In a recent post I pointed to a weird asymmetry.  Even though bubble theory proponents think that prices are more likely to fall after a large run-up, those who correctly predict that prices will go even higher seem less famous (at least in America) than those who correctly predict the bubble will burst (which is allegedly the easier market call.)  I suggested this is just a part of the general problem of cognitive bias, which leads people to see patterns where there is actually nothing more than randomness.

In the comment section of a recent Tyler Cowen post, Rajiv Sethi made the following observation:

Let me repeat that I admire Scott Sumner, the coherence of his vision, and his general approach to blogging (as laid out in his amazing birthday post). But I think that his faith in market efficiency is misplaced and his glib dismissal of those who take bubbles and crashes seriously (we suffer cognitive illusions) baffling.

On a certain level I agree with Sethi (who is a very smart guy.)  There’s nothing people like less than for someone to respond to their argument by calling them irrational, or suggesting they have bad motives.  But this also raises an interesting problem for the bubble theorists.  Unless I’m mistaken, most anti-bubble theories assume some sort of irrationality among market traders, or dare I say, cognitive illusions.  (Which is supposedly “proven” by economic experiments which in fact do nothing of the sort.)  I’m not sure Sethi was actually complaining about my cognitive illusions comment, although I got that impression.  But if so, is it really any different from what the bubble theorists assume about asset market participants?

I need to constantly repeat a very important point; I’m not arguing the EMH is true.  I’m arguing the EMH is useful and that anti-EMH models are not useful.  The reason I don’t think the EMH is true is because I believe market participants do have cognitive illusions.  And the reason I don’t think the anti-EMH theory is useful is because I think academics and policymakers are equally susceptible to cognitive illusions.

Paul Einzig made the same basic argument back in 1937:

“On June 9, 1937, this veteran monetary expert [Cassel] published a blood-curdling article in the Daily Mail painting in the darkest colours the situation caused by the superabundance of gold and suggesting a cut in the price of gold to half-way between its present price and its old price as the only possible remedy.  He took President Roosevelt sharply to task for having failed to foresee in January 1934 that the devaluation of the dollar by 41 per cent would lead to such a superabundance of gold.  If, however, we look at Professor Cassel’s earlier writings, we find that he himself failed to foresee such developments, even at much later dates.  We read in the July 1936 issue of the Quarterly Review of the Skandinaviska Kreditaktiebolaget the following remarks by Professor Cassel:  ‘There seems to be a general idea that the recent rise in the output of gold has been on such a scale that we are now on the way towards a period of immense abundance of gold. This view can scarcely be correct.’ . . . Thus the learned Professor expected a mere politician to foresee something in January 1934 which he himself was incapable of foreseeing two and a half years later.  In fact, it is doubtful whether he would have been capable of foreseeing it at all but for the advent of the gold scare, which, rightly or wrongly, made him see things he had not seen before.  It was not the discovery of any new facts, nor even the weight of new scientific argument that converted him and his fellow-economists.  It was the subconscious influence of the panic among gold hoarders, speculators, and other sub-men that suddenly opened the eyes of these supermen. This fact must have contributed in no slight degree towards lowering the prestige of economists and of economic science in the eyes of the lay public.” (1937, pp. 26-27.)

Sub-men and supermen.  Hmmm . . . I wonder into which group Paul Krugman would place himself?

Now let’s see if we can draw a broader set of conclusions from this pattern, these asymmetries.  We’ve seen bubble predictors are treated differently from bubble deniers, and in the previous post we saw that conservatives were gung ho about focusing on commodity prices, except when commodity prices showed a desperate need for much easier money.  Can we find a third example?

How often have you heard people remark that high gasoline prices are caused by the machinations of oil market speculators?  But we know that the net demand for oil by speculators averages out to roughly zero in the long run.  This means that for every period where speculators are raising prices, there is another period where they are reducing prices.  But how often in general conversation do you hear people say:

Hmmm, gas is really cheap right now, I wonder if speculators are depressing the price?

Because I’m a mind reader, I can answer the question for you.  Zero times.  And it’s not just because people prefer to talk about bad news, they don’t even think speculators depress oil prices.

The world is full of this sort of asymmetrical thinking.  And it’s almost always a sign of sloppy thinking, of cognitive illusions.  And it often leads to bad public policy.

PS.  This isn’t an exact analogy, but notice that narcotics and sex transactions are usually considered bad if money is involved.  But in most societies the selling of sex and drugs is considered far worse than the buying of sex and drugs, even though each participant has an equal role in the transaction.  A sign of bad public policy?

PPS:  Five minutes after posting this I came across another example. We think that people who make lots of money are evil villians, whereas people who lose lots of money are innocent victims.  Consider the following:

Earlier that year, Picard claimed in court filings that Picower was a key beneficiary of Madoff’s scheme. The trustee said Picower had withdrawn $7.8 billion from Madoff’s firm since the 1970s, even though he only deposited $619 million. Picower “knew or should have known that [he] was profiting from fraud, because of the highly implausible high rates of return” on his accounts, the trustee said.

Right after the Madoff scandal broke all the brain-dead critics of laissez-faire said “see, this shows that unregulated capitalism doesn’t work.”  Eventually people pointed out that we don’t have unregulated capitalism, the SEC is supposed to prevent these sorts of abuses.  Even worse, someone told the SEC about the Madoff fraud, and even pointed to absurdly high and persistent rates of return that anyone with half a brain knew were impossible.  Or anyone who believes in the EMH knew were impossible.  But apparently the SEC is one of those groups that doesn’t find the EMH to be “useful.”  So they ignored the whistle-blower.  Now when we find someone who actually made off with lots of money from Madoff (pun intended) we react in horror.  Surely that rich bastard knew he couldn’t be earning that money legitimately!

That’s right, the supposedly expert SEC is given a pass in not responding to these high returns, as people keep insisting this shows we need still more regulation.  But the person that benefited, who like all humans would just love to think his success was well earned, that it resulted from his investment acumen, is somehow obviously guilty.

I give up.

My favorite piece of furniture is an elegant rosewood desk that was custom made in Denmark.  Like most of my possessions, I bought it out of someone’s house.  This was back before Craigslist (I basically stopped buying stuff at age 45; thank God they don’t depend on me for sales tax revenue.)  Of course Scandinavian furniture is known for its “less is more” aesthetic, although I’d say Ikea overdoes the “less” part.  There’s a difference between timeless elegance and dorm room utilitarian.

I believe that there are some artistic theories that mix ethics and aesthetics.  I suppose simplicity is seen as being more honest.  Keat’s truth is beauty.  The Bauhaus aesthetic was linked to socialist ideals, whereas the Italian Baroque was associated with the Counter-Reformation.

I’m not a big fan of attempts to mix ethics and aesthetics, but when it comes to politics and economics, I definitely think less is more.  I was reminded of this when frequent commenter Malavel sent me a new Swedish regulation requiring at least 15% down-payments on all mortgages.  That’s it, no bells and whistles, just 15%.  Check out the simplicity of this press release.

Sweden also has an income tax that is much simpler than ours (yes, I know that’s faint praise), where many (most?) taxpayers simply receive a bill in the mail.  Their vouchers for education don’t require you to live in Milwaukee, or enter a lottery.  Everyone in the country is eligible, and their kids are free to go to any approved school; public, not-for-profit, or for-profit.

In America, the left told us that the banking fiasco was caused by “de-regulation,” which allowed banks to run amok making sub-prime loans.  The right insisted it was the government’s fault; Fannie Mae and Freddie Mac and FDIC creating moral hazard.  Both are partly right.  In response our legislators produced a 1000 page bill that failed to address any of the alleged causes of the crisis.  Not only are sub-prime loans not banned, but FHA is actually encouraging more sub-prime lending.  The GSEs got off scot-free, and FDIC has not been reformed at all.  It’s still insuring wildcat banks in the South, who take taxpayer-insured deposits and lend the money out to highly risky construction projects.

If only we could have an economic policy regime that reflected the simplicity and elegance of Scandinavian furniture.  When I saw the Fed’s alphabet soup of special vehicles created to address the financial crisis, I pretty much knew we were in trouble.  The Fed forgot that its duty was very simple—just provide enough money to keep the price level rising at 2%.

The left was ecstatic about the appointment of Elizabeth Warren.  I have nothing against her, although I was a bit puzzled to learn that the main lesson of this crisis was that we needed to do a better job of protecting the financial industry’s consumers.  (Scratches head.)  But let’s say I’m wrong, and she’s the superwoman her supporters believe her to be.  How does that really help us?  Before too long the Republicans will be back in power, and she’ll be out of a job.

If you are visiting a dysfunctional tropical country, it’s common to have people talk wistfully of the need for a “strong man” to be put in charge.  But with the possible exception of Singapore, that almost never works.  Unless you put into place a democratic, transparent and non-corrupt system of governance, there is a real danger of back-sliding as the strong man becomes corrupted by power, or is replaced by someone less honest.

It’s sad that we’ve reached the point where Congress writes a 1000 page bill that completely fails to address the problems that caused the worst economic disaster since the 1930s, and then we instead pin all our hopes on Elizabeth Warren.  The elation that greeted her appointment was the sort of thing you’d expect from a mob of supporters when a Putin or Chavez announces he’ll run again, as there is “no one else capable of doing the job.”

In art and architecture it is not always true that simplicity is best.  I’ll take Borromini’s Quattro Fontane over Le Corbusier’s Radiant City.  But in politics and economics the simplest and most transparent regulatory regime is generally best.  K.I.S.S.

PS.  Of course the Swedish program has problems just like any other system. But progressive skeptics might be surprised by the nature of those problems:

One of the first independent schools, Botkyrka Friskola, was started by an ex-communist in a low-income, immigrant suburb of Stockholm. With an emphasis on individual student responsibility, familial involvement, and efficient use of technology, it now has over 2000 students waiting for one of its 240 places and a continuous stream of educators interested in imitating its success (Svangren 1998).

Public Vouchers and Public Controls

Though public vouchers are invigorating the Swedish education system and broadening the educational choices available to families, they have come with some strings attached. The first of these is the government’s demand that independent schools select their pupils on a first-come, first-served basis. Special exceptions are granted only for siblings of current students, students with special needs, and those who live in the immediate vicinity of the school (Gustafsson 1998). Most independent schools are happy to accept students on this basis and would have done so even without this regulation.

The condition makes it difficult, however, for a school to establish a particular learning environment and does nothing to guarantee the equal access it was set up to ensure. Per Svangren, the principal of Botkyrka Friskola, hoped his school would become a challenging, multicultural environment for immigrant families poorly served by the local municipal school but, as its reputation grew, Swedish families in neighbourhoods with better schools began applying early. The school had to take the students who applied first, so it was forced to reject those whom its leaders believed would not only benefit most but also contribute most to the school’s unique environment. As a result, a fundamental aspect of the school’s mandate was compromised (Svangren 1998). Though they would be rare exceptions, (as experience in Denmark demonstrates) schools established for the academically gifted or those for a particular learning disability are impossible in this environment. It is a loss to Sweden that its politicians prohibit families from choosing a specialized education for their children and prohibit schools from making such educational alternatives available for them.

A recent post by Tyler Cowen discusses one possible reason why the Fed has refrained from setting a higher inflation target, despite the fact that many economists believe that doing so could boost AD.  The argument is that higher near-term inflation expectations would raise short term nominal rates, and cut into bank profits that are now earned by borrowing short at very low rates and lending long at higher rates.

I can’t say whether Tyler Cowen is correct that worry about bank profits may be a factor discouraging the major central banks from doing additional monetary stimulus.  But I haven’t seen any better explanations for their seemingly perverse behavior.  And I should add that Tyler has mixed feelings about the desirability of such a policy:

I also regard this as a somewhat gruesome hypothesis.  It means that “Main Street” is paying for “Wall Street” (forgive me the use of those awful terms) in at least two ways: high unemployment and inability to earn much on one’s savings.  Risk on the Fed balance sheet is also paying some big part of the bill, since presumably that is helping to maintain the interest rate spread.

I’d say it’s even worse—it isn’t even clear that this strategy would help the banking industry. I believe this “finance view” misses the most important factor influencing bank profits–the state of the macroeconomy.  Earlier this year the IMF lowered its estimate of the worldwide losses to banks from $4 trillion to $3.4 trillion.  The explanation was a slightly better than expected recovery in the world economy after March 2009.  The fact that a modestly better than expected macroeconomic outlook could shave $600 billion off expected banking losses is just one indication of how devastating the worldwide drop in AD was during late 2008 and early 2009.  It sharply reduced all sorts of asset values and severely damaged the financial system.  Indeed the damage was much worse than that from the earlier sub-prime fiasco.

If the sharp drop in AD had not occurred, i.e. if inflation had continued at its normal 2% to 3%, then the banking system would have survived the sub-prime crisis is much better shape.  Yes, banks may gain, ceteris paribus, from lower short-term nominal rates.  But in this case ceteris isn’t paribus.  The very thing that drove nominal rates to near-zero levels is the same thing that caused the bulk of the financial crisis.  And reversing that fall in AD would be a huge boon to the banking industry, even if nominal rates were higher as a result.  Put simply, in most cases when X is bad for an industry, then “opposite of X” is good for that industry.

[BTW, interest rates are often more closely related to the level of NGDP relative to trend, than the rate of change in NGDP.  So interest rates might remain fairly low even with a vigorous recovery in spending, at least until the economy got closer to full employment.  This pattern occurred in the 1930s.]

I don’t watch much TV, just sports and bloggingheads.tv.  One of the nice things about my blog is that people who I enjoyed watching on bloggingheads (and who seemed like larger-than-life figures) now pay attention to my views.  Matt Yglesias and Megan McArdle are examples.  In this post McArdle raises several objections to my argument that moral hazard was the root cause of our financial system problems.

Scott Sumner is a very smart guy, and I quail to disagree with him, especially on macroeconomic topics.  But I’ve been mulling over this argument a lot, and I’m just not convinced.  I go to a lot of pro-market think tank events where one speaker or another blames the financial crisis and the current recession on moral hazard, as well as basically everything else that has gone wrong in the last sixty years.  I’m afraid I don’t see it.

I appreciate the compliment but I am not that smart, and no one should “quail” to disagree with me.  Indeed until a few minutes ago I didn’t even know ‘quail’ could be used as a verb.  I only seem smart because for some reason I have always had an easy time understanding the paradoxes of monetary economics.  I got Cs in French, computer science, and freshman English.

Second, I don’t believe the current recession was caused by moral hazard, I believe it was caused by tight money.  But I do think a big part of the 1980s S&L crisis was caused by banks taking advantage of brokered $100,000 deposits to engage in real estate speculation.  I do regard that as an abuse of deposit insurance. 
Den ganzen Beitrag lesen…

. . . when Congress raises the top (combined federal and state) marginal tax rate to Swedish levels.  You guys will have brought this on yourselves.  In the early 1930s the forces of reaction controlled the Fed, and they did the bidding of the conservative bond holders on Wall Street.  Eventually deflation got so bad that the public revolted and the top income tax rate was raised from 25% to 90%.  A new and left-wing President tore up the gold clause in debt contracts.  The dollar was devalued.  Pro-union legislation was passed.  And of course the national debt ballooned. 
Den ganzen Beitrag lesen…