March 14, 2010
Click Here To Read: Robert Shiller: A Crisis of Understanding
Introduction (Via Robert Shiller @ Project Syndicate)
Few economists predicted the current economic crisis, and there is little agreement among them about its ultimate causes. So, not surprisingly, economists are not in a good position to forecast how quickly it will end, either.
Of course, we all know the proximate causes of an economic crisis: people are not spending, because their incomes have fallen, their jobs are insecure, or both. But we can take it a step further back: people’s income is lower and their jobs are insecure because they were not spending a short time ago – and so on, backwards in time, in a repeating feedback loop.
It is a vicious circle, but where and why did it start? Why did it worsen? What will reverse it? It is to these questions that economists have been unable to offer clear answers.
The state of economic knowledge was just as bad in the Great Depression that followed the 1929 stock market crash. Economists did not predict that event, either. In the 1920’s, some warned about an overpriced stock market, but they did not predict a decade-long depression affecting the entire economy.
Late in the Great Depression, in August 1938, an article by Ralph M. Blagden in The Christian Science Monitor reported an informal set of interviews with US “professors, banking experts, union leaders, and representatives of business associations and political factions,” all of whom were given the same question: “What causes recessions?” The multiplicity of answers seemed bewildering, and did not inspire confidence that anyone knew what was causing the deepest crisis of capitalism.
The causes given were “distributed widely among government, labor, industry, international politics and policies.” They included misguided government interference with markets, high income and capital gains taxes, mistaken monetary policy, pressures towards high wages, monopoly, overstocked inventories, uncertainty caused by the reorganization plan for the Supreme Court, rearmament in Europe and fear of war, government encouragement of labor disputes, a savings glut because of population shrinkage, the passing of the frontier, and easy credit before the depression.
Although economic theory today is much improved, if we ask people about the cause of the current crisis, we will mostly get the same answers. We would certainly hear some new ones, too: unprecedented real-estate bubbles, a global savings glut, international trade imbalances, exotic financial contracts, sub-prime mortgages, unregulated over-the-counter markets, rating agencies’ errors, compromised real-estate appraisals, and complacency about counterparty risk.
Click Here To Read: Robert Shiller: A Crisis of Understanding
March 7, 2010
More of a historical piece but with some interesting conclusions, bravo Mr. Shiller.
Click Here To Read: Robert Shiller: Mom, Apple Pie and Mortgages! Rethinking Housing Finance
Introduction (via NYT)
For decades, the federal government has subsidized housing — particularly owner-occupied housing. This has been especially true during the continuing financial crisis, with Fannie Mae, Freddie Mac and the Federal Housing Administration propping up the housing market by issuing guarantees for investors on most new mortgages.
But what is the long-term justification for putting taxpayers on the line to subsidize homeownership? Is this nothing more than a sacred cow in American society — a political necessity because so many voters own homes and are mindful of their resale value?
In fact, there is much more to the history of subsidizing housing. While the crisis in the housing market shows that our current approach is far from perfect, there is a certain wisdom behind it, related not only to economic stimulus but also to the preservation of a sense of national identity. It’s important to remember this as we consider re-engineering our institutions as the crisis ebbs.
Additional Excerpts (via NYT)
But consider what will happen once the economy is again operating at full capacity. Basic economics tells us that when Americans, over all, spend more on housing, they must ultimately spend less on something else. Why should housing consumption be better than other consumption, or investments that people might choose?
This time, the best answer isn’t found in traditional economics but rather in American culture: a long-standing feeling that owning homes in healthy communities is connected to individual liberties that embody our national identity. Historically, homeownership has been associated with freedom, while renting — often in tenements or mill villages — has been linked to the oppression of a landlord.
Most Important Lessons (via NYT)
American mortgage institutions encourage people to take a leveraged position in the real estate market, which is quite risky because home prices can and do decline, as we have learned so painfully. Leverage a risky investment 10 to 1 and you can expect trouble — and we have plenty of it today. More than 16 million homeowners owe more on their mortgages than their homes are worth, according to Mark Zandi of Economy.com.
If we choose to keep subsidizing individual homeownership, we must also commit to adding safeguards so that homeowners are less financially vulnerable. Of course, that will require some creative finance.
But first, we should rethink the idea of renting, which could be a viable option for many more Americans and needn’t endanger the traditional values of individual liberty and good citizenship.
Click Here To Read: Robert Shiller: Mom, Apple Pie and Mortgages! Rethinking Housing Finance
March 3, 2010
Via The Great Leigh Cadwell
Click Here To Read:Models of bounded rationality and the credit environment
Summary (via Vox.eu)
This column argues responses to the recession should not be based on unrealistic expectations of rational behaviour. It argues that models of bounded rationality provide reasons that traditional macroeconomic policy responses may fall short and suggests more sophisticated solutions that could break the crisis’s psychological hold on markets.
Excerpt (via Vox.eu)
Bounded rationality is the broad term for behavioural models that do not follow the rational-maximiser formula. There is not yet a generally accepted alternative model. Lots of individual non-rational behaviours have been discovered, but they are grafted onto a rather clunky ‘rational actor with bits’ instead of forming a coherent behavioural model.
However, the best place to test a new theory is often at the edges of the old one, where the existing model breaks down. So the current troubles in the financial and real economy may be a good opportunity to try out some alternative models and see which give a reasonable description of what we see.
Models of bounded rationality
Different models of bounded rationality vary basic assumptions of the rational agent model in different ways. Some of those assumptions are:
* Utility is discounted over time in a consistent way
* People have access to all relevant information
* All relevant information is expressed through market prices
* People can instantly weigh up the change in utility given by any buying or selling decision
* People act to maximise their utility
Click Here To Read:Models of bounded rationality and the credit environment
February 28, 2010
Here’s Thaler’s latest missive via NYT.
Click Here To Read: Richard Thaler: The Economics Of Free TV
Introduction (Via NYT)
HERE’S a list of national domestic priorities, in no particular order: Stimulate the economy, improve health care, offer fast Internet connections to all of our schools, foster development of advanced technology. Oh, and let’s not forget, we’d better do something about the budget deficit.
Now, suppose that there were a way to deal effectively with all of those things at once, without hurting anyone. And suppose that it would make everyone’s smartphone work better, too. (I’ll explain that benefit shortly.)
I know that this sounds like the second coming of voodoo economics, but bear with me. This proposal involves no magical thinking, just good common sense: By simply reallocating the way we use the radio spectrum now devoted to over-the-air television broadcasting, we can create a bonanza for the government, stimulate the economy and advance all of the other goals listed above. Really.
Key Insights (Via NYT)
The reason for this golden opportunity may be in your purse or pocket: that smartphone to which you could well be addicted. The iPhone, the BlackBerry and competing devices are already amazing technologies. But precisely because of the nifty features they offer, like the ability to text photos, stream video and provide GPS directions, the radio spectrum is looking as crowded as Times Square on New Year’s Eve. Demand for spectrum is growing rapidly — a trend that will surely continue.
The problem is that the usable radio spectrum is limited and used inefficiently. Think of it as a 100-lane highway with various lanes set aside for particular uses, including AM and FM radio, TV and wireless computer technology. The government — specifically, the Federal Communications Commission — is in charge of deciding which devices use which lanes.
Because we can’t create additional spectrum, we must make better use of the existing space. And the target that looks most promising in this regard is the spectrum used for over-the-air television broadcasts.
Summary (via NYT)
I KNOW that this proposal sounds too good to be true, but I think the opportunity is real. And unlike some gimmicks from state and local governments, like selling off proceeds from the state lottery to a private company, this doesn’t solve current problems simply by borrowing from future generations. Instead, by allowing scarce resources to be devoted to more productive uses, we can create real value for the economy.
Economists are fond of saying that there is no such thing as a free lunch. Here we have an idea that is even better than a free lunch: being paid to eat lunch. More paid-lunch ideas will be coming in future columns.
Click Here To Read: Richard Thaler: The Economics Of Free TV
February 26, 2010
I intended for this post to be about the challenges of health reform; notably how government structure, culture and social differences, human and administrative resource capacity, corruption and other bureaucratic obstacles muddy the reform waters. Theory and empirical evidence simply isn’t enough to get a health system effectively, efficiently and equitably implemented. I planned to talk about the work of William Hsiao and other reformers with decades of real world experience dealing with such issues. Turns out I’ll get to that next week. A family friend who has been running a successful business for over 30 years wrote to me after the last post and asked sincere, critical questions about why health care markets fail and what differentiates these problems from all other industries. Because it’s a major economic topic, critical to understand and perhaps the most controversial, I’d like to devote one more post to it and other myths.
The first question is “What’s so different about information gaps between health care and all other goods, like cars?” To begin, health care deals heavily with life and death, unlike most other industries — so people aren’t necessarily rational, economic actors when they or family members are extremely sick. They’ll often do and spend whatever it takes to get cured, even when prices rise. The concept was discussed in the 2nd post and indicated that many (but certainly not all) health care procedures incite inelastic patient demand. The economic evidence for this is overwhelming. Now here’s where it gets important. Third party payers, or insurance companies, are there to help us pay for services that we can’t afford. When they foot the bill, patients don’t feel the full price tag and are more willing to buy additional services and spend more money that isn’t theirs. Coupled with inadequate information, they’re even more likely to consume extra health services when the doctor tells them it’s necessary. These two factors cause the price of health care to rise in a vicious cycle.
The second question is, “So why not have the insurance company pay a set fee to the doctor (ie capitation) and let the patients pay the rest? Doctors should charge what they want, and patients can pay out of pocket based on quality.” The answer: That’s a wonderful idea. The Mayo clinic does this successfully, provides top quality care and only takes privately insured patients. But throughout entire health care systems the quality and prices set by doctors and hospitals are very difficult to measure without transparent and sound information – which is why billions of U.S. dollars are actually being spent on this kind of research.
For example, Harvard business expert Michael Porter recently wrote a book (Redefining Health Care, 2007) promoting the free market, incentives and coordinated patient care between providers as the primary tools to maintain high quality and drive down costs. Reviews from health experts around the world were, “Answering that is the million dollar question. When everyone has superb information on quality and price indicators, the market could largely run on its own, and we could have better competition. But until then, no way!” As an example, ever try asking the hospital how much a procedure costs before hand? Good luck finding that out. Also, the U.S. has been trying to implement electronic medical records (EMR) for all patients to improve efficiency and quality as well as reduce health care costs, but hospitals and doctors generally oppose this. Without open and shared information between providers about a given patient, providers can duplicate services, make more money and reduce efforts to improve quality of care.
Other OECD nations are better than the U.S. at implementing cost-effective analyses, EMRs and determining which procedures, technologies, drugs and prices to use, because external bodies either finance health care (Public Financing or Social Health Insurance) and or governments heavily regulate private insurers. Because information flow and transparency improve competition among organizations, the amount these nations (and ultimately patients) spend on health care is considerably less than the United States. This is exactly what I meant in the previous post by “regulation can actually improve failed markets and enable competition to occur, thereby lowering costs and improving quality.”
The third myth, specifically within the United States, is that covering the uninsured would certainly lead to rising health care costs. I make this statement carefully because, in the Massachusetts experience, mandating insurance and increasing coverage has increased overall health spending. Many economists believe the health reform bill would follow suit – primarily because there is not enough included to counteract the expected increase in demand. However, health care is unique in that spending comes full circle. The uninsured often wait until their cases worsen, then use the emergency department as an only option for finding health care. The price tag of such utilization is enormous – and these costs are passed on to all other patients in the form of increased premiums, co-pays, etc.
Experience from other developed nations indicates that if the poor received and utilized a basic, health insurance package that promoted primary and preventative care and reduced their ED visits, overall costs would surely decline. Among other conditional obstacles, convincing the public to pay for such coverage as well as expecting Congress to aggressively cut extraneous spending has proven challenging both domestically and in other nations. For instance, the Dartmouth Atlas – a major project that examines the large, unnecessary variation in Medicare spending across the nation, states and counties without improvements in clinical outcomes – has shown that nearly $500 billion could be cut without negatively impacting patients. Yet the probability of Congress acting on this would be unlikely. The point here is that in developed societies all patients, particularly the wealthy, will always pay for others. It simply depends on the transparency of those costs.
Here are some articles, the first being perhaps the first, most influential economics paper regarding why health care markets fail:
http://www.who.int/bulletin/volumes/82/2/PHCBP.pdf
http://www.economist.com/world/united-states/displaystory.cfm?story_id=15545834&fsrc=rss
February 25, 2010
Interesting piece by Ned Welch
Synopsis (Via Mc. Kinsey Quarterly)-
Marketers have been applying behavioral economics—often unknowingly—for years. A more systematicapproach can unlock significant value.
Click Here To Read: Mc.Kinsey Quarterly: A Marketers Guide To Behavioral Economics
Introduction (via Mc. Kinsey Quarterly)
Long before behavioral economics had a name, marketers were using it. “Three for the price of two” offers and extended-payment layaway plans became widespread because they worked—not because marketers had run scientific studies showing that people prefer a supposedly free incentive to an equivalent price discount or that people often behave irrationally when thinking about future consequences. Yet despite marketing’s inadvertent leadership in using principles of behavioral economics, few companies use them in a systematic way. In this article, we highlight four practical techniques that should be part of every marketer’s tool kit.
Keys To Behavioral Marketing: (via Mc.Kinsey Quarterly)
1. Make a product’s cost less painful-
In almost every purchasing decision, consumers have the option to do nothing: they can always save their money for another day. That’s why the marketer’s task is not just to beat competitors but also to persuade shoppers to part with their money in the first place.
….
Another way to minimize the pain of payment is to understand the ways “mental accounting” affects decision making. Consumers use different mental accounts for money they obtain from different sources rather than treating every dollar they own equally, as economists believe they do, or should.
2. Harness the power of a default option
The evidence is overwhelming that presenting one option as a default increases the chance it will be chosen. Defaults—what you get if you don’t actively make a choice—work partly by instilling a perception of ownership before any purchase takes place, because the pleasure we derive from gains is less intense than the pain from equivalent losses. When we’re “given” something by default, it becomes more valued than it would have been otherwise—and we are more loath to part with it.
3. Don’t overwhelm consumers with choice
When a default option isn’t possible, marketers must be wary of generating “choice overload,” which makes consumers less likely to purchase. In a classic field experiment, some grocery store shoppers were offered the chance to taste a selection of 24 jams, while others were offered only 6. The greater variety drew more shoppers to sample the jams, but few made a purchase. By contrast, although fewer consumers stopped to taste the 6 jams on offer, sales from this group were more than five times higher
4. Position your preferred option carefully
Economists assume that everything has a price: your willingness to pay may be higher than mine, but each of us has a maximum price we’d be willing to pay. How marketers position a product, though, can change the equation. Consider the experience of the jewelry store owner whose consignment of turquoise jewelry wasn’t selling. Displaying it more prominently didn’t achieve anything, nor did increased efforts by her sales staff. Exasperated, she gave her sales manager instructions to mark the lot down “x½” and departed on a buying trip. On her return, she found that the manager misread the note and had mistakenly doubled the price of the items—and sold the lot. In this case, shoppers almost certainly didn’t base their purchases on an absolute maximum price. Instead, they made inferences from the price about the jewelry’s quality, which generated a context-specific willingness to pay.
Click Here To Read: Mc.Kinsey Quarterly: A Marketers Guide To Behavioral Economics
February 24, 2010
“The point is that an inexplicable feeling – a judgment of risk we can’t justify – interferes with the rational calculation. The play might not be optimal, but it feels less likely to trigger a worst case scenario (interception, home run, etc.), and those scenarios carry a disproportionate weight.”
Sound interesting, Read on!
Click Here To Read: How does decision making really work on the field?
Introduction (via Frontal Cortex)
One of the lingering questions in decision science is the extent to which game theory – an abstract theory about how people can maximize their outcomes in simple interactions – is actually valid. It’s a lovely idea, but does it actually describe human nature?
As usual, the answer depends. With few exceptions, lab tests of game theory find that real human beings sharply deviate from the predictions of game theory. We don’t maximize gain, often because of misperceptions about risk. But people have actually performed better (i.e., we act like Von Neumann tells us to act) in the field. For instance, Mark Walker and John Wooders analyzed several thousand serves at Wimbledon:
………….
In other words, tennis players (like soccer goalies) are rational agents, at least when choosing where to serve. (The big exception is that even the best tennis players tend to switch the location of their serves a little too often.) This has led some to argue that the irrationality observed in the lab is a side-effect of lab artifice. Perhaps the incentives are too insignificant? Perhaps the subjects don’t understand the rules of the game? Or maybe they’re intimidated by the presence of the scientist, who is measuring their behavior?
The latest attempt to rectify this schism between lab data and real life observations comes from Kenneth Kovash and Steven Levitt. They began by seeking out vast data sets, since one of the central problems with the studies of soccer players and tennis stars was the smallness of their n. (For instance, the game theory goalie study looked at fewer than 500 penalty kicks.) And so Kovash and Levitt moved on to other sports:
This suggests that the lab data is actually correct, and that people (or at least MLB pitchers and NFL coaches) aren’t particularly good at obeying game theory. It’s a rational model we don’t naturally emulate. But why not? Wouldn’t natural selection want to endow us with a mind capable of maximizing competitive outcomes?
One possibility is that failing at game theory is the price we pay for having emotions. Just look at NFL coaches, who according to Kovash and Levitt don’t call pass plays often enough. Since 1960, quarterbacks have managed to increase their average gain per pass attempt by nearly 30 percent, from 4.6 yards to 6.5 yards. (Running backs only get about 4 yards per attempt, a number that hasn’t changed in thirty years.) Furthermore, even as quarterbacks have gotten more yards per pass, they have managed to throw fewer interceptions. In 1980, passes were picked off more than 6 percent of the time. By 1995, the rate of interceptions had been halved, which meant that passing the ball wasn’t any statistically riskier than rushing.
Click Here To Read: How does decision making really work on the field?
February 23, 2010
Unfortunately this is not a free paper… the most I can do is link to the abstract.
Abstract (via Oxford journals)
This paper attempts to bring some central insights from behavioural economics into the economics of climate change. In particular, it discusses (i) implications of prospect theory, the equity premium puzzle, and time-inconsistent preferences in the choice of discount rate used in climate-change cost assessments, and (ii) the implications of various kinds of social preferences for the outcome of climate negotiations. Several reasons are presented for why it appears advisable to choose a substantially lower social discount rate than the average return on investments. It also seems likely that taking social preferences into account increases the possibilities of obtaining international agreements, compared to the standard model. However, there are also effects going in the opposite direction, and the importance of sanctions is emphasized.
February 23, 2010
Click Here To Read: The New Yorker Profiles Paul Krugman -The Deflationist How He found politics.
Introduction (via The New Yorker)
When it is cold at home, or he has a couple of weeks with nothing to do but write his Times column, or when something unexpectedly stressful happens, like winning the Nobel Prize, the Princeton economist Paul Krugman and his wife, Robin Wells, go to St. Croix. Here it is warm, and the days are longer, and the phone doesn’t ring much. Here they live in a one-bedroom condo they bought a few years ago, nothing fancy but right on the beach. The condo’s walls are yellow and blue, the furniture is made of wicker, there are pillows and seashells. There are tall, sprawling bougainvillea bushes along the side of the road.
“We first fell in love with St. John,” Krugman says. “It was New York lawyers who’d decided to give up on the whole thing and live on a houseboat and wear their gray ponytails.”
“But St. John went too upscale,” Wells says.
“Our complex is more Midwesterners. Retired car dealers and so on.”
The east end of St. Croix is something of a tourist spot, but the west end, where they decided to settle, is where the Crucians live, and it has a Jimmy Buffett feel to it that they like. In Frederiksted, the west end’s tiny town, there are a couple of coffee shops, a KFC, a Wendy’s, a few churches, a post office, and a promenade by the sea with concrete picnic tables. Not many people about. Farther out along the coast, there are beach bars with plastic chairs and Christmas lights, men with beards and very tanned middle-aged women sitting and smoking in the afternoon.
“The west end is where the whites who’ve gone native live,” Wells says. “They have a couple of beach bars with not very good blues and jazz bands. They were playing Neil Young as we went by the other night, and Paul said, ‘Boy, that was an awful rendition.’ ”
“It was Buffalo Springfield.”
“Yes, Springfield, O.K. I said, ‘Aging boomers, they love any rendition, no matter how bad.’ ”
Here Krugman wears the same shirt for days, a short-sleeved plaid cotton shirt, and bathing trunks. He sits in the room where they eat their breakfast, which has a long window open to the sea. He types at a tiny table that folds out of a closet, which requires him to sit more or less inside the closet, but this is helpful, because the light can be so bright in the room that it becomes blinding. If he turns his head, he can see the sky.
First thing when he wakes up, he checks out a few Web sites, and if he’s not writing his column that day he and Wells will go for a walk on the beach, or they will stroll into Frederiksted and have breakfast at Polly’s, a little coffee shop that serves iced lattes and pretty good egg burritos. If he is writing his column, he will start it on the morning of the day it’s due, and, if the spirit is with him, he will be done soon after lunch. When he has a draft, he gives it to Wells to edit. Early on, she edited a lot—she had, they felt, a better sense than he did of how to communicate economics to the layperson. (She is also an economist—they met when she was a postdoc at M.I.T. and he was teaching there.) But he’s much better at that now, and these days she focusses on making him less dry, less abstract, angrier. Recently, he gave her a draft of an article he’d done for Rolling Stone. He had written, “As Obama tries to deal with the crisis, he will get no help from Republican leaders,” and after this she inserted the sentence “Worse yet, he’ll get obstruction and lies.” Where he had written that the stimulus bill would at best “mitigate the slump, not cure it,” she crossed out that phrase and substituted “somewhat soften the economic hardship that we face for the next few years.” Here and there, she suggested things for him to add. “This would be a good place to flesh out the vehement objections from the G.O.P. and bankers to nationalization,” she wrote on page 9. “Show us all their huffing and puffing before you dismiss it as nonsense in the following graf.”
Click Here To Read: The New Yorker Profiles Paul Krugman -The Deflationist How He found politics.
February 21, 2010
Click Here To Read: New Book: It’s money that matters-understanding economic inequality
Introduction (via Boston.com)
If you like to think of America as The Greatest Country on Earth, and you’d rather not examine its claim to that title too closely, “The Spirit Level” will not be your favorite new book. On nearly every one of its 250-plus pages, a stark, unflattering graph shows the USA topping the charts among developed countries for some social ailment: drug use, obesity, violence, mental illness, teenage pregnancy, illiteracy. But authors Kate Pickett and Richard Wilkinson, a pair of British social scientists, have another, more enlightening point to make. With striking consistency, they say, the severity of social decay in different countries reflects a key difference among them: not the number of poor people or the depth of their poverty, but the size of the gap between the poorest and the richest.
It is economic inequality, not overall wealth or cultural differences, that fosters societal breakdown, they argue, by boosting insecurity and anxiety, which leads to divisive prejudice between the classes, rampant consumerism, and all manner of mental and physical suffering. Though Sweden and Japan have low levels of economic inequality for different reasons – the former redistributes wealth, while in the latter case, the playing field is more level from the start, with a smaller range of incomes – both have relatively low crime rates and happier, healthier citizens.
The idea at the heart of the book is not new; human beings through the ages have intuitively understood as much. What is groundbreaking is Pickett and Wilkinson’s compilation of data, much of it only recently available, allowing sweeping comparisons across dozens of nations and areas of well-being, and showing, for the first time, the breadth and strength of the statistical link. Between the two of them, the authors say, they have devoted some 50 years to conducting and collecting the research. Their efforts have been hailed by left-leaning thinkers and critics as a compass for righting the nation’s current course; the book – its title refers to the tool known in America as a carpenter’s level, which measures slopes – is being translated into 13 languages, including Arabic, Korean, and Norwegian. The authors spoke to Ideas from a friend’s home in Washington, D.C., where they were wrapping up a three-week, cross-country book tour.
Excerpt (via Boston.com)
Wilkinson: I think people are extremely sensitive to status differentiation and to being looked down on, or disrespected, and those often seem to be the triggers to violence. We quote an American prison psychiatrist who goes so far as to say he’s never seen a serious act of violence that wasn’t provoked by loss of face or humiliation, and so on. And in more unequal societies, status matters even more. People judge each other more by status. There’s more insecurity. And people at the bottom are more often excluded from the markers of status, the jobs and housing and cars, so they become even more touchy about how they’re seen.
Click Here To Read: New Book: It’s money that matters-understanding economic inequality
