It might have turned out badly if I'd been on anything but a Harley

One Wednesday 1am in the years when I couldn't sleep I wandered into a ramshackle biker bar out route 46 and found a guitarist playing the blues. The guy was like 50 and looked like an accounting professor, but man could he play. I listened until he closed the place down and left on the quiet highway feeling better than I'd felt in a long time.

That said, randomly barging into intimidating roadhouses looking for decent music hasn't generally worked for me.

Music's important to me. Finding ways to keep up with it now that my once music-geek friends have moved on to other hobbies--like work--took me a while. AllMusic was a huge help, then Last.fm. And, of course, Hype Machine and, through them, the music blogs.

But finding live shows was still tough. Last.fm says I have played 1,328 different artists in the last couple of years. And I hate large venues. I'd love to see Andrew Bird live, but I'm not going to Radio City to do it. I told a friend that I needed something to tell me when my favorite bands were in town (and that I wasn't going to somehow link to all 1,328 of them through MySpace or somesuch.) He introduced me to the guys who started Livekick. Livekick goes through your iTunes library and scrapes your Last.fm or other account to find out what bands you like and then sends a weekly email telling you who is going to be playing near you. Genius! There's no way I would have known that Ted Leo & the Pharmacists is going to be at Maxwell's tonight without them.

Anyway, I put some money into the company, so maybe I'm just talking my book, but if you like music, you need to check them out.

But, then, why have a website at all?

I've been sitting in front of my computer all day, doing general industry research: who does what, who the competitors in specific micro-segments are (i.e. who the ten billion companies competing to be the leading real-time mobile app video advertising social behaviorial targeting data exchange are. OK, that was a bit of hyperbole, but not by much.), etc.

One thing I noticed is how hard it often is to figure out what a company does by looking at its website. I figured that after giving the elevator pitch 3,000 times to VCs-frantically-pushing-the-Door-Open-button, the entrepreneurs would be able to clearly and concisely say what they do.

First Ever Ad Market

I was out with Josh Grotstein--CEO of Motionbox--last week, and got to talking about how the inefficient market design of our current ad exchanges saps liquidity.

OK, maybe I was talking about it.

Possibly I was ranting*.

Josh wisely changed the subject to an episode of 1987's Max Headroom, featuring the first vision of an ad exchange that we could think of, the steam-punkish Ad Market. It's not entirely clear what the underlying is in this market, since elsewhere in the episode a big advertiser seems to be using Skype to tell a network head to get the ratings up. It could, perhaps, be a pure risk-hedging derivatives market without any delivery of the underlying, which would certainly explain the show's dystopian setting.

Elsewhere in the episode, Amanda Pays makes those 80s style big-shoulder suits look pretty damn good.

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* The thing about a rant is that it can't be kept in. So here it is.

Liquidity in a marketplace is generally determined by depth of limit order books. If the limit order book gets depleted, there is no liquidity. Most research on this subject focuses on the ratio of limit orders (supply liquidity) to market orders (deplete liquidity). This ratio depends on trader patience and market design.

Market design decides time to execution, the key endogenous factor traders take into account in deciding whether to place a market or limit order (mappable, perhaps, to the more classical 'waiting costs.') Variability is a function of spreads, spreads a function of liquidity, and liquidity of time to execution. Highly variable prices drive down the average price level.

In a well-designed market, time to execution can be minimized even with low volumes. Many marketplaces have historically kept TTE low by opening only for a limited period of time every day or every week. By concentrating order flow in a smaller period of time, the chance that each trade would clear quickly was increased.

Our current ad markets seem to be headed in the opposite direction. I consider these markets low-volume. But instead of working to decrease TTE by increasing the concentration of order flow, they seem to be motivated instead to decrease inventory risk by imposing a small TTE, diluting order flow. This depletes liquidity and must, in the aggregate, lower CPMs.

Of course, this is all speculative on my part, since I don't have the data to back it up. Also, this effect is probably a small part of why online CPMs are so low, the relative inefficacy of online ads being the bigger part. But liquidity is certainly more interesting to think about. It also makes me wonder what the heck Hal Varian does at Google.

On Regulation and Innovation in the Financial Industry

Yesterday President Obama said

We started taking shortcuts. We started living on credit, instead of building up savings. We saw businesses focus more on rebranding and repackaging than innovating and developing new ideas that improve our lives.

But contrast that with this, from November of last year:

The Securities and Exchange Commission this week issued a formal cease and desist order against peer-to-peer lender Prosper Marketplace Inc.

The San Francisco company said in October that it was no longer accepting new lenders or loans as federal regulators consider the company’s application to establish a secondary market for loans made on its person-to-person lending site. That process is expected to take months.

It's easy to talk the talk about wanting innovation, but government regulation and innovation are inimicable. It's hard enough to start a new company. It's next to impossible for a startup to comply with government regulation that is opaque, one-size-fits-all, slightly different in each of the 50 states and written by lobbyists to benefit incumbents. To comply with the regulations, companies have to hire expensive, well-connected lawyers and go through a several month process. As an early-stage investor, I probably wouldn't invest in working cold fusion if it required the company to be government regulated.

I know everybody and their mother thinks the solution to all our financial system woes is more regulation, but it's worth considering that the US financial services industry is probably the most heavily regulated industry in the world (and if it's not, then it's second only to our incredibly inefficient healthcare industry.) It seems everybody and their mother thinks that if beating your head against a brick wall isn't working, well, just beat harder.

I'm not against regulation, really. I just think that if the regulation we have isn't working, we need to go back and figure out why, rather than layering on a new layer of regs. We should also go back and figure out who wrote our current regulations and burn them in effigy, to better motivate the current regulation writers. Nothing focuses the mind like a hanging.

The first principle in writing new regulations should be an explicit statement of what we are trying to achieve. And if what we are trying to achieve is that no one loses money ever, then perhaps what we want is not a financial system at all. That goal would be best achieved by returning to the gold standard and issuing safes to every home.

But whatever the goals are, one of the primary ones should be to promote innovation. And one of the primary goals of that innovation should be promoting diversity of business models. After increased regulation, the primary prescription in the mass media for the financial system is making sure that no company is too big to fail. This worthy-sounding goal is a non-starter in today's economy. Even if every financial services firm in October of last year had been split into 100 identical sub-firms, we would have had the same problems. Paul Kedrosky has talked about making sure that firms are less tightly coupled as one solution to rolling failures. While I believe this, I wonder if it's possible to implement.

But if you turn the problem 90 degrees on a completely different axis, we can address the tight coupling along functional axes: if we had many types of firms, then even if they are financially intertwined, only a small subset will fail in any given crisis. This idea--that diversity is key to the resilience of an ecosystem--is widely understood by ecologists, biologists and evolutionary scientists. The benefits of biodiversity are inarguable.

We need an appreciation of diversity in our financial services companies. We need to encourage innovative startups that try to provide crucial financial services--like converting savings into investment--in new ways. We need hundreds of them, understanding that most will fail. (Innovation is akin to an evolutionary process in this.) We need to change our regulations to encourage innovation, rather than discourage it. The president needs to stop placing blame and start planting seeds.

And we need to get over the fact that some blameless people will lose some of their money some of the time. Because with the financial services monoculture we have now, every taxpayer loses a lot of money every ten years or so.

Why Bankers Will Continue to Make Just as Much as They Used To

I can understand the brouhaha over banker pay. Bankers make a lot of money. And the seeming unwillingness of the banks to lie low on the compensation front for even a quarter or two makes me wince.

Case in point, this New York Times article: After Off Year, Wall Street Pay Is Bouncing Back

Even as the industry’s compensation has been put in the spotlight for being so high at a time when many banks have received taxpayer help, six of the biggest banks set aside over $36 billion in the first quarter to pay their employees, according to a review of financial statements... If that pace continues all year, the money set aside for compensation suggests that workers at many banks will see their pay — much of it in bonuses — recover from the lows of last year.

Yes, bankers will get paid as much this year as they did before the financial services meltdown.

Another number in the article jumped out at me: "Historically, investment banks have paid workers about 50 cents for every dollar of revenue." This is surprisingly similar to the amount paid to employees of ad agencies and other marketing services firms. It is also surprisingly similar to the amount paid to consultants and lawyers (adjusting for the implied equity-ownership pay in partnerships.)

The headcount-expense/revenue ratio in professional services firms is so universal because the economics of salaries and revenue are linked. We (and the mass media) tend to think of firm revenue being set in one supply and demand market and eexpenses being set in another and firms forming only in that uncommon circumstance where the revenue is enough to support the expenses. This may well be true for companies that make widgets: whether or not the widgets are made is a consequence of whether or not they can be made for less than they sell for.

But in a professional services firm, this is not how it works. The demand for the firm's product is also the demand for the underlying labor, so these demand curves are linked in a simple fashion. The supply curves, obviously, are also linked. Because of this--and the industry dynamic it creates--professional services salaries are the amount left from firm revenue after rent, technology and returns to equity-providers are paid*. Since these other amounts are generally within a small range of percentage of firm revenue, the amount paid to employees will be as well.

If you think bankers make too much money, focusing on how much they are paid will get you nowhere. If they are not paid 50% of firm revenue, they will go to another bank that will pay them that much. If no bank will pay them that much, they will go start a new bank. If that sort of compensation is outlawed at any bank present or future, they will start a bank where they are the equity owners and get paid that much. The money has to go somewhere, and it's not going to go to the providers of capital because the providers of capital to professional services companies have no negotiating leverage.

Taxes would work. In most of the business world, it seems that the highly compensated are paid on a de facto post-tax basis, so if taxes are raised, compensation is raised to correct for it. But this can't be true under my theory of professional services firms. So that's one way.

But I believe that outsize salaries are the result of a market failure, so why screw around with taxes when we should be addressing the market failure itself? I'm no expert here, so I'm not going to expound in detail my pet theories of why banking services cost so much. But in general I think that financial services regulations are far too oriented around who is allowed to provide certain services and how they are licensed when they should be oriented around actually protecting people who need protection. These two things are supposed to be the same, in principle, but they have not turned out that way.

I know it's easier to get the average person incensed over someone's pay than to get them to think about reforming a market--especially a market the average person could care less about--but I guarantee that no matter what the government does, no amount of bluster over how much bankers make will change their pre-tax compensation a single iota unless they focus on why revenue per employee is so high.

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* Yes, I don't believe payments to owners in professional services firms are the residual profits. And why should they be, when the employees can leave and set up shop across the street with almost no need for equity capital? In the implicit negotiation over distribution of revenue, the employees have all the bargaining power. The equity will be paid a fair return, but will not receive any structural increases in revenue. On the other hand, the equity will continue to bear the majority of the variability in profits. This view, while not the standard economic view, has the advantage of being supported by reality. (It also accounts for why non-partner-owned professional services firms tend to conglomerate, but that's another post.)

There's lots of bad economic news, so much that not much of it breaks through the clutter for me anymore, but this did:

Tufts accepts 26 percent of pool, suspends need-blind admissions:

The admissions office ... stopped practicing a need-blind admissions policy toward the tail end of the process, a decision that affected five percent of applicants, Dean of Undergraduate Admissions Lee Coffin said.

Admissions officers were able to first read every application in a need-blind manner, during which they did not consider an applicant's ability to pay. But with more families requesting larger amounts of aid due to the recession, officers suspended need-blind practices for the final 850 applications -- of 15,038 total -- when potential financial aid ran out.

"We read every application need-blind, conducted committee need-blind, and then we ran the numbers and realized that we just couldn't do it, that we had gone as deeply as we could go," Coffin said.

I bet this is a problem a lot of colleges and universities are facing this year and may face the next few years. This is where the government funding should be going; investing in education for young people is the best possible use of our economy's surplus.

Read Romer in Post-Scarcity Prophet:

When you're thinking about the future, you never really know what we're going to discover, but I think there's a reason to set for ourselves an ambition of trying to raise the rate of growth by half a percent per year.

... If we can make the choices that increase the rate of growth or real income per person to 2.3 percent per year, in 50 years we can get extra income per person equal to what in 1984 it had taken us all of human history to achieve.

One policy innovation, for example, that would boost the growth rate would be to subsidize universities to train more undergraduate and graduate students in science and engineering.

Subsidizing education is as close to free for our society as anything we know of. I haven't run the numbers, but I suspect that the break even on this investment (in a steady state) is shorter than anything else we can think of.

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Two asides.

1. I don't agree with Romer on all of this, especially the idea that only science and engineering should be subsidized. Romer is focused on technological discovery as a driver of growth, but in my observation, ideas are discovered by people from all disciplines. Romer makes this point, although seemingly unintentionally, in his EconTalk podcast:

Research grants to universities are not the best way to develop all different types of ideas. Imagine that all music that we could listen to was produced by academic departments of music on college campuses. If you've ever listened to what music people write when they do research, it's pretty unlistenable stuff. The pure university research path isn't the way I want to get the music I listen to or the books I read. But, on the other hand, if you have the kind of things like open source, there is a kind of democratic element where people in open source have to cater to--or lots of things on the web that are free--they're catering to not just a narrow group of peers, but a wider audience. And that creates incentives for people to create things that are valuable for large numbers not just small elites.

If we want better music, give tuition subsidies to lots of music students rather than grants to a few music professors. This seems rather obvious in the arts, but it's almost certainly more true in other academic departments. The idea that "physics advances funeral by funeral" is a by-product of the current university system.

I also don't think that anyone, government included, know where we should focus our research to create ideas. Romer says "we never really know what we're going to discover..." and this is true not just within science, but within knowledge as a whole.

2. For my friends who conflate economics and finance: growth is not evil. The point of creating more income in a society is not to have more rich folk or to consume more stuff. Growth in income, although measured in dollars, is the ability to create more value, not more money or more things. We create additional value primarily by a better arrangement of materials, not the greater use of materials. So, a laptop today is more valuable than a mainframe computer of thirty years ago even though it uses less resources and costs quite a bit less. (There is a somewhat involved argument about why this creates a more even distribution of income, but that's pretty OT.) That growth often means more use of resources and more inequality is a bad outcome, but--IMHO--is not caused by growth itself but by the inefficient tuning of the institutions that encourage growth.

Growth is society becoming more productive. This additional productivity doesn't just mean that more people have gigantic flat-screen televisions (although certainly many people will use their excess production this way) but that we have better health outcomes, less incentive to fight over resources, more personal freedom and, hopefully, even the ability to increase the percentage of the pie that goes to people who currently have less.

New York Times Profitability Solved