Month: July 2014

Aaron Carroll: The Social Contract and health care reform: “The social contract is an implicit understanding…

between people and the society in which they live about how society should be organized, how benefits are distributed, and how shared responsibilities are defined for all citizens. The beauty of the social contract is that it conveys many messages, not a singular one. It conveys the message of shared decisionmaking, but equally it conveys a political message of accountability and responsibility…. Rousseau… society organizes itself according to the expectations that people have for human flourishing…. Hobbesian… limited rights and freedoms…. The beauty and the frustration of using social-contract speak is that it can convey political messages across the entire spectrum, from the most conservative to the most progressive…

Gillian Tett: A peek into the IMF machine: “Liaquat Ahamed, a Washington-based fund manager turned writer…

…flew to Tokyo to participate in the annual meeting of the International Monetary Fund…. Ahamed was not lobbying for policies, cutting business deals or reporting. Instead, for a few days he observed the IMF circus as if he were an ethnographer plunged into a strange tribe… A monograph, Money and Tough Love: On Tour with the IMF, are not just hilarious but shrewdly provocative…. Ahamed lifts the lid on seemingly irrelevant details about the fabric and rhythm of IMF life and on the myriad subtle cultural symbols that are used to signal hierarchy, tribal affiliation and power–and which the IMF economists themselves almost never talk about. Ahamed describes, for example, the dress code patterns, noting that:

the men [at IMF meetings are] uniformly dressed in dark suits and ties, apart, that is, for two groups: the Iranians, who have this odd habit of buttoning up their collars but refusing to wear ties, and the hedge fund managers, who [are] young, fit and wear designer suits… [they] no doubt refuse to wear ties for much the same reason as the Iranians–to signal their rather self-conscious freedom from arbitrary social conventions.

He also tries to explain how policy ideas emerge to dominate the debate–via media platforms…. A serious point. Although policy makers and economists might like to pretend that international governance is all about abstract ideas or quantitative models, it is actually rooted in complex cultural patterns and languages that outsiders struggle to understand. That is no surprise; all institutions have such traits. But I just hope that the experiment that Ahamed has started will now open the door to other ethnographic accounts of how our huge cross-border bureaucracies really work–not simply to spark more reflection among voters but also among the staff of groups such as the IMF too…

Carola Binder: Thoughts on the Fed’s New Labor Market Conditions Index: “The Fed economists employ a widely-used statistical model…

…called a dynamic factor model…. The LMCI is the primary source of common variation among 19 labor market indicators…. The main reason I’m not too excited about the LMCI is that its correlation coefficient with the unemployment rate is -0.96. They are almost perfectly negatively correlated–and when you consider measurement error you can’t even reject that they are perfectly negatively correlated– so the LMCI doesn’t tell you anything that the unemployment rate wouldn’t already tell you. Given the choice, I’d rather just use the unemployment rate since it is simpler, intuitive, and already widely-used…

Anil Kashyap et al.: Making macroprudential regulation operational: “Do the extant workhorse models used in policy analysis…

…support macroprudential and macrofinancial policies?… A new macroprudential model that stresses the special role played by banks…. Three theoretical channels through which intermediaries can improve welfare… extending credit to certain types of borrowers (e.g. Diamond 1984)… improving risk-sharing… creating liquid claims that are backed by illiquid assets (Diamond and Dybvig 1983)…. It is imperative to start with a general model where the financial system plays all three of these roles…. Regulation to fix potential runs, such as proposals for narrow banking (e.g. Cochrane 2014), also appears to be especially appealing. But if the fragility that creates the possibility of runs is not valuable on its own, of course, eliminating it would be desirable! The more challenging question is what happens if there is a fundamental underlying reason why maturity mismatches create value…. Intermediaries should operate in an environment where the savers who use them are forward looking, and the prices the intermediaries face adjust (endogenously) to the regulatory environment…. We are unaware of any existing models that satisfy these two principles. So, in Kashyap et al. (2014b), we have constructed one….

Savers can buy equity in a banking sector and save via deposits… banks choose to invest in safe assets or to fund entrepreneurs who have risky projects… banks and the entrepreneurs face limited liability… a probability of a run… governed by the banks’ leverage and mix of safe and risky assets…. The banks in this world not only offer liquidity insurance with their deposits, but they offer savers a better alternative to making direct loans to entrepreneurs…. This model is that it can be used to explore how capital regulation, liquidity regulation, deposit insurance, loan to value limits, and dividend taxes alter allocations and change the degree of run-risk and total risk-taking…. It is not correct to conclude that combining any two tools is necessarily enough to correct the two externalities in the model… interactions among the regulations are sufficiently subtle that it would be hard to guess which combinations prove to be optimal…. Finally, coming up with regulations that simultaneously eliminate runs and shrink total lending (and risk-taking) is hard… the usual interventions that make runs less likely either create opportunities for banks to raise more funds or take more risk, or so severely restrict the savers, banks or borrowers that one of them is made much worse-off. We hope that these ideas will lead others to move away from small perturbations of existing DSGE models and instead consider much more fundamental changes…

Simon Wren-Lewis: Further thoughts on Phillips curves: “This recent JEL paper by Mavroeidis, Plagborg-Møller and Stock….

…As Plagborg-Moller notes in an email to Mark Thoma:

Our meta-analysis finds that essentially any desired parameter estimates can be generated by some reasonable-sounding specification. That is, estimation of the NKPC is subject to enormous specification uncertainty. This is consistent with the range of estimates reported in the literature…. Traditional aggregate time series analysis is just not very informative about the nature of inflation dynamics.

This had been my reading based on work I’d seen.

This is often going to be the case with time series econometrics, particularly when key variables appear in the form of expectations. Faced with this, what economists often look for is some decisive and hopefully large event…. The Great Recession… might be just such an event. In earlier, milder recessions it was also much less clear what the monetary authority’s inflation target was (if it had one at all), and how credible it was….. Paul observes that recent observations look like a Phillips curve without any expected inflation term at all. He mentions various possible explanations for this, but of those the most obvious to me is that expectations have become anchored because of inflation targeting…. It would be a big mistake to think that the Ball and Mazumder paper finds support for the adaptive expectations Friedman/Phelps Phillips curve. They too find clear evidence that expectations have become more and more anchored. So in this sense the evidence is all pointing in the same way….

I’m happy to interpret anchoring as agents acting rationally as inflation targets have become established and credible, although I also agree that it is not the only possible interpretation…

Ed Glaeser et al.: Unhappy Cities: “There are persistent differences in self-reported subjective well-being…

…across U.S. metropolitan areas, and residents of declining cities appear less happy than other Americans. Newer residents of these cities appear to be as unhappy as longer term residents, and yet some people continue to move to these areas. While the historical data on happiness are limited, the available facts suggest that cities that are now declining were also unhappy in their more prosperous past. One interpretation of these facts is that individuals do not aim to maximize self-reported well-being, or happiness, as measured in surveys, and they willingly endure less happiness in exchange for higher incomes or lower housing costs. In this view, subjective well-being is better viewed as one of many arguments of the utility function, rather than the utility function itself, and individuals make trade-offs among competing objectives, including but not limited to happiness…

I have always understood expected-utility decision theory to be normative, not positive: it is how people ought to behave if they want to achieve their goals in risky environments, not how people do behave. One of the chief purposes of teaching expected-utility decision theory is in fact to make people aware that they really should be risk neutral over small gambles where they do know the probabilities–that they will be happier and achieve more of their goals in the long run if they in fact do so. Thus the first three things to teach people are:

1. That they are not risk-neutral over small gambles.
2. That elementary considerations of rationality in the sense of finding means to achieve one’s ends require risk-neutrality over small gambles.
3. Hence they should be risk-neutral over small gambles.

Then, of course, there is the fourth thing to teach people:

(4) When they are betting against other human minds, you should not be risk-averse over even small amounts–the fact that another mind is willing to take the opposite side of the bet tells you that your subjective probabilities are biased, and expected-utility decision theory based on your subjective probabilities does not incorporate that information about your biases, and so leads you astray.

Still open, however, is:

(5) Should you act as if you are risk-neutral for small gambles against nature if doing so makes you anxious and hence unhappy?

My view is that you owe it to yourself to train yourself not to be anxious and unhappy with respect to small gambles against nature, and thus train yourself to be risk-neutral with respect to small gambles against nature.

And then there is:

(6) Given that people aren’t rational Bayesian expected utility-theory decision makers, what do economists think that they are doing modeling markets as if they are populated by agents who are? Here there are, I think, three answers:

• Most economists are clueless, and have not thought about these issues at all.

• Some economists think that we have developed cognitive institutions and routines in organizations that make organizations expected-utility-theory decision makers even though the individuals in utility theory are not. (Yeah, right: I find this very amusing too.)

• Some economists admit that the failure of individuals to follow expected-utility decision theory and our inability to build institutions that properly compensate for our cognitive biases (cough, actively-managed mutual funds, anyone?) are one of the major sources of market failure in the world today–for one thing, they blow the efficient market hypothesis in finance sky-high.

The fact that so few economists are in the third camp–and that any economists are in the second camp–makes me agree 100% with Andrew Gelman’s strictures on economics as akin to Ptolemaic astronomy, in which the fundamentals of the model are “not [first-order] approximations to something real, they’re just fictions…”

Andrew Gelman: Differences between econometrics and statistics: “Economists seem to like their models…

…and then give after-the-fact justification. My favorite example is modeling uncertainty aversion using a nonlinear utility function for money, in fact in many places risk aversion is defined as a nonlinear utility function for money. This makes no sense on any reasonable scale… but economists continue to use it as their default model. This bothers me… like… doing astronomy with Ptolemy’s model and epicycles. The fundamentals of the model are not approximations to something real, they’re just fictions…

Andrew Gelman (1998): Some Class-Participations Demonstrations for Decision Theory and Bayesian Statistics: “5. Utility of Money and Risk-Aversion…

…To introduce the concept of utility, we ask each student to write on a sheet of paper the probability p₁ for which they are in different between (a)a a certain gain of $1, and (b) a gain of $1000000 with probability p₁ or $0 with probability (1-p₁)…. The students are then asked to write down, in sequence the probabilities p₂, p₃, p₄, and p₅, for which $1=p₂$10 + (1-p₂)$0; $10=p₃$100 + (1-p₃)$1; $100=p₄$1000 + (1-p₄)$10; and $1000=p₅$1000000 + (1-p₅)$100. One of the students is then brought the blackboard to get his or her answers to questions. The probabilities are checked for coherence… The questions involving piece to p₂ and p₃ or combine field comparison between $1, $100, $0. For example, suppose p₂=0.1 and p₃=0.15…. Then… U($1) = 0.064(U($100))+0.9836(U($0)). We then repeat this procedure using… p₄ to determine the utility of $1 relative to $1000 and $0, and then once again using p₅ to determine the utility of $1 relative to $1000000 and $0. finally, this derived values compared to the student’s original value of p₁. is will disagree, meaning that the students preferences are incoherent. The students in the class then discuss with the student that the blackboard how… To give coherent unreasonable answers….

A related demonstration…. a person is somewhat risk-averse and is indifferent between a certain gain of $10 and a 55% chance of $20 and a 45% chance of $0. similarly he or she is indifferent bring a certain gain of $20 and a 55% chance of $30 and a 45% chances of $10; and, in general, different between a certain gain of $x and a 55% chance of $10+x and a 45% chances of $x-10.

Is this reasonable? The students assent….

Then answer the following question: For what dollar value $y is this person in different between a certain game of $y and a 50% chance of $1000000000 and a 50% chance $0? The answer, surprisingly, is that Whitlers is between $30 and $40…. Setting U($0)=0 and U($10)=1… and evaluating… yields U($20)=1.818, U($30)=2.487…. U($40)=3.035…. U($1000000000)=5.5…. $y must be between $30 and $40.

The student believes each step of the argument but is unhappy with the conclusion. Where is the mistake? It is the theory uncertainty is not the same as “risk-aversion” in utility theory: the latter can be expressed as a concave utility function for money, whereas the former implies behavior that is not consistent with any utility function (see Kahneman and Tversky 1979). This is a good time to discuss cognitive illusions, many of which have been demonstrated the context of monetary gains and losses…. Is decision descriptive? Is it normatively appropriate?

John Maynard Keynes (1926): The End of Laissez-Faire: “The disposition towards public affairs…

which we conveniently sum up as individualism and laissez-faire, drew its sustenance from many different rivulets of thought and springs of feeling…. Locke and Hume… founded Individualism…. The purpose of promoting the individual was to depose the monarch and the church; the effect–through the new ethical significance attributed to contract–was to buttress property and prescriptions…. Suppose… individuals pursuing their own interests with enlightenment in condition of freedom always tend to promote the general interest at the same time! Our philosophical difficulties are resolved…. To the philosophical doctrine that the government has no right to interfere, and the divine that it has no need to interfere, there is added a scientific proof that its interference is inexpedient….

Yet some other ingredients were needed to complete the pudding. First the corruption and incompetence of eighteenth-century government…. Material progress between 1750 and 1850… owed almost nothing to the directive influence of organised society…/ The Darwinians could go one better than that–free competition had built man…. Socialist interferences became, in the light of this grander synthesis, not merely inexpedient, but impious, as calculated to retard the onward movement of the mighty process by which we ourselves had risen like Aphrodite out of the primeval slime….

These reasons and this atmosphere are the explanations, we know it or not–and most of us in these degenerate days are largely ignorant in the matter–why we feel such a strong bias in favour of laissez-faire, and why state action to regulate the value of money, or the course of investment, or the population, provokes such passionate suspicions in many upright breasts. We have not read these authors; we should consider their arguments preposterous if they were to fall into our hands. Nevertheless we should not, I fancy, think as we do, if Hobbes, Locke, Hume, Rousseau, Paley, Adam Smith, Bentham, and Miss Martineau had not thought and written as they did. A study of the history of opinion is a necessary preliminary to the emancipation of the mind. I do not know which makes a man more conservative–to know nothing but the present, or nothing but the past.