Behavioral economics - Daniel Kahneman

In my two years at Cornell the Professors that stood out were Harold Bierman who taught finance and Richard Thaler who taught economics.  From the latter the course of note was on behavioral economics of which he was a leading light.  The field drew heavily on the research of Daniel Kahneman and Amos Tversky. 

Behavioral economics essentially contends with the assumption of economics that people are rational actors, and through experiments finds how people consistently contradict what they would do if they were truly rational. 

Examples that I readily recall is that the people’s cost/benefit functions aren’t linear but rather curve so it is steeper to start and then tails off.  In time for the Christmas holidays this suggests an optimal strategy of wrap your gifts separately and pay in one bill (or in the lingo segregate your gains, consolidate your losses).

The other was the market anomaly—at least at the time—that markets tended to go down first thing on Monday, and go up towards the conclusion of trading on Friday.  This was a blow to efficient markets theories that always amused me (when are you in a better mood, at the start of the work week or its conclusion?).

What prompts the above is an article in Vanity Fair by Michael Lewis on Daniel Kahneman http://www.vanityfair.com/business/features/2011/12/michael-lewis-201112

As I’ve remarked on occasion MBAs are far from knowing everything, but that shouldn’t lead you to believe that they don’t know anything.  Behavioral economics was one of things I took away from Cornell’s Business School and have carried with me since the late 80’s.

Social Security as Ponzi scheme

I find it curious that there has been such a harsh reaction to Gov. Perry’s description of Social Security as a Ponzi scheme.  Of course it is.  And yet today an online Washington Post poll had about two thirds of respondents objecting, and a Gallup poll shows independents less favorably inclined towards Perry by a margin of 32% to 12% because he described it as such.

I don’t know where the controversy lies.  Are there still people out there that think their Social Security contribution is being invested in treasuries waiting for the day they retire and then being returned?  If so, then Perry’s comments are long overdue.

There is another way of thinking which is even clearer and that is to ignore the distinction between distinct taxes and benefit programs altogether.  In truth, we have different schemes for paying taxes—on property, on income, on usage—and we have different benefit programs which pay out based on various qualifications.  Total money in versus total money out equals the deficit.  The distinction of income, unemployment, medicare, social security taxes, etc. have more to do with political marketing—establishing buy in-- than economic reality. 

At any rate, Charles Krauthammer’s column on the Social Security/Ponzi description is worth a read  http://www.nationalreview.com/articles/277376/great-social-security-debate-charles-krauthammer

The Economy - the question of what to do

This morning I went to the Star & Tribune to find out how the Gopher football team did against USC.  Reading sports columnist Joe Souhan I naturally got political opinion: “Congress might want to take a few notes about quickly making good decisions.”  Behold the idiotic notion that it is only politics that keeps good things from happening right away.

The nub of course is “good decisions.”  What eludes Souhan is that what constitutes a good decision my not be obvious or shared by everyone; case in point, stimulus spending to drag an economy out of a recession.  If you are roughly my age, you’ve been fully drilled in this view, but as noted elsewhere on this blog, Keynesianism is premised on too much saving while our current predicament is too much debt. 

Then there is the question of whether Keynes’ solution really was the miracle cure of the last depression.  Arthur Herman’s piece in The Weekly Standard makes you wonder.  Herman takes a look at World War II—“the ultimate stimulus”—and points out how the economic data doesn’t quite support the deficit spending myth.  Economist Robert Barro states that “the data show that output expanded during World War Two by less than the increase in military purchases.”  If you read the piece you’re struck not by how government spending lifted the economy out of depression but rather how the story follows Bastiat’s broken windows fallacy, that you can grow an economy by breaking things because people will be employing in fixing them.

What is particularly illuminating is the post war boom and the reduction in government spending that went with it.  By Keynesian logic this should have led to contraction not expansion.

“This postwar boom has always posed a problem for Keynesians like Krugman. As government spending plummeted with the coming of peace— military spending alone collapsed from 37.5 percent of GDP in 1945 to just 5.5 percent in 1947—many predicted that, without this prop and with the new burden of millions of returning veterans looking for work, the economy would sink once more into the abyss. Paul Samuelson, later the dean of American Keynesian economists, wrote that unless the government did something drastic, “there would be ushered in the greatest period of unemployment and industrial dislocation which any economy has ever faced.”

Instead, after a brief hiccup in 1946, the economy rebounded, growing from $231 billion GDP in 1947—roughly what it was in 1945—to $258 billion in 1948, and from there to $285 billion in 1950. Unemployment, despite the dire predictions, increased only to 3.9 percent between 1945 and 1947, in spite of the fact that some 10 million new workers came into the civilian labor market”

Herman argues that what caused the boom was business investment, the very same thing that went in decline as America prepared for and went into war.  “Instead, the biggest trigger to growth turns out to have been a sharp rise in private capital investment, which the New Deal had slowed—one reason the Great Depression lingered as long as it did, Higgs argues—and the war had all but halted. That investment jumped from $10.6 billion in 1945 to $46 billion in 1948, as plants expanded and retooled for the production of civilian goods. Even though the overall personal savings rate fell, the private investment rate soared from 5 percent to almost 18 percent, with the biggest leap coming in 1946—a leap that would be reflected in GNP numbers only two years later. Meanwhile, business savings almost doubled in the same period, from $15.1 billion to $28 billion—providing a sure way to finance expansion and hiring.”

http://www.weeklystandard.com/articles/ultimate-stimulus_592145.html?page=3

Jeff Miron on capitalism and income distribution

“The 2^nd myth is that capitalism generates an unfair distribution of income. What true capitalism does is rewards people who are productive, people who work a lot of hours, people who have a lot of talent, people who come up with good ideas, they get big rewards.  People who don’t do those things get less.” http://gregmankiw.blogspot.com/2011/08/jeff-miron-on-capitalism.html

So says Harvard economics professor Jeff Miron in his three myths of capitalism.  Without a great deal of elaboration and qualification this statement is unlikely to convince anyone not already convinced.  Left alone it probably hurts the case of capitalism just like any other weak argument.

First, if you look at businesses it isn’t clear that profitability is aligned with the values of a society, to the extent we can ascribe values to a society.  For instance gaming and pornography are or have been lucrative businesses.  The social stigma attached to both probably helps their profitability in that it keeps out competition. 

In investment services it isn’t clear that the benefit of making the markets more efficient by closing small price discrepancies is worth the enormous profits and divergence of skilled manpower that has gone into this field.  Moreover, the people who could most critically benefit from having a skilled financial advisor can’t afford it, whereas those who already have a great deal of money have access to the best advice thereby accentuating differences in wealth.

For individuals the statement is even more dubious.  Consider sports where statistics provide at least something approaching objective measures of performance. Prof. Miron will have a tough time convincing White Sox fans that capitalism is in tune with performance when Adam Dunn in the first year of a four year contract that will pay him $56 million is on pace to have the lowest batting average of anyone who ever had enough at bats to qualify for the batting title (he’s hitting .163 with 157 strikeouts out of 368 at bats). 

In truth, as only who works outside of academia will notice, there is considerable luck involved in how much money you make.  How the company performs, how your area is perceived within the firm, how well your boss does and how well he or she supports you are at least as important as hard work and talent.  You can be an exceptional employee and if you are on the wrong side of an acquisition you’re likely to find yourself out of a job.

I would assume Mr. Miron would accept most of these objections, so what is he saying?  I believe his point should be understood by thinking of a normal distribution or the bell curve, that is with the bulk of the population in the middle and smaller numbers at the extremes.  Capitalism distributes income in something like a normal distribution when you look at businesses and individuals.  The majority will earn about what they are worth, with lesser numbers being either lucky or unlucky all the way to the extremes.  Attempts to equalize income aren't fair since they deny these differences.

But it is important not to oversell capitalism as I believe Prof. Miron does in this clip.  The “cure” for whatever unfairness exists in the distribution of income may well be worse than the disease.  And it should be kept in mind that the benefits of capitalism are largely derivative, that the chief argument for capitalism is that it is the only system consistent with a truly free people.  If Krushchev’s boast that communism would bury the West economically had come to pass it wouldn’t make it a better political system than ours.  What needs to be made more consistently is not an economic argument for capitalism but an argument for it that doesn’t rely on its material benefits.  And one that recognizes that life is indeed unfair.

Keynesianism and the stimulus

A Keynesian economics is of course central to the stimulus spending which we saw in '08 and will perhaps see again as the economy continues to go nowhere.  There is some question as to whether this approach actually worked in the 30's, a recent study by some academics at UCLA argued that the New Deal programs actually prolonged the depression rather than brought us out of it as is popularly taught in schools.

But beyond that question is the assumed universality of the Keynesian solution. It is like those in case of a fire break glass ideas, i.e. in case of a recession, increase government spending.  Thus, Moynihan in 1981 is asking a question via an observation that is especially pertinent to today:

"Keynesian economics was a huge idea that swept through the universities of Britain and this country in the 1930s by purporting to explain how the Great Depression came about, how to get out of it, and most important of all how to avoid another [it also promised a greater role for economists which probably didn't impede its sweep through the universities - me]....It was brilliant but it was flawed.  Central to Keynesian thought was the idea that modern industrial economies oversave and that as a result, large resources of capital and labor end up unused.  The Keynesian answer was to overspend.  For the government that is to overspend.  Enter the deficit as public policy.

In a curious way, this message was reinforced by the maturing of the industrial economy.  By this I mean nothing more complicated than that railroads, steel mills, and the assembly lines finally all got built.  Until then saving--the forgoing of consumption--was absolutely necessary in order to make those investments.  Now, those investments having been made, they could only return a profit if people commenced to consume their products.  The advertising business began in earnest.  Someone invented the installment plan.  The Federal  government began to guarantee home mortgages.  The logic our economy, as of our reigning economics, also decreed: overspend.       

9/25/81 (page 438) DPM A Portrait in Letters of an American Visionary

It isn't necessary here to agree with Moynihan's causation.  The point is that Keynesianism is premised on over-saving but the economy has transitioned to a different state.  We now over-spend not just at the level of government but privately.  So why are we still looking to Keynes for the solution?

Harvard Professor Jeff Miron - three myths of capitalism

On Greg Mankiw's blog, fellow Harvard prof. Jeff Miron on the three myths of capitalism.  I think myth #2 is the weakest of the three in reality, but is sound from a public policy standpoint
http://gregmankiw.blogspot.com/2011/08/jeff-miron-on-capitalism.html

Aging baby boomers and the stock market

The WSJ has an article highlighting a study from the San Francisco Federal Reserve Bank which argues that the retirement of baby boomers is likely to depress equity values for the coming 25 years or so.  http://blogs.wsj.com/marketbeat/2011/08/22/will-baby-boomers-sink-the-stock-market/

It’s easy to think of share price as being determined exclusively by the valuation of the company, but like everything else stocks are subject to supply and demand.  As boomers—like a demographic pig going through a snake-- have invested share values have gone up, and it follows that if they start pulling their money out or at the very least quit adding to their investments share values will go down.

Beyond other sources of funds, I think one mitigating factor may be what happens to retirement.  It seems to me likely that boomers are going to live far longer then their parents, and with that longevity are going to have to, and be inclined to, work longer.  If retirement is postponed the effect that the San Francisco Fed study is predicting should be mitigated.

I will go further and say that one of the challenges out there is for business and other groups to figure out how to make more effective use of an aging population.  What we’ve seen in recent decades of retirement isn’t going to work for anyone.  There is a real opportunity for business to reconfigure work so that it benefits the company so as to make use of men and women who may not be career driven but can still be very productive despite advancing age and who still want/need to work.

Federal Reserve policy

Like most of the people commenting on and fretting about the Federal Reserve's easing of the money supply, I'm so far from being qualified to be a central banker  I can't even see it.   Still, I've been surprised by how the velocity of money has been missing from the discussions of Fed policy that I've seen.  As I'm sure most of you will remember from your econ. courses the supply of money is a combination of the amount of currency in circulation and its velocity, that is how fast or often that currency is changing hands. 

Posting on Bloomberg, conservative writer Ramesh Ponnuru brings up velocity and doesn't accuse the Fed Chairman of treason.  Whether his analysis is correct I really don't know, but I'm inclined to believe that it is much better to try to attack our economic problems through the Fed than through any fiscal stimulus, and the velocity of money must have slowed dramatically.  Anyway, I think this is worth a look:
http://www.bloomberg.com/news/2011-08-16/loose-money-will-keep-economy-from-sliding-away-ramesh-ponnuru.html

One final point, I think this is where conservatives get themselves into a bit of trouble.  They have little or no faith with elites, and with good reason.  But not everything is simple or can be discerned through common sense.  Central banking is one of those areas where you need real expertise.  Populist rants against the Federal Reserve show more often than not, that the speaker doesn't know what he's talking about.  I sure hope Bernanke is right, because I'm certain that I couldn't tell you when or why he was wrong if he was wrong.

Federal Reserve Actions

In the wake of the Federal Reserve actions today, it may be instructive to listen to this discussion of former Fed officials via Greg Mankiw's site: http://gregmankiw.blogspot.com/2011/08/former-fed-officials-opine.html

Investment in Housing

Economist Greg Mankiw has a post on the relative cost in investing in housing vs business.  As long as I can remember my father has talked about this. 

"Investment in owner-occupied housing faces an effective marginal tax rate of just 3.5 percent. In contrast, investment in the business sector faces an effective tax rate of 25.5 percent. This leads to a tax-induced bias for capital to flow into housing-related uses rather than other types of projects. As a result, businesses are less likely to purchase new equipment and less likely to incorporate new technologies than otherwise might be the case. Less business investment results in lower worker productivity and ultimately lower real wages and living standards. While the housing sector provides employment and has other positive effects on the overall economy and on society, the resources employed in the housing sector displace investment that would otherwise occur in the business sector were it not for the favored tax treatment of housing. The resulting distortion in the allocation of capital likely lowers overall output, because resources are allocated based on tax considerations rather than economic merit. In effect, the United States has chosen as a society to live in larger, debt-financed homes while accepting a lower standard of living in other regards."  http://gregmankiw.blogspot.com/2011/07/housing-tax-subsidies.html

The argument here isn't that business investment should be favored in order to raise the standard of living--that is an enterprise association argument--but rather that policy should be neutral.  The standard comment in favor of a housing oriented policy, that it is the dream of every american to own their own home, makes the mistake of pre-supposing that government should be in the dream realization business.  That in turn requires government to prioritize among dreams, which should be beyond its purview.

Did they believe it?

With the announcement that Austan Goolsbee will be returning to the Univ. of Chicago, and the bad economic numbers, there has been a great deal of criticism of the statement made by Christina Romer that the stimulus would keep unemployment below 8%.  Of course, the stimulus plan was passed and current unemployment is 9.1% (at best).  What's missing from the discussions I've seen is whether these economic advisors truly believed the 8% figure.

a)  Anyone who has run numbers knows that you're going to be required to give a level of specificity to your analysis/projections which is simply not there.  I seriously doubt that this pressure is absent from our democratic process.
b)  I think it is undeniable that the economy is something of a confidence game and that comments made by the President's economic advisors have to be constructed with this in mind.  It seems quite possible to me that a more intellectually accurate statement that the stimulus would make things better but that there was no telling how high unemployment would go, would be a political non-starter.
c)  a) and b) could be off the mark and Romer et al really did believe in the 8% figure.  That anyone of such high rank could have such confidence, given the unprecedented situation that we faced, is astonishing.  If they really made such a claim with confidence and conviction then they really need to start over from scratch.