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The value of beliefs in economic decision-making.

July 24, 2017 Leave a comment

BE - Cognition.jpegThe economic environment is said to be determined by agents or economic decision-makers. Today, an economy is a much more intricate machine which aims to allocate scarce resources to satisfy the utility of economic agents such as individuals, firms and government. The dominant model for many years has been “Dynamic Stochastic General Equilibrium” (DSGE) and it takes all the characteristics of an individual (this person is typically called the representative agent) which is then cloned and taken to represent the typical person in an economy.These agents make supposedly perfect decisions by optimising, working out the kinds of mathematical problems in an instant. However the rise of behavioural economics has shown that cognitive errors are now assumptions in many aspects of economics namely – heuristics, confirmation bias, overconfidence and distorted probability weights.

According to a paper entitled “Mindful Economics: The Production, Consumption, and Value of Beliefs” by Roland Bénabou and Jean Tirol research has shown that beliefs often fulfill important psychological and functional needs of the individual. Examples include:

  • confidence in ones’ abilities,
  • moral self-esteem,
  • hope and anxiety reduction,
  • social identity,
  • political ideology
  • religious faith.

Therefore people hold beliefs because of the value they attach to them, as a result of the tradeoff between accuracy and desirability. As a consequence of this some of the beliefs do not consider prior knowledge of conditions or events that might be related to their beliefs – Bayseian Updating – this refers to people who are willing and able to modify their beliefs based on new, objective information. This non-Bayesian behaviour includes ignoring signals about their beliefs and denying what in turn will be the reality. Nevertheless motivated beliefs will respond to costs, benefits, and stakes involved in maintaining different self-views and world-views which leads to self-sustaining “social cognitions.”

Overconfidence
Bénabou and Tirol suggest that overconfidence is the most common indicator of the motivated beliefs experience. Overconfidence can be seen as quite damaging although moderate confidence can be quite useful as it often enhances an individuals ability to act successfully on their own behalf and work well with others. Research has shown that psychologically “healthy” people display some degree of overoptimism and biased updating, while it is primarily depressed subjects who seem to be more objective.

If beliefs are shared between parties they may magnify each other and there is a tendency to follow the herd, especially if information is uncertain, incomplete, and asymmetric (some people are more informed than others). Basically, in a world of bounded rationality (the limits of the human brain in processing and understanding information), herding makes sense to most people. Herding is a fast and frugal heuristic (short-cut) that has been used by both human and non-human animals across the millennia. Some behavioural economists see herding as irrational because people aren’t basing their decisions on objective criteria. If herding is seen as rational it can result in price cascades leading to excessive booms and busts in the prices of financial assets. Case and Shiller (2003) surveyed the expectations of homeowners during the real-estate bubbles of 1988 and 2003. In both cases, 90 percent of respondents thought housing prices in their city would “increase over the next several years,” with an average expected gain for their own property of 9 to 15 percent per year over the next ten years.

The strategies of self-deception and dissonance-reduction used to protect valued beliefs are many and varied, Bénabou and Tirol group them into three main types: strategic ignorance, reality denial, and self-signaling.

Strategic ignorance is when a believer avoids information offering conflicting evidence.

Reality denial refers to troubling evidence that is rationalised away: house-price bulls might conjure up fanciful theories for why prices should behave unusually, and supporters of a disgraced politician might invent conspiracies or blame fake news.

Self-signaling is when the believer creates his own tools to interpret the facts in the way he wants: an unhealthy person, for example, might decide that going for a daily run proves he is well.

Final thought

People derive utility from a sense of belonging to communities and having a positive self-image. Optimistic beliefs can also be valuable motivators to overcome self-control problems, as well as helpful in strategic interactions. In order to maintain this level of utility people tend to disregard Bayesian updating and are not willing to modify their beliefs based on new, objective information. Even if they did consider new information they will manipulate it to align with what their beliefs are.

Overconfidence is the most common indicator of the motivated beliefs experience and this can be impacted by the behaviour of others. Their confidence is often reinforced when people know that other people, including experts, and the rich and famous, are doing the same. In a world of bounded rationality, such behaviour may make sense – even though it can result in errors in decision making.

Sources:

“To err is human; so is the failure to admit it” – The Economist June 10th 2017

“Mindful Economics: The Production, Consumption, and Value of Beliefs” by Roland Bénabou and Jean Tirol. Journal of Economic Perspectives—Volume 30, Number 3—Summer 2016—Pages 141–16

Categories: Behavioural Economics

Does the US Fed Chair need a PhD?

July 22, 2017 Leave a comment

How important is it to have an economics background to run the Federal Reserve? The FT’s US economics editor Sam Fleming talks to several leading economists on whether being versed in the theory is a basic requirement for a Fed chair.

Current US Fed Chair Janet Yellen could be heading into the final six months of her first term at Fed Chair. If Donald Trump does not give her a second term it may usher in new thinking from the US Government. There is no requirement for Donald Trump to appoint someone who is from the academic world of economics. They mention the success of Paul Volcker as Fed Chair who didn’t have a PhD in Economics but had a Masters Degree and also experience in  banking (Chase) and commercial sector. From the left you have – Janet Yellen, Paul Volcker, Alan Greenspan and Ben Bernanke.

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What is the Trade Weighted Index?

July 20, 2017 Leave a comment

Trade Weighted Index (T.W.I)

  • An index that measures the value of $NZ in relationship to a group (or “basket”) of other currencies. The currencies included are from NZ’s major export markets i.e. Australia, USA, Japan, Euro area, UK and China. – $A, $US, ¥, €, £ RMB
  • Each of the currencies included in the TWI is “weighted” according to how important exports to that country are ( = % of total exports)
  • From the TWI we can see if the $NZ has appreciated or depreciated against our major trading partners currencies overall.

TWI - NZ 17.png

The interpretation of the effective exchange rate is that if the index rises, other things being equal, the purchasing power of that currency also rises (the currency strengthened against those of the country’s or area’s trading partners). That will reduce the cost of imports but will undermine the competitiveness of exports.

TWI NZ

Internationally, global growth is continuing to improve, suggesting that excess global supply is easing. However, offshore political uncertainty has grown and continues to cast a shadow on NZ’s inflation outlook. Further, the NZ Trade Weighted Index (TWI) is hovering around 78 again, in part due to NZ economic fundamentals but also in part due to the above offshore political events.

Source: ASB Bank

 

 

Don’t abandon the Phillips Curve

July 18, 2017 Leave a comment

I have done numerous blog posts on the Phillips Curve some of which have discussed the missing trade-off between inflation and unemployment. Recent data from the US suggest that reducing rates of unemployment have not activated higher levels of inflation. US Fed Chair Janet Yellen has suggest that the level of unemployment is below the natural rate of unemployment (the lowest rate of unemployment where prices don’t accelerate) and that prices should soon rise. However inflation in the US is only 1.5% (target 2%) so does the Phillips Curve still apply? The Economist looked at another instance where this theory has failed.

2019 – after the financial crisis unemployment exceeded 10% and the excess supply of labour should have had significant downward pressure on prices. However prices were at 1.3% just below what they are today. Some economist explained this situation by an increase in the natural rate of unemployment (NRU) – 6.5% was a figure quoted by some economists. But today with unemployment now at 4.3% and inflation at 1.5% this theory does not seem to stack up. The Fed estimates that the NRU is between 4.7% and 5.8%.

Reasons not to abandon the Phillips Curve

1. The effects of unemployment on inflation can be distorted by one off events such as:
* the rapid decline in oil prices in late 2014
* the price of mobile data – firms have been offering limitless data which has also been   given a higher weighing in the inflation calculation. Mobile phone deals have shaved 0.2% off the inflation rate

2. It is possible with such low unemployment that inflation will eventually increase. This happened in the late 1960’s with unemployment under 4%, inflation rose from 1.4% in November 1965 to 3.2% a year later. By 1969 inflation was at 5%.

3. Self-fulfilling inflationary expectations could explain the low inflation rate. In recent years more attention has been paid to the psychological effects which rising prices have on people’s behaviour. The various groups which make up the economy, acting in their own self-interest, will actually cause inflation to rise faster than otherwise would be the case if they believe rising prices are set to continue.

Source: The Economist – 17th June 2017

The theory of the Phillips Curve and the NAIRU

Bill Phillips (a New Zealander) discovered a stable relationship between the rate of inflation (of wages, to be precise) and unemployment in Britain from the 1850’s to 1960’s. Higher inflation, it seemed, went with lower unemployment. To economists and policymakers this presented a tempting trade-off: lower unemployment could be bought at the price of a bit more inflation. However, Milton Friedman and Edmund Phelps (who both later picked up Nobel prizes, partly for this work), pointed out that the trade-off was only temporary. In his version, Friedman coined the idea of the “natural” rate of unemployment – the rate that the economy would come up with if left to itself. Now economists are likelier to refer to the NAIRU (non-accelerating inflation rate of unemployment), the rate at which inflation remains constant. The theory is explained below:

NAIRUSuppose that at first unemployment is at the NAIRU, u* in the graph below, and inflation is at p0. Policymakers want to reduce unemployment, so they loosen monetary policy: that stimulates spending, so that unemployment goes down, to u1. Inflation rises to p1, along the initial short-run Phillips curve, PC1. But that raises inflationary expectations, so that workers demand higher wage increases and real wages rise again. Firms shed labour, returning unemployment to u*, but with a higher inflation rate, p1. The new short-run trade-off is worse, with higher inflation for any level of unemployment (PC2). In the long run the Phillips curve is vertical (LRPC).

Tacit Collusion at Martha’s Vineyard petrol stations.

July 16, 2017 Leave a comment

The Economist ‘Free Exchange’ had an article about tacit collusion and the role of algorithms in setting prices. Martha’s Vineyard, a popular holiday retreat for the wealthy in the US, has four petrol stations who had a price-fixing suit brought against them for what was seen as extremely high petrol prices when compared to those at nearby Cape Cod. The judges found no evidence that there was agreement between petrol stations to raise prices although they did note that the market encouraged tacit (silent) collusion amongst the four petrol stations. Whereas explicit collusion over prices is illegal, tacit collusion is not. The conditions conducive for tacit collusion include:

  1. The market is concentrated and there are strong barriers to entry from competitors. Martha’s Vineyard is cut off from the mainland.
  2. Prices are transparent in a way that renders any attempt to steal business by lowering prices self-defeating. A price cut posted outside one petrol station will soon be matched by the others. And if one station raises prices, it can always cut them again if the others do not follow.
  3. The product is a small-ticket and frequent purchase, such as petrol. Markets for such items are especially prone to tacit collusion, because the potential profits from “cheating” on an unspoken deal, before others can respond, are small.

Petrol Price App

Although the consumer maybe able to find out the price of petrol at various stations through a smartphone app but this app makes it easier for the petrol stations to monitor and match each others’ prices. A retailer would have little incentive to cut prices and as other competitors would be able to match their prices instantly leaving everyone worse off.

Collusion in oligopoly

It is often observed that oligopolistic firms are torn between two conflicting desires: The wish to compete on one hand, and the wish to collude on the other. The hope of winning any price war tempts some firms (particularly those with significant advantages, such as lower costs) but collusion is an attractive proposition given the desire to remove the uncomfortable uncertainty that interdependence brings to the market. Collusion reduces the fear of competitive price cutting or retaliatory advertising which could reduce industry profits.

Where oligopolists agree formally or informally to limit competition between themselves they may set output quotas, fix prices, or limit product promotion or development.

A formal collusive agreement is called a cartel. A cartel can achieve the same profits as if the industry were a monopoly. In the graph below the total market or industry demand curve is shown as D and the corresponding marginal revenue curve is MR. The cartel’s marginal cost curve (MC) is the horizontal sum of the marginal cost curves of the members of the cartel. The cartel will set a price of p1 (MC = MR) where profits are maximised. Alternatively the cartel could set output at q1 by giving each cartel member an output quota. This would produce the same price (p1).

By contrast, p2 shows the marginal cost price which would be the price under perfect competition, with q2 showing the corresponding output. This means that the cartel will operate with a higher price and lower output when compared to perfect competition.

Cartel with Monop Price

Cartel with a monopoly price

Covert (formal) collusion occurs where firms meet secretly and make decisions about prices or output. Tacit (informal) collusion is much more difficult to control. This is when firms act as if they have agreements in place without actually having communicated with each other.

Collusion between firms whether formal or informal is more likely when:

• there are only a few firms in the industry, so reaching an agreement is easier and any cheating can be spotted quickly.

• they have similar costs of production and methods of production making any agreement on price easier to reach.

• the firms produce similar products. Cartels have been common in industries such as cement production in recent years.

• the products have price inelastic demand meaning that a rise in price by the cartel will lead to a rise in sales revenue for the firms.

• the laws against collusion in a country are weak or ineffective.

Collusive agreements often prove difficult to sustain. Most are illegal as they raise prices to the detriment of the consumer. They cannot, therefore, be enforced by contract, even if cheating could be detected. Each and every party to the collusive agreement has an incentive to cheat by producing more than agreed. This will suppress price slightly, but the firm can still take advantage of artificially high prices as long as the other firms do not cheat as well. However, stable market conditions (a small number of firms; similar costs of production; similar products; high barriers to entry; easy detection of cheating on the agreement) make joint profit maximisation feasible.

DW Documentary – “The Money Deluge”

July 11, 2017 Leave a comment

Below is a recent documentary from Deutsche Welle (DW – Germany’s international broadcaster) on the impact of exploding real estate prices, zero interest rate (see graph below) and a rising stock market. The higher income groups are benefiting greatly from these conditions but how does it effect middle income earners especially those in retirement. The DW documentary addresses these issues and explains how money deals have become detached from the real economy. Worth a look.

For years, the world’s central banks have been pursuing a policy of cheap money. The first and foremost is the ECB (European Central Bank), which buys bad stocks and bonds to save banks, tries to fuel economic growth and props up states that are in debt. But what relieves state budgets to the tune of hundreds of billions annoys savers: interest rates are close to zero.

The fiscal policies of the central banks are causing an uncontrolled global deluge of money. Experts are warning of new bubbles. In real estate, for example: it’s not just in German cities that prices are shooting up. In London, a one-bed apartment can easily cost more than a million Euro. More and more money is moving away from the real economy and into the speculative field. Highly complex financial bets are taking place in the global casino – gambling without checks and balances. The winners are set from the start: in Germany and around the world, the rich just get richer. Professor Max Otte says: “This flood of money has caused a dangerous redistribution.

ECB Rates.png

Those who have, get more.” But with low interest rates, any money in savings accounts just melts away. Those with debts can be happy. But big companies that want to swallow up others are also happy: they can borrow cheap money for their acquisitions. Coupled with the liberalization of the financial markets, money deals have become detached from the real economy. But it’s not just the banks that need a constant source of new, cheap money today. So do states. They need it to keep a grip on their mountains of debt. It’s a kind of snowball system. What happens to our money? Is a new crisis looming? The film ‘The Money Deluge’ casts a new and surprising light on our money in these times of zero interest rates.

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