Archive for the Category Cognitive illusions

 
 

If something can’t go on forever . . . it will

Occasionally I do post inverting Ben Herbert Stein’s famous observation:

If something can’t go on forever, it won’t.

Some of my commenters say things that are clearly not true, such as the claim that NGDP cannot keep growing at 5% forever.  Yet even economists can make those sorts of claims, as when they argue that Australia can’t keep running 4% of GDP current account deficits forever.  (I heard that when I lived there in 1991, and yes it can.)  Here’s an old FT article by Willem Buiter from January 2009, which is worth re-reading to get a sense of how even very smart people can misjudge which trends are unsustainable:

Some of the excess returns on US investment abroad relative to foreign investment in the US may have reflected true alpha, that is, true US alpha – excess risk-adjusted returns on investment in the US, permitting the US to offer lower financial pecuniary risk-adjusted rates of return, because, somehow, the US offered foreign investors unique liquidity, security and safety.  Because of its unique position as the world’s largest economy, the world’s one remaining military and political superpower (since the demise of the Soviet Union in 1991) and the world’s joint-leading financial centre (with the City of London), the US could offer foreign investors lousy US returns on their investments in the US, without causing them to take their money and run.  This is the “dark matter” explanation proposed by Hausmann and Sturzenegger for the “alpha” earned by the US on its (negative) net foreign investment position. If such was the case (a doubtful proposition at best, in my view), that time is definitely gone.  The past eight years of imperial overstretch, hubris and domestic and international abuse of power on the part of the Bush administration has left the US materially weakened financially, economically, politically and morally.  Even the most hard-nosed, Guantanamo-bay-indifferent potential foreign investor in the US must recognise that its financial system has collapsed.  Key wholesale markets are frozen; the internationally active part of its financial system has either been nationalised or underwritten and guaranteed by the Federal government in other ways. Most market-mediated financial intermediation has ground to a halt, and the Fed is desperately trying to replace private markets and financial institutions to intermediate between households and non-financial operations.  The problem is not confined to commercial banks, investment banks and universal banks.  It extends to insurance companies (AIG), Quangos (a British term meaning Quasi-Autonomous Government Organisations) like Fannie Mae and Freddie Mac, amorphous entities like GEC and GMac and many others.

The legal framework for the regulation of financial markets and institutions is a complete shambles.  Even given the dismal state of the legal framework, the actual performance of key regulators like the Fed and the SEC has been appalling, with astonishing examples of incompetence and regulatory capture.

There is no chance that a nation as reputationally scarred and maimed as the US is today could extract any true “alpha” from foreign investors for the next 25 years or so. So the US will have to start to pay a normal market price for the net resources it borrows from abroad. It will therefore have to start to generate primary surpluses, on average, for the indefinite future.  A nation with credibility as regards its commitment to meeting its obligations could afford to delay the onset of the period of pain.  It could borrow more from abroad today, because foreign creditors and investors are confident that, in due course, the country would be willing and able to generate the (correspondingly larger) future primary external surpluses required to service its external obligations.  I don’t believe the US has either the external credibility or the goodwill capital any longer to ask, Oliver Twist-like, for a little more leeway, a little more latitude.  I believe that markets – both the private players and the large public players managing the foreign exchange reserves of the PRC, Hong Kong, Taiwan, Singapore, the Gulf states, Japan and other nations – will make this clear.

There will, before long (my best guess is between two and five years from now) be a global dumping of US dollar assets, including US government assets.

Maybe eventually, but don’t hold your breath.

Hmmm, I wonder if it’s time again for one of my “Apocalypse Later” posts on how another year went by without the expected collapse of the Chinese economy.  I’ll take China’s 7% RGDP growth with all its “imbalances” over Brazil’s 0% growth.

PS.  There are lessons in Buiter’s erroneous forecast.  He lets emotion get in the way of cold hard logic.  I can see how people believed that after all its economic/foreign policy screw-ups the US deserved to get its comeuppance.  But life is not fair.

What if Wittgenstein had been a macroeconomist?

The commenter Jason sent me a great Wittgenstein quotation, and I immediately knew I had to use it somewhere.  It took me 10 seconds to decide where:

“Tell me,” the great twentieth-century philosopher Ludwig Wittgenstein once asked a friend, “why do people always say it was natural for man to assume that the sun went around the Earth rather than that the Earth was rotating?” His friend replied, “Well, obviously because it just looks as though the Sun is going around the Earth.” Wittgenstein responded, “Well, what would it have looked like if it had looked as though the Earth was rotating?”

It’s quotations like this that make life worth living.  So I wondered what Wittgenstein would have thought of the current crisis:

Wittgenstein:  Tell me, why do people always say it’s natural to assume the Great Recession was caused by the financial crisis of 2008?

Friend:  Well, obviously because it looks as though the Great Recession was caused by the financial crisis of 2008.

Wittgenstein:  Well, what would it have looked like if it had been caused by Fed policy errors, which allowed nominal GDP to fall at the sharpest rate since 1938, especially during a time when banks were already stressed by the subprime fiasco, and when the resources for repaying nominal debts come from nominal income?

OK, not nearly as elegant as Wittgenstein’s example.  But you get the point.

Jason also wonders what future generations will think of the Keynesian/monetarist split.  Which model will seem like the Ptolemaic system?  I won’t answer that, but will take a stab at a related question.  The Great Depression was originally thought to be due to the inherent instability of capitalism.  Later Friedman and Schwartz blamed it on a big drop in M2.  Their view is now more popular, because it has more appealing policy implications.  It’s a lot easier to prevent M2 from falling, than to repair the inherent instability of capitalism.  Where there are simple policy implications, a failure to do those policies eventually becomes seen as the “cause” of the problem, even if at a deeper philosophical level “cause” is one of those slippery terms that can never be pinned down.

In 50 years (when we are targeting NGDP futures contracts) the Great Recession will be seen as being caused by the Fed’s failure to prevent NGDP from falling.  Not through futures contracts (which didn’t exist then) but through a failure to engage in the sort of “level targeting” that Bernanke recommended the Japanese try during their similar travails.

PS.  W. Peden thinks the quotation is apocryphal, and notes that it’s used in Tom Stoppard’s play “Jumper.”  For some reason I prefer it be Wittgenstein.

Tyler Cowen, Richard Rorty, and the truth about wealth

In several recent posts Tyler Cowen has tried to draw a distinction between how much wealth we believed we had, and how much wealth we really had.  I was somewhat skeptical of his argument, but also thought it had some merit.  Indeed in an earlier post (not posted yet!) I tried to distinguish between wealth we correctly thought we had, which was later lost due to bad policy (1929), and wealth we thought we had, that we never really had (2006.)  Now I have doubts about my argument, indeed I think we might both be wrong.  But I’m not sure.

Consider the following 5 scenarios:

1.  The bank makes a typo, which leads you to believe you have more money than you actually have.  The typo is eventually corrected.

2.  Your family believes it owns 10 1933 $20 gold pieces, worth $80 million.  Later you find out the government has a different view.

3.  The public believes it has lots of housing wealth in 2006, but there was never any prospect that these values could be maintained.

4.  The public believes it has lots of housing wealth in 2006, but later an immigration crackdown followed by tight money reduces housing prices.

5.  The public believes it is very wealthy in 1929, but later the Fed cuts NGDP in half and caused mass unemployment.

A few days ago I thought there was a clear distinction between case 1 and case 5.  Now I don’t know where to draw the line.  Indeed I don’t know if there is a line to be drawn.

I’d like to say the public really was wealthy in 1929, and that later decisions by the Fed destroyed that wealth.  But is that a scientific way of looking at things?  At levels about subatomic particles, we tend to assume that things follow deterministic laws.  Why couldn’t someone argue:  “That national wealth in 1929 was never real, because the Fed is a part of our economy.  It was a dysfunctional institution in 1929, so it was only a matter of time before they screwed up.  We just didn’t know it yet.”

Rorty argued that when people say “Most people think X is true, but I believe Y is true,” they actually mean “most people think X is true, but I predict that in the future people will come to believe Y is true.”  Rorty saw no distinction between what is true, and what we believe is true.

Rorty also believed; “That which has no practical implications, has no philosophical implications.”  So what are the practical implications of the distinction between believing one is wealthy, and actually being wealthy?  Obviously society acts on the basis of beliefs.  So for most people it is a distinction without any significance.  Like the difference between saying I believe X, and I believe X is true.   On the other hand the skeptic who believes the wealth is phony (i.e. predicts it will later be seen as phony), would obviously see practical implications for his belief.  Indeed policy implications.

Imagine I’m debating Tyler Cowen on the question of whether the 2006 wealth was real in 2006.  What’s at stake?  I might argue that the wealth was 100% real, but later policies like immigration crackdown and tight money reduced the wealth later on.  The practical implication is that we might want to reconsider those policies.  Or, one could argue that the extra wealth was only 40% real and the other 60% was irrational exuberance.  In that case the policy implication might shift slightly.  It doesn’t mean easier money couldn’t have helped a bit, but you’d also want to put in place banking regulations robust enough to prevent housing bubbles from damaging the banking system.  Indeed you might also want to do that if the problem was 100% the Fed’s fault, but the necessity would be greater if optimal monetary policy couldn’t solve the problem.

Are we rich if we believe we are rich?  I can’t answer that question.  Rorty would say beliefs are all we have.  Yet he also allows for dissenting voices.  Just because most people get swept up in the housing bubble, and believe ranch houses in San Bernardino are worth $500,000, doesn’t mean Shiller, Krugman, Baker and Roubini have to believe that.  One the other hand, current market values have a very practical implication, they’re what we can sell things for.  In that sense they are real.

Each day that goes by we find out that the previous day’s value of the S&P 500 was wrong, as new information comes in.  Or maybe it was right; maybe it was “true,” based on what we knew at the time.  What’s the TRUE value of the S&P 500?  God only knows.

PS.  I just noticed an interesting shift in wording between the first and second posts that I linked to above.  First post:

We were not as wealthy as we thought we were.

And second post:

We are not as wealthy as we thought we were

See the difference?  If applied to someone in 1933 talking about 1929, I’d have once said the first was false, and the second was true.  Now I don’t know what to think.  I wish Rorty was still alive to help me out.  Now I feel alone in the universe, with no one to provide true answers.

PS.  The second Cowen post that I linked to above didn’t make sense to me.  I left a comment over there—maybe someone can explain the connection to AD.

Another nail in the anti-EMH coffin

I generally don’t argue that the efficient markets hypothesis is true, rather I argue it is useful, and that anti-EMH theories are not useful.  I should say that I just focus on those anti-EMH theories that assert one can spot bubbles in real time, which imply one can predict markets (to some extent) over a longer period of time.  (Researchers like Rajiv Sethi analyze market inefficiency that doesn’t imply prediction.)

One famous argument against the “markets are predictable” anti-EMH view is that mutual funds that do well one year tend to do about average the next, indicating that it was more a question of luck then skill.  A popular retort is that the smart money isn’t managing mutual funds, which are an investment for suckers.  I don’t agree with this view, as successful stock picker Peter Lynch was highly beneficial to Fidelity Investments.  Mutual funds have an incentive to forecast well.   But let’s say I’m wrong.

A recent Boston Globe article sent to me by Miguel Barredo suggests that bubble forecasting success by economists is also pure luck:

That economist was New York University’s Nouriel Roubini. And since he called the Great Recession, he has become about as close to a household name as an economist can be without writing “Freakonomics” or being Paul Krugman. He’s been called a seer, been brought in to counsel heads of state and titans of industry “” the one guy who connected the dots while the rest of us were blithely taking out third mortgages and buying investment properties in Phoenix. He’s a sought-after source for journalists, a guest on talk shows, and has even acquired a nickname, Dr. Doom. With the effects of the Great Recession still being keenly felt, Roubini is everywhere.

But here’s another thing about him: For a prophet, he’s wrong an awful lot of the time. In October 2008, he predicted that hundreds of hedge funds were on the verge of failure and that the government would have to close the markets for a week or two in the coming days to cope with the shock. That didn’t happen. In January 2009, he predicted that oil prices would stay below $40 for all of 2009, arguing that car companies should rev up production of gas-guzzling SUVs. By the end of the year, oil was a hair under $80, Hummer was on its way out, and automakers were tripping over themselves to develop electric cars. In March 2009, he predicted the S&P 500 would fall below 600 that year. It closed at over 1,115, up 23.5 percent year over year, the biggest single year gain since 2003.  . . .

But are such people really better at predicting the future than anyone else? In October of last year, Oxford economist Jerker Denrell cut directly to the heart of this question. Working with Christina Fang of New York University, Denrell dug through the data from The Wall Street Journal’s Survey of Economic Forecasts, an effort conducted every six months, in which roughly 50 economists are asked to make macroeconomic predictions about gross national product, unemployment, inflation, and so on. They wanted to see if the economists who successfully called the most unexpected events, like our Dr. Doom, had better records over the long term than those who didn’t.

To find the answer, Denrell and Fang took predictions from July 2002 to July 2005, and calculated which economists had the best record of correctly predicting “extreme” outcomes, defined for the study as either 20 percent higher or 20 percent lower than the average prediction. They compared those to figures on the economists’ overall accuracy. What they found was striking. Economists who had a better record at calling extreme events had a worse record in general. “The analyst with the largest number as well as the highest proportion of accurate and extreme forecasts,” they wrote, “had, by far, the worst forecasting record.” . . .

Their work is the latest in a long line of research dismantling the notion that predictions are really worth anything. The most notable work in the field is “Expert Political Judgment” by Philip Tetlock of the University of Pennsylvania. Tetlock analyzed more than 80,000 political predictions ventured by supposed experts over two decades to see how well they fared as a group. The answer: badly. The experts did about as well as chance. And the more in-demand the expert, the bolder, and thus the less accurate, the predictions. Research by a handful of others, Denrell included, suggests the same goes for economic forecasters. An accurate prediction “” of an extreme event or even a series of nonextreme ones “” can beget overconfidence, which can lead to making bolder and bolder bets, and thus, more and more errors.

So it has gone with Roubini. That one big call about the Great Recession gave him an unrivaled platform from which to issue ever more predictions, and a grand job title to match his prominence, but his subsequent predictions suggest that his foresight may be no better than your average man on the street. The curious nature of his fame calls to mind two of economist Edgar Fiedler’s wry rules for economic forecasters: “If you must forecast, forecast often,” he wrote. And: “If you’re ever right, never let ’em forget it.”

There’s no great, complex explanation for why people who get one big thing right get most everything else wrong, argues Denrell. It’s simple: Those who correctly predict extreme events tend to have a greater tendency to make extreme predictions; and those who make extreme predictions tend to spend most of the time being wrong “” on account of most of their predictions being, well, pretty extreme. There are few occurrences so out of the ordinary that someone, somewhere won’t have seen them coming, even if that person has seldom been right about anything else.

But that leads to a more disconcerting question: If this is true, why do we put so much stock in expert forecasters? In a saner world than ours, those who listen to forecasters would take into account all their incorrect predictions before making a judgment. But real life doesn’t work that way. The reason is known in lab parlance as “base rate neglect.” And what it means, essentially, is that when we try to predict what’s next, or determine whether to believe a prediction, we often rely too heavily on information close at hand (a recent correct prediction, a new piece of data, a hunch) and ignore the “base rate” (the overall percentage of blown calls and failures).

And success, as Denrell revealed in an earlier study, is an especially bad teacher. In 2003 he published a paper arguing that when people study success stories exclusively “” as many avid devourers of business self-help books do “” they come away with a vastly oversimplified idea of what it takes to succeed. This is because success is what economists refer to as a “noisy signal.” It’s chancy, fickle, and composed of so many moving parts that any one is basically meaningless in the context of the real world. By studying what successful ventures have in common (persistence, for instance), people miss the invaluable lessons contained in the far more common experience of failure. They ignore the high likelihood that a company will flop “” the base rate “” and wind up wildly overestimating the chances of success.

To look at Denrell’s work is to realize the extent to which our judgment can be warped by our bias toward success, even when failure is statistically the default setting for human endeavor. We want to believe success is more probable than it is, that it’s the result of a process we can wrap our heads around. That’s why we’re drawn to prophets, especially the ones who get one big thing right. We want to believe that someone, somewhere can foresee surprising and disruptive change. It means that there is a method to the madness of not just business, but human existence, and that it’s perceptible if you look at it from the right angle. It’s why we take lucky rabbits’ feet into casinos instead of putting our money in a CD, why we quit steady jobs to start risky small businesses. On paper, these too may indeed resemble sucker bets placed by people with bad judgment. But cast in a certain light, they begin to look a lot like hope.

Yep.

Who are the famous bubble deniers?

More and more I think that the entire bubble/anti-EMH approach to economics is founded on nothing more than superstition.  Superstitions are caused by cognitive illusions; we think we notice more patterns than are actually there.  You dream your son got in a traffic accident, and the next day it happens.  You forget the other 10,000 dreams that didn’t predict the future.

In economics people notice bubbles bursting, but fail to pay much attention to bubbles not bursting.  But I admit I might be wrong, so I’ll give my opponents one more chance.  If it’s not really a cognitive illusion, then bubble deniers who are right ought to be just as famous as bubble predictors who are right.  Indeed as we will see they should be even more famous.

People who actually understand finance know that if the term “bubble” is to mean anything useful, it must contain an implied prediction of the future course of asset prices.  Not a precise prediction (everyone knows that would be impossible) but at least a better than a 50/50 prediction.  If someone said in 2005 that housing prices were a bubble, but still was unable to offer more than a 50/50 odds on whether real housing prices would rise or fall over the next 5 or 10 or 20 years, then what would their assertion actually mean?  Asset prices are very volatile; we know that at some point all markets will go down.  When I read predictions from people like Paul Krugman, I infer that there is an implied prediction that real prices will fall over some reasonable period of time—say 5 years.

And of course Krugman was right in predicting that real US housing prices would fall in the 5 years after 2005, as was Dean Baker, Nouriel Roubini, and some others who became well known and lauded for their predictions.

At the same time we also know that bubble-like patterns don’t always yield reliable predictions of future trends.  The Australian housing market looked just as bubbly as the US market in 2005, but since then has soared much higher.  Some day it will fall, but the 2005 prices no longer look excessive.

If people like Robert Shiller (another person who became famous from bubble predictions) are right about asset prices being too volatile, then it should be true that US-type cases are more common than the Australian case.  I don’t think that’s true— in most developed countries real housing prices have risen since 2005, despite real upswings before 2005.  But let’s say I’m wrong and Shiller’s right.  Then the easy prediction to make is that prices will fall after a big upswing.  The much harder prediction is that prices will keep rising, even from inflated levels.  Those cases would be much rarer, and those who correctly call them when they occur (as in the Australian housing case) should be lauded as great heros of the investment world.

So who are they?

If they don’t exist, I have a theory why.  Most people are convinced bubbles exist, regardless of the data.  Hence if the prediction doesn’t pan out, then the market was in some sense “wrong.”  Traders haven’t yet woken up to the stupidity of their behavior.  When they do, prices will crash and the bubble proponents will be proven right in the long run.  So most people would implicitly think; “Why praise someone for being right for the wrong reason?”  Of course this makes bubble theory into a near tautology, irrefutable in volatile asset markets that will almost always eventually show price decreases.

Perhaps I am wrong and there are lots of famous bubble deniers out there.  But if not, that would in my mind be the last nail in the anti-EMH coffin, pretty much confirming that people are seeing what they expect to see, indeed given the satisfaction we get from seeing the high and mighty brought low, perhaps what they want to see.

One final point; I also have noticed that lots of people are given credit for bubble predictions that were wrong.  John Kenneth Galbraith saying stocks were a bubble in January 1987.  Robert Shiller saying stocks were a bubble in 1996.  Dean Baker saying US housing was a bubble in 2002.  The Economist magazine touting its successful housing bubble predictions of 2003 in an ad, despite the predictions being incorrect for most of the countries listed.  That’s how strongly we want to believe in bubble predictions—we even assume that people who were wrong, were actually right.

PS.  For those interested in global housing prices, The Economist has a great interactive graph.  It helps to show the pattern from say 2000:1 to 2005:1, and then from 2005:1 to the present.  In the earlier period almost all countries showed gains in housing prices, even in real terms.  The two notable exceptions were Germany and Japan, where prices fell sharply.  If I was to use a Shiller-style model that predicts asset prices will self-correct after excessive swings, I would have predicted most housing markets to slump after 2005:1, but Germany and Japan to rise.  Instead almost the opposite happened.  Germany and Japan continued to do very poorly, while almost all other markets rose in nominal terms, and most rose even in real terms.

The two nominal decliners (in addition to Germany and Japan) were the US and Ireland—which is why people assume they had had a bubble.  But why didn’t all the other bubbles collapse?  Perhaps because asset prices are not as easily forecasted as most people naively assume.

BTW, if you can’t get a 2000:1 starting date, then white out all the country boxes and start over.  That worked for me.