Thursday, February 7, 2019

Book Review: From Fire, By Water

Author Sohrab Ahmari's memoir is entitled From Fire, By Water: My Journey to the Catholic Faith.

I first encountered Mr. Ahmari's writing in the pages of Commentary Magazine, the only print periodical to which I still subscribe. I do so because the writing is unfailingly excellent and about topics that interest me. Mr. Ahmari's contributions were no exception. In my mind's eye I pictured him as an old, wizened Iranian Jew, highly educated and long since exiled from his homeland.

So it was a shock to learn that he was born in Tehran in 1985, and raised in a nominally Muslim, mostly secular, upper-middle class family who imagined themselves to be "intellectuals." He and his mother emigrated to America when he was 13 years old, settling in (of all places) rural Utah. There he finished high school and attended college at Utah State, eventually graduating with a degree in philosophy from the University of Washington.

So I'm a sucker for the spiritual journey memoir. The first one I read many years ago was Thomas Merton's famous Seven Storey Mountain, a book describing his journey to a Trappist monastery. I even enjoy the genre in movies--among the few films I have watched more than once is the low-brow rom-com Finding Normal. While not explicitly churchy, the lady protagonist finds love, faith and happiness in small town Normal, Louisiana.

A spiritual journey typically involves a descent into "hell" (my term) followed by a climb back into the light. That is precisely the path followed by our protagonist, including a lot of drinking and loose living. Mostly it's an intellectual journey, beginning with the faux-intellectualism of his youth and bottoming out in dissolution.

Of specific interest to this blog's readers is his stop on the way down at Trotskyism. While a student at Utah State (must've been around 2003) he contacted a grouplet in Salt Lake City called the Worker's Alliance, supposedly affiliated with the Fourth International. They published a newspaper called Equity. I have never heard of this organization before, which given the plethora of Trotskyist grouplets is not surprising. But Google doesn't help--a search for Worker's Alliance or Equity turns up no relevant results.

My hunch is that our author has changed the names so as not to embarrass anybody.

Mr. Ahmari, now committed to his new ideology, moves to Seattle where the national headquarters was located, and to complete his education at UW. The only Trotskyist organization I know of headquartered in Seattle is the Freedom Socialist Party, along with sundry splinter sects therefrom. But that group is centered more around a bespoke version of feminism than Trotskyism--a topic never mentioned in the book.

One more odd thing: Mr. Ahmari refers to his comrades as "Trotskyites," a name that in our day we found insulting and derogatory. It was the term of abuse Stalinists employed against us. Accordingly we always called ourselves "Trotskyists." Though by 2003 the Stalin/Trotsky thing may have faded into history, and perhaps that bit of political correctness was no longer necessary.

Apart from walking a few picket lines, Mr. Ahmari didn't do very much. He never reports writing for their newspaper--a natural thing for him to do. Mostly he engaged in long conversations that he perceived as indoctrination sessions. For him, Trotskyism was an intellectual waystation--there was very little about it of practical significance. In my day we would have called him a dilettante--I don't think he'd disagree with that description.

Though the book is overwhelmingly intellectual, in one episode reality breaks through. Our author is locked in a room with a bunch of very poor, very desperate men about to embark on a dangerous and illegal journey, and for whom there was no turning back. Naturally, in that environment some people behave badly. In his words:
[The] house was a kind of charnel pit or Sheol, though the people in it were yet alive. It was a void, though it existed within the boundaries of space and time. It was on fire with degradation--and sin.
I wasn't there, so I don't know. But from his account I think he overstates the case. Yes, bad things happened. But there were also small acts of heroism and charity. There was degradation--but more because of poverty, panic and desperation than sin. Describing it as "Sheol" seems uncharitable.

Rather than spiritual journey, another way to read the book is as a coming of age story. In this it is remarkably similar to Hillbilly Elegy (my review here), authored by J.D. Vance. Unlike Mr. Ahmari, Mr. Vance didn't descend into "hell," but rather was born there. And the rise wasn't spiritual as much as sociological or political. Both of them found their calling at about age 30, which I think is when the (male) personality reaches maturity. (My history is similar.)

Mr. Vance, at least, is accompanied on his journey by other people, notably his sister, Lindsay. The book is as much about his grandparents as it is about him. But he acquires a wife only at the end--she arrives as a reward for successfully coming of age.

By contrast, Mr. Ahmari travels alone. His grandparents figure in the first chapter, and his mother also during the first years in Utah. But once he leaves home we barely hear from them again. I, for one, wanted very much to know how his mother made out. Unlike Mr. Vance, he gets married midway through his sojourn. The new bride makes a cameo appearance, after which he leaves her for London where he embarks on becoming a Catholic by himself.

Mrs. Ahmari must have been present (on the most important day of his life) when he'd "have the archdiocese convalidate my civil marriage." But she's not mentioned by name, and even the grammar of the sentence suggests she wasn't even there. She plays absolutely no part in his conversion, and behaves like she's a wooden post.

Weird.

There's probably an innocent explanation. Perhaps Mrs. Ahmari enjoys her privacy and doesn't want to be in the book? Or maybe he's convinced that conversion is an internal affair of the heart--solely a matter between him and God? Whatever--he comes across as a selfish cad.

How different this is from the movie Finding Normal, where the beloved is not only a suitor, but also an agent of transformation. It's the romance that makes the movie, and the movie can then carry the underlying message of faith, hope and love.

I have one more nit to pick, and only because I'm a certified geographical pedant. Mr. Ahmari's knowledge of our country's geography is simply appalling! Brownsville is not anywhere close to the Texas panhandle, nor is California north of Texas. I'm astonished that such obvious errors got by the book editors.

The above paints too negative a picture. I actually enjoyed this book--a lot. Mr. Ahmari is a good writer, it's an engaging read, I'm a fan of the genre, and it's not too long. I read it over two or three evenings just before bedtime. Beyond journeys, spiritual or otherwise, you'll learn a lot about both Iran and Utah. My review leaves out the good stuff. In part that's on purpose--go read the book for yourself.

Further Reading:

Saturday, February 2, 2019

Book Review: Fischer Black

The book is by Perry Mehrling and the full title is Fischer Black and the Revolutionary Idea of Finance.

I loved this book. I read it like a textbook--marking up my Kindle with extensive highlights, reading several chapters multiple times, and writing detailed notes so I don't forget so much. I was even inspired to look up a couple of Mr. Black's original papers.

It's not for beginners--I've read a couple econ textbooks, which seems sufficient. A little math background will be helpful--if you know what a random variable is you'll do just fine. That said, Mr. Mehrling writes extremely well, and a close reading will be rewarded.

Fischer Black (1938 - 1995) is most famous for the Black-Scholes equation for pricing options, in collaboration with Myron Scholes, following on work by Robert Merton. In 1997 Scholes and Merton were awarded the Nobel Prize in Economics, an honor Mr. Black would surely have shared had he lived long enough.

The mechanics of his life are not dramatic. He graduated in physics from Harvard, and then went to MIT to study computer science/statistics/economics, etc. He was sufficiently smart that they let him hang around without making much progress toward a degree, but eventually he settled on a thesis in operations research, for which he had already done the work. He graduated with a PhD within a year of formally entering the program.

He was married three times and fathered five children.

The first third of his career was spent as a consultant for Arthur D. Little. The second third was in academe, initially at the University of Chicago, and then at MIT. For the last decade he worked at Goldman Sachs. He died of throat cancer.

Mr. Black became interested in finance while still a grad student, during which time he met the founder of the modern discipline, Jack Treynor, who became his muse and colleague. Unlike Mr. Treynor, however, Black saw a deep connection between finance and economics. The result is he was always the odd man out--too much of finance guy for economists to take him seriously, and too much of an economist to fit in with the finance community.

The enormous progress in finance made during the 1960s was due largely to the newly available computer technology. Prior it had been impossible to test financial theories--investing was done on the basis of a hunch and hot tip. But computers demonstrated that stock prices moved randomly around a mean, and sometimes the variance was large. A lot of people traded on the noise, confusing it with the signal. Noise trading is never profitable on average, and including transaction costs it's a guaranteed loser.

Mr. Black asked why people persisted in noise trading--and that got him interested in behavioral economics.

Three themes dominated Mr. Black's thought: 1) the Capital Asset Pricing Model (CAPM), 2) the efficient market hypothesis, and 3) equilibrium.

CAPM, inherited from Jack Treynor, is summarized by this equation,
                                    E(R_{i})=R_{f}+\beta _{{i}}(E(R_{m})-R_{f})\, ,
where E(Ri) is the expected return on the investment in an individual stock i, and E(Rm) is the expected return on some market index (e.g., the S&P 500). The equation tells you how you should price an individual stock with respect to the market index. It can be generalized to include assets other than stocks, such as real estate, precious metals, etc.

The equation contains two parameters that Mr. Black considered to be of central importance to all economics. Rf is the risk-free interest rate, i.e., the interest rate you will receive for the safest investment you can imagine (e.g., the Fed funds rate). \beta _{{i}}~~is the volatility of stock i compared to the volatility of the index. Very risky (noisy) investments have a large beta, while safe (less noisy) investments have a very small beta. Beta is a measure of risk, and can be measured by calculating the variance (or variation) of price over time. CAPM says that the higher the risk, the greater the return on investment.

The efficient market hypothesis (EMH) claims that market always prices stocks in a way consistent with CAPM. That is, the price of share i will be E(Ri) + noise. If EMH is true, then it will be impossible to profitably trade stocks, since all you could do is trade on noise.

Or, to paraphrase Warren Buffett: if EMH is true, then how come I'm so rich? Mr. Buffett--who got rich by trading stocks--did not have much use for EMH.

That brings us to equilibrium, which is a funny word. In chemistry, a system is at equilibrium when it no longer changes over time. I think Keynesian economics views the concept in a similar way; they always talk about the natural rate of interest or the natural rate of unemployment. The goal of policy is to achieve that nirvana of natural rates where (absent external shocks) the economy will be stable, i.e., in equilibrium.

Mr. Black thought about equilibrium in a completely different way. In his view, equilibrium existed when there were no arbitrage opportunities. In other words, if assets were always priced by CAPM, and markets were invariably efficient, arbitrage would be impossible. There would only be noise, but never would there be time-independent stability as predicted by Keynesian models.

But EMH isn't always true. Markets are often out of equilibrium, and that leaves the door open for traders to make money. The effect of trading will be to pull the market back to CAPM and EMH.

In some cases disequilibrium arises from human nature. In particular, human intuition about risk is not accurate: we underestimate the risk of driving a car, and overestimate the risk of flying on a commercial airline. It's the same with stocks. We tend to be loss averse, which means we overvalue safety and undervalue risk.

That's precisely the disequilibrium that made Warren Buffett's fortune. He bought low risk stocks (calling it "value investing") instead of high risk stocks. Because people consistently underestimated the risk, he got them for cheap, which means he made a killing. He arbitraged our psychological biases.

I don't think that trick works as well anymore--sophisticated program trading is all over it. The arbitrage pushes the market back to CAPM, thus minimizing trading profits.

The biggest source of disequilibrium comes from government. The IRS taxes This and doesn't tax That. For Mr. Black that's a perfect trading opportunity--go long on This while going short on That, and pocket the delta (i.e., take money away from the IRS).

Armed with these concepts, Black and Scholes derived their famous options pricing formula--something that could never have happened prior to the computing age. An ability to price options has led to a whole zoo of derivatives and hedges, but in their day the only available option was the warrant. A warrant was an option to buy a stock at a particular price at some date in the future.

The counter-intuitive result was that the warrant price did not depend on the price of the underlying stock at all. It depended only on its volatility, i.e., its beta value.

Two things need to be said about Black-Scholes. First, it assumes a simplified, cartoon model of reality. For example, it supposed that the inflation rate was zero. In doing so it revealed a basic truth about the nature of things, but one had to be careful about its application to any particular problem. Second, suitably adjusted, Black-Scholes can be applied to any option--and even to things that aren't options but behave like them.

The quants enthusiastically adopted Black-Scholes, and completely forgot that it was too simple by half. They fell in love with their computers and took the results as good coin no matter what. The outcome--much to Mr. Black's dismay--was that Black-Scholes was increasing noise rather than decreasing it. It inspired him to write an essay entitled The Holes in Black-Scholes, in an attempt to reverse the trend.

I found Mr. Black's understanding of money to be exceptionally interesting, and I now describe it here in my own words. For simplicity we imagine a cartoon world.

Consider Germany and Italy back in pre-Euro days when the Germans counted their Marks while the Italians spent their Lira. Imagine also that Germans ate bratwurst every day, for breakfast, lunch and dinner. They bought bratwurst for Marks, and because the market was so large and so steady and so liquid, the price of a bratwurst hardly changed at all. The volatility was very low. A German in Berlin, spending Marks, could buy bratwurst at the risk-free price.

Similarly, our cartoon Italians are addicted to spaghetti, which they eat every day for breakfast, lunch and dinner. They pay for it in Lira, and for identical reasons an Italian in Rome, spending Lira, can buy spaghetti at the risk-free price.

Occasionally, however, Helmut and Hilda, feeling adventurous, instead of eating bratwurst for dinner they go to an Italian restaurant to eat spaghetti. The market for spaghetti in Berlin is much smaller, less liquid, and therefore much more volatile. Sometimes spaghetti is cheap, and other times it's expensive. Unlike bratwurst, spaghetti is a risky good--on bad days the restaurateur will lose money, while on good days he'll make a killing.

Likewise, back in Rome, Mario and Maria hire a babysitter so they can go out for some bratwurst. They hope it will be cheap that day, because like spaghetti in Berlin, bratwurst in Rome is a risky good. The price varies by a lot.

In Germany, bratwurst is a risk-free good, while spaghetti is a risky good. In Italy it's the other way round. When a German uses his Marks to buy Lira, what he really is doing is purchasing an option to buy spaghetti at the risk-free price. And likewise, when an Italian buys Marks, she is really purchasing an option to buy bratwurst at the risk-free price.

Please read that last paragraph again to make sure you understand it.

Thinking of currencies as an option to buy risk-free goods means that the Black-Scholes formula (suitably modified) applies to currency transactions as well. That is, the exchange price between Marks and Lira depends on the volatility of spaghetti prices in Berlin and bratwurst prices in Rome. That is, it will depend on the price of risk.

To make the model less cartoonish, substitute for "bratwurst," a market basket of items typically purchased by German consumers in Berlin, and for "spaghetti," a market basket of items typically purchased by Italian consumers in Rome. Both of those are risk-free goods, but move them to the opposite capital they become risky. The exchange rate between Marks and Lira is proportional to the cost of that risk.

Note that this way of thinking about currencies puts the gold bugs out to pasture. The cost of bratwurst in Berlin is incommensurate with the cost of spaghetti in Rome. And if you reverse the capitals the prices are equally incomparable. There is no single price of gold that's going to measure both of them meaningfully.

The Euro won't work, either, and for the same reason. Since market baskets in Germany and Italy really are different, I think the Euro project is doomed. It's an attempt to take the risk out of risky goods by fiat.

So I really like Mr. Black's model (and kudos to Mr. Mehrling for explaining it to me). But I'm skeptical, and here's why.

Note that, in Mr. Black's model, currency fluctuations depend on different consumption baskets in different countries. So I used to live in Buffalo, where we spent greenbacks. Forty miles away is the comparably-sized city of Hamilton, Ontario, Canada, where they buy stuff with Loonie coins. For the life of me, I can't see much difference in what we consumed in Buffalo vs. what they consumed in Hamilton. We eat the same food, live in the same houses, drive the same cars, speak the same language, attend similar schools, get the same haircuts, etc. There may be small differences, but no spaghetti/bratwurst distinction.

That implies that the exchange rate between dollars and Loonies should remain about constant. So I'll remind you that in 2014 the Loonie bought US$1.05, while today it only fetches $0.76. That's a big delta for what should be a near risk-free exchange!

The common reason given for fluctuations in CAD/USD exchange rates is the price of oil--Canada is dependent on oil exports to the US. In 2014 oil cost about $100/bbl--today the price hovers around $55, which seems to explain the drop in the Loonie. And maybe that's true, but it's inconsistent with Mr. Black's model. In his account currency exchange rates are established by differences in consumption patterns, not production patterns.

That aside, Fischer Black had lots of other thought-provoking ideas, and Perry Mehrling's book explains them clearly. I highly recommend Mr. Mehrling's biography of Fischer Black.

(Apologies for exceeding my self-imposed word-count limitation. I just had too much to say.)

Further Reading: