Valuing Risk

Love and Marriage

Love and marriage, Love and marriage

Goes together like a horse and carriage

Something things just go together.  Risks can’t be understood unless you understand both likelihood AND  consequences.

Understanding and properly valuing risks has become very important during the corona virus crisis.  We are being asked to properly quantify risks.  Part of the reason is that people don’t understand both components of risk and part is because people are approaching risk from a framework that can best be understood by viewing a previous blog post. https://dbeagan.blogspot.com/2020/06/a-framework-for-human-behavior.html.

Risk is based on the likelihood of an event occurring and the consequences if that event does occur.  The response to COVID-19, the disease caused by the corona virus, include measures to reduce the likelihood and to minimize the consequences.  The likelihood of catching the corona virus is lower if the chances for contracting it are lowered. That is why people are urge to wear masks and social distancing have been promoted, because they lower the likelihood of contracting the corona virus.

The other component of risk are also best understood by actions taken during the pandemic.  The ultimate consequence is that one could die from COVID-19.  That consequence is lowered if ventilators and Intensive Care Unit beds are available at hospitals treating those with COVID‑19.

However both the likelihood and the consequences are not the same for those with a user optimal or a system optimal framework.  Those with a user optimal perspective (“what’s in it for me”) can agree that they lower their likelihood by visiting places where others socially distance and wear masks.  They do not lower their own likelihood appreciably by wearing masks themselves.  Those with a system optimal outlook ( “I do this not for myself, but for others”) wear masks to protect others, not because it lowers their own likelihood of contracting the coronavirus. Even if both user and system optimalists agree on the likelihood  of contracting the coronavirus if they social distance and visit only paces wear other wear masks,  they may not agree on the value of the reduction in  likelihood of their own wearing of a mask.

Similarly consequences are viewed differently by those with a user or system optimizing perspective.  Those with a user optimal perspective only value actions that reflect consequences to themselves.  Acquiring ICU Beds or Ventilators that they will not use will have no value to them.  Those with a system optimal perspective place value if anyone in the system uses them.

The inclusion of others in the system also takes on a perspective in likelihood and consequence.  There is no value in reducing the likelihood for members not included in one's definition of a system.  Similarly there is no value in lowering the consequences of those not included in one’s definition of a system.

Even when individuals properly value likelihood and consequences, which means they properly value the risk, they may arrive at completely different values for the risk depending on their own framework.  Just because likelihood and consequences  go together like a horse and carriage when valuing risk, individuals can arrive at different assessments of risk depending on their framework.

A Framework for Human Behavior

United We Stand

For united we stand. Divided we fall

And if our backs should ever be against the wall

We'll be together, Together, you and I

Man is a social animal. What does this mean for understanding our behavior?

Man is a social animal.  When Darwin wrote “On the Origin of Species” it gave rise to the “Survival of the Fittest” as a phase, but Darwin was applying it to species in the plural, even if it has been often applied to the behavior of individuals.  How humans approach winning is only one dimension of understanding behavior.  In many disciplines two dimensions are used to understand behavior: time and distance; exclusive and rival; likelihood and consequence, etc.  I would propose that two dimensions are useful in classifying human behavior.  The first dimension is how they define winning, optimization; and the second dimension is how they approach others, inclusion.

Games Theory proposes two basic approaches to winning: User Optimization and System Optimization.  I would propose that when applied to human behavior this is not a binary either/or choice but instead is a continuum, spectrum. 

Humans are wary of others.  That definition of others can also be inclusive or exclusive, but also as a continuum, not as an either/or choice.

The proposed framework of two dimension is:

Optimization can be a spectrum depending on the degree of shadow prices (e.g. customs, rules, regulations, laws) that are willing to be accepted.  Libertarians could be classified as favoring extreme user optimal solutions, while socialists would favor extreme system optimal solutions.  Shadow prices must be imposed and collected by society, i.e. government.  People who believe in small government, like Republicans tend to favor system optimal solutions, but limited government. Democrats also favor system optimal solutions favor, but they favor larger government.

While Socialists favor System Optimal solutions, there is a difference between Marxists and Nazis ( whose very name is a shortening of the German for National Socialism). That  dimension is the view of others included in those system solutions.  Marxists favor a very broad inclusive view, while Nazis and other nationalists favor a narrower definition of those included in the system being optimized. This inclusion can be on a continuum from individuals, families, ethnicity, language, religions, race, etc.

A distinction is made between “Do As I Say” versus “Do As I Do”.  Humans may adopt a public System Optimal solution in theory for others, but a private User Optimal solution for themselves.  E.g. Nazis in public as opposed to Nazi officials in practice.  However, nature has stood firmly on the side of System Optimal solutions, Species, rather than User Optimal solutions, individual organisms. 

While it is convenient to define human behavior in two dimensions, it is not extreme behavior in these dimensions  Humans are a balance of both social and xenophobic.  Moderation in these opposing tendencies may be the preferred behavior.

Risk and Business

Risky Business

I'm afraid we've gone and laid it on the line 
      It's a risky business

If the business of government is really business, then why can’t government be run more like a business?

The answer is in the perception of risk.  Risk has two components: likelihood and consequence.  If you get the risk wrong, and the likelihood was high, but it had minimal consequences, then that is no big deal.  If the consequence is dire, but the likelihood is low and it did not happen, then that also is no big deal.  If an event happens even though the likelihood was small, and the consequences are dire, and you did not properly consider the risk, then God help you.

That is why there are insurance actuaries. They set insurance rates by quantifying the likelihood of something bad happening and valuing the consequences of that event. And that is why insurance is purchased, not because you expect something bad to happen, but you want to mitigate the consequences if something bad happens.

Many businesses do not purchase insurance, instead they self insure.  They accept the consequence that they might go out of business if the if the worst happens.  The problem with going out of business, bankruptcy, is that it impacts the creditors and customers of that business as well. Society does not have the option of declaring bankruptcy, since the customers and the creditors are society.  Governments can declare bankruptcy only if the customers and creditors are another government, if those governments agree to take on the customers and costs of the old government.

If businesses or businessmen do value risk properly then, yes governments can be run as that business.  But a string of bankruptcies and business failures should be a warning sign that the business or businessman does not understand risk.  A child learns not to pick up a hot object by experience.  If it never learns because it assumes nothing it touches will burn, then they might be lucky, but have not learned this lesson.  You learn from mistakes. You do not  keep doing so many things in the hopes of finding something in which you will make no mistakes, incur no consequences.

International Trade

Trade Winds

And we're caught in the trade winds
The trade winds of our time

Can the growth in international trade affect the US economy?

According to the United Nations Center for Trade and Development, global trade (exports) have grown from $61 Billion US Dollars in 1960 to a value of almost $20 Trillion US Dollars in 2018.  The US Dollar serves as the international reserve currency and has served this role, exclusive of gold, since 1971.  The Gross Domestic Product of the United States is also $20 Trillion  in 2018,  about 12% of which is exports.  Even if the US trade dropped to zero, this international trade between the countries would still require US Dollars.

A question becomes what is the future of international trade?  Fitting a Compound Annual Growth Rate curve to the trade from 1960, would forecast that the Global Trade in 2030 could be $85 Trillion.  However, if the pattern of recent years is fit to a logit curve, this suggests that international exports could amount to $24 trillion in 2030.

This difference in forecasts has implications for the domestic monetary policy of the Federal Reserve Bank.  While the Federal Reserve can control the domestic economy, they have little ability to affect international trade. International trade, which includes US exports, is projected to be as large as the US domestic economy, if not larger.  This has major implications for domestic national monetary policy.  

This conflict between domestic monetary policy and the international trading when a domestic currency is used as the international reserve currency was anticipated in the 1960s by the Belgian-American economist Robert Triffin. He pointed out that the country whose currency is the global reserve currency, that foreign nations wish to hold, must be willing to supply the world with an extra supply of its currency to fulfill world demand for these foreign exchange reserves.

International trade might be equal to the US domestic GDP by 2030, or might be several times greater than this amount.  In any event,  the continued use of the US Dollar as a global exchange has become a serious problem,  It remains to be seemed if the change in trade winds is a problem that can blow down the US economy.

User Optimization

The Winner Takes It All

 The winner takes it all

The loser has to fall

 It's simple and it's plain
Why should I complain 

You should complain because the winner taking it all is only one way that a game can be played. 

Everyone loves a winner.  However, whether the winner is a society or an individual depends on one’s strategy and the rules of the game.  In Games Theory there are two major strategies: User Optimization and System Optimization.  The first strategy could be characterized as “I do what is best for me”.  The second strategy could be characterized as “All for one and one for all."  The first strategy involves finding the solution that is best for that individual.  The second looks at the sum of the solutions by all of the individuals in that system and picks the set of solutions that are best for that system. 

The System Optimal solution requires that some individuals  “take one for the team”, that is they must accept a solution that is not best for them, because that is the best solution for society.  A System Optimal solution has been shown to be different than a User Optimal solution but may not be intuitively obvious.  Individual User Optimal solutions will be chosen when there are no constraints on an individual.  If one user chooses a solution that is best for him, every other similar individual should make that same choice.  However, the aggregate of these solutions is not the System Optimal solution.  For example, when choosing a route, each user will choose the  route that maximizes their utility, minimizes their time and cost.  In my discipline of transportation planning, this is known as Wardrop’s Principle.  A misconception that the sum of these User Optimal solutions is the System Optimal solution has led to Braess' paradox, where eliminating a link which forces travelers to change their paths could result in a better system utility. If the User Optimal and System Optimal solutions are accepted to be different, then there is no paradox.

Humans are a social animal, but they are also individual animals.  Societies prefer team, group,  sports.  The Super Bowl generates more viewers and more interest than the individual championships in track and field.  The best player in a team sport may not play on the best team.  Giannis Antetokounmpo might have been the NBA’s Most Valuable Player in 2019, but in that year the Toronto Raptors, not Giannis’ Milwaukee Bucks, won the NBA Championship.   

There is a way to make the user optimal solution be closer to the system, societal, optimal solution. That is by charging an extra utility for using a certain item.  Economists call this adding a shadow price. It is one of the reasons why tolls are charged on public roads. Customs, Rules, Regulations, and Laws are among the ways that society imposes these additional costs for using an item.  When this shadow price is added to the actual price, then the individual user chooses a solution that considers this shadow price.  The shadow prices that are added can be chosen such that the User Optimal solution becomes closer to the System Optimal solution.  The problem is that the society that imposes the shadow prices is also the same society that collects and distributes these shadow prices.  Society must trust that the shadow prices are imposed for the good of society and not the good of the those in charge of society.  It becomes a matter of “Who Watches the Watchmen/Quis custodiet ipsos custodes?”

Is Inflation Real?

Just My Imagination

I tell you I can visualize it all
This couldn't be a dream for too real it all seems
But it was just my imagination
 Once again runnin' way with me.

Inflation seems real, but it may be just our imagination.

Price inflation seems real.  Every year things get more expensive.  But it hasn’t always been this way.  See my earlier posting. https://dbeagan.blogspot.com/2018/08/the-happening-riding-high-on-top-of.html.  There was a time when prices seemed stable.  Prices rise because demand is increasing at a faster rate than supply.  Demand is growing because the economy is growing.  Everyone knows this, including the suppliers.  They should increase supply at the rate of demand in order to increase their profits. They know how much demand is growing, or is there some other reason why there is still inflation?

The US dollar serves as the medium of exchange in the United States, but also serves as the de facto international currency.  It did not have to serve as the international reserve currency.  John Maynard Keynes proposed at the 1946 Bretton Woods Conference that the international currency exchange should be the bancor, French for bank gold.  This was rejected in favor of a system a system of pegged exchange rates ultimately tied to physical gold in a system managed by the World Bank and International Monetary Fund, IMF. In practice, that system implicitly established the United States dollar, USD, as a reserve currency convertible to gold at a fixed price on demand by other governments. The dollar was implicitly established as the reserve by the large trade surplus and gold reserves held by the US at the time of the conference.

But these conditions would not endure for ever.  By the early 1970s, the US trade surplus was no more, and, in 1971, Nixon decoupled the US dollar from gold. This made the US dollar the explicit, not just the implicit, international currency.  A period of monetary inflation ensued, but this is only inflation based on the previous year. In fact, the Consumer Price Index, a measure of inflation, has consistently risen since that time, even while annual inflation has been declining.  Since 1971, the CPI appears to have been growing at a linear rate.  While Year Over Year, YOY, inflation from 2018 to 2019 was 1.8%, inflation from 1971 to 2019 was 531%.  Inflation reached a maximum annual inflation of 13.5% in 1980.  By contrast a linear regression of the CPI, assumes that much of the inflation happened immediately in 1971 when it was forecast to be a maximum of 21%, but by 2019, its forecast annual inflation drops to 1.8%, and has increased from 1971 by 549%.

Why is there any inflation at all? As stated in the  earlier posting, this is because of the Triffin dilemma. Since the USD is the international reserve currency, trade between, for example, China and Nigeria, even though it does not involve the United States, may require USD.  The growth in international trade according to World Trade Organization is forecast to be 1.6% in 2019.

The United States Federal Reserve Bank has been adjusting US monetary policy to reach its goal of 2% annual inflation but has admitted failure.  I am proposing that if the USD is the international trading exchange, then “inflation” is a consequence. If the USD was NOT the international exchange, then inflation might be just my imagination, and 0% would be the real inflation, which is certainly better than the Federal Reserve’s 2% goal.

Classification Systems

Horse in Striped Pajamas

No, that’s not what it is at all 
That's an animal people call a zebra
  I see, but it still looks like a horse in striped pajamas to me

There is no single best classification system, it just must be useful to you.

And I thought truck classification systems were screwed up!  It is nothing compared to product classification systems.  Humpty Dumpty was only partially wrong when he was talking to Alice in "Through the Looking Glass".  The word used to describe a thing may mean what I choose it to mean, but the word, or classification system, that I use depends on my purpose.  A shipment of household cleaner can go by many classifications.  A retailer might describe it by the UPC Code on the items in the shipment.  A customs official might use the Harmonized Series code to see what tariffs should be collected on that item.  The railroads might use the Standard Transportation Commodity Code to determine what price to charge for transporting that shipment by rail.  The US Department of Transportation might use the Standard Classification of Transported Goods to report on multimodal shipments.  The US Army Corps of Engineers might use the Public Monitoring System code if that shipment was transported by water.  An emergency first  responder might refer to that shipment by its United Nation’s Hazardous Material code.  An economist might refer to the industries that Make or Use that product.  Etc.

Each one of these classification systems is appropriate for the purpose that is intended, but each one is different.  An economist might have a classified a product but used a system that a hazardous material responder would like to use.  It is too much to expect that a single code could be developed, but in order to transfer information from one discipline to another, it is desirable that correspondence tables, crosswalks, be developed among those classification systems.  That way information developed for use by customs officials can be used by economists, and so on.  Those establishing systems should at least develop a crosswalk to one other commonly used system.  If enough correspondence systems are developed, then perhaps one of those tables could serve as a Rosetta Stone to translate that information from one from those who have information to those who would like to use that information.  That way you can still refer to a “horse in striped pajamas” if that is what makes sense to you.