Category Archives: Economics

Krugman: Baby-Sitting The Economy

Nobel-prize winning economist Paul Krugman recently did an IAmA on Reddit. One user asked Krugman why a growth oriented approach led by monetary and fiscal stimulus to solving our economic and fiscal problems is the correct approach (as opposed to austerity).

The user also requested that Krugman explain like the user was five years old. In response, Krugman mentioned an article he wrote in 1998 which uses a baby-sitting co-op as a representation of a nation’s economy. The article is worth reading:

The Sweeneys tell the story of–you guessed it–a baby-sitting co-op, one to which they belonged in the early 1970s. Such co-ops are quite common: A group of people (in this case about 150 young couples with congressional connections) agrees to baby-sit for one another, obviating the need for cash payments to adolescents. It’s a mutually beneficial arrangement: A couple that already has children around may find that watching another couple’s kids for an evening is not that much of an additional burden, certainly compared with the benefit of receiving the same service some other evening. But there must be a system for making sure each couple does its fair share.

The Capitol Hill co-op adopted one fairly natural solution. It issued scrip–pieces of paper equivalent to one hour of baby-sitting time. Baby sitters would receive the appropriate number of coupons directly from the baby sittees. This made the system self-enforcing: Over time, each couple would automatically do as much baby-sitting as it received in return. As long as the people were reliable–and these young professionals certainly were–what could go wrong?

Well, it turned out that there was a small technical problem. Think about the coupon holdings of a typical couple. During periods when it had few occasions to go out, a couple would probably try to build up a reserve–then run that reserve down when the occasions arose. There would be an averaging out of these demands. One couple would be going out when another was staying at home. But since many couples would be holding reserves of coupons at any given time, the co-op needed to have a fairly large amount of scrip in circulation.

Now what happened in the Sweeneys’ co-op was that, for complicated reasons involving the collection and use of dues (paid in scrip), the number of coupons in circulation became quite low. As a result, most couples were anxious to add to their reserves by baby-sitting, reluctant to run them down by going out. But one couple’s decision to go out was another’s chance to baby-sit; so it became difficult to earn coupons. Knowing this, couples became even more reluctant to use their reserves except on special occasions, reducing baby-sitting opportunities still further.

In short, the co-op had fallen into a recession.

Since most of the co-op’s members were lawyers, it was difficult to convince them the problem was monetary. They tried to legislate recovery–passing a rule requiring each couple to go out at least twice a month. But eventually the economists prevailed. More coupons were issued, couples became more willing to go out, opportunities to baby-sit multiplied, and everyone was happy. Eventually, of course, the co-op issued too much scrip, leading to different problems …

If you think this is a silly story, a waste of your time, shame on you. What the Capitol Hill Baby-Sitting Co-op experienced was a real recession. Its story tells you more about what economic slumps are and why they happen than you will get from reading 500 pages of William Greider and a year’s worth of Wall Street Journal editorials. And if you are willing to really wrap your mind around the co-op’s story, to play with it and draw out its implications, it will change the way you think about the world.

Continue reading here. And read Krugman’s IAmA here.

 

What have we learned in the last five years that should be imparted upon future generations of economists?

Throw Out the Probability Models by Nassim Taleb

After the events that started in 2007 and the subsequent reactions by economists, anyone who takes the current economics establishment seriously needs to spend time in a sanatorium.

This does not mean we should write off the entire body of knowledge. By now, we can see what works and what does not work. Simply, a certain class of consequential rare events, what I’ve called “black swans,” are not predictable and their probabilities unmeasurable, so anything that relies on a computation of the probability of these events should go out of the window. Now. Such models induce fragilities and bring harm. We’re better off with no model than with a defective model, something people understand intuitively, but they tend to forget when they don’t have “skin in the game.” If you are a passenger on a plane and the pilot tells you he has a faulty map, you get off the plane; you don’t stay and say “well, there is nothing better.” But in economics, particularly finance, they keep teaching these models on grounds that “there is nothing better,” causing harmful risk-taking. Why? Because the professors don’t bear the harm of the models.

The good news is that those models that miss rare events also break down when one introduces a higher layer of uncertainty into them, called “parameter uncertainty”. This gives us a fault detection mechanism. What goes out of the window? The entire discipline of modern finance and portfolio theory (the theories named after Harry Markowitz, William Sharpe, Merton Miller), the model-based methods of Paul Samuelson, much of time series econometrics (which don’t appear to predict anything), along with papers and theories that are based on “optimization.” These bring fragility into the system. So, simply, we would have great jumps in knowledge if we avoided teaching these models, and replaced them with anything, even gardening classes.

But the broad principles of economics survive such expurgation. We should just ignore much of what has happened in the past half-century of trying to be too sophisticated with quantitative and probability-based models, ending up in dangerous pseudo-science.

Continue reading what other debaters have to say at the New York Times.

Do Newspapers Matter?

The study of economics has always had a strong preference for theory rather than experimentation. New theories that gain wide acceptable are internally consistent with other theories, even if empirical evidence shows otherwise. Contrast this with the study of psychology, where experiments under laboratory conditions are widespread. Economics, on the other hand, often deal with social issues of such scale that experimentation is impossible — it is often not feasible to change one element of a highly complex system and observe the results.

Every once in a while a natural experiment presents itself, however. Sam Schulhofer-Wohl and Miguel Garrido of Princeton University study the impact of the closing of a newspaper on the level of civil and political engagement among readers in a working paper titled, “Do Newspapers Matter?”. Often times, a newspaper closes due to declines in readership, but in this case, the closing of the newspaper was contractually agreed upon thirty years in the past.This allows the researchers to examine the impact of the closing of the newspaper without the impact of other factors that normally accompany the closing of a newspaper. In other words, it’s a natural experiment — something that normally would only be possible in a laboratory setting happens to manifest itself in real life.

Schulhofer-Wohl and Garrido state that “a century ago, 689 cities in the United States had competing daily newspapers; at the start of this year, only about 15 did.” One might say that these newspapers have been replaced by something better (the Internet), but Schulhofer-Wohl and Garrido make a compelling argument that the closing of newspapers have a significant negative effect on the level of civic engagement and political awareness of readers:

The logo of the E.W. Scripps Co., printed on the front page of all its newspapers, is a lighthouse. This paper describes what happened when one of Scripps’ lights went out. The Cincinnati Post was a relatively small newspaper, with circulation of only 27,000 when it closed. Nonetheless, its absence appears to have made local elections less competitive along several dimensions: incumbent advantage, voter turnout, campaign spending and the number of candidates for office. We caution that although our preferred point estimates tell a compelling story, the results are statistically imprecise and sometimes sensitive to the treatment of very small municipalities. Further, our results cover only the Kentucky suburbs, because Ohio has not held regular municipal elections since the Post closed, and represent only the short-run consequences of the paper’s closing. Future research could investigate whether political engagement and competition return to their pre-closure level in the long run.

Several other well-known newspapers have closed since the Post (the largest being Scripps’ Rocky Mountain News , circulation 210,000, just this February) and more are in danger. Observers are energetically debating whether these closings matter: Do newspapers play a valuable, irreplaceable role in American democracy? Starr (2009) argues that the newspaper industry’s decline raises practical questions for anyone concerned about the future of American democracy.” On the other hand, after the Rocky closed, U.S. Rep. Jared Polis, Democrat of Colorado, said the paper’s demise was mostly for the better” (Crummy, 2009). Whether our results support Starr’s view or Polis’ depends on how one values competitive elections. But if voter turnout, a broad choice of candidates and accountability for incumbents are important to democracy, we side with those who lament newspapers’ decline.

 

Read the full paper here.

When Will China Overtake The United States?

The Economist presents an interesting way of visualizing data in this graphic:

Economic power is best gauged by looking at absolute size rather than per-person measures. On a few indicators, such as steel consumption, ownership of mobile phones and beer-guzzling (a crucial test of economic superiority), the milestone was reached as long as a decade ago. Several more have been passed since. In 2011 China exported about 30% more than the United States and spent some 40% more on fixed capital investment. China is the world’s biggest manufacturer, and partly as a result it burns around 10% more energy and emits almost 40% more greenhouse gases than America (although its emissions per person are only one-third as big). The Chinese also buy more new cars each year than anybody else.

The chart shows our predictions for when China will overtake America on several other measures. Official figures show that China’s consumer spending is currently only one-fifth of that in America (although that may be understated because of China’s poor statistical coverage of services). Based on relative growth rates over the past five years it will remain smaller until 2023. Retail sales are catching up much faster, and could exceed America’s by 2014. In that same year China also looks set to become the world’s biggest importer—a huge turnaround from 2000, when America’s imports were six times those of China.

I’m a fan of data visualization and I have never quite seen a visualization like this. It seems like the latest estimates indicate China’s GDP overtaking the US’s GDP sooner than I thought. What I didn’t know is that in several other important indicators, the Chinese economy overtook the US long ago.

Having traveled to Shanghai in October 2010 and in October 2011, I have strong anecdotal evidence that the growth is very real and noticeable.

Read the full article at The Economist here.

Have You Ever Tried To Sell A Diamond?

An excellent article from The Atlantic written in 1982:

De Beers proved to be the most successful cartel arrangement in the annals of modern commerce. While other commodities, such as gold, silver, copper, rubber, and grains, fluctuated wildly in response to economic conditions, diamonds have continued, with few exceptions, to advance upward in price every year since the Depression. Indeed, the cartel seemed so superbly in control of prices — and unassailable — that, in the late 1970s, even speculators began buying diamonds as a guard against the vagaries of inflation and recession.

The diamond invention is far more than a monopoly for fixing diamond prices; it is a mechanism for converting tiny crystals of carbon into universally recognized tokens of wealth, power, and romance. To achieve this goal, De Beers had to control demand as well as supply. Both women and men had to be made to perceive diamonds not as marketable precious stones but as an inseparable part of courtship and married life. To stabilize the market, De Beers had to endow these stones with a sentiment that would inhibit the public from ever reselling them. The illusion had to be created that diamonds were forever — “forever” in the sense that they should never be resold.

Read the full article here.

The Financial Modeler’s Manifesto: MODELERS OF ALL MARKETS, UNITE!

Emanuel Derman and Paul Wilmott in response to the financial crisis felt compelled to write a short paper on The Financial Modeler’s Manifesto:

Physics, because of its astonishing success at predicting the future behavior of material objects from their present state, has inspired most financial modeling. Physicists study the world by repeating the same experiments over and over again to discover forces and their almost magical mathematical laws. Galileo dropped balls off the leaning tower, giant teams in Geneva collide protons on protons, over and over again. If a law is proposed and its predictions contradict experiments, it’s back to the drawing board. The method works. The laws of atomic physics are accurate to more than ten decimal places.

It’s a different story with finance and economics, which are concerned with the mental world of monetary value. Financial theory has tried hard to emulate the style and elegance of physics in order to discover its own laws. But markets are made of people, who are influenced by events, by their ephemeral feelings about events and by their expectations of other people’s feelings. The truth is that there are no fundamental laws in finance. And even if there were, there is no way to run repeatable experiments to verify them.

Like all physicians, Derman and Wilmott want all modelers to swear by The Modelers’ Hippocratic Oath:

MODELERS OF ALL MARKETS, UNITE! You have nothing to lose but your illusions.

  • ~ I will remember that I didn’t make the world, and it doesn’t satisfy my equations.
  • ~ Though I will use models boldly to estimate value, I will not be overly impressed by mathematics.
  • ~ I will never sacrifice reality for elegance without explaining why I have done so.
  • ~ Nor will I give the people who use my model false comfort about its accuracy. Instead, I will make explicit its assumptions and oversights.
  • ~ I understand that my work may have enormous effects on society and the economy, many of them beyond my comprehension.

Given Derman’s background as an academic it is not surprising that he advocates an indexing approach in his newest book Models Behaving Badly. The Wall Street Journal provides a short review:

The basic problem, according to Mr. Derman, is that “in physics you’re playing against God, and He doesn’t change His laws very often. In finance, you’re playing against God’s creatures.” And God’s creatures use “their ephemeral opinions” to value assets. Moreover, most financial models “fail to reflect the complex reality of the world around them.”

It is hard to argue with this basic thesis. Nevertheless, Mr. Derman is perhaps a bit too harsh when he describes EMM—the so-called Efficient Market Model. EMM does not, as he claims, imply that prices are always correct and that price always equals value. Prices are always wrong. What EMM says is that we can never be sure if prices are too high or too low.

The Efficient Market Model does not suggest that any particular model of valuation—such as the Capital Asset Pricing Model—fully accounts for risk and uncertainty or that we should rely on it to predict security returns. EMM does not, as Mr. Derman says, “stubbornly assume that all uncertainty about the future is quantifiable.”

The basic lesson of EMM is that it is very difficult—well nigh impossible—to beat the market consistently. This lesson, or “model,” behaves very well when investors follow it. It says that most investors would be better off simply buying a low-cost index fund that holds all the securities in the market rather than using either quantitative models or intuition in an attempt to beat the market. The idea that significant arbitrage opportunities are unlikely to exist (and certainly do not persist) is precisely the mechanism behind the Black-Scholes option-pricing model that Mr. Derman admires as a financial model behaving pretty well.

Read the full paper here. Read a review of Derman’s latest book Models Behaving Badly here. Buy the book off Amazon here.

When Monkeys Use Money

What would happen is, you would bring Felix from the big cage to the little cage down here and you would give him a coin. Felix would take the coin; he would try to sniff it and eat it. When he could see that it’s not edible or that he couldn’t have sex with it, he’d get rid of it. Then what you would have to do is you would give the monkey a coin and offer some food. The monkey would take the food and then you would take the coin out of the monkey’s other hand. It took on average about six months for these seven monkeys to learn that if you give a coin then in exchange you get food — you can buy food.

A Conversation With Nobel Prize-Winning Economist Vernon Smith

Vernon Smith on what experimental economics has to say on the housing market:

Vernon Smith: We’re asking some questions that came out of the economic crisis. We started doing asset-trading experiments in the ’80s and discovered bubbles, quite unintentionally.

reason: In your experiments, you were able to create bubbles, or did they just pop up?

Smith: They popped up. We thought we would create bubbles, but we never had to.

reason: How does a bubble take place?

Smith: Right now, we don’t understand why people get caught up in self-reinforcing expectations of rising prices. The first time you’re in this experiment, you may have bought early and you may have sold before the break. Bring those same people back in another two or three days, put them in the same environment, and we get a lower-volume bubble. Typically, it booms earlier and crashes earlier; they are expecting a bubble. Bring them back a third time, and they tend to trade fairly close to fundamental value.

reason: How does this type of experiment map onto, say, the last five years in America?

Smith: If you think about the housing bubble, buyers, sellers, borrowers, lenders, real estate agents, government regulators—everybody believed that prices would rise and continue to rise. And that is the essence of a bubble. Suppose a regulator in 2003 or 2004 said, “Hey, this thing is not sustainable. We’ve got to do something to stop it.” I think he’d have been fired. If the bubble had been stopped in 2003 or 2004, it probably would have been a lot less damaging. But who’s going to know that?

On the Federal Reserve’s response to the financial crisis:

Smith: It’s really interesting to look at the Federal Open Market Committee press releases in 2007. On August 7, 2007, the press release said the housing market is going through an adjustment; we’re still concerned about inflation. Three days later, because of the collapse in the credit default market, that completely changed. The Federal Reserve, Bernanke realized they had a financial crisis on their hands. That’s how quickly it happened, and the signal came from a market. It did not come from the econometric models. I think to Bernanke’s credit that he changed. He turned on a dime. How many times had he said it was not the business of the Federal Reserve to rescue investors from the consequences of their own decisions? That’s exactly what he ended up doing. I don’t believe he wanted to do it. I think he meant the earlier statements, but he had no choice.

reason: If we hadn’t bailed out the banks, if we hadn’t passed TARP, the economy would have ceased to exist?

Smith: I think the more important thing is what the Federal Reserve did, not the Treasury program. You can always go back and say, well things should have been done earlier to prevent that from happening. Yes, yes, I agree. But the point is, what do you do in that case? Here it is, in spite of whatever mistakes had been made before. And Bernanke is testing the Friedman-Schwartz hypothesis right now—that if the Fed had acted and flooded the system with liquidity in the early ’30s, that we’d have prevented the Great Depression.

On economics as a profession:

reason: Economists enjoy a possibly unprecedented kind of cultural power now. They can write best-selling books. They can run the world economy. Where does economics as a serious discipline need to be moving next?

Smith: To me, the major problem in economic theory is the preoccupation with modeling for its own sake and not asking the fundamental questions. These fundamental questions have to do with dynamics; they have to do with property rights. Basic questions like: “How can it be that specialization, exchange, and property rights came about?” You can’t have one without the other. We think today of property rights as something that comes from the state. That couldn’t possibly be how they originated. Our small-group experiments are trust games. Imagine a trust game in which I’m a first mover and you’re the second mover. I move first. I can choose $10 for each of us, or I can pass to you. If I pass to you, the $20 becomes $40. You can give me 15 and keep 25, or you can give me nothing and get the whole 40. Game theory says I should never pass to you, because if you’re self-interested, you’ll take the 40. But what’s remarkable is half the people we recruit in the undergraduate lab—half of the first movers [pass] to the second. And two-thirds to three-quarters reciprocate with 15/25—they don’t take the total. You can’t understand that with game theory. You can understand it by reading The Theory of Moral Sentiments.

Read the full interview here.

Fed’s Response To Bloomberg’s Allegations Of Secret Loans To Banks

Ben Bernanke on Bloomberg’s recent allegations of secret loans to banks:

Fifth, the articles misleadingly depict financial institutions receiving liquidity assistance as insolvent and in “deep trouble.” During a financial panic, otherwise solvent banks and other financial institutions can be forced to sell assets at fire-sale prices in order to meet the demands of depositors and other sources of funding. Central bank liquidity lending is designed to stem the panic by giving financial institutions a source of financing that permits them to refrain from selling assets during the panic. Again, unmentioned in these articles — but a central point — all discount window loans extended during the crisis were fully repaid with interest, indicating that, with rare exceptions, recipients of these loans generally suffered from temporary liquidity problems rather than being fundamentally insolvent. In the handful of instances when discount window loans were extended to troubled institutions, it was in consultation with the Federal Deposit Insurance Corporate to facilitate a least-cost resolution; in these instances also, the Federal Reserve was fully repaid.

Read the full letter here. Read Bloomberg’s original article here.

The Rise and Fall of Bitcoin

Good summary of the history of Bitcoin so far on Wired:

One of the core challenges of designing a digital currency involves something called the double-spending problem. If a digital dollar is just information, free from the corporeal strictures of paper and metal, what’s to prevent people from copying and pasting it as easily as a chunk of text, “spending” it as many times as they want? The conventional answer involved using a central clearinghouse to keep a real-time ledger of all transactions—ensuring that, if someone spends his last digital dollar, he can’t then spend it again. The ledger prevents fraud, but it also requires a trusted third party to administer it.

Bitcoin did away with the third party by publicly distributing the ledger, what Nakamoto called the “block chain.” Users willing to devote CPU power to running a special piece of software would be called miners and would form a network to maintain the block chain collectively. In the process, they would also generate new currency. Transactions would be broadcast to the network, and computers running the software would compete to solve irreversible cryptographic puzzles that contain data from several transactions. The first miner to solve each puzzle would be awarded 50 new bitcoins, and the associated block of transactions would be added to the chain. The difficulty of each puzzle would increase as the number of miners increased, which would keep production to one block of transactions roughly every 10 minutes. In addition, the size of each block bounty would halve every 210,000 blocks—first from 50 bitcoins to 25, then from 25 to 12.5, and so on. Around the year 2140, the currency would reach its preordained limit of 21 million bitcoins.

When Nakamoto’s paper came out in 2008, trust in the ability of governments and banks to manage the economy and the money supply was at its nadir. The US government was throwing dollars at Wall Street and the Detroit car companies. The Federal Reserve was introducing “quantitative easing,” essentially printing money in order to stimulate the economy. The price of gold was rising. Bitcoin required no faith in the politicians or financiers who had wrecked the economy—just in Nakamoto’s elegant algorithms. Not only did bitcoin’s public ledger seem to protect against fraud, but the predetermined release of the digital currency kept the bitcoin money supply growing at a predictable rate, immune to printing-press-happy central bankers and Weimar Republic-style hyperinflation.

Read the full article here. Paul Krugman has an interesting criticism here:

But does that make the experiment a success? Um, no. What we want from a monetary system isn’t to make people holding money rich; we want it to facilitate transactions and make the economy as a whole rich. And that’s not at all what is happening in Bitcoin.

Bear in mind that dollar prices have been relatively stable over the past few years – yes, some deflation in 2008-2009, then some inflation as commodity prices rebounded, but overall consumer prices are only slightly higher than they were three years ago. What that means is that if you measure prices in Bitcoins, they have plunged; the Bitcoin economy has in effect experienced massive deflation.