Allison's ode to the second moment


Welcome to the seventeenth issue of Allison’s Ode to the Second Moment, a newsletter that believes there are no tail cases, life follows a uniform distribution.

The mother of all tail events

The election turned out differently than many of us had expected. Some might call it a tail event. For months, polls predicted near certain odds of a Clinton victory. Politics aside, us Pension Geeks can all learn something here. The election presents an opportunity to reflect on how we measure risk. Was this really a Black Swan, an event no data hound could've foreseen, or was the data was just interpreted incorrectly?

It is easy to mess up data inference if we are looking for a reason to validate our priors. I am not the biggest fan of behavioral economics, but I think it sometimes offers valuable insights into how we perceive probabilities and measure risk (and then make a rational decision based on the flawed information we do have!).

We often use historical data to calibrate our risk models, and so do election forecast models. Those models made inferences on voter turnout and undecided voters using past election data. The past is often a poor predictor of the future. But historical data is all we have; so we use it anyway. Still, one must be wary of structural breaks. And if there was one constant in this election, it was that the old relationships no longer applied.

Maybe we didn't want to see that the world had changed. Or we are often subject to heard behavior, in politics, media, academia, and finance. We like to think the numbers can speak for themselves, but really they speak for whomever is running the estimation.

So what does this all mean for risk?

Who knows? The only certainty right now is there is more uncertainty. There is a whole range of possibilities; I won’t even begin to try and predict how it will turn out. I think it's interesting that bond yields are up. Normally after a big shock, investors crave safety, buy lots of bonds, and yields fall. What does the 50-basis point increase on the 10-year mean? Maybe nothing. Or maybe markets are concerned about bigger deficits, less engagement in global markets, or even a possible default. There is also some indication of higher inflation expectations.

Maybe President Trump will bring back high interest rates and inflation….

I am not optimistic about entitlement reform, if campaign promises are any indication of the future. In honor of the impending handoff of power, and my hope entitlements will be on the agenda, here are my 4 least favorite arguments people make to put off entitlement reform:

  1. We can’t raise the retirement age. Some people need to retire early, that means we need to keep the retirement age low for everyone.

  2. Past predicts the future. All this talk of comparing projected income and assets to liabilities is silly. All that matters is that pensions were paid in the past, the money always comes from somewhere.

  3. We can make Social Security even bigger! All we have to do is increase marginal tax rates on high earners 12%+.

  4. The future is uncertain. Projected shortfalls are, after all, projections. Who knows? People might die early! There might be 7% growth! If that happens we needn’t make any changes. Let’s wait and see if it does. There’s no harm in waiting.

Those of us who believe in arithmetic see why these arguments are wrong. There is a cost. Waiting until 2034, when Social Security can no longer pay full benefits, requires bigger tax increases or benefit cuts than would be necessary if we fixed Social Security today.

It is an important program. Social Security is huge source of retirement income for many Americans. Delaying reform subjects them to more uncertainty. Why not just fix it, President-elect...Trump?

Let’s not romanticize the past

It seems like both candidates ran on the promise that they’d bring back the good old days, the 1950s and 60s. Back then a man with a high school diploma could earn enough to provide a middle class lifestyle for his family.

Things really weren’t that great back then, certainty not for women and minorities. And for everyone else, things weren’t so great in terms of basic standards of living, life expectancy, and poverty. But if you think inequality is the biggest economic problem we face, you might pine for the 1950s because at least income inequality was very low. Turns out it wasn’t

Wojciech Kopczuk took a hard look at tax data. And it turns out until tax reform in the 1980s, corporate tax rates were much lower than income tax rates. That induced business owners (who normally earn more) to retain their earnings within their companies and lower their tax bill. Kopczuk speculates, when you account for retained earnings, income inequality was pretty bad in the 50s and 60s too.

Let’s look toward to the future

Before the election, Tyler Cowen wrote an interesting column on how this election was a prime example of technology running ahead of our ability to understand and use it. That was clearly true of data interpretation. Other examples include multiple email scandals, leaks, and hacks.

There was also a realization that social media can be a more effective medium to connect with people than traditional campaigning. Joe Weisenthal has some interesting thoughts on how social media eroded our social norms. Your vote was once a private and dignified choice. I miss those days.

New technology often brings unintended consequences. It is the very nature of technological innovation. A wise man once told me that any new technology is only as good as:

  1. The quality of the innovation itself

  2. The person using it

  3. Applying it to the right problem

Many aspects of this election revealed that we don't always use data and email correctly. We do not fully understand the consequences of social media. It democratizes people’s ability to share information. On net, I think better communication tools are positive developments that will make us better. But that does not mean the process will be smooth and it may cause some surprises.

Until next time, Pension Geeks!