Krugman still thinking about Sweden — and still only gets it partly right

21 April, 2014 at 11:33 | Posted in Economics | 13 Comments

As I reported last week, Sweden is according to Statistics Sweden in a state of deflation. The inflation rate was -0.6 percent in March.

To a large extent the deflation is caused by tight monetary and fiscal policies  pursued by Sweden’s  Central Bank and the government. With a very defensive fiscal policy and a targeted inflation rate set at a very low level, real inflation has during the last 2-3 years been very close to zero, and now even negative. Another consequence of the austere fiscal and monetary policies is that overall unemployment is still at almost 9 % and youth unemployment close to 26 %.

This is deeply worrying. On this Krugman and yours truly seem to agree:

I’m still thinking about Sweden’s slide into deflation, which actually offers several lessons relevant to the rest of us.

First, it’s an object lesson in the power of sadomonetarism, the desire of many monetary officials to raise interest rates … In 2010 Sweden had high unemployment and low inflation; Econ 101 level macro should have said that this was no time to raise rates. Yet the Riksbank went ahead and did so anyway. Why?

It now says that it was all about financial stability, about fears of excessive house prices and borrowing. But that’s not what it was saying at the time! The bank’s governor did a chat in December 2010 in which he declared that it was about inflation:

“If the interest rate isn’t raised now, we’ll run the risk of too much inflation further ahead. This wouldn’t be good for the economy. Our most important task is to ensure that we meet our inflation target of 2%.”

Strange to say, however, when inflation started coming in well below the target, the Riksbank just kept raising rates, and switched to the financial stability justification.

Krugman’s argumentation, however, gives a somewhat too simplistic view of the problems facing the Swedish economy today. And just pooh-poohing deeply felt concerns and fears of a housing bubble with conspiracy theories (“excuses”) is debating economic policies analogous to playing tennis with the nets down.

So let’s try to get the full — and somewhat more complicated — picture right.

Lars E. O. Svensson — former deputy governor of the Riksbank — has repeatedly during the last year lambasted the Swedish Riksbank for having pursued a policy during the last fifteen years that has increased unemployment in Sweden:

The conclusion from the analysis is thus that the actual monetary policy has led to substantially lower inflation than the target and substantially higher unemployment than a policy that would have kept the policy rate unchanged at 0.25 percent.

The Riksbank has more recently justified the tight policy by maintaining that a lower policy rate would have increased the household debt ratio (debt relative to disposable income) and would have increased any risks connected with the debt. But, as I have shown … this is not true. A lower policy rate would have led to a lower debt ratio, not a higher one. This is because a lower policy rate increases the denominator (nominal disposable income) faster than the numerator (nominal debt). Then the debt ratio falls …

In summary, the Riksbank has conducted a monetary policy that has led to far too low inflation, far too high unemployment, and a somewhat higher debt ratio compared to if the policy rate had been left at 0.25 percent from the summer of 2010 until now. This is not a good result.

By the way, the latest report The Swedish Economy by the National Institute of Economic Research includes a very interesting special study, ”The Riksbank has systematically overestimated inflation,” which may be important in this context. In an analysis of the Riksbank’s inflation forecasts, the NIER shows that Riksbank forecasts have systematically overestimated inflation. The NIER concludes that “[t]he Riksbank’s overestimation of inflation has contributed to overly tight monetary policy with higher unemployment and lower inflation than would have been the case if, on average, its inflation forecasts had been on the mark.”

Why the majority of the Executive Board so systematically has exaggerated inflation risks so systematically is a question that may be worth returning to.

The Swedish Riksbank has according to Lars E. O. Svensson been pursuing a policy during the last fifteen years that in reality has made inflation on average more than half a percentage units lower than the goal set by the Riksbank. The Phillips Curve he estimates shows that unemployment as a result of this overly “austere” inflation level has been almost 1% higher than if one had stuck to the set inflation goal of 2%.

What Svensson is saying, without so many words, is that the Swedish Fed for no reason at all has made people unemployed. As a consequence of a faulty monetary policy the unemployment is considerably higher than it would have been if the Swedish Fed had done its job adequately.

So far, so good — I have no problem with Svensson’s — or Krugman’s — argument about the inadequacy of the Swedish inflation targeting policies.

However, what makes the picture more complicated than Krugman — and Svensson — wants to admit, is that we do have a housing bubble in Sweden — it’s not just a figment of imagination the “bad guys” use to intimidate us with. [That said, I, of course, in no way want to imply that central bank interest rate targeting (and/or accommodations) is the best way to counteract housing bubbles. Far from it.]

The increase in house loans – and house prices – in Sweden has for many years been among the steepest in the world.

Sweden’s house price boom started in mid-1990s, and looking at the development of real house prices since 1986, there are obvious reasons to be deeply worried:

Source: Statistics Sweden

The indebtedness of the Swedish household sector has also risen to alarmingly high levels, as indicated by the figure below (based on new data published earlier this year by Statistics Sweden, showing the development of household debts/disposable income 1990 – 2012):
householsdebts

Source: Statistics Sweden

As a result yours truly has been trying to argue with “very serious people” that it’s really high time to “take away the punch bowl.”

The Swedish housing market — with a high level of prices and household indebtedness — has become increasingly fragile during the last two decades. A ‘Minsky moment’ actually doesn’t seem to be that far away, and we may sooner than we think face a deflationary house price spiral driving the economy to a classic Fisher-Keynes-Minsky debt deflation crisis.

And this is the part of the story that Krugman doesn’t want to admit gives some credence to the arguments put forward recently by the Riksbank.

“Simple” models may sometimes help you think clearly about matters. But sometimes it’s also absolutely imperative to get the full picture. As H. L. Mencken once famously had it:

There is always an easy solution to every problem – neat, plausible and wrong.

Added 22 April: There’s more on the rather heated Swedish debate here and here.

Self-righteous Chicago drivel — far from everything you need to know about economics

20 April, 2014 at 22:21 | Posted in Economics | 1 Comment

In 2007 Thomas Sargent gave a graduation speech at University of California at Berkeley, giving the grads “a short list of valuable lessons that our beautiful subject teaches”:

1. Many things that are desirable are not feasible.
2. Individuals and communities face trade-offs.
3. Other people have more information about their abilities, their efforts, and their preferences than you do.
4. Everyone responds to incentives, including people you want to help. That is why social safety nets don’t always end up working as intended.
5. There are trade offs between equality and efficiency.
6. In an equilibrium of a game or an economy, people are satisfied with their choices. That is why it is difficult for well meaning outsiders to change things for better or worse.
Lebowski.jpg-610x07. In the future, you too will respond to incentives. That is why there are some promises that you’d like to make but can’t. No one will believe those promises because they know that later it will not be in your interest to deliver. The lesson here is this: before you make a promise, think about whether you will want to keep it if and when your circumstances change. This is how you earn a reputation.
8. Governments and voters respond to incentives too. That is why governments sometimes default on loans and other promises that they have made.
9. It is feasible for one generation to shift costs to subsequent ones. That is what national government debts and the U.S. social security system do (but not the social security system of Singapore).
10. When a government spends, its citizens eventually pay, either today or tomorrow, either through explicit taxes or implicit ones like inflation.
11. Most people want other people to pay for public goods and government transfers (especially transfers to themselves).
12. Because market prices aggregate traders’ information, it is difficult to forecast stock prices and interest rates and exchange rates.

Reading through this list of “valuable lessons” things suddenly fall in place. As Noah Smith writes:

10 out of Sargent’s 12 “lessons” are cautions against trying to use government to promote equality or help people … But I think that when this kind of list is put forth as a “summary of economics”, it does a disservice to the profession. It reinforces the notion that econ is basically a form of political advocacy, and that it’s main value-add is to innoculate us against communism … Econ has become a much more technocratic field, and new theories and discoveries have made the question of “government vs. markets” a much less simple one … Sargent, of course, knows that, and is just playing to a very particular audience of what he takes to be starry-eyed, wet-behind-the-ears, do-gooding Berkeley hippies. But it would be nice if bloggers did not hype lists like this as “everything you need to know about economics”.

This kind of self-righteous neoliberal drivel has again and again been praised and prized. And not only by econ bloggers and right-wing think-tanks.

Out of all 74 persons that have been awarded “The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel,” 28 have been affiliated to The University of Chicago — that is 37 %. The world is really a small place when it comes to economics …

Keynes on the illusory benefits of wage cuts

20 April, 2014 at 21:05 | Posted in Economics | 6 Comments

The world has been slow to realize that we are living this year in the shadow of one of the greatest economic catastrophes of modern history. But now that the man in the street has become aware of what is happening, he, not knowing the why and wherefore, is as full to-day of what may prove excessive fears as, previously, when the trouble was first coming on, he was lacking in what would have been a reasonable anxiety. He begins to doubt the future …

John-Maynard-Keynes-007

In this quandary individual producers base illusory hopes on courses of action which would benefit an individual producer or class of producers so long as they were alone in pursuing them, but which benefit no one if everyone pursues them … If a particular producer or a particular country cuts wages, then, so long as others do not follow suit, that producer or that country is able to get more of what trade is going. But if wages are cut all round, the purchasing power of the community as a whole is reduced by the same amount as the reduction of costs; and, again, no one is further forward.

Thus neither the restriction of output nor the reduction of wages serves in itself to restore equilibrium.

The Great Slump of 1930

Thomas Piketty and fierce critiques of brilliantly silly economic models

18 April, 2014 at 12:07 | Posted in Economics | 1 Comment

The French economist Thomas Piketty arrived in Washington, D.C., on Sunday for a week of talks at some of the nation’s leading policy-research centers but which might as well have been billed as a victory lap up the East Coast. The English translation of Piketty’s new book, Capital in the Twenty-first Century, a formidably rigorous, 700-page history of wealth, out barely five weeks, had just made The New York Times’s best-seller list. But even before it appeared, on the strength of a handful of advance reviews and a surge of Internet buzz, Piketty’s transformation was complete: from respected researcher on income distribution to ranking heavyweight, a scholar who, armed with reams of data and charts—and, unusual for an economist, a gilded tongue—proposed to upend decades of mainstream wisdom on inequality though an unprecedented analysis of the past.

wrong-tool-by-jerome-awApparently bedazzled by the book’s arguments, few reviewers mentioned its assault on the field. Yet Piketty’s disdain is unmistakable, the lament of a scholar long estranged from the mainstream of his profession. “For far too long,” he writes, “economists have sought to define themselves in terms of their supposedly scientific methods. In fact, those methods rely on an immoderate use of mathematical models, which are frequently no more than an excuse for occupying the terrain and masking the vacuity of the content. Too much energy has been and still is being wasted on pure theoretical speculation without a clear specification of the economic facts one is trying to explain or the social and political problems one is trying to resolve.”

In one sense, critiques of the discipline are nothing new. Economists, a voluble lot, seem to occupy a disproportionate amount of the blogosphere, and spend a good deal of their time there engaged in heated methodological debate. In a high-profile spat in March, Paul Krugman and Lars P. Syll, an economist at Malmö University, in Sweden, posted rival views of IS-LM (for investment saving-liquidity money), a model that has been a mainstay of macroeconomic theory for decades. Syll dismissed IS-LM as a “brilliantly silly gadget.” Krugman defended it as “a simplification of reality designed to provide useful insight into particular questions. And since 2008 it has done that job, yes, brilliantly.” (In a follow-up post, Krugman was more circumspect: “You should use models, but you should always remember that they’re models, and always beware of conclusions that depend too much on the simplifying assumptions.” )

Still, it’s one thing to trade barbs online, and quite another to present your magnum opus as an act of methodological sedition. Capital in the Twenty-first Century, Piketty makes clear, is his notion of what economics scholarship should look like: combining analyses of macro (growth) and micro (income distribution) issues; grounded in abundant empirical data; larded with references to sociology, history, and literature; and sparing on the math. In its scale and scope, the book evokes the foundational works of classical economics by Ricardo, Malthus, and Marx—to whose treatise on capitalism Piketty’s title alludes. The sizable recent literature on various aspects of inequality earns barely a mention. “There is a fair amount of empirical work out there,” says James K. Galbraith, of the University of Texas at Austin who studies wage inequality and who published one of the few skeptical reviews of the book to date, in Dissent. “He has a tendency to make deferential reference to mainstream thinkers while ignoring the critiques that already exist.”

Whether Capital in the Twenty-first Century survives its spectacular debut to become an inspiration for future scholarship—let alone future policy—will depend in part on how Piketty’s data and interpretation hold up over time … Even detractors agree that the World Top Incomes Database, which Piketty and his collaborators have assembled at the Paris School of Economics, where he now teaches, is invaluable. Covering 30 countries to date, it is by far the largest international database on inequality.

Less likely to endure is Piketty’s remedy for inequality: a progressive global wealth tax on fortunes over 1-million euros.

In Washington, a policy town, remedies were what many of Piketty’s commentators wanted to talk about, and they tended to dismiss his proposal, while taking the opportunity to promote their own ideas instead. Even Piketty concedes that enforcing a global wealth tax would require unprecedented levels of international cooperation and, at least in the United States, where higher taxes are widely believed to lead to lower growth, overcoming entrenched political opposition.

Emily Eakin/The Chronicle Review

Lower wages is NOT the solution

17 April, 2014 at 21:19 | Posted in Economics | 5 Comments

In connection with being awarded The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel for 2011 – Thomas Sargent, in an interview with Swedish Television, declared that workers ought to be prepared for having low unemployment compensations in order to get the right incentives to search for jobs.

This old mercantilist idea has very little support in research, since it has turned out to be exceedingly difficult to really get clear cut results of causality on the issue. However, the Swedish right-wing finance minister – Anders Borg – appreciated Sargent’s statement and declared it to be a “healthy warning” for those who wanted to increase compensation levels.

workers-wages-vsIn an article published in today’s Dagens ETC it is documented how one of Sweden’s more well-known and influential economists, Lars Calmfors, for 25 years has written out the same prescription — lower wages — for solving no matter what problem facing our economy.

Sargent’s, Borg’s and Calmfors’s view is symptomatic. As in the 1920s, more and more right-wing politicians — and some economists — suggest that lowering wages is the right medicine to strengthen the competitiveness of their faltering economies, get the economy going, increase employment and create growth that will get rid of the towering debts and create balance in the state budgets.

But, intimating that one could solve economic problems by impairing unemployment compensations and wage cuts, in dire times, should really be taken more as a sign of how low the confidence in our economic system has sunk. Wage cuts and lower unemployment compensation levels – of course – do not save neither competitiveness, nor jobs.

What is needed more than anything else in these times is stimulus and economic policies that increase effective demand.

On a societal level wage cuts only increase the risk of more people getting unemployed. To think that that one can solve economic crisis in this way is a turning back to those faulty economic theories and policies that John Maynard Keynes conlusively showed to be wrong already in the 1930s. It was theories and policies that made millions of people all over the world unemployed.

It’s an atomistic fallacy to think that a policy of general wage cuts would strengthen the economy. On the contrary. The aggregate effects of wage cuts would, as shown by Keynes, be catastrophical. They would start a cumulative spiral of lower prices that would make the real debts of individuals and firms increase since the nominal debts wouldn’t be affected by the general price and wage decrease. In an economy that more and more has come to rest on increased debt and borrowing this would be the entrance-gate to a debt deflation crises with decreasing investments and higher unemployment. In short, it would make depression knock on the door.

The impending danger for today’s economies is that they won’t get consumption and investments going. Confidence and effective demand have to be reestablished. The problem of our economies is not on the supply side. Overwhelming evidence shows that the problem today is on the demand side. Demand is – to put it bluntly – simply not sufficient to keep the wheels of the economies turning. To suggest that the solution is lower wages and unemployment compensations is just to write out a prescription for even worse catastrophes.

Microfoundations and the Ramsey model — hardly worthy of grown-ups

16 April, 2014 at 08:47 | Posted in Economics | Leave a comment

4703325-2So in what sense is this “dynamic stochastic general equilibrium” model firmly grounded in the principles of economic theory? I do not want to be misunderstood. Friends have reminded me that much of the effort of “modern macro” goes into the incorporation of important deviations from the Panglossian assumptions that underlie the simplistic application of the Ramsey model to positive macroeconomics. Research focuses on the implications of wage and price stickiness, gaps and asymmetries of information, long-term contracts, imperfect competition, search, bargaining and other forms of strategic behavior, and so on. That is indeed so, and it is how progress is made.

But this diversity only intensifies my uncomfortable feeling that something is being put over on us, by ourselves. Why do so many of those research papers begin with a bow to the Ramsey model and cling to the basic outline? Every one of the deviations that I just mentioned was being studied by macroeconomists before the “modern” approach took over. That research was dis missed as “lacking microfoundations.” My point is precisely that attaching a realistic or behavioral deviation to the Ramsey model does not confer microfoundational legitimacy on the combination. Quite the contrary: a story loses legitimacy and credibility when it is spliced to a simple, extreme, and on the face of it, irrelevant special case. This is the core of my objection: adding some realistic frictions does not make it any more plausible that an observed economy is acting out the desires of a single, consistent, forward-looking intelligence …

For completeness, I suppose it could also be true that the bow to the Ramsey model is like wearing the school colors or singing the Notre Dame fight song: a harmless way of providing some apparent intellectual unity, and maybe even a minimal commonality of approach. That seems hardly worthy of grown-ups, especially because there is always a danger that some of the in-group come to believe the slogans, and it distorts their work …

There has always been a purist streak in economics that wants everything to follow neatly from greed, rationality, and equilibrium, with no ifs, ands, or buts. Most of us have felt that tug. Here is a theory that gives you just that, and this
time “everything” means everything: macro, not micro. The theory is neat, learnable, not terribly difficult, but just technical enough to feel like “science.”

Robert Solow

INET — marginalizing heterodox economics rather than transforming the discipline

15 April, 2014 at 18:20 | Posted in Economics | Leave a comment

Big-vs-SmallIn a report published by The Association for Heterodox Economics, INET is criticized for actually marginalizing heterodox economics:

Our main concern is that the positive potential of INET is steadily being closed down. What began as recognition of fundamental problems that require fundamental change is becoming a more modest set of alterations. A sense of failure is, for all intents and purposes, being translated into a context of relative success requiring more limited changes – though these are still being seen as significant. Part of the reason that they are seen as significant is that changes from within mainstream economics do not have to be major in order to appear radical. It is our contention that heterodox economics is being marginalised in this process of ‘change’ and that this is to the detriment of the positive potential for transforming the discipline …

Marginalising heterodoxy creates problems for teaching economics as a discipline in which economists constructively disagree and can be in error. This is important because it is through a conformity that suppresses a continual and diverse critical awareness that economics becomes a dangerous discourse prone to lack of realism, complacency, and dogmatism. Marginalising heterodoxy reduces the potential realisation of the different components of economics one might expect to be transformed as part of a project to transform the discipline …

Highlighting the points we have may seem like simple griping by a special interest. But there is far more involved than that. Remember we are talking about the failure of a discipline and how it is to be transformed. The marginalisation of heterodoxy has real consequences. In a general sense the marginalisation creates manifest problems that hamper teaching economics in a plural and critically aware way. For example, the marginalisation promotes a Whig history approach. It is also important to bear in mind that heterodoxy is a natural home of pluralism and of critical thinking in economics … Unlike the mainstream, heterodoxy does not have to be made compatible with pluralism and with critical thinking; it is predisposed to these and is already a resource for their development. So, marginalising heterodoxy really does narrow the base by which the discipline seeks to be renewed. That narrowing contributes to restricting the potential for good teaching in economics (including the profoundly important matter of how economists disagree and how they can be in error).

Sweden hit by deflation — a sad and worrying reminder of the impotence of mainstream economics

14 April, 2014 at 22:24 | Posted in Economics | 3 Comments

irvingSweden is according to new statistics from  Statistics Sweden in a state of deflation. The inflation rate was -0.6 percent in March.

To a large extent the deflation is caused by tight monetary and fiscal policies  pursued by Sweden’s  Central Bank and the government. With a very defensive fiscal policy and a targeted inflation rate set at a very low level, real inflation has during the last 2-3 years been very close to zero, and now even negative. Another consequence of the austere fiscal and monetary policies is that overall unemployment is still at almost 9 % and youth unemployment close to 26 %.

This is deeply worrying.

So yours truly thought he should give the Swedish Fed and the Swedish finance minister - Anders Borg –  a suggestion for reading …

Zoltan Pozsnar and Paul McCulley have written an absolutely splendid essay on what a liquidity trap means and why mainstream neoclassical economics has nothing to offer in way of solving the problems that it brings along – and why it is so important to get hold of the insights that Fisher, Keynes, Minsky and Krugman have given us on debt-deflation processes and liquidity traps:

A liquidity trap is a circumstance in which the private sector is deleveraging in the wake of enduring negative animal spirits caused by the bursting of joint asset price and credit bubbles that leave privatesector balance sheets severely damaged. In a liquidity trap the animal spirits of the private sector cannot be revived by a reduction in short-term interest rates because there is no demand for credit. This effectively means that conventional monetary policy does not work in a liquidity trap …

Deleveraging can be rational for an individual household. It can be rational for an individual corporation. It can be rational for an individual country. However, in the aggregate it begets the paradox of thrift1: what is rational at the microeconomic level is irrational at the community, or macroeconomic, level.

This is not to say that the private sector should not deleverage. It has to. It is a part of the economy’s healing process and a necessary first step toward a self-sustaining economic recovery.

However, deleveraging is a beast of a burden that capitalism cannot bear alone. At the macro level, deleveraging must be a managed process: for the private sector to deleverage without causing a depression, the public sector has to move in the opposite direction and re-lever by effectively viewing the balance sheets of the monetary and fiscal authorities as a consolidated whole.

Fiscal austerity does not work in a liquidity trap and makes as much sense as putting an anorexic on a diet. Yet, “diets” are the very prescriptions that fiscal austerians have imposed (or plan to impose) in the U.S., U.K. and Eurozone. Austerians fail to realize, however, that everyone cannot save at the same time and that in liquidity traps, the paradox of thrift and depression are fellow travelers that are functionally intertwined.

Historically, austerity has only worked when accompanied by monetary easing – where wealth effects and stronger private demand for credit helped offset the effects of fiscal austerity – and/or a weaker currency – which helped steal others’ demand.

In a liquidity trap, however, austerity cannot work because monetary policy is neither functioning correctly nor able offset lost demand, and weak currencies work only at a time of strong global demand and only for individual countries, not for several major countries at one time. Imposing austerity without potential offsets and at a time of weak global aggregate demand is deflationary, which makes deleveraging much harder, balance sheet repair much slower and recovery much less likely to achieve. In a liquidity trap, governments have no logical option but to borrow and to invest.

How could governments borrow more if government debt is also a problem everywhere? Would it not be irresponsible to increase borrowing at a time of record government debt levels? Fiscal austerians are quick to invoke age-old textbook orthodoxies: (1) that additional borrowing will be too much for future generations to handle, citing the law of Ricardian equivalence; (2) that increased borrowing will crowd out private sector borrowing and will most likely delay the economic recovery; and (3) that bond investors will stop buying and send yields higher.

However, in the topsy-turvy world of liquidity traps, these textbook orthodoxies do not apply, and acting irresponsibly relative to orthodoxy by increasing borrowing will do more good than harm. Austerians argue that reducing deficits and putting nations’ fiscal houses in order will help growth through confidence. However, Ricardian equivalence does not work in reverse! It is not confidence, but Godley’s tyranny of arithmetic that matters: someone simply has to borrow and invest to fill missing demand.

Crowding out, overheating and rising interest rates are also not likely to be a problem as there is no competition for funds from the private sector. For evidence, look no further than the impact of government borrowing on long-term interest rates in the U.S. during the Great Depression, or more recently, Japan …

Held back by concerns borne of these orthodoxies, however, governments are not spending with passionate purpose. They are victims of intellectual paralysis borne of inertia of dogma that, in the present circumstances, do not apply. As a result, their acting responsibly relative to orthodoxy and going forth with austerity may drag economies down the vortex of deflation and depression.

The importance of fiscal expansion and the impotence of conventional monetary policy measures in a liquidity trap have profound implications for the conduct of central banks. This is because in a liquidity trap, the fat tail risk of inflation is replaced by the fat tail risk of deflation. In turn, the fatness of the deflation tail is a function of the government’s willingness and ability to pump-prime, i.e. to borrow and spend.

Added 19 April: Paul Krugman comments on the Swedish situation.

Flipism

12 April, 2014 at 11:33 | Posted in Economics | 2 Comments

We investigate the possibility that a decision-maker prefers to avoid making a decision and instead delegates it to an external device, e.g., a coin flip. In a series of experiments our participants often choose stochastically dominated lottery between outcomes, contradicting most theories of choice such as expected utility …

images-3In situations where decision-making is hard, a possible procedural preference arises: the decision-maker may wish for the decision to be taken away from herself. Her cognitive or emotional cost of deciding may outweigh the bene fits that arise from making the optimal choice. For example, the decision-maker may prefer not to make a choice without having sufficient time and energy to think it through. Or, she may not feel entitled to make it. Or, she may anticipate a possible disappointment about her choice that can arise after a subsequent resolution of uncertainty. Waiving some or all of the decision right may seem desirable in such circumstances even though it typically increases the chance of a suboptimal outcome.

The difficulty of such preferences is that they are non-consequentialist and are therefore excluded by most models of choice such as expected utility. For example, flipping a coin between different choice options contradicts expected utility theory except if the decision-maker is exactly indifferent between these options. Yet people regularly do flip coins or revert to other random decision aids. More general than expected utility theory, a basic axiom of choice — stochastic dominance — postulates that whenever the decision-maker has a strict preference for one of the options, she makes the choice herself rather than delegate it to randomness.

This paper discusses preferences that allow for coinflipping. It then presents several data sets, experimental and field-empirical, where stochastic dominance is violated by decision makers.

Nadja Dwenger   Dorothea Cabler   Georg Weizsäcker

Emotional finance — on taking uncertainty seriously

11 April, 2014 at 11:54 | Posted in Economics | 5 Comments

Conventional thinking about financial markets begins with the idea that security prices always accurately reflect all available information; it ends with the belief that price changes come about only when there is new information. Markets are supposed to reflect new information quickly and efficiently, albeit with a few anomalies.

emotion-pendulum-pictureIn 2007, I interviewed over 50 investment managers mainly in New York, Boston, London, and Edinburgh. Talking to them I came to the conclusion that conventional theories of finance miss the essence of market dynamics. Information is usually ambiguous and its value uncertain. When information is ambiguous and outcomes are fundamentally uncertain, decisions are not clear cut. They necessarily rely on human imagination and judgment, not simply calculation. Human imagination and judgment are impossible without human emotion. Conventional theories of finance, which ignore emotion, are therefore a very poor basis for understanding and policy.

“As long as we neglect emotion’s role in financial markets, and fail to understand and adapt to dimensions of human social and mental life that influence judgement, financial markets will be inherently unstable.”

Uncertainty and ambiguity are what make financial markets interesting and possible. They generate feelings that manifest in exciting stories, problematic mental states and strange group processes. As long as we neglect emotion’s role in financial markets, and fail to understand and adapt to dimensions of human social and mental life that influence judgement, financial markets will be inherently unstable. They will also be likely to create poor outcomes for ordinary savers and significant distortions in capital allocation – exactly what we have been witnessing in the market today.

The uncertainty to which I refer can be termed radical, fundamental, Knightian or Keynesian uncertainty. I use these descriptions to stress the fact that, although we can imagine the future, we cannot know it in advance. My interviewees collectively risked over $500 billion every day. Every one of the positions they took depended on interpreting ambiguous information and each would be vulnerable to unforeseen events. Consider the present possibilities that the Euro crisis will lead to a return to national currencies, and that disputes in the US congress will lead to problems meeting US debt obligations. What the existence of such possibilities will do to the prices of commodities, currencies and securities over the next thirty-six months, and what different financial decision-makers will think about it, is not knowable – and there will be many more unexpected developments with significant ramifications.

Decisions made in a radically uncertain context are totally different in their implications from decisions made in conditions of risk modelled as a Gaussian probability distribution. A Gaussian model constrains future probabilities, thereby creating known unknowns. The outcome of decisions becomes predictable and what is rational becomes clear. Under radical uncertainty this is not the case. What will happen tomorrow involves far more complexity and interaction than can be captured by analogies to games of chance. Taking radical uncertainty seriously, therefore, changes everything.

David Tuckett

 

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