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1980’s hyperinflation in Bolivia

June 19, 2017 Leave a comment

When you think of hyperinflation countries like post-war Germany and Zimbabwe come to mind. However Bolivia in the 1980’s seems to have been a forgotten example. Below is a very good video about the hyperinflation in Bolivia from the PBS Commanding Heights series. I use it teaching the impact of hyperinflation on an economy and policies that to try and control its impact. Some of the main issues from the video are:

  • Inflation reached 23,500%
  • 7 out of 10 Bolivians live in poverty – the poor get hurt by inflation
  • Inflation averaged 1% every 10 minutes
  • One of the causes of the inflation was government finances – they just printed money and didn’t collect taxes
  • How do you stop a hyperinflation or an inflation? Gradualist steps don’t work and as Jeff Sachs said: “All this gradualist stuff just doesn’t work. When it really gets out of control you’ve got to stop it, like in medicine. You’ve got to take some radical steps; otherwise your patient is going to die.”
  • Bolivia didn’t use highly sophisticated economic theory to deal with hyperinflation: Government spending was slashed – Price controls were scrapped – Import tariffs were cut – Government budgets were balanced. 

Inflationary Expectations

A lot of the inflationary problems in Bolivia were caused by inflationary expectations which accelerates the problem. 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.

Workers, who have tended to get wage rises to ‘catch up’ with previous price increases, will attempt to gain a little extra compensate them for the expected further inflation, especially if they cannot negotiate wage increases for another year. Consumers, in belief that prices will keep rising, buy now to beat the price rises, but this extra buying adds to demand pressures on prices. In a country such as New Zealand’s before the 1990’s, with the absence of competition in many sectors of the economy, this behaviour reinforces inflationary pressures. ‘Breaking the inflationary cycle’ is an important part of permanently reducing inflation. If people believe prices will remain stable, they won’t, for example, buy land and property as a speculation to protect themselves.

 

Behavioural Economics and reclining airline seats

June 2, 2017 Leave a comment

I picked up this topic from Michael Cameron’s blog Sex, Drugs, and Economics which looked in detail at the economics behind reclining airline seats. The issue that he refers to is – who owns the space between reclining airline seats?

Externalities

The person (Recliner) who reclines their seat reduces the amount of space that the person (Reclinee) behind has especially if they have their tray table down and becomes a negative externality to them. Some airlines are worse than others with regard to space – American carriers tend to have very little room as do the low cost airlines. However carriers that operate more long haul flights especially Emirates seem to be more generous with the space between seats. However if there is nobody in the seat behind then there is no externality. This refers to the Coase Theory (see previous blog post) in which Ronald Coase stated that problems are jointly produced by the person who creates the externality and the person who is affected by it. He argued that bargaining between parties could produce a mutually beneficial and efficient solution to problems like the scares resource i.e. the space between airline seats.

An article on the site Evonomics by Buccafusco (Cardozo School of Law) and Sprigman (NYU School of Law) looked at research into how much passengers would be willing to pay to recline their seat. They looked at the following scenarios.

Default – you have the right to recline your seat
Recliners wanted on average $41 to refrain from reclining, while reclinees were willing to pay only $18 on average. Only about 21 percent of the time would ownership of the 4 inches change hands

Default – you don’t have the right to recline your seat and have to negotiate
Recliners were only willing to pay about $12 to recline while reclinees were unwilling to sell their knee room for less than $39. Recliners would have ended up purchasing the right to recline only about 28 percent of the time—the same right that they valued so highly in the other condition.

The Coase theorem suggests that the initial allocation of rights should not matter, because if the person who values the right the most doesn’t start out with it, they will simply purchase it from the other. But what Buccafusco and Sprigman found suggests that this simple solution might not work. What they found was an endowment effect.

Loss Aversion and the  Endowment Effect

Loss aversion can be explained by prospect theory, which states that an individual’s value function (whether for money or otherwise) is concave for gains but convex for losses. In other words, people are more sensitive to losses compared to gains of similar magnitude. This is illustrated below.

Prospect theory

The reference point in the diagram is the current position of the individual concerned. Gains and losses are evaluated with reference to this neutral reference point. The value function takes an asymmetric S-shape because marginal value (or sensitivity) declines as absolute gains and losses increase in size. A dollar lost more than outweighs a dollar gained. In conventional economics, gains and losses are treated equally – a dollar lost simply cancels out a dollar gained. Golf provides a perfect example of a reference point: par. Every hole on a golf course has a number of strokes associated with it; the par provides the baseline for good – but not outstanding – performance. For a professional golfer, a birdie (one stroke under par) is a gain, and a bogey (one stroke over par) is a loss. Economists have compared two situations a player might face when hear the hole:

  • putt to avoid a bogey
  • putt to achieve a birdie

One group of economists analysed more than 2.5 million putts in exquisite detail to test that prediction and found that whether the putt was easy or hard, at every distance from the hole, the players were more successful when putting for par than for a birdie. The difference in their rate of success when going for par (to avoid a bogey) or for a birdie was 3.6%.

Note that endowment effects are working for the ‘reclinees’ as well – they are willing to give up their extra knee room for $39 if they had the right to keep it, but would only be willing to pay $18 to get that right if they didn’t start out with it.

The endowment effect means that this problem isn’t really amenable to a simple solution, because recliners already have the default rights, and are understandably unwilling to give those rights up. And any change in policy is going to incur passenger protest – because even though we may gain knee room, passengers would be giving up their right to recline, and loss aversion almost ensures that would be a painful and unwelcome trade-off for most passengers.

J.Cole and the Hedonic Treadmill

May 15, 2017 Leave a comment

Below is a very good video from rapper J.Cole in which he talks about the insatiable demand for material things and how it will never make people happy.

Affluent youth in the USA have rates of depression and anxiety which is more than twice the national average. Wealth has been linked to high rates of depression, anxiety, psychosomatic issues and self-mutilation. It seems that the very wealthy have the same problems as the rest of us but only on a much larger scale. A research paper from Boston College entitled “Secret fears of the super-Rich found that the top fears of the rich are:

  1. The rich need increasing amounts of money to make them feel financially secure.
  2. They feel isolated and don’t share their concerns or stress as they will sound ungrateful.
  3. Thy worry that their children will become spoilt by inheriting so much wealth or resentful if its too little.
  4. You are unsure if your friends genuinely like you or your money
  5. There is constant dissatisfaction with consumption as something better / new is always being launched. They can’t get off the hedonic treadmill
  6. Parents are concerned that money will rob their children of ambition and getting a job.

“ONE OF THE SADDEST PHRASES I’ve heard,” Kenny says of his time counseling the wealthy, is when the heir to a fortune is told, “‘Honey, you’re never going to have to work.’” The announcement is often made, Kenny explains, by a rich grandparent to a grandchild—and it rarely sounds as good to the recipient as to the one delivering it. Work is what fills most people’s days, and it provides the context in which they interact with others. A life of worklessness, however financially comfortable, can easily become one of aimlessness, of estrangement from the world. The fact that most people imagine it would be paradise to never have to work does not make the experience any more pleasant in practice.

The Atlantic 

 

Behavioural Economics Presentation – download.

April 2, 2017 Leave a comment

Below is a pdf download of a presentation on consumer behaviour that I did for our Yr12 and Yr 13 students last week. It focuses on the following:

Hedonic Treadmil – Paradox of Choice – Algorithms and Choice – Happy Money – Well-being around the world.

Click here to download. I particularly like these images.

Hedonic-TreadmillTV - paradox

Sky TV and the Paradox of Choice

March 13, 2017 Leave a comment

Flicking through the TV channels one evening one found that what was supposed to be a time of relaxation was actually quite tiring. Surely with more choice and freedom to chose what to watch I would be a lot more content. In the age of the Internet, smartphones etc  there is a paradoxical effect in that we have access to an endless amount of movies, TV programmess, documentaries, sport etc.

My mind went back to Barry Schwartz’s TED talk “The Paradox of Choice” and what he calls the “official dogma of all western industrial societies” – see below. This is the common belief that by maximising one’s choice, we are maximising their freedom, and therefore their welfare. A clear intuitive example is a medical doctor offering a patient certain treatment options. The patient has choice, but he/she would most likely lack the knowledge and physical state of mind to make the best decision. Obviously, it should be better if the doctor, with all their experience and knowledge, makes the decision, even though it restricts the patient’s choice.


However freedom can do more harm than good in that it paradoxically causes paralysis in decision-making. When people have a lot of freedom, they have to spend time and effort considering the many options and making a decision. Should I watch rugby, cricket, league or ESPNFC on Sky? What about PBS News, CNN or Discovery? Some will say just record the programmes you didn’t watch but what you end up doing is filling your disk so that you can’t record anything else. These rather futile, yet difficult decisions make us indecisive, slow, and permanently pre-occupied in our lives, all thanks to the “problem” of having a bit too much freedom. Growing up in Ireland we had access to BBC1 Match of the Day (two games of highlights from English Football Division 1 – Premier League now) and it was something that you really looked forward to – 10pm on a Saturday night. Here there is limited choice and because of this maybe more satisfaction in that I didn’t have to worry about who or what to watch. In fact the pleasures of anticipation of Match of the Day on Saturday built throughout the week and provided more happiness – research shows that waiting for something – a chocolate – makes it taste better when we get it.

However, there are some more subtle cognitive effects that come with more freedom. First, it is very easy to imagine that there was a better choice than the one that you had chosen – i.e. the opportunity cost can take away your happiness from your current decision. This causes us to regret our own decisions (even if the option we took was the best choice), and this can seriously damage how satisfied we are with something. And with more freedom, comes more capacity to imagine that the grass is greener on the other side.

Finally, in this “choice-full” world of today, people are bound to choose an option that is almost perfect. Schwartz talks about how there only used to be one kind of jeans that you could buy, compared to the many different colours, fabric, fit, and size that you can buy today. He claims that by being able to buy such near-perfect jeans, you have such high expectations for the next pair that you can’t be completely satisfied. He jokes: “the secret to happiness is low expectations.”

Maximizers and Satisficers

With so much choice today we tend to fall into two categories of consumers.

Maximizers are those people that spend all their time exhaustively search for every piece of information about a product in order to make what they believe to be the perfect choice. However it can lead to nagging doubts about their choice and they can become unhappy.

Satisficers are those people that settle with the decision that is good enough and seem to be happier with their decision.

Macroeconomic models – a new approach needed.

March 3, 2017 Leave a comment

In 1776 Scottish economist Adam Smith talked of the economy as the invisible hand. Here he emphasized the self-regulating nature of the economy as individuals, firms and companies independently seek to maximize their gain which may produce the best outcome for society as a whole. The capitalist systems seems to rely more on the relentless growth of consumer spending and, although it can lead to dramatic improvements in standard of living, it does require people to become resolutely addicted to products/services and be prepared to get into significant debt.

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.

DSGE.png

Therefore it assumes that all individuals and firms have identical needs and wants which they pursue with total self-interest and complete knowledge of what they desire. DSGE also takes into account the impact of shocks like oil prices, technological change, interest rates, taxation etc. However a couple of areas that it doesn’t represent accurately is the financial sector and the instability of markets – booms and slumps. A new task will be to include the banking sector into the models as macroeconomists assumed it to be a screen between savers and borrowers rather than profit orientated organisations prepared to take big risks with increased leverage and sub-prime lending. For example as house prices increase banks are willing to lend more money to speculators who bid up the price above what is the fundamental value. The opposite applies if banks become more risk adverse and marginal buyers are forced out of the market causing prices to drop. By representing the financial sector in an economic model you go some way to help solve the major problem with DSGE and other models in that they are useful only if they are not unsettled by external factors like a banking crisis.

Keynes said “If economists could manage to get themselves thought of as humble, competent people, on a level with dentists, that would be splendid!”. To achieve this there needs to be structural reform in the discipline.

Agent-based modeling

An emerging field called agent-based modelling has grabbed the attention of some economists. This is where large amounts of data is collected from individuals who are unique to each other in they have different motives and actions in the market place. The behaviour of these individuals overlap and interact which generate predictions through a messy process but similar to what happens in real life, unlike DSGE and the clean old-fashioned macroeconomic models. Agent-based modeling has also shown promise in other disciplines like Physics and involve real-world problems. The example used by John Lanchester (New York Times magazine) is how Brazil nuts seem to end up towards the top of the mixed-nut package and nut research has since found real-life applications in industries such as pharmaceuticals and manufacturing.

With a better sense of what is influencing behaviour in the economy, economists might become less blinkered by their own theory, and better able to foresee the next crisis. Meanwhile, they would be wise to repeat (daily) the words: “My model is a model, not the model.”

Final thought

Macroeconomic models need to be adapted to take account of the events of the last 20 years. For so long typical macro model has been DSGE but as yet no model includes the impact of recessions and the eighty-year depressions. Economics failed to predict or prevent the GFC and this was based on conceptual faults which included a refusal to engage with the role of the banking and finance system in the economy.

Dani Rodrik of Harvard University splits economists into two camps: hedgehogs and foxes.

Hedgehogs take a single idea and apply it to every problem they come across.

Foxes have no grand vision but lots of seemingly contradictory views, as they tailor their conclusions to the situation.

Maybe more fox like behaviour is needed.

References

New York Times Magazine – The Major Blind Spots in Macroeconomics

The Economist – A less dismal science

 

Cash is a rational birthday present but inappropriate

February 23, 2017 Leave a comment

Here is a clip from Seinfeld that I use when teaching Behavioural Economics. It seems rational that Jerry gives Elaine $182 for her birthday but it really is inappropriate. Cash replaces social norms by market norms and ruins the feelings usually evoked by a typical non-cash birthday gift. The deadweight loss of giving is the loss of efficiency that occurs when the value of the gift to the recipient is less than the cost of the gift to the giver. In this case, economists argue that cash would be a more efficient gift.

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