Knowing and Making

The Cognitive Microfoundations Project: a behavioural economics world tour

2012-06-07T23:18:00.002+01:00

There has been much talk about microfoundations on the economics blogs in the last few months [Noahpinion, Mark Thoma, Simon Wren-Lewis twice, Andrew Gelman twice, Karl Smith, Paul Krugman twice, Robert Waldmann, Rajiv Sethi from 2009]. The idea of microfoundations is that a model of the overall economy should be consistent with how individual people act. The aggregate behaviour of variables like GDP, government deficits and unemployment should be derived by adding up the choices of individuals, not by treating the whole population as if it were a single entity.

(A microfounded model might start off like this: "Imagine N agents, each of which has income y_n, consumes c_n and saves s_n. Then y_n = c_n + s_n. For each agent, s_n varies with the interest rate r according to the following relation..." while a non-microfounded model is more likely to start: "Total spending in the economy is C and saving is S. C+S must sum to Y, total income. S varies with the interest rate r...")

But does the microfoundations approach really work? It seems a good idea in principle. It works well in some other fields like physics and chemistry (though less so in biology). Building things from the ground up protects us against falling into certain mathematical traps. Some concepts (like the idea of people trading different goods with each other) don't really even exist at the aggregate level, so are hard to talk about without microfoundations. The idea that we can understand things in this level of detail is an appealing one.

Unfortunately, the idea of microfoundations has come to be closely associated with rational agent theory. Most microfounded economic models are implementations of DSGE (dynamic stochastic general equilibrium), which assume a population of rational utility-maximising agents who are given certain preferences and resources and respond logically to those. Readers of this blog, or of any behavioural economics book, will be unsurprised to hear that real people do not maximise utility in the way DSGE models insist - as demonstrated in numerous psychology experiments. Economists usually respond to this objection in one of two ways, neither of them quite satisfactory.

Response one: to claim that rational utility maximisation is close enough to the truth to describe the economy reasonably well. Sure, there are exceptions: people might not always discount future earnings in a consistent way, and sometimes we buy things because they’re on sale and not because our utility from the product exceeds the price paid - but those are minor errors, they mostly cancel each other out, we learn to be more rational over time, and the limits imposed by our income force us to act fairly rationally. So, DSGE models, maybe with a couple of small tweaks, are still the best way to describe the economy and work out how to manage it. We can still make inferences about how tax rates will change the choices of individual workers, or how interest rates will affect investment and savings decisions, and draw conclusions from that about how the whole economy will evolve.

Response two: to agree that individual rational agent models are too far from the truth to be useful but then to give up. For many, the failures of economic forecasting in the leadup to the 2008 crisis prove this. There are better ways to describe individual decisions - behavioural economics gives us some hints - but these are mathematically too hard to build models with. Therefore we shouldn’t bother with microfoundations - instead, we should reason from aggregates, such as the total amount of money, production, employment and debt in the economy. It is possible to work out, for example, that if companies try to save more money (as we can see they currently are), individuals try to pay off their debts (as they are), and governments try to cut their deficits (as they say they are) something must give. The model may not tell you which one will fail, but it can tell you that something must. These models can’t describe all economic phenomena because the aggregates don’t always tell you enough, but maybe they are all we have.

The first response is wishful thinking. The second is fatalism.

What if there is another way? Maybe, by choosing the right models from cognitive psychology and behavioural economics, and aggregating them in the right way, we can develop an accurate representation of large-scale systems after all. Then perhaps we can get the benefits of a microfounded model - which lets us understand many different economic phenomena, and gives us confidence via experiments that its conclusions are sound - but with greater accuracy, predictive power and robustness than today’s DSGE models.

Such models, microfounded not on rational utility theory but on real cognitive processes, might focus on specific domains such as consumer product markets or labour markets. They might let us explore the effects of specific economic policies such as tax or interest rate decisions. Eventually, they might develop into a unified theory that can be used to investigate any aspect of the economy - the cognitively sound equivalent of Arrow-Debreu general equilibrium theory.

Can this be done? It’s too early to say for sure, but it’s one of the most important questions for the economics discipline to ask itself.

So this year I’m going on tour. I will travel to wherever I can meet researchers in different economic domains and work out with them how psychology can be incorporated into their models. Although it might be possible to work out cognitive microfoundations from first principles, I suspect it will be more practical to start asking what kind of foundations will illuminate each different economic domain.

My initial objective is to work with people in each of the following disciplines:

Consumer behaviour
Competition and market organisation
Labour economics
Trade and international economics
Fiscal policy
Development economics
Monetary theory
Industrial organisation
Personal finance
Financial markets and asset pricing
Environmental economics
Health economics

I have a few collaborations lined up already, but there’s no restriction to just one in each field. So if you work in one of those areas - or would like to propose another - get in touch and I can add your location to my itinerary.

So far I’ve been to Madrid, Barcelona, Marseille, Paris and Honolulu. From today, my immediate plans are:

Until 13th June: San Francisco and Berkeley.
13th-19th June: Atlanta.
19th-30th June: the northeastern US - DC, NYC and all points between.
July: the UK and South Africa.

If you’re near any of those locations why don’t we meet up? If we discover anything useful there’s a co-author credit in it for you.

Did he jump or was he pushed; is there a difference?

2012-04-30T03:15:00.000+01:00

This New Yorker article about why so many Americans are single reminded me of the debate about unemployment prompted by Casey Mulligan. Here’s why:

From the New Yorker: "...do people live alone because they want to or because they have to?"

Paraphrasing Mulligan and his critics: “Are workers choosing to be unemployed or are they forced to be?”

[actual quotes from Mulligan: "there are sensible people...who will recognize that 2009 is not the time for them to...commute a long distance to work...[unemployment insurance has] dramatically reduced the costs to them of making this the year they coach junior's baseball team, or do some work on their house, or spend time with an ailing parent" "the market tends to create and allocate jobs for those people who are most interested in working" and "my research has been to examine...changes in the willingness and availability of people to work" versus Dean Baker's "this does not mean that less-educated workers could find jobs if they really want them"]

Both quotes reveal a simplistic view of the nature of choice. It’s as if our choices are fixed – and we will always make the same choice unless there is some barrier in the way. The New Yorker assumes that each of us either definitively wants to be single or wants to be married, and that we’ll get our way unless something thwarts us. The debate over Mulligan's claims, on the other hand, take literally the fact that we have free will – so if someone laid off from a Detroit factory or a Texas high school has chosen not to take the minimum wage job at Walmart, their unemployment is voluntary.

Mulligan’s view is often mocked – Ryan Avent calls it “The Great Vacation” (did he coin the phrase?) – but it does at least have some internal consistency. People intuitively object to this story because it seems to imply people’s preferences have changed, and they have just decided they now want more leisure. But in fact this model assumes that preferences are exactly the same, and it’s the available options that are different. Simon Wren-Lewis writes here:

"In RBC models, all changes in unemployment are voluntary. If unemployment is rising, it is because more workers are choosing leisure rather than work. As a result, high unemployment in a recession is not a problem at all. It just so happens that (because of a temporary absence of new discoveries) real wages are relatively low, so workers choose to work less and enjoy more free time"

One defence of Mulligan is to read his claim more narrowly: that unemployment benefit reduces people's desire to work by a bit, increasing unemployment by an unknown amount - which seems plausible - and not that the whole recession arises from this cause.

Regardless, the right approach to both claims - that unemployment is voluntary or that Americans are forced to be single - is that people's actions are a result of both our individual wants and the environment we find ourselves in. Our wants might indeed change over time – though this tends to be a slow process. Our choices change much more quickly, because the same person in a different environment will make a different choice from the same options. A man with £10 in McDonald’s may choose to eat, while a man with £10 in Gordon Ramsay’s may choose not to eat (even though technically he could buy something from the lunch menu). The man is the same, and his budget is the same, but his actions are different.

Even the idea of “the same options” is dubious. Has the man in Gordon Ramsay’s really been offered “the same options” as the man in McDonald’s? Is a worker turning down a cashier job in Walmart choose from “the same options” as a worker taking a project management job at Boeing? Economics is partly about abstracting away the differences between different situations, but we must recognise when we’re abstracting too much.

Standard economics takes us up to about this point, and Noah Smith says as much in this post. Each person has preferences which determine the relative exchanges they’re willing to make. These preferences define a particular value for my time – £20/hour – so that if the wage offered (adjusted a little to take account of employment terms, location etc) is greater than £20/hour, I’ll take the job; otherwise I’ll stay at home. Similarly, my preferences may determine that the effort and sacrifice of being in a couple has a certain cost to me, and only if the benefits outweigh that cost will I enter a relationship. Thus, I may be more willing to go into a relationship with a person who I find more attractive (thus increasing the benefit of the relationship) or if housing prices rise (increasing the cost of staying single).

The psychology of decision-making says things aren’t this simple. The factors that determine the cost and benefit of each option are not stable. My preferences fluctuate according to how I feel, and my perception of the options I’m choosing between will change according to what I’m thinking of, what I’ve been reminded of, and what I’m looking at. Some factors become more important because they are more salient, and others may be ignored altogether.

Some particular factors become important to me which, according to a rational utility model of choice, should not matter at all. For instance, the wage I was paid last month should not be relevant to whether I accept a job at Walmart this month. But you can be sure it will be. There are a whole range of possible reasons for this: I may have mortgages and bills to pay that require me to earn over a certain level; I may treat my last wage as a signal of what I’m likely to be able to earn if I hold out for a better job offer; or I might simply feel ashamed to accept a 50% cut in pay. Whatever the reason, either my preferences, or my beliefs about the context I’m in, or both, are now seen to be dynamic and not static.

This means it is too simple to say “my preferences have changed” or even “the environment has changed”. Both are always changing. My choices are constructed in each moment out of the information available to me from inside and outside my mind.

There is not even a clear distinction between preferences and context. My preference to work at £21/hour instead of staying at home is in turn influenced by the context I live in, in particular the level of my mortgage payments or whether I think the economy is getting better. So the choice is in fact a tradeoff between one external factor (the job offer) and a series of others (mortgage, economy) with my mind as the calculating device that sits in between, weighing up the factors.

My mind of course is not perfect, and it can only roughly estimate the strength and future path of each factor. So it relies (I rely) on rules of thumb, heuristics, to save time and make it possible in practice to actually make any decisions at all. Those heuristics themselves can change over time, as I have new experiences which I learn from – and which may invalidate old heuristics or lead to new ones. Maybe the last time I took a low-paying job, in high school, my brother got a better one the following week, and laughed at me. The heuristic that I might learn from that is fairly clear, even if I’m not conscious of it when I make my decision now. If I turn down this job and don’t get another offer for three months, perhaps my heuristic will change.

Can we even distinguish between heuristics, preferences and environment? Not clearly. From the outside we cannot tell whether the man turning down the Walmart job is doing so because he has a clear, conscious preference for a £20/hour job, or whether he’s subconsciously applying a rule of thumb his brother taught him by teasing 20 years ago, or whether he simply cannot afford to work for less because it won’t pay the mortgage and he has to hope for a better offer next week. Even internally, the man himself probably does not clearly know the difference between these three causes. So is it meaningful to say that they are three distinct phenomena?

We haven’t even discussed the signalling and cultural implications of taking a job at Walmart, or the influence of the way in which the offer is communicated (“We’d really appreciate if you’d take this job, to help us to serve your community better” or “Head Office has approved your application for employment, and subject to security and identity checks you may arrive on Monday at 8am sharp.”). Language and culture too shape our interpretation of the choices we are offered and the factors that we take into account; this can be seen as part of the cognitive process or as part of the environment in which we choose.

We are left with two ways to think about choice. The first option is to declare the process of choosing to be too complex for simple interpretations like “unemployment is voluntary” or “Americans are single because they have no choice” to be entirely true (or entirely false). The second option we can find a new and more accurate abstraction to describe choice – I like to think of it as “a cognitive algorithm which translates external and internal signals into actions”. In this view, the idea of voluntary unemployment or involuntary singledom simply lose their meaning. The very term voluntary becomes moot.

Then, did the unemployed man jump or was he pushed? All we can say is that a confluence of factors - physical, or emotional - and his response to them, caused his fall.

Where, then, has free will gone? Was it ever there in the first place? That must wait for another post.

Behavioural economics: the Kylie Minogue of market research

2012-03-20T15:47:00.000Z

Do you remember those catchy tunes from the late 1980s? I Should Be So Lucky? The Locomotion?

The first time you heard them they were quite fun, memorable even. But then they got more airplay. And more. And more. Radio stations figured out that the sugary, bubbly popness of the tunes would cut through a lot of background noise and get your attention, so they played them again and again. Soon we had Got To Be Certain, and Je Ne Sais Pas Pourquoi, which were exactly the same as the first two songs. Then a "strategic inter-agency collaboration" with Jason Donovan on Especially For You. (Jason looks a bit less lifelike in this alternative version).

After a short interlude in late 1989, another number 1 with Tears On My Pillow, which was meant to be more sophisticated but was equally artificial, overproduced and in fact just the same old song as I Should Be So Lucky. By this time anyone who wasn't a 13-year-old girl was thoroughly sick of Miss Minogue, who wasn't even on Neighbours any more. Interest and record sales rapidly declined, and thankfully Nirvana showed up to distract us.

On a completely unrelated subject, do you remember those talks about behavioural economics that infected the market research industry in 2009? Someone had read Nudge, and someone else got a copy of Predictably Irrational. It's quite easy to write a behavioural economics talk - you just claim that everyone else in the world thinks people are irrational, but you have spotted (with the help of Daniel Kahneman perhaps) that they're not. Read out a list of cognitive biases - anchoring, hyperbolic discounting, social norms. Show some slides with illustrated examples of each bias. If you're brave, test one of them on your audience and hope they haven't yet been to enough identical talks to see through your ultimatum game or your auction. I am just as guilty of this as anyone else.

As straightforward as this formula is, it's no surprise that throughout 2010 and 2011 you've had the opportunity to attend perhaps twenty workshops, panel discussions and seminars every year containing exactly the same content. Every Market Research Society conference since 2009 has had a behavioural economics session. Every agency has sent one director and two junior researchers to a training course. Every agency at the top of the GRIT rankings has a behavioural economics link on its website or its case study at ESOMAR.

(Don't get me started on fecking neuromarketing.)

The backlash was smooth, professional and equally predictable. "But isn't behavioural economics just what good marketers have been doing all along? This theory is all very well, but how do we use it? Cognitive biases are all very well in the lab, but how do you know the results apply to consumers in the real world? Anyway, it's all just a fad."

Put any three market researchers in a pub and mention behavioural economics, and I guarantee the conversation will proceed swiftly along the above lines.

But wait one second.

It's 2000. Kylie hasn't had a number 1 single for ten years, or even a top ten hit since 1994. She's a joke. She's been dropped by her record label. There isn't even a nostalgia industry around her yet. In fact, Nicole Kidman's the only Australian we recognise now.

Paula Abdul writes a song but decides not to record it. It is hawked around the industry and eventually gets passed on to Kylie.

Spinning Around is a worldwide hit, number 1 in the UK and Australia, and revolutionises Kylie's career. The theme of the song reflects Kylie's own transition: she's grown up. No more novelty singles or soap opera posing. She's sexy now.

Behavioural economics is ready to grow up too. Enough with the cognitive biases, the party tricks. The field is actually based on much deeper psychological research into judgement and decision-making, cognitive theory and information processing. It's time to abandon the false tension between "rationality" and "irrationality". Our minds process information and choose actions in a way that is locally rational. But when viewed globally, these choices show that there are conflicts between the different interests and needs that a single human being has.

Behavioural economics, and the cognitive theories that underpin it, gives us insight into how people interpret the world, what people want, and the actions people take in response. It invalidates traditional methods of market research and marketing cliches - but only once it is taken seriously. It tosses out the basis of conventional economics, consumer preferences - and the very notion that we make "decisions" between "products".

There is a proper, integrated theory here, based on the idea that people adapt to a basic level of satisfaction, and act to restore it when it is disturbed. They rely on efficient but imperfect memory to retrieve a variety of strategies to restore that homeostatic equilibrium, and only when those strategies lead them towards product acquisition do they apply something a little bit like a standard consumer choice process - but one constrained by the brain's information processing limits. Experimental psychologists can help you design experiments to measure each of these stages, and you can design interventions to change the behavioura of the average consumer at each point.

Yet we only have access to these insights once we stop playing at party tricks; stop pretending that people are really rational except when we pull the wool over their eyes with a clever heuristic. Only when we use a well-founded model of cognition and design our research methods to uncover its parameters, will we be able to predict, and more importantly influence, what consumers do.

Behavioural economics has a new record company, and it's about ready for its serious phase. Time to reinvent it. That complex, but scientifically measurable, cognitive model is what runs your mind, and you can't get it out of your head.

Clearing my tabs for 2012

2011-12-31T15:15:00.000Z

During 2011 I have probably spent about four days waiting for my browser to respond, due to the number of tabs I habitually keep open. Between the four computers I use, I probably have 200 blog posts in tabs waiting for me to comment. Here are a few of them (in no particular order), so my Chrome may enjoy a faster 2012.

A note from Paul Krugman on what makes economics economics. Not a rhetorical discipline but one based on mathematical models. (However, see also Deirdre McCloskey's Knowledge and Persuasion in Economics, which puts forth a persuasive case that it is both. Also, I believe that rhetoric, culture and all forms of speech will one day themselves be modelled within economics - a tantalising prospect).
Talking of persuasion, here is Steve Randy Waldman on market monetarism, and whether we can fix recessions by simply persuading people to change their economic expectations, or whether there are real constraints that can't be solved just by monetary easing. I could plausibly have picked any article on his interfluidity blog as article of the year (if I were doing an article of the year), but this quote alone shows more insight than most entire blogs: "Central banks may significantly shape patterns of consumption and investment by choosing to whom they are willing to lend and on what terms. They may pick winners and losers, not for a brief ~~Paul Volcker~~ Chuck Norris moment but for the indefinite future."
A good overview of Daniel Kahneman's life and work, including the origins of behavioural economics and how Kahneman and Tversky's work has influenced other fields.
The limits of the scientific method in economics (see also part two): an article whose conclusions I don't agree with, but which asks the right question: can economics model (and predict) the behaviour of people whose behaviour is itself influenced by economics? In answer, Roger Martin claims that we can't use deduction or induction to predict the future, only to model the past; to look forward we must use "abduction", or "invent a new hypothesis". This seems a very nihilistic, not to mention impractical, view. He too calls on rhetoric and postmodernism, but unlike McCloskey, who analyses what those things actually consist of, Martin simply attempts to use them as a get-out clause from the anti-scientific logic of his argument.
Mark Thoma's more economics-friendly response to the above. His response to Martin's question, pointing out how the field of rational expectations was invented to answer it, and defending economists' work in coming up with new models as the old ones are proved wrong, is much more to my liking.
An article from the Economist's Blighty blog about behavioural economics - or, more precisely, behavioural social policy and behavioural politics. Despite co-opting Nassim Nicholas Taleb as a behavioural economist - believe me, we don't want him - this piece has some good insights into psychology and why so-called "irrationality" (let's call it "fast heuristics" instead, shall we?) isn't always a bad thing.
Also from Mark Thoma, a quote from Keynes to the effect that society can only build railways and other bits of infrastructure when it participates in a shared illusion that enables it to invest, not consume, the fruits of its wealth.
Why values, as well as resources and incentives, are important in economics. As usual, a thoughtful essay by Tyler Cowen, one of the most open-minded writers on the right. I hasten to add that this degree of open-mindedness is also rather hard to find on the left.
Some excerpts and a review in the New York Review of Books by John Lanchester of Michael Lewis's Boomerang, including possibly the quote of the year: "you have a dog, and I have a cat. We agree that each is worth a billion dollars. You sell me the dog for a billion, and I sell you the cat for a billion. Now we are no longer pet owners but Icelandic banks, with a billion dollars in new assets". I haven't yet read the book itself, but I'm interested in its attempts to explain economic differences - and similarities - by reference to local culture. As Lanchester says, "The collective momentum of a culture is, for more or less everybody more or less all of the time, overwhelming. This is especially true for anything to do with economics". He draws a broadly downbeat conclusion, but I believe the real need - and opportunity - is to analyse what culture is and how it affects economic behaviour - at which point we might be able to figure out what to do about it.
See if you can boil this FT article about crowds, behavioural economics and neuroscience into nine insightful, factual sentences while ignoring the rest of the silly oversimplifications.

Of course, the time I've spent writing this article far outweighs any browser speedup I am likely to earn over the next twelve months - especially taking into account the forty further tabs I will undoubtedly open over the next week. But I hope you've found the links useful in helping waste some of your own valuable time.

What is "playing"?

2011-12-29T12:23:00.000Z

In between work on some more serious posts (not to mention the day job), let me post a brief comment on Margaret Robertson's article on gamification, "Can't play, won't play". It was written a year ago, so I'm not expecting to provoke an intense debate, but the same argument could easily be made today and it's worth responding to.

In short, Margaret claims:

gamification isn’t gamification at all. What we’re currently terming gamification is in fact the process of taking the thing that is least essential to games and representing it as the core of the experience. Points and badges have no closer a relationship to games than they do to websites and fitness apps and loyalty cards.

Her preferred vision of games is:

Games manage to produce [rich cognitive, emotional and social] drivers by being complex, responsive mechanisms. Games set their players goals and then make attaining those goals interestingly hard.

My involvement and interest in games is much shallower than Margaret's. She's a leading game designer and spends (I imagine) much of her life either playing or creating games. My interest in games is a psychological one - for me, they are a simplified, purified version of the motivations that drive us in real life. They provide a simple domain in which we can either examine, or manipulate and take advantage of, those motivations.

Undoubtedly Margaret, and the millions of other people who have a sophisticated and detailed experience of many different games, would be unsatisfied with the simple games that might keep me happy. Similarly, a novel which entertains an occasional reader may not provide meaning or interest to a literature graduate. But it doesn't mean it isn't a novel.

Margaret doesn't agree. She says:

...there is no way, not one single way, in which [Nike+] is a game.

Her distinction is between "gamification" (creating meaningful choices, which change the way you experience the game or the world) and "pointsification" (adding quantitative measures which simply count up your achievements). But I don't see why this is a category distinction - rather, it is a matter of degree. There are simple games - like Nike+, which helps you measure your progress as you run further and faster each day - and complex, subtle games like, I don't know, Portal or World of Warcraft. They can both provide meaning if the player invests it into them; or they can both be mechanistic, boring processes if you're not engaged.

Perhaps Margaret sees no meaning in the distinction between running 1k and running 5k in Nike+ - but I certainly did, when I "played" it. I was pretty damn proud to get through the 3k and 5k barriers, having started running for the first time a couple of weeks before - and the transformational experience when I first realised I was not forcing my legs to move, but was enjoying running for its own sake, was packed full of genuine meaning. And it would not have happened without Nike+.

So, no doubt advanced gamers have higher standards. They are no longer satisfied with what entertains us neophytes, and they need more advanced games to engage them and provide meaning. But this doesn't mean the games that entertain me aren't still games. My simple points-based achievements fulfil the same psychological role for me as those meaning-laden choices and consequences do for an experienced game consumer. There are degrees of meaning.

I suspect it's easy for an advanced consumer of any art form to forget the simple pleasures that inexperienced consumers get. Once you've seen The Wire it's easy to dismiss Cagney & Lacey. When you learn the subtleties of Beethoven you may not think the Spice Girls are real music any more. If you have translated Beowulf into modern English, the crudeness of Dan Brown is ruthlessly exposed. But the commuter who enjoys Dan Brown on the tube will be left equally cold by Beowulf, until they've learned how to appreciate it.

Games are no different. Until you've invested enough playtime to become familiar with the distinctions offered by the subtler choices and more complex consequences of Minecraft or Skyrim, points, levels and badges still provide a sense of achievement and, yes, meaning, that can be psychologically very powerful.

A thought experiment: why the ECB should print money...

2011-12-13T05:35:00.000Z

...and why the Bank of England and Fed are right to have done so already.

I'm not talking about whether the European Central Bank should directly buy eurozone government bonds. This causes a moral hazard problem - it might encourage governments to be profligate and reduce incentives for structural reform. It's, at the very least, debatable. I'm talking about a more general question: why should central banks print money in a recession?

This post won't have much new to say to macroeconomists, but it attempts to address a concern of many non-economists - won't printing money just cause more inflation?

First, let's run a thought experiment. Imagine that your national government has decided that profligate use of fossil fuels is a problem. Probably because of the risk of climate change. Instead of using a carbon tax, the government decides to restrict the supply of oil coming into the country. It could allow more oil in if necessary - in fact it has a large reserve stored up for emergencies - but it chooses to limit how much oil its citizens use, by keeping the supply at the level which corresponds to a sustainable quantity of carbon emissions. Aside from this intervention, it lets the market set prices and doesn't regulate who uses the oil or what for.

Over time, people come to know what the supply of oil is going to be each day, and they know how much they use, so prices adjust to the level that balances supply and demand. Most people have a certain "stock" of oil - petrol in their car, oil in their heating tanks, or - for electricity generators - a reserve of oil to run their power stations for a certain number of days.

Suddenly there is a disruption to oil supply. Maybe terrorists start attacking oil pipelines and people start to get very worried about whether they will still be able to get petrol. Perhaps a couple of refineries break down and there's a global shortage of refining capacity. Maybe a couple of petrol tankers explode, and 80% of tankers are taken off the roads for a few months until they can be fitted with new safety equipment. What happens now?

The first thing is, people's demand to hold spare oil reserves will go up. They are aware of the supply risks, and the disruptions to the oil distribution system makes them worry that they won't be able to get petrol when they want it. So people start to hoard oil and petrol. Maybe there are knock-on effects - petrol stations can't get the petrol they need to sell, and some of them might become bankrupt. Probably, the price of petrol would soar. Electricity companies will, if they can, increase prices or reduce the amount of power generated so that they in turn can build up their inventories. Note that all this may happen even if the supply problem is more feared than real.

People try to buy extra petrol to build up a reserve, while still maintaining their normal lifestyle - but they can't, because there's only so much petrol to go around. So there are shortages at the pump - which of course receive national news coverage. The next day, everyone else shows up to fill their tanks - the gas stations run out within a few hours - and the problem gets worse and worse.

Everyone is trying to hoard petrol just in case the next person gets in and hoards it first. Of course oil prices might eventually stimulate new distribution channels or new sources of production, but it will take a while. In the meantime, the economy is seriously disrupted because everyone is forced to use less oil and petrol than they are used to, and the country will probably quickly enter a recession, with high unemployment, reduced GDP - and government deficits following automatically.

What should policymakers do (if anything)?

Even though the government still regards climate change as a serious risk (and let's say voters agree with this concern), there's a paradox: demand is up but petrol usage is down. All the extra demand is for reserves, not petrol usage.

I say the government should gradually release its reserves into the market. This will let people build up their stocks of oil and petrol to whatever level they are comfortable with, and usage will go back to normal. Once this happens, the government can stop releasing the reserves and a new equilibrium will be reached. Petrol stations will get back to roughly the level of sales they had before, electricity companies will get the reserves they need and start generating power at normal levels again.

The story is: a demand has arisen for people to hold more petrol stocks, but not to burn more petrol. The government is the regulator of petrol supply, and has a reserve, so it can open the taps and let people have the stocks they want, without causing any more carbon emissions. Then, if people's worries about supply reduce over time, they will run down the spare petrol stocks, and the government can restrict national supply a little more to balance this out and build up its reserves again.

To get the timing and the supply just right, the government will have to keep a close eye on petrol prices, but that isn't too difficult to do - the market signals are all available. Opening the reserves seems an obvious solution with no real downside.

Now you may have figured out where I'm going with this. In this story, replace "oil" and "petrol" with "money", "national oil reserve" with "central bank printing press" and "carbon emissions" with "inflation". Now we have the story of the financial crisis and the recession.

The government (via the central bank) in normal times deliberately restricts the supply of money to keep inflation under control (interest rates are just another way of doing this). They have a reserve - they can in fact print as much money as they want - but they choose not to use it, because that's their way of managing inflation and maintaining the value of their currency.

When the credit crunch happened in 2007-08 - a couple of banks went bust, so people naturally became concerned that the supply of money and loans was going to shrink. Everyone wanted to hang onto more money, just in case. Banks stopped lending to each other in order to keep more of their money in reserve - and because they were worried that the other banks couldn't repay them. People cut back on spending not because they didn't want as much stuff any more, but in order to keep some spare cash just in case they lost their jobs. And of course, these actions feed off each other - when the whole population cuts spending, people do lose their jobs. When all banks stop lending to each other, they don't end up with more money - they end up with less.

We have a situation where there is high demand for money - not because people want to spend more, but because they want to save more. To stop this from causing a recession, the central bank has to "open the taps" - by printing more money. Normally this would be the equivalent of cutting interest rates - but when interest rates get to zero, it needs to be done in other was.

This will not cause inflation if they only release just enough new money to let people increase their reserves to their new "safety level". And later, when people are reassured and don't need to hold as much spare cash any more, the central bank can reduce the money supply again and/or increase interest rates to soak up the money back into the reserve.

Just as with the oil reserve, there are different ways of doing this. The government could give out petrol directly to individual households. Or it could sell it to the oil companies (at market prices) and let them sell it on - this would probably result in it going more accurately to where it's needed, but the oil companies would make a profit too, so it might not be politically popular. No doubt you can see the parallel again - some people would like the central bank to just give money directly to citizens, but instead they normally do this by "selling" money to banks (by buying government bonds from the banks) and let the banks lend it out, again making a profit. This is a more economically sound way of getting the money to where it's needed, but the banks will make a profit on it - because distributing money is, after all, their business.

If the political situation calls for it, perhaps the government will impose a windfall tax on the oil companies/banks to compensate for the extra profits they are deemed to have made while helping to solve the problem.

It turns out the Federal Reserve, Bank of England and Bank of Japan have been doing just this throughout the last few years. While it hasn't resulted in those economies returning to full health, it has probably helped stop them going back into recession. Many economists think they just haven't released enough reserves, and should do a bit more; though there is also an argument that some of the economic slowdown would have happened anyway, while the economy rebalances away from housing and finance, towards other industries.

The one major central bank that has not done it is the European Central Bank. They have cut interest rates - though probably not enough - and loaned a bit of extra money to some of the banks to tide them over (imagine giving the petrol companies enough extra reserves to help them stock up their spare petrol tankers, but not enough to satisfy the demands of the population itself).

And now there's a new twist: imagine that eurozone governments themselves use a lot of oil (money), and now they can't get enough petrol (money) to fuel their own operations. With petrol (money) prices soaring, some of them have used up their internal reserves and may have to shut down some of their operations. This in turn would cause more problems for the economy, making things even worse for the citizens who are short of both oil (money) and the government support they partly rely on.

The ECB's job now is to open the reserves. An infusion of money into the Eurozone would help cure the capital problem that the private banks are suffering from, restoring economic growth and automatically improving the financial position of Eurozone governments. It would help prevent or soften the recession that is currently expected in Europe, making it more likely that Italy, Spain and Greece will be able to finance or refinance their debts, which in turn will let them borrow at more reasonable rates.

The ECB does not need to buy the bonds of those countries directly, if it is concerned about setting a bad precedent - just as the oil reserve would not need to be issued on credit to unstable petrol companies. Just increasing the supply to the good companies (good banks, creditworthy eurozone countries) will have a knock-on effect on the others.

Because the problem has been allowed to get this bad, there is now a risk that the money (petrol) will not get to where it is most needed. To help fix this, other steps might be needed. In the petrol scenario, the government might part-nationalise some of the weaker petrol companies, or subsidise investment in new pipelines to make sure the petrol gets to all parts of the country. In the Eurozone, some big capital investment programmes in southern Europe might be a better way to distribute money than simply giving it directly to the Italian, Portuguese or Greek governments. But these are less important than the emergency response.

It's time to open the taps - or as Doug Saunders put it the other day: Mr Draghi: TURN ON THAT PRINTING PRESS!

Does Nudge require regulators to be "more rational" than consumers?

2011-11-08T00:44:00.000Z

A couple of times recently - notably in Bill Easterly's otherwise very positive review of Daniel Kahneman's new book - I've seen the following common critique of Nudge-style approaches: "But if people are irrational, regulators are irrational too - so how can they make rules to counter citizens' irrationality?" Easterly says:

But [the case for libertarian paternalism] is much too sweeping, because it overlooks everything the rest of the book says about how the experts are as prone to cognitive biases as the rest of us. Those at the top will be overly confident in their ability to predict the system-wide effects of paternalistic policy-making...

While it's right for regulators to be humble about their degree of knowledge about the world, and to be cautious in creating new regulations, there are several reasons why this particular criticism is wrong.

First, we are not comparing like with like. There is no claim that a regulator, when placed in the same situation and making the same decision as a citizen, will come up with a better answer. Instead, we are looking at times when citizens make snap decisions without thinking them through - or, often, make no overt decision at all because they do not notice that there is a decision to be made. In these cases, the regulator's goal is either to say "what would the citizen decide if they did think about it carefully?", or even better, to encourage the citizen to make the effort of thinking it through themselves. If the answer to "what would the citizen decide?" is controversial or ambiguous, the regulator is unlikely to try to intervene.

Second, everyone specialises in something. A lawyer specialises in the law - I wouldn't expect them to be better at making business decisions than me, but where my business decisions have legal ramifications I'd like to have their input. A doctor does not know better than me what I should choose to eat for dinner, but they can give me useful information to help me pick the foods that are right for me. And similarly, somebody who spends their professional life thinking about decision-making and examining the extensive research in this field is likely to be able to help me make decisions that I'll be happier with.

Third, even if regulators are not perfect, a best-effort regulation may well be better than none at all. The absence of regulation does not mean the absence of nudging. As Thaler and Sunstein point out in Nudge, our decisions are going to be influenced by context, framing and defaults no matter what. If the government takes no part, then the influences will be random, or chosen by private companies (whose interests are sometimes opposed to mine, though not always). If a democratically accountable government can help to move from one default frame to another that is more likely to be in my interest, then why would I not prefer that one?

There are people who read public choice theory as implying that most government policies are likely to be corrupt and wrong-headed. These people may well oppose Nudge-style regulations as they oppose most other regulations. But I think that view is not a mainstream one.

Indeed, mainstream economics has a clear place for regulations - where the action of a private party imposes an unpriced cost or "externality" on others, an appropriate regulation will actually make the market function more like a genuine free market, not less. One could argue that the framing carried out by private companies acts as an externality by imposing hidden costs on the consumer - in which case a better market outcome will be achieved by reversing these frames.

Finally, Nudge policies are designed to be optional. Anyone who does not trust government to provide a default which is in her own interest is welcome to ignore the government's recommendation and make her own choice. Those who would prefer to make the tradeoff of trusting the government's (carefully researched, democratically supervised) recommendations can simply take the default and save themselves the effort of thinking it through, and reduce their risk of making a mistake.

Easterly certainly raises an interesting challenge for behavioural research: the "system-wide effects of paternalistic policy-making" are indeed not well-understood. The fact that the policies are optional for the citizen is (I suspect) likely to mean that the system exhibits stability rather than instability, with any effects of Nudge regulations being damped rather than amplified by the interactions of the system. But it's not certain yet. My own research focuses partly on this area, as I think it's important to find out how a more accurate picture of human behaviour, scaled up to the systemic level, will affect our understanding of how markets work.

I notice that I have written on this subject before, so I'll finish by quoting myself:

We don't expect aeronautical engineers to be immune from the law of gravity. Yet we still trust them to design planes that can help us transcend our own gravitational problems.

Prompted Pareto improvements

2011-10-31T22:00:00.009Z

I'm going to attempt to introduce a new concept here. It is a bit technical, but I'll try to provide background for non-economists first. I may indulge in some modelling to help me understand it better, so if that's not your thing, feel free to skip the equations and just read the words.

I'm also struggling for the name of this concept. The title of the post, "Prompted Pareto improvements" is a name I'm reasonably happy with, but catchier suggestions are welcome.

I'll start by explaining the idea of Pareto efficiency and a Pareto improvement. There's lots of information at the Wikipedia page if you'd like to know more.

Pareto efficiency is one of the standards that is often used in economic theory as something we should aspire to, because it is a standard almost nobody can disagree with. It means that we should consider any transaction, or change in an economic allocation, to be a good thing if it makes at least one person better off and nobody worse off. A transaction which meets these criteria is called a Pareto improvement, and a system in which no possible Pareto improvement can still be made is called Pareto optimal.

It is intuitively problematic in two ways, however. First, because it's hard to achieve. In practice, there are always still opportunities to improve the world, so we are never really at a Pareto optimum. Second, it demands an unlikely level of respect for rich people. Accepting this as our standard yardstick of economic goodness implies that if we could take one dollar from Warren Buffett to cure malaria and hunger, we should not do it. Even though billions of people would be better off, Warren would be a dollar worse off, so this is not a Pareto improvement.

I imagine that most people who have studied economics have wondered whether this is a good principle. It has the appeal of removing all coercion from the economic system: people only take an action if it benefits them. Thus it seems that nobody should object to a Pareto improvement.

One can certainly debate whether it's legitimate to tax Warren Buffett to make Youssou, Mike and Mary better off; strict libertarians would probably say no, while most utilitarians would say yes. Traditional economics sidesteps this question and asks what is the best we can do without such coercion.

I don't want to go into the utilitarian question right now. What I want to explore is the borderline. Why is Pareto efficiency not a useful standard in practice? The two reasons I gave above can be looked at in a single framework.

Start with the second problem: the billionaire who can solve hunger. The take-a-dollar-from-Warren example is an extreme case, but one can imagine lots of situations where a very small cost to a wealthy person would make a huge difference to one or more poor folk. Wealth need not be defined only by money: the same might apply to bone marrow or knowledge, where recipients can gain much more than the donor gives up.

Some cases are so close to the borderline that if we point out the situation to Warren, he may well voluntarily give up his resources to help the person who needs them. Without the reminder, it doesn't occur to him to seek out someone who can use the dollar better than him; but if we do the seeking and tell him about it, he will probably be amenable to a deal. In the conventional model, we could say that his preferences simply change when he gains more information about the situation: his preference for compassion then outweighs his preference to retain one extra dollar.

However this assumes away everything interesting about the problem. If we simply posit that preferences can change, then almost anything can happen; the model becomes too general to be useful. In any case, even traditional economics requires preferences to be stable - it doesn't allow them to change when new information becomes available.

There are several more useful ways to look at this situation:

the preferences for compassion change
preferences are not a constant, but a function applied to context. When the context changes, the effective utility value of the preferences change.
preferences are over a set of objects within the world that we know about. When the world we know about changes, we re-optimise over our newly learned preferences
attention is limited and we only make decisions within the scope of our current attention. A new message can shift our attention, and a decision becomes available which was not possible before.
the information itself creates a new preference; in the same sense as being told the first line of a joke creates a desire or demand to hear the punchline.

Regardless of which of these explanations is closest to accurate, we can certainly imagine a situation where Warren does not make a particular exchange when unprompted. However, when told about the consequences of the exchange for the other party, he chooses to make it.

I mentioned another reason why a Pareto optimum is never achieved - practicality. There is no realistic way to get to a Pareto optimum because we cannot know all the trades that are available in the world. There are probably many things I would want to buy or sell right now, and people who would willingly sell them to or buy them from me - if only I knew who they were, what was on offer and why it would benefit me.

We can look at this in exactly the same way: if I were prompted with the right information, I would choose to make the trade. Lack of information is what prevents us reaching a Pareto optimum.

The consequences of introducing this concept

So let's imagine we introduce the idea of a "prompted Pareto improvement". A trade between two parties which both parties would willingly make if they receive a certain piece of information, but without that information they do not proceed.

If this concept finds its way into our economic models, what does it allow us to do?

First, it broadens the range of economic transactions which are permissible. This may raise the welfare of the society we are studying (depending on our definition of welfare).

Second, it starts to suggest how we could incorporate the transmission of knowledge into our models. There is little place for knowledge in the main general equilibrium models of the economy. But surely in reality it is one of the most important factors that controls economic behaviour and welfare. Not just explicit knowledge - the possession of intellectual property, or knowing how to write a Java program - which has economic value. But tacit knowledge of the choices we have and the chance they'll make us happy.

How far should we bend the rules?

Can we say that giving ANY message to the individual is permitted? Imagine you told Warren that you had kidnapped his daughter and would kill her if he doesn't give a billion dollars to buy malaria nets. No doubt his preferences would be changed, but on the basis of a false picture of the world (I'm assuming you have not actually kidnapped his daughter. If you have, please contact me and I'll correct this post). But I am loth to add a condition that the information must be "true" - because of the difficulty of defining what that means. Indeed, many messages will have no defined truth value (like "I suggest you go onto the following website...").

Passing a message of this kind would have consequences. Presumably you would be arrested; giving the message in itself would therefore result in a diminution of your utility. Thus you would become a party to the Pareto transaction, and your interests would need to be considered in whether it is a permissible transaction.

This is an unusual case. But it highlights a factor we will have to consider: the provider of information may incur a cost to provide it. A more straightforward example than the above is if A wants to sell a product to B, but in order for B to know it is available, A must pay to advertise it.

Another relevant example may be the threat of force from the legal authorities. In a typical economic model, payment of an income tax is not a Pareto transaction, as the taxpayer does not benefit from it and does not choose to participate. However, most self-employed people pay tax not because they are physically forced to, but because of information that has been communicated to them about the consequences if they don't. The communication of this information affects the choice that the taxpayer makes, even though they never actually suffer the consequence.

More generally, it is logical to suppose that people do not form preferences without receiving information. Some information is directly received by experiencing a product, some is communicated from other people.

With all these interesting factors, how might we design a tractable and useful model?

What we'd need to model to include information in our view of the world:

State K of knowledge of an agent (setting aside the question of whether this "knowledge" is all true)
Message M which can be received by agent A and will alter K

There exists some M which can be received by A which will induce A to choose to make an exchange of goods with agent B.

We can define three different kinds of improvement:

One-sided prompted-Pareto improvement (if B prefers the new allocation unprompted, but A needs prompting).
Two-sided prompted-Pareto improvement (if both parties need prompting).
Zero-sided prompted-Pareto improvement (an ordinary Pareto improvement without any prompting)

Questions to think about:

does B know what the message M is?
does A know what the message M is?
is there a cost to transmitting M?
does M depend on source, timing, other context as well as content?
can there be messages N which contradict M? What if multiple messages affect the preferences differently?

Finally, what might be the generalisations of a Pareto optimum?

An unprompted Pareto optimum; where no pair of agents wish to make an unprompted exchange
A prompted Pareto optimum; where every possible prompted Pareto improvement has been made (does this mean they have all been prompted? Presumably yes)
An intermediate optimum, where every improvement that has so far been prompted has been made, but other prompted Pareto improvements are still possible

These are nice, elegant concepts but they ignore some of the more difficult questions listed immediately above.

What are the consequences?

We are able to start constructing an economic model where information flows are explicitly modelled and their effect on preferences can be understood. To be useful, the model will certainly need to make further assumptions about the relationship between information and preferences. For example, might preferences for goods be made up by composing different product benefits along with some knowledge of how they will satisfy other pre-existing preferences?

It will give us a richer understanding of a real world in which traditionally Pareto efficient outcomes are not reached.

It will allow us to see how a system can get closer to Pareto efficiency - or whatever standard of welfare we decide is appropriate - by becoming more open to the flow of messages that can more effectively allow people to make welfare-maximising choices.

Just as conventional economics has a standard of allowing the maximum voluntary exchange, cognitive economics could develop a standard of maximum information transparency, which in turn would improve the operation of voluntary exchange in practice.

"Maximum transparency" is only, of course, a theoretical goal - no more realistic than "perfect information" in the neoclassical model. Passing messages has a cost. So a model which lets us see what types of information unlock Pareto-improving transactions will help determine what kind, or amount, of information, should be passed. No doubt there will be an indifference point at which the marginal cost of providing one more piece of information will outweigh the marginal benefit from enabling one more Pareto improvement. What will that point look like?

Is this original?

Finally, I would welcome anyone more familiar with the information economics literature than I to say whether this concept has been examined already. Greenwald and Stiglitz proved that a Pareto optimum cannot necessarily be reached when there are information asymmetries; and I am aware of the idea of a "constrained Pareto optimum" which is the best that can be achieved given a certain state of information held by agents. The idea of a prompted Pareto improvement may help to solidify those concepts and provide a more useful framework to implement them in practice.

Please vote for us and help a charity

2011-09-07T13:56:00.000+01:00

My company Inon, which applies behavioural economics to help our clients set the right pricing strategy, has been nominated for the Smarta 100 - the top innovative businesses in London.

If we win, our £10,000 prize will be donated to charity - please leave a comment if you would like to nominate your preferred charity as one of the recipients.

If you'd like to support us and your chosen charity, please click here and vote for us. You'll need to register but it only takes a few seconds.

Thanks for your support - we have reached 20th in the rankings and it seems like we might have a chance if you can help spread the word.

Has the nature of investment in the economy changed?

2011-08-31T13:34:00.000+01:00

I may have more to say about this in the next few weeks, but this New York Times article about industrial policy reminds me of a question I asked on twitter the other day:

...hedge funds and venture capitalists are geared toward investing in financial instruments and software companies. In such endeavors, even modest investments can yield extraordinarily quick and large returns. Financing brick-and-mortar factories, by contrast, is expensive and painstaking and offers far less potential for speedy returns.

This might not just be a change in investors' preferences. (Although if they have decided they prefer fast returns over slow ones, I don't know that I'd criticise them for that.)

What if something deeper has happened. In the late 1940s and early 50s, macroeconomic trends were fairly clear: Europe was on the verge of a major recovery, and American growth was likely to continue. In conjunction with this, we could predict with some confidence what people would want to spend the proceeds of that growth on. Most people would want cars, houses, refrigerators and TVs.

Therefore it was fairly clear that you could make decent money by investing in factories to build cars, refrigerators, TVs - or on land in Western Europe where houses would be built. Which is fortunate, because those are long-term investments. It takes several years to build a car factory and longer to build all the related distribution infrastructure - but that investment would keep paying back into the 1970s and even 80s - thirty years out.

Today, the macroeconomic trends are still fairly clear - China and India will get much richer over the next twenty years, while the Western economies and Japan will grow more slowly, though there will still be plenty of consumer demand there.

But it looks like consumer preferences are changing much faster than fifty years ago. The thirty-year predictions we could make in the fifties would be crazy to make now. I have no clue what consumer goods or services people will want to buy in 2041.

Of course there will still be cars and fridges on sale. But those will earn lower margins than in the 1970s, and if you don't already run Toyota or LG, it's almost impossible to invest profitably in that market. Anything that takes ten years to build, when we have no idea what consumers will want in ten years, is a losing investment.

So is it any surprise that investors turn to software - which, although it is also kind of unpredictable, at least turns around quickly. You will know in 18 months whether your bet has paid off. And if it pays off, it pays off big - the returns are quick, high, and disappear in a few years.

Presumably there are some long-term physical investments that look sensible - the car battery plants in the NYT article seem to be one example - but will the current investors be able to capture the returns, or will they be competed away as employees move around and patents expire?

Maybe this is what investment looks like now - short-term, individually risky but diversified via venture capital portfolios - instead of long-term and (relatively) low-risk via stockmarket holdings. You can make a long-term investment out of lots of short-term VC stakes, rolling them over when they mature; but that's a model that most investors are probably not willing to get involved in, except via shareholdings in the occasional company like Google which can afford to operate that kind of product development model in-house. Perhaps those who want to invest for the long term have no real choice but to buy government bonds.

Why Obama should propose a Balanced Budget Amendment

2011-08-14T19:19:00.005+01:00

It's the one simplest thing President Obama could do to seize control of the economic agenda. It's counterintuitive - but done right, it could be the tonic both for the economy and for a divided political scene. Don't click on your back button yet - I haven't gone crazy.

Obama should propose a Balanced Budget Amendment with the following key features:

The balance must be achieved over ten years, not one
It should include automatic (not discretionary) investment programmes when unemployment is high, which are scaled down when the economy is doing well
It should commit to share the proceeds of future growth between deficit reduction/debt repayment, tax cuts and investment

This policy would provide countercyclical intervention - exactly as a responsible government should. Right now, the US economy could use five to ten million more jobs (that's about $500 billion a year, by the way). Five years ago it didn't need anything like that - there was plenty of private investment going on, so the government wasn't needed so much. We hope that in five years time the same will be true again. Responsible Keynesians promote smaller government in boom times, just as they argue for larger government during recessions.

The stability provided by such an amendment would allow "shovel-ready" plans to be prepared in advance. Any needed stimulus could be spent well, on public goods which genuinely provide physical infrastructure or education that the private sector cannot. Individual states might sometimes decide to execute these plans on their own, if the federal government is in a low-spending year; that is up to them - after all, they're closer to the ground and know the needs of their own people and businesses better.

And by precommitting some of the proceeds of growth - which will increase government revenue - to repay debt, the plan would show responsibility towards the future without hurting current income. It would allow government to grow in absolute terms - something that is probably inevitable - but to grow more slowly than the economy, meaning that government spending as a percentage of GDP would fall in the long run.

There are a number of options which might help strengthen the plan:

The debt ceiling rules should change to include an allowance for the government's assets as well as its debts. Voters understand that it's OK to take out a mortgage as long as the value of your house keeps up with it. The figures would look at lot better if the government could put all those roads, schools and aircraft carriers on its balance sheet.
A clarification of the Fed's mandate - ideally towards a target for total nominal spending, but almost any change would be an improvement - would reduce uncertainty. In any case, being able to predict the fiscal balance of the economy would make the Fed's job a lot easier.
A serious look at the education system would be a worthwhile investment in the future. American education and educators are sometimes unfairly criticised - it really isn't that bad - but the system does fail to give a lot of people the skills they really need to innovate and compete in new industries.
The countercyclical argument can be framed like this: Today, we are asking wealthier Americans to lend a little to help their fellow citizens through this time. In five years, they will be repaid with a faster growing economy and lower taxes. The same argument applies across states with low and high unemployment, and across generations.
In the long run, it may be more effective to structure the balanced requirement as a rule stabilising the long-term ratio of debt to GDP. However, politically it is probably necessary to reduce this ratio before it can be frozen (at perhaps 60%).

A package like this could surely achieve significant political support across much of the population. It is fiscally responsible; it recognises the need for reform of government (and education) to help the private sector compete better; it includes a hard-to-break commitment to future tax cuts; and it also provides jobs, investment in public goods, and makes available a new future stream for spending when growth allows for it.

I wouldn't pretend that Republicans in Congress are going to jump on board with this - they have a strong political interest in not doing so - but it would reflect the desires of many Republican and independent voters. If Obama wants to bring the country together and transcend partisanship, recognising the validity of some Republican arguments, without caving in directly to Republican politicians, is a good way to do it.

This proposal is hardly a panacea. There are economic problems and budget issues that it doesn't handle; and there are political groups whose anger or alienation won't be assuaged by this kind of coalition-building. But it would be a start. Politically it would spike one of the right's rhetorical weapons, the call for a balanced-budget amendment, and it would make progress towards satisfying the genuinely held economic beliefs of both sides. It might therefore allow that particular left-right battle to fade into the background for a while, allowing space for society to deal with some other issues.

Update: I had missed a recent discussion by Reihan Salam of a similar proposal from Alex Tabarrok, a related (but stricter) offering from Ed Glaeser and the policies of the governments of Sweden and Chile (via Ed Dolan). Thanks to @KhalMojo on twitter for alerting me. I could also mention Gordon Brown's fairly successful policy from around 1997-2006 of a structurally balanced budget (excluding net investment) over the business cycle - which, however, was never enshrined in legislation and was weakened by the lack of an objective definition of "the business cycle".

Those articles focus on the economics of the proposal; I would emphasise that the politics are equally important. This could be a rare opportunity to unite some widely separated constituencies in America.

Update 2: Could this help the US to regain its AAA rating from S&P? Recall that S&P cited politics more than economics as its reason for the rating. Ratings alone aren't a good reason to make economic policy. But it wouldn't do any harm.

Update 3: Mark Thoma has written an article about this proposal today as well. It must be in the air.

The cost of making a hit single

2011-08-01T22:18:00.000+01:00

I've been listening to NPR's Planet Money podcast, and one of the recent episodes [mp3 link] is about how much it costs to make - and promote - a hit single. Or more accurately: to attempt to make a hit single.

A friend in the music industry asked me to write down their figures with so he doesn't have to listen to the whole podcast. So here they are. The record in question is Rihanna's "Man Down", which her record company Def Jam was hoping would be one of the anthems of the summer. The costs break down like this:

Initial demos made at a "writing camp": $18,000 (it costs around $200,000 to hire 10 studios for a couple of weeks and make 50-100 demos for Rihanna to choose between; this cost is apportioned over the 11 tracks on the album)
Fee to lyricist: $15,000
Fee to producer/composer: $20,000
Fee to vocal coach/producer: $10-15,000
Cost of other studios and recording costs: $10,000

Total production cost: around $78,000

And then the marketing - advertising, (allegedly, and indirectly) paying DJs, other promotional costs. They don't break this down - there's an interesting debate about why payola is illegal and to what extent it still happens anyway - but they put an estimate on it of $1 million.

And the video: $200,000.

So the total cost of creating this single was about $1.25 million. And it wasn't even a hit!

There were three other hit singles on the album, it has sold 1.3 million copies - so they may have made their money back in the end. But this case certainly suggests, if no more, that the business model of the record industry is rather precarious.

The blame might be put on illegal downloads, or on a general change in how people consume entertainment, or on changes in how artists and the recording industry are perceived; or maybe you have your own theory.

Some people respond by suggesting artists cut out the record companies - and, by implication, all those marketing costs. That would presumably free up a higher proportion of the money to go to the artist (if they can still monetise their work). But on the other hand, maybe the marketing costs are necessary to get an audience, in which case there might be no way for most bands to make the free-plus-premium-box-set model work.

Maybe the marketing money is an implicit cross-subsidy to the radio stations (at least in the US) and keeps them afloat; or maybe most of the marketing money is burned in a status game, where the money spent on one song just cancels out the money spent on another. If we want to know what kind of business models will work for music, these are some of the questions that have to be answered.

Two challenges for behavioural economics - one real, one fictional

2011-07-30T23:55:00.000+01:00

It seems that some people from outside behavioural economics are, like me, getting frustrated with the lack of progress within the field.

Eric Falkenstein says here:

I read Kahneman, Tversky and Slovic's Judgement under Uncertainty in the 80's (published 1982), which mainly discussed a series of papers published in the 1970s, and found it fascinating, but now it's now 30 year old stuff and pretty boring. There's a couple hundred academically based confirmed biases which are all kinda true, but not very profound

This part of the posting is quite right. A commenter at the bottom sums up the problem with state-of-the-art behavioural "economics":

Behavioral economics is not economics but psychology. It focuses on individuals instead of exchanges and markets.

Economics makes assumptions about actors to make market predictions. BE makes predictions of actor choices just like psychologists.

The question BE must address is how do biases create market conditions. To date I have not seen BE translate into markets.

I have written something similar here; part of my ongoing research is to build good descriptive and predictive models of how markets work under "behavioural agent" assumptions. This is a good insight and I would like it to be more widely recognised.

However, Falkenstein goes on to make the following common, but fallacious, argument:

So, Sendhil likes to play to standard liberal pieties about how government can help and inequality is the result of evil and prejudice (he's big on the stereotype bias, another publication bias result gone viral). Yet he forgets the most profound behavioral bias in this literature that is delightfully recursive:

We think we are better than average at not being biased in thinking that we're better than average.
This is true especially for people who have studied this subject at college. Thus, the behavioralists neatly infer from the literature that everyone else is biased.

This is nonsense.

Experts in psychology are fully entitled to claim to understand others' biases without being biased themselves. This is not because they are magically immune from cognitive effects themselves. Of course, psychologists are fooled by pricing tricks or guided by default options just like the rest of us (maybe a little less, but not much).

No - the problem with this argument is that it's based on a blatant category error. The reason that experts are allowed to talk about biases is that while being an expert, they are operating in a completely different context than the things they are describing. We allow politicians to make laws about drunk-driving, despite the fact that many of them drink alcohol themselves: because when making laws, they are not driving (and mostly not drinking). Would you refuse to be prescribed glasses by an optician who wears contact lenses herself? No - prescribing glasses is an entirely different activity to being able to see. Could you talk in July about the possibility of eating too much at Christmas? And can a physicist write about how aeroplanes defy gravity while being personally held firmly on the ground by a gravitational force? Er, yes.

There is no contradiction in any of those situations. You can describe a process while not currently experiencing it. You can sit back and rationally consider - or model - a psychological effect, using your imperfect brain to do so, and then go out onto the street an hour later and find yourself subject to the exact same effect.

This argument is so nonsensical that - in the absence of bad faith - I can only imagine a series of intellectuals sitting back in their chairs with a whisky, so self-satisfied with cleverness in spotting the behaviouralists' hypocrisy that they smugly and immediately write it up without ever stopping to ask if the reasoning makes any sense. I am sure there's a cognitive bias to describe that, but if I claim right now to know what it is, I might be accused of suffering from it. Better wait till I'm feeling rational again.

Notes from banking fragility talk

2011-07-28T08:20:00.002+01:00

Here are my unedited notes from David Miles' talk on monetary policy and banking fragility tonight. This may not be of much sense or interest to everyone, so feel free to skip it if you're not into this topic.

[Here is the somewhat more coherent post I wrote before the talk]

Miles – recently wrote a paper about the benefits (and costs) of higher bank capital.

LSE is intellectual home of MPC in many ways.

Links between monetary policy and financial stability: strong and significant

Compared to pre-recession trend in 2007, this recession is almost as bad as 1929, and on current projections will be WORSE from 2012 onwards.

Changes in banking sector since previous eras – more gross debt (now being reduced), more fiscal compensation (mostly automatic stabilisers), much higher bank leverage. There would have had to be a rebalancing of some kind, but the rebalancing is now happening in the context of a financial crisis.

One challenge: policy compensations for imbalances (VAT rise, sterling depreciation) plus commodity price rises, all lead to short-term inflation. Likely to go higher still due to domestic energy prices. Squeeze on household real incomes has been very large. Some people criticise the MPC for allowing this to happen – but this is bad economics. The MPC cannot have any control over this. VAT rise, imports and commodity price increases all require real incomes to fall. In fact, if MPC had increased interest rates real incomes would have fallen even further.

Emphasises: the fall in living standards are caused by real rebalancing after the recession, not nominal phenomena.

People’s main responses to inflation: cut back spending, shop around. Few bring forward purchases or push for higher wages. Wage settlements have remained low, 2%.

Domestically generated inflation probably below 2% now.

Reinhart & Rogoff say that a 10% fall from trend growth is typical after a financial crisis.

We need to make the financial system more robust – the single best way to do this is for banks to use much more equity capital than they have to date.

Leverage has already fallen – in UK, from about 40 to 20 on average – in the US, 40 in 2007, 50 in 2008, now about 16. Spread between different banks has fallen even more.

Has suggested that equity capital should be twice as high as suggested in Basel III (relative to total assets not risk-weighted assets).

Leverage has fallen, but it’s partly because assets have fallen as well as because capital increased. Assets fallen because of lower demand for, as well as lower supply of, lending.

There’s an argument that higher bank equity will be costly (banks will reduce lending). This is not clearly borne out by recent data, but it’s a fair question: where will the equity come from?

If banks today needed to double the amount of common equity from today’s levels, you’d need a trillion dollars of extra equity. But if this is done over a number of years, it won’t pose great difficulties and won’t have substantial knock-on effects – will show why.

Liabilities of UK banks look like:

Deposits:

14% banks

5% other companies

16% households

18% other financial corporations

8% Bonds
6% other securities
2% subordinated
26% derivatives
5% equity (of which 4% core tier 1 equity)

You could think of this change as a portfolio switch from other forms of liability.

[Is the problem that there is no demand for equity-like assets? Do people insist on liquid, fixed-income assets in debt form?]

How can we persuade people to provide equity-like financing instead of debt-like? This might be easier than we think. Ultimately, it all comes from household – though very indirectly. Investor distribution in bank shares:

57% investment advisors
2% mutual funds
1% other
3% pensions
11% unclassified
4% banks
1% corporations
18% government
0% hedge fund managers
0% holding companies
1% individuals
2% insurance companies

Similar for US and Germany.

Thought experiment: assume all bank equity and non-deposit debts of banks is owned by a single financial intermediary – an asset manager, a bit like a pension fund, unit trust, insurance company rolled into one.

Imagine banks now issued a whole lot more equity and retired a corresponding amount of bonds. The asset manager finds that in order not to change the underlying characteristics of their portfolio, they need to sell bank bonds and buy the new equity. [not demonstrated convincingly]

Claim: asset manager owns all equity but is liable for all its debts [huh?]

Like MM reasoning

Claim: asset manager owns equity and some bank debt in bond form. A switch in funding makes no difference to this manager.

Accepts that there are some problems in this: some investors only invest in equity or in debts, may not want to switch.

There is an argument (Diamond and Rajan) about why banks may need to finance a lot of their operations in demandable debt: it’s hard for people who provide debt to be sure about what the banks are doing with their money. Maybe the managers are taking high risks. One of the advantages of demandable debt is that if it looks like management are taking advantage of their control of the assets, individuals with retail deposits can respond by getting their money back. This will cause a bank run. The fear of this disciplines the management of the bank.

But most bank debt is owned by asset managers and is not demandable in this way. So this argument doesn’t really hold.

Question is: would a change to more equity funding hurt the economy significantly? Conclusion from above arguments is – not really, as long as it’s done in a gradual way. Having banks hold substantially more capital is therefore likely to make the system safer.

Notes on audience questions from twitter feed (these are in reverse order):

#lsefragility Miles: amount of truly liquid assets held by banks was much lower in 2007 than the past. Would suggest liquidity requirements.

1 hour ago

leighblue Leigh Caldwell

#lsefragility final Q: should regulatory reserves be used in addition to interest rates as a monetary policy lever?

1 hour ago

leighblue Leigh Caldwell

#lsefragility Q: the UK isn't isolated - will any new defences be swept away anyway by EU/US problems? Miles: we ought to do this worldwide.

1 hour ago

NoelBell Noel Bell

@paulmasonnews #lsehvk #lsefragility my questions following last night’s excellent debate. wwwnoelbell.blogspot.com/2011/07/hayek-…

1 hour ago

leighblue Leigh Caldwell

#lsefragility Q: will this directly help the economy now? Miles: no, it's insurance for the future. Shouldn't pursue too quickly.

1 hour ago

leighblue Leigh Caldwell

#lsefragility Miles: MM doesn't hold perfectly, but is still as useful as say Newton's laws, which also aren't perfect.

1 hour ago

leighblue Leigh Caldwell

#lsefragility Miles: MM does not hold fully. But if equity increases, volatility& return on equity is influenced, making it more attractive

1 hour ago

leighblue Leigh Caldwell

#lsefragility Q: doesn't your MM argument also rely on Ricardian equivalence, because investors are also on hook through taxes?

1 hour ago

leighblue Leigh Caldwell

#lsefragility Q: Selgin said in #lsehvk we should have let banks in 2008 go bust. Should we? Miles: I don't see the zombie banks out there

1 hour ago

leighblue Leigh Caldwell

#lsefragility Miles: to preserve risk-return characteristics of existing equity-debt portfolios, investors will have to buy the new equity.

1 hour ago

leighblue Leigh Caldwell

#lsefragility Q from asset manager: who's going to buy this equity? I don't see the demand.

1 hour ago

leighblue Leigh Caldwell

#lsefragility My version: distance betw ultimate asset holder and asset manager, differing incentives, leads to risks being misallocated

1 hour ago

leighblue Leigh Caldwell

#lsefragility Miles: unclear. But may be to do with tax advantage of debt; or to do with limited liability and implied state backing.

1 hour ago

leighblue Leigh Caldwell

#lsefragility Q: MM says high leverage causes higher financing costs. So why did banks increase leverage so much?

2 hours ago

leighblue Leigh Caldwell

#lsefragility Miles: not quite true, because benefits are also external (to bank borrowers eg small business) and that's not captured by MM

2 hours ago

leighblue Leigh Caldwell

#lsefragility Q: can you use Modigliani-Miller argument - in a world where MM holds, you don't need capital reserves anyway.

2 hours ago

leighblue Leigh Caldwell

#lsefragility audience Q: how about hybrid/convertible bonds? Miles: the danger is the uncertainty in the criteria for conversion.

2 hours ago

leighblue Leigh Caldwell

#lsefragility my Q about correlation. Miles: in a crisis, most things are correlated even if they don't appear so before. So doesn't help.

2 hours ago

Banking fragility and money

2011-07-27T16:36:00.000+01:00

Another day, another LSE lecture.

This one features David Miles from the Bank of England and is chaired by Charles Goodhart. It's on monetary policy and banking fragility. There are two aspects of this problem that are particularly important.

The first is transmission mechanisms – an important aspect of monetary macroeconomics. Simple monetary models highlight that there is a relationship between the amount of money in the economy and the amount of economic output (consumption, investment or both). From this we can infer that printing money may increase GDP.

Slightly more sophisticated theories give a causal explanation of how this can happen. The central bank prints money and uses it to buy bonds. More money (and fewer bonds) mean that the price of bonds rises – this is simple supply and demand. The price of bonds is the inverse of the interest rate (that is, if a bond pays £50 per year interest and it costs £1000, interest is 5%. If the bond price goes up to £2000, it still pays £50, so interest rates are now 2.5%). Thus, when bond prices go up, interest rates fall. And when interest rates fall, it is easier for companies to borrow money to invest, and for people to borrow money to buy flat-screen TVs. Thus, GDP increases.

The banking question is this: if the financial system is broken, can monetary macroeconomics still work? If companies can’t borrow money anyway because the banks won’t lend it, or if people can’t spend money because the ATMs have stopped working, it won’t make any difference if the central bank buys all the bonds in the world. The situation in 2008 wasn’t as extreme as that, but in some ways the banking system did stop working. The interbank markets, where banks lend money to each other, seized up because every bank was worried about every other. This meant that even if the average interest rate had fallen, money could not find its way to where it was needed. Governments were able to borrow money very cheaply, but lots of companies could not; and nor could consumers, because the biggest channel of consumer finance (remortgages) were also on hold. Thus, the GDP-boosting effect of monetary policy did not work as it usually would.

One argument is that when government can borrow and spend but companies cannot, Keynesian government spending policies are the only way to sustain economic activity. Government spending has its own problems, which need to be weighed up against how serious and how long-lived the banking problems are likely to be. But it’s an argument that can be had.

So I imagine this will be one of the topics this evening: how does the stability of the banking system affect the efficacy of monetary policy, and what’s the appropriate course for macroeconomic policy?

The other key question is in the opposite direction: how do macroeconomic changes lead to banking fragility? If they do, then we could have a vicious cycle where macroeconomics hurts the banks; and the banks in turn prevent monetary policy from being effective. Unfortunately, there is a tendency, built into the financial system, for banks to be overexposed to macroeconomic fluctuations. The cause of this: asset correlation.

One of the main problems in 2008 was that the banks were all doing the same things. Of course, some banks were too big, and they were all highly interconnected. But even had they been smaller and less confusingly connected – like the savings and loans (building societies) in the US in the 80s, the crisis could still have happened. This is because they were all overinvested in property at the same time. They had lent – directly, or through mortgage-backed securities, or via the US government agencies Fannie Mae and Freddie Mac – trillions of dollars secured on people’s homes. When the housing market slowed and went into reverse – a macroeconomic effect which could have been limited to just the property sector – all of these loans and securities were at risk at the same time. This meant that (nearly) every bank was in trouble, and it was impossible to let just a couple of them go bust in the hope that the rest would get by OK.

My contention is that this excessive correlation of assets was a main cause of the financial crisis. But before looking at regulatory solutions, we must ask why the market didn’t correct for this automatically? There are three answers to this.

The first is information-driven herding. Banks are always seeking better returns at lower risks (as they should do). But when a new type of financial product is introduced, it is unlikely to provide that right away. Any new instrument – an insurance policy, or a new type of bond, or anything else – suffers from uncertainty about how it should be valued. Some brave people might give it a try, but while the market is small, and there is a shortage of data about past performance, it will be discounted for uncertainty. It will also be discounted for low liquidity, because if there aren’t many people trading the new product, it might be hard to offload if you need to switch strategies. These effects make the product less profitable than it would otherwise be.

However, once a particular asset class becomes more popular, these problems go away. Once there is a market to trade it, the liquidity discount disappears. And once there is a longer history of data in the asset, the uncertainty discount goes away – though there is still (as there should be) a discount for the measurable risk of the asset going wrong.

This is effectively a learning process. The community of traders as a whole gradually learns about new types of asset; and the ones they have learned most about are the ones that are considered safe to trade. This in turn helps people to learn more about them, and the effect reinforces itself. So, once an asset class – mortgage-backed securities, say – becomes reasonably popular, a cascade will make it more and more broadly accepted across the financial sector.

This results in a herding effect – where banks and traders focus excessively on a small number of asset types, and bank balance sheets become less diversified.

The second reason the market can’t fix this on its own is because of positive externalities. As a society, we want people to experiment with many new ideas – across the worlds of finance, business, science and social policy. Part of the reason we want this is because the people who do the experiments don’t capture all the value. If a trader in a bank tests out a new investment in a green technology incubator, everyone can see whether it is successful or not. So the bank bears the whole cost if it fails, but if it succeeds, everyone else gets some of the value – because they can copy the idea without having taken the initial risk.

So for this reason too, banks will underinvest in new ideas and overinvest in old ones that have already been tested.

Finally, there’s a negative externality – the risk of systemic failure. Correlation of bank assets is a danger to the banks, but it’s a bigger danger to the rest of us – as we saw in 2008. Therefore, some of the costs of conformity are passed onto the rest of us; and banks don’t have enough incentives to avoid excessive correlation.

So the market has three strong tendencies towards conformism. This exposes the rest of us to high risks – because macroeconomic problems often start in a single sector, and if that sector (like property) is one in which banks are overinvested, the effects will quickly spread to the rest of the economy. We should therefore seek a way to correct this.

My proposal is to require banks to hold capital reserves which depend on how closely their assets are correlated with those of other banks. If a bank’s investments are very similar to the investments of other financial institutions, they should have to keep larger buffers of spare capital.

A valid question is: how do we measure this correlation? We can’t easily predict which assets will move in line with each other. There are a number of ways to come close, however.

One is to require banks to trade future-dated asset swaps with one another. Imagine a contract which gives me the option to buy $1 million of JP Morgan’s balance sheet and sell $1 million of Citigroup’s balance sheet, on 31 July 2016. If those balance sheets are closely correlated, the contract will have a very low value. If the balance sheets are very different, the contract will have a high value because it will offer me the opportunity to make a good profit.

We need only look at the market value of this instrument (and the corresponding swaps between a series of other banks) to find out how much capital each bank should have to hold. The lower the value of these contracts, the higher the capital reserves.

The existence of these instruments would create a group of traders with a powerful incentive to examine the underlying assets of each bank and look at the relative risks of each. And the capital reserves would either themselves improve the safety of the banking system, or drive the banks to diversify their assets and thereby protect the system.

Tickets for tonight’s event are sold out so I can’t invite you along; but let me know if you are interested in hearing what went on. There should be a podcast on the LSE website in a few days.

Keynes vs Hayek and cognitive macroeconomics

2011-07-26T17:32:00.003+01:00

This evening Paul Mason leads a debate for LSE, ~~the Adam Smith Institute~~ [Update: I made this assumption based on the debate being listed on the ASI's "Events" page. A BBC editor has kindly emailed me to correct my mistake. Thanks!] and Radio 4 on Keynes versus Hayek. It’s a good day to talk about it, with UK growth figures coming in at a disappointing 0.2% and a lot of uncertainty about whether public sector austerity is slowing economic growth, or conversely enabling more private investment which will improve things in the long term.

[Update 3 August 2011: The programme will be broadcast this evening at 8pm UK time, and will be available after that from this address]

On Hayek’s side, Jamie Whyte and George Selgin are speaking; for Keynes, Duncan Weldon and Lord Skidelsky. Do come along if you can, though the event is likely to be full so arrive early (5.30 is suggested). If you don’t get in, come to the Old Bank of England pub on Fleet Street afterwards for drinks and email (leigh@inon.com) or tweet (@leighblue) me if you want to meet up.

The Keynes versus not-Keynes debate (in this country at least) is often seen as a straight left-versus-right argument. It’s not as simple as that. There is certainly a broad identification of Keynes with the centre-left (I’ll explain why below). But the right’s arguments fall into three distinct camps: neoclassical free-market economics, monetarist models (confusingly, the “New Keynesian” school is mostly a monetary argument) and Austrian school, whose intellectual leader was Hayek.

Actually, Keynes, Hayek and monetarism are closer together than we usually think. They all differ from neoclassical economics in a similar way, but their interpretations and responses are distinct.

First I’ll outline the neoclassical argument and explain its weaknesses. Neoclassical economics is in fact the textbook microeconomic argument: a market is made up of many people, each of whom is aware of all the goods and services available, knows which ones they want and in what proportions, and can see how much they have to pay for them. The theory also makes a value judgment about Pareto efficiency, which effectively means that all trades should be voluntary, and any market transaction will only happen if it makes both parties better off. From these assumptions one can build the whole theory of competitive markets and general equilibrium, which says that everyone will become as well off as they can possibly be through private trades.

The assumptions are clearly artificial – not everyone knows all the goods that are available, there are lots of transaction costs when we trade with each other, and most markets are not fully competitive. The question is: is the real world close enough to neoclassical assumptions so that free markets alone will still achieve the best outcomes?

The answer seems to be no. In a neoclassical world there can be no recessions, no unemployment and no inflation. Yet all three of these phenomena are present and worrying right now, and throughout most of recorded economic history. The whole field of macroeconomics has arisen out of this answer, and from the corresponding questions: how does the world differ from those simple assumptions, and what should we do about it?

This is where the three schools of macroeconomic thought diverge – though parts of their answers to those questions are still similar.

The fundamental difference between the real world and the neoclassical world is that there are limits on our brains. We cannot access all the information about all the products in a market, the different people and companies that make them, or even the prices that they are sold for. We cannot even fully process the information we have, because cognitive processing takes time, so we use heuristic shortcuts to reach approximate answers.

The three intellectual traditions differ in what they do with this insight.

The Keynesian school observes that – for various reasons – people sometimes become more risk-averse. Emotions are a factor in the economic decisions we make; so are news stories and peer pressure; and these can lead to a widely held concern about the future. In this circumstance, people want to save more money than before – which they do by spending less on buying things from other people. However, if everyone wants to save money at the same time, you get an effect which was once described to me as “mattress economics”. If everyone puts their money under the mattress at the same time, nobody ends up with any more money; you will save the money you would have spent hiring me to cut your hair, but I will also save the money I would have spent buying the apples you’ve grown. We both end up with the same amount of money, but with no haircuts or apples.

This problem would be solved if we could all cut our prices at the same time – if haircuts suddenly cost half as much, and apples cost half as much, then my savings would be worth twice as much in real terms, and I would feel it was safe to spend some of it. But we can’t do this – both because we have a cognitive bias towards keeping things the same, and because it is very hard to get a clear picture of what’s happening in the market. Maybe this is just a temporary disruption because of the snow, and you’ll come for a haircut tomorrow. Maybe I have a new banana pie recipe, so I just don’t feel like apples today. Market insight is hard to acquire and takes a long time, so prices take a long time to adjust.

The Keynesian response: government spending. If the government borrows money from us all collectively, it can soak up all the savings under the mattress. And it can then buy your apples (and maybe give them to the poor) and hire me to give haircuts to the army – or give the money to poor people who haven’t had a haircut in years (insert joke about investors in Greek debt).

So that’s Keynes.

Hayek agrees with Keynes about one thing – markets are not neoclassical, because we don’t have full knowledge of everything that is going on. Hayek’s work is partly based on that of von Mises, who wrote a lot about the limits of human cognition and knowledge – he invented a whole field to study it, called praxeology. However, Hayek disagrees on the consequences – and the remedy.

The Austrian model says that things change over time, in an unpredictable way (another difference from the neoclassical models, where everything is either fixed for all time or highly predictable). If I stop buying apples, it might be because someone has discovered strawberries. Or because scientists found that we shouldn’t eat so much fruit after all. Or the fashion has just changed, and apples are now less popular than blackberries.
If this happens, it’s inevitable that apple farmers will become unemployed. It’s a sad fact of life but there’s no point subsidising someone to just keep growing a fruit that nobody wants. Apple prices will fall (maybe not right away, but soon enough), the farmers won’t be able to keep trading – or they will find that they can make more money by ploughing up the orchards and planting strawberries, or building cottages.

Government should accept this and let it happen. There’s no way for a government – sitting in Washington DC or London, thousands or hundreds of miles from the orchards and the supermarkets – to know whether apple demand has fallen permanently or temporarily. Only the farmers, supermarkets and consumers can know that – or at least, even if they don’t know it yet, they will find out by experimenting with new prices or different ways to promote apples.

If the government does try to intervene, it will just cause more trouble – either by buying millions of apples that nobody wants, or by giving money to poor people who will not buy apples either, but will instead try to spend it on strawberries – driving the price of strawberries up and causing inflation.

And that’s Hayek.

I’ll briefly mention monetarism because it’s an important strand of thought, even though not part of this evening’s debate. Monetary policy starts from roughly the same place as Keynes – there is an overall fall in economic demand because people want to save more money. But, instead of the Keynesian approach of saying “OK, we’ll let them save more money (by lending it to the government) and we’ll spend it for them”, monetarists say “if people want to save more money, we’ll give them more money directly”. This is done by, in effect, printing money at the Bank of England or the Federal Reserve. With this money, they buy government bonds or something similar, so that the money finds its way out into the market and people can spend or save it as they wish. This in turn reduces interest rates (unless they’re already close to zero, like now) and makes more money available for investment. Investment increases GDP and helps to end the recession.

Austrian economists disagree with this too, because they say the central bank can’t know whether interest rates are too high or too low – it is for the market to decide. Keynesians tend to be broadly accepting of monetary policy, though some argue that it stops working when interest rates are too low and the banking system is in danger – like now.

So the technical differences between the schools, in summary: Keynesians say that mass psychology drives falls in demand across all sectors of the economy, and needs to be fixed with government intervention; Hayekians say that technological or other changes drive falls in demand in some sectors, and that the market is the only way the economy can adjust to this.

There are philosophical differences too. Keynesians tend to see the economy as one big aggregate – the goal is to generate the maximum amount of wealth across the whole of society. This might mean taxing some people to spend on others – if the net effect is positive, that’s fine. Hayekians are usually more individualistic. It’s a bad thing to forcibly take money from people, even if it makes the whole population better off (and anyway, they say, it usually doesn’t).

This is why the two schools largely correspond with left and right wing politics respectively. Keynesians are OK with government spending in general (which by its nature, nearly always implies some degree of taxing the rich to spend on the poor) – so they believe government spending is a legitimate tool to cure economic problems. And if they can use the opportunity to get some more schools or hospitals built, or more transfers to poor inner-city children, that might not have been passed otherwise, so much the better.

Hayekians don’t like the government taking anyone’s resources, and they also believe that doing so is not effective at improving the economy. In fact, they believe it’s actively counterproductive, because it slows the natural process of economic change and progress, as well as providing the wrong incentives for people to invest and generate wealth.

Both beliefs may be a little self-serving: it’s not that common to find someone who believes in government spending and redistribution but thinks Keynesian policies are economically damaging; nor someone who doesn’t like government spending philosophically but believes Keynesian intervention is effective anyway. But that’s life – our beliefs about which solutions are effective often match our values about what kind of solutions are morally legitimate. It’s hard to know which causes which.

My final question is this: Is there really an unbridgeable gap between these two philosophies?

Personally, I believe in herding, and in the effect of emotions on economic decision-making, because I’ve seen them both regularly in my research. And I believe the Keynesian diagnosis that increased desire for savings can directly cause an economic slowdown across all sectors.

And yet, I also believe that there are big inter-sectoral changes. It’s hard to know whether a slowdown (such as today’s slow growth) arises from overall fear and lack of demand, or from snow, royal weddings and a growing desire to use twitter instead of going to the cinema.

There is truth to both models – the economy is made of thinking, feeling, cognitively biased people who do not act like rational economic agents; and it also changes quickly and unpredictably because of new technology, countries getting richer or older, and many other pressures.

Are there policy solutions that can handle both of these problems? Yes, there are.

We should work with the grain of human knowledge and cognition instead of against it.

Use cognitive and psychological research to understand when the economy is suffering an overall fall in demand and not just a sectoral change.

Use monetary policy to increase the amount of money in the economy in a targeted way – which will cause mild inflation (the good kind) and reduce the effect of sticky prices.

Use deficit spending – but in targeted ways which will help the economy to make its transitions instead of hindering it. Education and job training are the most important of these – guided especially by the needs of newly emerging industries. More unemployment insurance, but partly tied to the recipient’s willingness to try new things and absorb new ideas.

Market testing of new services; randomised testing of new policies. A financial system that is structured to encourage diversity of investments and reduce herding – for example capital reserve requirements which are higher if the bank’s assets are closely correlated with those of other banks.

And freedom for individuals and companies to come up with good ideas and try them out; minimal regulations and openness of government to working with private or voluntary service providers in all areas.

In short, subsidise the production and testing of new ideas; let the market flourish; and if people start herding, all heading the same way and reducing diversity, disrupt the flow and shake things up.

This is what a cognitive macroeconomics would look like – and I think both Keynes and Hayek might like it.

Writing in prison - is choice restriction beneficial?

2011-07-26T12:57:00.001+01:00

Tony Perrottet in the NY Times suggests that writers can be more productive inside prison than out.

Completely counter to rational choice theory, of course, but surprisingly plausible. I have several writing jobs to do myself, and though I haven't missed my deadlines yet, I absolutely recognise the seductive danger of twitter (follow me!). Jonathan Franzen apparently superglued the ethernet port on his computer to stop himself from going online. Extreme, but effective.

Rationality suggests that we can never suffer from the availability of more options - because we will always choose the one that is most beneficial to us. If choice A (e.g. using the Internet) is a worse outcome than choice B (e.g. writing another 100 words) we will pick B. If we pick A, then it means that using the Internet was better for us at that moment than writing.

So why did these writers deliberately stop themselves from being able to make choice A? Why can't we apply effective self-control by simply deciding not to go on the Internet? (of course, sometimes we can, but not all the time).

Let me advance one particular theory. We are making decisions all the time. Whether we're writing, or eating, or breathing, or walking along the street - we are continually considering the other things we could be doing. This consideration takes mental effort. The fact that I have the option of going on twitter right now is a factor in that effort.

The effort of making the choice itself reduces my ability to write. It distracts me, especially at the deep level where much creativity takes place. And so, by removing the choice, I am not only taking away one path towards happiness; I am actually changing the environment and therefore changing what my optimal choice would be.

Almost paradoxically, then - putting this in the language of rational choice - when choice A is available, it is the best choice for me to take, in utilitarian terms. But in the new cognitive environment that's created when choice A has been removed, choice A wouldn't have been the preferred option anyway.

Is this clear? Please comment, as I suspect I can make it more comprehensible - but my power is about to be turned off so I must post now.

Behavioural economics and news #askeconomist

2011-07-12T16:51:00.000+01:00

The Economist is running a one-hour chat session on the #askeconomist hashtag today, which I'd recommend for some thought-provoking questions.

My own interest, of course, is in the behavioural, cognitive and information-processing aspects of this. Two particular questions are relevant:

Rational people would apply an appropriate level of skepticism to crowdsourced news; weighting its credibility according to who the messenger is, by the number of times the same message has been recycled or retweeted, by the number of independent sources. But real people do not. Psychology tells us that we inevitably overweight a message the first time we hear it (anchoring), and by the degree to which it confirms our prior beliefs (confirmation bias). The role of a professional journalist, in part, is to check facts and give us appropriate caveats on how much we should believe what we're told.

How can this be done in the world of participatory journalism? Maybe we can develop automated tools of analysis which take into account behavioural biases. Twitter might be a powerful mechanism to do this: it lets us follow tweets back to their original source, find out how quickly they are being retweeted, and even estimate the potential bias of a message by the political opinions of those who are retweeting it. A tool like this would be a useful check on messages emerging from the citizen crowd.

I suspect we will also see the emergence of automated rapid-response - imagine if everyone retweeting an allegation about last week's News of the World scandal had received a message via twitter saying "there are two sides to this story - here's our version". An immediate response before people have fully formed a view would make negative opinions less likely to crystallise. At the very least it would have given the mass some pause. I'm not saying the popular consensus about the story is wrong, but News International would have benefited from better monitoring of that consensus and responding to it as it formed. (for that matter, could Twitter's long-awaited business model be partly based around detecting stories and allowing companies this kind of response?)
The business model for news is likely to be determined in large part by behavioural or psychological factors. Behavioural issues are, arguably, the reason that the old economic model of news breaks down: readers do not try to rationally predict the utility from each news source and make a rational judgment about buying quality news; instead, they focus on what is free and try to sample the best from that. But behavioural economics also shows us ways to get past the free-rider problem and get people to pay for news.

There is a view that "if we figure out what people value, they'll pay for it". (e.g. these comments from @jangles and @katie15price on the #askeconomist conversation) This is not enough, though. For more on why this doesn't work, and an exploration of the business model question much more broadly, please do download our report on the behavioural economics of media and publishing.

And for more on the editorial model, try this from Jay Rosen as a starter.

Incentives, belief in incentives, the left, the right and moral hazard

2011-06-14T15:42:00.000+01:00

Several old political problems turn out to be based on the same underlying question. Here are some examples.

Should we tax the rich more? The "yes" argument says rich people need the money less (that is, poor people's utility from wealth is higher), and wealth partly arises from luck and therefore is a legitimate target for taxation. The "no" argument says that if people expect to be taxed when they're rich (and receive handouts when they're poor) they have less incentive to earn wealth, and therefore less wealth will be produced by society.

Should we pay higher unemployment benefits? The "yes" argument: people are unemployed through no fault of their own; their spending will support the economy; it's moral to share resources with the poor; if it happened to you, you'd want benefits too. The "no" argument: it gives people an incentive not to work; it requires confiscation of resources from hardworking people to pay those who are (for whatever reason) not working; we don't know whether people are unemployed only through bad luck or whether their behaviour and choices contributed to it.

Should Greece default on its debts? The "yes" argument says its people need the money more than international bond investors, and if a default is inevitable there's no point wasting cash now if the consequences are going to come anyway. The "no" argument says debts should be honoured, and that Greece won't be able to borrow in the future if it defaults now.

Should we target higher inflation? The "yes" argument says inflation is bad for rentiers (who live off past earnings) and good for people currently earning; therefore it increases GDP - and what's more, helps the poor, who need it more, at the expense of the rich. The "no" argument says not all rentiers are wealthy, and not all wage-earners are poor, so we might be hurting the wrong people; and more fundamentally, inflation reduces the incentives to invest and save money which will lead to bad results in the long run.

Should we treat people better in prison? The "yes" argument says it's humane to do so, and it results in better outcomes for prisoners once they're released, and less repeat offending. The "no" argument says that if we let people believe prison isn't so bad, the incentives to commit crime are distorted and there will eventually be more crime.

Should we bail out struggling banks (or General Motors, or the airlines back in the day when they needed it?) The "yes" argument says that if we don't, there will be economic chaos in the short term, a major recession, and lots of people thrown out of work. The "no" argument says if we do, banks will come to believe they will always be rescued, and will take more risks in the future; we must set an example so we are better off in the future.

In all of these debates, the "no" argument is essentially this: if we act expediently now, people will come to believe we will act expediently in the future. And this will reduce their incentive to earn money, stay in a job, lend to Greece, save money, act lawfully, or avoid excessive risks - all forms of "good behaviour". The "yes" people want us to do what's best right now; the "no" people want us to make a sacrifice now in the hope of creating the right incentives for a better future.

The "no" strategy is a risky one. In all cases it involves definite costs today. But will it create strong enough incentives to bring those promised benefits tomorrow? The answer depends on how people's beliefs are formed today, because those beliefs are what influence tomorrow's behaviour.

The "yes" strategy is also risky, because it cashes in benefits today without any certainty about the impact on tomorrow. At least we get some definite benefits today, but the long-term costs might be much greater.

We'd quite like to have it both ways: have people act as if the incentives for good behaviour are powerful and sharp, but when things go wrong, do what's convenient and somehow avoid changing anyone's future behaviour. I guess this dilemma will be familiar to parents who love their children and don't want to cause them pain, but believes punishment is sometimes necessary to help them know how to behave in future.

This lays open an unstated question underlying the old debate between economists and other behavioural scientists: "do people act purely according to incentives?" In fact, even if they do act according to the incentives they think they face, what beliefs do they have about those incentives? We don't know enough about how beliefs are formed to give a clear answer to this question. But the answer is critical. I would argue that many of our beliefs about those incentives are formed at an early age and are very hard to change by the mere application of evidence. Evidence clearly has some impact - we don't really know how much - but most psychological research shows that people put less weight on evidence than they statistically should. So maybe we can act for today with impunity, because people will mostly ignore the bailouts/taxes/whatever and the impact on tomorrow will be minimal? That feels a bit too easy.

You may have noticed that the "yes" position in all of the above cases is the left-wing or liberal choice; the "no" argument is the right-wing or conservative policy. The particular yes/no framing is simply a matter of how I have asked the question, but the underlying relationship is genuine: the left-wing position is about what's best for today, while the right-wing position is about setting the best example for tomorrow. That is an unusual characterisation of the political spectrum, but it fits with the traditional constituency-based descriptions of left versus right: rich people can more easily afford to defer gratification until tomorrow, so they're more likely to be right wing.

Or let's put it another way. The left believes that if people are going to behave well, they will do so regardless of (or with little regard to) material incentives. The right believes the incentives are really important. (You can see this same division in the debate over competition in the NHS, or privatisation and market discipline in general.) We might draw the conclusion that people project their own self-image onto everyone else - and therefore left-wingers believe they are not influenced by incentives, while right-wingers believe themselves to be guided only by incentives. But that's also too simplistic.

Yet another way to ask this question: Does moral hazard really exist? Do we behave badly when we have an incentive to do so? To some extent, sure. But how much? Crudely, the right believes there is a lot of moral hazard, the left thinks there is only a little. There have been a few experiments on this but I don't think they answer the question clearly. Maybe it is unknowable.

Thaler, annuities, freedom and self-knowledge

2011-06-11T13:21:00.000+01:00

Richard Thaler has an oddly limited writeup of the "annuity puzzle" in the New York Times this week. He presents a choice between two people retiring at 65. One gets a guaranteed $4,000/month for the rest of their life (a standard annuity). The other retains a standard investment portfolio and draws down $4,000/month until it runs out (at the age of 85, if he lives that long) - or $3,000/month till he's 100.

Presenting only these three options, he argues that people should really opt for the annuity as it is lower-risk and saves your family the worry of having to support you after the money runs out. The puzzle, in Thaler's view, is that most people don't buy the annuity but instead keep their money in an investment portfolio that they manage themselves.

But I'm not sure this is all that puzzling. In reality, someone who keeps their money in a portfolio is not likely to draw on it at a consistent $4,000/month rate. Why would they happen to withdraw exactly the same monthly income as they would happen to get if they bought an annuity? Anyone who has managed to save this much (about $600-700,000) has many more options.

You might take a lump sum of $20,000 for a cruise, $40,000 for your dream car or $200,000 for a holiday cottage; or you may prefer to make a contribution to your grandchildren's education. Conversely, you might live more frugally some of the time, getting by on $2,000/month when you can, and spend more at Christmas or in the summer.

You could have all sorts of reasons for this. Your needs may change from month to month; you might have been waiting years for the chance to have that car or cruise and want to enjoy it while you can. You might have specific concerns about the future. You might (as Thaler mentions) want to leave some money in your inheritance in case you die before 85. But one powerful rationale could be that you just want to see how it goes - you won't know how much you will want to spend each month until you have figured out your new lifestyle.

Thaler ascribes most of the behaviour to risk aversion and how the annuity choice is framed (and whether it's a default). But the "see how it goes" effect must be a major factor. This particular form of bias (if it is a bias) results from a lack of knowledge of our own preferences, and as such is not accounted for by either rational choice models, nor most behavioural explanations. But I believe it's much more fundamental to the behavioural economy than defaults, risk framing or some of the other Nudge party tricks.

The economics zeitgeist, 5 June 2011

2011-06-05T23:56:00.001+01:00

This week's word cloud from the economics blogs. I generate a new one every Sunday, so please subscribe using RSS or the email box on the right and you'll get a message every week with the new cloud.

The words moving up and down the chart are listed here.

I summarise around four hundred blogs through their RSS feeds. Thanks in particular to the Palgrave Econolog who have an excellent database of economics blogs; I have also added a number of blogs that are not on their list. Contact me if you'd like to make sure yours is included too.

I use Wordle to generate the image, the ROME RSS reader to download the RSS feeds, and Java software from Inon to process the data.

You can also see the Java version in the Wordle gallery (please ignore the "5 May" caption, my mistake - it's actually 5 June).

If anyone would like a copy of the underlying data used to generate these clouds, or if you would like to see a version with consistent colour and typeface to make week-to-week comparison easier, please get in touch.

Loss aversion and fundraising for Bletchley Park

2011-05-31T10:49:00.000+01:00

I celebrate the good news that Bletchley Park has been saved by my new friend @Dr_Black among others. It's a good story and you should read it if you aren't familiar with the background.

However, is it wise to announce and frame the news in this way? The post suggests an optimistic transition:

I mentioned "Saving Bletchley Park" as part of this conversation and Simon said "...hold on, Bletchley Park is saved, there is no way we are going to shut now with all the support that we have. What we need to talk about now is Building Bletchley Park for the future". I sat there with a big smile on my face...

Bletchley Park is Saved - It is no longer about *Saving* Bletchley Park but about *Building* Bletchley Park.

It sounds great. But surely it is much easier to raise money to "save Bletchley Park" from an impending emergency than to "build Bletchley Park" for an undetermined future? I predict that, unfortunately, donations will fall if the campaign is presented as one of building, rather than saving, the institution. The cognitive effects of loss aversion, hyperbolic discounting and the salience generated by urgency will all contribute to this.

However, it's certainly a more optimistic way of talking about the situation. Maybe it will result in better motivation from volunteers - and maybe it's a more accurate description.

What do you think - if there is a genuine choice of ways to frame a request, is it appropriate for charitable appeals to choose the framing that will raise the most money? Or should it be their responsibility to use the framing that they feel most closely and neutrally represents the situation?

The economics zeitgeist, 29 May 2011

2011-05-29T23:57:00.009+01:00

This week's word cloud from the economics blogs. I generate a new one every Sunday, so please subscribe using RSS or the email box on the right and you'll get a message every week with the new cloud.

The words moving up and down the chart are listed here.

I use Wordle to generate the image, the ROME RSS reader to download the RSS feeds, and Java software from Inon to process the data.

You can also see the Java version in the Wordle gallery.

The hot hand in airline pilots

2011-05-27T15:06:00.000+01:00

I read the following quote in an article about the near-crash of a 747 plane in San Francisco:

"In the past months, we have had several operational incidents," airline jargon for close calls, W.J. Carter, chief of United's Honolulu-based pilots, wrote in a Feb. 23 internal memo to his flight crews. "Major accidents historically are preceded by a series of these seemingly unrelated incidents. This disturbing trend is cause for concern"

I was immediately skeptical, because patterns like this are often not real. The "hot hand" effect - often seen in sports, especially basketball - is a kind of momentum effect, where a player who has scored lots of baskets in the last few minutes is thought to be more likely to score again. It intuitively makes sense that someone could be "on a streak" where they are playing at the peak of their ability - those times when every shot you attempt seems to go in. Equally there could be times when you just keep missing and missing.

The only problem is that - according to Gilovich, Vallone & Tversky, who studied the effect - it doesn't exist. They found that statistically, a player who has just made a series of successful shots is no more likely to make the next shot.

Lots of people have researched this area since, and though the results aren't completely conclusive, most psychologists agree that the effect is in the mind of the viewer. We seek to understand the world and this leads us to see patterns in random events, whether in basketball, coin tosses or roulette spins. It may seem natural that a hot hand effect could exist, but it seems that professional sports players know how to operate consistently near the limit of their ability, and any fluctuations from this are random. Most players, close as they are to their peak, are competing against other players also at their peak, so small and unconnected changes in conditions can lead to apparent randomness in outcomes.

Back to the airlines: my assumption was that the pilot quote was seeing patterns where none really exist. When there is a crash, it's easy to look back and see a series of "seemingly unrelated" incidents in recent times - and draw the conclusion that they are related after all.

But in fact it might not be an illusion. The illusion hypothesis is most likely when the events are genuinely random - that is, where there is no real underlying cause which could link them together. This might not be true in the case of pilot error.

The article linked presents a potential explanation of what that cause might be. Pilot training procedures are likely to be correlated across a company. If there is a weakness in these procedures (such as a lack of experience in 747 takeoffs, or training which is not frequent enough) then this could cause multiple incidents which have no obvious connection.

If the issue is specifically related to 747s, then one would expect the incidents to be related to 747s. But if the cause is a more general training failure - for instance people being trained only once a year, with their skills declining during the year - then the pattern would be different, perhaps with incidents showing up near the end of an individual pilot's yearly cycle.

This means there are no instant answers - when we think we see a phenomenon in the world it might be a result of a cognitive bias, or it might be real. Cognitive biases can give us one explanation, but if the effect is important, it's worth checking against real factors too. Statistics is a powerful tool to distinguish between these two possibilities: if we have enough data, and we find correlations in it that are statistically convincing, these can often show us where to look.

This doesn't mean a statistical correlation guarantees that mental factors are not involved. If the correlations seem to be related to the context or manner in which we make the observations, then a cognitive bias remains plausible. If we can observe the data in a different way and the effect still stands, we may then be able to eliminate observation, interpretation and other cognitive factors as a part of the correlation. At that point it's more likely that there may be something real going on underneath.

The Great Stagnation and consumption-biased change

2011-05-23T12:29:00.001+01:00

A debate has been going on within economics (and in my head) about how the economy is changing.

Tyler Cowen thinks there is a "Great Stagnation": all the low-hanging technological fruit (trains, planes, automobiles) has been harvested; we've grown for the last thirty years by getting some efficiencies out of existing processes, but that has limits; and there's no new major new invention on the horizon which will transform living standards further in the coming century.

Umair Haque says something similar in more provocative language: the old models are bankrupt, we need a new mode of life - moving away from consumption and towards eudaimonia. A bigger TV doesn't provide any more satisfaction, just a shallow, temporary endorphin hit and a status upgrade relative to some of your friends. [Update: Umair comments on twitter that "my definition of eudaimonia is economic, not just psychological"]

But the default position of economists - including me - until recently has been: things are always getting better, even if it isn't obvious. Economic growth continues; on average, we are twice as rich as we were in 1985, and four times as rich as in 1965. We might not feel that much richer - because we spend the money on new things, and because some of the wealth has gone to China, India or Dubai - and above all because we quickly acclimatise to any change in circumstances. Regardless, things are indisputably better.

The second part of this argument is that we are still creating new inventions - most of them on the Internet - but that much of this production is not captured in GDP figures, because people don't pay directly for a lot of the value they receive.

Who's right? Haque would argue that the default position is complacent, indeed wilfully blind to what's really happening. Cowen would argue, I think, that we have just about managed to squeeze some growth out of the last fifteen years but its lack of productive foundations has caught up with us and shown up in the financial crisis and recession; and there's not much hope for the future. Other regions of the world might still have some catch-up growth to sustain them for a while, but the West does not.

Bryan Caplan looks at this in an interesting way. He suggests that we have experienced "consumption-biased technical change":

Firms are figuring out ways for small numbers of workers to create tons of value - then give it away to consumers for pennies or less. And as far as I can tell, the CPI totally ignores these benefits. CPI bias: Now worse than ever. Quality of life: Now better than ever.

So we may have all the consumption goods we could possibly want - many of them being informational goods like Twitter feeds or TV shows rather than physical ones. But the production of these goods might be concentrated in the hands of an ever-smaller group of people.

If this is true, it raises a couple of important questions. Take this insight to its logical conclusion: imagine that in 30 years time we have a world in which everything we need is produced by 5% of the population, and the other 95% is happily consuming the costless electronic outputs of those 5%.

Do we get satisfaction from production as well as consumption? Surely we do. This was the main insight of Will Hutton's mid-90s work The State We're In. If so, then just being able to consume without producing will not make us happy.
What will society - and its power relationships - look like in this world? If 5% of people can produce everything, what will they demand from the other 95 in return?

The classical answer to the second question is that demand for goods and services is limitless, so the 5% will still want something that the 95% can provide: whether it's more convenient takeaway food deliveries at all times of the night, or ever more massages and haircuts. In plain economic terms, that's fine; but the work may not be at all satisfying.

I still tend to be optimistic - I think both individuals and societies are good at finding solutions that work for them - but put in these terms, I can more clearly see what the problem is.

What might the solutions look like? It would be a bit contradictory to suggest that I can deliver the answer to a problem which by its nature needs decentralised answers; but here are some ideas that might contribute:

Production will become more competitive; on twitter, production and consumption are closely intermingled and it's hard to clearly distinguish the two. This might help to spread both the satisfaction of being productive, and the material rewards for it, to a wider group.
Production and consumption might become more specialised into groups. Some production will certainly be carried out at a global scale (Hollywood movies or Justin Bieber's twitter account); but others will be country-wide (Downton Abbey, Stephen Fry's twitter account) and others specialised to individual groups like economists (the Keynes-Hayek rap, Tim Harford's twitter account) and even smaller, overlapping groups (random economics lectures on YouTube, or my twitter account). The global scale, as you'd expect, is ahead of the local on these measures. So it currently appears that we have asymmetric rewards, with only the global producers picking up the attention (and money). But perhaps a new middle class will emerge, composed of all those who sit at nodes in a worldwide network producing anything with an audience of more than a few dozen.
Competition might drive up standards of production - so that blog posts, tweets, YouTube videos - even Daily Mail columns - need to have a high quality of research and production behind them in order to get any attention. This would provide more people with a role in producing them. (The same argument applies to sandwiches and cars, by the way, not just virtual products)
Investment in education may increase, so that more people are capable of competing for the attractive production roles (and in turn, more production roles are created to absorb them). This is likely to be required anyway if any of the first three outcomes are to occur.
I'm not a fan of this one, but I know some people believe in it: local production may return. Organic farms, local microbreweries and community-based tailors or housebuilders could become important to the economy again. However, I think the appetite for being involved in productive work is not sufficient to outweigh the low efficiency of this kind of economic model.

The insight that might help close the gap is this: while there is probably a limit to the quantity of what we can enjoyable consume, there is no limit to its quality. Quality can be in the traditional sense of better-made and better-performing objects; or funnier, more cleverly written TV shows; or most fundamentally, objects that are more tailored to their audience.

When a continually growing production efficiency from one direction, meets a growing and diversifying market for tailored goods and services from the other, a new balance will emerge: a more personalised life where your production and consumption are integrated, in which you are a member of several audiences, smaller and more intimate than the mass market you participate in today.