Trading in risk

The excellent essay aggregator The Browser linked this week to an essay by Steve Randy Waldman on the relationship between freedom and risk. It's an interesting piece and well worth reading. I want to instead talk about the blurb that The Browser wrote to recommend it:

Learned essay on the contradictions between freedom and risk. We almost all want freedom, but few of us want to carry the risks that go with freedom. The history of finance is the history of attempts to lay off or mitigate risk: all of which are doomed to failure. The risk has to accumulate somewhere. And, as in 2008, it eventually blows up.

I know I shouldn't take this too seriously---it is, after all, just a little hook to encourage readers to click on the link---but I think there are a couple of important things to mention.

I am extensively on record that economics is not the same thing as finance, but of course they are related. Let's say for the moment that if we can think of economics as being about the allocation of scarce resources, we can think of finance as being about the allocation of scarce capital or money. At the core of economic theory is the idea of mutually beneficial trade: it is possible that we can trade resources and both be better off than before. More than that: a trade willingly entered into by two parties with good information on the things being traded seems almost tautologically mutually beneficial. If it doesn't benefit both, why do it?

Now of course "good information" is important. For example, when you sell me a used car knowing that it is in fact a few miles away from becoming kaput, I may later be upset. Similarly, in finance, if my information on the riskiness of an asset is bad, I may be sad later, and not just in the sense of being unlucky. But the claim that "all [attempts to lay off or mitigate risk] are doomed to failure" is very peculiar. There are two problems here. The easy one first: clearly not all risks "eventually blow up". This is the point of risk! If all risks eventually come to pass, then surely they are not risks but racing certainties.

The second problem is that where the risk goes matters. Naturally "the risk has to accumulate somewhere"; we cannot magic away risk by passing it around. But where does it end up? Can the trade of a risky asset be mutually beneficial? Yes: if you are more willing to bear the risk than I am, then you will be willing to part with more to buy that risk than I am willing to accept to sell it. You can buy that risk from me---assume it for your own---and we can both be happier. Think of unemployment insurance: for me to lose my job may be catastrophic. I will be destitute; this risk is very costly for me to bear. For an insurance company, the risk that I lose my job is trivial. The insurance company is happy to absolve me of (some of) this risk, and I am happy to pay them a premium to do so. We are both happy. Dare I even say that my freedom is enhanced when I can trade risk in this way?

So yes, the risk accumulates. But the idea behind all trade is that we might be able to send resources to the place where they are most valuable. And so it is with risk: if we can trade risk, perhaps we can have it accumulate in the hands of those to whom it will be the most bearable. While we do not eliminate the risk, we minimize the pain that is caused if the bad outcomes happen. Hey presto!

Of course there is fraud and lies and bad information, and of course some risks can aggregate into systemic kerfuffles, but let's not throw the baby out with the bathwater. Trade in risk is not an inherently destructive activity.

Mana from government

One sentence stuck out to me from an otherwise poignant article on healthcare and assistance for the very elderly:

Politicians are champing at the bit to cut back on Social Security and Medicare at a time when so many of us will depend on them.

I know this is just a throwaway shorthand and I shouldn't get so worked up about it. But I find it incredibly difficult to believe that any self-interested politician wouldn't lavish cash on the elderly (a.k.a. reliable voters) if it was feasible to do so. Even if I'm wrong about that, this is an example of an omission that sometimes bothers me: in some broad sense, resources have to come from somewhere. Slightly earlier in the article is this:

American political leaders are not preparing adequately for the huge demographic shift caused by the aging of the boomers, who began turning sixty-five in 2011. 

So surely the earlier quotation should really say that all else equal politicians will have to find a way to cut back on Social Security and Medicare? What would the preparation be? The proportion of the population that is working-age is going to fall. That means fewer people working to turn stuff into other useful stuff, and more people not working but hoping for a share of the stuff. Something must give. Either more stuff has to be foregone by the workers, or less stuff enjoyed by the non-workers.

Government, whatever it is, isn't a grumpy gatekeeper protecting a bottomless barrel of stuff and saying "no, no, no". We can disagree about what government should do, of course, but let's not pretend that there aren't constraints.

Loaded words and modeling

Here is a nice review by Burton Malkiel of "Models Behaving Badly" by Emanuel Derman. The models of the title are from the world of finance: how are assets priced?

I am a layperson to the world of finance, so I find it difficult how to apportion "blame" for financial crises on faulty models or fraudulent inputs to them. Certainly history is littered with financial crises, so the influence of modern modeling alone cannot explain everything.

In any case, I just want to take this opportunity for a small lament that the beautiful act of modeling must be dragged through the mud by a financial crisis in this way. It would be fair to say that I am almost fanatical about the virtues of the concept and practice of modeling. I believe that modeling is inescapable. The world is complicated. Our senses deliver so much information, our mental apparatus must work so hard, that to process the world around us is to model. It is too much to ask that we understand everything; we have to understand a version of everything that is not so complex as the world.

This is also why economics works with models. We don't have a scale replica of the world that we can play with to see how this affects that. We have to build a scale replica from scratch, using our best judgment to push insistently at the boundary between complexity (so that we can understand our model) and usefulness (so that we can make something from it).

In a way we are much luckier in economics than in finance. Progress in economic theory comes as our models are improved upon and refined, but we are more able to iterate forward because our models are not embedded in a Leviathan global finance industry that depends on their continued function. Creative destruction of old models is hard when the house comes down with them.

With all this in mind I want to highlight this passage from the review:

He sums up his key points about how to keep models from going bad by quoting excerpts from his "Financial Modeler's Manifesto" (written with Paul Wilmott), a paper he published a couple of years ago. Among its admonitions: "I will always look over my shoulder and never forget that the model is not the world"; "I will not be overly impressed with mathematics"; "I will never sacrifice reality for elegance"; "I will not give the people who use my models false comfort about their accuracy"; "I understand that my work may have enormous effects on society and the economy, many beyond my apprehension."

How many of these will I accept for economics? Certainly the first; the model is not reality. Certainly the second; math is helpful in model-building but is not the point of model-building. The fourth and fifth are hard to argue with.

The third I don't like. Everything that we do must sacrifice reality. The test of a model is not its realism (a realistic model airplane would be no fun at all). All models are unrealistic because all models are wrong. Of course elegance is not the test of a model either, except that an elegant model is one that illuminates a relationship in a clear way by cutting to the heart of what matters.

Anyway, the point is that I think that "model" is not a dirty word. I feel possessive about "modeling" much the same way as I feel possessive about "rationality" - what they mean to me is important and wonderful and I hate to see them sullied by misrepresentation that stems from their overlap with the real-world ideas of modeling and rationality. I wish that all of the things like these could have their own words that are not borrowed from natural language.

Abstract revolutions or: if something is new, the old thing must be bad

There is a part of this small, otherwise enjoyable article about the advent of neuroeconomics that bothers me. The premise of the piece is that neuroeconomics is "seeking a physical basis for [economic theory] inside the brain". This is a field that is certainly sexy and possibly exciting; a while back I argued that it is a field that in some sense rediscovers the absolute primacy of "preferences" as the keystone of economic theory. I said:

The potentially exciting thing about neuroeconomics is that, even allowing for inexactness, it might tell us more about the actual hedonic motivators of people. Ambitious, yes, but not unimaginable. Of course, to an economist who wasn't under the mistaken impression that simplified preferences are supposed to be realistic, it might just amount to saying "your simplification is a simplification", which is slightly less exciting news. Or not news at all.

OK. In today's article, we learn that 

modern economic and financial theory is based on the assumption that people are rational, and thus that they systematically maximize their own happiness, or as economists call it, their “utility.”

Since it's hard to figure out what is going on in people's heads, the argument continues, we employed an idea called revealed preference, the reconstruction of unobserved objectives from observed choice. Neuroeconomics, the claim runs, may one day be able to identify brain structures that are associated with various components of choice, and so neatly sidestep the problem of unobservability.

But this is much too much:

While Glimcher and his colleagues have uncovered tantalizing evidence, they have yet to find most of the fundamental brain structures. Maybe that is because such structures simply do not exist, and the whole utility-maximization theory is wrong, or at least in need of fundamental revision.

Utility-maximization theory is wrong. It is wrong by construction, because it is a model, and models are wrong by construction. Why must we go through this? It might be easier to sell me an iPod if you first convince me that CDs are useless, but that's marketing. Why do we need to market neuroeconomics this way? That tiny little word "wrong" up there is a sin, because it belies the very essence of modeling as a means to make sense of things.

Is it perhaps that what we should understand by the quote is that looking into the brain will tell us that people are not, in some sense, maximizing their hedonic pleasure by the choices they make? This amounts to both an attempt to open the black box called "preferences" and to pin down the (biological?) process by which decisions are actually made. If this is the sense in which utility-maximization will be proved "wrong", then in the first place it is not clear to me that neuroeconomics can accomplish such a thing. Leaving aside the tricky questions of intent, free will and consciousness, can there be anything inside the black box but another, and another? The leap from the correlates of physical choices in brain activity to the content or existence of a utility function is huge.

But more importantly, even taking literally the notion that we will be able somehow to trap preferences or process in a cage, it is surely impossible that any breadth or depth of evidence on what these preferences are could preclude the need for us to model. What if the thankless treadmill of refining imperfect models of the world could at last be switched off, that there is an apple of knowledge that will free us from the need for models ever again? This is a seductive idea, but it cannot be. To do away with models would be to be as complex as reality, and that is a fight that reality will win every time. 

More rationality, and a million models

Here is an article on a conversation with Raquel Fernández that I found very interesting. The whole thing is worth reading, but I will quote at length this passage on rationality:

There is a beauty to the models in and of themselves. You assume, for example, that people are rational. I don’t think any really good economist thinks that people are perfectly rational, but, on the other hand, if you want to model people as not rational, all of a sudden it’s not clear what choice you should make. There are a million and one ways to be non-rational; there’s only one way to be rational within the confines of a model. Rationality means one thing: you’re maximizing your welfare subject to constraints. Now, if you say people don’t always maximize, and they’re beset by this and that, then all of a sudden you can have a million models. And that’s a little bit unsatisfactory too.

This is pretty close to my own view. My extra take is that any "irrational" behavior - and so anything that the "million models" generate - can be rationalized, either by revising what we assume that the decision-maker cares about, or by adding constraints on the decision-maker's ability to choose: the question of rationality is a red herring.

Daniel Kahneman and the rational choice model

Daniel Kahneman has a new book, "Thinking Fast and Slow", that is prompting a lot of excellent articles about his work. For example, Vanity Fair has a nice article by Michael Lewis. Back when I was an undergraduate, Kahneman and Amos Tversky's Prospect Theory paper was one of the first academic papers I read that motivated me to become an economist.

The article quotes Kahneman as being astonished to learn early in his career that:

The agent of economic theory is rational, selfish, and his tastes do not change.

I just want to point out that this model of decision-makers in economic models is more innocuous than it seems. It means that when we put a decision-maker in an economic model, we assume that she

•  has things that she cares about, and
• will do the best she can to achieve the things she cares about. 

This is what we mean by rationality. The great thing about this assumption is that it is completely flexible - it can accommodate any preferences at all.

For example, the decision-maker might care about the wellbeing of her neighbor, and so give up some of her own material wealth to help her neighbor be better off. This is both rational and selfish!

For any decision we observe, some preferences will rationalize it. As economic theorists, the crucial assumption is therefore not rationality, but on what it is that the decision-maker cares about and what constraints there are on her making a good decision.

The great contribution of Kahneman and Tversky was to present evidence on the psychological constraints on our decision-maker's ability to achieve the things she cares about. Making decisions is hard: even if I know what I want to achieve, "doing the best I can" is subject to how I process the options I have to choose from.

Rationality is not supposed to be a realistic model of the process by which people actually make decisions. Rather it attempts to capture the outcomes of decision-making in a plausible way, so that we can try bit by bit to analyze economic settings without simply saying "people are completely unpredictable, so let's give up". Kahneman and Tversky helped to show how to write models of rational choice that better reflect the decisions we observe people make.

Meta-ignorance

The "how badly people do on civics and general knowledge test" sub-category of Cheap Journalism is always good for some light entertainment. But this recent example from Newsweek is especially delightful for the pontificating it inspires.

For more than two centuries, Americans have gotten away with not knowing much about the world around them. But times have changed—and they’ve changed in ways that make civic ignorance a big problem going forward. While isolationism is fine in an isolated society, we can no longer afford to mind our own business. What happens in China and India (or at a Japanese nuclear plant) affects the autoworker in Detroit; what happens in the statehouse and the White House affects the competition in China and India. Before the Internet, brawn was enough; now the information economy demands brains instead.

Goodness, where to begin!

Let's start with the obvious. It's always puzzling to see "competition" used with blithe disregard for what it means; why is it that competition is considered a lovely value at the level of the firm but a horror at the level of the country? Does a similar principle not apply? Of course decisions are interrelated and it is worthwhile to understand that interrelation, but the latent assumption seems to be that if we ain't getting ahead we're falling behind. It is not a fundamentalist opinion to demonstrate that the global economy is not a zero-sum game.

But that's too close to real arguments for my taste. Let's focus instead on

Before the Internet, brawn was enough; now the information economy demands brains instead.

This is a remarkably peculiar statement. To achieve more with a given set of resources requires innovation: once upon a time the only "production" humans achieved was to transform time and stone tools into dead animals and dinner. "Brains" have, of course, are irreplaceable in the process of achieving more. This is not abstract: the printing press, electricity, the loom, agriculture... we could populate this list ad infinitum. One entry on the list would be the Internet. The article is instead in a peculiar corner of arguing that brawn was enough to invent the Internet which immediately made brawn redundant.

Which is trivially nonsense. The "information economy", whatever that may be, is not a revolution in the progress that pushes gently but tangibly at the constraint inherent in turning scarce resources into output that humans value. That process has never been the brute force of brawn.

Shared economics

Roger Goodell has joined the debate on the semantics of the word "economics". Welcome, Roger! From ESPN (warning: obnoxious auto-load video alongside article) today:

Commissioner Roger Goodell wrote NFL players Thursday, outlining the league's last proposal to the union and cautioning that "each passing day puts our game and our shared economics further at risk."

Now what might "shared economics" mean? Of the several points of disagreement between NFL owners and players in the current conflict, one is, of course, money. I'm going to regretfully assume that the resource to which Goodell's "economics" refers is only money. So what does he mean about that money?

Can "shared economics" mean a "shared allocation of resources"? It's possible; the two sides can take, in some sense, shared ownership of a specific or formulaic allocation of the pot o' gold from professional football. But this is odd. A problem (paraphrased) is that the owners want a larger cut of money off-the-top, which is different from the status quo. So the mutually agreed allocation of resources from the last CBA has thus far never been on the table.

The whole problem, of course, is in the sharing, in the allocation. It is nearly tautological that a disagreement about the allocation threatens the allocation. So that can't be it.

Can "shared economics" mean "shared money"? This is also possible. There's a work stoppage. In the worst case, the 2011 season is lost or curtailed and there will be a massive loss of revenue. Even in the best case, there is the fuzzier risk of alienating fans, contractual partners, and antitrust authorities, which could plausibly do the same. This seems a much likelier contender for what Goodell had in mind when he picked the word "economics" in his letter.

So to Goodell economics is a synonym for money, or revenue, or resources. This is depressing even for someone of my own view that the word "economics" is hopelessly lost to language forever. "Economics" is no more the resource than football is 22 people running around on some grass.

Hey, it's nearly Christmastime again!

Look out! It's a book by Joel Waldfogel based on the deadweight loss of Christmas! I have made my point on the topic already, so I'm going to do my best to hide from any and all reviews of the new book.

Did I mention it's called "Scroogenomics"?

Leech the economy

Anatole Kaletsky's evisceration of "old economics" in the London Times may be consistent with the general backlash during the current recession, but it's half-baked.

Today’s academic approach prevented economists from thinking about a world that is, by its very nature, unpredictable and inconsistent... others may revive the literary and anecdotal traditions of the great economists of the past... Smith and Hayek produced no real mathematical models. Their eloquent writing lacked the “analytical rigour” demanded by modern economics. And none of them ever produced an econometric forecast.

To wish simultaneously for a return to an "anecdotal tradition" and for theories to be "tested against reality" is perverse. The economy is indeed a complex system, and to draw correct conclusions on the relationships in a complex system requires more than anecdote. As epidemiology is to medicine, so econometrics is to economics; a
patient's recovery after leeching does not prove leeching effective, and folk inference in economics would be just as counterproductive, in its own way. The "analytical rigour" so disdained by Mr. Kaletsky represents the struggle to understand and draw inference from the very real complexity that to rely on anecdote risks ignoring.

The first idea, known as “rational expectations”, maintained that capitalist economies with competitive labour markets do not need stabilising by governments.

The second idea — “efficient markets” — asserted that competitive finance always allocates resources in the most efficient way, reflecting all the best available information and forecasts about the future.

The specific "theories" attacked by Mr. Kaletsky are also grossly misrepresented. Hell, the concept of a theory is being misrepresented. An economic theory is an if-then statement, and this is not a matter of mathematics, which is after all just a language like any other. No theory, no matter how it is expressed, can ever do more than suggest the outcome that would pertain under a given set of conditions. No theory, then, can "[maintain] that capitalist economies... do not need stabilizing by governments", or "[assert] that competitive finance always allocates resources in the most efficient way". To attack the assumptions underlying these theories is good and rigorous; to either attack the value of their existence is to distort the purpose of academic inquiry. It is precisely because
theories are if-then that any single conclusion can be given an 'if' and be co-opted and championed by the politically powerful of the moment, but the "assertions" come always from the interpreter, not from the theorem.

Literary and cross-disciplinary approaches to economics can have great value in conveying economic ideas and in complementing other forms of research. What would be unacceptable, however, would be the abandonment of valuable tools to help us to understand the way things are. Perhaps attacking economists makes us feel better, but this is like blaming the shipbuilder, engineer or mathematician for a drunk captain's crash.

And finally, because that felt a bit too serious, I must mention these:

Today’s academic economics reverses this process: if models disagree with reality, it is reality that economists want to change.

Policymakers who turned to academic economists for guidance in last year’s crisis were told in effect: "The situation you are dealing with is impossible: our theories prove that it simply cannot exist."

This is garbage.

It's called "the ivory tower"

Here's a thoughtful antidote to "boo economists!" by Barry Eichengreen at The National Interest. Perhaps the most forceful point is this:

What got us into this mess, in other words, were not the limits of scholarly imagination. It was not the failure or inability of economists to model conflicts of interest, incentives to take excessive risk and information problems that can give rise to bubbles, panics and crises. It was not that economists failed to recognize the role of social and psychological factors in decision making or that they lacked the tools needed to draw out the implications. In fact, these observations and others had been imaginatively elaborated by contributors to the literatures on agency theory, information economics and behavioral finance. Rather, the problem was a partial and blinkered reading of that literature. The consumers of economic theory, not surprisingly, tended to pick and choose those elements of that rich literature that best supported their self-serving actions. Equally reprehensibly, the producers of that theory, benefiting in ways both pecuniary and psychic, showed disturbingly little tendency to object. It is in this light that we must understand how it was that the vast majority of the economics profession remained so blissfully silent and indeed unaware of the risk of financial disaster.

Eichengreen notes that business schools, for example, are part of the production line of financial labor and ideas and so have no inventive to rock the boat; however, he also directs a lot of fire at academic economists for being part of the stitch-up. I accept that the author surely knows better than me the "pecuniary and psychic" benefits to academics from the use of their work, but a counter-hypothesis would be ignorance rather than malice, a sin of omission, not commission. How many in economics departments know what's going on in industry - or even business schools? Is it enough to claim a quorum of the profession?

There's probably analog to the hard sciences here. Newspaper science (cf. Bad Science, for example) is to natural science research as financial industry models are to economics research, or something like that. Imagine a house full of economists (reality show idea?) - every so often one wanders out to hand some obscure technical document to someone from the outside world, and something inevitably gets lost in translation. 

More navel-gazing

Since there are now, I estimate, more articles on the economics profession's predictions/responses to the recession than there are atoms in the known universe, replying to them all would presumably take a very long time. One example will probably suffice. 

In the Financial Times yesterday, John Kay talks about "How economics lost sight of real world". 

The past two years have not enhanced the reputation of economists. Mostly they failed to point out fundamental weaknesses of financial markets and did not foresee the crisis, and now they disagree on appropriate policies and on the likely future course of events.

As I have (almost) argued before, this is - for better or for worse - not in the job description of the vast majority of academic economists. It is precisely like attacking a physics professor because there was a blackout last night. More importantly:

Economists, like physicists, have been searching for a theory of everything. If there were to be such an economic theory, there is really only one candidate, based on extreme rationality and market efficiency.... a few deranged practitioners of the project believe that their theory really does account for all human behaviour, and that concepts such as goodness, beauty and truth are sloppy sociological constructs.

I have addressed the "economists don't feel feelings" argument before. And, by the way, I guess you can color me deranged. Economics is a theory of everything! 

First: the assumption of "rationality" that is central to economic theory is a modeling assumption and makes no restriction on behavior whatsoever. The auxiliary assumptions of what people care about - the things that they "rationally" try to achieve with their limited resources - are restrictive. Second: "market efficiency" is neither a theory or a modeling assumption. It is either a metric (one of many) by which we can evaluate outcomes (i.e. is this "efficient"?) or a result of an economic theory, which, like all economic theories, will probably require many assumptions. 

I would agree with the proposition that it is wrong to assume that markets are "efficient" (and what does that even mean?). Economists do not make such an assumption. I would agree with the proposition that it is wrong to assume that people care only about their own material wellbeing. Economists do not make such an assumption.

Academic economists did not predict this recession because that is not what academic economists are "supposed" to do with their time. 

Learning from your mistakes

The big policy lesson from our current recession is: save money in good times to see you through the bad. Obvious? Apparently not, especially in Britain, where the government spent the unprecendentedly long expansion period from the late 90s to 2007 running deficits. But it's good to know that we can learn from our mistakes, right? 

But [Alistair Darling] made clear his plans depended on a rapid economic bounce-back - with a forecast of 1.25% growth next year rising to 3.5% in 2011. [link]

The IMF World Economic Outlook (WEO) report predicts the UK economy will shrink by 4.1pc in 2009, with the downturn expected to continue into next year when the economy will fall by 0.4pc. [link]

This is unacceptable. After years of squandering prosperity by running deficits in boom years, now the government proposes to dig even deeper. 

My university, Brown, is cutting staff right now. By anecdote, it is far from alone in the higher education world in doing so. Why is it that a bad year means the operating budget is slashed? Why was the financial plan based on an assumption of constant, unlimited growth in the endowment (i.e. a constant, unlimited rise in stock prices)? Why were national governments operating under the same assumptions? 

Experimental philosophy, experimental economics

Interesting article at Prospect Magazine called Philosophy's Great Experiment, about the rise of 'experimental philosophy'. Doubly interesting to me, because it could equally well be talking about experimental economics, albeit a few years too late. Or about "neuroeconomics"; the philosophers in the article are using fMRI machines "to look for patterns of neuronal activity when subjects are presented with philosophical problems", just like the researcher who does the same for resource allocation - economics - problems. But here's the rub:

Some philosophers quietly dismiss the movement as a cynical step by researchers to appear cutting edge and to tap into scientists’ funding.

Indeed, it's easy to feel this way about the kind of experiments in which economists step on psychologists' toes. The drive toward empiricism in philosophy that the article talks about seems to be symptomatic of social sciences' and humanities' desire to be taken "seriously" as science.

And as we know, that means we need something falsifiable or verifiable. "There is no article in Prospect Magazine called Philosophy's Great Experiment" is falsifiable, because I can find such an article and falsify the statement. "There is at least one article in Prospect Magazine called Philosophy's Great Experiment" is verifiable, because I can find such an article and verify the statement. 

In experimental economics, often it seems (at least to this observer) that we're replicating, or at least mirroring, psychology experiments. Unfortunately, the economics experiment is much less likely to be "scientific", not because of the method or the issue at hand, but because of the specific question. This is precisely what Lawrence Boland discusses in the paper "On the futility of criticizing the neoclassical maximization hypothesis" (pdf), which I read as a welcome withering put-down to all of those who claim to "disprove rationality", etc etc. He says:

Properly stated, the neoclassical premise is: ‘For all decision makers there is something they maximize’... The person who assumed the premise is true can respond: ‘You claim you have found a consumer who is not a maximizer but how do you know there is not something which he is maximizing?’

For experimental economists and experimental philosophers alike, the challenge is to pose a scientific question; without that, no method will save us. "Are people ethical?", for example, is equally a dead end as "are people rational?". 

Failures of imagination?

There's an excellent (long) article on the role and response of academic economists in the current crisis/recession/apocalyse/trendy-noun over at the Boston Globe. Not a lot of it is tremendously surprising, but it does interview a lot of big names in the profession to get their opinions. The rub is this: why didn't economists see all this coming, and what now for the profession?

There are (at least) two distinct kinds of failure that are possible here. The first one is a failure in reality, a failure to see things coming. The second is a failure of imagination, a failure to imagine what would happen as a result of that unforseen thing. In today's terms, the first would be a failure to predict that everything would go all to hell, while the second would be a failure to predict the consequences if things had gone to hell.

If you ask me, the first one is forgiveable. The article quotes Laurence Ball as saying "Nobody ever sees anything coming," he says. "Nobody saw stagflation coming, nobody saw the Great Depression coming, nobody saw Pearl Harbor or 9/11 coming. Really big, bad things tend to be surprises", which might be a tad extreme but is a sentiment I can agree with. It takes an extreme fatalist to think that we can see everything coming if we just try hard enough. 

However, the second might not be forgiveable at all. It represents a failure of contingency planning. One might stem from the other: if I think it's very, very unlikely to rain, I might not want to waste too much time planning my umbrella strategy. If, however, we believe the article's claim that "some warned of a housing bubble, but almost none foresaw the resulting cataclysm. An entire field of experts dedicated to studying the behavior of markets failed to anticipate what may prove to be the biggest economic collapse of our lifetime", then we should be a bit perturbed. Again, the failure to see something coming is forgiveable, but to see it coming and fail to imagine the consequences is just plain strange. 

This is a little scary, but I confess I have very little idea of how I, an economist, would be able to attack macroeconomic questions. I disagree with the first half of this (though not the second, which is that failure of imagination again):

"We have a very restrictive set of language and tools, and we tend to work on the problems that are easily addressed with those tools," says Jeremy Stein, a financial economist at Harvard. "Sometimes that means we focus on silly questions and ignore greater ones."

Similarly, I'm sceptical of this:

"...many of the models used to explain and predict the dynamics of financial markets or national economies have been scrubbed clean, in the interest of theoretical elegance, of the inevitable erraticism of human behavior. As a result, the analytical tools of the trade offer little help in a crisis, and have little to say about the sort of collapses that led to this one."

I am a believer in the predictive and descriptive power of the abstract model. Instead, the view I relate to is that of Jeffrey Kling:

"What we're experiencing now is a good old-fashioned financial panic... This is perhaps the biggest scale, but on some level it's not that different."

I think the economist's toolbox - the one that contains no doctrine, no assumption, just method - is well equipped to understand most everything. Unfortunately, the principle of 'garbage in, garbage out' applies to economics as much as it does to computer programming; perhaps the real failure is not of the discipline of economics, but the imagination of those who practice it. We are, of course, not rewarded by universities or journal editors for asking questions like "if there is a housing bubble, and if it bursts, then what?" Those questions aren't "research"; they're not rewarded and we don't have time for them. How can we be surprised that we were surprised?

Christmas redux

It's Christmas time again. Tim Harford's on the case of that gift-giving economics article I talked about back in January, with typical accuracy:

"Waldfogel’s work is often misinterpreted as suggesting that gift-giving is pointless. That is not true. He explicitly excluded the sentimental value of gifts from his calculations, and, of course, the sentimental value is part of the purpose of giving presents."

More than that, though; his positivist reading of the original article leads to some very sensible, common-sensical normative prescriptions:

"the economists Sara Solnick and David Hemenway have discovered that we prefer unsolicited presents to those we have specifically requested... All this points to the optimal gift-giving strategy: you need to minimise the deadweight loss while maximising the sentimental value. This suggests buying small gifts and striving for emotional resonance. Look for something inexpensive, and consider supplementing it with a letter, a photo, or time spent together."

Prescriptions we can all relate to.

Best article on banking culture

Excellent article from Michael Lewis at Portfolio.

More ultimatum game ignorance

I wonder what it is about the ultimatum game that makes for journalistic error? More of the same from Emily Yoffe in Slate:

We like to think we go through life as rational beings. Much of economic theory is based on the notion that humans make rational choices (which may mean that economists don't get out much). 

"Rationality" is a model, and admits any form of behavior. It does not say how someone "should" behave.

In 1982, some economists came up with a little game to study negotiating strategies. The results showed that rationality is subservient to more powerful drives—and demonstrated why human beings so easily conclude they are being wronged. The idea of the "ultimatum game" is simple. Player A is given 20 $1 bills and told that, in order to keep any of the money, A must share it with Player B. If B accepts A's offer, they both pocket whatever they've agreed to. If B rejects the offer, they both get nothing. Economists naturally expected the players to do the rational thing: A would offer the lowest possible amount—$1; and B, knowing $1 was more than zero, would accept. Ha!

This is the Nash Equilibrium of the game, if both players cared only about money. It has nothing to do with "rationality". 

In the years the game has been played, it's been found that almost half the A's immediately offer to split the money—an offer B's accept. When A offers $9 or even $8, B usually says yes. But when A's offer drops to $7, about half the B's walk away. The lower A's offer, the more likely the B's are to turn their backs on a few free dollars in favor of a more satisfying outcome: punishing the person who offended their sense of fairness. This impulse is not illogical; it is essential. 

Only the hypothetical economists in the article found it illogical, and they're not real. Once more: rejection of a lowball offer in the ultimatum game is rational under the entirely realistic assumption that people care about more than money. Please stop attacking the straw economist who disagrees with that statement.  

Economist versus economist

This mostly innocuous entry at the Freakonomics blog is comparing the rejection of offers in the ultimatum game (where I propose a division of some money, you either accept or reject, we get the money if you accept but don't if you reject, and then we go home) to the rejection of the 'bailout' of the financial sector. It raised my ire with this:

Many economists cannot understand why they’d do such a thing. To an economist, an offer of even 1 percent would be worth accepting since it is free money, and because for the second player it is ultimately irrelevant how much money the first player takes home.

But most people do not think like economists. When offered 10 percent or 20 percent or even 30 percent of the total, they are disgusted by the inequity — and willing to pay the price for that disgust by rejecting the offer.

Show me a scrap of evidence that "many economists cannot understand why they’d do such a thing." Pardon my language, but that's bullshit. Really, what the hell. In fact, it's so infuriatingly ridiculous that I'm going to be forced to actually say something as clearly and calmly as I can, but I'm going to have to do it in boldface:

Economists are capable of feeling things.

Phew. No, seriously, the quotation claims that:

1. Economists don't understand that people care about things.
2. Economists don't feel feelings.
3. Economists do not conduct life in the same way as people who actually care about things.

Give me a break. 

Big picture

Neat little story related by Tim Harford:

Shortly after the Soviet Union collapsed, a Russian bureaucrat travelled to the west to seek advice on how the market system functioned. He asked the economist Paul Seabright to explain who was in charge of the supply of bread to London. He was astonished by the answer: "Nobody."

I like that because it is astonishing that these things take care of themselves (well, not that bread is wandering in to London by itself, but you see what I mean). It's also a fun reminder of the massive economic policy differences that are possible in the world - a reminder of the size of the question "how should I/we/the country allocate resources".