The Gaussian Copula Function

Have you ever heard of David X. Li? Probably not. Li is a mathematician who created something called Gaussian Copula Function—an elegant solution to a heretofore intractable problem that allowed banks, bond traders, insurance companies, hedge funds and others on Wall Street assess risk by examining the correlation of disparate, seemingly unrelated events that had little relation to the actual history of the entity under examination. In 2000, Li published a paper that—through misinterpretation by others, greed by many, and irresponsibility by most—would ultimately lead to the worst financial disaster of the last 100 years.

In an article that you should read in its entirety, Felix Salmon of Wired magazine describes the dangers of mathematical modeling when it loses sight of the realities of the real-world:

For five years, Li's formula, known as a Gaussian copula function, looked like an unambiguously positive breakthrough, a piece of financial technology that allowed hugely complex risks to be modeled with more ease and accuracy than ever before. With his brilliant spark of mathematical legerdemain, Li made it possible for traders to sell vast quantities of new securities, expanding financial markets to unimaginable levels.

His method was adopted by everybody from bond investors and Wall Street banks to ratings agencies and regulators. And it became so deeply entrenched—and was making people so much money—that warnings about its limitations were largely ignored.

It was Li’s model, misused and misunderstood, that allowed credit rating agencies to look at toxic mortgage tranches and rate them AAA. Why? Because Li’s model never considered the realities of falling housing prices, the innate instability and unpredictability of mass markets, the irresponsibility of people who took loans they couldn’t afford, or the greed and stupidity of the Wall Street masters-of-the-universe who were making too much money to be bothered with questions about the reliability of the Gaussian Copula Function. Most of them probably never even heard of it—and they didn’t care.

The real world has a way of intervening, and it did in 2008. Salmon comments:

Then, the model fell apart. Cracks started appearing early on, when financial markets began behaving in ways that users of Li's formula hadn't expected. The cracks became full-fledged canyons in 2008—when ruptures in the financial system's foundation swallowed up trillions of dollars and put the survival of the global banking system in serious peril.

Salmon titled his article “Recipe for Disaster: The Formula That Killed Wall Street.” But it did far more than that. Although Li himself is not to blame, the irresponsible fools who used it improperly destroyed small and large businesses, froze credit, caused 401Ks to evaporate, and did more damage our economy than can be imagined. The regulators and rating agencies shrug their collective shoulders and argue that they were just following the then-existing rules—process over common sense. The politicians who stood by—too ill-informed or stupid to properly understand and regulate the irresponsible fools—now pontificate on the need for fiduciary responsibility. And what about those of us who were responsible, who paid every debt, who never purchased more than we could afford? Why are we so quiet, so calm in the face of this travesty?

Maybe it’s because deep down we know that the people who lead us are less than we think they are. The people have a fiduciary responsibility to run financial houses, banks, and insurance companies in a responsible way are in it only for the year end bonuses. The people who regulate them are lazy or corrupt or both. And the people on “main street?” Most are solid citizens, but some are blatantly dishonest and greedy in their own way.

So we shrug our shoulders and lick our financial wounds and hope against hope that it’ll be different next time. It won’t.

Direct talks

If it weren’t such a serious subject, it would be comical to listen to Left-leaning foreign policy types who appear regularly in the media and attempt to convince us that we need to do a better job of “negotiating” or “talking” with the leadership of Iran. The idea, of course, is to provide “incentives” that would cause a cessation in their rush to develop nuclear weapons. Christopher Hitchens comments:

Now, does anyone—I mean anyone at all—imagine that the Iranian government's flirtation with "direct talks" is anything—anything at all—but a precisely similar attempt to run out the clock while the centrifuges spin and to buy (or, more accurately, to waste) time until sufficient fissile material is ready and the mask can be thrown off?

Estimates differ, but it seems quite plausible that Iran will be able to make some such announcement before the end of this year. That would mean that all international agreements, all negotiations with bodies like the European Union, all "inspections" by the International Atomic Energy Agency had been, in effect, farcical and void. It would mean being laughed at by the mullahs in the here and now. And it would involve, for the rest of the future, having to treat them with exaggerated politeness. What a wonderful world that would be.

So … what to do? The Obama administration will go through the charade of “direct talks,” satisfying those who are more interested in process and the appearance of “sitting down and reasoning together” rather than actual results. The Bush administration kicked the can down the road using a deeply flawed NIE as its excuse. But President Obama doesn’t have that luxury. What will his administration do when Iran nears its first weapon? My guess is nothing—hoping against hope that Christopher Hitchen’s prediction is accurate:

For decades, we have wondered what might happen when or if an apocalyptic weapon came into the hands of a messianic group or irrational regime. We are surely now quite close to finding out. I am not one of those who believe that the mullahs will immediately try to incinerate the Jewish state. This is for several reasons. First, the Iranian theocracy is fat and corrupt and runs a potentially wealthy country in such a way as to enrich only itself. A nuclear conflict with Israel would be—in a grimly literal sense—the very last thing that it would embark upon. Second, and even taking into account the officially messianic and jihadist rhetoric of the regime, it remains the case that a thermonuclear weapon detonated on the Zionist foe would also annihilate the Palestinians and destroy the Al-Aqsa mosque. (Even Saddam Hussein at his craziest recognized this fact, promising with uncharacteristic modesty only to "burn up half of Israel" with the weapons of mass destruction that he then boasted of possessing.)

Nor, I think, would the mullahs hand over their hard-won nuclear devices to a proxy party such as Hezbollah or seek to make a nuclear confrontation with the United States or Western Europe. What they almost certainly will do, however, is use the possession of nuclear weapons for some sort of nuclear blackmail against the neighboring gulf states, most of them Arab and Sunni rather than Persian and Shiite, but at least one of them (Bahrain) with a large Shiite population and a close geographical propinquity to Iran.

The problem, of course, is that no one really knows what the mad mullahs will do. One thing is certain—what they do won’t promote stability in the Middle East and will be an existential threat to Israel.

Treating the Patient

The more I read and learn about the “stimulus” package, the more I get the gnawing feeling that the authors have created a generous lottery in which their most favored constituencies get tens of billions, regardless of whether there is any real impact on the economy. Congressional leadership and the President say the right words—jobs, jobs, and more jobs. They use the fear, uncertainty and doubt (FUD) meme to convince us all that “catastrophic” outcomes will surely follow if we’re not stampeded into immediate spending. They believe that big government will somehow rescue the economy, while disregarding the fact that over the past eight years, under George Bush and the Republicans, deficit spending grew at unprecedented rates, and yet, this massive spending did nothing to avoid our current problems. Why is it, I wonder, that still more deficit spending will fix these problems?

Victor Davis Hansen comments on all of this when he writes:

I think we are ignoring three things about the stimulus package. First, the soaring deficits and mounting aggregate debt in the 2000s contributed to our present debacle. (Yes, Bush and the Republican Congress are to be blamed for spending sprees that cannot be explained entirely by 9/11, Katrina and the two wars). We were already 'stimulated' and running a Keynesian economy, so why is more of what got us into this trouble the solution?

Second, the crash in oil prices from $148 a barrel to less than $40 has resulted in, along with dives in imported natural gas, a monstrous stimulus-perhaps three-quarters of a trillion dollars per year for consumers. Can't we pause a month or three to see the effects of thousands of dollars in cheaper heating and transportation costs for the American household?

Third, interest on US treasury bonds is nearing almost nothing. Yet, Asia and Europe are still buying them. The result is that the US is receiving trillions in free loan money that should be translating into cheap mortgages and interest rates, and an infusion of cash that will soon kick in unexpectedly dramatic fashion.

In other words, while we scream about the Great Depression, there are insidious, rarely mentioned stimuli already in play that are far more helpful that borrowing a $1 trillion to redistribute and hire more government employees.

There is no doubt that the economy is in trouble. But if you believe Nancy Pelosi, Harry Reid and President Obama, eight years of mismanagement got us there. It would seem that a few months of careful, deliberative analysis might be worthwhile before acting. We just might be able to design a true stimulus package that would cost half a much and accomplish something meaningful.

My physician friends tell me that all young doctors hear the wry comment that “despite what you do or prescribe, most patients will heal themselves.” I suspect that despite what our governmental leadership does, the economy will also heal itself. But Pelosi et al feel compelled to treat the patient. I just hope the treatment doesn’t have long lasting, negative side affects.

Stimulus

I spent last week as a speaker at a technical conference in Japan. Among the many differences between Japan and the US is the quality of their infrastructure. A stark example is the passenger rail system. Japan’s is modern, very high speed, reliable, and efficient. The American equivalent is … well, let’s just say it needs work.

As the Japanese recession slogged on over the last 10 years, their government spent billions upgrading transportation infrastructure, as well as power grids and many other structural elements that support thier economy. Their infrastructure spending did create jobs, but it didn’t provide a quick fix for their recessionary problems. It did however, greatly improve the one element—infrastructure—that is the backbone of modern commerce. Only private job creation can cure recessionary trends.

Now it’s our turn. Barack Obama initially indicated that the stimulus plan he invisioned would focus on job creation. So far, so good. He further indicated that he’d endorse major infrastructure spending, creating construction and related jobs. Still good. His mistake was turning the authorship of the bill over the Nancy Pelosi. The Speaker, with the help of others in the Democratic leadership, crafted a “stimulus” bill that was not very stimulative. Only 12 percent of all monies allocated went to infrastructure improvement. The rest went for social welfare programs, and a non-trivial percent was allocated to pure pork and completely unnecessary spending.

Instead of asking for major modifications, President Obama defended the indefensible. The Wall Street Journal comments:

Speaking to a House Democratic retreat on Thursday night, Mr. Obama took on those critics. "So then you get the argument, well, this is not a stimulus bill, this is a spending bill. What do you think a stimulus is? (Laughter and applause.) That's the whole point. No, seriously. (Laughter.) That's the point. (Applause.)"

So there it is: Mr. Obama is now endorsing a sort of reductionist Keynesianism that argues that any government spending is an economic stimulus. This is so manifestly false that we doubt Mr. Obama really believes it. He has to know that it matters what the government spends the money on, as well as how it is financed. A dollar doled out in jobless benefits may well be spent by the worker who receives it. That $1 of spending will count as economic activity and add to GDP.

But that same dollar can't be conjured out of thin air. The government has to take that dollar away from someone else -- either in higher taxes, or by issuing new debt in the form of a bond. The person who is taxed or buys the bond will have $1 less to spend. If the beneficiary of that $1 spends it on something less productive than the taxed American or the lender would have, then the net impact on growth will be negative.

Some Democrats claim these transfer payments are stimulating because they go mainly to poor people, who immediately spend the money. Tax cuts for business or for incomes across the board won't work, they add, because those tax cuts go disproportionately to "the rich," who will save the money. But a saved $1 doesn't vanish from the economy, unless it is stuffed into a mattress. It enters the financial system, where it is lent to others; or it is invested in the stock market as capital for businesses; or it is invested in entirely new businesses, which are the real drivers of job creation and prosperity.

The media is reporting this morning that the Senate has agreed to support a 780 billion “stimulus” package. The details have not yet emerged, but its fair to say that the bill will be more spending than stimulus. If you follow the logic of the WSJ argument, that’s not really what we need for a solid recovery over the long term.

In a way it’s kind of sad. Barack Obama campaigned on a promise to reform business-as-usual in Washington. A noble goal. What we see with this “stimulus” package is the very worst of Washington politics ... business-as-usual on steroids.

Danny—An Anniversary

It's been seven years this week since the brutal murder of Wall Street Journal reporter Daniel Pearl. For those who may have forgotten, Pearl was beheaded by Islamist terrorists in Pakistan. Pearl was kidnapped because he was an American, but all evidence indicates that he was beheaded because he was a Jew.

I recall that even at the time, the MSM treatment of Pearl’s execution was muted. Sure there were many articles expressing concern and sorrow, but relatively few expressed the outrage that should have been widespread in the media community. The reason, even then, was an effort by the media to downplay the utter brutality and irrationality of the Islamist mindset. Over the intervening years, things got even worse. Consumed by opposition to Bush’s war on terror, Left-leaning media adapted a see-no-evil, hear-no-evil, speak-no-evil approach to Islamist acts of terror.

Daniel’s Pearl’s father, Judea Pearl is a professor of computer science at UCLA. Yesterday, he penned a moving op-ed in the WSJ in which he asks many questions that should embarrass those on the Left who insist on post-modern moral equivalence when they consider acts of terror:

But somehow, barbarism, often cloaked in the language of "resistance," has gained acceptance in the most elite circles of our society. The words "war on terror" cannot be uttered today without fear of offense. Civilized society, so it seems, is so numbed by violence that it has lost its gift to be disgusted by evil.

I believe it all started with well-meaning analysts, who in their zeal to find creative solutions to terror decided that terror is not a real enemy, but a tactic. Thus the basic engine that propels acts of terrorism -- the ideological license to elevate one's grievances above the norms of civilized society -- was wished away in favor of seemingly more manageable "tactical" considerations.

This mentality of surrender then worked its way through politicians like the former mayor of London, Ken Livingstone. In July 2005 he told Sky News that suicide bombing is almost man's second nature. "In an unfair balance, that's what people use," explained Mr. Livingstone.

But the clearest endorsement of terror as a legitimate instrument of political bargaining came from former President Jimmy Carter. In his book "Palestine: Peace Not Apartheid," Mr. Carter appeals to the sponsors of suicide bombing. "It is imperative that the general Arab community and all significant Palestinian groups make it clear that they will end the suicide bombings and other acts of terrorism when international laws and the ultimate goals of the Road-map for Peace are accepted by Israel." Acts of terror, according to Mr. Carter, are no longer taboo, but effective tools for terrorists to address perceived injustices.

I have on many occasions commented on the bizarre phenomenon that somehow justifies barbaric acts of terror based on “oppression” or “resistance” or “grievance.” The stupidity of this justification is breathtaking, but it continues to accelerate as the years pass, particularly among the Leftist intelligencia (I used that term guardedly) and much of academia.

Judea Pearl comments:

When we ask ourselves what it is about the American psyche that enables genocidal organizations like Hamas -- the charter of which would offend every neuron in our brains -- to become tolerated in public discourse, we should take a hard look at our universities and the way they are currently being manipulated by terrorist sympathizers.

At my own university, UCLA, a symposium last week on human rights turned into a Hamas recruitment rally by a clever academic gimmick. The director of the Center for Near East Studies carefully selected only Israel bashers for the panel, each of whom concluded that the Jewish state is the greatest criminal in human history.

The primary purpose of the event was evident the morning after, when unsuspecting, uninvolved students read an article in the campus newspaper titled, "Scholars say: Israel is in violation of human rights in Gaza," to which the good name of the University of California was attached. This is where Hamas scored its main triumph -- another inch of academic respectability, another inroad into Western minds.

Why is it that those in academia feel compelled to demonize the victims of terror but not the terrorists themselves? Why do they live in a through-the-looking-glass world in which America and Israel are “oppressors” and “terrorist states” but Hamas, Hezballah and even al Quaida are “victims?” Over the years, I’ve tried to answer that question here, here, here and here, but even good answers will do little to assuage the deep sadness of Judea Pearl—a father who must live the rest of his life knowing his son was brutally murdered.