process is found. If credibility is attained in online education it may be possible for it to signal things that regular universities don’t, such as discipline, initiative, independence or even entrepreneurship.

# Demand and Supply

In my mind there are two main types of demand for these MOOCs, mainly seeking mental stimulation (perhaps old retirees) and career advancement. There are likely to be cases where the human capital model applies for career advancement, as some jobs might offer on-site testing but it’s perhaps better if centers for testing were established that people can just show up for and use their knowledge to gain accreditation and then not have to re-take endless amounts of tests. In any case if the goal is accreditation the cost will generally be higher, but if the goal is the acquisition of skills or recreational purposes, it’s very cheap to provide since no involvement with test centers and diplomas is required.

A special demand market that the flexibility of online education can tap into is people who are full time workers. This pool of people is likely to be gigantic and the talent endless, these people are people who are so valuable to companies that the company cannot afford to let them off for a year to do an MBA or specialist program. Let’s also not forget that this extra choice for students will create competition with Universities, and with competition, there won’t be as strong of ability for Universities to select the very best candidates since the pool of people they will be selecting from will be smaller. This will dilute their selection criteria, and subsequently their signalling value.

On the supply side, the business model of providers this will shift attention to the lecturers, probably significantly cutting down non-lecturer staff of universities. It could be argued that if some of these fields being taught online aren’t expanding(I want to say fields like Anthropology generally evolve slower) enough every couple of years, the maintenance of updating the videos will be very low resulting in very few lecturers being required. For instance it could be that the same videos of mathematics will be watched 100 years from now, essentially killing the market for math lecturers. This could result in a winner take all effect, such as the music industry has witnessed, but not likely to be as prevalent since the language barrier might be important, this is because it is the main source of communication (where as music today barely relies on language).   This winner take all effect could be monetized through textbooks, although the market for textbooks will shrink in aggregate because of MOOC’s (controlling for shifts from developing to developed). This is an inevitable consequence of the winner take all effect, it is likely that successful textbooks will be boosted as the reputation of its author (who is an MOOC lecturer) rises and offers higher brand value to the University hosting the lecturer, which can also be monetized in a number of ways. This also implies much fewer universities being around unless people still value other things about them such as the cultural or extra-curricular aspect, but it is also just possible people meet that demand by participating more in their local clubs.  There are also legal boundaries preventing such supply shifts from occurring, such that you need to be accredited by government agencies and I am not certain how that affects online courses.

# Present and future structures

Imagine a moving platform that holds a product and goes through different points to add new elements to the product. Now imagine that those elements are dependent on the previous one’s being properly installed. Well that’s how I view education as it is right now, only the products are people. This method causes way too many defects, and not necessarily by being more efficient either, since the energy expended to make sure each sequential piece was properly placed would be given by the people themselves. So the main cost is the switching cost, the initial cost of change. It doesn’t make sense for someone (regardless of their age) who hasn’t mastered a subject to move on to a more advanced subject that has the un-mastered subject as a prerequisite.  I don’t really need to produce evidence that it’s harder for a child that hasn’t learned the power rule to apply the chain rule.

It seems the easiest step to take in making education more dynamic is pushing it online, students have the ability to rewind, fast forward and pause and really go at their own pace, the Khan Academy model also seems fairly effective, they have a quiz after each concept is introduced, making sure students have mastered a concept by acing a quiz before being recommended to move on, so all students are A students. Not to mention that the world would be much more efficient if degrees were given out for every concept mastered, like that, people would not get over or under educated.

Perhaps the most backwards mechanics we apply is grading on curves that is giving x% of a class an A or a B. This gives no indication of mastered material, and makes the goal to be better than the rest as opposed to learning the material. This relative grading passes on an information cost to employers since they have to employ capital to learn what different kinds of grades mean, to see if they meet an absolute qualification and to see how they fare compared to graduates of other systems. An employer knows very little if an A or a B was received in a curved class and his only way of knowing how much stuff they learned in these classes is by knowing something about the school or university which channels money to the elite who have an already established reputation and costs the employers less. This is in part why it’s good to have national/international wide testing (eg. GCSE, IB, AP etc) that is widely accepted, so we can compare people. However this information cost must still be borne when comparing people who took different types of tests and in the case of Universities, the lack of such test types makes it very hard to compare students.

The structure of education needs to be taken into account, especially in government funding; it could be funneling us to towards some of these theories. For instance the French education system which I previously discussed has government pushing the status and signalling theories, which could amplify inequality. Online degrees probably haven’t had enough time to be able to project degree type value, in the future the mere fact that you have an online education could signal things like discipline and initiative to employers, and may probably offer value in that people can boost their job experience whilst simultaneously boosting their education credentials but these things will likely emerge over time.

As a final note, let’s not forget that online education is today much cheaper, which allows students to more flexibly choose their career, whilst traditional graduates will have to choose things that will repay their loans, even if their career advancement prospects in this given position are limited. However this cannot be properly observed without specific econometric techniques to get rid of the selection bias of people who did not attend regular university.