Evan Davis, the telegenic and usually excellent BBC Economicscorespondent, had a heart-stoppingly bad argument this morning on theToday show. Darling is hauling in the gas and power companiesto hear justifications of the 60% price increases we've seen this year.Evan Davis went through A-level oligopoly theory, explaining that"prices are sticky ... energy firms won't reduce prices because theyknow that others will follow them if they do, so doing no good buthurting profits ... and that our energy suppliers know that we don'teasily switch anyway." So much, so (half) true.

There's a new buzz about the way Internet watchers are trying to understand what's happening on the web - a sort of generalised hunt for the next web 2.0. Tim O'Reilly---the one who Trade Marked web 2.0 --- has been posting about the links between financial markets and web services like Google, Wikipedia, etc. He is particularly intrigued by the parallel between market makers trading on their own accounts (possibly in conflict with their clients), and Google entering content provision, in services like YouTube and Blogger (and now Knol, in a head-on with Wikipedia). CoryDoctorow and Jim Wales are writing about the possibility of open source, transparent search --- the moment and the reason for the community to take the power back from Google. Indeed, "Jimbo" has announced the launch of Wikia with the hope that "Transparency" and social aggregation will yield better results than Google.

All this is exciting stuff --- we are getting to the point at which we have digested how social information can be aggregated by networked computers, and we are wondering what comes next.

What I haven't seen fully laid out is the analogy between Web 2.0 services and economic mechanisms. Having this analogy clear is useful because it allows us to ask how all the results known about economic mechanisms translate to Web mechanisms. By and large, I think it also shows that Web 2.0 represents the naif phase of web service development--- akin to economists' modeling of perfect competition. The reality is clearly some way from that, but the lessons from mechanism design are not all encouraging: from the point of view of quality of results, the best from the wisdom of the crowds is behind us.

Google:Attention Auction

Let's start with the PageRank algorithm. This mechanism "auctions" attention (the screen position in a search result) and is paid for in links. At a wine auction, lots are ordered from most to least valuable. Value is measured by bidders' willingness to pay. In a "Google search auction"web sites are ordered from most relevant to least, where relevance is measured by the number of quality-weighted links pointing to a page. If I want to get "openDemocracy.net" to number 1 slot on a "Democracy"search, I need to make sure that no one has better quality-weighted links relating Democracy to the domain "openDemocracy.net".Google is auctioning slots in the results pages. On the left hand side are slots auctioned for links; in the right hand side, they are auctioned for money.

So? What of this parallel?

First, to Cory's point about search not being neutral: the design of the algorithm selects what information is returned, and what meaning is given to "relevance". This is generally the case with all auction-like mechanisms. In the wine auction, you will end up allocating wine to different bidders depending on whether you use an ascending or descending auction; and open out-cry auction or a sealed-bid auction. There is a sort of "gold standard" --- Cory's notion of the "neutral search" --- which in the auction literature is called the "efficient"outcome: the one that allocates each good to the bidder that truly values it most. ("Relevance" is a bit trickier than efficiency because of the philosophical issues it raises, so I am not sure Cory's ideal of neutrality exists for long). The auction literature suggests that achieving efficiency is very hard and often requires unbelievably contorted mechanisms.

The auction design literature tells us that whatever mechanism you adopt, bidders will modify their behaviour to do best for themselves. So, in a "first price" auction (one in which you pay what you announce as being prepared to pay --- as opposed to the E-Bay style second price auction), you think hard about what the next person below you is prepared to pay and bid close to that rather than bidding your own maximum willingness to pay. The electricity markets that I worked on inthe 1990's were, would you believe it, mostly designed as first price auctions! This started years of very profitable manipulation by all power companies. Enron was particularly adept.

PageRank manipulation has also turned into an industry. In its simplest form, you buy awell-regarded web property and you then sell links from that property to other sites that are trying to rise in the ranks.

The mechanism literature is very keen on discovering implementable mechanisms that are non-manipulable, in the sense that it is in everyone's selfish interest to reveal the true information about their valuation. In the PageRank analogy, this would be an algorithm that would lead you to create your content without regard for its impact on its Google position, but only with regard to your readers' best interests. So, for example, the simple Search Engine Optimisation advice that all links should be made with descriptive, meaningful terms, might lead one to make this sort of link in an article: "openDemcoracy's "Democracy in Kenya" coverage suggests that ..." instead of "Peter Kimani suggests that ..." If I do the first rather than the second because that is what the SEO handbooks say will improve PageRank's recognition of openDemocracy's links to "Democracy" and"Kenya" ,I am gaming PageRank just as I am gaming the wine auction by second-guessing how cheaply I can let it go before losing it.

The essence of the efficient mechanism design results is that it is important to divorce what someone pays from the outcome of the mechanism. So, the beauty of the E-Bay style "second price" auction is that what I pay is determined by the bid of the next lowest person, not by my bid. It is quite easy to see that it doesn't (usually) make sense for me to game the E-Bay system. (For the interested, the generalisation of the E-Bay auction to many goods --- which a Google page of results is, since it has many slots, is tricky. See Ausubel).

What does this mean for search? I've thought for a while that the equivalent would be for Google to give you not your own PageRank as as core, but the PageRank of your next closest "competitor", or web site. You could then SEO all you like, it won't affect your PageRank, except in so far as it affects your closest competitors'. The trick in this scheme will be implementing who your "nearest neighbour" is for any web page.

PageRank is a market mechanism. Implementing it---like all mechanisms---requires endless fixing around corner cases. An intriguing example is Google's trouble with Jewishness. This kind of "corner case fixing"  might make one think that longevity in the market allows you to perfect the algorithm like no one else does, and so protects you from entry.

But if I were a Google shareholder, I would be worried by the analogy between Google search and a market mechanism. As every web content producer adjusts to Google, its results become necessarily less and less compelling. The joy of Google past was to think hard about the search query and get a first screen result full of relevant but quirky, even obscure material. A Google result today is much less sensitive to the searcher, because every content maker is trying to "buy" space that it can't pay for in "genuine" links. SEO-- even the unconscious SEO that is now so widely practised --  will ossify Google and a better solution will wipe it out with the speed of an epidemic. The web has become over-fitted to Google like a strain of wheat becomes over-designed to a specific ecology. The web is covered in content strategies over-designed to Google, and a new mechanism will find a source of meaningful, un-manipulated information---just as thehyper-link was before PageRank made it a gameable commodity.

Google will disappear much faster than Wikipedia, because Google provides a flow of services, while the Wikipedia mechanism has been accumulating an asset in its millions of pages. But Wikipedia is not out the woods yet. There is an auction analogy there too, from which I forecast that Wikipedia will be gradually locked down, the process for editing more and more institutionalised. Moreof that in a future post.

predictive-jan08.html

The oD Sophocrats

openDemocracy launched a set of predictivemarktes in January 2007. The idea was that byallowing oD readers to buy and sell forecasts, the oD crowd wouldreveal its special wisdom.

350 readers signed up to the markets over the year. They were give$1000 to buy forecasts. For example, at the start of the year, youcould buy "Sarkozy becomes French President" for $40. When he becamepresident, you could cash that out for $100. In between time, if theprice on Sarkozy seemed to you out-of-kilter, you could trade andspeculate on the price movements. The top ten traders have shown a realskill and dedication. Tan Copsey, my colleague from China Dialogue,had an eye-popping run of profitable predicting, turning those $1,000into $135,442 - I am sure that he can rest assured of an alternativecareer as a carbon trader.

I've been looking forward to Becker's blog posting on sub-prime for a while. I think the current financial crisis will be to economic liberalism what Iraq was to political liberalism: a failure so vast, so shameful, that many will be led to re-assess their world view.

So what does Chicago-school Becker make of it?

He starts with a great piece of fighting rhetoric: The "belief in the beneficial effects of greater knowledge aboutmortgage terms is inconsistent with the evidence that the mostsophisticated banks and investment companies, including Merrill Lynch,Citibank, and Morgan Stanley, have written down their housinginvestments by billions of dollars. No one can reasonably claim that these banks lacked the skills andknowledge to evaluate all the terms of, or the likelihood of repayment,on the subprime and other mortgages that they originated or held asassets."

How should we interpret the massive investments from sovereign wealth funds being taken by UBS, Citi and Morgan Stanley to shore up their capital reserves? Just when the central banks are making huge amounts of liquidity available cheaply, why are these banks going elsewhere for capital? This seems strange: the public is trying to force cheap money into your pockets, and you go elsewhere to shore-up your balance sheet. Are the Chinese and Gulf States offering even cheaper money?

Not likely. Banking shares have fallen sharply, indicating that equity finance is very expensive at the moment. In fact, you can expect that the new part-owners have negotiated very good terms. The banks are taking money when they need it - always a sign that they'll get it over a barrel.

Will Hutton was interviewed on Today - the jolly slot at 0857 - about whether the 30,000 UK resident super-rich are good for the country. He talked about incentives, Scandinavia, giving back, Quaker business, Robert Owen ... but I think he missed a real trick - the one Martin Wolf points out in a recent column: the banking super-rich are there thanks to taxpayer subsidy.

In a profoundly radical column in the FT, Martin Wolf asks why the City is so rich and why banks have such a high return on their invested capital - most of the time. For the past 10 years, UK banks have returned an average of 20% on equity, year in, year out. This is huge. The usual defense is that bankers take big risks: hard cash is put up for the mere promise of more later. This is the essence of capitlalistic risk-taking. Of course it earns! - you have to compensate everyone for the roller-coaster ride.

Brad Setser at RGE Monitor has a very worrying picture:

It shows that long term lending to the US has dried up since August.

The consequences seem to me to be quite stark. Either

• the US starts to save much more, or
• the US offers much higher interest rates to foreign lenders

The first case means US, then world recession; the second case means financial market panic and recession. Anyone see any cheer in this?

 

The banks

The big banks have lost a lot of money in the credit crunch. The utterly engrossing live transcript of FT Alphaville's Chat on November 1st, when the big banking losses started to scare the stock-markets, shows all the gallows humour of a truly bleak picture for UBS, Merrill Lynch, Citi, etc.

We're not quite sure how bad it is, because the assets the banks hold don't currently have a price: no one will trade them. Gillian Tett, in the FT, has an alarming article: she points out that the banks' auditors, remembering Enron, are now getting nervous about how the banks are reporting losses. Assets that were considered valuable safe bets one day are turned into highly risky, devalued paper the next.

Nasim Taleb has a great piece in the FT arguing that the economics Nobel's are not just clever but dishonest marketing, but are actually damaging to the financial system. Taleb claims:

The environment in financial economics is reminiscent of medieval medicine, which refused to incorporate the observations and experiences of the plebeian barbers and surgeons. Medicine used to kill more patients than it saved – just as financial economics endangers the system by creating, not reducing, risk.

The beautifully named SIV Master Liquidity Enhancement Conduit (SMLEC), the fund the big investment banks are putting together to rescue each other, is a stitch-up. Roubini has a dense but compelling post about it that argues:

it is not about resolving a "coordination / liquidity" crisis because so many of the assets that are held by the "Special Investment Vehicles" (SIV) are in fact dud, rather than illiquid. So the SMLEC super-fund, if it attracts new lenders, will have to cherry pick the good assets out of the SIVs. But if it cherrypicks, then the SIV problem, and facing up to the losses, only gets worse - they are left with all the bad assets. (Remember, and this is important for later, the SIVs are the not-quite-arm's-length companies set up by the banks to hold these risky, mis-priced assets. Some of them are fully fledged hedge-funds, some of them are pure legal fictions ... there is a continuum of specialness in the SIV world).

HSBC, my bank, has been acting strangely lately. I called them for some simple shuffling of funds from one place to another, and they immediately started suggesting that I move some of my funds into term deposits - that would guarantee I wouldn't be asking for my cash soon. Then, I got a letter in the post saying: "you haven't used your credit card in a long time, and it is costing you £25 a year ... are you sure you don't want to cancel it?"

This worries me. Why does HSBC, usually so keen to lend to me, need to try to make sure that 1. it can count on being able to borrow my meagre balance (that is what the term deposit is, in effect - me lending to them), and 2. that I do not even have the capacity to borrow the £3,000 they extend to me on my un-used credit card?

RGEMonitor, long my favourite reading on macro-economics (at least the non-subscription pieces of it ...), has launched an open Euro-economics publication at http://www.rgemonitor.com/euro-monitor.

Just 2 posts up there for now, but it looks good, and I look forward to it.

The piece by Dennis Snower on what can still go wrong with the world economy, despite the weird calm that has descended after the half point cut, is admirably clear. As is his cool assessment of the longer term adjustment: the US spends less, saves more; China does the opposite ... and order is restored. How hard it is to be an economist and to resist Panglossianism. Keynes famously had to resort to the threat of death - where we all end up, eventually - to resist the "eventuallies" of long run equibilibrium forces.

So Bernanke decided tohug the hedgies after all ...By cutting the federal funds rate by a 1/2 percent, Bernanke has rewarded the banking system for its latest panic. Think of it like this: money is banking's most important raw material, and the Fed, the sort of OPEC of the world money supply, has just reduced the price of that raw material by over 10%.

Think of this behaviour in any other industry. As an oil firm, for example, I drill oil wells in distant expensive locations hoping it will be profitable. It tuns out not to be. So OPEC decides to cut me some cheap oil to compensate me. What sort of incentive does that give me?