Supposedly irrelevant factors

There is a version of this magic market argument that I call the invisible hand wave. It goes something like this. “Yes, it is true that my spouse and my students and members of Congress don’t understand anything about economics, but when they have to interact with markets. ...” It is at this point that the hand waving comes in. Words and phrases such as high stakes, learning and arbitrage are thrown around to suggest some of the ways that markets can do their magic, but it is my claim that no one has ever finished making the argument with both hands remaining still. 
 
Hand waving is required because there is nothing in the workings of markets that turns otherwise normal human beings into Econs. For example, if you choose the wrong career, select the wrong mortgage or fail to save for retirement, markets do not correct those failings. In fact, quite the opposite often happens. It is much easier to make money by catering to consumers’ biases than by trying to correct them. 
 
Perhaps because of undue acceptance of invisible-hand-wave arguments, economists have been ignoring supposedly irrelevant factors, comforted by the knowledge that in markets these factors just wouldn’t matter. Alas, both the field of economics and society are much worse for it. Supposedly irrelevant factors, or SIFs, matter a lot, and if we economists recognize their importance, we can do our jobs better. Behavioral economics is, to a large extent, standard economics that has been modified to incorporate SIFs.
 

Richard Thaler on behavioral economics. Again and again, studies have put cracks in the edifice of rational homo economicus.

SIFs exist in product design, too. The myth of the rational utility-maximizing user can be just as pernicious and misleading an assumption. If it wasn't, we wouldn't need concepts like smart defaults in apps, the design equivalent of nudges like retirement savings programs that are opt out instead of opt in.

Negative interest rates

It’s not unusual for interest rates to be negative in the sense of being lower than the rate of inflation. If the Federal Reserve pushes interest rates below inflation to stimulate growth, it becomes cheaper to borrow and buy something now than to wait to make the purchase. If you wait, inflation could make prices go up by more than what you owe on the loan. You can also think of it as inflation reducing the effective amount you owe.
 
What is rarer is for interest rates to go negative on a nominal basis—i.e., even before accounting for inflation. The theory was always that if you tried to impose a negative nominal rate, people would just take their money from the bank and store cash in a private vault or under a mattress to escape the penalty of paying interest on their own money. When the Federal Reserve slashed the federal funds rate in 2008 to combat the worst financial crisis since the Great Depression, it stopped cutting at zero to 0.25 percent, which it assumed to be the absolute floor, the zero lower bound. It turned to buying bonds (“quantitative easing”) to lower long-term rates and give the economy more juice.
 
...
 
Now comes the interesting part. There are signs of an innovation war over negative interest rates. There’s a surge of creativity around ways to drive interest rates deeper into negative territory, possibly by abolishing cash or making it depreciable. And there’s a countersurge around how to prevent rates from going more deeply negative, by making cash even more central and useful than it is now. As this new world takes shape, cash becomes pivotal.
 

Fascinating. It's understandable why banks would want to move to a cashless society, but it might not be a bad idea. The mindset shift required might take a generation or two to overcome, cultural inertia being such a powerful force. What usually wipes the slate clean, as morbid as it may be, is simply the dying off of the previous generation.

Heist movies would be a lot less fun minus Brinks armored trucks and giant vaults filled with cash. I'm fine with a cashless society, but I may be more trusting of government than the average citizen. Those less trusting in government might be more inclined to have a virtual currency like Bitcoin replace cash, but virtual currencies come with technological opacity for the average person that carries its own trust issues.

Like chemotherapy, negative interest rates are a harsh medicine. It’s disorienting when people are paid to borrow and charged to save. “Over time, market disequilibria are dangerous,” G+ Economics Chief Economist Lena Komileva wrote to clients on April 21. Which side of the debate you fall on probably comes down to how much you trust government. On one side, there’s an argument to be made that cash has become what John Maynard Keynes once called gold: a barbarous relic. It thwarts monetary policy and makes life easy for criminals and tax evaders: Seventy-eight percent of the value of American currency is in $100 bills. On the other side, if you’re afraid that central banks are in a war against savers, or that the government will try to control your financial affairs, cash is your best defense. Taking it away “is a prescription for revolution,” Cecchetti says. The longer rates break on through to the other side, the more pressing these questions become.

Neighborhood destiny

A new study by the Harvard economists Raj Chetty and Nathaniel Hendren, when read in combination with an important study they wrote with Lawrence Katz, makes the most compelling case to date that good neighborhoods nurture success. (The Upshot has just published a package of articles and interactives on the study.)
 
Let me be upfront about my own reading: These two new studies are the most powerful demonstration yet that neighborhoods — their schools, community, neighbors, local amenities, economic opportunities and social norms — are a critical factor shaping your children’s outcomes. It’s an intuitive idea, although the earlier evidence for it had been surprisingly thin. As Sean Reardon, a professor of education and sociology at Stanford, said of the study, “I think it will change some of the discussion around how where children grows up matters.”
 

That's Justin Wolfers on this paper (PDF) by Chetty and Hendren.

Those earlier analyses grouped children who moved to a neighborhood as toddlers with those who moved in their late teens. So comparing all of the children whose parents won the lottery with all of those whose parents lost showed small effects. Yet if what matters are years of exposure to a good neighborhood — a hypothesis strongly suggested by the second of these two studies — then the effects might be very different, as those who moved as toddlers enjoyed most of their childhood in better neighborhoods, while those who moved as teens received few such benefits yet still had to deal with the disruption of moving.
 
Armed with this hypothesis and also newer data on the longer-run outcomes of these children, Mr. Chetty, Mr. Hendren and Mr. Katz reanalyzed the outcomes of the same families. (Full disclosure: Lawrence Katz was my Ph.D. adviser.)
 
And the findings are remarkable. In particular, the previous results actually hide two quite distinct findings, one positive and one negative. The children who moved when they were young enjoyed much greater economic success than similarly aged children who had not won the lottery. And the children who moved when they were older experienced no gains or perhaps worse outcomes, probably the result of a disruptive move, paired with few benefits from spending only a short time in a better neighborhood.
 

As Tyler Cowen notes, the biggest problem with poverty tends to be “you usually end up living near other poor people.” Or, as Judith Rich Harris wrote in her groundbreaking book The Nurture Assumption, a children's peer group may have a great influence on that child's outcomes than their parents. I first learned all this from Boyz in the Hood.

How does this square with the popular theory that general intelligence is most important to one's future outcome? I hypothesize some interaction effects between the two, with the right neighborhood being an environment most conducive to wringing all the potential from genetically inherited general intelligence. Peer emulation or peer pressure exerting an activation effect.

Whatever the reason, it's clear how complex it is to break the cycle of poverty. So many nested problems, from education to urban planning to crime, all nearly impossible to isolate.

The marriage squeeze is hitting China and India

Fascinating read on how the marriage squeeze, already established in countries like Japan and South Korea, has finally hit a third of the world's population, namely that of China and India. It's not just that sex selection at birth has led to a large gender imbalance in the population. Other factors exacerbate the problem.

Countries with normal sex ratios can experience a marriage squeeze if their fertility rates are falling fast. Fertility is important, because men tend to marry women a few years younger than themselves. In India the average age of marriage for men is 26; for women, it is 22. This means that when a country’s fertility is falling, the cohort of women in their early 20s will be slightly smaller (or will be rising more slowly) than the cohort of men they are most likely to marry—those in their late 20s (this is because a few years will have gone by and the falling fertility rate will have reduced the numbers of those born later). This may not sound like a big deal. But in fact between 2000 and 2010 the number of Indian men aged 25-29 rose by 9.2m. The number of Indian women aged 20-24 (their most likely partners) rose by only 7.6m.
 
Even if India’s sex ratio at birth were to return to normal and stay there, by 2050 the country would still have 30% more single men hoping to marry than single women. This is explained by a rapid decline in India’s fertility rate. But in China, where fertility has been low for years, the more gradual decline in fertility still means there will be 30% more single men than women in 2055, though the distortion declines after that. A decline in fertility usually benefits developing countries by providing a “demographic dividend” (a bulge of working-age adults compared with the numbers of dependent children or grandparents). But it does have the drawback of amplifying the marriage squeeze.
 
The problem is further accentuated by a so-called “queuing effect”. The length of a queue is determined by how many people join it, how many leave, and how long queuers are prepared to wait. In the same way, marriage numbers are a result of how many people reach marriageable age (the joiners); how many get married (the leavers) and how long people are willing to wait. In India and China, marriage remains the norm, so men keep trying to tie the knot for years.
 
Hence, a marriage queue in India and China builds up. At stage one, a cohort of women reaches marriageable age (say, 20-24); they marry among the cohort of men aged 25-29. But there are slightly more men than women, so some members of the male cohort remain on the shelf. Later, two new cohorts reach marriageable age. This time, the men left over from the previous round (who are now in their early thirties) are still looking for wives and compete with the cohort of younger men. The women choose husbands from among this larger group. So after the second round even more men are left on the shelf. And so on. A backlog of unmarried men starts to pile up. Just as you need only a small imbalance between the number of people joining a queue and the number leaving it to produce a long, slow-moving line, so in marriage, a small difference in the adult sex ratio can produce huge numbers of bachelors.
 

One can't help but conclude that India and China must prepare for an end to universal marriage. Is that so bad? Could both countries start to shift their policies to prepare for a post-universal-marriage society? Are there any countries with economic policies that can cope with declining birth rates?

Perhaps, but it's difficult to imagine a world in which the consequences are anything but a net negative.

There may be positive side effects: a shortage of brides in India is causing dowry prices to fall in some areas, for instance. Overall, though, the impact is likely to be negative. A study by Lena Edlund of Columbia University and others found that in 1988-2004, a one-point rise in the sex ratio in China raised rates of violent crime and theft by six to seven points. The abduction of women for sale as brides is becoming more common. The imbalance is fuelling demand for prostitution.

Altruistic punishment

Steve Randy Waldman on the rioting in Baltimore.

Politically motivated riots are a form of altruistic punishment. Look it up. Altruistic punishment is a “puzzle” to the sort of economist who thinks of homo economicus maximizing her utility, and a no-brainer to the game theorist who understands humans could never have survived if we actually were the kind of creature who succumbed to every prisoners’ dilemma. Altruistic punishment is behavior that imposes costs on third parties with no benefit to the punisher, often even at great cost to the punisher. To the idiot economist, it is a lose/lose situation, such a puzzle. For the record, I’m a fan of the phenomenon.
 
Does that mean I’m a fan of these riots, that I condone the burning of my own hometown? Fuck you and your tendentious entrapment games and Manichean choices, your my-team “ridiculing” of people you can claim support destruction. Altruistic punishment is essential to human affairs but it is hard. It is mixed, it is complicated, it is shades of gray. It is punishment first and foremost, and punishment hurts people, that’s its point. Altruistic punishment hurts the punisher too, that’s why it’s “altruistic”. It can’t be evaluated from the perspective of winners or losers within a direct and local context. It is a form of prosocial sacrifice, like fighting and dying in a war. If you write to say “they are hurting their own communities more than anyone” you are missing the point. Altruistic punishment is not a pissing match over who loses most. The punisher disclaims personal gain, accepts loss, sometimes great loss, in the name of a perceived good or in wrathful condemnation of a perceived evil.
 
So you want to evaluate riots, then, as tactic. Surely these rioters can’t imagine that this — this — will reduce the severity of policing, bring jobs to the inner city, diminish the carceral state. By the way, have I told you, fuck you? Altruistic punishment is generally not tactical. Altruistic punishment is emotional. The altruism in altruistic punishment is not pure, not saintly. The soldier takes pleasure even as he takes wounds exacting revenge for a fallen comrade on another human who was not, as an individual, his friend’s killer. The looter takes a pair of shoes, because why the fuck not? If you perceive the essence of the riots in the shoes you are an idiot. Altrustic punishment is not tactical, it is emotional, and it is sometimes but not always functional. It functions, sometimes, to change expectations about what is possible or desirable or acceptable. In economist words, people’s propensity for altruistic punishment changes the expected payoffs associated with nonaltruistic behavior by those punished directly and, more importantly, by third parties who observe the unpleasantness. Changes in expected payoffs change the equilibria that ultimately prevail, in ways which may be beneficial for some groups or for “society as a whole”, however you define the welfare of that entity. Of course, there are no guarantees. Changes in expected payoffs can alter equilibria in undesirable directions as well. Drones anybody? This is a risky business.
 

Economists, game theorists, and psychologists come up with some of the most elegant names for various phenomena. I'd never heard of altruistic punishment, but I'll never forget it now. That is, sometimes when you bear the costs of the world unjustly, it can feel like the only way to set things right is to force a more even distribution of the costs across the population.

Housing and wealth inequality

In the last 50 years, the two societies have become even more unequal. Although a relatively small black middle class has been permitted to integrate itself into mainstream America, those left behind are more segregated now than they were in 1968.
 
When the Kerner Commission blamed “white society” and “white institutions,” it employed euphemisms to avoid naming the culprits everyone knew at the time. It was not a vague white society that created ghettos but government—federal, state, and local—that employed explicitly racial laws, policies, and regulations to ensure that black Americans would live impoverished, and separately from whites. Baltimore’s ghetto was not created by private discrimination, income differences, personal preferences, or demographic trends, but by purposeful action of government in violation of the Fifth, Thirteenth, and Fourteenth Amendments. These constitutional violations have never been remedied, and we are paying the price in the violence we saw this week.
 
...
 
Nationwide, black family incomes are now about 60 percent of white family incomes, but black household wealth is only about 5 percent of white household wealth. In Baltimore and elsewhere, the distressed condition of African American working- and lower-middle-class families is almost entirely attributable to federal policy that prohibited black families from accumulating housing equity during the suburban boom that moved white families into single-family homes from the mid-1930s to the mid-1960s—and thus from bequeathing that wealth to their children and grandchildren, as white suburbanites have done.
 

A must read on all the policies that have entrenched and amplified segregation in Baltimore. If we learned nothing from The Wire we should have learned that the forces aligned against the black population in Baltimore was structural, built in to our institutions, and not just the work of a few pernicious people. The whole environment is hostile, toxic.

Baltimore, not at all uniquely, has experienced a century of public policy designed, consciously so, to segregate and impoverish its black population. A legacy of these policies is the rioting we have seen in Baltimore. Whether after the 1967 wave of riots that led to the Kerner Commission report, after the 1992 Los Angeles riot that followed the acquittal of police officers who beat Rodney King, or after the recent wave of confrontations and vandalism following police killings of black men, community leaders typically say, properly, that violence isn’t the answer and that after peace is restored, we can deal with the underlying problems. We never do so.
 
Certainly, African American citizens of Baltimore were provoked by aggressive, hostile, even murderous policing, but Spiro Agnew had it right. Without suburban integration, something barely on today’s public policy agenda, ghetto conditions will persist, giving rise to aggressive policing and the riots that inevitably ensue. Like Ferguson before it, Baltimore will not be the last such conflagration the nation needlessly experiences.
 

This ties closely with a 2014 paper (PDF) from MIT grad student Matthew Rognlie that argues that what's responsible for the rise in wealth inequality is not, as Piketty argues, r - g, but instead the ability for the wealthy to capture outsized returns on housing and to pass that wealth on to future generations through that real estate. 1

  1. Rognlie's paper, fascinatingly, began as a comment on economics blog Marginal Revolution on a post about Krugman's review of Piketty (search for “Rognlie” on that post to see his two comments that launched, if not a revolution, at least an intellectual salvo). Here is a great profile of Rognlie and the story of how his comment turned into a paper that was the talk of the economics world.

At the heart of Rognlie and Piketty's debate is how easy it will be for capital to substitute for labor in the future. Today it is still difficult, and thus Rognlie's prediction that the marginal returns to capital is still sound. Until robots can replace humans in more tasks, that should hold. In that environment, our best bet to decrease wealth inequality is to fight NIMBY-ism, loosen development codes, and build more housing.

Hedonic adaptation

A fundamental question in economics is whether happiness increases pari passu with improvements in material conditions or whether humans grow accustomed to better conditions over time. We rely on a large-scale experiment to examine what kind of impact the provision of housing to extremely poor populations in Latin America has on subjective measures of well-being over time. The objective is to determine whether poor populations exhibit hedonic adaptation in happiness derived from reducing the shortfall in the satisfaction of their basic needs. Our results are conclusive. We find that subjective perceptions of well-being improve substantially for recipients of better housing but that after, on average, eight months, 60% of that gain disappears.
 

That's the abstract of this paper (free to download).

Hedonic adaptation is a central principle of the human condition, and it's been fascinating to see more and more research on how it works, how it varies under different conditions. Is it really true that money can't buy happiness? Or does that only apply after you reach some baseline of economic well-being? The paper provides a solid overview of the current state of the thinking on the subject.

The hedonic adaptation hypothesis is that there is a psychological process that attenuates the long-term emotional impact of a favorable or unfavorable change in circumstances, such that people’s level of happiness eventually returns to a stable reference level (Frederick and Lowenstein 1999). According to the hedonic adaptation hypothesis, then, variations in happiness and unhappiness are merely short-lived reactions to changes in people’s circumstances. In other words, while people initially have strong reactions to events that change their material level of well-being, they eventually return to a baseline level of life satisfaction that is determined by their inborn temperament (Diener et al., 2006). In psychology, this idea is known as the set point theory and was labeled the hedonic treadmill in the seminal work of Brickman and Campbell (1971). Indeed, in a widely cited paper, Brickman et al. (1978) present evidence that lottery winners report life satisfaction levels that are comparable to those of people who did not win a lottery one year after the event.2
 
Frederick and Lowenstein (1999) hypothesized that people do not adapt to shocks in terms of basic necessities that are related to survival and reproduction. This suggests that hedonic adaptation is manifested the most in people who have achieved a certain level of basic material well-being rather than being a persistent phenomenon that is evenly distributed across all socioeconomic groups. The idea is analogous to the notion of diminishing marginal utility, where the marginal increase in happiness derived from material gain is higher at lower levels of material wealth. The analog in hedonic adaptation is that adaption is more limited at lower levels of material wealth. In essence, then, the idea is that the happiness levels of the poor do not adapt, or do not adapt completely, to shocks in terms of basic necessities.
 
In this paper, we present the first piece of experimental evidence on hedonic adaptation among the poor to improvements in the satisfaction of their basic necessities, specifically shelter. 
 

I'm no expert on the subject, but in my experience this holds true: being rich doesn't guarantee happiness, but being really poor is almost certain to make you unhappy. Even if hedonic adaptation affects the poor, even if those who are well-off are unhappy if their neighbors are more well-off (a common Silicon Valley disease), I still think the greatest human welfare gains to be made in the world come from bringing those in poverty up to some baseline of economic self-sufficiency and good health. Reducing unhappiness is often undervalued in comparison to creating happiness.

So much brainpower devoted to trying to create so many consumer behaviors, but someday someone will figure out how to make philanthropy addictive and habitual, and that will change the world.

Game theory of thrones

Peter Antonioni uses game theory to analyze the situation in Westeros to see if he can determine who will end up on the Iron Throne.

Game theory doesn’t look at behaviour so much as it looks at outcomes, assuming that people will choose the highest payoff if they can.

Martin even helps on a couple of occasions by spelling out those payoffs. Advising Joffrey, the fearsome Tywin Lannister gives a great example of what to do in a repeated game:
 
Joffrey, when your enemies defy you, you must serve them steel and fire. When they go to their knees, however, you must help them back to their feet. Elsewise no man will ever bend the knee to you.
 
This is a pretty good distillation of a what game theorists call tit-for-tat. If you start off with equal participants in a repeated game, the best overall strategies combine punishing transgression with forgiveness; there are variants, but all of them get better results than “all or nothing” punishment strategies such as the grim trigger.
 
Tywin’s strategy works in this case because it assumes a capability for punishment. In advising Joffrey, he’s not telling him how to gain the Iron Throne but how to hang on to it. The equilibrium stays stable as long as the Throne can dominate all of the potential competitors, as Aegon I could with his dragons. Then, rebellion is easily put down, and whatever the consequence to the smallfolk of Westeros, at least they don’t get the kind of devastation inflicted on the Riverlands by the War of the Five Kings.
 

The strategic maneuvering and statecraft are the most intriguing aspects of Game of Thrones. I'm less interested in the economics or religion, though I was amused by this proposal for a central bank in Westeros.

Overall, the rulers, religions, and other institutions of the known world all seem to lack the fundamental characteristics necessary to function as a central bank of Westeros. The difficulty of creating long lasting, independent, and benevolent institutions, I would argue, is why the Seven Kingdoms of Westeros use a commodity currency and lack monetary policy. But I don’t think a central bank in Westeros is impossible. In fact, there is one institution in the realm that does have these characteristics and could potentially serve as a central bank: the Night’s Watch.
 
The watch operates independently of the crown, has existed for thousands of years, and is dedicated to the public good. The longevity of the Watch is undebatable, as it was reportedly founded 8,000 years before the time of Game of Thrones.   Their staunch independence is evidenced by the nuetrality they maintained during the rebellion that unseated the Targaryens. The Watch’s military might ensures they can maintain that independence. Their dedication to the public good is seen in the mission of the Watch, which is the protection of the Seven Kingdoms.
 
Members of the watch currently serve in one of three groups: Rangers, Builders, and Stewards. It’s easy to imagine adding Economists as a fourth group, and adding price stability and full employment to oath that all members must swear to. Public acceptance would likely require the crown mandating that Night’s Watch currency be accepted as legal tender. But after that, the Night’s Watch could independently determine the money supply and even conduct monetary policy.
 

Sawmell Tarly, Westeros Fed Reserve Chairman?