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game theory

False Flag or Not

Reading Time: 8 minutes

The contemporary term false flag describes covert operations that are designed to deceive in such a way that activities appear as though they are being carried out by entities, groups, or nations other than those who actually planned and executed them. [Wikipedia]

Think of a time when you acted on false information. You knew it might be false, but you acted as if it was true. Why did you do that?

As absurd as it seems, people do this all the time. People behave as if something were true even though it might not be true.

Think about runaway stocks. Remember the Iomega Zip Drive stock surge of the 1990s?

A lot of people thought Iomega would become bigger than Apple or Microsoft. I know of a man who sold all of his investments in 1995 to buy Iomega and only Iomega. He said at the time, “this will be the most valuable company of all time.”

Was he right?

From a technology standpoint, no. I was a techie back then, and I knew that Iomega Zip Drives would have a short life expectancy. Maybe two or three years tops. Rewritable CD-ROMs and massive online storage would soon make the Zip Drive a clunky burden. The Zip Drive would die fast.

But in 1995, everybody knew Iomega was the king. In fact, the Zip Drive remains to this day the number one selling computer peripheral of all time.

Because the mid-90s were the peak of nerd-worship, anyone in the tech business learned what everyone thought about technology. At family gatherings, everybody wanted to talk to me about computers. People wanted to know more, and they saw me as an expert. They also wanted to share with me their knowledge. So I learned what people were thinking.

That’s how I learned that a senior vice president at a very large corporation, a man with an MBA from a school you’ve heard of, took his life savings and bought Iomega.

Well, Motley Fool also bought a lot of IOM in 1995. And the value of their Iomega stock rose 1,500% in the next 13 months.

I ask again, did my acquaintance make the right move on IOM?

To answer the question, you need more information. You also need an understanding of the game theory concept of “common knowledge.” For that, I’ll let genius Ben Hunt of Salient Partners explain:

Your feelings about a stock, as opposed to your feelings about a company, should be completely determined by your beliefs about other investors and their feelings about the stock. In the lingo … your preference functions for stocks qua stocks are entirely exogenously derived and epiphenomenal. There is no rational internally-developed preference for one stock versus another stock, any more than I prefer a $5 chip from Harrah’s to a $5 chip from Caesar’s Palace. The only thing I care about is whether other investors, for whatever reason, will value the Harrah’s chip at $6 tomorrow.

Common knowledge is something everyone knows and everyone knows everyone knows. It’s information on which you can expect other people to act a certain way.

For example, imagine that on a Thursday NOAA and the local weather fearmongers bombard St. Louis with news of the “winter storm of the millennium” scheduled to begin the following Tuesday. You can bet store shelves will be devoid of bread, milk, eggs, and rock salt by midday next Monday. It doesn’t matter whether the prediction is right. What matters is that most people will behave as if it’s right. If you need bread or milk, you better get it on Sunday.

Except . . . other people will also think ahead, so you better beat them by shopping on Saturday. But what if a lot of people also think about shopping on Saturday? So you decide to shop on Friday.

Until . . . you think of all the other people who might be reasoning backward like you are. So, you stop at Schnuck’s on your way home from work Thursday and find bread, milk, and salt already running low. You buy three gallons of milk, three loaves of bread, and 100 pounds of rock salt. The perishables will go bad before you finish them, but that doesn’t matter. You beat both the storms and the common knowledge game. And if worse comes to worst, you can always sell your excess milk and bread to desperate, short-sighted neighbors at a high price.

That’s common knowledge. Again, it doesn’t matter whether the forecast is right. What matters is what everyone else will do in response to the forecast.

Now, back to Dr. Hunt and the old newspaper beauty queen contests:

[The 1930s was] the heyday of the Miss America contest and “bathing beauty” pageants everywhere), less so to us. Here’s how it works.

A newspaper would run a page of photographs of pretty girls, and readers were invited to mail in a ballot with their choice of the prettiest. If you picked the girl who got the most votes, you were entered into a drawing for some sort of prize. Voting for the girl you think is the prettiest is what Keynes would call the first degree of decision-making.

Now it doesn’t take a lot of thought before you realize that choosing the girl who you truly believe is the prettiest is probably not a winning strategy. To win, you need to choose the girl who gets the most votes as the prettiest, and your personal preferences aren’t nearly as useful in that task as figuring out who everyone else is going to vote for as the prettiest. Voting for the girl you anticipate more people will consider to be the prettiest is what Keynes would call the second degree of decision-making.

But there’s a big problem with the second degree. It assumes that everyone else is making a first degree decision, that everyone else is making a choice “on the merits” of the photographs and you’re the only one smart enough to think about the average preference of the group. As a result, you quickly realize that everyone will be thinking exactly like you are, so you need to make a third-degree decision – who will get the most votes when all the voters are basing their votes on who they think will get the most votes? This is the Sentiment game!

Note that this third-level decision probably has nothing to do with the relative or objective prettiness of the girls. If “everyone knows” that the brunette with the biggest smile tends to win, then that’s where you should place your vote regardless of your personal preference or your knowledge of everyone else’s personal preferences. It’s the “everyone knows” component of the contest – regardless of what the contest is fundamentally supposed to be about – that determines voting behavior and contest winners. To get beyond the third degree of decision-making requires a superior identification of whatever it is that “everyone knows”. As Keynes wrote, “We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.”

Just like shopping for staples before the snow storm, winning these beauty pageant contests required knowing what everyone else knows and anticipating their behavior.

My friend with all the Iomega stock was smart to buy when he did. If he sold near the peak, he was brilliant. If not, he might have lost a lot. Either way, though, he bought Iomega for the wrong reason. He bought Iomega because he loved the company, not because he expected everyone else to buy the stock. He wasn’t playing the common knowledge game. He was playing the corporate strategy game. My guess is he held onto the stock all the way to bottom. Unless he learned about game theory before the crash.

When you’re in a game like stocks, shopping for stables, or geopolitics (and geopolitics is a formal game), common knowledge must determine your moves. And common knowledge means you must behave as if everyone else will behave as if the key information were true even if it’s not.

Which brings us to Michael Savage and the Syrian sarin gas attack.

Dr. Savage has determined that the sarin gas attack was a false flag. Dr. Savage is not alone.

Now, let’s pretend Dr. Savage is right. Let’s just pretend that the sarin gas attack was a false flag. In other words, let’s pretend the Russians were right and there was no gas attack. Instead, anti-Assad forces staged the whole thing.

Remember, this is just make-believe, so don’t assume I’m a false-flagger. And don’t believe I’m not, either. Instead, ask yourself this: should the US response be different if Savage is right?

Your immediate answer will probably be, “Yes, of course.” You will probably tell yourself that, if the sarin attack was a false flag perpetrated by the rebels, then we should punish the rebels instead of Assad. That’s the logical and moral answer.

But is that the game theory answer?

Well, how many people besides Michael Savage and a few others believe the sarin attack was a false flag? Of those people who believe in the false-flag theory, what is their role in the game of geopolitics? Are they heads of state or of government? Do they have armies? Are they in the mass media, broadcasting into billions of brains 24/7?

Dr. Hunt reminds us what’s most important in the common knowledge game:

But the more precise answer is that the role of the Missionary is served by any signal that is propagated widely enough and publicly enough so that everyone thinks that everyone has heard the signal. The important thing is NOT that lots of people actually hear the signal. The important thing is that lots of people believe that lots of people heard the signal. The power source of Common Knowledge is not the crowd seeing an announcement or a press conference. The power source of Common Knowledge is the crowd seeing the crowd seeing an announcement or a press conference. This is why sitcom laugh tracks exist. This is why American Idol is filmed in front of an audience. This is why the Chinese government still bans any media mention of the Tiananmen Square protests more than 20 years after they occurred. The power of a crowd seeing a crowd is one of the most awesome forces in human society. It topples governments. It launches Crusades. It builds cathedrals. And it darn sure moves markets.

Geopolitics is a different game than national or local politics. But it’s still a game like stock markets. Geopolitics influences local politics, and vice versa. But it’s not a direct influence. And it’s imbalanced. Geopolitics has an immediate and ubiquitous effect on local politics, while local politics has a very slow, very gradual, and muted effect on geopolitics. Until those local events reach a tipping point.

WWII was a geopolitical event that affected the local politics of just about every country in the world. But WWII resulted from local political developments over the previous 30 years. It took a long time for local events in Germany and Japan to hit the world stage. And those local events in two countries had little influence on local politics in the USA. Until December 7, 1941, of course. Then everything changed.

Just as we stipulated that Savage was right about the false flag, let’s stipulate that all of the players in the geopolitical game will behave as if Savage was wrong. They might all know he’s right, but they also know that all the other players will behave as if he’s wrong. Like the beauty contest players, picking the prettiest girl isn’t the game. Picking the girl who will get the most votes is the game.

In Syria, the crowd saw the crowd seeing Bashar al-Assad gas babies, little babies. And that’s all that matters.

The US response, then, must be appropriate to a game in which all the other players will behave as if Assad gassed his own people. Who actually did it, if it was done at all, matters morally but not strategically.

If this story leaves you feeling dissatisfied. I’ll give you a thought experiment. What would happen if Trump had acted as if the Savage was right? How might that game unfold?

You may have your say in the comments below.

P.S. Even if you’re not interested in stocks, markets, and investments, Ben Hunt’s Epsilon Theory is a must-read site for anyone who likes to learn and think.

 

How a Strategist Looks at the Supreme Court Nomination Battle

Reading Time: 5 minutes

In a moment, we’re going to look the Supreme Court nomination of Merrick Garland and find the best strategy for Senate Republicans. In a moment. First, let’s just relax and think about a party. And pretend you’re a paid strategist.

Hennessy’s View  Podcast:

Party Now or Party Later?

Tim and Mary Johnson want to have a party for their friends. They’ve been talking about it since spring, and now it’s nearly winter. Their condo is too small and the walls too thin for a big party inside, so they decide they must hold the party outside on their patio and common ground. Finally, they decide “it’s now or never.”

Mary and Tim start calling their friends on Tuesday. They invite 20 people to their house on Saturday afternoon for barbecue and drinks. Weather is supposed to be perfect: clear, sunny, 70 degrees, zero percent chance of rain. You couldn’t ask for better day. The problem is, only 15 people can make it this Saturday.

The Johnsons really want all of their friends to be there, so they ask about the following weekend. It turns out everyone can make it the following weekend, so Tim checks the weather on Wednesday. Even though it’s over a week out, the weather the following weekend is expected to be cold with highs in the 40s with occasional rain and drizzle throughout the weekend. Tim knows that forecasts a week out are only about 50 percent accurate.

Before reading on, please write what you think the Johnson’s should do. Should they hold a party this weekend for 15 of the 20 people they want and 99 percent chance of great weather, or should they plan their party for the following weekend when all 20 of their friends can make it but there’s a 50-50 chance they’ll have to cancel it altogether? Please, write your answer and how you arrived at it. I’ll wait. [You should write your answers in the comments below.]

Strategists reduce uncertainty to risk. Uncertainty cannot be quantified; risk can. Here’s how I conclude the Johnsons should hold their party this weekend instead of next week.

  • This weekend, they have a 100 percent chance of a party with 75 percent of their friends. Multiply those values, and you get a party quality of .75.
  • Next weekend they have (at best) a 50 percent change of a party with 100 percent of their friends and a 50 percent chance of no party at all. .5 * 1 = .50.
  • Therefore, with information available on Wednesday, the Johnsons choice is obvious. Seventy-five percent of a perfect party is better than fifty percent chance of a perfect party and fifty percent chance at no party at all.

Answer: Party Now!

Confirm or Don’t Confirm?

And that’s exactly the situation facing Senate Republicans in the confirmation question of Merrick Garland. First, ignore the emotional issues and wishing to “beat” Obama. Think about the issue strategically and find your best strategy.

Let’s say that, as a judge, Antonin Scalia was a 99 on a scale of 100. For comparison, let’s call Ruth Bader Ginsberg a 1 on the same scale. From everything I’ve read, Merrick Garland is about a 75 on that scale, probably like Anthony Kennedy. You might disagree with that, but there’s no way to prove anything. So I’m basing my 75 score for Garland on the descriptions and ratings from several Supreme Court watchers left and right. I’m pretty sure 75 is a good score for Garland.

So if the Republicans confirm Garland, they are fairly certain of adding a judge who’s 75 percent of their ideal.

Now, let’s see if they decide not to confirm.

  • If the Senate holds hearings and rejects Garland, Obama will not appoint someone more to the Republicans’ liking, so we need go no further down that path.
  • If a Republican wins the White House and the Republicans keep control of the Senate, the next president could appoint another 99 judge like Scalia. Let’s call that the best-case scenario.
  • If a Democrat wins the White House and the Republicans keep the Senate, the new president will likely appoint someone more like Ginsburg. Let’s call that a 25 score. And the Senate will eventually confirm someone.
  • If Democrats wins the White House and the Senate, expect the new president to appoint another 1 on the 100 scale.

So what are the odds of each of these scenarios?

I’m going to do some wishful thinking here and ignore the current prediction markets. Prediction markets are far more accurate at forecasting political outcomes than opinion surveys. That’s because asking people who they think will win is more effective than asking who they hope will win. I’m very optimistic and say there’s a 50-50 chance of either party winning the White House and a 60-40 chance the Republicans will control the next Senate. (Prediction markets are far less optimistic.)

(Here’s more on Exceptions vs. Opinion)

Now, we just do the math:

  • Merrick Garland: 75 * 1.0 = 75
  • R President, R Senate: 99 * .5 *.6 = 29.7
  • D President, R Senate: 25 * .5 *.4 = 5
  • D President, D Senate: 1 * .5 *.4 = .2

This formula is pretty simple. It’s just the expected conservatism of the judge (1 to 99) multiplied by the chance of each variable based on my very optimistic values. I use .5 for either party winning the White House and .6 that the GOP will keep the Senate.

You can make the case that you think Ted Cruz will win both the nomination and the general election and that the GOP will keep control of the Senate, but that’s not strategy. It’s daydreaming. If you’re 100 percent certain that Cruz will be the next president, how certain were you in October 2012 that Romney would win?

You can fudge my numbers and try it your way, but only blind wishful thinking will return a result where not confirming Garland becomes a winning strategy. Think the GOP has 75 percent chance at the White House? Okay: 99 * .75 * .6 = 44.55. Confirming Garland is still the strongest play. Give the GOP 75 percent chance at both President and Senate? That’s 55.89, still almost 20 points below confirming Garland now.

I urge you to do the math until you get the results you want. You’ll then make a great government budgeting expert, because wishful thinking is why we have a $19 trillion debt. But it won’t make you a strategist, and our side needs strategy now.

(For more on how the Republican vanguard discourages new blood, read this.)

Strategy, Not Emotions

At this point, the only argument for not confirming Garland is purely emotional: you don’t want Obama to “win.” Fitness to lead requires, at some point, getting over emotional wins and losses and going for real wins using logic and reason.

“But, Bill,” you might say, “if the Senate confirms Garland, then Cruz wins, we’ll have wasted the appointment.” It might seem that way, but think about this: how long will Ruth Bader Ginsburg stay on the bench? And she’s a 1, remember. So let’s say the GOP confirms Garland now. That’s a net lost of 24 points from Scalia. Then Ginsburg leaves the bench and Cruz appoints another 99 to replace her. That’s now a net gain of 75 for our side. Thinking about the next move is critical to strategy, and you’re becoming a more strategic person with every word you read.

Plus, confirming Garland would send a signal to the non-ideological voters that Republicans can get something done. That’s a good signal to send to the 80 percent of voters who are more ambivalent ideologically. That would increase the chances that the Republicans keep the Senate in November.

Finally, I’ll say this. If Garland had been confirmed two weeks ago, he might have ruled with the conservatives on the public union ruling last week. That victory alone would have been huge. But now it’s lost for a generation.

Therefore, I reluctantly say the Senate should confirm Garland to the Supreme Court before Obama withdraws the appointment. It’s nothing personal; it’s just math.


If this post makes you think I’ve lost my mind, wait till you read my new book.

Correction

Reading Time: 2 minutes

Something weird happened in the stock market today.

Yesterday I blogged about the stock markets. I’d been up early to see what was going on in Europe and Asia. I was watching US futures, too.

I decided to write about what might happen. And I told you about Ben Hunt, my favorite economics writer. Ben combines remarkable knowledge of game theory and psychology with his genius in finance and economics.

I also declared the end of the Golden Era of Central Banker:

There’s good news in all this loss. First, stocks were overpriced. At some point, they will bottom out and it will be time to start buying. Second, the Golden Age of the Central Banker seems to be over. And that is very good news.

And I attributed the phrase “Golden Age of the Central Banker to Ben.

Well, today I was tickled to find a new note from Ben in my inbox. But Ben says my call on the Central Bankers is too early:

I see very little weakness in either the US growth story (best house in a bad neighborhood, mediocre growth but zero chance of recession) or the Narrative of Central Bank Omnipotence. Do I think that the Fed is being stymied in its desire to raise short rates in order to reload its monetary policy gun with conventional ammo? Yes, absolutely. Do I see a significant diminution in the overwhelming investor belief that the Fed and the ECB control market outcomes? No, I don’t. Trust me, I’m keeping my eyes peeled (see “When Does the Story Break?”), because in many respects this is the only question that matters. If this story breaks, then in the immortal words of Chief Brody when he first saw the shark, “You’re gonna need a bigger boat.”

(BTW, do yourself a favor and read When Does the Story Break? One of the best lessons in narrative and common knowledge ever.)

If Ben says the narrative of central bank omnipotence is unbroken, I believe him. And I read his warning of how ugly things will get when that story breaks, I shudder.

But based on the time Ben’s email hit my inbox, I’d say he wrote it–or edited it–this morning while the DJIA was up over 300 points. By the time I read it, the DJIA had closed down 205. It was biggest intraday rollercoaster since Lehman.

And then I read this on Business Insider:

By my reckoning, most investors already have little faith in the political leadership of many developed economies. But there has been a deep faith in the ability of monetary policy to both lift asset prices and, ultimately, generate an adequate inflation rate over the medium term. If investors start to doubt that – and the decline in break-even inflation rates suggests concern (Exhibit 8) – then things could get significantly worse.

And, from the same BI article:

The bull market is not over even if the unusual characteristic that was the powerful driver for price-to-earnings expansion is probably over, namely the power of zero rates and central bank/government ability to distort or manipulate the markets.

Look, Ben Hunt’s forgotten more about game theory and narratives and markets than I’ll ever know, so I’ll accept that the fat lady hasn’t sung the end of the Golden Era of the Central Banker.

But I hear somebody humming.

Don’t Expect Boehner To Play The Black Knight

Reading Time: 2 minutes

The GOP didn’t really have a plan in place in case it lost. It certainly didn’t have a plan for getting snotclobbered. And if you try to spin Tuesday’s results as anything less than a good old-fashioned ass-kicking, you’re deluding yourself.

Black-Knight

Republicans Got Creamed

I know Michelle Malkin found 20 things that went right on election night, but there about 60 million things that went wrong. Let’s take a look:

  • Obama was re-elected handily in a terrible economy with American prestige at its lowest level since Carter’s administration
  • Republicans lost ground in the Senate despite a huge number of open seats and unpopular Democrats (McCaskill)
  • Stupid comments by Senate candidates set back the pro-life movement 20 years
  • In Missouri, Republicans lost every statewide race except Lieutenant Governor
  • Liberal ballot initiatives dominated
  • Conservative turnout was low except for Evangelicals
  • Conservative mega-donors broke the bank on this election and came up less than empty

Boehner Told House Republicans There Will Be No Fiscal Cliff Fight

Considering all this, it comes as no surprise that John Boehner told House Republicans that there will be no death match over the Fiscal Cliff.

Their party lost, badly, Mr. Boehner said, and while Republicans would still control the House and would continue to staunchly oppose tax rate increases as Congress grapples with the impending fiscal battle, they had to avoid the nasty showdowns that marked so much of the last two years. (source: NYTimes)

That’s a bitter pill for Tea Partiers and conservatives, but it’s probably unavoidable.

Mitt Romney and many other Republican candidates for federal offices campaigned without any big ideas for people to champion. They made the election about policy differences, and the status quo won.

You can say that bitter fights over debt and budgets are part of that status quo. You’d be missing the point, which is this:

The only card in Boehner’s hand is shutting down the government. Voters—even some who voted for Romney—would see that as a repudiation of the election and the people, not of Obama. Boehner would look like the Black Knight in Monty Python And The Holy Grail.

There’s a chance, of course, that Obama would cave and hand the Republicans a victory. But there’ a good chance the subsequent unemployment, the stock plunge, the recession, and the starvation horror stories would land squarely on Republican shoulders. (Do you think media would see an Obama capitulation as anything but statesmanlike sacrifice to help the most vulnerable?)

Republicans simply won’t take the chance that 2014 will be a referendum on government shutdowns by a party that just got its ass handed to it on Nate Silver platter.

Game Theory and History Help Explain

Here’s a SlideShare I’ve put together to explain the Republican position. I looked back at Reagan’s 1981 budget battle with Congressional Democrats.

Pay attention to how that battle turned out. (Best viewed full screen)

Bottom Line: The Republicans cannot choose a strategy first. They must force Democrats to make the first move.

Game Theory and the Ryan Pick

Reading Time: 2 minutes

 

If Mitt Romney applied game theory in choosing Paul Ryan, I have renewed respect for him. I’ll explain why, but first a bit of background on game theory.

Game theory is a branch of social science concerned with strategic decision-making. It is most closely associated with economics. Professor John Nash, the subject of the movie A Beautiful Mind, won a Nobel Prize in Economics for his work in game theory. (For a great primer on the subject, read Thinking Strategically: the competitive advantage in business, politics, and everyday life.)

According to professors and authors Avinash K. Dixit and Barry J. Nalebuff:

a game is a situation of strategic interdependence: the outcome of your choices (strategies) depends upon the choices of another person or persons acting purposively.

Borrowing from an example in from Dixit and Nalebuff, two-person political races are somewhat sequential. Each candidate has a choice of which road to take. If Obama takes the high road and campaigns on a ideas, Romney has a choice: he can take the high road, too, or he can take the low road and sling mud.

Each team must think ahead and reason backwards. He must discern his rival’s response, his counter to that response, etc.

If Romney moved first, his decision tree might look like this:

In this case, Romney concludes that taking the low road won’t work. Everyone already knows that Obama is a failed president, a radical who believes America needs to be “taken down a notch.” He also knows that negative campaigning lowers public approval of both parties. Therefore, Romney might figure that taking the high road is his only hope.

In this case, though, Romney didn’t move first. Obama did. Obama, too, realizes that he’s a failed president with a goal for America that dare not speak its name. So Obama actually moved first. Obama has been slinging mud since last fall. His minions pile on more mud–some half-truths, some complete lies–every day. He shows no sign of changing course.

This made Romney’s decision easier. By asking Ryan to be his running mate, Romney can campaign on ideas, on America’s future, on a transparent and important vision for our future. After years of hearing voters complain that they wish politicians would be more serious about the nation’s problems and cut back on the vitriol, Romney has finally done it. He’s left the low road to Obama and seized the high road.

This give Obama a choice: he can remain on the low road, and risk alienating voters who want a national debate about the legitimate role of government in our lives, or he can take the high road and risk alienating voters who would cringe at his twisted and starkly un-American vision of our future.

I don’t know that Romney reasoned this way, but if he did, it bold, brilliant, and brave.