frames and prospects

When I think about "prospect theory" and behavioral economics in general, I tend mostly to think about loss-aversion and to be bemused by framing effects, but one of the other reliable findings is that agents who face losses become risk-seeking rather than risk-averse. Someone presented with a sure $25 or a coin-toss for $50 will usually take the bird in hand, but presented with losses of the same magnitude, people will frequently prefer the coin toss — any chance to maybe, possibly reduce the losses.

It occurs to me that this is something we observe on the macro level. Insurance companies do well for a while, rates start to come down, they start seeking out riskier insurees and refuse to give up share of unprofitable business, and eventually KABOOM! Financial institutions see risk premia or even just interest rates come down, they think they're entitled to higher returns, they go "yield-chasing" (buying up riskier assets) and increase leverage, and eventually KABOOM!

I wonder if there's a good institutional way to check this propensity for making a bad thing worse. Getting insolvent companies into bankruptcy before they can cause harm seems like a good start.

factors of production

Are slaves labor or capital?

I was just reading the introduction to Hayek's "The Pure Theory of Capital" — a book I fully expect not to finish — and he ultimately decides to use the term "capital" to mean "the total stock of the non-permanent factors of production". Presumably this includes some of "natural resources", insofar as those are depletable; I typically think of "capital" as something in which one can invest. (What "human capital" and "physical capital" have in common; each represents the devotion of some economic resources in the past to enhance production in the future. Natural resources I suppose represent a decision not to have depleted them faster in the past than we have. Perhaps Hayek's distinction makes sense.)

Of course, I can gear my slaves toward reproduction rather than production of something else, thereby enhancing my future stock of slaves. This isn't so different from human capital in general, though. In many ways, labor simply looks like a particular kind of capital. I wonder how fundamental the "factors of production" are, and how much they rely on ontology to be useful.

The Wealth and Debt of Nations

Consider an international economic system in which there is relatively little trade, and then it opens up to trade in goods and to mobility in one and only one factor of production. Assume the different nations have different total factor productivities, due to technology or institutions, but that such differences are factor-neutral. What one would see is that the mobile factor would tend to move toward productive nations, increasing (even further) the marginal product of the other factors in those countries, while reducing the comparative attractiveness of the now abundant factor in those countries. If domestic "supply" of factors is at all elastic, the domestic supply of the mobile factor should decrease as its supply from foreigners surges.

I just read a snippet suggesting that it is inappropriate or confusing that the wealthiest nation on earth should have become (based on net foreign investment) a huge debtor nation. That doesn't strike me as a paradox; it just tells me that capital is more mobile than labor.

GDP as a welfare proxy

GDP growth is popularly spoken of as though it were the ne plus ultra of economic policy; if growth is high, policy is succeeding, and if it's low, it's failing. Exogenous effects aside, GDP is not a perfect proxy for what economists call "welfare", namely how well off everyone is. One illustration of the discrepancy was recently given by Mankiw; longer ago the misuse of GDP was decried by Bobby Kennedy*. The best defense of the use of GDP in these ways has been that, while it doesn't conceptually capture everything it should, it's likely to correlate with welfare, and that eras of high GDP growth tend to be better for welfare growth than other eras. (I've made this argument myself.)

As Robert Lucas noted, though, correlations can be true under certain policy regimes but not others; in particular, policy tailored to a historical correlation, by creating an incentive by policy-makers to optimize a single (imperfect) measure of welfare rather than (unmeasurable) welfare itself, is likely to reduce that measure's correlation with welfare. Just as a chandelier factory in the USSR, told it would be paid by weight for its product, produced the heaviest chandeliers in the world, the focus on a particular measure will optimize that measure, both in ways that optimize what it should be measuring, and in ways that do not. As Mankiw pointed out, it's possible to design stimulus that increases GDP but not welfare. If GDP is being optimized, those forms of stimulus will look like a good idea.

In every popular, simple, short-term policy model of the economy — I'm thinking in particular of a sticky-wages model for the effects of unexpected inflation, but I've also thought in the last couple days that this is likely true of a simple microeconomic analysis of Keynesian demand-pumping — a boost in GDP comes at the expense of welfare. Unexpected inflation reduces real wages, so that workers work more than they would prefer at that wage; a deficit reduces savings, boosting consumption at the expense of capital accumulation. Other sticky prices or other mechanisms that these models leave out might change things, and certainly a good argument for boosting GDP is the psychological effect it has — the recession-as-a-coordination-problem model — and I'm pretty sure that in both cases I give above, the GDP boost is first-order while the welfare loss is second-order, so that a small error of analysis is likely to change the qualitative outcome. Still, it seems worth remembering that there is a distinction, and worth occasionally asking whether something targeted at GDP as a proxy for welfare is actually welfare-enhancing or not. I'm not sure Keynesian stimulus usually or always is.

* I would quibble with some of what Kennedy says, e.g. that GDP counts "destruction of our redwoods and the loss of our natural wonder". A better welfare measure would subtract environmental losses; GDP does not include additions for them, but does include additions for products that entail those losses. In any case, his broad thesis is correct.

time-ordering and information-ordering

There is a famous puzzle, which some googling suggests is known as Newcomb's paradox, involving an expert on human nature (or something) who presents each player of a game with two envelopes, one of which the player knows to contain $1000. The player is permitted to receive either just the other envelope, or both envelopes; if this expert believes both envelopes will be taken, the second envelope is empty, while if the expert believes that only that second envelope will be taken, then it contains $1,000,000. After observing several other players, for each of whom the expert's prediction was correct, do you choose to accept both envelopes, or do you decline the $1,000 to take just the second?

My answer is that I take only the second envelope. I don't know what's going on in precise detail, but it appears to me that, one way or another, my decision is available to the expert when the envelopes are sealed. I apparently take my action after the expert acts first, but, the way the game appears to me, the information I have available when I act is circumscribed — I don't know what's in the second envelope — but the expert's decision is made knowing what I will do. The game, in information order, is that I make my decision, and then the expert places the checks, even though that is not the time-ordering of events.

There are a lot of situation in which uncertainty is of importance in economics, and it is very rarely the case that it matters whether the uncertainty is due to a lack of knowledge about the present or a lack of knowledge about the future. If you and I are stuck together for six hours, and we know that a football game has taken place during that time but that neither of us knows how it has gone, it is just as reasonable for us to bet on it at the end of six hours as at the beginning; in the former case we are betting on an event that has, in a time sense, already happened, but for which we are just as uninformed as if it hadn't taken place yet. Similarly, if I am about to have a test done to determine whether I have a genetic predisposition to some disease, it seems reasonable to ask an insurance company to provide me insurance against an adverse result, provided I don't initially know any more than the insurance company does, even though the genes are already there and the information in some sense already exists.

Studying actions of policy-makers or financial markets is invariably complicated by causal relationships running both directions in time; the stock market may rise because the economy is likely to improve in six months, but the economy may improve because the stock market rose. In that case, the effects likely reintensify their own causes — a "positive feedback loop" — but there are negative (i.e. stabilizing) feedback loops as well. Monetary economists speak of a "price puzzle" when one does a naive analysis of the effect of monetary policy on the economy, where tighter monetary policy seems to be followed by an increase in inflation for a short period of time; this is what one would expect if monetary policy is being done competently — the monetary authority should tighten policy when an increase in inflation is coming. Because the earlier event is being taken on the basis of anticipation of the later event, the causal relationship runs backward in time (though, in these cases, it runs forward as well).

I think the real-world solutions to a lot of game theory conundrums — incidentally, I've done less reading on this than I should — involve effects of this nature. People will work out that a repeated Prisoners' dilemma can yield cooperation, at least for a while, so long as future results are discounted relative to current ones, or some such, but, while time-preferences can be screwy and extreme, it usually seems to require too big a discount to generate the results you see in experiments (or real life), and almost certainly isn't in accord with how the agents themselves would describe their rationales. They might talk in moral terms, but it seems likely to me that a certain amount of what is going on is that people know that other people are somewhat cooperative, and — especially in real life — they believe they can tell "what kind of person" some counterparty to some arrangement is. Insofar as one can be read ahead of time, one is at least partially precommitted before the game formally begins.

microspeculation

I first used the term "microspeculation" to refer to people topping off their gas tanks in advance of a coming hurricane; clearly some of the demand for gasoline was being driven not by a consideration of immediate need as weighed against the current price but by the expectation that future needs could be better met now than at the price at which any gasoline might be available a few days later. The phenomenon is much more pervasive, though, in less blatant terms; many people will buy something because its price is lower than what they consider typical for the item, and, to the extent that this is rational, it is often on the presumption that one would like to consume some of the item occasionally at the given price, and that the given price is low relative to an alternative price at which one might be able to buy it at the future. Perhaps more clearly, someone will forego a purchase at a higher price than was expected, not because that price exceeds its value to the purchaser, but in anticipation of being able to get a better deal later. If the current price were expected to prevail for a long period of time, the buyer would be better off purchasing it immediately, but is holding off in speculation that the price will come down. By and large, microspeculation is characterized by its size (small), its pervasiveness, and by the lack of intention to sell; one is substituting a purchase at one time for a purchase at another time, rather than performing an actual sale on the visible market.

For goods that can be stored in a straightforward manner microspeculation can be effected through "stocking up" on an item at what seems to be a temporarily low price; insofar as an item cannot be stored, the only way this comes into play is in a taste for diversification over time. Consumption of fresh fruit, for example, may be more sensitive to price changes in the short run than in the long run because one can gain more pleasure from eating apples during some portion of the year if one is comparatively deprived of them the rest of the year than if consumption is steady. Canned fruit, on the other hand, can be more readily stored, and short-run price elasticity can be driven higher (relative to long-run price elasticity) because one can "stock up" in anticipation of rising prices; while the response of fresh fruit sales to price changes is limited to one's willingness to consume it now, canned fruit can be purchased now to be consumed later.

To some extent this is a question of technical substitutability; it is easy to turn a can of canned fruit now into a can of canned fruit tomorrow (just wait 24 hours), while fresh fruit will start to deteriorate, and can not be so substituted. This is different from the question of consumption substitution, but from the standpoint of the visible market, it looks the same, and any attempt to measure substitution of consumption is likely to include this as well.

While some price-stickiness is surely "behavioral", in the sense that it probably can't be put on a strictly rational basis, I imagine that a fair amount of price-stickiness originates in microspeculation on the part of market participants' responding much more elastically to changes in conditions than they might if they believed that every change was permanent.

financial catastrophe bonds and moral hazard

Four months ago, at the Jackson Hole conference, Kashyap, Rajan, and Stein proposed something of a financial catastrophe bond scheme for financial companies, in which they be required to meet a more stringent capital reserve requirement conditional on a financial catastrophe; the expectation was that this requirement might be met with an insurance mechanism of some kind that would cause the financial company to receive an equity infusion in that situation. They suggested a kind of secured insurance, but it seemed to me that a financial catastrophe bond (which they mention late in their paper) was both simpler and otherwise superior; the company would have a liability that, in the event of crisis, would disappear, converting to stockholders' equity.

The usual problem with insurance is moral hazard, and there's some of that here. There is some hope that, to a reasonable approximation, the financial company would not be able to instigate a financial crisis, but it does seem as though some behavior can be expected to reap worse whirlwind in case of financial crisis than otherwise, and that this sort of private behavior on a large scale intensifies systemic fragility. Historically financial crises are frequently preceded by bursts of poor loan underwriting; this is the sort of macroeconomic misalignment that finds itself in need of wrenching correction when the mania abates. A bank that finds itself choosing between loans that are relatively uncorrelated with the likelihood of disaster and loans that are feeding a mania (and are likely to go bad when it ends) will find the latter partially insured by the KRS scheme, and may well find them more relatively attractive than they should.

What seems perhaps safer to me is, rather than to have the liability disappear altogether, to have the liability convert to preferred equity. Concerns about an effective bank run or even an unwillingness of banks to lend should be alleviated just as well in this case as in theirs, insofar as the assets and liabilities pari passu and junior to senior unsecured debt work out the same. The common equity, however, is not shielded from the losses; the catastrophe bond claim remains senior to it. If equity drops dangerously low, the large subordinated class allows for a straightforward nondisruptive prepackaged bankruptcy, wiping away the liability only by handing the ownership of the bank over to the holders of what were originally the catastrophe bonds. It might, in fact, be worthwhile to give that preferred stock voting rights even before control of the company might pass to it; in any event where the liability is converted, it is likely that a good portion of the marginal dollar in assets belongs to that class rather than common equity. To avoid a bank's being permanently stuck with a capital structure that it may not like, it might make sense that such a preferred stock also be callable — it would be expected that calling the preferred stock would not be allowed by regulators unless the equity position of the company were comfortable.

Such a catastrophe-bond-converting-to-preferred-stock would surely be more expensive than ordinary unsecured debt, with which it would be pari passu if the institution fails idiosyncratically, but would likewise be less expensive than preferred equity. Which it falls closer to would provide a hint as to market perceptions of the correlation between the bank's risk and financial sector disaster risk. It should be somewhat cheaper than the original financial catastrophe bond variant. It also, insofar as management can be trusted to exercise its fiduciary duty to the shareholders, also largely eliminates the moral hazard problem mentioned in the second paragraph. It's a little bit more complicated (though not more complicated than the original secured insurance suggestion that KRS made), and it's more complicated in such a way that I expect there are complications I've missed. (One I've not missed so much as glided past is the disposition of dividends on that preferred stock.) Still, I think this is a step in a positive direction from what I've read before.