In praise of human, over machine intelligence

The late Milton Friedman was famous for his quip that monetary policy should be run by a computer. It was likely with Friedman's views in mind that Republican legislators challenged Janet Yellen to conduct monetary policy using a preset formula, which she resisted (according to this WSJ report):

Ms. Yellen, responding to some of the toughest questioning she has faced on Capitol Hill since becoming the Fed's leader in February, said provisions in a recently introduced House bill would lead to greater political meddling in the Fed's affairs, curtailing its independence and constraining the ability of policy makers to manage crises.

"It would be a grave mistake for the Fed to commit to conduct monetary policy according to a mathematical rule," Ms. Yellen told the House Financial Services Committee on Wednesday, amplifying her message in testimony to the Senate Banking Committee a day earlier.

The House bill would require the Fed to adopt a mathematical formula for determining the appropriate level for its benchmark short-term interest rate, which influences other borrowing costs across the economy. The bill's proponents cite as an example the so-called Taylor rule, devised by Stanford University economics professor John Taylor, which calculates the ideal level of the rate based on changes in several economic variables.

What's better? A rules based approach or a discretionary one? The debate rages on:

Economists have been debating for years the relative merits of basing interest rate policy on rules versus discretion—that is, whether they should adhere to a mathematical formula or maintain some flexibility to respond based on circumstances and judgment. Mr. Taylor and some Fed officials are in the first camp, saying rules-based policy-making creates more predictability and transparency, leading to better economic outcomes. Ms. Yellen and other Fed officials are in the latter camp. She said Wednesday that the recent recession would have been deeper if the Fed had stuck closely to the Taylor rule.

The trouble with robots
I have long been an advocate of an intelligent application of rules. That's why I describe myself as a "left and right brained modeler of quantitative systems" in my LinkedIn profile. I don't agree with Yellen on a number of issues (more in a future post), but human intelligence is far more flexible than rules-based machine intelligence and you need human oversight over machine intelligence.

While rules-based quantitative systems can be great, they have their limitations. They do exactly what you tell them to do, but at the same time they can be very stupid.

Consider this Kenny Polcari CNBC commentary of what happened on Thursday when news of the downing of MH17, followed by the Israeli invasion of Gaza. The first selling wave came in the wake of the MH17 tragedy and the selling appeared to have caused by trading algos:

The first "sell" reaction was actually created by algorithms. The speed at which the market took the hit indicates that the order flow was generated and then delivered — or really sprayed out — across the 70+ venues that exist in current market structure by high-speed algorithms designed to react to words in a headline.

Recall the "hacked Associated Press" Tweet last summer —"Breaking: Two Explosions in the White House and Barack Obama is injured" — this caused a swift 200-point selloff that quickly reversed itself when the AP announced that they were hacked and it was a false headline. The speed at which the market sold off and then re-balanced is only possible with the help of high-speed automated order generation and delivery.

So yesterday's headlines to the effect of "Malaysian Airliner Shot Out of the Sky" or "Russian Forces Down Malaysian Air Passenger Flight 17" clearly weren't positive and triggered the high-speed algorithms to have a field day.

News of the Israeli incursion caused the next wave of selling:

Then came the news that Israel had begun the invasion of Gaza as a result of Hamas not respecting the temporary ceasefire. Once again, the computers kicked in, causing the market to immediately plunge 50 more points in their "take no prisoner" style, taking the Dow down 125 points as traders and investors assessed the new news.

We built the technology to quickly profit on news and it`s causing unexpected adverse effects:
Technology today allows for a computer with artificial intelligence to make a determination as to the meaning of the headline and then shoot first, ask second. This is the state of affairs for the U.S. capital markets thanks to the Internet, the social media, and the need to know.

As a result, we see the markets get whipped around on just the headline alone, and then once the human being gets to read and digest the news, the move is either confirmed or not. So, did traders believe in the end that this was an act of terrorism or an act of stupidity? The jury says: stupidity.

The next day, the market recovered all of the losses from the previous day. As for the previous day's volatility? Oh, well. Life goes on.


How bad paperwork becomes a sex crime
Rules-based systems, however intelligently designed, can go horribly wrong. Consider this account of how someone became a sex offender at the age of 12 because he played ”doctor” with his 8 year old sister:

Josh became a sex offender at age 12. That's when he touched his sister's vagina, twice. His sister told their mom, Josh said it was true (he was too embarrassed at the time to mention that he himself had been raped as a young boy by three local high school kids), and their mom called a counseling service for advice. The counsellor said Josh's mother was required to report his crime to the authorities and the next day, he was arrested.

He spent the next four years in juvenile prison: the Texas Youth Commission, as it is officially called.

The charge was “aggravated sexual assault,” because any sex offense against a person under age 14 is automatically “aggravated.” He got out at age 16 and was put on the sex offender registry, which, in Dallas, requires him to report in person to the authorities once a year, as well as anytime anything in his life changes.

Here is the story of he became a re-offender at the age of 27:

Today he is 27, married with children, and smiley. We met up, had a jolly breakfast (except for the fact he said he felt too pudgy to start a speaking tour), and then we went off to the registry, because his family had just moved to a new house and he had to let the state know no more than seven days after the move.

Just as the detective in the nondescript office finished typing this information into the system and Josh and I were about to go to lunch, a man with a beard and a badge strode up and said, “Joshua Gravens?”

“Yes.”

“You are under arrest for not alerting the authorities to your new address.” He whipped out handcuffs. “Put your hands behind your back.”

As the man tightened the cuffs, Josh calmly explained he was registering his new address that very minute.

“The law says you you have to register the fact you are going to move seven days before the move, too.”

“I think you're mistaken,” said Josh, as pleasantly as if discussing the weather.

“I was told to arrest you,” was the reply, and that was that. Josh handed me his car keys and followed the man out to his van along with a handcuffed woman who was crying. She was going to jail for having listed her address as a hotel when she actually lives in her car in front of the hotel.

(This statute suggests that the officer was correct: Registrants must report their intention to change addresses seven days before actually moving, according to the statute.)

Under such circumstances, Josh would be charged with a sex crime and the penalties can be severe:

“I might be mistaken,” said Jon Cordeiro, a sex offender registrant and director of a Fort Worth re-entry program for offenders, “but technically he has broken the law and failure to comply with the registry laws is considered a new sexual offense.”

A sexual offense?

Yes. Any registering snafu is considered a sex crime, and depending on the judge, it can be punished as harshly as the original offense. In other words: Josh, at 27, will be treated as if he just touched an 8 year old's vagina again.

“Typically, there's a mandatory minimum of two to five years,” said Cordeiro.

“In Arkansas, he'd be looking at six,” said another attendee.

I recognize that there are elements who want greater control over the Fed, but after hearing these snafus about how rules-based systems work, do we really want a robot to manage monetary policy?