A peregrination on the nature of money

I’ve never studied economics. What I have read of economics appears to be ideology combined with bad math. Since so much of what passes for modern thought is annoying ideology combined with bad math, I try to avoid such unpleasantry. History, on the other hand, I always have time for. I would like to think using history to think about mysterious concepts like money is useful, but maybe not. It amuses me to do so in any case.

What is money? As I see it, money is a measure of economic output, which is used to create liquidity in markets, and which is backed by social agreement. Without money, you can’t buy things. If you can’t buy things, you’re stuck with your own economic output to make a living. Have fun dirt farming.

The earliest form of money was commodities. If you wanted a horse, you’d trade some grain for it. Later on, people learned to love silver and gold, and the rarity and density of these metals made them useful to trade for other things. The fact that gold was rare, inert and next to impossible to fake made gold that much more valuable than other materials as a trading instrument. The Lydians were the first to invent coin money in the 600’s BC. Coin money was a standardized mass of precious metal with a proof mark on it. People seem to think commodities are good hedges against inflation, and this is sometimes true, but, for example, Europe experienced hyper inflation in the 1500s and 1600s when Spain brought enormous gold hoards into the European economy. In a commodities denoted economy, if there is a sudden increase in supply of a commodity without an increase in economic output, inflation follows. Nobody did any more useful work, but there was more money. Therefore, you needed more money to buy a given amount of work, or anything else. If an increase in the supply of gold was accompanied by a similar increase in productivity, everything would balance out. For example, if your increase in gold comes from inventing the steam engine, you can use the gold to buy all kinds of other stuff made with steam engine productivity. On the other hand, if you only use gold for money, and experience a huge increase in per-capita productivity without an increase in the amount of gold, money doesn’t circulate freely; you get deflation. This means, holding gold is a better idea than spending it on stuff. This happened in the 1930s in America. This is why the 1930s sucked. This is also why people who want to return to the gold standard are insane. Gold works great when your society and economy doesn’t change much, but when it does, you need more flexible kinds of money. Another way to think of it: imagine your society has one hundred people with X pounds of gold. Now imagine hundreds more goldless people start to move in. Your gold becomes more valuable, so you’re less inclined to spend it as long as people keep moving in. That’s deflation. Now imagine your population of 100 people with X pounds of gold catches plague. The amount of gold stays the same, but the number of people who can do work gets smaller, so you get inflation.

A slightly different form of money is commodity backed money. In the old days, for example, the British Pound was backed by a pound of sterling silver. The first form of commodity backed money I know about was from ancient Sumeria, where they used clay figurines of goats to represent real goats. Between 1945 and 1971 (or 1973, depending how you count it), the US dollar was backed by gold reserves, though it was illegal for individuals to own gold reserves of their own, to prevent a run on the bank. Why? Because the Federal Reserve didn’t have enough gold in it to pay every depositor off. So, even though we used to have gold backed paper money, it was really just an idea of being paid off in gold. Between 1945 and 1971 nearly all forms of money in the world were based on US dollars. We had large gold reserves because we looted the world of gold as payment for WW-2. Since nobody else had any gold, and there really wasn’t enough physical gold, the convenient method of exchange was the dollar, as symbol of gold. The fact that all currencies were based on the dollar was not necessarily a good system for anybody (and it periodically had to be adjusted by moron economists: whenever it was, it caused huge problems), but it is an important historical fact. Commodity backed money is simple to understand. It’s just a convenient symbol for the stuff it’s backed by. In principle, it’s equivalent; just more portable. While people may look at that era as an, um, “golden era of hard currency, they somehow overlook the fact that the gold was a social fiction. I’m certain we didn’t have as much gold as dollars, though I don’t know how well this is documented, or even where it would be documented. The gold standard was really an idea, rather than a big pile of metal.

Another form of money is fiat money. That’s what we use now since the dissolution of the Breton Woods agreement. This agreement was broken in 1968, because the US was systematically devaluing its currency to fund Johnson’s “great society” programs, the Vietnam war, and the Space Program. Gold began to float against the dollar in 1971, basically because we didn’t have any more gold to keep up the social fiction. Now, US dollars are worth whatever you want to pay for them. In some ways, dollars are a bet on the US economy, which remains the largest, most stable and most productive in the world, despite all the present horrors. So, people still tend to base their currencies on dollars. Especially when they do a lot of business with America, which virtually everyone does. Problems can happen, however. If you export a lot to America, and your currency is fixed to dollars, you have to buy American debt. Which means, you’re buying your own currency, setting it on fire and sending America stuff in exchange for the currency you set on fire. This more or less works, until the debt becomes close to your GDP. Once the trade imbalance becomes severe, a correction is inevitable, and unfortunately for the holder of the bonds, they end up being worth a lot less. Fiat money is a bet that the US government will give you stuff if you give them dollars. Fiat money in America was originally issued by states to pay state taxes with.

Fiat money was not invented in 1971. America had gone on and off this type of money many times in its history. The glorious Song Dynasty in China invented fiat money in the 10th century. It was generally used by governments through out history when they wanted to fund large projects, like wars. It has many advantages over commodity backed money; for example, you can easily make more of it if your economy expands. If you have less money than you need to run your economy, you get big problems, like Great Depressions. Why buy anything when your money is a better investment than the economy itself? Currency which is a better investment than the economy itself is an abomination which negates its own purpose. Let that sink in: it is important and as far as I can tell, irrefutable.

If you have too much currency in circulation for your economic output, you get inflation, which is a sort of tax on people who have too much money saved up. Inflating currency on purpose can be done to avoid deflation; as the Fed is attempting now. Inflating currency on purpose can be done to avoid paying debts, as the Germans did after Versailles. You generally don’t want too much inflation, or your money isn’t worth anything (post WW-1 Germany), and so it isn’t useful for trade, but it is really just as harmful if money deflates even a little bit. When currency becomes more valuable over time, people will sit on their dumb pile of money, and nothing will ever happen. America and most of the world in the 1930s was an example of not enough money in circulation. One of the reasons the fascists (and, more obviously, the Swedes) did so well economically, is they issued fiat money. When you read the primary sources for the history of the Great Depression, you can see that all of FDR’s crazy ideas were ham-fisted attempts to create inflation without actually going into debt (Hoover was doing the same thing; I don’t know why he gets such a bad rap). The real answer was much simpler; create more money. When FDR did this to fund the destruction of Europe and Japan, the economy finally got better.

A prevalent but mysterious form of money is “credit money,” which is fiat money backed by banks, rather than by governments. People make a lot of noise about how credit money is some new form of supreme evil. Credit money is actually very old. Any time a bank would issue cheques or notes which were not backed by gold, they invented credit money. Now a days, banks issue credit money when they sell bonds. You can think of fiat money as a form of credit money issued by a government. But banks issue even more money by writing loans which are backed by bonds. In the old days, this was even more obvious: banks actually would issue their own notes. You might have “Wells Fargo dollars.” In more recent times, this sort of money is created by banks and hedge funds issuing derivative securities or exotic bonds, either backed by nothing, or backed by other securities; securities for which there may or may not be a market, and which may or may not have actual value. The use of credit money seems to help more than it hurts, as it allows private entities to create money when liquidity is needed by the economy to do things like, say, buy lots of stupid houses in the suburbs. Credit money is no different in principle than the government selling “war bonds.” You’re just funding different kinds of activity. Is it a bubble? Not a bubble? The way to answer the question is, is the credit money used for something worth investing in.

One of the little appreciated facts of American history: the Westward expansion was funded mostly by credit money. Banks and companies would set up shop with tiny gold reserves, people would use their money as currency, and the banks would regularly explode, making the issued money worthless paper. Why on earth would anyone back such a hare brained scheme? Simple, really: there was no other form of money available, because the government removed vast amounts of money from circulation in the form of greenbacks (fiat money which funded the Civil War) and silver notes. That, combined with the very real economic expansion brought on by new technologies and exploitation of new resources in the American West required much more money than was available. So, seemingly silly monopoly money was the only game in town. This caused problems to the people who held a lot of cash backed by an exploding bank, but it solved more problems than it caused, as it enabled markets, trade and economic growth at an important time in American history. You think derivatives are complicated? At the outbreak of civil war, there were over 7000 different kinds of Bank issued credit money in circulation in America; and there were no computers to sort this all out. Yet, America in that era was a Capitalist marvel; one of the greatest economic and industrial expansions of human history was funded on credit money. Sure, we were in the Long Depression but it was also the gilded age. “Funny money” works just fine, if your purpose is to get people to do useful work. The point of money isn’t to keep something in the bank like most people think: the purpose of money is to circulate. The “funny money” was used directly for what it is good for: people worked for it, and the fruits of their labor continued to exist after the money disappeared: aka, all of America West of the Mississippi. All the rail lines, mines, buildings, plumbing: they’re mostly still there. Sort of like all the houses, fabs and facebooks which were built in the 00’s, when that pile of credit money disappeared.

So, history indicates money is a measure of economic output backed by social agreement, which is used to create liquidity in markets. This sort of historical definition probably implies all kinds of other interesting questions, like what is a market, a bank, economic output, liquidity and so on. I’m not real interested in creating a school of economics, but it’s good to get to some kind of basic understanding of this sort of thing without looking through someone else’s blinders.

For a view into current events, I think Krugman is uncharacteristically spot on:
http://krugman.blogs.nytimes.com/2009/10/19/americas-chinese-disease-not-quite-what-you-think/

And on a lighter note:

The problem with Lee Smolin and physics

Lee Smolin wrote a very important book a few years ago called, “the trouble with physics.” I give Lee a lot of credit: he recognizes there is trouble with physics; thousands of men have been working on string theory since the 1980s, and have yet to make anything resembling scientific progress in the subject. On the other hand, he misses out on an obvious reason why physics is in trouble, and I feel a powerful need to correct my intellectual superior in physics.

This book came out at around the same time as Woit’s “not even wrong,” which is on a similar topic, though Woit takes a different tack. Both contain decent descriptive histories of what string theory is, and where it went pear-shaped. Both books explain the sociological and ‘economic’ forces in building up a large community of very smart people … which doesn’t function properly. Both also miss out on an important thing which is pretty obvious to people outside his field. What all quantum gravity people (Smolin and his crew of merry misfits included with the string theorists) are doing is entirely aesthetically driven. There is no reason gravity should have a quantum theory any more than a ham sandwich should have a quantum theory associated with it. There are no experimental, or even observational reasons to presume gravity has a quantum limit. It’s all aesthetics. They’re nice aesthetics, but science has no real business doing aesthetics. The image Smolin paints of his flamboyant Italian colleague waving a knife around at the idea that the universe might not live up to his aesthetic ideals is supposed to be funny, but the knife fighter is emblematic of a very serious problem. Science is about learning about how the universe works, not seeking aesthetic answers to questions that the universe isn’t asking. While many great physicists have been prey to neo-platonic grandiosity as to how the universe works, they’re not being physicists when they think like that. They’re being art critics.

Allow me to explain what I mean with some other examples from Lee’s book. In his first chapter he defines what he claims are the five great outstanding problems in physics today. I must respectfully disagree with all but his second one. The four I disagree with are essentially cosmological questions; the questions string theory (and Smolin and Rovelli’s rival idea of “loop quantum gravity”) ultimately attempt to answer. Quantum gravity may be a silly question. I’m not some kind of lone heretic in saying this: I’m stealing the idea from people much smarter than I. People like the grand old man of physics, Freeman Dyson -or perhaps better yet for credential worshippers, Phil Anderson, a man who discovered something of mind-boggling importance which is largely met with a world-weary shrug by theoretical physicists in noodle theory land. Both Dyson and Anderson agree that we may no more have a quantum limit for gravity than steam engines and other grossly macroscopic phenomena have a quantum limit. Assuming gravity does have a quantum limit may be the great intellectual folly of theoretical physics of the last 50 years. Don’t do it just because Einstein did it. Einstein was also a communist, and we know that communism was a very, very bad idea.

Smolin’s outstanding problems numbers three and four, I count as essentially the same: he thinks it is important to come up with a unified field theory that predicts fundamental constants observed in nature. Why should things work this way, besides the fact that it would make Lee and his pals happy? Again; this “problem” is an aesthetic guess how he thinks things should be. These ideas about how a “theory of everything” should be are problematic for the same reasons the idea of quantum gravity itself is problematic. While many people do indeed think the universe should have some sort of ultimate theory which can unify the particles and forces, and predict why the fine structure constant is what it is, the reasons people think such are historical and aesthetic -these reasons can not remotely be described as physics. Aesthetically, physicists like only having to remember a few things, rather than many things. You can derive everything about electromagnetism by memorizing very few simple facts; same with statistical physics. Historically, the unification of magnetism, electricity and light into one theory really was a tremendous breakthrough in human knowledge. 50 years later, all manner of practical uses were found for it.

Let us compare E&M to the most successful unification of modern times, the electro-weak theory (a unification of a force governing certain kinds of nuclear decay with that of electromagnetism). Unlike Maxwell’s equations, electroweak theory is abysmally ugly. Unfortunately for aesthetics, it does appear the universe works this way. The wise and benign god who wrote Maxwell’s equations must have contracted electroweak theory out to some perverse lesser daemon, like Loki. Comparing practical implications; 50 years from the invention of modern electrodynamics we had the creation of the modern world of AC power, radio and almost everything else involving electricity which you take for granted. 50 years from the creation of electroweak theory: there have been no technological implications. I’ll go out on a safe, sturdy limb and assert there will be none, ever. As an intellectual project, glorious electroweak theory is literally more technologically sterile than … I don’t know: Thomas Aquinas ideas on how many angels fit on the head of a pin. And electroweak theory is a smashing success compared to any kind of quantum gravity; it was motivated and verified by experiment.

As for the many outstanding problems in astronomical cosmology which Smolin collects together as the fifth major outstanding problem in physics; I find it hard to get too worked up about them, as the astronomers seem to find new “anomolies” every time they fire up a new telescope. Historically, astronomy gave us Newton’s laws, but what has astronomy done for us lately in terms of real physics? Sure, dark matter and so on are interesting and worth thinking about, and it is nice to have someone telling the telescope johnnies what to look for, but there are far more frightening lacunae in physics which should be on this list.

I’m a lowlife quant: I went to a cow college and did fairly badly for myself while I was screwing around in physics. Very few of my former colleagues will stand up for me and talk about my ultimate brilliance, because frankly, I didn’t display any. However, even a mercenary dirtbag like me can come up with a better list than Lee Smolin, or, for that matter, any physicist in the public eye today. Here is the Scott Locklin’s five most important unanswered unquestions in theoretical physics today:

1. The fundamentals of quantum mechanics. I admit it; I stole this one from Lee Smolin. I just want to know how it works when it starts to turn into classical physics. Seriously: this is important, and it isn’t known. This is the subject I concerned myself with when I was doing physics. I made no progress at all, but I think it’s one of the things worth spending your time on. There are several small sub-fields of active research in the subject: quantum chaos and Mesoscopic physics. Maybe quantum information theory -though it’s been a long time since I’ve thought about it, and beyond Shor’s algorithm, I have read an awful lot of silly bullshit coming from this quarter. For some reason, there are not 10,000 physicists thinking about the basic question of nature, like there are in string theory. Smolin correctly identified the reason why: physics bureaucracy does not favor it.
2. The second law of thermodynamics, chaos and the arrow of time. If you never thought about this, you will say, “yeah, whatever,” but this is important. It’s important in all kinds of places; information theory, finance, psychology, and it’s not really understood why it is so.
3. Self-organization and emergent properties in matter. Sure, you have “nanotech” types of people (subject for another rant) trying to exploit this. Why doesn’t anyone even attempt to understand this? Ilya Prigogine won the Nobel for this; it seems to be worthy of study, and there is tons more to do. Meanwhile, armies of vast string theorists count the angels on heads of a boson.
4. Why is life? Never mind “how does life work,” tell me why life works at all! You’re all faced with an ultimate mystery of physics every morning in the shaving mirror. Why don’t you think about it a little? Don’t wave your hands on this one; tell me what’s going on. There is obviously order here; order which can presumably be understood by mathematics.
5. How do neural computers, aka brains work? Another problem of immense import. People are studying it; there are even good pop science books on the subject. Nobody is seriously studying it from a theoretical point of view.

I have this idea that physics, along with Western civilization in general, never fully escaped from the wandervogel era “playing indian in the woods” navel gazing of post WW-1 Europe. In fact, I think as a result, physics attracts moosh-headed people who think this sort of “looking into the mind of god” thinking is, well, acceptable, when it really shouldn’t be for a serious scientist. In the Victorian era which spawned the ideas of Maxwell and (early) Einstein, a theoretical physicist’s job was to come up with models that fit the experimental data; a physicist was a sort of mathematical phenomenologist. He was not an aesthetician, though he might create something of great aesthetic merit. An interesting observation which might be made is how physics followed many other formerly rigorous fields in to the badlands of ‘theory.’ String theory is to Victorian physics what modern Literary theory or artistic technique is to their Victorian analogs. Certainly, the modern things can be said to be more ’sophisticated’ -but it is also more useless for understanding the world.

Smolin’s idea that more affirmative action is going to help physics is laughably insane. I’d go so far as to say this is probably a symptom of the type of mental illness which thinks doing quantum gravity is important “because it must be so,” aesthetically. Physicists did better before they were required by their Universities to engage in ritual Maoist witch hunts against racism and sexism. That’s a historical fact. Throwing away the simple, effective idea of judging physicists based on something resembling competence isn’t going to get us anywhere good.

My attempt at a solution to this social problem (and it is a social problem) is a lot more radical and frightening to people who work within the University-Industry axis of mediocrity. It is positively heretical to people who worship education as some kind of secular sacrament. To my mind, the strength of the institution you belong to is the weakness of the individual. The very idea of a University is medieval and feudalistic, or at best Industrial. You want to do real original research? Quit academia and become a free lance consultant. Smolin’s most interesting menagerie of oddball physicists did just this, so I know he’d be behind me. Smolin himself works in a very nontraditional institute funded by private industry. It’s what I have done, and freed of the bureaucratic need to churn out nonsense papers, or spend my time baking vacuum chambers, my creativity has blossomed. I’ll never be an eminence grise like Smolin in any subject, as I’m not as clever as he is, but I will likely die richer, and have enjoyed my life more than chaining myself to some horrific bureaucracy whose purpose is to crush all original thought. Do you think Kepler would have had his brilliant idea if he were rotting in a University or government observatory somewhere? I don’t, and I think if you want to be Einstein or Kepler, your path is clear, and is far away from a safe life of vegetable contentment, sucking at the public teat.

Someone needs to write a futurist manifesto of physics, because physics is no longer bringing us into the future. With apologies to F.T. Marinetti:

The universities? Government labs? Cemeteries! Public dormitories where one lies forever beside hated or unknown beings. Absurd abattoirs of play actors ferociously slaughtering each other with bureaucratic slaps, idiot journal editing blows, the length of the fought-over walls!

That one should make an annual pilgrimage, just as one goes to the graveyard on All Souls’ Day—that I grant. That once a year one should leave a floral tribute beneath the icon of Albert Einstein, I grant you that… But I don’t admit that our sorrows, our fragile courage, our morbid restlessness should be given a daily conducted drudge through the universities and neuroses of long dead physicists. Why poison ourselves? Why rot?

And what is there to see in quantum gravity except the laborious contortions of an artist throwing himself against the barriers that thwart his desire to express his dream of original research?… Admiring unification theory is the same as pouring our sensibility into a funerary urn instead of hurtling it far off, in violent spasms of action and creation.
Do you, then, wish to waste all your best powers in this eternal and futile worship of the past, from which you emerge fatally exhausted, shrunken, beaten down?

In truth I tell you that daily visits to government labs and academies (cemeteries of empty exertion, Calvaries of crucified dreams, registries of aborted beginnings!) are, for physicists, as damaging as the prolonged supervision by parents of certain young people drunk with their talent and their ambitious wills. When the future is barred to them, the admirable past may be a solace for the ills of the moribund, the sickly, the prisoner… But we want no part of it, the past, we the young and strong Futurist physicists!

So let them come, the gay incendiaries with charred fingers! Here they are! Here they are!… Come on! set fire to the government labs! Turn aside the canals to flood the universities!… Oh, the joy of seeing the glorious old frauds bobbing adrift on those waters, broken and shredded!… Take up your pickaxes, your axes and hammers and wreck, wreck the long dead academic system, pitilessly!

Links:
Lubos Motl is a righteous peckerwood for a mainstream physicist. If he reads this, he’ll probably dismiss me as an insignificant dunderhead who couldn’t make it in physics: that’s one of the reasons I like the guy; I respect a straight shooter.

Some other guy’s list of important questions; typical “quantum gravity” bias, but at least he notices some other interesting stuff I don’t bother mentioning. Some of them are literally table top physics you could do at home.

A horrible example of the psychedelic quackery that passes for “science” from the New York Times “science” page

In which I stomp on some of our glorious “green shoots”

These are apparently America’s top under-25 entrepreneurs. Allow me to summarize: they are:

1. A guy who rents airplanes to wealthy bored people. Not a bad idea, but … being the Avis of aviation nerds doesn’t sound like it has a lot of growth potential to me. Maybe there are more aviation nerds than I know.
2. Some dudes who are attempting to sell something google gives away a better version of for free. Inspired by this, perhaps I’ll start selling canned Berkeley air.
3. A marketing consultant and expert in twitter judo. She apparently wrote a thesis on why people use things like twitter and facebook. I wonder if she noticed rampant barking narcissism has anything to do with it?
4. Three “green energy consultants” whose services are so in demand … their combined revenues are smaller than one middle class salary slinging HTML. If their success keeps up, maybe they’ll be able to afford to move out of their parents basements.
5. Some chick who makes webpages; cool, someone who makes stuff. However, my pal Mischa makes them with clever database back ends. He also didn’t need a grant to get started, probably makes more money and I’m willing to bet his poker games are more fun, therefore he wins the coveted, “Scott’s top under age 25 most excellent Bay Area entrepreneur of the decade” award, which consists of me giving him a noogie the next time I see him.
6. Someone who places coffee fetching slave^H^H^H um, interns, using the connections she made by doing an impressively insane sounding 15 internships herself. Get this: she charges applicants money to sell them into slavery, and she charges companies money to list their internships. Brilliant! Someone go get me a cup of coffee while I figure out how to steal her business model. Maybe I’ll be the first Quant pimp who charges candidates for a “pre-screen,” capitalizing on all the connections I made at failed bank interviews.
7. A sort of hierarchical etsy knock off -far and away the most promising of the lot, and the most likely to contribute to national wealth. It even yanks on my small businessman heartstrings the way their business benefits people who design clothes and can’t break into the NYC/Paris axis of evil. May they profit tremendously and help get Americans out of our collective proletarian uniform of jeans and t-shirt.
8. An ebay for people who want to cheat on their college exams. OK, really, it’s described as a sort of note-sharing service, where you charge money for your notes. This seems sort of like belonging to a college fraternity without the additional benefits of beer bongs and date rape. Let’s face it: if this idea flies, it’s because people are paying money to get an unfair edge. Probably a lot of growth potential here: more than half the population has some college, and they can’t all be above average.
9. A service where some woman (who isn’t under 25 or very well dressed herself) plays “queer eye” for a dude over webcam and demeans him into buying her choice of clothes. The sadist in me loves the psychological component in her sales pitch, but ultimately, going to Brooks Brothers is going to be a similar experience, and I’m likely to get a better fit from the mean Serbian lady on Post Street. Better yet: support people who know how to cut a suit rather than the Americano fashion for purchasing a pup tent with shoulder pads.
10. A crappy blog/twitter knockoff that doesn’t know how to sell online ads or make any money. You have to love those businesses with no revenue stream, hoping an adult will buy them and make them rich. I thought those went out in the late 90s, but I guess not. I will give them some free advice: sell ads.

Dear America: you can’t have an economy based on narcissism, good intentions, marketing, catering to rich bored people, really excellent webpages, and selling underpants on the internet. I’m afraid you’ll have to make something of value. If this is the best the “almost under 25″ generation is able to come up with, we are well and truly screwed. I may as well prepare my emigration papers to Singapore, stat. Perhaps I can get a job for their Sovereign Wealth Fund. My job would be simple: buy stocks in nations which make stuff using paper money you get from nations whose main exports are Ivy League educated swindlers trying to sell baloney as a service.

Believe it or not, I admire each and every one of these entrepreneurs, despite my sneers at the vacuousness of their ideas. They are all brave and vigorous people for trying to strike out on their own, particularly in this insane business climate, and some of them may very well some day create something of value. The problem is, other than the one marginal exception making markets for clothing designers, what they’re doing is fundamentally worthless, and these guys are presumably the best American youth has to offer -as nominated by Business Week. Nothing described above is an actual innovation which improves human power over nature, productivity, or any aspect of the human condition. By contrast, Philo Farnsworth built his first working model of the television at age 21. Bill Gates wrote a BASIC interpreter and founded Microsoft at age 20. Nikola Tesla invented the AC motor which powers civilization at age 25. I’m not saying every entrepreneur needs to be continually struck by thunderbolts of sheer genius the way Philo Farnsworth or Nikola Tesla was. I’m not saying that their money making activities need provide some obvious benefit to humanity. None the less, you’d figure at least one of the ten best in America might do something which adds to the aggregate national wealth. We’re not going to fund any sort of economic recovery by providing new ways to cheat on college exams or by telling people to unplug their DVD player when they’re not using it. The present situation of “not quite such a rate of utter collapse” isn’t an economic recovery: it’s a profusion of paper money at best.

Someone send me some optimistic or happy links so I don’t hurl myself from one of those new buildings the Glorious People’s University is bankrupting the state of California with.

Edit add: since none of you were able to cheer me up, I actually went back and clicked on the slide show. Many of the business ideas not featured in the main article are reasonable and will actually generate wealth. I don’t know why they picked such stinkers to feature in the main article.

applications of financial ideas to everyday life

The capital assets pricing model (CAPM) was developed by Bill Sharpe in 1964. The basic idea is, your expected rate of return on an investment is proportional to the risk you take:

The derivation of CAPM assumes a lot of things, for example that you are on the “efficient frontier.” The efficient frontier means you will maximize your returns if you make smart risky bets. For example, playing russian roulette is extremely risky, but it only pays off if you’re a character in the Deer Hunter -otherwise Russian roulette is very far from most people’s efficient frontier.

Like most “laws” of finance, CAPM is only approximately true, but it is still a broadly useful model. If you look at stocks with big rates of return, and run the machinery, you see that they have a high beta: a high risk versus the market average risk. It’s easier to think about with a concrete example: if you bought GE shares in 1998 and sold them in 2007, you’d make a little money. If you bought Ebay shares in 1998, you’d have made bank. Of course, you may have bought Pets.com in 1998, in which case you would have lost your entire investment. Both Pets.com and Ebay were inherently risky propositions, as nobody really knew if they were ideas which would take off, let alone of they were well run companies. If you gamble on risk, you might get a big payout, or you might get nothing.

People make a big deal about the philosophical implications of weird things in physics. For example, the seeming psychedelic unreality of quantum mechanics is often used by mush-headed people to justify whatever solipsistic spiritual nonsense they believe in. This was great discovery to me when I was a dorky grad student. When I discovered that women who believe in “new age” ideas will find you incredibly interesting if you mention Hilbert space, I’m pretty sure Alzo Sprach Zarathustra was playing in the background, like when the Ape-man in 2001 discovered that you can kick ass using bone clubs. At last I found a way to use Hilbert space for something in my everyday life! I’m pretty sure my discovery is the source of all the quantum mechanical mystical gobbledygook out there; surely other people noticed this as well. Certainly my theory makes more sense than the idea that quantum mechanics as weird mysticism has anything to do with actual reality.

“This is what it was like when I discovered an application of Hilbert space to everyday life!”

Regardless of the prurient uses of Hilbert spaces, the fact of the matter is, life is a lot more like finance than it is like misunderstandings of post 1920s physics. Finance is a purely human endeavor, so you’d expect the laws of finance to have some bearing on everyday life.

In ordinary life, CAPM is a useful law. People who take risks have more rewarding lives than people who don’t. People who don’t take risks end up living lives with the consistency of bland porridge, and are often struck down by the chances of fortune no matter how hard they try to live an orderly life. I am pretty sure that the only time your life will be risk-free is when you are dead, sort of like your financial life is only risk free when you have no money. The closer you get to a risk free life, the closer to waiting for death you are. It’s an odd phenomenon that people who live in modern societies are so often miserable. I used to think it was because life was too soft. Now I think it’s more related to the fact that modern life doesn’t contain enough perceived risk to make it seem worth living. Human beings are adapted to a world of random chance; we like taking chances. Deprived of chance, we become miserable.

Most people don’t think of themselves as gamblers; they prefer to think of themselves as people who make deliberate and rational choices in a deterministic world. Modern society is set up to give us all the illusion that we can be protected from all risk. Tort law in America is set up with the assumption that everything works in a Cartesian fashion, for example. There is very little allowance for randomness and fate: someone or something is always held responsible for bad things. The way modern people think about life, if you don’t eat enough broccoli, you’ll die of cancer, or if you eat too much bacon, your heart will explode. The reality of things is you will probably die of cancer, stroke or a heart attack no matter what you do. If not, you got into a car wreck: driving cars is a risk most people willingly take which is much more serious and deadly than eating bacon.

Similarly, people misunderstand the role of risk and randomness in their professional lives. Most people, for example, get jobs. A job seems like a relatively risk-free lifestyle. Jobs certainly remove virtually all upside potential, so you’d expect to be compensated with lower volatility. I think a lot of people are now finding out they mis-calibrated their job volatility risk. Is a job on the efficient frontier? Probably not as often as you might think. For example: if you attempt a career in physics in the 21st century, your chances of having a nice life are fairly low. The probability of actually getting a job in physics is fairly low. Even if you manage a job in physics by being lucky, marshaling all of your military and naval power, and having no life for a couple of decades, you’ve basically gotten yourself a job which pays about the same as being a cop or an auto mechanic (I know: I’ve done all three). Job security … well, tenure appears safe for now, but I’m of the opinion that higher education is another speculative bubble: so, best of luck with that. Some might argue that the potential for great discoveries outweighs all these low expectations; guts for glory as it were. By my calculations, moving to Hollywood and getting a job as a waiter in hopes of becoming a celebrity has a higher probability of success than hoping to become an immortal in the world of physics. How many great breakthroughs in physics have you heard of in the last 50 years? Can anyone name any? Yet, there are 47,000 members of the American physical society, each one of them at least secretly hoping at one time or another to win the lottery. I guess probability theory isn’t taught correctly in physics grad school. That’s probably a factor in why nobody understands quantum mechanics. A fun irony of all this: their career choice makes modern physicists much more the gamblers than, say, quants. I’d like to think this is because quants understand CAPM.

When you come to appreciate the fact that life inherently involves randomness and gambling, you can start taking risks that make sense. The casino is a great metaphor for life; potentially filled with fun and games, but random and with a mean expectation of zero. Once you understand that your life is governed by the laws of probability rather than Cartesian determinism, it becomes easier to accept the vicissitudes of fate. Once you realize that most decisions in life involve significant risk and uncertainty, you can start making intelligent decisions about your life. Once you understand the applications of CAPM to your life, you can realize your own efficient frontier. People may think I’m some sort of mad scientist for advocating treating your life as a gambling game, but you can see this at work in many individual lives.

If life worked according to Cartesian determinism, you’d expect chess players to do very well in life, and gamblers to do poorly. What we observe in life is the exact opposite. Great chess players who are capable of calculating complex moves many steps ahead have horrible chaotic lives. They think they can plan things and understand the world using determinism, and this world view fails them. Poor Bobby Fischer, one of the greatest chess wizards who ever lived, had a miserable life. His belief in determinism turned him into a raving madman, hardly capable of the simplest of human interactions. Gary Kasparov, a man capable of beating supercomputers at chess, tried his hand at Russian politics and failed miserably. By contrast, the colossi who rest their feet upon the world of politics, finance and industry are gamblers: almost every last one of them. From Julius Caesar to T. Boone Pickens; games of chance have taught great men how to win in life using probability theory. Gambling games teach you to remain calm in the face of fortune and keep your wits about you, as you wait for the right time to place your bets. Autistic deterministic games like chess may train logic and the memory, but they teach you nothing about life.

“It is a great piece of skill to know how to guide your luck even while waiting for it.” -Baltasar Gracian